Working Capital Management


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Working Capital Management

  1. 1. WORKING CAPITAL Planning and Management
  3. 3. Introduction to Working Capital Management • The term working capital refers to current assets which may be defined as (i) those which are convertible into cash or cash equivalents within a period of one year, and (ii) those which are required to meet day to day operations. • Working Capital Management is management of firm’s sources and uses of working capital in order to maximize the wealth of the shareholders .
  4. 4. Term Working Capital-two different ways • GROSS WORKING CAPITAL : • It refers to the firm’s investment in all the current assets taken together. • NET WORKING CAPITAL : • The term net working capital may be defined as excess of total current assets over total current liabilities.
  5. 5. • Excess of current assets over current liabilities are called the net working capital or net current assets. • Working capital is really what a part of long term finance is locked in and used for supporting current activities. • The balance sheet definition of working capital is meaningful only as an indication of the firm’s current solvency in repaying its creditors. • When firms speak of shortage of working capital they in fact possibly imply scarcity of cash resources. • In fund flow analysis an increase in working capital, as conventionally defined, represents employment or application of funds.
  6. 6. Operating Cycle • The operating cycle may be defined as the time duration starting from the procurement of goods or raw materials and ending with the sale realization. • The operating cycle of a firm consists of the time required for the completion of the chronological sequence of some or all of d following • Procurement of raw materials & services. • Conversion of raw materials into work-in-progress. • Sale of finished goods (cash or credit) • Conversion of receivables into cash.
  7. 7. OPERATING CYCLE PERIOD= Inventory Conversion period + Receivables Conversion Period Inventory Conversion Period: It is the time required for the conversion of raw materials into finished goods sales. ICP= RMCP+WPCP+FGCP. Receivables Conversion Period: It is the time required to convert the credit sales into cash realization. It refers to the period between the occurrence of credit sales and collection of debtors.
  8. 8. Calculation of TOCP & NOC FGCP= Average finished goods Total cost of goods sold RCP= Average Receivable Total Credit Sales DP = Average Creditors Total Credit Purchase +WMCP ----Days ----Days +RCP ----Days TOCP ----Days ----Days NOC ----Days 365 365 365 ----Days -DP WPCP= Average work in progress Total cost of production 365 RMCP +FGCP RMCP= Average raw material stock Total raw material consumption 365
  9. 9. Receivable Conversion Period RMCP WPCP FGCP Inventory Conversion Period Net Operating Cycle Deferral Period THE OPERATING CYCLE
  10. 10. EXCESS OR INADEQUATE WORKING CAPITAL • 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.
  11. 11. Disadvantages of Redundant or Excess Working 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 Due to low rate of return on investments, the market value of shares may fall
  12. 12. Disadvantages or Dangers of Inadequate or Short Working Capital • • • • • Can’t pay off its short-term liabilities in time. Economies of scale are not possible. Difficult for the firm to exploit favorable market situations Day-to-day liquidity worsens Improper utilization the fixed assets and ROA/ROI falls sharply
  13. 13. Different types of working capital policies • Moderate Working Capital Policy : The increase in sales level is coupled with proportionate increase in level of current assets. • Conservative working capital policy: For every increase in sale there is more than proportionate increase in current assets. It reduces the risk of shortage of working capital by increasing the safety component of current assets. • Aggressive working capital policy: the increase in sale does not result in proportionate increase in current assets. It lead to risk of insolvency & difficulty to face unexpected changes. Reduced investment in current assets, result in increase in profitability of the firm.
  14. 14. Types of Working Capital Needs • Permanent working capital: the minimum level of working capital which is constantly required by a firm in order to maintain its activities irrespective of the level of activities. Even during slack season, every firm maintains some current assets. • Temporary working capital: The working capital required over and above the permanent working capital to meet the requirements arising out of fluctuations in sales volume
  15. 15. Difference between permanent & temporary working capital Variable working capital Amount of working capital Permanent working capital Time
  16. 16. Variable Working Capital Amount of working Capital Permanent Working Capital Time
  17. 17. Financing of Current Assets • An important aspects of working capital management is to decide the pattern of financing the current assets and one of the major problem in working capital management is the decision whether to finance the working capital with one source or the other. Breaking down working capital needs into permanent and temporary components over time provides a useful by product in terms of financing choice. • So the two components of working capital needs to be finance accordingly for which the different sources of fund can be grouped as follows.
