Working capital management

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basic principles of working capital management

basic principles of working capital management

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  • 1. BY-
  • 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. CURRENT ASSETS That can be converted into cash within one accounting year. Includes : cash receivables Inventory Marketable securities
  • 4. TYPES OF WORKING CAPITAL CONCEPT TIME Gross working temporary capital Net working permanent capital
  • 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. 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. OPERATING CYCLE
  • 8. OPERATING CYCLE  Time required to convert sales into cash  Three major phases are : PURCHASING THE RESOURCES PRODUCING THE PRODUCT SELLING THE PRODUCT
  • 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. GROSS OPERATING CYCLE Can be determined by –GOC = ICP+DCPICP = RMCP+WIPCP+FGCP DCP= debtors collection period ICP = inventory conversion period
  • 11. INVENTORY CONVERSION PERIOD RMCP WIPCP FGCP
  • 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. WORK IN PROCESS CONVERSIONPERIOD (WIPCP ) Average time taken to complete the semi finished workWIPCP=(WIPinventory*360) COP
  • 14. FINISHED GOODS CONVERSIONPERIOD (FGCP ) Average time taken to sell the finished goods.FGCP= FGI*360 COGS
  • 15. DEBTORS CONVERSION PERIOD (DCP) Average time taken to convert debtors into cash.DCP = debtors*360 credit sales
  • 16. GROSS OPERATING CYCLE RMCP DCP GOC WIPCP FGCP
  • 17. NET OPERATING CYCLE NOC = GOC – CDPNOC = RMIHP + WIPIHP + FGIHP + ACP – APP
  • 18. CREDITORS DEFERRAL PERIOD (CDP) Average time taken by the firm in paying its debts.CDP= creditors*360 credit purchases
  • 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. GRAPHICAL INTERPRETATION OFWORKING CAPITAL Permanent and temporary working capital
  • 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. ISSUES IN WORKING CAPITALMANAGEMENT Current assets to fixed assets ratio Liquidity Vs profitability – RISK RETURN TRADE OFF THE COST TRADE--OFF
  • 23. (1.) CURRENT ASSETS TO FIXEDASSETS RATIO Alternative current asset policies
  • 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. 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. (2.)THE COST TRADE--OFF Cost Trade-off
  • 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. 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. 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. 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. THREE APPROACHES FOR MIX OFSHORT TERM AND LONG FINANCNG  Matching approach  Conservative approach  Aggressive approach
  • 32. MATCHING PLAN ( HEDGINGAPPROACH ) Financing under matching plan
  • 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. CONSERVATIVE APPROACH Conservative financing
  • 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. AGGRESSIVE FINANCING
  • 37. AGGRESSIVE APPROACH When a firm relies more on short term financing. Permanent fixed assets are also financed with short term funds.
  • 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. RISK RETURN TRADE OFF Short term financing  Long term financing Less expensive  Less expensive Greater risk  Lower risk High returns  Lower return