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Understanding the working capital requirement in a company and how it is determined
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WORKING CAPITAL
MANAGEMENT
Working capital
It refers to the funds, which a company must
possess to finance its day-to-day operations
-Ramamoorthy
Working capital refers to short-term funds to meet
operating expenses.
Kinds of Working Capital
Working capital may be classified on the basis of:
A. Concept :
1. Gross Working Capital (Quantitative concept)
2. Net working capital (Qualitative Concept)
B. Time base:
1. Permanent Working capital
2. Temporary or Variable working capital
Concepts of Working Capital
Gross working capital (GWC)
Net working capital (NWC).
Gross working capital (GWC)
GWC refers to total current assets
It is a Quantitative concept
GWC focuses on
1. Optimisation of investment in Current Assets:
Investment in current assets must be adequate to the needs of the firm-NOT inadequate or excessive
Inadequate - interruption in production, threaten solvency (if current obligations are not met)
Excessive Reduces firms profitability
2. Financing of current assets
Net working capital (NWC)
NWC refers to the difference between current assets and current liabilities
NWC focuses on 1. Liquidity position of the firm
NWC indicates or measures the liquidity position of the firm
To maintain liquidity position, current assets should be
sufficiently in excess of current liabilities (As buffer)
1. Judicious mix of short-term and long-term financing
NWC is the portion of current assets that should be financed by
long-term funds
This concept helps to decide the extent of long-term funds
required in finance current assets
Current Assets
Current assets are the assets which can be converted
into cash within an accounting year (or operating
cycle)
Include:
Cash
Short-term securities
Debtors (accounts receivable)
Bills receivable
Stock (inventory)
Prepaid expenses Characteristics of current assets:
(1) short life span and
(2) swift transformation into other asset forms.
Current Liabilities
Current liabilities (CL) are those claims of outsiders which are expected to mature for payment within an accounting year
Are liabilities that have to be paid within the accounting year or within a year
Include :
Creditors (accounts payable)
Bills payable
Outstanding expenses
Bank overdraft
Permanent or fixed working capital
A minimum level of current assets, which is
continuously required by a firm to carry on its business
operations.
Fluctuating or variable working capital
The extra working capital needed to support the
changing production and sales activities of the firm at
different times
Permanent and Fluctuating Working Capital
Working Capital
Time
Permanent
Working Capital
Temporary
Working Capital
Permanent and Fluctuating Working Capital (Stable Firm)
Working Capital
Time
Permanent WC
Temporary WC
Permanent and Fluctuating Working Capital (Growing Firm)
Determinants Of Working Capital
Level of Taxes and Dividend Policy
Growth & Expansion
Business Cycle
Inflation (Price level changes)
Operating efficiency
Availability of Suppliers credit
Conditions of Supply
Market Conditions and credit policy
Production Policy
Production cycle and technology
Seasonality of Operations
Nature and size of Business
Working capital management
Management of working capital refers to the
management of current assets and current
liabilities.
Major thrust is on the management of current
assets.
Significance of Working Capital Management
Time
A lot of time spent by finance managers on managing WC
Investment
Investment in current assets represents a substantial portion of total investment.
Criticality
o Significant for all firm but Critical for small firms
Growth
o Investment in current assets and the level of current liabilities have to be geared quickly to change in sales.
Need For Working Capital
The need for working capital arises due to
existence of operating cycle.
The longer the operating cycle, the more the
requirement for working capital
Operating Cycle
Operating cycle is the time duration required to
convert sales, after the conversion of resources into
inventories, into cash.
Operating cycle is the time that elapses between the
purchase of raw materials and the collection of cash for
sales
Operating Cycle
The operating cycle of a manufacturing
company involves three phases:
Acquisition of resources such as raw material,
labour, power and fuel etc.
Manufacture of the product which includes
conversion of raw material into work-in-progress
into finished goods.
