WORKING CAPITAL

Prepared By : - PARAG VORA MANISH AGHASIYA

MILAN DAVE

CONTENTS Introduction. Concept of Working Capital Types of Working Capital Working Capital cycle Working Capital needs of a business Nature and Importance of Working Capital Working Capital management concepts Management of Working Capital Measures of Working Capital management

Efficiency Objectives of Working Capital management

Analysis of Liquidity position Methods for estimating Working Capital

requirement Conclusion

INTRODUCTION

WHAT IS WORKING CAPITAL?

Working capital is the difference between current assets and current liabilities.

Working capital is how much in liquid assets that a company has on hand. Working capital is needed to pay for planned and unexpected expenses, meet the short-term obligations of the business, and to build the business.

CONCEPT OF WORKING CAPITAL

The core of the Working capital concept has been subjected to considerable change over the years. A few years ago the concept was viewed as a measure of the debtor’s ability to meet his obligation in case of liquidation. The prime concern was with whether or not the current assets were immediately realizable and available to pay debts in case of liquidation.

The concept of WCM was first evolved by KARL MARX but it was something different , they used the word variable Capital means outlays for payrolls advanced to workers before the goods they worked on were complete.

TYPES OF WORKING CAPITAL

WORKING CAPITAL

BASIS OF CONCEPT

BASIS OF TIME

Gross Working Capital

Net Working Capital

Permanent / Fixed

WC

Temporary / Variable

WC

Regular WC

Reserve WC

Special WC

Seasonal WC

WORKING CAPITAL CYCLE The Working Capital Cycle can be defined as:

The period of time which Elapses between the point at which cash begins to be expended on the production of a product and the collection of cash from a customer.

The diagram below illustrates the Working Capital Cycle for a manufacturing firm.

WORKING CAPITAL CYCLE

Work in progress

Raw-material stock Finished goods stock

Wages and overheads

Trade creditors

Taxation

sale

Trade debtors

Shareholders

cash

Fixed assets Loan creditorsLease payment

Selling expenses

REQUIREMENTS OF WORKING CAPITAL IN BUSINESS

Business with a lot of cash sales & few credit sales should have minimal trade debtors. Supermarkets are good examples of such business.

Business that exists to trade in completed products will only have finished goods in stock. Compare this with manufacturers who will also have to maintain stocks of raw-material & work-in-progress.

Some finished goods, notably foodstuffs, have to be sold within a limited period.

Larger companies may be able to use their bargaining strength as customers to obtain more favorable, extended credit terms from suppliers. By contrast, smaller companies, particularly those that have recently started trading may be required to pay their suppliers immediately.

Some businesses will receive their money at certain times of year, although they may incur expenses throughout the year at a fairly consistent level. This is often known as “SEASONALITY” of cash flow.

OPERATING CYCLEOPERATING CYCLE

Accounting receivable

finished Goods

WIPRAWmaterial

cash

Nature & Importance of Nature & Importance of WCWC

Short term financial requirement

Reduce the financing cost

Helpful in expansion

Success of a firm

Working capital Working capital management management

(WCM)(WCM)

Management of the Management of the WCWC

MEASUREMENT OF WORKINGCAPITAL REQUIREMENT

The form & amount of working capital componenets vary overthe operating cycle.

Working capital efficiency can be measured in terms of “DAYS OF WORKING CAPITAL (DWC)”

DWC value is based on amount of each of equally weighted receivable, inventory & payable accounts.

THE MEASUREMENT OF WORKING CAPITAL EFFICIENCY IS AS UNDER

The DWC represents the time period between purchase of material on account from the supplier untill the sell of finished goods.

Thus it reflects the firm’s profitability to finance it’s core operations with vendor credit.

The firm’s profitability is measured using(IA) approach.

Another profitability measure is (IS) approach.

To measure the liquidity of the firm the

cash conversion efficiency (CCE) & current ratio are used.

The CCE is the cash flow generated from operating activities related to sales.

OBJECTIVES OF WORKING CAPITAL MANAGEMENT

THE WORKING CAPITAL OBJECTIVES ARE CONSIDERED AT MAIN FOUR LEVELS. (1) INVENTORY:- High Level Low Level (a) benefit:- (a) Cost:-

Happy Customers Shortages Few Prod’n Delays Dissatisfied

Customers

(b) Cost:- (b) Benefits

Expensive Low Storage cost

High Storage Cost Less Risk of Obso

Risk of obsolence lence lence

(B) CASH:- High level Low Level (a) benefit:- (a) benefit Reduces Risk Reduces

Financing Cost (b) cost:- (b) Cost:- Increases Financing Increases Risk cost

(C) Account Receivables :- High level Low Level (Favorable (Unfavorable cre Credit Terms) Terms) (a) benefit:- (a) cost:- Happy Customers Dissatisfied

Customers High Sales Lower Sales

(b) cost:- (b) benefit:- Expensive Less expensive

High Collection Cost Increases Financing Cost

(D) PAYABLE & ACCRUALS:- High Level Low Level (a) benefit:- (a) benefit:- Reduces need for Happy suppliers external finance / employess using a spontane ous financing re sources (b) Cost:- (b) Cost:- Unhappy suppli Not using a

spontaneous ers financing source

(1)- LIQUIDITY:- It reflects the firm’s ability to meet it’s

short term obligations using those assets which are most readily converted into cash.

Assets that may be converted into cash in

a shorter period of time are referred as liquid assets.

