working capital management

Working Working Capital Capital

ManagemeManagementnt

Definition of Working CapitalDefinition of Working Capital

Working Capital refers to that part of the Working Capital refers to that part of the firm’s capital, which is required for firm’s capital, which is required for

financing short-term or current assets such a financing short-term or current assets such a cash marketable securities, debtors and cash marketable securities, debtors and

inventories. Funds thus, invested in current inventories. Funds thus, invested in current assets keep revolving fast and are assets keep revolving fast and are

constantly converted into cash and this cash constantly converted into cash and this cash flow out again in exchange for other current flow out again in exchange for other current

assets. Working Capital is also known as assets. Working Capital is also known as revolving or circulating capital or short-revolving or circulating capital or short-

term capital.term capital.

KINDS OF WORKING CAPITALKINDS OF WORKING CAPITAL

WORKING CAPITAL

BASIS OF CONCEPT

BASIS OF TIME

Gross Working Capital

Net Working Capital

Permanent / Fixed

WC

Temporary / Variable

WC

Regular WC

Reserve WC

Special WC

Seasonal WC

Significance of Gross WC Significance of Gross WC

Optimum investment in CAOptimum investment in CA Investment in CA must be adequate CA investment should not Investment in CA must be adequate CA investment should not

be inadequate or excessive inadequate WC can disturb be inadequate or excessive inadequate WC can disturb production and can also threaten the solvency of firm , if it fails production and can also threaten the solvency of firm , if it fails to meet its current obligation excessive investment in CA to meet its current obligation excessive investment in CA should be avoided , since it impairs firms profitability should be avoided , since it impairs firms profitability

Financing of CAFinancing of CA Need for WC arises due to increasing level of business activity Need for WC arises due to increasing level of business activity

& it is to provided quickly some time surplus fund may arises & it is to provided quickly some time surplus fund may arises which should be invested in Short term securities , they should which should be invested in Short term securities , they should not be kept idle not be kept idle

Significance of Net Working CapitalSignificance of Net Working Capital

Maintaining Liquidity positionMaintaining Liquidity position

For maintaining liquidity position there is a For maintaining liquidity position there is a need to maintain CA sufficiently in excess of need to maintain CA sufficiently in excess of CL CL

Judge Financial Soundness of a firm Judge Financial Soundness of a firm

The Net working capital helps creditors and The Net working capital helps creditors and investors to judge financial soundness of a investors to judge financial soundness of a firm firm

BALANCE SHEET OF ABC COMPANY AS ON 31-3-BALANCE SHEET OF ABC COMPANY AS ON 31-3-20002000

LiabilitiesLiabilities R’sR’s AssetsAssets R’sR’s

Equity SharesEquity Shares2000020000

00 GoodwillGoodwill 2000020000

8% Debentures8% Debentures1000010000

00Land and Land and BuildingBuilding

150001500000

Reserve & SurplusReserve & Surplus 5000050000Plant and Plant and MachineryMachinery

100001000000

Sundry CreditorsSundry Creditors1500015000

00 InventoriesInventories

Bills PayableBills Payable 3000030000 Finished Goods Finished Goods 6000060000

Outstanding Outstanding ExpensesExpenses 2000020000 Work in processWork in process 4000040000

Bank OverdraftBank Overdraft 5000050000 Prepaid ExpensesPrepaid Expenses 2000020000

Provision for Provision for TaxationTaxation 2000020000

Marketable Marketable SecuritiesSecurities 6000060000

Proposed DividendProposed Dividend 3000030000 Sundry DebtorsSundry Debtors 9000090000

Bills ReceivablesBills Receivables 2000020000

Cash & Bank Cash & Bank

BalanceBalance 9000090000

TOTALTOTAL6500065000

00 TOTALTOTAL6500065000

00

Difference between permanent & Difference between permanent & temporary working capital temporary working capital

Amount Variable Working CapitalAmount Variable Working Capitalof of WorkingWorkingCapitalCapital

Permanent Working CapitalPermanent Working Capital

TimeTime Permanent and temporary working capital for Stable firm

Variable Working CapitalAmount of WorkingCapital

Permanent Working Capital

Time Permanent and temporary working capital for Growing firm

Operating cycle conceptOperating cycle concept

Maximization of share holder’s wealth of a firm is Maximization of share holder’s wealth of a firm is possible only when there are sufficient return from possible only when there are sufficient return from the operationsthe operations

Successful sales activity is necessary for earning Successful sales activity is necessary for earning profit sales do not convert into cash immediatelyprofit sales do not convert into cash immediately

There is invisible time lap between the sale of good There is invisible time lap between the sale of good and receipt of cash and receipt of cash

The time taken to convert raw material into cash is The time taken to convert raw material into cash is known as operating cycle known as operating cycle

