Working capital management

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basic principles of working capital management

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Working capital management

  1. 1. BY-
  2. 2. DEFINING WORKING CAPITAL Holding of the firm in current assets. Part of firm’s capital that is required for financing short term current assets. It is never exhausted. Revolves in the operating cycle.
  3. 3. CURRENT ASSETS That can be converted into cash within one accounting year. Includes : cash receivables Inventory Marketable securities
  4. 4. TYPES OF WORKING CAPITAL CONCEPT TIME Gross working temporary capital Net working permanent capital
  5. 5. NET WORKING CAPITAL GROSS WORKING CAPITAL FOCUSSES ON :-  FOCUSSES ON : Liquidity position of the  Financing of current firm assets Judicious mix of short term and long term  Optimization of financing. investments in current assets.
  6. 6. TYPES OF WORKING CAPITALON THE BASIS OF CONCEPT  NET WORKING  GROSS WORKING CAPITAL CAPITAL  CA-CL  Investment in CA  +ive CA>CL  -ive CA < CL
  7. 7. OPERATING CYCLE
  8. 8. OPERATING CYCLE  Time required to convert sales into cash  Three major phases are : PURCHASING THE RESOURCES PRODUCING THE PRODUCT SELLING THE PRODUCT
  9. 9. OPERATING CYCLE TYPES NET OPERATING  GROSS OPERATING CYCLE CYCLE RM IHP+WIP PIH + FG  DCP+ICP IHP + DCP - CDP  RM IHP+ WIP IHP+ FG IHP+DCP
  10. 10. GROSS OPERATING CYCLE Can be determined by –GOC = ICP+DCPICP = RMCP+WIPCP+FGCP DCP= debtors collection period ICP = inventory conversion period
  11. 11. INVENTORY CONVERSION PERIOD RMCP WIPCP FGCP
  12. 12. RAW MATERIAL CONVERSION PERIOD(RMCP) Average time taken to convert material into work in process. It depends upon – ( i ) raw material consumption per day ( ii ) raw material inventoryRMCP = RM inventory*360 RM consumed
  13. 13. WORK IN PROCESS CONVERSIONPERIOD (WIPCP ) Average time taken to complete the semi finished workWIPCP=(WIPinventory*360) COP
  14. 14. FINISHED GOODS CONVERSIONPERIOD (FGCP ) Average time taken to sell the finished goods.FGCP= FGI*360 COGS
  15. 15. DEBTORS CONVERSION PERIOD (DCP) Average time taken to convert debtors into cash.DCP = debtors*360 credit sales
  16. 16. GROSS OPERATING CYCLE RMCP DCP GOC WIPCP FGCP
  17. 17. NET OPERATING CYCLE NOC = GOC – CDPNOC = RMIHP + WIPIHP + FGIHP + ACP – APP
  18. 18. CREDITORS DEFERRAL PERIOD (CDP) Average time taken by the firm in paying its debts.CDP= creditors*360 credit purchases
  19. 19. PERMANENT AND TEMPORARYWORKING CAPITAL PERMANENT WC – minimum level of required current assets. TEMPORARY WC – extra WC needed to support the changing production and sales activities of the firm.
  20. 20. GRAPHICAL INTERPRETATION OFWORKING CAPITAL Permanent and temporary working capital
  21. 21. DETERMINANTS OF WORKING CAPITAL Nature of business Market and demand conditions Technology and manufacturing policy Credit policy Availability of credit from suppliers Operating efficiency Price level changes
  22. 22. ISSUES IN WORKING CAPITALMANAGEMENT Current assets to fixed assets ratio Liquidity Vs profitability – RISK RETURN TRADE OFF THE COST TRADE--OFF
  23. 23. (1.) CURRENT ASSETS TO FIXEDASSETS RATIO Alternative current asset policies
  24. 24. CURRENT ASSETS TO FIXED ASSETSRATIO Optimum level of current assets so that the wealth of the shareholders is maximized. APPROACHES TO DETERMINE OPTIMUM LEVEL OF CA/FA RATIO - conservative - aggressive - moderate
  25. 25. CA/FA RATIO APPROACHES( CONSTANT LEVEL OF FIXED ASSETS ) CONSERVATIVE  AGGRESSIVE Higher CA/FA ratio  Lower CA/FA ratio Higher liquidity Lower risk Lower return  Higher risk  Poor liquidity  Higher return
  26. 26. (2.)THE COST TRADE--OFF Cost Trade-off
  27. 27. THE COST TRADE OFF cost of liquidity : If a firm’s level of CA is very high it has excessive liquidity. Its return on assets is very low because funds are tied up in idle stocks which earns nothing. Cost of illiquidity: Cost of holding insufficient current assets.
  28. 28. OPTIMUM LEVEL OF CURRENT ASSETS With the level of CA the cost of liquidity increases while the cost of illiquidity decreases. The firm should maintain current assets at that level where the sum of these two cost is minimized.
  29. 29. ESTIMATING WORKING CAPITALNEEDS BEST METHOD – OPERATING CYCLE THREE APPROACHES ARE :-i. Current assets holding periodii. Ratio of salesiii. Ratio of fixed investments.ROR = PBIT / NET FIXED INVEST. + WC
  30. 30. POLICIES FOR FINANCING CURRENTASSETS ( TYPES ) LONG TERM FINANCING – sources are ordinary share capital , preference share capital , debentures , long term borrowings. SHORT TERM FINANCING : banks, public deposit, factoring of receivables etc. SPONTANEOUS FINANCING – automatic sources of short term funds arising from normal course of a business.
  31. 31. THREE APPROACHES FOR MIX OFSHORT TERM AND LONG FINANCNG  Matching approach  Conservative approach  Aggressive approach
  32. 32. MATCHING PLAN ( HEDGINGAPPROACH ) Financing under matching plan
  33. 33. MATCHING APPROACH Firm can adopt a financial plan that matches the expected life of assets. Long term financing – fixed assets Short term financing – variable current assets.
  34. 34. CONSERVATIVE APPROACH Conservative financing
  35. 35. CONSERVATIVE APPROACH Financing policy depends more on long term funds. The firm finances its permanent current assets and also a part of temporary current assets with long term financing.
  36. 36. AGGRESSIVE FINANCING
  37. 37. AGGRESSIVE APPROACH When a firm relies more on short term financing. Permanent fixed assets are also financed with short term funds.
  38. 38. (3.) RISK RETURN TRADE OFF If firm wants to use short term financing it must determine it its portion in total financing. Short term financing is preferred because: cost advantage flexibility
  39. 39. RISK RETURN TRADE OFF Short term financing  Long term financing Less expensive  Less expensive Greater risk  Lower risk High returns  Lower return

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