Principles Of Working Capital Management

PRINCIPLES OF WORKING CAPITAL MANAGEMENT LECTURE - 1

INTRODUCTION 

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One of the most important areas in the day to day management of the firm is the management of working capital. Working capital refers to the funds held in current assets. Current assets are essential to use fixed assets. The requirements for current assets are usually greater than the amount of funds available through current liabilities.

OPTIMUM INVESTMENT 

The importance of adequate working capital can never be over emphasized.

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A firm has to be very careful in estimating its working capital. The effective management of working capital is the primary means of achieving the firm’s goal of adequate liquidity.

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A very big amount of working capital would mean that the firm has idle funds. This results in over capitalization.

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Over capitalization implies that the firm has too large funds for its requirements, resulting in a low rate of return.

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If the firm has inadequate working capital, it is said to be under capitalized. Such a firm runs the risk of insolvency.

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Shortage of working capital may lead to a situation where the firm may not be able to meet its liabilities.

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Hence it is very essential to estimate the requirements of working capital carefully and determine the optimum level of investment in it.

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At the optimum level of working capital the profitability will be maximum.

CONCEPTS OF WORKING CAPITAL 1.

Gross Working Capital :

The Gross working capital refers to investment in all the current assets taken together. 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, bills receivable and inventory. 2. Net working Capital : The term ‘net working capital’ refers to excess of total current assets over total current liabilities. Current liabilities are those claims of outsider’s which are expected to mature for payments within an accounting year and include creditors, bills payable and outstanding expenses. Net working capital can be positive (CA>CL) or negative (CA< CL). Net working capital is that position of current assets which is financed with the long term funds.

NEED FOR WORKING CAPITAL MANAGEMENT Firms differ in their requirements for the working capital. A firm should aim at maximizing the wealth of its shareholders. In its endeavour to do so, a firm should earn sufficient return from its operations. Earning a steady amount of profit requires successful sales activity. The firm has to invest enough funds in current assets for generating sales. Current assets are instantaneously.

needed

because

sales

do

not

convert

into

cash

Similarly inventory cannot be converted into cash as and when the firm require. All the above aspects result in the funds of the firm being blocked for a certain period. To operate the business in this period, a firm needs working capital.

IMPORTANCE OF ADEQUATE WORKING CAPITAL A firm needs funds for its day to day running. Adequacy or inadequacy of these funds would determine the efficiency with which the daily business may be carried on. It is to be ensured that the amount of working capital available with in the firms is neither too large nor too small for its requirements. For the following reasons working capital should be adequate. 

To meet the short term obligations.

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To avail the market opportunities such as purchase of raw materials at the lowest price, with discount etc.

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To enable the firm to operate more efficiently and meet the raising turnover thus peak needs can be taken care off.

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To enable the firm to extend favourable credit terms to the customers.

OPTIMUM WORKING CAPITAL 

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Current ratio, with acid test ratio to supplement it, has traditionally been considered the best indicator of the working capital situation. A current ratio of 2 for a manufacturing firm implies that the firm has an optimum account of working capital. This is supplemented by the Acid Test Ratio which should be at least one. It is considered that there is a comfortable liquidity position if liquid current assets are equal to current liabilities. Optimum working capital can be determined only with reference to the particular circumstances of a specific situation. In a firm where the inventories are easily saleable and the sundry debtors are as good as liquid cash, the current ratio may be lower than 2 and yet firm may be sound. An optimum working capital ratio dependent upon the business situation as such, and the nature and composition of various current assets.

WORKING CAPITAL CYCLE 

The working capital cycle/ Operating cycle refers to the length of time between the firms paying cash for materials etc., entering into the production process/inventory and the inflow of cash from sale of finished goods.

PHASES OF OPERATING CYCLE The operating cycle (working capital cycle) in a manufacturing firm consists of the following events, which continues throughout the life of business.    

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Conversion of cash into raw materials Conversion of raw materials into work in progress Conversion of working progress into finished goods Conversion of finished goods into accounts receivable through sales and Conversion of account receivable into cash (OR finished good into cash in the case cash sales)

The duration of the Gross operating cycle for the purpose of estimating working capital is equal to the sum of the durations of each of above said events. Net operating cycle is calculated as Gross operating cycle less the credit period allowed by the suppliers.

Determination of operating cycle 

Operating cycle = R + W + F + D – C

R = Raw material storage period =

Average stock of raw material Average cost of consumptio n per day

W = Work in progress holding period =

F = Finished goods storage period =

D = Debtors collection period = C = Credit period availed =

Average work in progress inventory Average cost of production per day

Average stock of finished goods Average cost of goods sold per day

Average book debts Average credit sales per day

Average trade creditors Average credit purchases per day

TYPES OF WORKING CAPITAL From the point of view of time, the term working capital can be divided into two categories: 1. Permanent working capital: It is that minimum level of investment in the current assets that is carried by the firm at all times to carry out minimum level of its activities. It also refers to the Hard core working capital. 2. Temporary working capital: It refers to that part of total working capital, which is required by a business over and above permanent working capital. It is also called as variable or fluctuating working capital. Since the volume of temporary working capital keeps on fluctuating from time to time, according to the business activities it may be financed

Estimation of working capital 

This involves two steps

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Estimation of Current Assets

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Estimation of Current Liabilities

Estimated Working Capital requirement = Estimated Current Assets – Estimated Current Liabilities

Estimation of Current Assets 

Raw Materials inventory: The funds to be invested in raw materials inventory may be estimated on the basis of production budget, the estimated cost per unit and average holding period of raw material inventory. Raw material inventory =

