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This PPT is an explanation of basic WCM

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  1. 1. Working Capital Management
  2. 2. Definition of Working Capital Working Capital refers to that part of the firm’s capital, which is required for financing short-term or current assets such a 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. KINDS OF WORKING CAPITAL WORKING CAPITAL BASIS OF BASIS OF CONCEPT TIME Gross Net Permanent Temporary Working Working / Fixed / Variable Capital Capital WC WC Seasonal Special WC WC Regular Reserve WC WC
  4. 4. Significance of Gross WC  Optimum investment in CA Investment in CA must be adequate CA investment should not be inadequate or excessive inadequate WC can disturb production and can also threaten the solvency of firm , if it fails to meet its current obligation excessive investment in CA should be avoided , since it impairs firms profitability  Financing of CA Need for WC arises due to increasing level of business activity & it is to provided quickly some time surplus fund may arises which should be invested in Short term securities , they should not be kept idle
  5. 5. Significance of Net Working Capital  Maintaining Liquidity position For maintaining liquidity position there is a need to maintain CA sufficiently in excess of CL  Judge Financial Soundness of a firm The Net working capital helps creditors and investors to judge financial soundness of a firm
  6. 6. BALANCE SHEET OF ABC COMPANY AS ON 31-3-2000 Liabilities R’s Assets R’s Equity Shares 200000 Goodwill 20000 8% Debentures 100000 Land and Building 150000 Reserve & Surplus 50000 Plant and Machinery 100000 Sundry Creditors 150000 Inventories Bills Payable 30000 Finished Goods 60000 Outstanding Expenses 20000 Work in process 40000 Bank Overdraft 50000 Prepaid Expenses 20000 Provision for Taxation 20000 Marketable Securities 60000 Proposed Dividend 30000 Sundry Debtors 90000 Bills Receivables 20000 Cash & Bank Balance 90000 TOTAL 650000 TOTAL 650000
  7. 7. Difference between permanent & temporary working capital Amount Variable Working Capital of Working Capital Permanent Working Capital Time Permanent and temporary working capital for Stable firm
  8. 8. Variable Working Capital Amount of Working Capital Permanent Working Capital Time Permanent and temporary working capital for Growing firm
  9. 9.  Operating cycle concept  Maximization of share holder’s wealth of a firm is possible only when there are sufficient return from the operations  Successful sales activity is necessary for earning profit sales do not convert into cash immediately  There is invisible time lap between the sale of good and receipt of cash  The time taken to convert raw material into cash is known as operating cycle  Conversion of cash into raw material  Conversion of raw material into work in progress  Conversion of Work in progress into finished goods  Conversion of finished good into Sales ( Debtors and cash )
  10. 10. Raw WIP Materials Operating Cycle in Finished Cash Manufacturing firm Goods Debtors SALES
  11. 11. Operating cycle of Non Manufacturing Firm Receivables cash Stock of finished goods
  12. 12. Formula for calculating Operating cycle for Manufacturing firm OC = ICP+ARP OC = Operating cycle ICP = Inventory Conversion period ARP = Account Receivable Period ICP = Average Inventory Cost of good sold /365 ARP = Average Account Receivable Sales/365
  13. 13.  ABC Company Provide the following information , Compute the operating cycle  Sales 3000 Lakhs  Inventory Opening R’s 610 Lakhs ; closing R’s 475 Lakhs  Receivable opening R’s 915 Lakhs; Closing R’s 975 Lakhs  Cost of Goods Sold R’s 2675 Lakhs
  14. 14. CASH CONVERSION CYCLE The amount of time a firm’s resources are tied up calculated by subtracting the average payment period from the operating cycle the time period between the date a firm pays its supplier and the date it receives cash from its customer CCC = OC – APP AAI = Average Inventory Cost of good sold /365 ARP = Average Account Receivable Annual Sales/365 APP = Account Payable Period Cost of good sold /365
  15. 15. Calculate CCC (CASH CONVERSION CYCLE)  Average use of Inventory 80 days  Account receivable collection period 50 days  Account payable period is 40 days CCC= OC- APP OC = AAI+ARP 80+50=130 CCC =130-40 =90 days
  16. 16. Purchase of Sale of Goods Collection of Raw Material on Credit Account Receivables On credit Average age of Account receivable Inventory (AII) period (ARP) Account Payable Period (APP) Payment to suppliers Receipt of Invoice Operating Cycle (OC) Cash Conversion cycle
