Working Capital Management

BY

Punit K Dwivedi

Introduction:

Any business firm requires two types of assets- long term and short assets.

In investment decision we studied that how a firm should select the most profitable project to acquire some capital assets or long term asset.

Meaning and Concept of WC

Funds invested in Current Assets. Means investment in Stocks,sundry

debtors,cash and other Current Assets. The requirement of current assets are usually

greater than the amount of funds payable through current liabilities. In other words,the

Current assets are to be kept at a higher level than the Current Liabilities.

Contd.

In financing decision making we discussed the concepts of leverages, capital structure theories and EBIT & EPS analysis through which we can how the shareholders wealth can be increased.

Contd.

In Dividend decision we acquired little bit knowledge about the dividend policies; payout and retention ratio and how a firm can increase it market value of share at given EPS by making change in payout ratio.

Contd.

Now, all this may happen in any business if it can run smoothly. The question is what is essential to run a business or to make fixed assts operative ?

The answer is Working Capital.

Theory of Working Capital Management:

Working capital represents the value of current assets in the firm.

The management of short term assets is so important for a firm that it can survive only after keeping adequate level of short term assets.

The working capital plays a role in business firm like a lubricants and fuel in automobile. It converts an asset from non productive to productive one and vice-versa.

It applies for all the factors of production. In every business the receipts are uncertain where as the payments are certain.

Contd.

So, to fill this gap,a firm needs optimum quantity of working capital.

The working capital management refers the matching of current assets and current liabilities to maintain long term assets and to pay respectable compensation to the long term funds.

It establishes the relationship between current assets and current liabilities. It should be adequately supplied to increase the wealth of the organization.

Contd.

Working capital management involves two main processes.

Determining the size of the working capital Arranging the sources of working capital

Determining the size of the working capital:

It is determined on the basis of certain factors, like – Nature of Industry Size of Business Manufacturing Cycle Production Policy Volume of Sales Terms of purchase & Sales

Contd.

Business Cycle Growth and Expansion Supply of Raw Materials Price Level changes Operating Efficiency Profit Margin Profit Appropriation Capital Structure Monetary Policy

Arranging the sources of working capital:

It depends mainly upon the availability of funds and different application of this working capital. Current assets or working capital includes mainly three components

Inventories Cash ReceivablesSo, in short we can also say that the working

capital management means to manage all these three components in the firm.

Contd.

Types of Working Capital: There two broad classifications of the working capital. Gross Working Capital Net Working Capital

There are two more classifications which are also very important. Permanent Working Capital Temporary Working Capital

Gross Working Capital:

It refers to the firm’s investment in current assets which include mainly cash, short term securities, and debtors, bills receivable and stock.

The concept of the current assets is the assets which can be converted in to cash within one accounting year.

Net Working Capital:

It refers to the difference between current assets and current liabilities.

Current liabilities are those which are expected to mature for claim within one accounting year and which include trade creditors, bills payables and outstanding expenses.

Permanent Working Capital:

It refers to the amount of working capital which is required by the firm every time.

It shows the minimum level of working capital which required maintaining day to day operations of the firm.

Temporary Working Capital:

It is required by the when while some changes in production or sales volume or change in the price level of any factors of production.

Contd.

The net working capital may be positive or negative.

Positive working capital shows the surplus of current assets over current liabilities and

Negative shows deficiencies

Determining the Financing mix

In working capital finance we will discuss two things-

Sources of Working Capital Approaches for determining the Financing

Mix

Sources of Working Capital:

On the basis of sources, we can classify it in to three broad categories-

Long Term Financing Short Term Financing Spontaneous Financing

Long Term Financing:

It includes the following Term loans from financial institutions Issue of Debentures Issue of Shares Accepting Public Deposit Internal Financing (Retained Earnings)

Short Term Financing:

It includes following- Short term bank loan (Bank Overdraft) Commercial Papers (like bills hundies etc.)

Spontaneous Financing:

This source of finance is cost free sources. It includes following-

Trade Creditors Outstanding Expenses etc.

Approaches for determining the Financing Mix:

There are following three types of approaches to finance the working capital

Matching Approach or Hedge Approach Conservative Approach Aggressive Approach

Matching Approach or Hedge Approach:

In this approach of financing the working capital the firm tries to finance the permanent working capital through the long term funds and temporary working capital through short term funds.

The concept behind this is that the maturity of source of funds should match the nature of assets to be financed.

Conservative Approach:

According this approach the whole amount of working capital should be financed through the long term funds. In this approach the firm does not want to take any risk.

It is a costly approach in comparison to matching approach.

