WORKING CAPITAL MANAGEMENT

SUBMITTED TO : DR. DHARA JETHAV &

DR. MAYUR PARMAR BY GROUP NO. 3 ROLL NO. 15 – 20

TYPES OF CAPITAL

Two types of Capital are needed in the business enterprise—

Fixed Capital Working Capital

FIXED CAPITAL

WORKING CAPITAL Capital is also needed for short-term

purposes, i.e. meeting day to day operations.

Capital invested for this purpose is known as - Current Capital OR Working Capital

TWO CONCEPTS OF WORKING CAPITAL

Gross Working Capital Concept- Quantitative Aspect,

Net Working Capital Concept- Qualitative Aspect.

GROSS WORKING CAPITAL CONCEPT

Gross Working Capital is also known as‘Current Capital.

VALID REASONS FOR GROSS WORKING CAPITAL

Current Assets, Whatever may be the sources of acquisition, are used in activities relating to day-to-day operations and their forms keep on changing. Therefore, they should be considered as Working Capital.

NET WORKING CAPITAL CONCEPT

According to this concept Current Assets minus Current Liabilities is known as Working Capital.

W.C. = C.A.- C.L.Positive W.C.= C.A.> C.L. (company position is

sound) ANDNegative W.C. = C.A.< C.L. (it indicates financial

crisis)

Thus, the concept lays emphasis on qualitative aspect which indicates the liquidity position of the concern.

VALID REASONS FOR NET WORKING CAPITAL

The material thing in the long run is the surplus of current assets over current liabilities.

COMPONENTS OF WORKING CAPITAL

Working Capital as per Net Concept has two components-

1. Current Assets and,

2. Current Liabilities.

CURRENT ASSETS

Assets which can easily be converted into cash in the normal course of the business are known as current assets. These assets may include:-

1. Cash in hand or at Bank,2. Debtors and Bills Receivable,3. Stock or inventory of– raw materials, stores, and spares,

-- Works in Progress, -- Finished Goods.

4. Advance payments towards expenses, purchases and other short term advances.

5. Temporary investment of surplus funds.6. Accrued incomes.

One common characteristics of all the above items of current assets is that each component is swiftly transformed into other assets forms.

CURRENT LIABILITIES

A part of the need for the funds to finance the current assets may be met from supply of goods on credit and deferment, on account of custom, usage of arrangement of payment of expenses.

CURRENT LIABILITIES INCLUDES -

Typical items of Current Liabilities are—

1. Trade creditors i.e. goods purchased on credit and Bills Payable.

2. Outstanding and Accrued expenses.3. Short term borrowings.4. Taxes and Dividend payable.5. Advances received from parties against goods to be

sold to them or as short term deposits.6. Bank overdraft.7. Outstanding liabilities currently payable.

KINDS OF WORKING CAPITAL1. CORE, PERMANENT OR FIXED WORKING

CAPITAL.

2. FLUCTUATING OR VARIABLE WORKING CAPITAL.

FIXED OR PERMANENT WORKING CAPITAL

This is irreducible minimum amount necessary for maintaining the circulation of the current assets.

This is permanently locked up in the business and therefore, it is referred to fixed or Permanent Working Capital.

VARIABLE WORKING CAPITAL Variable working capital refers to that portion of

total working capital which is needed over and above fixed working capital.

Such need for Variable Working Capital arise on account of:-- Seasonal changes,- Abnormal and Unanticipated conditions,- To face tough conditions in the market,- To meet contingencies like strikes and lockouts,- Special Advertising Campaigns or other Promotional activities,

Are financed by variable working capital

Dr. Sudhendu G

iri

Apr

June

Aug Oct Dec Feb

0

10

20

30

40

50

60

70

80

90

100

Variable W.C.Permanent W.C.

Apr

June

Aug Oct Dec Feb

0

20

40

60

80

100

120

140

Variable W.C.Permanent W.C.

Firm “A” Steady Annual Sales Firm “B” Growth Situation

CURRENT ASSETS TO FIXED ASSETS RATIO The financial manager should determine

the optimum level of current assets so that the wealth of shareholders is maximized.

A firm needs fixed and current assets to support a particular level of output.

CURRENT ASSETS TO FIXED ASSETS RATIO A higher CA/FA ratio indicates a conservative current

assets policy. It implies greater liquidity and lower risk;

A lower CA/FA ratio means an aggressive current assets policy, it indicates higher risk and poor liquidity.