Conversion of cash into raw material Conversion of cash into raw material Conversion of raw material into work in progressConversion of raw material into work in progress Conversion of Work in progress into finished goods Conversion of Work in progress into finished goods Conversion of finished good into Sales ( Debtors and Conversion of finished good into Sales ( Debtors and

cash )cash )

Operating Cycle in Operating Cycle in Manufacturing firmManufacturing firm

Cash

RawMaterials

W I P

Finished Goods

Debtors SALES

Operating cycle of Non Operating cycle of Non Manufacturing FirmManufacturing Firm

cash

Receivables

Stock of finished goods

Formula for calculating Operating Formula for calculating Operating cycle for Manufacturing firmcycle for Manufacturing firm

OC = ICP+ARPOC = ICP+ARPOC = Operating cycle OC = Operating cycle ICP = Inventory Conversion period ICP = Inventory Conversion period ARP = Account Receivable PeriodARP = Account Receivable Period

ICP = ICP = Average InventoryAverage Inventory Cost of good sold /365Cost of good sold /365

ARP = ARP = Average Account ReceivableAverage Account Receivable Sales/365 Sales/365

ABC Company Provide the following ABC Company Provide the following information , Compute the operating information , Compute the operating cyclecycle

Sales 3000 Lakhs Sales 3000 Lakhs Inventory Opening R’s 610 Lakhs ; Inventory Opening R’s 610 Lakhs ;

closing R’s 475 Lakhs closing R’s 475 Lakhs Receivable opening R’s 915 Lakhs; Receivable opening R’s 915 Lakhs;

Closing R’s 975 LakhsClosing R’s 975 Lakhs Cost of Goods Sold R’s 2675 LakhsCost of Goods Sold R’s 2675 Lakhs

CASH CONVERSION CYCLECASH CONVERSION CYCLEThe amount of time a firm’s resources are tied up The amount of time a firm’s resources are tied up calculated by subtracting the average payment calculated by subtracting the average payment period from the operating cycle the time period period from the operating cycle the time period between the date a firm pays its supplier and the between the date a firm pays its supplier and the date it receives cash from its customer date it receives cash from its customer

CCC = OC – APPCCC = OC – APPAAI = AAI = Average InventoryAverage Inventory

Cost of good sold /365Cost of good sold /365ARP = ARP = Average Account ReceivableAverage Account Receivable

Annual Sales/365 Annual Sales/365 APP = APP = Account Payable PeriodAccount Payable Period

Cost of good sold /365Cost of good sold /365

Calculate CCC Calculate CCC

(CASH CONVERSION CYCLE)(CASH CONVERSION CYCLE) Average use of Inventory 80 days Average use of Inventory 80 days Account receivable collection period Account receivable collection period

50 days 50 days Account payable period is 40 days Account payable period is 40 days

CCC= OC- APPCCC= OC- APP

OC = AAI+ARPOC = AAI+ARP

80+50=13080+50=130

CCC =130-40 =90 days CCC =130-40 =90 days

Purchase of Sale of Goods Purchase of Sale of Goods Collection of Collection of Raw Material Raw Material on Credit on Credit Account Receivables Account Receivables On creditOn credit

Average age of Average age of Account receivableAccount receivable

Inventory Inventory (AII)(AII) period period (ARP)(ARP)

Account Payable Account Payable

Period Period (APP)(APP)

Payment to Payment to suppliers suppliers

Receipt of InvoiceReceipt of Invoice Operating Cycle (OC)Operating Cycle (OC)

Cash Conversion cycle Cash Conversion cycle

Resource flows for a Resource flows for a

manufacturing firmmanufacturing firm

Fixed Assets

ProductionProcess

Generates

Inventory

Via Sales Generator

Accounts receivable

Used in

Accrued DirectLabour and materials

Accrued FixedOperatingexpenses

Cash andMarketable Securities

SuppliersOf Capital

External Financing

Return on Capital

Collection process

Used topurchase

Used topurchase

Used in

WorkingCapitalcycle

Calculate cash conversion cycleCalculate cash conversion cycle Sales R’s 1587.95Sales R’s 1587.95 Cost of Good sold R’s 1406.27Cost of Good sold R’s 1406.27 Inventory opening 195.82, closing Inventory opening 195.82, closing