Aggressive Approach:

Under this approach the firm uses the short term funds to finance some part of permanent working capital and the whole of part of temporary working capital.

But this approach is more risky for the firm, however this the cheapest approach.

Planning of working capital

Every firm must maintain a sound working capital otherwise; its business activities may be adversely affected.

The objective of financial management i.e. to maximize the wealth of the shareholder cannot be attained if operations the firm are not optimized.

Thus, every firm has to maintain adequate working capital. It should have neither the excessive working capital nor inadequate working capital.

Need To increase operating profit, the firm should

increase its sales. In practical life it has been seen that when

firm increases its sales the profit may increase but it is not necessary that the cash profit may increase, because sales include the cash and credit sales.

Cash sales increase the cash position whereas credit sales increase the receivables.

….Need The collection of cash from receivables

require some times span. So, to meet out day to day expenses the firm needs some sort of funds to run uninterrupted business operations, the amount will be locked up in the current assets.

It happens due to operating cycles. The need of working capital is based on the length of operating cycles. The length of operating cycle depends mainly on the nature of business it self.

Operating CycleCash Raw material

Work in progress Finished

Goods Sales Debtors Bills receivables

Cash  

Concept and Computation of Operating Cycle:

The operating cycle concept refers to the time lag, which is required to convert the raw material in to finished products and finished product to cash again.

Computation of Operating Cycle

The Total Operating Cycle Period (TOCP) will be equal to Inventory Conversion Period (ICP) + Receivable Conversion Period (RCP).

The firm might get some credit form supplier of raw material, wages earners etc.

…Cont.

The period for which the payments to these parties are delayed or deferred is known as Deferred Period (DP).

The Net Operating Cycle (NOC) of the firm may be calculated by deducting Deferred Period (DP) from the Total Operating Cycle Period (TOCP).

NOC = TOCP – DP

or

NOC = ICP + RCP – DP

For calculation of TOCP and NOC, various conversion periods may be calculated as follows:

Average Raw Material Stock

RMCP = X 365

Total Raw Material Consumption

Average Work in Progress

WPCP = X 365

Total Cost of Production

Average Finished GoodsFGCP = X 365

Total Cost of Goods Sold Average Receivables

RCP = X 365Total Credit Sales

Average CreditorsDP = X 365

Total Credit Purchase

On the basis of above conversion periods, TOCP and NOC may be ascertained as follows.

Particulars Numbers of Days

RMCP ……..Days

+ WMCP ……..Days

+ FGCP ……..Days

+ RCP ……..Days

TOCP ……..Days

-DP ……..Days

NOC ……..Days

RMCP Raw Material Conversion Period

+ WMCP Work in Progress Conversion Period

+ FGCP Finished Goods Conversion Period

+ RCP Receivables Conversion Period

TOCP Total Operating Cycle Period

-DP Deferred Period

NOC Net Operating Cycle

Example

Rs, In 000

Sales 3,000

Cost of Production 2,100

Purchase 600

Average Raw Material 80

Average Work in Progress 85

Average Finished Goods 180

Average Creditor 90

Average Debtors 350

Solution:

Particulars Numbers of Days

RMCP 49 Days

+ WMCP 15 Days

+ FGCP 31 Days

+ RCP 43 Days

TOCP 138 Days

-DP 55 Days

NOC 83 Days

Problems Associated with Excess and Inadequate Working Capital:

This is very important aspect of working capital management that excessive as well as inadequate working capital both are harmful to the organization. Excess working capital creates idle funds, which cannot earn any return, whereas shortages of working capital will hamper the production process and other business operations. In both the situations firm has to suffer loss.

Demerits of Excessive Working Capital

There may be following problems It can accumulate unnecessary inventories. Thus chance

of mishandling, theft, wastage of inventories may occur. It also indicates poor collection of receivable and very

liberal credit policy regarding sales. The bad debts will increase it such situation continues for long time.

It allows to the management to inefficiently Accumulation of excessive inventories also leads to

speculative profit. This may tend to make dividend policy liberal, which may create serious problems in future.

Excessive availability of cash tempts the executive to spend more.

Demerits of Inadequate Working Capital:

There may be following problems- It becomes difficult for the firms to undertake profitable projects due

to shortage of working capital. The firm may face problems in implementing the operating plans

and achieve the firm’s profit target. It also creates problem in meeting out day-to-day or routine

expenses. Fixed assets can be utilized more effectively, thus the overall return

may go down. Due to inadequate working capital firm may loose some good credit

opportunities The firm may spoil its fame and reputation if it fails to honour short-

term obligations. As a result, the firm faces tight credit terms. It directly affects the liquidity positions of the business firms.