FINANCIAL MANAGEMENT

WORKING CAPITAL MANAGEMENT

OVERVIEW OF WORKING

CAPTITAL MANAGEMENT

Working capital

Significance of WC Management

Kinds of working capital

Working Capital Issues

Financing Current Assets

Combine structure of CA & CL

Motives for holding cash

Speeding up CR & slowing down CP

WORKING CAPITAL

working capital management involves the

relationship between a firm's short-term assets and

its short-term liabilities.

The basic goal of working capital management is to

ensure that a firm is able to continue its operations

and that it has sufficient ability to satisfy both

maturing short-term debt and upcoming

operational expenses.

SINGNIFICANCE OF

WORKING CAPITAL

MANAGEMENT

In a typical manufacturing firm, current assets

exceed one-half of total assets.

Excessive levels can result in a substandard Return

on Investment (ROI).

Current liabilities are the principal source of external

financing for small firms.

Requires continuous, day-to-day managerial

supervision.

Working capital management affects the company’s

risk, return, and share price.

WORKING CAPITAL CONCEPTS

Net Working Capital:

net working capital refers to the difference between current assets and current liabilities. Current liabilities are those claims of outsider, which are expected to mature

for payment within an accounting year & include creditors, bills payable & the outstanding expenses. In other words you can say that this is the excess of current assets over current liabilities.

Current Assets – Current Liabilities

Gross Working Capital:

• It refers to the firm’s investment in current assets.

• Current assets are the assets, which can be converted into cash within an accounting year or within an operating cycle

• cash, short-term securities, debtors (accounts receivable & book debts), bills receivable and stock.

Working capital turnover:

Working capital turnover= sales/working capital

Working Capital Management:

The administration of the firm’s current assets and the financing needed to support current assets.

CLASSIFICATION OF WORKING CAPITAL

CONCE

PT

BASIS

TIME

BASI

S

NWCPerm

anent

WC

Temp

orary

WC

Regu

lar

WC

Rese

rve

WC

Seas

onal

WC

Spec

ial

WC

GWC

CURRENT ASSETS

Inventories: Inventories represent raw materials and components, work-in-progress and finished goods.

Trade Debtors: Trade Debtors comprise credit sales to customers.

Prepaid Expenses: These are those expenses, which have been paid for goods and services whose benefits have yet to be received.

Loan and Advances: They represent loans and advances given by the firm to other firms for a short period of time.

Investment: These assets comprise short-term surplus funds invested in government securities, shares and short-terms bonds.

Cash and Bank Balance: These assets represent cash in hand and at bank, which are used for meeting operational requirements. One thing you can see here is that this current asset is purely liquid but non-productive.

CURRENT LIABILITY

Sundry Creditors: These liabilities stem out of purchase of raw materials on credit terms usually for a period of one to two months.

Bank Overdrafts: These include withdrawals in excess of credit balance standing in the firm’s current accounts with banks

Short-term Loans: Short-terms borrowings by the firm from banks and others form part of current liabilities as short-term loans.

Provisions: These include provisions for taxation, proposed dividends and contingencies.

WORKING CAPITAL FORMAT

CURRENT ASSETSCURRENT

LIABILITIES

Cash

Accounts receivable

Notes receivable

Marketable securities

Inventory

Prepaid expenses

Total current assets

Accounts payable

Notes payable

Accrued expenses

Taxes payable

Total current liabilities

DETERMINANTS OF WORKING

CAPITAL

• Nature of business

• Terms of sales and purchases

• Manufacturing cycle

• Business cycle

• Changes in technology

• Seasonal variation

• Market conditions

• Seasonality of operation

• Dividend policy

• Working capital cycle

WORKING CAPITAL ISSUES

Assumptions

50,000 maximum units

of production

Continuous production

Three different policies

current asset levels are

possible

IMPACT ON LIQUIDITY

Liquidity Analysis

Policy Liquidity

A High

B Average

C Low

Greater current asset levels generate more

liquidity; all other factors held constant.

IMPACT ON EXPECTED

PROFITABILITY

Return on Investment

=Net profit/Total Assets

Let,

Current Assets

=(Cash+Rec.+Inv.)

Return on Investment

=(Net Profit/Current +Fixed Assets)

IMPACT ON EXPECTED

PROFITABILITY

Profitability Analysis

Policy Profitability

A Low

B Average

C High

As current asset levels decline, total assets will decline and the ROI will

rise.

IMPACT ON RISK

Decreasing Cash reduces the firm’s ability to meet its financial obligations. “More risk!”

