Working Capital Management

Working Capital Management

• Concepts of working capital• Gross working capital (GWC)

GWC refers to the firm’s total investment in current assets.

– Current assets are the assets which can be converted into cash within an accounting year (or operating cycle) and include cash, short-term securities, debtors, (accounts receivable or book debts) bills receivable and stock (inventory).

Concepts of working capital

• Net working capital (NWC).• NWC refers to the difference between current

assets and current liabilities. • Current liabilities (CL) are those claims of

outsiders which are expected to mature for payment within an accounting year and include creditors (accounts payable), bills payable, and outstanding expenses.

• NWC can be positive or negative. – Positive NWC = CA > CL– Negative NWC = CA < CL

Concepts of working capital

• GWC focuses on– Optimization of investment in current assets;

– Financing of current assets

• NWC focuses on – Liquidity position of the firm;

– Judicious mix of short-term and long-tern financing

Computation of Working Capital

• Estimation of Current Assets:1. Raw Materials Inventory: (Budgeted production in units

X Cost of R.M. per unit X Average holding period) / 12 months or 365 days.

2. WIP Inventory: Relevant costs to determine WIP inv. are proportionate share of cost of raw materials & conversion costs (labour & manufacturing overhead excluding depreciation). :

(Budgeted production in units X Estimated WIP cost per unit X Average holding period of WIP inventory) / 12 months or 365 days.


3. Finished Goods Inventory: (Budgeted production in units X Cost of goods produced per unit (excluding Depreciation) X Finished goods holding period) / 12 months or 365 days.

4. Debtors: (Budgeted credit sales in units X Cost of sales per unit (excluding Depreciation) X Average debt collection period) / 12 months or 365 days.

5. Cash & Bank Balance: Depends on attitude of management towards risk, access to the borrowing sources in times of need etc.


• Estimation of Current Liabilities: Working capital needs of firms are lower to that extent, such needs are met through current liabilities (other than bank credit), arising in ordinary course of business.

1. Trade Creditors: (Budgeted production in units X Raw material cost per unit X Credit period allowed by creditors) / 12 months or 365 days. Proportional adjustments to be made to cash purchases.


2. Direct Wages: (Budgeted yearly production X Direct Labour cost per unit X Average time-lag in payment of wages [months/days]) / 12 months or 365 days.

• The average credit period for the payment of wages approximates to a half-a-month in the case of monthly wage payment:

• (first day’s monthly wages paid on 30th day of the month, extending credit for 29 days; second day’s wages again paid on 30th , extending credit for 28 days).


3. Overheads (other than Depreciation & Amortization) : (Budgeted yearly production in units X Overhead cost per unit X Average time-lag in payment of overheads [months/days]) / 12 months or 365 days.

• Amount of overheads may be separately calculated for different types of overheads. In case of selling overheads, relevant item would be sales volume instead of production volume.

Determination of Working Capital

• (i) Estimation of Current Assets:• (a) Minimum desired cash & bank balances• (b) Inventories: Raw materials, WIP, Finished Goods• (c) Debtors• Total Current Assets• (ii) Estimation of Current Liabilities:• (a) Creditors• (b) Wages• (c) Overheads• Total Current Liabilities• (iii) Net Working Capital – [I – ii]• Add, Margin for contingency• (iv) Net Working Capital Required

Operating Cycle

• Total quantum of working capital depends on the total duration of operating cycle.

• Operating cycle is the time duration required to convert sales (after the conversion of resources into inventories), into cash. 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. Credit sales create account

receivable for collection.

Time Line Representation of the Cash Conversion Cycle

Duration of Operating Cycle

A. Raw Materials &Stores Storage Period: Reflects the number of days for which raw materials, consumable stores, spares etc. remain as inventory prior to be issued for production purposes.

• Average Stock of Raw Materials & stores ------------------------------------------------- Average raw materials consumed per day

Duration of Operating Cycle B. Duration of W-I-P Storage Period

Indicates number of days that elapses in the W-I-P stage.

Average W-I-P Inventory----------------------------------------------------

Average WIP value of raw materials committed per day

C. Duration of Finished Goods Storage Period

Represents number of days finished goods remain in inventory before being sold out.

Average Inventory of finished goods----------------------------------------------------

Average cost of goods sold per day

Duration of Operating Cycle• D. Duration of Sundry Debtors collection Period:• Indicates number of days required to collect sundry debtors.

