Working Capital(2)

8/6/2019 Working Capital(2)

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Working Capital Management

By

Dr. Gurendra Nath BhardwajAssociate Professor

IILM Graduate School of Management,16 Knowledge Park - II, Greater Noida - 201 306,Tel: 0120 - 3374335 (O), Mobile - 9910634497

Email: [email protected], [email protected]


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Introduction

Any business firm requires two types of

assets- long term and short assets.

In investment decision we studied thathow a firm should select the most

profitable project to acquire some capital

assets or long term asset.


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Contd.

In financing decision, we discuss the

concepts of leverages, capital structure

theories and EBIT & EPs analysis throughwhich we can how the shareholders

wealth can be increased.


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Contd.

In Dividend decision we acquire little bit

knowledge about the dividend policies;

payout and retention ratio and how a firmcan increase it market value of share at

given EPS by making change in payout

ratio.


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Contd.

Now, all this may happen in any business

if it can run its day to day operations

smoothly. The question is what is essential to run a

business or to make fixed assts operative.


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The answer-

Working Capital


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Theory of Working Capital

Management Working capital represents the value of current assets in the firm.

The management of short term assets is so important for a firm that

it can survive only after keeping adequate level of short term assets.

The working capital plays a role in business firm like a lubricants

and fuel in automobile.

It converts an asset from non productive to productive one and vice

versa.

It applies for all the factors of production.

In every business the receipts are uncertain where as the payments

are certain.


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Contd.

So, to fill this gap a firm needs optimum quantity of working

capital.

The working capital management refers the matching of

current assets and current liabilities to maintain long term

assets and to pay respectable compensation to the long term

funds.

It establishes the relationship between current assets and

current liabilities.

It should be adequately supplied to increase the wealth of the

organization.


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Contd.

Working capital management involves two

main processes.

Determining the size of the working capital

Arranging the sources of working capital


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Determining the size of the working

capital:

It is determined on the basis of certainfactors, like

Nature of Industry

Size of Business

Manufacturing Cycle

Production Policy

Volume of Sales Terms of purchase & Sales


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Contd.

Business Cycle

Growth and Expansion

Supply of Raw Materials

Price Level changes

Operating Efficiency

Profit Margin

Profit Appropriation

Capital Structure

Monetary Policy


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Arranging the sources of working

capital:

It depends mainly upon the availability of funds and different

application of this working capital. Current assets or working

capital includes mainly three components

Inventories

Cash

Receivables

So, in short we can also say that the working capitalmanagement means to manage all these three components in

the firm.


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Components of Working Capital


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Types of Working Capital

There two broad classifications of the working

capital.

Gross WorkingC

apital Net Working Capital

There are two more classifications which are also

very important.

Permanent Working Capital

Temporary Working Capital


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Gross Working Capital

It refers to the firms investment in current

assets.

It include mainly cash, short term securities,

and debtors, bills receivable and stock.

The concept of the current assets refer those

assets which can be converted in to cash

within one accounting year.


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Net Working Capital

It refers to the difference between current assets and current

liabilities.

C

urrent liabilities are those which are expected to mature forclaim within one accounting year and which include trade

creditors, bills payables and outstanding expenses.

The net working capital may be positive or negative.

Positive working capital shows the surplus of current assets

over current liabilities and negative shows deficiencies.


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Permanent Working Capital

It refers to the amount of working capital

which is required by the firm every time.

It shows the minimum level of workingcapital which is required for maintaining

day to day operations of the firm.

For example, a firm needs Rs. 50,000 as

working capital during a particular financial year.

It will be termed as Permanent Working Capital.


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Example -Permanent WorkingCapital


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Temporary Working Capital

It is required by the firm, when some

changes occur in production or sales

volume or change in the price level of any

factors of production.

For example due to change in season a

firm fluctuates its requirement of working

capital during one particular year.


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Example- Temporary WorkingCapital


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Determining the Financing mix

In working capital finance we will discuss

two things-

Sources of WorkingC

apital Approaches for determining the Financing

Mix


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Sources of Working Capital:

On the basis of sources, we can classify it

in to three broad categories-

Long Term Financing Short Term Financing

Spontaneous Financing


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Long Term Financing:

It includes the following

Term loans from financial institutions

Issue of Debentures Issue of Shares

Accepting Public Deposit

Internal Financing (Retained Earnings)


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Short Term Financing

It includes following-

Short term bank loan (Bank Overdraft)

Commercial Papers (like bills hundies etc.)


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Spontaneous Financing

This source of finance is cost free sources.

It includes following-

TradeC

reditors Outstanding Expenses etc.


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Approaches for determining the

Financing Mix:

There are following three types of

approaches to finance the working capital

Matching Approach or Hedge Approach

Conservative Approach

Aggressive Approach


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MatchingApproach or Hedge

Approach

In this approach of financing the working capital

the firm tries to finance the permanent working

capital through the long term funds and temporary

working capital through short term funds.