IMPORTANCE OF ADEQUATE WORKING CAPITALWorking capital is the life blood and

nerve centre of a business . Just as circulation of blood is essential in the human body for maintain life, working capital to maintain the smooth running of a business. The main advantages of maintaining adequate amount of working capital are as follows:

Solvency of the business: Adequate amount of working capital helps

in maintaining solvency of the business by providing uninterrupted flow of production.

Good will: Sufficient working capital enables a

business concern to make prompt payments and hence helps in creating and maintaining goodwill.

Regular supply of Raw material: Sufficient working capital ensures regular

supply of raw materials and continuous production.

Regular payment of salaries, wages &

other day commitments: A company which has ample working

capital can make regular payment of salaries, wages and other day-to-day commitments which rates the morale of its employees., increase their efficiency, reduces wastage and cost and enhances production and profits.

Quick & regular return on Investment:

Every investor wants a quick and regular return on his investments. Sufficiency of working capital enables a concern to pay quick and regular dividends to investors as there may not much pressure to plough back profits. This gain confidence of its investors and creates a favorable market to raise additional funds.

Cash discount: Adequate amount of working capital also

enables a concern to avail cash discount on the purchases and hence it reduces costs.

Easy loans: A concern having adequate amount of

working capital, having solvency and good credit standing can arrange loans from banks and others on easy and favorable term.

Ability to face crisis: Sufficient working capital enables a

concern to face business crisis in emergencies such as depression because during such periods, generally, there is much pressure on working capital.

Exploitation of favorable market conditions:

Only concern with adequate working capital can exploit favorable conditions such as purchasing its requirements in bulk when the prices are lower and by holding its inventories for higher prices.

EXCESS OR INADEQUATE WORKING CAPITAL

Disadvantage of redundant or excessive working capital

When there is a redundant working capital, it may lead to unnecessary purchasing and accumulation of inventories causing more chances of theft, waste and losses.

Excessive working capital means idle funds which earn no profits for the business and hence the business cannot earn a proper rate on its investments.

Excessive working capital implies excessive debtors and defective credit policies which may cause higher incidence of bad debts.

When there is excessive working capital, relations with banks and other financial institution may not be maintained.

Due to low rate of return on investments, the value of share may also fall.

Due to low rate of return on investments, the value of shares may also fall.

The redundant working capital gives rise to speculative transactions.

It may results into overall inefficiency in the organization.

Disadvantage or danger of inadequate working capital

A concern which has inadequate working capital cannot pay its short term liabilities in time. Thus, it will lose its reputation and shall not be able to get good credit facilities.

It cannot buy its requirements in bulk and cannot avail of discounts, etc.

It become difficult for the firm to exploit favorable market conditions and undertake profitable projects due to lack of working capital.

The firm cannot pay day-to-day expenses of its operations and it creates inefficiencies, increases costs and reduces the profits of the business.

It becomes impossible to utilizes the fixed assets due to non-availabilities of liquid funds.

The rate of return on investments also fall with the shortage of working capital.

THE NEED OR OBJECTS OF WORKING CAPITALo For the purchase of raw materials,

components and spares.o To pay wages and salaries.o To incur day-to-day expenses and overhead

costs such as fuel, power and office expenses, etc.

o To meet the selling costs as packing, advertising, etc.

o To provide credit facilities to the customers.o To maintain their inventories of raw

material, work-in-progress, stores and spares and finished socks.

FACTORS AFFECTING THE WORKING CAPITAL

REQUIREMENT

The working capital requirements of a concern depends upon a large number of factors such as nature & size of business , The character of there operation, The length of production cycle, The rate of stock turnover & The state of economic situation.

Following are important factors generally influencing the working capital requirements:

1. NATURE OR CHARACTER OF BUSINESS.2. SIZE OF BUSINESS.3. PRODUCTION POLICY.4. MANUFACTURING PROCESS.5. SEASONAL VARIATION.6. WORKING CAPITAL CYCLE.7. RATE OF STOCK TURNOVER.8. CREDIT POLICY.9. BUSINESS CYCLE.10. RATE OF GROWTH OF BUSINESS.11. EARNING CAPACITY.12. PRICE LEVEL CHANGE.13. OTHER FACTORS.

MANAGEMENT OF WORKING CAPITAL Working capital in general practice refer to

the excess of CA over CL. Management of working capital therefore is

concerned with the problems that arise in attempting to manage the CA, the CL and the inter-relationship that exists between them.

The basic goal of WCM is to manage the CA & CL of a firm in such a way that a satisfactory level of WC is maintained.

