Lect 3 Working Capital Mgt

8/13/2019 Lect 3 Working Capital Mgt

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WORKING CAPITAL MANAGEMENT


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The mismanagement related to currentoperations is the leading cause ofbusiness failure. - Ralph Kennedy and Steward Mc Mullar

Working capital decisions are oftremendous importance for any firm


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Learning Points

Concept of Working Capital

Factors Influencing Working Capital

Requirements

Operating Cycle Analysis


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Working capital is the investment made byfirms in their current assets.

Current assets comprise all assets that thefirm expects to convert into cash within theyear. This includes

Cash and bank balance (already in cash form), Marketable securities, Accounts receivable, and Inventories.

Meaning of Working Capital


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Gross and Net Working Capital

Gross working capital (GWC) is defined asinvestment in current assets.

Net working capital (NWC) is defined as excessof current assets over current liabilities.


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Managers Concern is more on

Gross working capitalOr

Net Working Capital ?

Both concepts (GWC and NWC) are equallyimportant in the management of working capital,as both are related.

One is a measure of the level of current assetswhile the other measures the extent to whichlongterm sources of financing have been used tofinance current assets.


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Negative Working Capital

Negative working capital emerges whencurrent liabilities exceed current assets. Such asituation is not absolutely theoretical, andoccurs when a firm is nearing a crisis of somemagnitude.


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Features ofWorking Capital Decisions

Working capital decisions are typically Shortterm financial decisions

The concepts of risk and time value of moneyare less pertinent to working capitaldecisionmaking .


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Working Capital Elements

Working capital elements are:- Inventory Management Receivables Management Cash Management


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Objective of WCM

The objective of WCM is to run the firm withas little money tied up in the current accountsas possible


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InventoryHigh Levels Low Levels

Benefit: Happy customers

Few production delays (always have needed partson hand)Cost: Expensive

High storage costsRisk of obsolescence

Cost: ShortagesDissatisfied customers

Benefit: Low storage costsLess risk of obsolescence

CashHigh Levels Low Levels

Benefit:Reduces risk

Cost:Increases financing costs

Benefit:Reduces financing costs

Cost:Increases risk

Befits and cost of high and low levels of workingcapital


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Accounts ReceivableHigh Levels Low Levels

Benefit: Happy customers supplied quicklyHigh sales - no backorders or stockouts

Cost: ExpensiveHigh collection costsIncreases financing costs

Cost: Dissatisfied customersLower Sales

Benefit: Less expensive

Payables and Accruals

High Levels Low LevelsBenefit:

Reduces need for external finance--using aspontaneous financing source

Cost:Unhappy suppliers

Benefit:Happy suppliers/employees

Cost:Not using a spontaneous financingsource

Befits and cost of high and low levels of working capital


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Short life span

Swift transformation into other asset forms

Current Assets Cycle

Accountsreceivable

Finishedgoods

Wages, salaries,factory overheads

Work-in-process

Raw materials

Cash Suppliers

Characteristics of Working Capital


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Operating Cycle

Operating cycle refers to the time elapsedbetween procurement of raw material torealization of cash from the finished goods .

Larger the operating cycle, larger is therequirement of working capital.


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Cash Cycle

Cash cycle refers to the time elapsed betweenpayment of raw material to realization ofcash from the finished goods.


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Operating Cycle and Cash Cycle


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Note that

Operating cycle generally is larger than thecash cycle.

Cash cycle = Operating cycle Credit periodavailed on raw material.

Cash cycle would be larger if firms makeadvance payment for procuring raw material.


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Estimating Working Capital

Estimation of working capital can be stated as a four stepprocess:

Step 1: Determining the duration (or conversion period) of

blockage of funds.

Step 2: Estimation of weights of the different componentsof operating cycle

Step 3: Determination of weighted operating cycle (WOC).

Step 4: Computation of working capital requirements


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Step 1: Determining the duration


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Step 2: Estimation of weights of the different components of operating cycle


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Step 3: Determination of weightedoperating cycle (WOC).


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Step 4: Computation of working capitalrequirements


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Nature of Business

Seasonality of Operations

Production Policy

Market Conditions

Conditions of Supply

Factors Influencing Working Capital Requirements


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Nature of Business

The requirements of working is very limited inpublic utility undertakings such as electricity,water supply and railways

because they offer cash sale only and supplyservices not products, and no funds are tied up ininventories and receivables.

On the other hand the trading and financialfirms requires less investment in fixed assetsbut have to invest large amt. of working capitalalong with fixed investments.


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Size of The Business

Greater the size of the business, greater is therequirement of working capital.


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Production Policy

If the policy is to keep production steady byaccumulating inventories it will require higherworking capital.


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Length of Production Cycle

The longer the manufacturing time, the rawmaterial and other supplies have to be carriedfor a longer in the process.


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Seasonal Variations

Generally, during the busy season, a firmrequires larger working capital than in slackseason.


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Working Capital Cycle

The speed with which the working cyclecompletes one cycle determines therequirements of working capital. Longer thecycle larger is the requirement of workingcapital.


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Rate of Stock Turnover

There is an inverse co-relationship betweenthe question of working capital and thevelocity or speed with which the sales areaffected.A firm having a high rate of stock turnover willneed lower amt. of working capital as

compared to a firm having a low rate ofturnover.