  17. 17. Resource flows for a manufacturing firm Used in Accrued Direct Accrued Fixed Used in Labour and Operating Production materials expenses Process Used to Working purchase Generates Capital cycle Cash and Inventory Marketable Securities Used to Collection purchase Via Sales Generator process Fixed External Financing Assets Return on Capital Accounts receivable Suppliers Of Capital
  18. 18. Calculate cash conversion cycle  Sales R’s 1587.95  Cost of Good sold R’s 1406.27  Inventory opening 195.82, closing 202.29  Account receivables opening 423.03 closing 449.46  Account payable opening 140.40, closing 168.33 CCC = OC –APP OC = AAI + ARP
  19. 19. FORECASTING / ESTIMATION OF WORKING CAPITAL REQUIREMENTS Factors 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
  20. 20. PROFORMA - WORKING CAPTIAL ESTIMATES 1. TRADING CONCERN STATEMENT OF WORKING CAPITAL REQUIREMENTS Amount (Rs.) Current Assets (i) Cash ---- (ii) Receivables ( For…..Month’s Sales)---- ---- (iii) Stocks ( For……Month’s Sales)----- ---- (iv)Advance Payments if any ---- Less : Current Liabilities (i) Creditors (For….. Month’s Purchases)- ---- (ii) Lag in payment of expenses -----_ WORKING CAPITAL ( CA – CL ) xxx Add : Provision / Margin for Contingencies ----- NET WORKING CAPITAL REQUIRED XXX
  21. 21. 1. MANUFACTURING CONCERN STATEMENT OF WORKING CAPITAL REQUIREMENTS Amount (Rs.) Current Assets (i) Stock of R M( for ….month’s consumption) ----- (ii)Work-in-progress (for…months) (a) Raw Materials ----- (b) Direct Labour ----- (c) Overheads ----- (iii) Stock of Finished Goods ( for …month’s sales) (a) Raw Materials ----- (b) Direct Labour ----- (c) Overheads ----- (iv) Sundry Debtors ( for …month’s sales) (a) Raw Materials ----- (b) Direct Labour ----- (c) Overheads ----- (v) Payments in Advance (if any) ----- (iv) Balance of Cash for daily expenses ----- (vii)Any other item ----- Less : Current Liabilities (i) Creditors (For….. Month’s Purchases) ----- (ii) Lag in payment of expenses ----- (iii) Any other ----- WORKING CAPITAL ( CA – CL )xxxx Add : Provision / Margin for Contingencies ----- NET WORKING CAPITAL REQUIRED XXX
  22. 22. Prepare an estimate of Working capital requirement from the following information of a trading concern: Projected annual sales 100000 units Selling price R’s 8 per unit % age of Net profit on sales 25% Average Credit Period allowed to customer 8 weeks Average Credit Period allowed by supplier 4 weeks Average stock holding in terma of sales requirement 12 weeks contingencies 10%
  23. 23. Points to be remembered while estimating WC  (1) Profits should be ignored while calculating working capital requirements for the following reasons.  (a) Profits may or may not be used as working capital  (b) Even if it is used, it may be reduced by the amount of Income tax, Drawings, Dividend paid etc.  (2) Calculation of WIP depends on the degree of completion as regards to materials, labour and overheads. However, if nothing is mentioned in the problem, take 100% of the value as WIP. Because in such a case, the average period of WIP must have been calculated as equivalent period of completed units.  (3) Calculation of Stocks of Finished Goods and Debtors should be made at cost unless otherwise asked in the question.
  24. 24. Prepare statement of working capital requirement, Profit &Loss A/C, Balance Sheet Assuming  Share Capital 150000  8% Debentures 200000  Fixed asset 130000  Material 40%  Direct lab our 20%  Overheads 20%
  25. 25. The following further particular are available  It is proposed to maintain a level of activity of 2,00,000 units  Selling price is R’s 12/- per unit  Raw Material are expected to remain in stores for an average period of one month  Material will be in process , on average half a month  Finished goods are required to be in stock for an average period of one month  Credit allow to debtors is two month  Credit allow by supplier is one month
  26. 26. Working Capital Financing Mix Approaches to Financing Mix The Hedging or The Conservative The Aggressive Matching Approach Approach Approach
  27. 27. Hedging approach to asset financing Total Assets Short-term Debt Fluctuating Current Assets Long-term Permanent Current Assets Debt + Equity Capital Fixed Assets Time
  28. 28. The Hedging approach  Hedging approach refers to a process of matching maturities of debt with the maturities of financial need . In this approach maturity of source of fund should match the nature of asset to be financed  This approach is also known as matching approach.  The hedging approach suggests that the permanent working capital requirement should be financed with fund from long term sources while the temporary working capital requirement should be financed with short term funds.
