Sanjay kothari

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Sanjay kothari

  1. 1. WORKING CAPITAL FINANCE CA. SANJAY KOTHARI
  2. 2. DEFINITION Working Capital refers to that part of the firm’s capital, which is required for financing short- term or current assets such as cash marketable securities, debtors and inventories. Funds thus, invested in current assets keep revolving fast and are constantly converted into cash and this cash flow out again in exchange for other current assets. Working Capital is also known as revolving or circulating capital or short-term capital.
  3. 3. FACTORS DETERMINING WORKINGCAPITAL Nature of the Production Cycle Industry Credit control Demand of Industry Inflation or Price Cash requirements level changes Nature of the Profit planning and Business control Manufacturing time Repayment ability Volume of Sales Cash reserves Terms of Purchase Operation efficiency and Sales Change in Technology Inventory Turnover Firm’s finance and Business Turnover dividend policy Business Cycle Attitude towards Risk Current Assets requirements
  4. 4. WORKING CAPITAL CYCLE Cash Debtors RM Sales WIP FG
  5. 5. TIME AND MONEY CONCEPTS INWORKING CAPITAL CYCLE Each component of working capital (namely inventory, receivables and payables) has two dimensions ........TIME ......... and MONEY, when it comes to managing working capital. You can get money to move faster around the cycle or reduce the amount of money tied up. Then, business will generate more cash or it will need to borrow less money to fund working capital. As a consequence, you could reduce the cost of bank interest or youll have additional free money available to support additional sales growth or investment. Similarly, if you can negotiate improved terms with suppliers e.g. get longer credit or an increased credit limit, you effectively create free finance to help fund future sales.
  6. 6. If you Then ......Collect receivables You release cash from the(debtors) faster cycleCollect receivables Your receivables soak up(debtors) slower cashGet better credit (in terms You increase your cashof duration or amount) resourcesfrom suppliersShift inventory (stocks) You free up cashfasterMove inventory (stocks) You consume more cashslower
  7. 7. TYPE OF WORKING CAPITAL Concept Basis Gross WC Net WC Time Basis Permanent/Fixed WC Regular WC Reserve WC Temporary/variable WC Seasonal WC Special WC
  8. 8. SOURCES OF WORKING CAPITAL Sources of working capital are: Owned fund (Equity, Reserves, etc.) Bank borrowings(Cash Credit, Packing Credit, B/D, L/C) Sources of additional working capital include the following: Existing cash reserves Profits (when you secure it as cash !) Payables (credit from suppliers) New equity or loans from shareholders Bank overdrafts or lines of credit Long-term loans
  9. 9. METHODS OF ASSESSMENT OF WORKINGCAPITAL TURNOVER METHOD Mainly used for small trading companies Not appropriate for manufacturing and big trading companies CASH BUDGET SYSTEM Mainly used for service sector companies Cash inflow – Cash outflow = Bank finance in form of WC TONDON COMMITTEE RECOMMENDATIONS Out of 3 methods recommended, method II also known as Maximum Permissible Bank Finance (MPBF) is mainly used by the banks for assessment of WC finance
  10. 10. CREDIT MONITORING ARRANGEMENT(CMA) CMA data is a tool used by the bankers to assess the requirement of working capital. It is divided into six parts as follows:Form I Particulars of Existing & Proposed LimitsForm II Operating StatementForm III Analysis of Balance SheetForm IV Comparative Statement of Current Assets & Current LiabilitiesForm V Computation of Maximum Permissible Bank Finance (MPBF)Form VI Funds Flow Statement
  11. 11. KEY RATIO LEVELSPARTICULARS LOW RISK MEDIUM RISK HIGH RISKCurrent Ratio > 1.40 1.20 - 1.40 < 1.20 11TOL/TNW < 2.00 2.00 - 3.50 < 3.50Interest Coverage > 3.50 2.00 - 3.50 < 2.00PAT/SALES% > 10.00 4.00 - 10.00 < 4.00Inventory (No. of days) < 60 60 - 90 > 90Debtors (No. of days) < 45 45 - 90 > 90Debt – Equity Ratio < 1.25 1.25 - 1.75 > 1.75DSCR (For TL) > 2.00 1.25 - 2.00 < 1.25
  12. 12. FORECASTING/ESTIMATION OF WORKINGCAPITAL REQUIREMENTFactors to be considered Total costs incurred on materials, wages and overheads The length of time for which raw materials remain in stores before they are issued to production. The length of the production cycle or WIP, i.e., the time taken for conversion of RM into FG. The length of the Sales Cycle during which FG are to be kept waiting for sales. The average period of credit allowed to customers. The amount of cash required to pay day-to-day expenses of the business. The amount of cash required for advance payments if any. The average period of credit to be allowed by suppliers. Time – lag in the payment of wages and other overheads
  13. 13. WORKING CAPITAL PRODUCTS Fund based Domestic Cash Credit Overdraft facility Bill Discounting Export Preshipment Credit Post shipment Credit Non-fund based Letter of credit Bank Guarantee
  14. 14. SPECIAL SITUATIONS CYCLICAL PRODUCTION/SALES PHASED EXPANSION PROGRAMS EXPANSION PROGRAMS WITH ENHANCEMENT IN EXISTING LIMITS MAJOR ORDERS ENHANCEMENT DURING THE YEAR SHORT TERM FUND USED FOR ACQUISITION OF LONG TERM ASSETS DRAWING POWER NOT ALLIGNED TO MPBF DEVALUATION / EROSION OF CURRENT ASSETS
  15. 15. STRUCTURED WORKING CAPITALPRODUCTS Commercial Paper Corporate Loan Suppliers/ Buyers Credit Securitisation of receivables Factoring Forfeiting
  16. 16. IMPORTANCE OF ADEQUATE WORKINGCAPITAL Every business concern should have adequate working capital to run its business operations. It should have neither redundant or excess working capital nor inadequate or shortage of working capital. Both excess as well as shortage of working capital situations are bad for any business. However, out of the two, inadequacy or shortage of working capital is more dangerous from the point of view of the firm.