Sale of the product either for cash or on credit
resulting in increase in accounts receivable
RAW MATERIALS
WORK-IN-PROCESS
FINISHED GOODS
CREDIT SALES DEBTORS
CASH
Operating Cycle
CASH SALE
OPERATING CYCLE AND CASH CYCLE
Order
placed Stock
arrives Goods sold Cash
received Inventory
Conversion
Period (ICP)
Accounts
receivable
(Debtors
Conversion period
(DCP)) Accounts
payable period
Firm receives invoice Cash paid for materials
Operating Cycle
Cash Cycle
(Cash Conversion Cycle)
(CCC)
Operating Cycle
The length of the operating cycle of a manufacturing
firm is the sum of:
Inventory conversion period (ICP)
Is the time from the purchase of raw materials to the
sale of finished goods
Accounts Receivable period/ Debtors
(receivable) conversion period (DCP)
is the time required to collect the outstanding
amount from the customers.
Operating Cycle
Period conversion Debtors Period ConversionInventory
cycle Operating
COGS/365 Average
inventory Average (ICP) Period ConversionInventory
sales/365Credit Annual Average
Receivable Accounts Average (DCP) Period Conversion Debtors
Inventory Conversion Period
Inventory conversion period is the total time
needed for producing and selling the product.
Typically, it includes:
raw material conversion period (RMCP)
work-in-process conversion period (WIPCP)
finished goods conversion period (FGCP)
Inventory Conversion Period
FGCP WIPCP RMCP Period ConversionInventory
n/365Consumptio Material Raw ofCost Average
inventory Material Raw Average
(RMCP) Period Conversion Material Raw
/365Production ofCost Average
inventory Process-in- WorkAverage
(WICP) Period Conversion Process-in-Work
Sold/365 Goods ofCost Average
inventory Goods Finished Average
(FGCP) Period Conversion Goods Finished
Cash Cycle
Cash cycle is the difference between operating cycle
and accounts payable period.
Accounts payable period or Creditors (payables)
deferral period (CDP) is the length of time the firm is
able to defer payments on various resource purchases.
WC Qs.doc
OPERATING CYCLE AND CASH CYCLE
Period Deferral Creditors - Cycle Operating cycleCash
365Purchases/Credit Annual Average
Payable Accounts Average (CDP) Period Deferral Creditors
ISSUES IN WORKING CAPITAL POLICY
DETERMINATION OF LEVEL OF CURRENT ASSETS
i.e. What should be the level of investment in current assets?
CURRENT ASSETS FINANCING POLICY
i.e. What mix of long-term and short-term financing should the firm employ to support current assets?
LEVEL OF CURRENT ASSETS
The policy for level of current assets may be:
1. Conservative Policy (Flexible Policy)
2. Aggressive Policy (Restrictive Policy)
LEVEL OF CURRENT ASSETS
1. CONSERVATIVE POLICY (FLEXIBLE POLICY):
Means more liquidity and less risk of insolvency
Implies HIGHER investment in current assets- Huge balance of cash and marketable securities
High levels of inventory
High level of debtors (due to liberal credit to customers)
Consequences:
Results in fewer production stoppages,
ensures quicker deliveries to customers,
stimulates sales
BUT
Reduces return/profitability
LEVEL OF CURRENT ASSETS
2. AGGRESSIVE POLICY (RESTRICTIVE POLICY):
Means LESS liquidity and HIGHER risk of insolvency
Implies LOWER investment in current assets- Small balance of cash and marketable securities
Less inventories
Low level of debtors (due to stiff terms of credit to customers)
Consequences:
leads to more production stoppages
delayed deliveries to customers
lost sales
BUT
Higher return/profitability
LEVEL OF CURRENT ASSETS: RISK-RETURN TRADE-OFF
Theres a riskreturn tradeoff in holding current assets. INVESTMENT IN CURRENT ASSETS
LIQUIDITY
HIGH LOW
RISK OF
INSOLVENCY
RETURN/
PROFITABILITY
Conservative policy Aggressive policy
HIGH LOW
Conservative policy Aggressive policy HIGH LOW
Conservative policy Aggressive policy
WC Qs.doc
Cost trade-off
Determination of optimal level of current assets involves a
trade-off between Carrying Costs (cost of liquidity) and
Shortage Costs (cost of illiquidity).