  18. 18. 1. LONG TERM SOURCES These provides fund for a relatively longer period. Major long term sources: • Share capital • Retained earning • Debentures • Long term borrowings 2. SHORT TERM SOURCES These provide funds for a short period say up to one year or so Major short term sources: • Bank credit • Pubic deposit • Commercial papers • Factoring 3. TRANSACTIONARY SOURCES These provide funds to a business through the normal business operations Major sources: • Credit allowed by suppliers • Outstanding labor • Other expenses
  19. 19. Approaches related to financing mix Hedging Approach: Fixed working capital is financed by long term sources of funds while the additional or fluctuating working capital needs are financed by short term sources Total WC Amount of WC Short term sources Long term sources
  20. 20. Conservative Approach • Working Capital needs are primarily financed by long term sources and the use of short term sources may be restricted to unexpected and emergency situation only. Amount of WC Total WC Long term sources Time
  21. 21. Aggressive Approach • The firm decide to finance a part of the permanent working capital by short term sources. So, the short term financing under the aggressive policy is more than the short term financing under the hedging approach. It seek to minimize excess liquidity while meeting the short term requirements. Total WC Permanent WC Amou nt of WC Short term financing Long term sources
  22. 22. Working Capital: Monitoring & Control • Monitoring the operating cycle: The actual operating cycle period should be ascertained for each element that is the raw material, WIP, Finished goods etc. over a period of time and should be compared with the standard operating cycle period set for the same firm or for the industry as a whole. There should always be an attempt to reduce the length of the operating cycle. Efforts in particular are needed to control the receivable conversion period.
  23. 23. Working Capital Ratios • Another analytical tool that can be used to monitor the working capital is the accounting ratios, mainly the working capital ratios. 1. Current ratios: CA/CL 2. Liquid ratio: quick assets/CL 3. current assets to total assets ratios. 4. Current assets to total sales ratios.
  24. 24. 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
  25. 25. Estimation of Working Capital Current Assets I Minimum Cash Balance Inventories : Raw material WIP Finished goods Receivables: Debtors Bills Gross working capital II Current liabilities: Creditors for Purchases Wages Overhead Total Current Liabilities Excess of CA over CL + Safety Margin Net working capital Amount Amount Amount
  26. 26. Meaning of Cash Management • Cash management refers to management of cash and bank balance, or in a broader sense it is the management of each inflows and outflows. In ordinary parlance cash implies ready money or its equivalent. However, Management Accountants define cash as the most liquid assets, need to carry out the day-to-day activities of the business. For cash management purposes, the term cash is used in broader senses i.e., it covers cash, cash equivalents and those assets which are immediately convertible into cash. • It is the duty of finance manger to have liquidity at all parts of the organization while managing cash • He has also to ensure that there are no funds blocked in idle cash. Idle cash resources entail a great deal of cost in
  27. 27. Objectives of Cash Management • Meeting the cash outflows and minimizing the cost of cash balance. • Management of cash is an important function of modern business. The main objective of cash management is to determine the optimal cash balance i.e., a balance which is neither in excess not inadequate because idle cash produce nothing and shortage cash affects firm’s liquidity. Thus, the objectives of cash management are two fold; • to meet the disbursement needs, and • to minimize funds committed to cash balances. • The task of cash management is to reconcile these two conflicting and mutually contradictory aspects. The idle cash should be invested in temporary securities so as to earn some return and shortage of cash should be arranged by raising short-term loans. Thus, cash management is concerned with management of cash affairs in such a way that gives the least possible cost of maintaining cash. The objective is maximizing profitability without sacrificing liquidity.