The concept behind this is that the maturity of

source of funds should match the nature of assets

to be financed.


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ConservativeApproach

According this approach the whole amount

of working capital should be financed

through the long term funds.

In this approach the firm does not want to

take any risk.

It is a costly approach in comparison to

matching approach.


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AggressiveApproach

Under this approach the firm uses the

short term funds to finance some part of

permanent working capital and the whole

of part of temporary working capital.

But this approach is more risky for the

firm, however this the cheapest approach.


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Planning of working capital Every firm must maintain a sound working capital

otherwise; its business activities may be adversely

affected.

The objective of financial management i.e. to maximizethe wealth of the shareholder cannot be attained if

operations the firm are not optimized.

Thus, every firm has to maintain adequate working

capital.

It should have neither the excessive working capital nor

inadequate working capital.


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Need

To increase operating profit, the firm should

increase its sales.

In practical life it has been seen that when firmincreases its sales the profit may increase but it is

not necessary that the cash profit may increase,

because sales include the cash and credit sales.

Cash sales increase the cash position whereas

credit sales increase the receivables.


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The collection of cash from receivables require some times

span. So, to meet out day to day expenses the firm needs

some sort of funds to run uninterrupted business operations,

the amount will be locked up in the current assets.

It happens due to operating cycles.

The need of working capital is based on the length of

operating cycles.

The length of operating cycle depends mainly on the nature

of business it self.


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Operating Cycle


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Concept and Computation of

Operating Cycle

The operating cycle concept refers to the

time lag, which is required to convert the

raw material in to finished products and

finished product to cash again.


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Computation ofOperating Cycle

The Total Operating Cycle Period (TOCP)

will be equal to Inventory Conversion

Period (ICP) + Receivable ConversionPeriod (RCP).

The firm might get some credit form

supplier of raw material, wages earners

etc.


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The period for which the payments to these

parties are delayed or deferred is known as

Deferred Period (DP).

The Net Operating Cycle (NOC) of the firm

may be calculated by deducting Deferred

Period (DP) from the Total Operating Cycle

Period (TOCP).


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NOC = TOCP DP

or

NOC = ICP + RCP DPFor calculation of TOCP and NOC, various

conversion periods may be calculated as

follows:


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Average Raw Material Stock

RMCP = X 365

Total Raw Material Consumption

Average Work in Progress

WPCP = X 365

Total Cost of Production


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Average Finished Goods

FGCP = X 365

Total Cost of Goods Sold

Average ReceivablesRCP = X 365

Total Credit Sales

Average Creditors

DP = X 365

Total Credit Purchase


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On the basis of

above conversion

periods, TOCP and

NOC may beascertained as

follows.

Particulars Numbers of

Days

RMCP ..Days

+ WMCP ..Days

+ FGCP ..Days

+ RCP ..Days

TOCP ..Days

-DP ..Days

NOC ..Days


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RMCP Raw Material Conversion Period

+ WMCP Work in Progress Conversion Period

+ FGCP Finished Goods Conversion Period

+ RCP Receivables Conversion Period

TOCP Total Operating Cycle Period

-DP Deferred Period

NOC Net Operating Cycle


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Solution

Particulars Numbers of Days

RMCP 49 Days

+ WMCP 15 Days

+ FGCP 31 Days

+ RCP 43 Days

TOCP 138 Days

-DP 55 Days

NOC 83 Days


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Problems Associated with Excess and

Inadequate Working Capital

This is very important aspect of working capital

management that excessive as well as inadequate

working capital both are harmful to the organization.

Excess working capital creates idle funds, which cannot

earn any return, whereas shortages of working capital

will hamper the production process and other business

operations.

In both the situations firm has to suffer loss.


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Demerits ofExcessive Working Capital

There may be following problems

It can accumulate unnecessary inventories. Thus chance of

mishandling, theft, wastage of inventories may occur.

It also indicates poor collection of receivable and very

liberal credit policy regarding sales. The bad debts will

increase it such situation continues for long time.


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It allows to the management to inefficiently

Accumulation of excessive inventories also leads to

speculative profit. This may tend to make dividend policy

liberal, which may create serious problems in future.

Excessive availability of cash tempts the executive to spend

more.


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Demerits of Inadequate Working Capital

There may be following problems-

It becomes difficult for the firms to undertake profitable

projects due to shortage of working capital.

The firm may face problems in implementing the operating

plans and achieve the firms profit target.

It also creates problem in meeting out day-to-day orroutine expenses.


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Fixed assets can be utilized more effectively, thus the overall

return may go down.

Due to inadequate working capital firm may loose some good

credit opportunities

The firm may spoil its fame and reputation if it fails to honour

short-term obligations. As a result, the firm faces tight credit

terms.

It directly affects the liquidity positions of the business firms.

Documents

Working Capital(2)