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Working-Capital Management
Working Capital Concepts Net Working Capital = Current Assets – Current Liabilities Gross Working Capital :  The firm’s investment in current assets
Significance of Working Capital Management In a typical manufacturing firm, current assets exceed  one-half of total assets. Current liabilities are the principal source of external financing for small firms. Requires continuous,  day-to-day  managerial supervision. Working capital management affects the  company’s risk, return, and share price .
TYPES OF WORKING CAPITAL Permanent working capital Temporary /Variable working capital
Permanent Working Capital The amount of current assets required to meet a firm’s long-term minimum needs. Permanent current assets TIME AMOUNT
Temporary Working Capital The amount of current assets that varies with seasonal requirements. Permanent current assets TIME AMOUNT Temporary current assets
Matching approach or Hedging approach Conservative approach •   Aggressive approach Determining Financial Mix How current assets will be financed?
Balance Sheet Current Liabilities  Current Assets  Long-Term Debt  Preferred Stock  Fixed Assets Common Stock  To illustrate, let’s finance  all current assets with current liabilities , and finance  all fixed assets with long-term financing .
Balance Sheet Current Liabilities  Current Assets Long-Term Debt   Preferred Stock  Fixed Assets   Common Stock  Suppose we use  long-term  financing  to finance some of our  current assets .  This strategy would be  less risky , but  more expensive!
Balance Sheet Current Liabilities  Current Assets  Long-Term Debt   Preferred Stock  Fixed Assets    Common Stock    Suppose we use  current liabilities   to finance some of our  fixed assets .  This strategy would be  less expensive , but  more risky!
Financing Current Assets:  Short-Term and Long-Term Mix Spontaneous Financing :   Trade credit, and other payables and accruals, that arise spontaneously in the firm’s day-to-day operations.
The Hedging Principle Permanent Assets Fixed assets and permanent current assets are financed with long-term debt and equity  and  spontaneous sources of financing Temporary Assets --Seasonal needs are financed with short-term loans
Financing Needs and  the conservative Approach Permanent current assets  and seasonal portion of current assets are financed with long-term debt and equity which is  less risky , but  more expensive! Short term funds  are used in emergency situation
Financing Needs and  the Aggressive Approach Permanent current assets  and  seasonal portion of current assets  are financed with  short term sources  of financing but  less expensive , but  more risky!
Trade off between Profitability and Risk Example: The three possible  current assets  holdings of the firm are Rs.5,00,000/-, Rs. 4,00,000/- and Rs. 3,00,000/-. It is assumed that  fixed asset  level is constant. The firm has the following data: Sales  Rs.15,00,000/- EBIT Rs. 1,50,000/- Fixed Assets Rs. 5,00,000/-
Effect of Alternative working capital policies A Rs. B Rs. C Rs. Sales  15,00,000 15,00,000 15,00,000 EBIT 1,50,000 1,50,000 1,50,000 Current Assets 5,00,000 4,00,000 3,00,000 Fixed Assets 5,00,000 5,00,000 5,00,000 Return on Total Asset (EBIT/Total Asset) 15% 16.67% 18.75% C. A / F. A 1.00 0.80 0.60 So  B  demonstrates a moderate policy and generate an average return which will be viable from the firms point of view.
Impact on Liquidity Liquidity Analysis Policy Liquidity A High B Average C Low Greater current asset levels generate more liquidity; all other factors held constant. 0  50,000 OUTPUT (units) ASSET LEVEL ($) Current Assets Policy C Policy A Policy B
Impact on  Profitability Profitability Analysis Policy   Profitability A Low B Average C High As current asset levels decline, total assets will decline and the ROI will rise. 0  50,000 OUTPUT (units) ASSET LEVEL ($) Current Assets Policy C Policy A Policy B
Impact on Risk Risk Analysis Policy Risk A Low B Average C High Risk increases as the level of current assets are reduced . 0  50,000 OUTPUT (units) ASSET LEVEL ($) Current Assets Policy C Policy A Policy B
Summary of Current Assets S UMMARY  O F  C URRENT  A SSET  A NALYSIS Policy Liquidity   Profitability   Risk   A   High   Low   Low B Average   Average   Average C   Low   High   High 1.  Profitability varies inversely with  liquidity. 2.  Profitability moves together with risk. (risk and return go hand in hand!)