  28. 28. The Need for Cash • The following are three basic considerations in determining the amount of cash or liquidity as have been outlined: • 1.Transaction need: Cash facilitates the meeting of the day-today expenses and other debt payments. Normally, inflows of cash from operations should be sufficient for this purpose. But sometimes this inflow may be temporarily blocked. In such cases, it is only the reserve cash balance that can enable the firm to make its payments in time. • 2. Speculative needs: Cash may be held in order to take advantage of profitable opportunities that may present themselves and which may be lost for want of ready cash/settlement. • 3. Precautionary needs: Cash may be held to act as for providing safety against unexpected events.
  29. 29. Managing Cash Collection and Disbursements • (a) Speed up the mailing time of payments from customers; • (b) Reduce the time during which payments received by the firm remain uncollected and speed up the movement of funds to disbursement banks. (i) Concentration Banking: • Collection center are opened as near to the debtors as possible, hence reducing the time in dispatch, collection etc. • The firm may instruct the customers to mail their payment to a regional collection Centre rather than to the central office.
  30. 30. (ii) Lock Box System: 1. To eliminate the time between the receipt of remittances by the company and deposited in the bank. 2. Under this arrangement, the company rents the local post-office box and authorizes its bank at each of the locations to pick up remittances in the boxes. 3. The bank picks up the mail several times a day and deposits the cheques in the company’s account. The cheques may be microfilmed for record purposes and cleared for collection. 4. The company receives a deposit slip and lists all payments together with any other material in the envelope. 5. This procedure frees the company from handling and depositing the cheques. 6. The main advantage of lock box system is that ‘lag between the time cheques are received by the company and the time they are actually deposited in the bank is eliminated. 7. The main drawback of lock box system is the cost of its operation. 8. Lock box arrangements are usually not profitable if the average remittance is small.
  31. 31. Managing the Float With reference to the control of inflows and outflows, float is an important technique to lessen the length of the cash cycle. So when a firm receives or makes payments in the form of cheques etc., there is usually a time gap between the time the cheque is written and when it is cleared. This time gap is known as float. The float of the paying firm refers to the time that elapses between the point when it issues a cheque and the time at which the funds underlying the cheque are actually debited in the bank account. For the payee firm, float refers to the time between the receipt of the cheque and the availability of the funds in its account. Float has 3 components: (i) Mail Time : It is the period between the issue of a cheque and its receipt by the payee. (ii) Processing Time : It is the time between the cheque received by the payee and the deposit of the cheque in the bank account of the payee, and (iii) Collection Time : It is the amount of time for transferring funds, through banking system, from the payer’s account to that of the payee. In India, this collection time is generally three days, including the day of depositing a cheque.
  32. 32. Cash budget: • Cash budget represents cash requirements of business during, the budget period. It is the plan of receipts and payments of cash during the budget period. Cash budget can be prepared for short period or for long period. • • Purpose of cash budget • Cash budget is a device for planning and controlling the inflows & outflows of cash the ensure the availability of cash when it is needed • • As regards receipts 1. Receipts from debtors; 2. Cash sales and; 3. Any other sources of receipts of cash (say, dividend from a subsidiary company).
  33. 33. • As regards payments 1. Payments to be made for purchases; 2. payments to be made for expenses; 3. payments that are made periodically but not every month; a. debenture interest; b. income tax paid in advance; c. sales tax etc. 4. Special payments to be made in a particular months, for example, dividends to shareholders, redemption of debentures, repayments of loan, payment for assets acquired etc.
