Financial Reporting and Analysis subject For undergraduate students (semester 4)

1. Working Capital
Meeting 5

2. • A. The definition of working capital
• B. The type of working capital
• C. Management of working capital
• D. Working capital policy
• E. The source and use of working capital
• F. Ratio’s of working capital

3. The definition of working capital
• Working capital is money available to a company for day-to-day
operations.
• Working capital is a measure of both a company's efficiency and its
short-term financial health. Working capital is calculated as:
• Working Capital = Current Assets - Current Liabilities

4. Working capital: components
• Working capital is a common measure of a company's liquidity,
efficiency, and overall health.
• Because it includes cash, inventory, accounts receivable, accounts
payable, the portion of debt due within one year, and other short-
term accounts,
• a company's working capital reflects the results of a company’s
activities, including inventory management, debt management,
revenue collection, and payments to suppliers.

5. Positive/Negative working capital:
• Positive working capital generally indicates that a company is able to pay
off its short-term liabilities almost immediately.
• Negative working capital generally indicates a company is unable to do so.
• This is why analysts are sensitive to decreases in working capital; they
suggest a company is becoming overleveraged, is struggling to maintain or
grow sales, is paying bills too quickly, or is collecting receivables too slowly.
Increases in working capital, on the other hand, suggest the opposite.
• There are several ways to evaluate a company's working capital further,
including calculating the inventory-turnover ratio, the receivables ratio,
days payable, the current ratio, and the quick ratio.

6. The types of working capital: 1
• On the basis of Balance Sheet View:
• Gross Working Capital (GWC): Current assets in the balance sheet of a
company are known as gross working capital. Current assets are those
short term assets which can be converted into cash within a period of one
year.
• Net Working Capital (NWC): There are two ways to understand networking
capital. First, one says it is simply the difference between current assets
and the current liabilities on the balance sheet. The other understanding
discloses hidden meaning of the term. NWC is that part of current assets
which are indirectly financed by long-term assets.
• Compared to gross working capital, net working capital is considered more
relevant for effective working capital financing and management.

7. The types of working capital: 2
• On the basis of Operating Cycle View:
• Permanent / Fixed Working Capital: Determining the financing
requirement in the case of fixed assets is simply the cost of the asset.
• Temporary / Variable WC: Temporary working capital is the
difference between net working capital and permanent working
capital.
• The main characteristic which can be made out of the example is
“fluctuation”. The temporary working capital, therefore, cannot be
forecasted.

8. • Types of working capital on the basis of time
• 1) Permanent working capital - it is also called fixed working capital. It means to carry
on the day to day expenses the firm is required to maintain the minimum amount of
working capital. For example the firm is required to maintain the minimum level of raw
material, finished goods or cash balance etc.
• a) Regular working capital - it means the minimum amount which the firm has to keep
with itself to carry on the day to day operation.
• b) Reserve working capital - it means the excess amount over the regular working capital
for uncertain circumstances like strike, lock out, depression etc.
• 2) Temporary working capital - it is also called variable working capital, which is required
to meet the seasonal demands as well as for special purposes.
• a) Seasonal working capital - it is required to meet the seasonal needs of the enterprise.
• b) Special working capital - it is required for some special purposes of the enterprise. For
example advertising the product of the firm requires special working capital.

10. Management of working capital
• Working capital management commonly involves monitoring cash
flow, assets and liabilities through ratio analysis of key elements of
operating expenses, including the working capital ratio, collection
ratio and the inventory turnover ratio.
• Efficient working capital management helps with a company's smooth
financial operation, and can also help to improve the company's
earnings and profitability.
• Management of working capital includes inventory management and
management of accounts receivables and accounts payables.

11. Working capital policy: 1
• Cash Policies
• Do not invest funds in illiquid investment vehicles. Even if a long-term investment
opportunity offers the opportunity for outsized returns, do not make the investment
unless you are sure there are sufficient funds on hand to support all reasonable working
capital needs during the period when the funds will be tied up in the investment.
• No investment duration shall exceed the forecasting period. If you are willing to tie up
cash in somewhat illiquid investments, then at least keep from making investments that
cannot be accessed for periods longer than what the company is currently forecasting.
Otherwise, the company may find itself with a large cash requirement and no funds
available to offset it.
• All deposited funds must be insured. Only invest cash in accounts that are insured by
the FDIC, to guard against the loss of funds due to bank failure. This is a difficult policy to
enforce, since a business may have to distribute excess cash among many bank accounts
to fit within the insured limit.