The Operating Cycle and the Cash Cycle A firm’s  operating cycle (OC)   is the time from the beginning of the production process to collection of cash from the sale of the finished product. The operating cycle is the sum of the inventory period and the accounts receivable period,  whereas the  cash cycle   is equal to the operating cycle  less  the accounts payable period. The  Operating Cycle (OC)   is the time between ordering materials and collecting cash from receivables.
Inventory conversion period,   which is the average time required to convert materials into finished goods and then to sell those goods. If average inventories are 2,00,000 and sales are 10,00,000, then the inventory conversion period is 73 days: Inventory conversion period =  __Inventory__   Sales per day =  __2,00,000___  =  73 days 10,00,000/365
Receivables collection period,   which is the average length of time required to convert the firm’s receivables into cash, that is, to collect cash following a sale. The receivables collection period is also called the  days sales outstanding (DSO).  If receivables are Rs.65754 and sales are Rs.10,00,000. The receivable collection period is   Receivables collection period  =  ___Accounts receivable___   Average credit sales per day or Receivables collection period  = DSO =  Receivables   Sales/365 =  _65754__  =  24 days 10,00,000/365
Payables  period,   which is the average length of time between the purchase of materials and the payment of cash for them.   If the firm on average has 30 days to pay for materials, if its cost of goods sold are 8,00,000 per year, and if its accounts payable average 65754 then its payables deferral period can be calculated as follows: Payables  period =  ____Payables____   Purchases per day =  ______Payables_____  =  __65754__  =  30 days purchases/365  8,00,000/365
The Operating Cycle Cash cycle  = Operating cycle – Acco unts payable period Operating = cycle Inventory conversion  + period Receivables collection  period 73 days + 24 days =97
Cash Conversion Cycle Cash conversion cycle,  the cash conversion cycle can be expressed by this equation: Days in Cash Conversion Cycle = 73 days + 24 days – 30 days = 67 days Cash Conversion  = cycle Inventory conversion  + period Receivables collection  - period Payables deferral  . period
 

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Working capital-management

  • 2. Working Capital Concepts Net Working Capital = Current Assets – Current Liabilities Gross Working Capital : The firm’s investment in current assets
  • 3. Significance of Working Capital Management In a typical manufacturing firm, current assets exceed one-half of total assets. Current liabilities are the principal source of external financing for small firms. Requires continuous, day-to-day managerial supervision. Working capital management affects the company’s risk, return, and share price .
  • 4. TYPES OF WORKING CAPITAL Permanent working capital Temporary /Variable working capital
  • 5. Permanent Working Capital The amount of current assets required to meet a firm’s long-term minimum needs. Permanent current assets TIME AMOUNT
  • 6. Temporary Working Capital The amount of current assets that varies with seasonal requirements. Permanent current assets TIME AMOUNT Temporary current assets
  • 7. Matching approach or Hedging approach Conservative approach • Aggressive approach Determining Financial Mix How current assets will be financed?
  • 8. Balance Sheet Current Liabilities Current Assets Long-Term Debt Preferred Stock Fixed Assets Common Stock To illustrate, let’s finance all current assets with current liabilities , and finance all fixed assets with long-term financing .
  • 9. Balance Sheet Current Liabilities Current Assets Long-Term Debt Preferred Stock Fixed Assets Common Stock Suppose we use long-term financing to finance some of our current assets . This strategy would be less risky , but more expensive!
  • 10. Balance Sheet Current Liabilities Current Assets Long-Term Debt Preferred Stock Fixed Assets Common Stock Suppose we use current liabilities to finance some of our fixed assets . This strategy would be less expensive , but more risky!
  • 11. Financing Current Assets: Short-Term and Long-Term Mix Spontaneous Financing : Trade credit, and other payables and accruals, that arise spontaneously in the firm’s day-to-day operations.
  • 12. The Hedging Principle Permanent Assets Fixed assets and permanent current assets are financed with long-term debt and equity and spontaneous sources of financing Temporary Assets --Seasonal needs are financed with short-term loans
  • 13. Financing Needs and the conservative Approach Permanent current assets and seasonal portion of current assets are financed with long-term debt and equity which is less risky , but more expensive! Short term funds are used in emergency situation
  • 14. Financing Needs and the Aggressive Approach Permanent current assets and seasonal portion of current assets are financed with short term sources of financing but less expensive , but more risky!