202.29 202.29 Account receivables opening 423.03 Account receivables opening 423.03

closing 449.46closing 449.46 Account payable opening 140.40, Account payable opening 140.40,

closing 168.33 closing 168.33

CCC = OC –APPCCC = OC –APP

OC = AAI + ARPOC = AAI + ARP

FORECASTING / ESTIMATION OF FORECASTING / ESTIMATION OF WORKING CAPITAL REQUIREMENTSWORKING CAPITAL REQUIREMENTS

Factors to be consideredFactors to be considered Total costs incurred on materials, wages and overheadsTotal costs incurred on materials, wages and overheads The length of time for which raw materials remain in stores before The length of time for which raw materials remain in stores before

they are issued to production.they are issued to production. The length of the production cycle or WIP, i.e., the time taken for The length of the production cycle or WIP, i.e., the time taken for

conversion of RM into FG.conversion of RM into FG. The length of the Sales Cycle during which FG are to be kept waiting The length of the Sales Cycle during which FG are to be kept waiting

for sales.for sales. The average period of credit allowed to customers.The average period of credit allowed to customers. The amount of cash required to pay day-to-day expenses of the The amount of cash required to pay day-to-day expenses of the

business.business. The amount of cash required for advance payments if any.The amount of cash required for advance payments if any. The average period of credit to be allowed by suppliers.The average period of credit to be allowed by suppliers. Time – lag in the payment of wages and other overheadsTime – lag in the payment of wages and other overheads

PROFORMA - WORKING CAPTIAL PROFORMA - WORKING CAPTIAL ESTIMATESESTIMATES

1.1. TRADING CONCERNTRADING CONCERNSTATEMENT OF WORKING CAPITAL REQUIREMENTS

Amount (Rs.)Current Assets(i) Cash ----(ii) Receivables ( For…..Month’s Sales)---- ----(iii) Stocks ( For……Month’s Sales)----- ----(iv)Advance Payments if any ----Less : Current Liabilities(i) Creditors (For….. Month’s Purchases)- ----(ii) Lag in payment of expenses -----_WORKING CAPITAL ( CA – CL ) xxxAdd : Provision / Margin for Contingencies -----

NET WORKING CAPITAL REQUIRED XXX

STATEMENT OF WORKING CAPITAL REQUIREMENTS Amount (Rs.)

Current Assets(i) Cash ----(ii) Receivables ( For…..Month’s Sales)---- ----(iii) Stocks ( For……Month’s Sales)----- ----(iv)Advance Payments if any ----Less : Current Liabilities(i) Creditors (For….. Month’s Purchases)- ----(ii) Lag in payment of expenses -----_WORKING CAPITAL ( CA – CL ) xxxAdd : Provision / Margin for Contingencies -----


1. MANUFACTURING CONCERN1. MANUFACTURING CONCERNSTATEMENT OF WORKING CAPITAL REQUIREMENTS

Amount (Rs.)Current Assets(i) Stock of R M( for ….month’s consumption) -----(ii)Work-in-progress (for…months) (a) Raw Materials ----- (b) Direct Labour ----- (c) Overheads -----(iii) Stock of Finished Goods ( for …month’s sales) (a) Raw Materials ----- (b) Direct Labour ----- (c) Overheads -----(iv) Sundry Debtors ( for …month’s sales) (a) Raw Materials ----- (b) Direct Labour ----- (c) Overheads -----(v) Payments in Advance (if any) -----(iv) Balance of Cash for daily expenses -----(vii)Any other item -----

Less : Current Liabilities(i) Creditors (For….. Month’s Purchases) -----(ii) Lag in payment of expenses -----(iii) Any other -----WORKING CAPITAL ( CA – CL )xxxxAdd : Provision / Margin for Contingencies -----


Prepare an estimate of Working capital requirement Prepare an estimate of Working capital requirement from the following information of a trading concern: from the following information of a trading concern:

Projected annual sales Projected annual sales 100000 units100000 units

Selling priceSelling price R’s 8 per unit R’s 8 per unit

% age of Net profit on sales% age of Net profit on sales 25%25%

Average Credit Period allowed to Average Credit Period allowed to customercustomer 8 weeks 8 weeks

Average Credit Period allowed by Average Credit Period allowed by suppliersupplier 4 weeks4 weeks

Average stock holding in terma of Average stock holding in terma of sales requirement sales requirement 12 weeks12 weeks

contingenciescontingencies 10%10%

Points to be remembered while Points to be remembered while estimating WCestimating WC

(1) Profits should be ignored while calculating working (1) Profits should be ignored while calculating working capital requirements for the following reasons.capital requirements for the following reasons.

(a) Profits may or may not be used as working capital(a) Profits may or may not be used as working capital (b) Even if it is used, it may be reduced by the amount of (b) Even if it is used, it may be reduced by the amount of

Income tax, Drawings, Dividend paid etc.Income tax, Drawings, Dividend paid etc. (2) Calculation of WIP depends on the degree of completion (2) Calculation of WIP depends on the degree of completion

as regards to materials, labour and overheads. However, if as regards to materials, labour and overheads. However, if nothing is mentioned in the problem, take 100% of the value nothing is mentioned in the problem, take 100% of the value as WIP. Because in such a case, the average period of WIP as WIP. Because in such a case, the average period of WIP must have been calculated as equivalent period of completed must have been calculated as equivalent period of completed units.units.

