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Working Capital Management &
Cash Flow Analysis
Anjana Vivek Ketoki Basuwww.venturebean.com [email protected]
Working Capital Cycle
Working Capital Cycle
What does it measure?– Moment business starts investing in a
business to the time when business receives payment for that product/service.
Why is it important?– A good management of working capital
balances incoming and outgoing to maximize working capital
How can you maximize working capital? Determine time lag between each
item Identify items with long time lag Reduce time lag Cycle is critical for success in some
types of business. Eg. - retail, consumer goods and consumer goods manufacturer
Working capital changes due to
Changes in operational activities/ level of sales
Changes in company policy-internal Changes in business environment-
external
Factors affecting working capital Nature of business Production cycle Business cycle and operations-
efficiency Production policy Credit policy
How to calculate working capital? Gross working capital
– Total of current assets i.e. Net working capital
– Total current assets less total current liabilities
Current Assets- inventory, cash and debtorsCurrent Liabilities- dues to suppliers, employee
Caselet- DHS
DHS a hypothetical business with current assets of Rs.50, 000 and current liabilities of Rs.25, 000, has working capital of Rs.25 000 (Rs.50, 000 minus Rs.25 000).
The business has Rs. 2 of current assets for every Re. 1 of current liabilities.
DHS’s working capital or current ratio is expressed as 2:1 which appears to be adequate, safe and liquid.
Real Life Situations
Situation 1
Current Assets Current Liabilities-Rs. 100,000 Rs. 50,000
Working Capital Ratio = 2:1- Safe and adequate
Real Life Situations
Situation 2
Current Assets = Rs. 100,000 = Current LiabilitiesWorking Capital Ratio = 1:1- Too low for businesses. But often the case in organizations with high turnover and low debtors- eg. supermarket
Real Life Situations Situation 3
Current AssetsRs. 40,000 Current Liabilities Rs. 50,000
Working Capital Ratio = 0.8 :1Very low for businesses. Company has only 80% assets to cover its liabilities. Not recommended. Can arise in companies with unpredictable cash flows.
Cash Flow Movement of money in and out of your
business Cycle of the inflow and outflow of cash
determines your business solvency Cash flow analysis:
– To study the inflow and outflow of cash of the business to maintain adequate cash balance
– Study each component of cash cycle and determine how to increase efficiency
Cash flow: importance
Similar to a bank statement- deposits and withdrawals
Importance is not only cash flow but also timing
Cash FlowFrom Operations Principal revenue producing activities and others
that are not investing or financing
From Investing Acquisition and disposal of long-term assets and
other investments which are not short term
From Financing Result in changes in equity and borrowings of
enterprise
Cash from operational activities
Earning from operations before deducting income tax, depreciation and amortization
Deduct income tax Adjust for movement in working capital
– Increase in Debtors/ Inventory – money has not come in-reduces cash
– Decrease in Debtors/ Inventory- money has been collected-increases cash
– Increase in Supplier dues- money has not gone out- cash balance is high
– Decrease in Supplier dues- payment made- cash reduced
Cash from investing activities
Assets purchased- money spent- cash balance down
Assets sold- money comes in to increase cash balance
New Investments made- money spent- decreases cash balance
Investments liquidated- money comes in to increase cash balance
Assets- Computers, Software, Furniture, BuildingInvestments-Bonds, Fixed Deposits
Cash from financing activities New loan taken- money comes in –
cash balance goes up Loan repaid- payment made- cash
moves out Interest paid on loan- cash balance
reduces Capital contribution- inflow of cash
Quick solutions… to improve cash flow Invoice without delay Ask for an advance payment upfront-
before you start a project Introduce rewards for quick
payments Make all efforts to collect sales
promptly Pay all your bills only when due
Close the cash flow gap Cash flow gap is when your cash
inflows and cash outflows don’t keep pace with one another, leaving the business with cash shortage
Common among small businesses Monitor closely- if total unpaid bills >
sales due at the end of each month
Cash flow need
– Projection of future cash flow helps – integrate short term and long term needs– to anticipate surplus and deficits to plan– helps compare actuals with budgets– to make sure funds are available when needed
Immediate solutions in cash crunch situations– Increase borrowings, reschedule plans &
payments, in worst case distress sale of assets
Inventories
Raw material Work in progress Finished goods
Inventories
Inventory balance to be maintained also depends on:
Projected sales for each product Availability of raw material,
supplies Storage space available Life of stock, based on expected
obsolescence, deterioration
Accounts receivable: Motives for credit
Financial - generally at higher sale price
Operating - eg. when inventory accumulates
Contracting motive – eg. in warranty period
Marketing motive - to push sales
Control on trade credit Mental attitude to credit control Clear practices as company policy, to be
understood by executives, suppliers, customers
Check on potential customer Continuously review limits set for
customer Invoice promptly, clearly Consider charging penalty, as per invoice
Control on trade credit Determine whether invoices are paid
according to sales terms Status of unshipped orders to be known Determine total outstanding in any
customers account Monitor total debtors accounts very
closely Develop close links with large
customers
Some possible problem areas Single large or key customer Improper credit judgement Poor collection procedures Lax enforcement of credit terms Delay in invoicing Errors in invoicing Customer dissatisfaction
Accounts payableTrade credit vs bank credit Relatively shorter (30 - 90 days) Usually unsecured, more lenient in
lending credit Amounts involved with individual
suppliers usually smaller
Dues to creditors Purchase authorisation in company Purchase quantities to be planned based
on financial & non-financial requirements Alternate sources of supply to be
identified, shop for best deals, credit terms and dependence on single supplier
If supplier defaults in delivery, what is the impact
Dues to creditors Purchase authorisation in company Purchase quantities to be planned based
on financial & non-financial requirements Alternate sources of supply to be
identified, shop for best deals, credit terms and dependence on single supplier
If supplier defaults in delivery, what is the impact
Caselet: MainLab - Cash FlowMainLab develops pharmaceutical products and has several patents to its credit. The company has grown fast, chiefly due to new products being developed and sold. The company does not pay dividend, but has a high P/E ratio. Due to very rapid growth, the company has experienced cash shortages and wants to improve this.
Caselet: MainLab - Cash FlowStrategies suggested: Customers to pay within 30 days as against 60 days now allowed
Reduce R&D expenditure by 20%.
Evaluate this as A short term creditor An investor
Caselet: MachCo – Cur. RatioMachCo owns many retail stores selling machinery and hardware. The current ratio in October is 1.7:1. This is lower than that of its competitors. To get better credit terms from suppliers, the company wants to improve this ratio to at least 2:1 by year end in December
Caselet: MachCo – Cur. Ratio
Strategies suggested: Pay some current liabilities Purchase inventory on account Offer debtors discount on quick payment Evaluate whether current ratio will increase or
decrease in each case Propose some ethical steps to increase the
current ratio before year end.
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Thank you