Working Capital Management Policies of a firm have a great effect on its profitability, liquidity and structural health of the organization

WORKING CAPITAL MANAGEMENT IS 3 DIMENSIONAL IN NATURE

Dimension IProfitability,

Risk, & Liquidity

Dimension II

Composition & Level

of CA

Dimension IIIComposition & Level

of CL

WORKING CAPITAL ISSUES

Assumptions 50,000 maximum

units of production

Continuous production

Three different policies for current asset levels are possible

Optimal Amount (Level) of Current Assets

0 25,000 50,000OUTPUT (units)

ASSE

T LE

VEL

Current Assets

Policy C

Policy APolicy B

IMPACT ON LIQUIDITY

Liquidity AnalysisPolicy Liquidity A High B Average C LowGreater current asset levels generate more

liquidity

Optimal Amount (Level) of Current Assets

0 25,000 50,000OUTPUT (units)

ASSE

T LE

VEL

Current Assets

Policy C

Policy APolicy B

IMPACT ON EXPECTED PROFITABILITY

Return on Investment =Net Profit

Total AssetsLet Current Assets = (Cash + Rec. + Inv.)

Return on Investment = Net Profit

Current + Fixed Assets

Optimal Amount (Level) of Current Assets

0 25,000 50,000OUTPUT (units)

ASSE

T LE

VEL

Current Assets

Policy C

Policy APolicy B

IMPACT ON EXPECTED PROFITABILITY

Profitability AnalysisPolicy Profitability A Low B Average C HighAs current asset levels

decline, total assets will decline and the ROI will

rise.

Optimal Amount (Level) of Current Assets

0 25,000 50,000OUTPUT (units)

ASSE

T LE

VEL

Current Assets

Policy C

Policy APolicy B

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 stockouts and lost sales. More risk!

Optimal Amount (Level) of Current Assets

0 25,000 50,000OUTPUT (units)

ASSE

T LE

VEL

Current Assets

Policy C

Policy APolicy B

IMPACT ON RISK

Risk AnalysisPolicy Risk A Low B Average C HighRisk increases as the level of current assets

are reduced.

Optimal Amount (Level) of Current Assets

0 25,000 50,000OUTPUT (units)

ASSE

T LE

VEL

Current Assets

Policy C

Policy APolicy B

SUMMARY OF THE OPTIMAL AMOUNT OF CURRENT ASSETS

SUMMARY OF OPTIMAL CURRENT ASSET ANALYSISPolicy 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!)

Dr. Sudhendu G

iri

OPERATING CYCLE APPROACH TO WORKING CAPITAL MANAGEMENT What has been considered in figure above as

working capital cycle is more popularly known as the operating cycle.

This title is more expressive in the sense that the normal business operations of a manufacturing and trading company start with cash, go through the successive segments of the operating cycle, viz, raw material storage period, conversion period, finished goods storage period and average collection period before getting back cash along with profit.

The total duration of all the segments mentioned above is known as ‘gross operating cycle period’.

Dr. Sudhendu G

iri

OPERATING CYCLEGross Operating Cycle =

Raw Material Storage Period + Conversion period + Finished Goods Storage Period + Average Collection Period

Net Operating Cycle = Gross Operating Cycle – Average Payment period

TECHNIQUES OF ANALYSIS OF WORKING CAPITAL

The analysis of working capital can be conducted through a number of devices such as

Ratio analysis Fund flow analysis Working capital Budgeting Ratio analysis : A ratio is a simple arithmetical

expression of the relationship of one number to another , this technique can be employed for measuring short term liquidity or working capital position of a firm.

THE FOLLOWING RATIOS MAY BE CALCULATED FOR THIS PURPOSE

Liquidity Ratioa) Current Ratiob) Acid test ratio/quick ratio/liquid ratio c) Cash Position ratio/absolute liquid ratio Inventory turnover ratio Receivable turnover ratio Payable turnover ratio Working capital turnover ratio

o Current ratio may be define as the relationship between CA and CL

o This ratio is also known as WCR. (Working capital ration).

o It is helpful to measure short – term financial position or liquidity of a firm

o Current ratio: Current asseto Current liabilities

CURRENT ASSETS CURRENT LIABILITIESCash in hand

Bills Payable Cash at bank Sundry Creditors

Sundry DebtorsAccrued or Outstanding

Expenses

Marketable securities (Short term)

Short term loan and advances

Bills Receivable Dividend payable Inventories of Stock Bank OverdraftWork in progress  Finished goods  Prepaid Expenses  

QUICK OR ACID TEST OR LIQUID RATIO An asset is said to be liquid if it can be convert

into cash with in a short period with out loss of value

Inventory cannot be termed to be liquid asset because they cannot be convert into cash immediately