  29. 29. Estimated Total Investment in Current Asset of company X for the year 2000 Permanent or Investment Fixed Temporary in Current Asset Investments or seasonal Invest Month (R's ) (R's) (R's) January 50400 45000 5400 February 50000 45000 5000 March 48700 45000 3700 April 48000 45000 3000 May 46000 45000 1000 June 45000 45000 - July 47500 45000 2500 August 48000 45000 3000 September 49500 45000 4500 October 50700 45000 5700 November 52000 45000 7000 December 48500 45000 3500 TOTAL 44300
  30. 30. Conservative Approach  This approach suggested that the entire estimated investments in current asset should be finance from long term source and short term should be use only for emergency requirement  Distinct features of this approach  Liquidity is greater  Risk is minimized  The cost of financing is relatively more as interest has to be paid even on seasonal requirement for the entire period
  31. 31. Conservative approach to asset financing Total Assets Short-term Debt Fluctuating Current Assets Long-term Permanent Current Assets Debt + Equity capital Fixed Assets Time
  32. 32. Trade off between Hedging and conservative approaches  The hedging approaches implies low cost , high profit and high risk while the conservative approach leads to high cost , low profit , low risk Both the approaches are the two extreme and neither of them serve the purpose of efficient working capital management  A trade off between the two will then be an acceptable approach , One way of determining the trade off is by finding the AVG of maximum and minimum requirement of current asset or working capital
  33. 33. Aggressive approach to asset financing Total Assets Short-term Debt Fluctuating Current Assets Long-term Permanent Current Assets Debt + Equity capital Fixed Assets Time
  34. 34. Aggressive approach  The aggressive approach suggests that the entire estimated requirement of current asset should be financed from short-term sources and even a part of fixed asset investment be financed from short - term sources This approach make the finance mix :  More Risky  Less costly  More Profitable
  35. 35. Prepare a projected balance sheet , profit and loss a/c and then an estimation of working capital .  Issued Share Capital 300000  6% Debentures 200000  Fixed asset 200000  Raw Material 50%  Lab our 20%  Overheads 20%  Profit 10%  There is a regular production and sales cycle
  36. 36.  Raw Material are kept in stores for an average period of two month  Finished goods remain in stock for an average period of three month  Production during the previous year was 180000 units and it is planned to maintain the same in the current year also  Each unit of production is expected to be in process for half a month  Credit allow to customer is three month and given by supplier is two month  Selling price is Rs 4 per unit  Calculation of debtors may be made at selling price
  37. 37. 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
  38. 38. Working capital management is 3 dimensional in Nature Dimension I Profitability, Risk, & Liquidity
  39. 39. Working Capital Issues Optimal Amount (Level) of Current Assets Assumptions  50,000 maximum units Policy A of production Policy B ASSET LEVEL  Continuous production Policy C  Three different policies for current asset levels Current Assets are possible 0 25,000 50,000 OUTPUT (units)
  40. 40. Impact on Liquidity Optimal Amount (Level) of Current Assets Liquidity Analysis Policy Liquidity Policy A A High Policy B B Average ASSET LEVEL Policy C C Low Current Assets Greater current asset levels generate more liquidity; all other factors held constant. 0 25,000 50,000 OUTPUT (units)
  41. 41. Impact on Expected Profitability Optimal Amount (Level) of Current Assets Return on Investment = Policy A Net Profit Total Assets ASSET LEVEL Policy B Let Current Assets = (Cash + Policy C Rec. + Inv.) Current Assets Return on Investment = Net Profit Current + Fixed Assets 0 25,000 50,000 OUTPUT (units)
  42. 42. Impact on Expected Profitability Optimal Amount (Level) of Current Assets Profitability Analysis Policy Profitability Policy A A Low Policy B B Average ASSET LEVEL Policy C C High Current Assets As current asset levels decline, total assets will decline and the ROI will rise. 0 25,000 50,000 OUTPUT (units)
  43. 43. Impact on Risk Optimal Amount (Level) of Current Assets  Decreasing cash reduces the firm’s ability to meet its Policy A financial obligations. More Policy B ASSET LEVEL risk!  Stricter credit policies reduce Policy C receivables and possibly lose sales and customers. More risk! Current Assets  Lower inventory levels increase stockouts and lost sales. More risk! 0 25,000 50,000 OUTPUT (units)
  44. 44. Impact on Risk Optimal Amount (Level) of Current Assets Risk Analysis Policy Risk Policy A A Low Policy B B Average ASSET LEVEL Policy C C High Current Assets Risk increases as the level of current assets are reduced. 0 25,000 50,000 OUTPUT (units)
  45. 45. Summary of the Optimal Amount of Current Assets SUMMARY OF OPTIMAL CURRENT ASSET ANALYSIS Policy 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!)