ANALYSIS OF LIQUIDITY POSITION

Current assets are often referred to as working capital, since they represents resources needed for day to day operations of the firm’s long term capital investments.

Current assets are used to satisfy short term obligation or current liability.

(2)- The Operating Cycle:- The operating cycle is the duration from

the time cash is invested into goods & services to the time the investment produces cash.

It includes four phases which are as under.

(A)- Purchase of raw-material & produces goods, investing in inventory.

(B)- Sell goods, generating sales, which may or may not be in cash.

(C)- Extent credit, creating a/c receivable.

(D)- Collects a/c receivable, generating cash.

FOUR PHASES OF OPERATING CYCLE

(3)- Liquidity Ratio:-

Liquidity ratio or Solvency ratio include the,

(A) Current Ratio:-

(B) Quick Ratio:-

(C) Net Working Capital:-

The current ratio compares current assets to current liability.

It also gives an idea of a company’s ability to meet day to day payment obligation.

Generally higher ratio is better.

(A) CURRENT RATIO

CURRENT RATIO= Current Asset Current Liability

It includes cash, account receivables, marketable securities, inventory & prepaid expenses like insurance & taxes.

The benchmark current ratio is 2:1

The quick ratio is similar to current ratio but it’s a tougher measure of liquidity than the current ratio.

Generally a higher ratio is better.

(B) QUICK/ ACID TEST RATIO

QUICK RATIO= Current Assets- Inventory Current liability Generally, the quick ratio should be lower than the current ratio because the

inventory figure drops from the calculations.

The desired quick ratio is 1:1

(A) Advantages of favorable discount:-

(B) Profitable Opportunities:-

(C) Management Actions:-

(D) Coverage of Current obligations:-

LIQUIDITY CAN LIMIT:

(A) Lower Profitability:-

(B) Restricted Opportunities:-

(C) Loss Of Owner Control:-

(D) Loss Of Capital Investment:-

(E) Insolvency & Bankruptcy:-

SEVERE LIQUIDITY OFTEN PROCEEDS

METHODS FOR ESTIMATING WORKING CAPITAL REQUIREMENT Methods for estimating working capital require ments of a firm are, (1) Percentage Of Sales Method:- (2) Regression Analysis Method:- (3) Operating Cycle Method:-

(1) Percentage Of Sales Method:- In this method, level of w.c requirement is

decided on the basis of past experience. The past relationship between sales & w.c. is

taken as a base for determining the size of w.c.

requireme nts for future.

BALANCE SHEET OF ZELLET STEEL COMPANY AS ON 31-3-2006

Liabilities Rs.(in lakhs) Assets Rs.(in lakhs)

Share capital 200 Land & Building

60

Reserve & Surplus

160 Plant & Machinery

200

Term Loans 160 Inventories 200

Surplus creditors

120 Receivables 220

Provisions of tax

60 Cash & Bank 20

700 700

The Company’s Turnover For 2005-06 Was Rs.12 Crore. It anticipates a sales turnover of Rs.18 crore

in 2006-07.

Estimate the working capital requirement for 2006-07

ESTIMATE OF W.C. REQUIREMENTS FOR THE YEAR 2006-07PARTICULARS % OF SALES BASED ON

2005-06 FIGURESACTUAL (2005-06) ESTIMATSE (2005-06)

Sales 100.00 1200 1800

Current assets

Inventories 16.67 200 300

Receivables 18.33 220 330

Cash & bank 1.67 20 30

TOTAL(A) 36.67 440 660

Current Liabilities

Sundry creditors 10.00 120 180

Provision of tax 5.00 60 90

TOTAL(B) 15.00 180 270

Working capital (A-B) 21.67 260 390

(2) Regression Analysis Method:- This is a statistical method of determining working capital requirements by establishing the sales & wor king capital & it’s various components in the past years. The equation of this methods is as under. Y= a + bx a= fixed variable, b= variable components x = sales, y = inventory, n = no. of observation

TABLE 2.6

YEAR

SALES

CURRENT ASSETS

2001 64 44

2002 88 54

2003 104 63

2004 114 87

2005 138 90

ESTIMATE WORKING CAPITAL REQUIREMENTS FOR THE YEAR 2006

YEAR SALES(x) CU.ASSETS(y) xy X2

2001 64 44 2816 4096

2002 88 54 4752 7744

2003 104 63 6552 10816

2004 114 87 9918 12996

2005 138 90 12420 19044

N = 5 X = 508 Y = 338 XY = 36458 X2 = 54696

Y = na + bx. 338 = 5a + 508b 71.7677b = a + 107.6629 6.0629 = b + 416.771b a = -2.167622 b = 0.6866892

(3) Duration Of Raw-Material:- It reflects the no. of days for which raw-

material remain in inventory before they are issued for prod’n. R = avg. stock of raw- material per day consumption of raw- material

(4) DURATION OF WORK-IN-PROGRESS:- It denotes the no. of days required in the work-

in- progress stage.

W = avg. work-in-progress inventory avg. production per day

(5) DURATION OF FINISHED GOODS :- It refers to the no. of days for which financial

goods remain in inventory before they are sold.

F = avg. finished goods inventory per day sale of goods

(6) DURATION OF ACCOUNT RECEIVABLE:- It represents the no. of days required to the

collect the account receivable.

A = avg. book debt avg. credit sales per day

(7) DURATION OF ACCOUNT PAYABLE :-

It refers to the no. of days for which the suppliers

of raw-material offer credit.

P = avg. trade creditors avg. credit purchase per day