Average Sundry Debtors---------------------------------------

Average credit sales per day

• E. Duration of Sundry Creditors Availability period:• Denotes the number of days for which supplier’s credit is available

to the firm.Average Sundry Creditors---------------------------------------

Average credit purchases per day

• Total days of Operating Cycle = A+B+C+D - E

Requirements

• Requirements of Working Capital:1. To meet the wage bill for a particular

time period;2. To continue process till the finished

goods are sold in the market & cash is realized;

3. To maintain sufficient inventory so that the production process does not get stalled.

Implications

• Implications of Working Capital Management:

1. Decisions pertaining to working capital management are repetitive & frequent;

2. Difference between profit & present value are insignificant;

3. Close interaction among all working capital components implies that efficient management of one component can not be undertaken without simultaneous consideration of others.

Permanent and Temporary Working Capital

• Temporary working capital supports seasonal peaks in business

• Working capital is permanent to the extent that it supports a constant of minimum level of sales

Working Capital Needs of Different Firms

Working Capital Policy1. Current Asset Policy (Relating to Sales)

• In the face of uncertainty, outlay on current assets would consist of a basic component meant to meet normal requirements & a safety component designed for unusual requirement.

• Safety component refers to & depends on how conservative/ aggressive the current asset policy of the firm is.

• Conservative: High levels of current assets in relation to sales – Reduces risk; Highly liquid reducing technical insolvency – Low profitability.

• Aggressive: Low levels of current assets in relation to Sales – High risk; low liquidity & high profitability.

Effects of Current Asset Policy Example

• Particulars Conservative Aggressive• Sales (Rs.) 10,00,000 10,00,000• COGS 8,00,000 8,00,000• EBIT 2,00,000 2,00,000• C.A.s 6,00,000 4,00,000• F.A.s 5,00,000 5,00,000• Total Assets 11,00,000 9,00,000• Return on Assets 18.2% 22.2%

Effects of Current Asset Policy

Current Assets

Total Sales

CONSERVATIVE

MODERATE

AGGRESSIVE

Working Capital Policy2. Current Asset Financing Policy

• Current assets are usually financed by spontaneous current liabilities like trade creditors, provisions, short term bank financing & by long-term finances (Debentures & Equity Capital).

• What should be the proportion of long-term to short-term financing?

1. Conservative:- Relies more on long-term sources & less on short-term sources; -Reduces risk, enhances cost of financing, reduces profit.

2. Aggressive:- Depends heavily on short-term bank finances & seeks to reduce dependence on long-term financing – High degree of risk, low cost, more profit.

Working Capital Financing Policies

Working Capital Policy(A combination of Current asset Policy & Current Asset

Financing Policy)

MODERATE

Overall

Working Capital

Policy

AGGRESSIVE

Overall

Working Capital

Policy

CONSERVATIVE

Overall

Working Capital

Policy

MODERATE

Overall

Working Capital

Policy

Current Asset Financing Policy

Current Asset Policy

Aggressive

Conservative

Conservative Aggressive

Sources of Short-term Financing

• Spontaneous financing– Accounts payable and accruals

• Unsecured bank loans

• Commercial paper

• Secured loans

Spontaneous Financing

• Accruals– Money you owe employees (for example) for work

they have performed but not yet been paid • Tend to be very short-term

• Accounts payable (AKA trade credit)– Money you owe suppliers for goods you bought on

credit• Credit Terms: Terms of trade specify when you are to repay

the debt– Example of terms of trade: 2/10, net/30

» You must pay the entire amount by 30 days» If you pay within 10 days, you will receive a 2% discount


• The prompt payment discount– Passing up prompt payment discounts is generally a very

expensive source of financing

– Example

If the terms of trade are 2/10, net 30, and you elect to not pay by the 10th day, you are essentially paying 2% interest for 20 days’ use of money. There are 18.25 20-day periods in one year (365 days 20). We can convert the 2% foregone discount into an annual rate by multiplying 2% by 18.25 to obtain 36.5%. Thus, most prompt payment discounts are very attractive.


• Abuses of Trade Credit Terms– Trade credit, while originally a service to a

firm’s customers, has become so commonplace it is now expected

• Companies offer it because they have to

– Stretching payables is a common abuse of trade credit

• Paying payables beyond the due date (AKA: leaning on the table)

• Slow paying companies receive poor credit ratings in credit reports issued by credit agencies

Unsecured Bank Loan

• Represent the primary source of short-term loans for most companies

• Promissory note (AKA Notes Payable)– Note signed promising to repay the amount

borrowed plus interest• Bank usually credits the amount to borrower’s

checking account

Unsecured Bank Loan

• Represent the primary source of short-term loans for most companies

• Promissory note (AKA Notes Payable)– Note signed promising to repay the amount

borrowed plus interest• Bank usually credits the amount to borrower’s

checking account

Unsecured Bank Loans

• Line of credit– Informal, non-binding agreement between bank and

firm that specifies the maximum amount firm can borrow over a specific time frame (usually a year)

• Borrower pays interest only on the amount borrowed

• Revolving credit agreement– Similar to a line of credit except bank guarantees the

availability of funds up to a maximum amount (effectively a binding agreement)

• Borrower pays a commitment fee on the unborrowed funds (whether they are used or not)


Q: The Ventures Company has a Rs.10 million revolving credit agreement with its bank at prime plus 2.5% based on a calendar year. Prior to the month of June, it had taken down Rs. 4 million that was outstanding for the entire month. On June 15, it took down another Rs. 2 million (assume the funds were available on June 16). Prime is 9.5% and the bank’s commitment fee is 0.25% annually. What bank charges will Ventures incur for the month of June?