  34. 34. EXAMPLE • The following forcast has been made for ABC Ltd January feb march april sales 75000 105000 180000 105000 Raw material 70000 100000 80000 85000 Manufactur 10000 ing expenses 20000 29000 16000 instalment 11000 21000 21000 1000 • • All sales are made on credit basis. 2/3 of debtors are collected in the same month and balance in the next month. There is no expected bad debts. The debtors on jan 1, 2014 were Rs. 30000. • The minimum cash balance is Rs 5000. cash balance on jan 1 is 65000. • Borrowing if any made in multiples of 100
  35. 35. SOLUTION jan feb march april Opening cash 6500 5500 5000 5000 Debtors previous current 30000 50000 25000 70000 35000 120000 60000 70000 Total cash(A) 86500 100500 160000 135000 Raw material Manufacturin g expense installment 70000 10000 100000 20000 80000 29000 85000 16000 1000 11000 21000 21000 Total outflows(B) 81000 131000 130000 122000 Cash balance(A-B) 5500 -30500 30000 13000 35500 -25000 -8000 Borrowing (refund)
  36. 36. Baumol’s Model of Cash Management • William J. Baumol developed a model for optimum cash balance which is normally used in inventory management. The optimum cash balance is the trade-off between cost of holding cash (opportunity cost of cash held) and the transaction cost (i.e. cost of converting marketable securities in to cash held) . Optimum cash balance is reached at a point where the two opposing costs are equal and where the total cost is minimum. This can be explained with the following diagram: Total cost Holding Cost Cost (Rs.) Transaction cost Optimum Cash Balance
  37. 37. • The optimum cash balance an also be computed algebraically Optimum Cash Balance = • A = • T = • H = cost) 2AT H Annual Cash disbursements. Transaction cost (Fixed cost) per transaction Opportunity cost one rupee per annum (holding
  38. 38. The model is based on the following assumptions:  Cash needs of the firm are known with certainty.  The cash is used uniformly over a period of time and it is also known with certainty  The holding cost is know and it is constant  The transaction cost also remains constant.
  39. 39. Miller-Orr Cash Management model • According to this model the net cash flow is completely stochastic. When changes in such balance occur randomly, the application of control theory serves a useful purpose. The Miller – Orr model is one of such control lime it models. This model is designed to determine the time and size of transfers between and investment account and cash account. In this model control limits are set for cash balances. These limits may consist of ‘h’ as upper limit, ‘z’ as the return point and zero as the lower limit.
  40. 40. H Upper Control Limit Cash Balance (Rs.) z 0 Return Point Time Lower Control Limit
  41. 41. • When the cash balance reaches the upper limit, the transfer of cash equal to ‘ h – z’ is invested in marketable securities account. When it touches the lower limit, a transfer from marketable securities account to cash account is made. During the period when cash balance stays between (h, z) and (z, o) i.e. high and low limits, n transactions between cash and marketable securities account is made. The high and low limits of cash balance are set up on the basis of fixed cost associated with the securities transaction, the opportunities cost of holding cash and degree of likely fluctuations in cash balances. These limits satisfy the demands for cash at the lowest possible total costs.
  42. 42. Inventory Management • Inventory management means planning, organizing, directing & controlling of inventory. The basic objective of inventory management is to place an order for material • at the right time • for the right source • to acquire the right quantity • at right place and • of right quality.
  43. 43. INVENTORY MANAGEMENT  Inventories constitute a major element of working capital.  Inventory management covers a large number of problems including: a. fixation of minimum and maximum levels, b. determining the size of inventory to be carried, c. deciding about the issues, d. receipts and inspection procedures, e. determining the economic order quantity, f. proper storage facilities, g. keeping check over obsolescence and ensuring control over movement of inventories
  44. 44. • Meaning • Inventory means stock of goods that is maintained to facilitate the continuous production of goods and services. Investment involves the commitment of firm’s resources. If the inventories are too big, they become a strain on the firm’s resources. However, if they are too small, the firm may lose the sales. Therefore, the firm must have an optimum level of inventories.