Stricter credit policies reduce receivables and possibly lose sales and customers. “More risk!”

Lower inventory levels increase stock outs and lost sales.

IMPACT ON RISK

Risk Analysis

Policy Risk

A Low

B Average

C High

Risk increases as the level of current assets are

reduced.

SUMMARY OF THE OPTIMAL

AMOUNT OF CURRENT

ASSETSSUMMARY OF OPTIMAL CURRENT ASSET ANALYSIS

Policy Liquidity Profitability Risk

A High Low Low

B Average Average Average

C Low High High

1. Profitability varies inversely with liquidity.

2. Profitability moves together with risk. (risk and return go hand in hand!)

ASSETS:

SHORT-TERM AND LONG-

TERM MIX

Spontaneous Financing:

It refers to the automatic source of short term funds

arising in the normal course of business

Example: trade credit &outstanding expenses.

No explicit cost is requried and firm expect to use it

to full extent.

We are concerned with managing non-spontaneous

financing of assets.

HEDGING(or MATURITY

MATCHING) APPROACH

A method of financing

where each asset would

be offset with a

financing instrument of

the same approximate

maturity..

HEDGING(or MATURITY

MATCHING) APPROACH

Less amount financed

spontaneously by

payables and accruals.

In addition to

spontaneous financing

(payables and

accruals).

FINANCING NEEDS AND THE

HEDGING APPROACH

Fixed assets and the non-seasonal portion of current

assets are financed with long-term debt and

equity(long-term profitability of assets to cover the

long-term financing costs of the firm).

Seasonal needs are financed with short-term loans

(under normal operations sufficient cash flow is

expected to cover the short-term financing cost).

SELF-LIQUIDATING NATURE

OF SHORT-TERM LOANS

Seasonal orders require the purchase of inventory

beyond current levels.

Increased inventory is used to meet the increased

demand for the final product.

Sales become receivables.

Receivables are collected and become cash.

The resulting cash funds can be used to pay off the

seasonal short-term loan and cover associated long-

term financing costs.

RISKS VS. COSTS TRADE-OFF

(CONSERVATIVE APPROACH)Long-term Financing Benefits:

Less worry in refinancing short-term obligations

Less uncertainty regarding future interest costs

Short-term Financing Risks:

Borrowing more than what is necessary

Borrowing at a higher overall cost(usually)

Result:

Manager accepts less expected profits in exchange for taking less risk.

RISKS VS. COSTS TRADE-OFF

(CONSERVATIVE APPROACH)

Firm can reduce risks

associated with short-

term borrowing by using

a larger proportion of

long-term financing.

COMPARISON WITH AN

AGGRESSIVE APPROACHShort-Term Financing Benefits:

Financing long-term needs with a lower interest cost than

short-term debt

Borrowing only what is necessary

Short-Term Financing Risks:

Refinancing short-term obligations in the future

Uncertain future interest costs

Result:

Manager accepts greater expected profits in exchange

for taking greater risk.

RISKS VS. COSTS TRADE-OFF

(AGGRESSIVE APPROACH)

Firm increases risks

associated with short-

term borrowing by using

a larger proportion of

short-term financing.

SUMMARY OF SHORT- VS.

LONG-TERM FINANCING

COMBINING LIABILITY

STRUCTURE AND CURRENT

ASSET DECISIONS

The level of current assets and the method of

financing those assets are interdependent.

A conservative policy of “high” levels of current

assets allows a more aggressive method of financing

current assets.

A conservative method of financing (all-equity)

allows an aggressive policy of “low” levels of current

assets.

MOTIVES FOR HOLDING CASH:

TRANSACTION MOTIVE

SPECULATIVE MOTIVE

PRECAUTIONARY MOTIVE

SPEEDING UP CASH PECEIPTS &SLOWING

DOWN CASH PAYOUTS

CUSTOMER

MAILS

CHECK

FIRMS

RECEIVES

CHECK

FIRM

DEPOSITS

CHECK

FIRM’s

BANK A/C

credit

COLLECTION FLOAT &ITS COMPONENTS

Availability

floatProcessing floatMail float

Deposit float

SPEEDING UP CASH RECEIPTS:

EARLIER BILING

LOCKBOX SYSTEM

ARC

CHECK 21 AND BEYOND

CONCERATION SERVICE FOR TRANSFERRING

FUNDS:

• DTC

• ACHET

• WT

SLOWING DOWN CASH PAYMENTS:

PAYABLE THROUGH DRAFT

PAYROLL AND DIVIDEND PAYMENT

REMOTE DISBURSEMENT

CONTROLLED DISBURSEMENT