  • 15. Trade off between Profitability and Risk Example: The three possible current assets holdings of the firm are Rs.5,00,000/-, Rs. 4,00,000/- and Rs. 3,00,000/-. It is assumed that fixed asset level is constant. The firm has the following data: Sales Rs.15,00,000/- EBIT Rs. 1,50,000/- Fixed Assets Rs. 5,00,000/-
  • 16. Effect of Alternative working capital policies A Rs. B Rs. C Rs. Sales 15,00,000 15,00,000 15,00,000 EBIT 1,50,000 1,50,000 1,50,000 Current Assets 5,00,000 4,00,000 3,00,000 Fixed Assets 5,00,000 5,00,000 5,00,000 Return on Total Asset (EBIT/Total Asset) 15% 16.67% 18.75% C. A / F. A 1.00 0.80 0.60 So B demonstrates a moderate policy and generate an average return which will be viable from the firms point of view.
  • 17. Impact on Liquidity Liquidity Analysis Policy Liquidity A High B Average C Low Greater current asset levels generate more liquidity; all other factors held constant. 0 50,000 OUTPUT (units) ASSET LEVEL ($) Current Assets Policy C Policy A Policy B
  • 18. Impact on Profitability Profitability Analysis Policy Profitability A Low B Average C High As current asset levels decline, total assets will decline and the ROI will rise. 0 50,000 OUTPUT (units) ASSET LEVEL ($) Current Assets Policy C Policy A Policy B
  • 19. Impact on Risk Risk Analysis Policy Risk A Low B Average C High Risk increases as the level of current assets are reduced . 0 50,000 OUTPUT (units) ASSET LEVEL ($) Current Assets Policy C Policy A Policy B
  • 20. Summary of Current Assets S UMMARY O F C URRENT A SSET A NALYSIS Policy Liquidity Profitability Risk A High Low Low B Average Average Average C Low High High 1. Profitability varies inversely with liquidity. 2. Profitability moves together with risk. (risk and return go hand in hand!)
  • 21. The Operating Cycle and the Cash Cycle A firm’s operating cycle (OC) is the time from the beginning of the production process to collection of cash from the sale of the finished product. The operating cycle is the sum of the inventory period and the accounts receivable period, whereas the cash cycle is equal to the operating cycle less the accounts payable period. The Operating Cycle (OC) is the time between ordering materials and collecting cash from receivables.
  • 22. Inventory conversion period, which is the average time required to convert materials into finished goods and then to sell those goods. If average inventories are 2,00,000 and sales are 10,00,000, then the inventory conversion period is 73 days: Inventory conversion period = __Inventory__ Sales per day = __2,00,000___ = 73 days 10,00,000/365
  • 23. Receivables collection period, which is the average length of time required to convert the firm’s receivables into cash, that is, to collect cash following a sale. The receivables collection period is also called the days sales outstanding (DSO). If receivables are Rs.65754 and sales are Rs.10,00,000. The receivable collection period is Receivables collection period = ___Accounts receivable___ Average credit sales per day or Receivables collection period = DSO = Receivables Sales/365 = _65754__ = 24 days 10,00,000/365
  • 24. Payables period, which is the average length of time between the purchase of materials and the payment of cash for them. If the firm on average has 30 days to pay for materials, if its cost of goods sold are 8,00,000 per year, and if its accounts payable average 65754 then its payables deferral period can be calculated as follows: Payables period = ____Payables____ Purchases per day = ______Payables_____ = __65754__ = 30 days purchases/365 8,00,000/365
  • 25. The Operating Cycle Cash cycle = Operating cycle – Acco unts payable period Operating = cycle Inventory conversion + period Receivables collection period 73 days + 24 days =97
  • 26. Cash Conversion Cycle Cash conversion cycle, the cash conversion cycle can be expressed by this equation: Days in Cash Conversion Cycle = 73 days + 24 days – 30 days = 67 days Cash Conversion = cycle Inventory conversion + period Receivables collection - period Payables deferral . period
  • 27.