(3) Calculation of Stocks of Finished Goods and Debtors (3) Calculation of Stocks of Finished Goods and Debtors should be made at cost unless otherwise asked in the should be made at cost unless otherwise asked in the question.question.

Prepare statement of working Prepare statement of working

capital requirement, Profit capital requirement, Profit &Loss A/C, Balance Sheet &Loss A/C, Balance Sheet AssumingAssuming

Share Capital Share Capital 150000150000 8% Debentures 8% Debentures 200000200000 Fixed asset Fixed asset 130000130000 MaterialMaterial 40%40% Direct lab our Direct lab our 20%20% Overheads Overheads 20%20%

The following further particular are available The following further particular are available It is proposed to maintain a level of activity of It is proposed to maintain a level of activity of

2,00,000 units2,00,000 units Selling price is R’s 12/- per unitSelling price is R’s 12/- per unit Raw Material are expected to remain in stores for Raw Material are expected to remain in stores for

an average period of one monthan average period of one month Material will be in process , on average half a Material will be in process , on average half a

month month Finished goods are required to be in stock for an Finished goods are required to be in stock for an

average period of one month average period of one month Credit allow to debtors is two monthCredit allow to debtors is two month Credit allow by supplier is one monthCredit allow by supplier is one month

Working Capital Financing MixWorking Capital Financing Mix

Approaches to Financing Mix

The Hedging or Matching Approach

The Conservative Approach

The Aggressive Approach

Hedging approach to asset Hedging approach to asset financingfinancing

Fixed Assets

Permanent Current Assets

Total Assets

Fluctuating Current Assets

Time

Short-termDebt

Long-termDebt +EquityCapital

The Hedging approach The Hedging approach Hedging approach refers to a process of Hedging approach refers to a process of

matching maturities of debt with the matching maturities of debt with the maturities of financial need . In this maturities of financial need . In this approach maturity of source of fund should approach maturity of source of fund should match the nature of asset to be financed match the nature of asset to be financed

This approach is also known as matching This approach is also known as matching approach.approach.

The hedging approach suggests that the The hedging approach suggests that the permanent working capital requirement permanent working capital requirement should be financed with fund from long should be financed with fund from long term sources while the temporary working term sources while the temporary working capital requirement should be financed capital requirement should be financed with short term funds.with short term funds.

Estimated Total Investment in Current Asset of company X for Estimated Total Investment in Current Asset of company X for the year 2000the year 2000

MonthMonth

Investment Investment in Current in Current

AssetAsset (R's )(R's )

Permanent or Permanent or Fixed Fixed Investments Investments (R's)(R's)

Temporary Temporary or seasonal Invest or seasonal Invest (R's)(R's)

JanuaryJanuary 5040050400 4500045000 54005400FebruaryFebruary 5000050000 4500045000 50005000

MarchMarch 4870048700 4500045000 37003700AprilApril 4800048000 4500045000 30003000MayMay 4600046000 4500045000 10001000JuneJune 4500045000 4500045000 --JulyJuly 4750047500 4500045000 25002500

AugustAugust 4800048000 4500045000 30003000SeptemberSeptember 4950049500 4500045000 45004500

OctoberOctober 5070050700 4500045000 57005700NovemberNovember 5200052000 4500045000 70007000DecemberDecember 4850048500 4500045000 35003500

TOTALTOTAL 4430044300

Conservative Approach Conservative Approach This approach suggested that the entire This approach suggested that the entire

estimated investments in current asset estimated investments in current asset should be finance from long term source should be finance from long term source and short term should be use only for and short term should be use only for emergency requirement emergency requirement

Distinct features of this approach Distinct features of this approach Liquidity is greaterLiquidity is greater Risk is minimizedRisk is minimized The cost of financing is relatively more as The cost of financing is relatively more as

interest has to be paid even on seasonal interest has to be paid even on seasonal requirement for the entire periodrequirement for the entire period

Conservative approach to asset Conservative approach to asset

financingfinancing

Fixed Assets


Total Assets


Time

Short-termDebt

Long-termDebt +Equity capital

Trade off between Trade off between Hedging and Hedging and

conservative approachesconservative approaches The hedging approaches implies low cost , The hedging approaches implies low cost , high profit and high risk while the high profit and high risk while the conservative approach leads to high cost , conservative approach leads to high cost , low profit , low risk Both the approaches low profit , low risk Both the approaches are the two extreme and neither of them are the two extreme and neither of them serve the purpose of efficient working serve the purpose of efficient working capital managementcapital management

