Working capital management 1


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Working capital management 1

  1. 1. Working Capital Management Roshankumar S
  2. 2. Working Capital Management Part-1 Working capital is business’s life blood. A concern needs funds for its day-to-dayworking. Adequacy or inadequacy of these funds would determine the efficiency withwhich the daily business may be carried on. A finance manager has to ensure thatthe amount of working capital the concern is holding is not too less or too much.Since large working capital indicates idle funds for which the entity has to bear costto hold such funds and low working capital gives rise to risk of insolvency. Thevarious studies conducted by the Bureau of Public Enterprises have shown that oneof the reasons for the poor performance of public sector undertaking in India hasbeen the large amount of funds locked up in working capital. This results in overcapitalization. Over capitalization implies that a company has too large funds for itsrequirements, resulting in low rate of return. Most of the times a company is notperform well despite of the fact that its product has really good demand, just becauseits working capital management is poor. Maintaining working capital is not justimportant for short term but it is necessary to ensure long term survival.There are two concept of working capital- gross and net. Gross working capital refersto firm’s investment in current assets. Net working capital refers to differencebetween current assets and current liabilities. Current assets are those assets whichcan be converted into cash within an accounting year. It includes stock of rawmaterial, work-in-progress, finished goods, trade receivables, prepayments, cashbalances etc. Current liabilities are those liabilities which mature for payment withinan accounting year. It includes trade payables, accruals, tax payable, bills payables,outstanding expenses, dividends payable, short term loans etc. A positive workingcapital means that the entity is able to pay off its short term liabilities, whereas anegative working capital indicates its inability to pay off its short term liabilities.The term working capital is divided in two categories viz. Permanent and temporary.Permanent working capital is the hard core working capital. It’s the minimuminvestment in the current assets that the entity needs to carry out minimum level ofactivities. Temporary working capital on the other hand is the working capital overand above permanent working capital. It’s also called variable working as its volumekeeps changing with change in business activities.Liquidity Vs Profitability:Profitability and liquidity are inversely related to each other. A firm with good liquidityhas less risk of insolvency, it will hardly experience a cash shortage or a stock outsituation, but at the same time the cost of maintaining high liquidity will reduceprofits. On the other hand if the firm maintains low level of current assets the risk ofinsolvency is high but profitability is high due to low cost of maintaining
  3. 3. Various combinations of policies and technique are used for working capitalmanagement. The various steps in management of working capital are: o Cash management- cash level should be maintained at a level so that the day-to-day expenses can be met and cash holding cost is low. o Inventory management- maintain quantity of inventory at such level so that production is not interrupted and at that same time too much money is not blocked in raw materials. o Debtors’ management- an appropriate credit policy should be adopted so that the credit term which will attract customers, such that the impact on cash flows and the cash conversion cycle will be offset by increased revenue and hence return on capital. The tools like discounts and allowances are used for this. o Short term financing- inventory is normally financed by credit granted by suppliers and to finance other components of working capital other sources are needed such as bank loan ( or overdraft), or to convert debtors to cash through factoring.Following are the factors which generally influence the working capital requirementsof the firm: o Nature of business o Credit policy of firm o Availability of credit from suppliers o Technology and manufacturing policy o Operating efficiency o Market demand and conditions o Price level changesEstimation of Working capital needs: o Current assets holding period: working capital needs are estimated based on average holding period of current assets and relating them to costs based on company’s experience in the previous year. This method is based on the Operating cycle concept. o Ratio of sales: to estimate working capital needs as a ratio of sales on the assumption that current assets change with change in sales. o Ratio of fixed investment: to estimate working capital requirement as a percentage of fixed investment.Operating OR Working capital cycle CASH RAW MATERIAL/LABOUR/OVERHEAD
  4. 4. FINISHED GOODS DEBTORS CASHOperating cycle is one of the most useful tools for managing working capital. Theoperating cycle analyzes the accounts receivable, inventory and accounts payablecycle in number of days. Most of the businesses cannot finance the operating cyclewith accounts payable alone so working capital financing is needed. This shortfall iscovered by the net profits generated internally or by externally borrowed funds or bycombination of two.Each component of working capital has two dimensions i.e. ‘time’ and ‘money’. If themoney moves faster around the cycle or the amount of money tied up is reduced, thebusiness will generate more cash or it will need to borrow less money to fundworking capital which will ultimately reduce bank interest or the entity will haveadditional free money to support additional sales growth or investment. If increasedcredit limits can be negotiated from suppliers, entity gets free finance.Working capital cycle indicates the length of the time between a company’s payingfor materials, entering into stock and receiving the cash from sales of finished goods.It can be determined by adding the number of days required for each stage of cycle.For example, a company holds raw material on an average of 60 days, it gets creditfrom the supplier for 15 days, production process needs 15 days, finished goods areheld for 30 days and 30 days credit is extended to debtors.Operating cycle = R+W+F+D-CWhere,R= Raw material storage periodW= Working capital holding periodF= Finished goods storage periodD= Debtors collection periodC= Credit period availedOperating cycle= 60+15+30+30-15 = 120 days.Now the above components may be calculated as:RM storage period = Avg stock of RM / Avg cost of RM consumption per
  5. 5. WIP holding period = Avg WIP / Avg cost of production per dayFG storage period = Avg stock of FG / Avg COGS per dayDebtors collection period = Avg book debts / Avg credit sales per dayCredit period availed = avg trade creditor / Avg credit purchases per dayThe net operating cycle represents the net time gap between investment of cash andits recovery of sales revenue. If depreciation is excluded from expenses in thecomputation of operating cycle, the net operating cycle also represents the cashconversion cycle. The net operating cycle represents the time interval for which thefirm has to negotiate for working capital from its Bankers.Estimation of Working Capital based on current asset and current liabilitiesThe holding period of various components of operating cycle may either expand orcontract the net operating cycle period. Longer the operating cycle, higher will be therequirement of working capital and vice-versa.Estimation of current assets o Raw materials inventory: (Estimated production in units * estimated cost of RM p.u. * Avg RM holding period) / 360 days o WIP Inventory: (Estimated production in units * estimated WIP cost p.u. * Avg WIP holding period) / 360 days o Finished goods: (Estimated production in units * Cost of production p.u. excluding depreciation * Avg FG holding period) / 360 days o Debtors: (Estimated credit sales in units * cost of sales p.u. excluding depreciation * Avg debtors collection period) / 360 days o Minimum desired Cash and Bank balances to be maintained by the entity have to be added to current assets for computation of working capital.Estimation of current
  6. 6. o Trade creditors: (Estimated production in units * RM requirements p.u. * credit period granted by suppliers) / 360 days o Direct wages: (Estimated production in units * Direct labour cost p.u. * Avg time lag in payment of wages) / 360 days o Overheads (other than depreciation and amortization) (Estimated production in units * overhead cost p.u. * Avg time lag in payment of overheads) / 360 days In simple words it’s just the reverse of the process used to determine the operating capital cycle. Estimation of working capital requirement on cash cost basisThis approach is based on the fact that in case of current assets like debtors andfinished goods etc, the exact amount of funds blocked is less than the amount ofsuch current assets. For example, if we have sundry debtors worth Rs 1 lakh and ourcost of production is Rs 80000, the actual amount of funds blocked in debtors is Rs80000 the balance Rs 20000 is profit. Now suppose out of this Rs 80000, Rs 5000 isdepreciation then actual funds blocked are Rs 75000. In other word Rs 75000 is theamount needed to finance debtors worth Rs 1 lakh. Thus this approach ignores profitand non cash item while determining working capital