12. Working capital policy: 2
• Accounts Receivable Policies
• Do not allow payment terms greater than __ days. Do not allow the sales staff to
offer terms to customers that exceed a specific number of days without prior
approval by a senior manager.
• The maximum credit offered a customer is ___. Use a formula that best fits your
industry to arrive at a reasonable maximum amount of credit to offer customers,
over which a senior manager must approve the terms.
• Stop customer credit once days outstanding exceed __ days. This policy is
designed to keep additional credit from being extended to a customer who is not
paying in a timely manner.
• Stop customer credit if a customer check does not clear the bank. This is a prime
indicator of impending customer insolvency, and so can be used as a trigger to
withhold credit and thereby reduce bad debt.

13. Working capital policy: 3
• Inventory Policies
• Review inventory on hand exceeding __ days of usage. It is exceedingly
difficult to adopt rules that will minimize inventory, but consider this policy
to bring excessive inventory levels to the attention of management.
• Adopt just-in-time purchasing on qualified raw materials and
merchandise. This policy is designed to minimize on-hand inventories by
making purchases as late as possible and having items delivered in small
quantities.
• Drop shipped inventory is the preferred stocking method. This policy
shifts inventory ownership to the company's suppliers, who ship directly to
the company's customers on its behalf.

14. Working capital policy: 4
• Accounts Payable Policies
• Do not pay accounts payable early. Adopt a monitoring system that
highlights any payment made earlier than the due date required by the
supplier.
• Require purchase orders for amounts exceeding $___. This policy enforces
an examination of larger expenditures before they are actually made.
• Disallow purchases exceeding the department budget. If a manager
commits to a specific expenditure level for his department, then do not
allow expenditures above that level without approval by a senior manager.

15. THREE TYPES OF WORKING CAPITAL POLICIES: 1
• RESTRICTED POLICY
• In restricted policy, the estimation of current assets for achieving
targeted revenue is done very aggressively without considering for
any contingencies and provisions for any unforeseen event.

16. THREE TYPES OF WORKING CAPITAL POLICIES: 2
• RELAXED POLICY
• In this policy, the estimation of current assets for achieving the
targeted revenue is prepared after careful consideration of uncertain
events such as seasonal fluctuations, a sudden change in the level of
activities or sales etc.

17. THREE TYPES OF WORKING CAPITAL POLICIES: 3
• MODERATE POLICY
• Moderate policy is a balance between the two policies i.e. restricted
and relaxed. To strike a balance, moderate policy assumes risk which
is lower than restricted and higher than conservative. In profitability
front also, it lies between the two.
• The biggest benefit of this policy is that it has reasonable assurance of
smooth operation of working operating capital cycle with moderate
profitability.

18. Aggressive vs. Conservative Working Capital: 1
• Aggressive Working Capital
• is one in which you try to squeeze by with a minimal investment in current
assets coupled with an extensive use of short-term credit.
• Your goal is to put as much money to work as possible to decrease the time
needed to produce products, turn over inventory or deliver services.
• Speeding up your business cycle grows your sales and revenues. You keep
little money on hand, cut slow-moving inventory and unnecessary supplies
to the bone and stretch out your bill payments for as long as possible.
• The one payment you cannot delay is interest - your creditors can sue you,
force you into bankruptcy and liquidate your assets. You would also want
to avoid missing tax payments.

19. Aggressive vs. Conservative Working Capital: 2
• Conservative Working Capital
• Companies in volatile or seasonal industries such as tourism, farming
or construction might adopt conservative working capital policies
against risk.
• If you employ a conservative working capital policy, there’s plenty of
cash in the bank, your warehouses are full of inventory and your
payables are all up to date.
• Conservatively managed working capital will help lower your risks of
short-term cash shortages but might hurt your long-term profitability,
because excess cash doesn’t earn much of a return.

20. The source working capital
• 1. Funds from Business Operations
• 2. Sales of Non-Current Assets
• 3. Long-Term Borrowing
• 4. Issue of Additional Equity Capital

22. Uses of Working Capital:
• 1. Declaration of Cash dividend
• 2. Purchase of Non-Current Assets
• 3. Repayment of Long-Term Debt
• http://www.yourarticlelibrary.com/financial-management/working-
capital/sources-and-uses-of-working-capital/52980/
• http://www.accountingnotes.net/working-capital/working-capital-
meaning-sources-and-uses/5636