A trade off between the two will then be A trade off between the two will then be an acceptable approach , One way of an acceptable approach , One way of determining the trade off is by finding the determining the trade off is by finding the AVG of maximum and minimum AVG of maximum and minimum requirement of current asset or working requirement of current asset or working capital capital

Aggressive approach to asset Aggressive approach to asset

financingfinancing

Fixed Assets


Total Assets


Time

Short-termDebt

Long-termDebt +Equity capital

Aggressive approachAggressive approach

The aggressive approach suggests that The aggressive approach suggests that the entire estimated requirement of the entire estimated requirement of current asset should be financed from current asset should be financed from short-term sources and even a part of short-term sources and even a part of fixed asset investment be financed from fixed asset investment be financed from short - term sourcesshort - term sources

This approach make the finance mix :This approach make the finance mix : More RiskyMore Risky Less costly Less costly More Profitable More Profitable

Prepare a projected balance Prepare a projected balance sheet , profit and loss a/c and sheet , profit and loss a/c and then an estimation of working then an estimation of working capital .capital .

Issued Share Capital Issued Share Capital 300000300000 6% Debentures 6% Debentures 200000200000 Fixed asset Fixed asset 200000200000 Raw MaterialRaw Material 50%50% Lab our Lab our 20%20% Overheads Overheads 20%20% ProfitProfit 10%10% There is a regular production and There is a regular production and

sales cyclesales cycle

Raw Material are kept in stores for an Raw Material are kept in stores for an average period of two monthaverage period of two month

Finished goods remain in stock for an Finished goods remain in stock for an average period of three month average period of three month

Production during the previous year was Production during the previous year was 180000 units and it is planned to maintain 180000 units and it is planned to maintain the same in the current year alsothe same in the current year also

Each unit of production is expected to be Each unit of production is expected to be in process for half a monthin process for half a month

Credit allow to customer is three month Credit allow to customer is three month and given by supplier is two monthand given by supplier is two month

Selling price is Rs 4 per unit Selling price is Rs 4 per unit Calculation of debtors may be made at Calculation of debtors may be made at

selling price selling price

Management of Working Management of Working Capital Capital

Working capital in general practice refer Working capital in general practice refer to the excess of CA over CL. to the excess of CA over CL.

Management of working capital therefore Management of working capital therefore is concerned with the problems that arise is concerned with the problems that arise in attempting to manage the CA, the CL in attempting to manage the CA, the CL and the inter-relationship that exists and the inter-relationship that exists between them. between them.

The basic goal of WCM is to manage the The basic goal of WCM is to manage the CA & CL of a firm in such a way that a CA & CL of a firm in such a way that a satisfactory level of WC is maintained.satisfactory level of WC is maintained.

Working Capital Management Policies of Working Capital Management Policies of a firm have a great effect on its a firm have a great effect on its profitability, liquidity and structural profitability, liquidity and structural health of the organizationhealth of the organization

Working capital management is 3 Working capital management is 3 dimensional in Nature dimensional in Nature

Dimension IProfitability,

Risk, & Liquidity

Dimension IProfitability,

Risk, & Liquidity

Dimension II

Composition & Level

of CADimension II

Composition & Level

of CA

Dimension III

Composition & Level of CL

Dimension III

Composition & Level of CL

Working Capital IssuesWorking Capital Issues

AssumptionsAssumptions 50,000 maximum 50,000 maximum

units of productionunits of production Continuous Continuous

productionproduction Three different Three different

policies for current policies for current asset levels are asset levels are possiblepossible

Optimal Amount (Level) of Current AssetsOptimal Amount (Level) of Current Assets

0 25,000 50,000OUTPUT (units)

AS

SE

T L

EV

EL

Current Assets

Policy CPolicy C

Policy APolicy A

Policy BPolicy B

Impact on LiquidityImpact on Liquidity

Liquidity AnalysisLiquidity Analysis

PolicyPolicyLiquidityLiquidity

AA HighHigh

BB AverageAverage

CC LowLow

Greater current asset Greater current asset levels generate more levels generate more

liquidity; all other liquidity; all other factors held constant.factors held constant.


0 25,000 50,000OUTPUT (units)

AS

SE

T L

EV

EL

Current Assets

Policy CPolicy C

Policy APolicy A

Policy BPolicy B

Impact on Impact on Expected Expected

ProfitabilityProfitability

Return on Investment Return on Investment ==

Net ProfitNet ProfitTotal AssetsTotal Assets

Let Let Current Assets Current Assets = = (Cash + Rec. + Inv.)(Cash + Rec. + Inv.)

