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Financial Management 3
Working Capital
Management & Financing
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Topics to be covered Theory of Working Capital Management
Nature for Working Capital Trade-off between Profitability & Risk Determining Financing Mix
Planning of Working Capital Need for Working Capital Determinants of Working Capital Computation of Working Capital
Working Capital Financing Trade Credit Bank Credit Commercial Papers Factoring
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Theory of Working Capital Management
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Nature of Working Capital Working Capital Management is concerned with the problems that
arise in attempting to manage the current assets, the current liabilities and the interrelationship that exists between them
Current Assets are those assets Which in ordinary course of business can be or will be converted into cash within
one year. Without any diminution in value and without disturbing the operations of the
firm. Examples Sundry Debtors / Accounts Receivable , Inventory/Stock
Current Liabilities are those liabilities Which are intended, at their inception, to be paid in the ordinary course of
business, within a year, out of the current assets or the earnings of the business. Example Sundry Creditors / Accounts Payable , bank overdraft
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The goal of W.C. Management is to manage the firms currentassets and liabilities in such a way that a satisfactory level ofworking capital is maintained.
This is so because if the firm cannot maintain a satisfactory level ofWorking Capital, it is likely to become insolvent and may even beforced into bankruptcy.
In order to maintain a reasonable margin of safety the currentassets should be large enough to cover its current liabilities.
Each of the current assets must be managed efficiently in order tomaintain the liquidity of the firm while not keeping too high a levelof any one of them.
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Some important definitions
Gross Working Capital means total current assets
Net Working Capital means the difference between currentasstes and current liabilities
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Net Working Capital is used as an indicator of the firms liquidity.
While analysing a companys financial strength, its Net WorkingCapital is seen to understand the liquidity position of the company.
The greater the margin by which the current assets cover the short
term obligations (i.e. current liabilities), the more is the ability topay obligations when they become due for payment.
NWC is necessary because the cash outflows and inflows do notcoincide.
Cash outflows resulting from payment of current liabilities arerelatively predictable. However the cash inflows are difficult topredict.
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The more predictable the cash inflows are, the less NWC is required.
A firm, say an electricity generation company, with almost certainand predictable cash inflows can operate with little or no NWC.
But where cash inflows are uncertain, it will be necessary to
maintain current assets at a level adequate to cover currentliabilities.
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Trade-off between Profitability & Risk
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Trade-off b/w Profitability & Risk While evaluating a firms NWC position, an important consideration
is the trade-off between profitability & risk.
In other words, the level of NWC has a bearing on profitability aswell as risk.
Profitability means profits after expenses
Risk defined as probability that a firm will become technicallyinsolvent so that it will not be able to meet its obligations when theybecome due for payment.
This trade-off between profitability and risk is an important elementin evaluation of the level at which the firm should maintain its NWC.
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Nature of trade-off In evaluating the profitability risk trade-off related to the level of
NWC, two ratios are used:
1) Current Assets to Total Assets ratio (CA / TA)
2) Current Liabilities to Total Assets ratio (CL / TA)
Current Assets to Total Assets ratio indicates the percentage of CAin the total assets of the firm.
Since CA for a business firm is likely to be less than fixed assets, theincrease in CA/TA ratio would decrease profitability but on the otherhand would reduce the risk of technical insolvency.
A decrease in the ratio will result in an increase in profitability aswell as risk.
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The CL/TA ratio indicates the percentage of total assets financed bycurrent liabilities.
An increase in the ratio will yield higher profitability (due todecrease in costs) and higher risk (due to decrease on NWC,assuming no change in CA).
The decrease in profitability as well as risk.
The combined effects of change in CA and CL on profitability-risktrade-off can be evaluated by considering them simultaneously also.
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Determining Financing Mix
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Apart from the profitability-risk trade-off, another importantingredient of the theory of working capital management isdetermining the financing mix.
Financing mix means as to how the current asset will be financed.
There are broadly two sources for this:
1) Short-term sources (Current liabilties)
2) Long-term sources- share capital, long-term borrowing, internally generated resources
like retained earnings and so on.
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There are three approaches to determine an appropriate financingmix :
1) Hedging or Matching Approach
2) Conservative Approach
3) Trade-off between Hedging & Conservative Approach
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Hedging Approach:
According to Hedging approach, long term funds should be used tofinance the permanent / core part of CA.
And the purely temporary and seasonal requirements (over and
above the permanent needs) should be met out of short-term fundsi.e. out of CL.
As a result, the short term financing (CL) would be just equal tocurrent assets (i.e NWC = Zero)
This approach is a high profit high risk financing mix.
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Conservative Approach:
According to this approach, the estimated total requirements of theCA should be financed from long-term sources.
The short-term sources of finance should be used only in emergency
situations.
The firm has NWC equal to excess of long term financing over thepermanent requirement.
This approach is a low-profit, low-risk combination.
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