The quick ratio can be calculated Quick ratio: liquid asset

Current liabilities

Quick or liquid Current Liabilities

Cash in hand Bills Payable

Cash at bank Sundry CreditorsSundry Debtors Accrued or Outstanding

Expenses

Marketable securities Short term advances

Temporary Investments Dividend payable

Bank Overdraft Income tax payable

Convection quick ratio of 1:1 is consider satisfactory

CASH POSITION RATIO/ABSOLUTE LIQUID RATIO Absolute Liquid assets include cash in hand

and cash at bank and marketable securities or temporary investments

The acceptable norms for this ratio is 50% or .05%

Cash ratio: Cash & bank + Short –term securities

Current liabilities

CALCULATE ALL THE THREE RATIOLiabilities Rs Assets Rs9% preference share 500000 Goodwill 100000Equity share capital 1000000

Land and building 650000

8% debentures 200000 Plant 800000

Long term loan 100000Furniture and fixtures 150000

Bills payable 60000 Bills receivable 70000Sundry creditors 70000 Sundry debtors 90000Bank over draft 30000 Bank balance 45000Outstanding expenses 5000

short term investments 25000

 Prepaid expenses 5000

  Stock 300001965000   1965000

CONCLUSION: o Current ratio of the company is not

satisfactory because the ratio 1:6 is much below then the expected Standards .

o Acid test ratio on the other hand is more than the normal standard of 1:1

o Absolute ratio is slightly low because it is 0.42 where as the accepted standard is 0.5

o In this company need to improve its short term financial position

CONT... Inventory conversion period Inventory conversion period = Days in a

year Inventory Turnover Ratio

Debtor/Receivable turnover ratio/Debtor velocity

Debtor(Receivable) = Net credit Annual sales

Average Trade debtors

AVERAGE COLLECTION PERIOD The average collection period represent the average

number of days for which a firm has to wait before its receivable are converted into cash

Average Collection period = Average Trade Debtors (Drs + B/R) Sales per day Sales Per day = Net Sales

No of working days

OrAverage collection period = average trade debtors * no. of net sales working daysIf period is in months : average collection period= no.of working days Debtors turnover ratioThe two basis component of the ratio are debtors

and sales per day

CREDITOR/PAYABLE TURNOVER RATIOThe analysis for credit turnover is basically the same as

of debtors turnover ratio except that in place of trade debtor, the trade creditor are taken and in place of sales , average daily purchase are taken as the other component of the ratio.

Creditors turnover ratio= Net credit annual purchase

Average Trade creditors

Average Payment period Ratio = Average Trade Creditors( Creditors+ Bills

payable)/Average Daily purchases.Average daily purchase = Annual Purchase /No of

working days in a year.Average Payment Period = Trade creditor * No of

working days / Net annual purchase. Average Payment Period = No of working days / Credit

turnover Ratio.

WORKING CAPITAL TURNOVER RATIOWorking capital of a concern is directly related to

sales and current asset like debtors , bills receivable , cash , stock etc .

Working capital turnover ratio = Cost of Sales / Average working capital

Average working capital = Opening working capital + Closing Working capital/2

** If cost of sales is not given , then the figure of sale can be used . O n the other hand if opening working capital is not disclosed then working capital at the end of the year will be used.

Cost of sale /Net working capital

Fund flow analysis : Fund flow analysis is a technical device designated to study the sources from which additional fund were derived and the use to which these sources were put . It is an effective management tool to study change in the financial position of business

The fund flow analysis consists of Preparing schedule of change in working capital Statement of sources and application of funds

Working capital Budgeting : Working capital budget as a part of total budgeting process of a business , is prepared estimating future long term and short term working capital need and the sources of finance them .

The objective of a working capital budget is to ensure availability of fund as and when needed and to ensure effective utilization of these resources .

WORKING CAPITAL FINANCING MIX

Approaches to Financing Mix

The Hedging or Matching Approach

The Conservative Approach

The Aggressive Approach

HEDGING APPROACH TO ASSET FINANCING

Fixed Assets

Permanent Current Assets

Total Assets

Fluctuating Current Assets

Time

Short-termDebt

Long-termDebt +EquityCapital

CONSERVATIVE APPROACH TO ASSET FINANCING

Fixed Assets

Permanent Current Assets

Total Assets

Fluctuating Current Assets

Time

Short-termDebt

Long-termDebt +Equity capital

Trade off between Hedging and

conservative approaches

AGGRESSIVE APPROACH TO ASSET FINANCING

Fixed Assets

Permanent Current Assets

Total Assets

Fluctuating Current Assets

Time

Short-termDebt

Long-termDebt +Equity capital