Return on Investment Return on Investment = =

Net ProfitNet ProfitCurrent Current + + Fixed AssetsFixed Assets


0 25,000 50,000OUTPUT (units)

AS

SE

T L

EV

EL

Current Assets

Policy CPolicy C

Policy APolicy A

Policy BPolicy B

Impact on Impact on Expected Expected

ProfitabilityProfitability

Profitability AnalysisProfitability Analysis

PolicyPolicy ProfitabilityProfitability

AA LowLow

BB AverageAverage

CC HighHigh

As current asset levels As current asset levels decline, total assets will decline, total assets will decline and the ROI will decline and the ROI will

rise.rise.


0 25,000 50,000OUTPUT (units)

AS

SE

T L

EV

EL

Current Assets

Policy CPolicy C

Policy APolicy A

Policy BPolicy B

Impact on RiskImpact on Risk

Decreasing cash Decreasing cash reduces the firm’s reduces the firm’s ability to meet its ability to meet its financial obligations. financial obligations. More risk!More risk!

Stricter credit policies Stricter credit policies reduce receivablesreduce receivables and and possibly lose sales and possibly lose sales and customers. customers. More risk!More risk!

Lower inventory levels Lower inventory levels increase stockouts and increase stockouts and lost sales. lost sales. More risk!More risk!


0 25,000 50,000OUTPUT (units)

AS

SE

T L

EV

EL

Current Assets

Policy CPolicy C

Policy APolicy A

Policy BPolicy B

Impact on RiskImpact on Risk

Risk AnalysisRisk Analysis

PolicyPolicyRiskRisk

AA LowLow

BB AverageAverage

CC HighHigh

Risk increases as the Risk increases as the level of current assets level of current assets

are reduced.are reduced.


0 25,000 50,000OUTPUT (units)

AS

SE

T L

EV

EL

Current Assets

Policy CPolicy C

Policy APolicy A

Policy BPolicy B

Summary of the Summary of the Optimal Amount of Optimal Amount of

Current AssetsCurrent AssetsSSUMMARYUMMARY O OFF O OPTIMALPTIMAL C CURRENTURRENT A ASSETSSET A ANALYSISNALYSIS

PolicyPolicy LiquidityLiquidity ProfitabilityProfitability RiskRisk

AA High High Low Low Low Low

BB AverageAverage Average Average Average Average

CC Low Low High High High High

1. Profitability varies inversely with 1. Profitability varies inversely with liquidity.liquidity.

2. Profitability moves together with risk.2. Profitability moves together with risk.(risk and return go hand in hand!)(risk and return go hand in hand!)

Techniques of analysis of Techniques of analysis of working capital working capital

The analysis of working capital can be The analysis of working capital can be conducted through a number of devices conducted through a number of devices such as such as

Ratio analysisRatio analysis Fund flow analysis Fund flow analysis Working capital Budgeting Working capital Budgeting Ratio analysis : A ratio is a simple Ratio analysis : A ratio is a simple

arithmetical expression of the relationship arithmetical expression of the relationship of one number to another , this technique of one number to another , this technique can be employed for measuring short term can be employed for measuring short term liquidity or working capital position of a liquidity or working capital position of a firm. firm.

The following ratios may be The following ratios may be calculated for this purpose calculated for this purpose

Liquidity RatioLiquidity Ratio

a)a) Current RatioCurrent Ratio

b)b) Acid test ratio/quick ratio/liquid ratio Acid test ratio/quick ratio/liquid ratio

c)c) Cash Position ratio/absolute liquid Cash Position ratio/absolute liquid ratio ratio

Inventory turnover ratioInventory turnover ratio Receivable turnover ratioReceivable turnover ratio Payable turnover ratioPayable turnover ratio Working capital turnover ratioWorking capital turnover ratio

Current ratio may be define as Current ratio may be define as the relationship between CA the relationship between CA and CLand CL

This ratio is also known as This ratio is also known as WCR. (Working capital ration).WCR. (Working capital ration).

It is helpful to measure short – It is helpful to measure short – term financial position or term financial position or liquidity of a firm liquidity of a firm

Current ratio: Current ratio: Current assetCurrent asset

Current liabilitiesCurrent liabilities

CURRENT ASSETS CURRENT LIABILITIES

Cash in hand Bills Payable

Cash at bank Sundry Creditors

Sundry DebtorsAccrued or Outstanding

Expenses

Marketable securities (Short term)

Short term loan and advances

Bills Receivable Dividend payable

Inventories of Stock Bank Overdraft

Work in progress

Finished goods

Prepaid Expenses

Quick or Acid test or Quick or Acid test or Liquid RatioLiquid Ratio

An asset is said to be liquid if it can An asset is said to be liquid if it can be convert into cash with in a short be convert into cash with in a short period with out loss of value period with out loss of value

Inventory cannot be termed to be Inventory cannot be termed to be liquid asset because they cannot be liquid asset because they cannot be convert into cash immediatelyconvert into cash immediately