Estimated production (in units) X Estimated cost of raw material per unit X Average raw material holding period(in months/in days) 12 months/360 days

Estimation of Current Assets

Work in progess inventory =

Estimated production (in units) X Estimated WIP(cost per unit) X Average holding period of WIP(in months/in days) 12 months/360 days

Estimation of Current Assets

Finished Goods inventory =

Estimated production (in units) X Cost of production(per unit without dep.) X Average holding period of finished goods inventory(in months/in days) 12 months/360 days

Estimation of Current Assets Trade Debtors =

Estimated credit sales (in units) X Cost of sales(per unit without dep.) X Average Debtors collection period(in months/in days) 12 months/360 days

Estimation of Current Assets 

Minimum desired Cash and Bank balances to be maintained by the firm has to be added in the current assets for the computation of working capital

Estimation of Current Liabilities Trade Creditors =

Estimated yrly production (in units) X Raw material requirement per unit X Credit period granted by suppliers(in months/in days) 12 months/360 days

Estimation of Current Liabilities

Direct Wages =

Estimated production (in units) X Direct Labour cost per unit X Average time lag in payment of wages(in months/in days) 12 months/360 days

Estimation of Current Liabilities Overheads (other than depreciation and amortisati on) =

Estimated yrly production (in units) X Overhead cost per unit X Average time lag in payment of overheads(in months/in days) 12 months/360 days

DETERMINANTS OF WORKING CAPITAL There are no hard fast rules or formulae to determine working capital needs of the firms. A large number of factors influence working capital needs of firms. All factors are of different importance. The

Nature & Size of business 

The shorter the manufacturing process, the lower is the requirements for the working capital. This is because, in such a case, inventories have to be maintained at a low level. Longer the manufacturing process the higher would be the requirements of working capital. This is the reason why highly capital intensive industries require a large amount of working capital to run their sophisticated and long production process.

Business cycle 

Business fluctuations lead to cyclical and seasonal changes in production and sales and affect the working capital requirements.

Production Policy 

The plan for production, has great influence on the level of inventories. The raw material procurement varies from industry to industry. In all such cases, the need for working capital will vary in accordance with production plans. Similarly, the decision of the management regarding automation, etc., also affect working capital requirements.

Conditions of supply 

If prompt and adequate supply of raw materials, spares, stores etc., is available, it is possible to manage with small investments in inventory of work on ‘Just in Time’ inventory principles. However if supply is erratic, scanty, seasonal, channelised through government agencies etc., it is essential to keep larger stocks increasing working capital requirements.

Inventory policies 

Since a large amount of funds is normally locked up in inventories, the inventory policy of a company has an impact on the working capital requirements. An efficient firm may stock raw material for a smaller period and may, therefore, require lesser amount of working capital.

Credit Policy 

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The credit policy of the firm also determines the requirements of working capital. A firm, which allows liberal credit to its customers may have higher sales but consequently will have larger amount of funds tied up in sundry debtors. Similarly a firm, which has a very efficient debt collection machinery and offers strict credit terms, may require lesser amount of working capital than the one where debt collection system is not so efficient or where the credit terms are liberal. The credibility of a firm in the market also has an effect on the working capital requirements. Reputed and established concerns can purchase raw material on credit and enjoy many other services also like door delivery, after sales service etc.,. This would mean that they can easily have large current liabilities. Therefore the required working capital may not be very high.

Market conditions 

Working capital requirements are also affected by market conditions like degree of competition. Large inventory is essential as delivery has to be off the shelf or credit has to be extended on liberal terms when market competition is fierce or market is not very strong or is a buyer’s market.

Growth and expansion: 

The growth in volume and growth in working capital go hand in hand. However, the change may not be proportionate and the increased need for working capital is felt right from the initial stages of growth.

Level of taxes/Dividend Policy Level of taxes:  The amount of taxes paid depends on taxation laws. These amounts usually have to be paid in advance. Thus need for working capital varies with tax rates and advance tax provisions. Dividend policy:  Payment of dividend utilizes cash, while retaining profits acts as a source of working capital. Thus dividend policies affect working capital.

Price level changes/Operating efficiency Price level changes:  Inflationary trends in the economy necessitate more working capital to maintain the same level of activity. Operating efficiency:  Efficient and coordinated utilization of capital reduces the amount required to be invested in working capital.

Abnormal factors 

Abnormal conditions like strikes and lockouts, also require additional working capital. Recessionary conditions, necessitate a higher amount of stock of finished goods remaining in stock. Similarly, inflationary conditions necessitate more funds for working capital to maintain the same amount of current assets.

Approach to working capital 

A firm can adopt different financing policies namely long term, short term and spontaneous.

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A firm should take maximum advantage of the Spontaneous finance sources such as trade credit.

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The approach a firm used in mixing these sources can be matching, conservative or aggressive.

Approaches 1. Matching or Hedging approach: 

When the firm uses long term sources to finance fixed assets and permanent current assets, and short term financing to finance temporary current assets.

2. Conservative approach: 

Under this approach a firm finances its permanent assets and also a part of temporary current assets with long term financing. It relies heavily on long term financing and is less risky so far as solvency is concerned, however, the funds may be invested in such instruments, which fetch small returns to build up liquidity. This adversely affects profitability.

3. Aggressive Approach: 

The firm uses more short term financing than what is justified, in this approach. The firm finances a part of its permanent current assets with short term financing. This is more risky but may add to the return on assets.