  46. 46. 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.
  47. 47. The following ratios may be calculated for this purpose  Liquidity Ratio a) Current Ratio b) 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
  48. 48.  Current ratio may be define as the relationship between CA and CL  This ratio is also known as WCR. (Working capital ration).  It is helpful to measure short – term financial position or liquidity of a firm Current ratio: Current asset Current liabilities
  49. 49. CURRENT ASSETS CURRENT LIABILITIES Cash in hand Bills Payable Cash at bank Sundry Creditors Accrued or Outstanding Sundry Debtors Expenses Marketable securities Short term loan and (Short term) advances Bills Receivable Dividend payable Inventories of Stock Bank Overdraft Work in progress Finished goods Prepaid Expenses
  50. 50. 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
  51. 51. Quick or liquid Current Liabilities Cash in hand Bills Payable Cash at bank Sundry Creditors Accrued or Outstanding Sundry Debtors Expenses Short term advances Marketable securities Temporary Investments Dividend payable Bank Overdraft Income tax payable Convection quick ratio of 1:1 is consider satisfactory
  52. 52. 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
  53. 53. Calculate all the three ratio Liabilities Rs Assets Rs 9% preference share 500000 Goodwill 100000 Equity share capital 1000000 Land and building 650000 8% debentures 200000 Plant 800000 Furniture and Long term loan 100000 fixtures 150000 Bills payable 60000 Bills receivable 70000 Sundry creditors 70000 Sundry debtors 90000 Bank over draft 30000 Bank balance 45000 Outstanding short term expenses 5000 investments 25000 Prepaid expenses 5000 Stock 30000 1965000 1965000
  54. 54. CONCLUSION:  Current ratio of the company is not satisfactory because the ratio 1:6 is much below then the expected Standards .  Acid test ratio on the other hand is more than the normal standard of 1:1  Absolute ratio is slightly low because it is 0.42 where as the accepted standard is 0.5  In this company need to improve its short term financial position
  55. 55. Inventory turnover ratio Inventory turn over ratio = Cost of good sold Average Inventory at cost Generally , the cost of good sold may not be known from the published financials , in such circumstances Inventory turn over ratio = Net Sales Average Inventory at cost Inventory turn over ratio = Cost of good sold Average Inventory at selling price
  56. 56. Inventory conversion period Inventory conversion period = Days in a year Inventory Turnover Ratio M/s Rakesh & Co supplies you the following information for the year ending 31st Dec 1999 Credit Sales Rs 150000 Cash Sales Rs 250000 Return Inward Rs 25000 Opening Stock Rs 25000 Closing Stock Rs 35000
  57. 57. Debtor/Receivable turnover ratio /Debtor velocity Debtor(Receivable) = Net credit Annual sales Average Trade debtors Trade debtors = Sundry debtor + Bill Receivable and account receivable s Average Trade Debtors = Opening Trade debtor + Closing Trade Debtor /2 Note : Debtor should always be taken at gross value , No provision for doubtful debt be deducted from them but when the information about opening and closing balance of trade debtor and credit sales is not available , then the debtors turnover ratio calculated by dividing the total sales by the balance of debtors(inclusive of Bills receivables) given Debtors turn over Ratio = Total sales Debtors
  58. 58. 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
  59. 59. Or Average collection period =Average trade debtors Net Sales No of working days If the period is in months: Average collection period =No of working days Debtors turnover ratio The two basis component of the ratio are debtors and sales per day
  60. 60. Creditor/Payable turnover ratio The 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
  61. 61. 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.
  62. 62. Working capital turnover ratio Working 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.
  63. 63. The following information is given about M/s S.P Ltd for the year ending Dec 31 2000  Stock turnover ratio = 6times  Gross Profit ratio = 20% on sales  Sales for 2000 = Rs 300000  Closing stock is Rs 10000 more than the opening stock  Opening Creditors = Rs 20000  Closing Creditors = Rs 30000  Trade debtor at the end = Rs 60000  Net Working Capital = Rs 50000
  64. 64.  FIND OUT  Average Stock  Purchases  Credit turnover ratio  Average Payment Period  Average Collection Period  Working Capital turnover ratio
  65. 65. 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
  66. 66.  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 .