The quick ratio can be calculated The quick ratio can be calculated

Quick ratio: Quick ratio: liquid assetliquid asset


Quick or liquid Current Liabilities

Cash in hand Bills Payable

Cash at bank Sundry Creditors

Sundry DebtorsAccrued or Outstanding

Expenses

Marketable securities Short term advances

Temporary Investments

Dividend payable

Bank Overdraft

Income tax payable Convection quick ratio of 1:1 is consider satisfactory

Cash Position ratio/absolute liquid Cash Position ratio/absolute liquid ratioratio

Absolute Liquid assets include cash in Absolute Liquid assets include cash in hand and cash at bank and hand and cash at bank and marketable securities or temporary marketable securities or temporary investments investments

The acceptable norms for this ratio is The acceptable norms for this ratio is 50% or .05%50% or .05%

Cash ratio: Cash ratio: Cash & bank + Short –term Cash & bank + Short –term securitiessecurities


Calculate all the three Calculate all the three ratioratioLiabilities Rs Assets Rs

9% preference share 500000 Goodwill 100000Equity share capital 1000000 Land and building 6500008% debentures 200000 Plant 800000

Long term loan 100000Furniture and fixtures 150000

Bills payable 60000 Bills receivable 70000Sundry creditors 70000 Sundry debtors 90000Bank over draft 30000 Bank balance 45000Outstanding expenses 5000

short term investments 25000

Prepaid expenses 5000

Stock 30000

1965000 1965000

CONCLUSION: CONCLUSION: Current ratio of the company is not Current ratio of the company is not

satisfactory because the ratio 1:6 is satisfactory because the ratio 1:6 is much below then the expected much below then the expected Standards .Standards .

Acid test ratio on the other hand is Acid test ratio on the other hand is more than the normal standard of 1:1more than the normal standard of 1:1

Absolute ratio is slightly low because Absolute ratio is slightly low because it is 0.42 where as the accepted it is 0.42 where as the accepted standard is 0.5 standard is 0.5

In this company need to improve its In this company need to improve its short term financial position short term financial position

Inventory turnover ratioInventory turnover ratioInventory turn over ratio = Inventory turn over ratio = Cost of good sold Cost of good sold

Average Inventory at cost Average Inventory at cost

Generally , the cost of good sold may not be known Generally , the cost of good sold may not be known from the published financials , in such from the published financials , in such circumstances circumstances

Inventory turn over ratio = Inventory turn over ratio = Net Sales Net Sales

Average Inventory at costAverage Inventory at cost

Inventory turn over ratio = Inventory turn over ratio = Cost of good sold Cost of good sold

Average Inventory at selling Average Inventory at selling priceprice

Inventory conversion Inventory conversion period period

Inventory conversion period = Inventory conversion period = Days in a year Days in a year Inventory Turnover Inventory Turnover

Ratio Ratio

M/s Rakesh & Co supplies you the following M/s Rakesh & Co supplies you the following information for the year ending 31information for the year ending 31stst Dec Dec 19991999

Credit Sales Rs 150000Credit Sales Rs 150000

Cash SalesCash Sales Rs 250000Rs 250000

Return Inward Rs 25000Return Inward Rs 25000

Opening Stock Rs 25000Opening Stock Rs 25000

Closing Stock Rs 35000Closing Stock Rs 35000

Debtor/Receivable turnover ratioDebtor/Receivable turnover ratio/Debtor velocity/Debtor velocity

Debtor(Receivable) = Debtor(Receivable) = Net credit Annual sales Net credit Annual sales

Average Trade debtorsAverage Trade debtors

Trade debtors = Sundry debtor + Bill Receivable and Trade debtors = Sundry debtor + Bill Receivable and account receivable saccount receivable s

Average Trade Debtors = Opening Trade debtor + Average Trade Debtors = Opening Trade debtor + Closing Trade Debtor /2Closing Trade Debtor /2

Note : Debtor should always be taken at gross Note : Debtor should always be taken at gross value , No provision for doubtful debt be deducted value , No provision for doubtful debt be deducted from them but when the information about opening from them but when the information about opening and closing balance of trade debtor and credit and closing balance of trade debtor and credit sales is not available , then the debtors turnover sales is not available , then the debtors turnover ratio calculated by dividing the total sales by the ratio calculated by dividing the total sales by the balance of debtors(inclusive of Bills receivables) balance of debtors(inclusive of Bills receivables) given given

Debtors turn over Ratio = Debtors turn over Ratio = Total sales Total sales

DebtorsDebtors

Average Collection Average Collection Period Period

The average collection period represent The average collection period represent the average number of days for which the average number of days for which a firm has to wait before its receivable a firm has to wait before its receivable are converted into cash are converted into cash