• A: Ventures will have to pay both interest on the money borrowed and a commitment fee on the unused balance of the revolving agreement.– Monthly interest rate: (Prime + 2.5%) 12 = 1%– Monthly commitment fee: 0.25% 12 = 0.0208%– Rs.4 million was outstanding for the entire month of June and

Rs.2 million was outstanding for 15 days of June, so the total dollar interest charges are:

• (Rs.40,00,000 X 0.01) + { Rs.20,00,000 X [15/30]}= Rs.50,000• The commitment fee must be paid on an average of Rs.50,00,000

that was unused during June• Or, 50,00,000 X 0.000208 = Rs.1,040• Total Interest Payment = Rs.51,040.


• Compensating balances– A minimum amount by which the borrower’s

bank account cannot drop below (therefore it is unavailable for use)

– Increases the effective interest rate on a loan

– Typically between 10% and 20% of amounts loaned


• Q: A firm borrows Rs.1,00,000 subject to a 20% compensating balance. The firm will only receive Rs. 80,000 in usable funds and the remaining Rs. 20,000 must remain in the firm’s account. If the stated rate on the loan is 12%, what is the effective rate?

• A: The firm must pay the 12% on the entire Rs. 1,00,000 borrowed. Thus, the firm will pay Rs. 12,000 in interest for a year on Rs. 80,000 of usable funds. This translates to an effective annual rate of 15%, or Rs.12,000 Rs. 80,000.


• Clean-Up Requirements– Theoretically a firm can constantly roll-over its

short-term debt• Borrow on a new note to pay off an old note

– Risky for both the firm and the bank

– Banks require that borrowers clean up short-term loans once a year

• Remain out of short-term debt for a certain time period

Commercial Paper

• Notes issued by large, financially-strong firms and sold to investors– Basically a short-term corporate bond

• Unsecured (usually)• Buyers are usually other institutions (insurance companies,

mutual funds, banks, pension funds)• Maturity is less than 270 days• Considered a very safe investment, therefore pays a

relatively low interest rate• Rather than paying a coupon rate, interest is discounted• Commercial paper market is rigid and formal—no flexibility in

repayment terms

Short-Term Credit Secured by Current Assets (Secured loans)

• Receivables Financing: – Accounts receivable represent money that is to be

collected in the near future– Banks recognize that this money will be collected

soon are are willing to lend money based on this soon-to-be-collected money

• Pledging AR: firm promises to use the money paid from the collected AR to pay off bank loan (but AR still belong to firm which still collects the accounts)

– If firm doesn’t repay, lender has recourse to borrower

• Factoring AR: firm sells AR to lender (at a severe discount) and the lending firm (factor) takes control of the accounts

Short-Term Credit Secured by Current Assets

• Pledging Accounts Receivable– Firm promises to use the money paid from the collected

accounts to pay off bank loan – Accounts Receivable still belong to firm which still collects the

accounts• If firm doesn’t repay, lender has recourse to borrower

– Lender can provide• General line of credit tied to all receivables

– Lender likely to advance at most 75% of the balance of accounts

• Specific line of credit tied to individual accounts receivable– Evaluates based on creditworthiness of account

» Lender likely to advance as much as 90% of the balance of accepted accounts

– Expensive form of financing

Short-Term Credit Secured by Current Assets—Example

• Q: Ventures Company has an average receivables balance of Rs.1,00,000 which turns over once every 45 days. It generally pledges all of its receivables to the SBI Factoring, which advances 75% of the total at 4% over prime plus a 1.5% administrative fee. If prime is 11%, what total interest rate is Ventures effectively paying for its receivables financing?

• A: Since the finance company advances 75% of the receivables balance, the average loan amount is Rs. 75,000. Interest at 4% over prime is 15%. The firm pledges all of its receivables, thus Rs.8,00,000 in new receivables are pledged each year (Rs.1,00,000 x 360/45). The administrative fee of 1.5% is charged on this amount and is Rs.12,000, or 1.5% x Rs. 8,00,000. This amounts to 16% of the average loan balance (Rs.12,000 Rs. 75,000), thus the annual interest rate is 16% + 15%, or 31%.