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Business Cycle

In period of boom, when the business is prosperous,there is need for larger amt. of working capital dueto rise in sales, rise in prices, optimistic expansion ofbusiness, etc. On the contrary in time of depression,the business contracts, sales decline, difficulties arefaced in collection from debtor and the firm mayhave a large amt. of working capital.


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Rate of Growth of Business

In faster growing concern, we shall requirelarge amt. of working capital.


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Earning Capacity and Dividend Policy

Some firms have more earning capacity than otherdue to quality of their products, monopolyconditions, etc. Such firms may generate cashprofits from operations and contribute to theirworking capital.The dividend policy also affects the requirement ofworking capital. A firm maintaining a steady high

rate of cash dividend irrespective of its profitsneeds working capital than the firm that retainslarger part of its profits and does not pay so highrate of cash dividend.


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Price Level Changes

Changes in the price level also affect theworking capital requirements. Generally rise inprices leads to increase in working capital.


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Others factors

Operating efficiencyManagement abilityIrregularities of supplyImport policyAsset structure

Importance of laborBanking facilities


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Working Capital Policy

Two important issues in working capitalpolicy are:

What should be the level of investment incurrent assets?

What mix of long-term and short-termfinancing should the firm employ to supportcurrent assets?


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Working Capital Policy Flexible Conservative Policy A flexible policy results in fewer production stoppages, ensures quicker deliveries to

customers, and stimulates sales .. but

HIGHER INVESTMENT IN CURRENT ASSETS

Restrictive Aggressive Policy A restrictive policy leads to more production stoppages, delayed deliveries to customers,

and lost sales but

LOWER INVESTMENT IN CURRENT ASSETS

Matching Approach Short-term assets (current assets) should be financed with short-term liabilities (current

liabilities) and that long-term assets (fixed assets) should be financed with long-termsources of financing (long-term debt, preferred stock, and common equity).

BALANCED INVESTMENT IN CURRENT ASSETS


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Figure : Conservative Policy


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Figure : Aggressive Policy


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Methods Of Estimating Working Capital

Two methods usually followed in determiningworking capital requirements:

1. Conventional Method : According to theconventional method, cash inflows and outflows

are matched with each other.2. Operating Cycle Method

Operating cycle of an enterprise is the length oftime which is required to convert cash intoresources, resources into final product, the finalproduct into receivables and receivables backinto cash.


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Operating cycle

No. of Days Inventory raw materials 85 Work-in-progress 40 Semi-finished goods 16 Credit granted to Customers 30

171 Less: Credit allowed by suppliers 25

146

This means that, during the year, there will be

365 / 146 = 2.5 Operating CyclesIf the operating expenditure during the year is Rs.5,OO,OOOeach operating cycle will cost the business5,00,000 /2.5 = Rs. 2,00,000


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Adequacy Of Working Capital

Adverse effects of shrinkage Cash discounts Credit standing Carrying of inventories Credit terms No delay in obtaining materials Business runs smoothly.


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Dangers of Excessive Working Capital

Ralph Kennedy and McMullen have observedthat the availability of excess working capitalmay lead to carelessness about costs, andtherefore, to inefficiency of operations.


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Trade offsOptimal Amount of Current Assets

Profitability varies inversely with liquidity.


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note

In 1987-88, the Reserve Bank of Indiaconducted a study on the finance of 417public limited companies. The overall pattern

of distribution of working capital was: Inventories - 42.13 per cent; Loans, advances, investments and book debts

- 52.27 per cent; Cash and Bank balances - 5.6 per cent.


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WCM in Action

How to get out of Accounts Receivables? Calling Customers Communication Corporate Culture : Incentive system (Value Oriented,

Cash oriented) Quality of Product Benchmarking ?

Intimate knowledge of value chain Future Cash

flows Leverage of Bargaining Power with suppliers Equilibrium Negotiating Power


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Summary

Working capital is a financial metric whichrepresents operating efficiency in a business,organization or other entity.


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Test your understanding

The excess of current assets over the currentliabilities can be expressed as .

The need for working capital varies withchanges in the volume of business.( True or False)

The two methods of estimating workingcapital requirements are ...


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Case Dell Computer


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WCM in Power Sector

Working capital gives an idea of the company's underlying operationalefficiency

Power industry is one of the basic the infrastructural industry of a nation. It hasgreater utility and is one of the capital intensive industries. Due to their capital-intensive nature, electric utilities are a major presence in the financial markets,particularly in terms of short-term borrowing.

Maintaining and improving credit standing and financial health is always important toelectric utilities.

Among the many challenges facing power utility companies today have to maintainsufficient levels of cash for paying creditors, without negatively affecting the supplychain.

Power utilities have to carefully monitor the changing dynamics within their ownbusiness environment.

Maintaining a particularly sharp focus on internal costs, including the operations andmaintenance (O&M) budget, is a prudent course of action to follow.

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Many power utilities entities maintainnegative working capital balances


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A study shows that many companies in powersector in India have inadequate current ratio(current assets divided by current liabilities).

Some other companies showed moderatelypositive results. The study showed that 94 percentof the companies recorded a positive correlationbetween sales, output and working capital.

It is, thus, inferred that the concerns needs moreand more working capital when there is moreproduction and more sales and vice versa.


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Regulators can play an important role Internal Control can play an important role

Documents

Lect 3 Working Capital Mgt