Average Collection period = Average Collection period =

Average Trade Debtors (Drs + B/R)Average Trade Debtors (Drs + B/R)

Sales per day Sales per day

Sales Per daySales Per day = = Net SalesNet Sales

No of working daysNo of working days

Or Or

Average collection period =Average collection period =Average Average trade debtorstrade debtors Net SalesNet Sales

No of working No of working daysdays

If the period is in months: If the period is in months:

Average collection period =Average collection period =No of No of working daysworking days Debtors Debtors turnover ratio turnover ratio

The two basis component of the ratio The two basis component of the ratio are debtors and sales per day are debtors and sales per day

Creditor/Payable Creditor/Payable turnover ratioturnover ratio

The analysis for credit turnover is basically The analysis for credit turnover is basically the same as of debtors turnover ratio except the same as of debtors turnover ratio except that in place of trade debtor, the trade that in place of trade debtor, the trade creditor are taken and in place of sales , creditor are taken and in place of sales , average daily purchase are taken as the average daily purchase are taken as the other component of the ratio. other component of the ratio.

Creditors turnover ratioCreditors turnover ratio

= = Net credit annual purchase Net credit annual purchase

Average Trade creditorsAverage Trade creditors

Average Payment period Ratio Average Payment period Ratio

= Average Trade Creditors( Creditors+ = Average Trade Creditors( Creditors+ Bills payable)/Average Daily purchases.Bills payable)/Average Daily purchases.

Average daily purchase = Annual Average daily purchase = Annual Purchase /No of working days in a year.Purchase /No of working days in a year.

Average Payment Period = Trade Average Payment Period = Trade creditor * No of working days / Net creditor * No of working days / Net annual purchase. annual purchase.

Average Payment Period = No of Average Payment Period = No of working days / Credit turnover Ratio.working days / Credit turnover Ratio.

Working capital turnover Working capital turnover ratioratio

Working capital of a concern is directly Working capital of a concern is directly related to sales and current asset like related to sales and current asset like debtors , bills receivable , cash , stock etc .debtors , bills receivable , cash , stock etc .

Working capital turnover ratio = Cost of Working capital turnover ratio = Cost of Sales / Average working capital Sales / Average working capital

Average working capital = Opening working Average working capital = Opening working capital + Closing Working capital/2capital + Closing Working capital/2

** If cost of sales is not given , then the figure ** If cost of sales is not given , then the figure of sale can be used . O n the other hand if of sale can be used . O n the other hand if opening working capital is not disclosed opening working capital is not disclosed then working capital at the end of the year then working capital at the end of the year will be used. will be used.

Cost of sale /Net working capital Cost of sale /Net working capital

The following information is given The following information is given about M/s S.P Ltd for the year about M/s S.P Ltd for the year ending Dec 31 2000ending Dec 31 2000

Stock turnover ratio = 6timesStock turnover ratio = 6times Gross Profit ratio = 20% on salesGross Profit ratio = 20% on sales Sales for 2000 = Rs 300000Sales for 2000 = Rs 300000 Closing stock is Rs 10000 more than Closing stock is Rs 10000 more than

the opening stock the opening stock Opening Creditors = Rs 20000Opening Creditors = Rs 20000 Closing Creditors = Rs 30000Closing Creditors = Rs 30000 Trade debtor at the end = Rs 60000Trade debtor at the end = Rs 60000 Net Working Capital = Rs 50000Net Working Capital = Rs 50000

FIND OUTFIND OUT Average StockAverage Stock PurchasesPurchases Credit turnover ratio Credit turnover ratio Average Payment PeriodAverage Payment Period Average Collection PeriodAverage Collection Period Working Capital turnover Working Capital turnover

ratioratio

Fund flow analysisFund flow analysis : Fund flow analysis : Fund flow analysis is a technical device designated to study is a technical device designated to study the sources from which additional fund the sources from which additional fund were derived and the use to which these were derived and the use to which these sources were put . It is an effective sources were put . It is an effective management tool to study change in the management tool to study change in the financial position of businessfinancial position of business

The fund flow analysis consists The fund flow analysis consists of of

Preparing schedule of change in working Preparing schedule of change in working capital capital

Statement of sources and application of Statement of sources and application of funds funds

Working capital Budgeting : Working capital Budgeting : Working capital budget as a part Working capital budget as a part of total budgeting process of a of total budgeting process of a business , is prepared estimating business , is prepared estimating future long term and short term future long term and short term working capital need and the working capital need and the sources of finance them . sources of finance them .

The objective of a working capital The objective of a working capital budget is to ensure availability of budget is to ensure availability of fund as and when needed and to fund as and when needed and to ensure effective utilization of ensure effective utilization of these resources . these resources .