• Factoring Accounts Receivable– Firm sells Accounts Receivable to lender (at a severe

discount) and the lending firm (factor) takes control of the accounts

• Accounts Receivable are now paid directly to lender– Factor usually reviews accounts and only accepts

accounts it deems creditworthy– Factors offer a wide range of services

• Perform credit checks on potential customers• Advance cash on accounts it accepts or remit cash after

collection• Collect cash from customers• Assume the bad-debt risk when customers don’t pay


• Inventory Financing– Use a firm’s inventory as collateral for a short-term loan– Popular but subject to a number of problems

• Lenders aren’t usually equipped to sell inventory• Specialized inventories and perishable goods are difficult to market

– Types of methods used• Blanket liens —lender has a lien (claim) against all inventories of

the borrower but borrower remains in physical control of inventory• Chattel mortgage agreement —collateralized inventory is

identified by serial number and can’t be sold without lender’s permission (but borrower remains in physical control of inventory)

• Warehousing —collateralized inventory is removed from borrower’s premises and placed in a warehouse (borrower’s access controlled by third party)

– When inventory is sold a paper trail is generated and copy sent to lender (signaling lender to expect money from borrower soon)

Benefits and Costs of Carrying Adequate Inventory

• Benefits– Reduces stockouts and backorders– Makes operations run more smoothly, improves customer

relations and increases sales

• Costs– Interest on funds used to acquire inventory– Storage and security– Insurance– Taxes– Shrinkage – Spoilage– Breakage– Obsolescence

Economic Order Quantity (EOQ) Model

• EOQ model recognizes trade-offs between carrying costs and ordering costs– Carrying costs increase with the amount of inventory

held– Ordering costs increase with the number of orders

placed• EOQ minimizes the sum of ordering and carrying costs

1

22 Fixed Cost per Order Annual DemandEOQ =

Annual Carrying Cost per Unit

Economic Order Quantity (EOQ) Model—Example

• Venture Company buys a part that costs Rs. 5. The carrying cost of inventory is approximately 20% of the part’s rupee value per year.

• It costs Rs. 45 to place, process and receive an order. The firm uses 1,000 of the Rs. 5 parts per year.

• What ordering quantity minimizes inventory costs and how many orders will be placed each year if that order quantity is used?

• What inventory costs are incurred for the part with this ordering quantity?

Economic Order Quantity (EOQ) Model—Example

• A: Since the unit carrying cost is 20% of the part’s price, the annual carrying cost per unit in rupees is Rs.1, or 20% x Rs.5. Substituting the known information into the EOQ equation, we have:

• EOQ = {(2 X Rs.45 X 1,000) ÷ Re.1}½• The annual number of re-order is 1000÷300, or 3.33.

Carrying costs are Rs.150 a year, or (300÷2) X Rs.5 X 20%;

• and ordering costs are Rs.45 X 3.333, or Rs.150. • The total inventory cost of the part is Rs.300.

Cash Management

• Why have cash on hand?– Transactions demand: need money to pay

bills (employees, suppliers, utility/phone, etc.)– Precautionary demand: to handle

emergencies (unforeseen expenses)– Speculative demand: to take advantage of

unexpected opportunities (purchase of raw materials that are on sale)

– Compensating balances

Objective of Cash Management

• Cash doesn’t earn a return

• Want to maintain liquidity without losing too much in return– Can place a portion of cash balance into

marketable securities (AKA: near cash or cash equivalents)

• Liquid investments that can be held instead of cash and earn a modest return

– Examples include Treasury bills, commercial paper

Cheque Disbursement and Collection Procedures

• When you pay a bill, the process generally works like this:– You write a Cheque and place it in the mail to payee (2-3 days of

mail float)– Payee receives Cheque and performs internal processing (1 day

of processing float)– Payee deposits Cheque in its own bank (1 day of processing

float)– Payee’s bank sends Cheque into RBI’s inter-bank clearing

system which processes the Cheque (2 days of transit float)

• As a payer, you want to extend this time period• As a payee, you want to reduce this time period

The Cheque-Clearing Process

Accelerating Cash Receipts

• Lock-box systems– A post office box(es) located near customers in order to shorten

mail and processing float• Payee rents post office box(es) in strategic locations and hires a

bank to check the box and deposit payments received into account• After deposits are made, copies are send to payee’s office and

internal processing completed

• Concentration Banking– A single concentration bank manages balances in multiple

remote accounts, sweeping excess cash into a central location for investment in marketable securities

• Funds can be moved electronically or via a depository transfer check

Documents

Working Capital Management