Carrying costs include:
Cost of financing a higher level of current assets
Any losses from obsolescence of inventory or bad debts
Shortage costs include:
Losses due to stoppages in production
Loss of sales
Loss of customer goodwill
Cost Trade-off
Level of current assets
C
o
s
t
Optimum level of current assets
Minimum
cost
Total cost
Carrying
cost
Shortage cost
Working Capital Finance
Sources of financing working capital are:
1. Long-term
2. Short-term
3. Spontaneous
1. Long- Term Financing
Are funds available for more than 1 year
Examples:
Ordinary share capital
Preference share capital
Debentures
Long-term borrowings from financial institutions and
banks
Reserves and surplus (Retained Earnings)
2. Short- term Financing
Are funds available for short period of time usually less
than one year. It has to be arranged from banks and other
suppliers of short- term finance in the money market.
2. Short- term Financing
Short- Term Finances include:
Public Deposits
Intercorporate deposits
Commercial Paper
Factoring of Receivables
Working Capital funds from Banks includes:
Overdraft
Cash Credit
Purchase or Discounting of Bills
Letter of Credit
Working Capital Loan
3. Spontaneous Financing
It is finance obtained in normal course of business, without any formal negotiation.
It is an automatic sources of short- term funds which arises in the normal course of a business.
Examples:
Trade (suppliers) credit (including bills payable)
Outstanding expenses
No explicit cost of this financing
Short-term Vs. Long-term financing
1. Cost
2. Flexibility
3. Risk
Short-term funds less costly (less return)
more flexible
more risky.
Hence, a Risk-Return trade-off has to be achieved while deciding the financing mix.
Working Capital Finance Policies
These are the approaches to working capital
financing
There are three Working Capital Financing policies
(approaches) based on the mix of short term and
long term sources of financing Working Capital:
1. Conservative Policy
2. Aggressive Policy
3. Matching/Hedging Policy
1. Conservative Policy
This policy places more emphasis on the use of long-term sources to finance current assets as well as fixed assets.
Long term sources are used to finance
I. Fixed Assets
II. Permanent current assets
III.Part of the Variable current assets
This policy involves lower level of risk of shortage of funds as only a part of the variable current assets are financed through short-term sources
Financing Under Conservative Policy
Fixed Assets
Le
ve
l o
f A
ss
ets
Time
Short Term Financing
Long Term Financing
2. Aggressive Policy
This policy involves using more Short-term
sources of funds to finance assets.
Short term sources are used to finance:
I. Part of Permanent current assets
II. Temporary Current Assets
Long-term sources are used to finance:
I. Part of Permanent current assets
II. Fixed Assets
Fixed Assets
Le
ve
l o
f A
ss
ets
Time
Short Term Financing
Long Term Financing
Financing Under Aggressive Policy
3. Matching Policy
This policy involves matching the life of the assets with
the maturity period of the source of finance i.e.
Fixed assets are financed by long term sources of finance
Current assets are financed by short term sources of finance.
Therefore Matching approach to financing working capital
involves:
Financing of Fixed assets and Permanent Current
Assets by long-term sources
Financing Variable Current Assets by short-term
sources.
Financing Under Matching Policy
Time
Le
ve
l o
f A
ss
ets
Fixed Assets
Long Term Financing
Short Term Financing
Estimation Of Working Capital Requirements
Step 1 : Estimate the cash cost of various current assets required by the firm.
Step 2 : Deduct the spontaneous current liabilities from the cash cost of current assets
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