  45. 45. Objective of inventory management  To avoid the situation of excessive and inadequate inventory and  To determine and maintain optimum level of inventory  After achieving a trade off between the profitability and liquidity  So as to maximize the wealth of shareholders as a whole
  46. 46. Excessive inventory 1 2 3. Inadequate inventory Opportunity cost of funds tied up in Interruption of production inventory Excessive carrying cost eg. Storage Excessive stock out cost cost, insurance cost, handling cost etc. Risk of liquidity
  47. 47. Need for holding inventory 1. Transaction motive • • • Sufficient stock of raw material is to be held by the stores so as to ensure continuous and uninterrupted supply of raw material to production Sufficient stock of WIP is to be held due to production cycle Sufficient stock of finished goods is to be held to facilitate continuous supply of product to customers 2. Precautionary motive • To hold inventory to meet contingencies 3. Speculative motive • To hold inventory in order to take advantage of profitable opportunities.
  48. 48. Types of Inventory • Raw materials: the raw materials inventory consists of goods which are to be converted into finished goods through the manufacturing process. • Work-in-progress: It refers to the raw materials engaged in various phases of production process. The degree of completion may be varying for different units. Some units might have been just introduced, while some others may be 40% complete others may be 90% complete. The work-in-progress refers to semifinished goods. The quantity and the value of work-in-progress depend on the length of the production cycle. • Finished Goods: Finished goods consist of final products which are ready for sale.
  49. 49. Economic order quantity/ reorder quantity  The quantity for which order is placed when the stock reaches reorder level  Quantity which is most economical to order  The quantity of inventory, at which total of ordering costs and carrying costs is minimum. Ordering costs refers to the cost incurred for acquiring material i.e. inputs. These costs include:• cost of placing an order • cost of transportation • cost of receiving goods • cost of inspecting goods There is an inverse relationship relationship between order size and ordering cost .
  50. 50. • Carrying cost refers to the cost incurred in maintaining a given level of inventory. These costs include:• cost of storage space • cost of handling material • cost of insurance • cost of deterioration or obsolescence • cost of store staff There is positive relationship between order size and carrying cost. Assumptions:  Ordering cost per order & carrying cost per unit, per annum are given & they are fixed.  Usage of material in units is known.  Cost p.u of material is constant & is known.  The quantity of material ordered is lead immediately i.e. lead time zero.
  51. 51. • Determination of EOQ • There are three methods for determination of EOQ a) Graphical method b) Tabular method c) Formula method Graphical method Total cost Holding Cost Cost (Rs.) Ordering cost EOQ
  52. 52. Tabular method/ trial & error method Particulars Order size I Order size II a. Annual consumption b. Order size c. No. of orders d. Cost per order e. Total ordering cost f. Average inventory g. Carrying cost per unit h. Total Carrying cost i. Total cost X X X X X X X X X X X X X X X X X X
  53. 53. • Formula method • The optimum cash balance an also be computed algebraically Optimum Cash Balance = 2AO C • A •O • C = Annual Requirement = Ordering cost = Carrying cost
  54. 54. ABC Analysis • This technique is based on selective control of inventory. Under this technique various item of inventory are classified into three group of priority and allocates managerial efforts in proportion of the priority. The most important items are Classified as Class A, those of intermediate importance are classified as Class B and the remaining items are classified as Class C. in other words, under this system, all items of inventory are categorized according to their value significance: • ‘Category A’ includes high value, low volume items. These constitute only a small percentage share in the total value of inventory. • ‘Category B’ includes medium value items. Their percentage share in total quantity is nearly equal to their percentage share in the total value of inventory. • ‘Category C’ includes low value, high volume items. Their percentage share in total quantity of inventory is very large, bur their percentage share in the total value of inventory is small.
  55. 55. On the basis of physical quantities and value of material used a table as follow may be constructed. Material Categories % share in total % share in total value of total quantities – units, weight or volume of inventories total inventory A (High value, Low 70 volume) B (Medium value) 20 10 C (Low value, High 10 volume) Total 100 70 20 100 ‘Category A’ item represent 70% of the total value of total inventories but 10% of total quantity of inventory. Maximum control must be exercised on this category. ‘Category C’ comprising 70% in quantity but only 10% in value, needs a simple and economic system of control.
  56. 56. THANK YOU