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Working Capital Decision

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Introduction:

Any business firm requires two types of assets-

long term and short assets. In investment

decision we studied that how a firm shouldselect the most profitable project to acquire

some capital assets or long term asset.

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Contd.

In financing decision making we discussed the

concepts of leverages, capital structure theories

and EBIT & EPs analysis through which we canhow the shareholders wealth can be increased.

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Contd.

In Dividend decision we acquired little bit

knowledge about the dividend policies; payout

and retention ratio and how a firm can increaseit market value of share at given EPS by making

change in payout ratio.

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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 fixedassts operative. The answer is Working Capital.

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Theory of Working Capital

Management:

Working capital represents the value of current assets inthe firm. The management of short term assets is soimportant 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 assetfrom 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 thepayments are certain.

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Contd.

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

The working capital management refers thematching of current assets and current liabilitiesto maintain long term assets and to payrespectable compensation to the long termfunds.

It establishes the relationship between currentassets and current liabilities. It should beadequately supplied to increase the wealth ofthe organization.

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Contd.

Working capital management involves two main

processes.

Determining the size of the working capital

Arranging the sources of working capital

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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

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Contd.

Business Cycle

Growth and Expansion

Supply of Raw Materials Price Level changes

Operating Efficiency

Profit Margin

Profit Appropriation Capital Structure

Monetary Policy

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Arranging the sources of

working capital:

It depends mainly upon the availability of fundsand different application of this working capital.

Current assets or working capital includesmainly three components

Inventories

Cash

ReceivablesSo, in short we can also say that the working

capital management means to manage all thesethree components in the firm.

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Contd.

Types of Working Capital: Theretwo 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

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Gross Working Capital:

It refers to the firms investment in current

assets which include mainly cash, short term

securities, and debtors, bills receivable andstock. The concept of the current assets is the

assets which can be converted in to cash within

one accounting year.

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Net Working Capital:

It refers to the difference between current assets

and current liabilities. Current liabilities are

those which are expected to mature for claimwithin one accounting year and which include

trade creditors, bills payables and outstanding

expenses.

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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 requiredmaintaining day to day operations of the firm.

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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.

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Contd.

The net working capital may be positive or

negative. Positive working capital shows the

surplus of current assets over current liabilitiesand negative shows deficiencies

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Determining the Financing mix

In working capital finance we will discuss two

things-

Sources of Working Capital

Approaches for determining the Financing Mix

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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

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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)

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Short Term Financing:

It includes following-

Short term bank loan (Bank Overdraft)

Commercial Papers (like bills hundies etc.)

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Spontaneous Financing:

This source of finance is cost free sources. It

includes following-

Trade Creditors

Outstanding Expenses etc.

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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

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Matching Approach or Hedge

Approach:

In this approach of financing the working capitalthe firm tries to finance the permanent working

capital through the long term funds andtemporary working capital through short termfunds. The concept behind this is that thematurity of source of funds should match the

nature of assets to be financed.

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Conservative Approach:

According this approach the whole amount of

working capital should be financed through the

long term funds. In this approach the firm doesnot want to take any risk. It is a costly approach

in comparison to matching approach.

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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 oftemporary working capital. But this approach is

more risky for the firm, however this the

cheapest approach.

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Planning of working capital

Every firm must maintain a sound workingcapital otherwise; its business activities may be

adversely affected. The objective of financial management i.e. to

maximize the wealth of the shareholder cannotbe attained if operations the firm are not

optimized. Thus, every firm has to maintain adequate

working capital. It should have neither theexcessive working capital nor inadequate

working capital.

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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 mayincrease but it is not necessary that the cash

profit may increase, because sales include

the cash and credit sales.

Cash sales increase the cash positionwhereas credit sales increase the

receivables.

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The collection of cash from receivablesrequire some times span. So, to meet outday to day expenses the firm needs some

sort of funds to run uninterrupted businessoperations, the amount will be locked up inthe current assets.

It happens due to operating cycles. The

need of working capital is based on thelength of operating cycles. The length ofoperating cycle depends mainly on thenature of business it self.

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Operating Cycle

Cash Raw material

Work in progress Finished

Goods Sales

Debtors Bills receivables

Cash

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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 finishedproduct to cash again.

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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.

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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).

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NOC = TOCP DP

or

NOC = ICP + RCP DPFor calculation of TOCP and NOC, variousconversion periods may be calculated as

follows:

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Average Raw Material StockRMCP = X 365

Total Raw Material Consumption

Average Work in Progress

WPCP = X 365

Total Cost of Production

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Average Finished Goods

FGCP = X 365

Total Cost of Goods SoldAverage Receivables

RCP = X 365

Total Credit Sales

Average Creditors

DP = X 365Total Credit Purchase

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On the basis of

above conversion

periods, TOCP and

NOC may beascertained as

follows.

Particulars Numbers of

Days

RMCP ..Days

+ WMCP ..Days

+ FGCP ..Days

+ RCP ..Days

TOCP ..Days

-DP ..Days

NOC ..Days

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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

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Example

Rs, In 000

Sales 3,000

Cost of Production 2,100

Purchase 600

Average Raw Material 80

Average Work in Progress 85Average Finished Goods 180

Average Creditor 90

Average Debtors 350

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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

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Problems Associated withExcess and InadequateWorking Capital:

This is very important aspect of workingcapital management that excessive as

well as inadequate working capital bothare harmful to the organization. Excessworking capital creates idle funds, whichcannot earn any return, whereas

shortages of working capital will hamperthe production process and other businessoperations. In both the situations firmhas to suffer loss.

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Demerits of ExcessiveWorking 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 baddebts will increase it such situation continues forlong time.

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

to speculative profit. This may tend to makedividend policy liberal, which may create seriousproblems in future.

Excessive availability of cash tempts theexecutive to spend more.

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Demerits of InadequateWorking 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 firms 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 facestight credit terms.

It directly affects the liquidity positions of the businessfirms.

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Management of cash

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Objectives

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Factors determining Cash needs,

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Motive for holding Cash

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Cash Budgeting as a tool

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Cash Reports for monitoring

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Receivable Management

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Objectives

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Credit Policies

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Terms and Collection Policies