  17. 17. DISADVANTAGE OF INADEQUATEWORKING CAPITAL Idle funds, non-profitable for business, poor ROI. Unnecessary purchasing & accumulation of inventories over required level. Excessive debtors and defective credit policy, higher incidence of B/D. Overall inefficiency in the organization. When there is excessive working capital, Credit worthiness suffers. Can’t pay off its short-term liabilities in time. Economies of scale are not possible. Difficult for the firm to exploit favourable market situations. Day-to-day liquidity worsens . Improper utilization the fixed assets and ROA/ROI falls sharply. Due to low rate of return on investments, the market value of shares may fall.
  18. 18. OVERTRADINGTrying to operate without adequate working capital. Itis often caused by an expansion in credit sales, andthus in trade receivables. This causes a shortage ofcash.Early warning sign of overtrading include: Pressure on existing cash Exceptional cash generating activities e.g. offering high discounts for early cash payment Bank overdraft exceeds authorized limit Seeking greater overdrafts or lines of credit Part-paying suppliers or other creditors Paying bills in cash to secure additional supplies Management pre-occupation with surviving rather than managing Frequent short-term emergency requests to the bank (to help pay wages, pending receipt of a cheque Declining liquidity ratio
  19. 19. CURING OVERTRADINGOvertrading may be cured or reduced by: Borrowing or increasing in capital to increase current assets Sale of non-trading assets Tightening terms of credit granted to customers Negotiating longer credit terms from major suppliers.
  20. 20. CASH FLOW STATEMENT –BACKBONE OFGROWTH Regular cash flow are the backbone of long-term growth and sustainability. It highlight the strength of the company’s business model in meeting its working capital and capex requirements, coupled with its ability to ensure orderly operations even during a cyclical downturn. A company with healthy operating cash flow is in a position to plough this cash into its projects/wc cycle. It can thus grow at a steady space, compared to the companies that mostly rely on external sources to fund their growth. This was on display during the credit crisis last year, which put the future of companies with poor cash flows in doubt. It may be possible that company reports very good earnings but it may not be generating sufficient cash. Cash flow can be negative while profitability is positive. Income statement and cash flow statement should be analyzed to assess the operational efficiency of the company
  21. 21. SIGN OF POTENTIAL LIQUIDITYPROBLEMS Buildup of inventories and declining inventory turnover. Increases in debt and debt ratios. Increases in costs that cannot be passed on. Increases in accounts receivables and collection periods. Decline in net working capital and daily cash flows.
  22. 22. NECESSITY TO EFFECTIVELY MANAGEWORKING CAPITAL Working capital doesnt come free -- there is an opportunity cost (returns that it could have generated from any other avenue) besides the interest burden due to the short-term bank borrowings. This cost can be substantial during an economic slowdown, when a companys inventories and receivables rise, bloating current assets. But current liabilities do not rise in proportion to current assets, since creditors tend to shy away at such times. It becomes more expensive to finance working capital, and profits are hit to that extent.
  23. 23. ADVANTAGE OF EFFECTIVEMANAGEMENT OF WORKING CAPITAL The important thing for a shareholder is how well the working capital is managed. Though measured at a point of time, it still says a lot about how healthy a companys revenues are. In last 2 years, companies that managed their working capital well have reported relatively strong profits, and their shareholders have been rewarded with capital appreciation despite an overall trend of declining share prices. Others, especially commodity producers and companies whose products face cyclical demand, have floundered.
  24. 24. IMPACT ON STOCK VALUATIONS As there is a cost associated with working capital, a company that can generate more revenues from a specified amount of working capital than others will eventually be more profitable, with better cash flows and will command superior valuation. Most commodity-based companies are capital-intensive and have high working capital requirements. Their business is cyclical in nature, which puts an additional burden on the working capital when the chips are down. That explains why these companies are not able to extract a higher valuation from the stock markets. Also, with piling receivables and inventories, cash inflows are affected. This can lead to problems in paying large cash outflows like interest and dividend. Many companies can do nothing other than use their long-term funds to finance this shortfall -- which can also lead to falling profits. Companies that prefer to maintain low levels of working capital score well on working capital turnover ratio (Net sales / Net working capital).Though this level varies with the nature and scale of operations, the stock market attaches a premium to companies with low working capital requirements. Likewise, a company with a high working capital turnover ratio vis-a-vis its peers tends to get a higher price to earnings (PE) ratio.
  25. 25. CONCLUSIONAny change in the working capital will have aneffect on a businesss cash flows. A positive changein working capital indicates that the business haspaid out cash, for example in purchasing orconverting inventory, paying creditors etc. Hence,an increase in working capital will have a negativeeffect on the businesss cash holding. However, anegative change in working capital indicates lowerfunds to pay off short term liabilities (currentliabilities), which may have bad repercussions tothe future of the company.

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