Working Capital Management and Finance

Acknowledgement

CHAPTER 1

MEANING & DEFINITION OF WORKING CAPITAL

A. OVERVIEW

The word ‘working capital’ seems relatively simple to comprehend. But quantification of working capital for an enterprise or assessment of it for lending purposes is as complex as anything else in the financial domain.

Though there is no scientific method for defining working capital, in simple language we can say that it is that part of capital (money) which is required for running the day-to-day operations of a business or industry without a break. It involves getting the raw material, the manufacturing process or dispatch of goods to buyers on cash or credit and realization/conversion of book debts into cash, payment of wages and salaries and other expenses like electricity and operating expenditure etc.

B. DEFINITIONS BY SOME ECONOMISTS:

i. Shubin: Working capital is the amount of funds which is necessary to cover the cost of operating the enterprise.

ii. Gerstenberg: Circulating capital means current assets of a company that are changed in the ordinary course of business from one form to another form.

iii. Hoagland: Working capital is descriptive of that capital which is not fixed.

iv. Weston & Brigham - Working capital refers to a firm’s investment in short term assets, such as cash amounts receivables, inventories etc.

v. Mead, Baker and Malott –Working capital means current assets.

vi. J.S. Mill: The sum of the current assets is the working capital of the business.

vii. Annual Survey of Industries (1961);-- working capital is defined to include, Stocks of materials, fuels, semi-finished goods including work-in-progress and finished goods and by-products; cash in hand and bank and the algebraic sum of sundry creditors as represented by (a) outstanding factory payments e.g., rent, wages, interest and dividend; b) purchase of goods and services; c) short-term loans and advances and sundry debtors comprising amounts due to the factory on account of sale of goods and services and advances towards tax payments.

Keeping in view the above, we can divide working capital into four parts:

a. Funds deployed for managing business operations:

The money which is required for running a business in the most efficient way so as to ensure the continuity of operations is working capital. This money has no relevance with the money required for purchasing the land and buildings, machinery or any other fixed assets.

b. Working capital refers to that part of the firm’s capital, which is required for financing short-term or current assets such as cash, marketable securities, debtors and inventories.

This capital is only for a short period. What is a short period? Though a short period is generally defined as up to 12 months, in financial parlance, however, when we say short period in reference to working capital it is applicable to many factors i.e., period of credit available, period of credit provided, period of manufacturing process, quantity of raw material/semi-finished goods/finished goods required at a particular time (depending on the period of the operating cycle). But at this point, we can assume that the short-term period is 12 months only.

c. Funds invested in current assets keep revolving fast and are constantly converted into cash and this cash flows out again in exchange for other types of current assets as mentioned in ‘b’ above.

In the beginning, cash is converted into the purchase of raw material to semi-finished goods to finished goods to cash if goods are sold on a cash basis. If they are sold on credit, the cash is converted to sundry debtors and ultimately these sundry debtors are converted into cash through realisation of book debts/sundry debtors, and again this cash moves in the same cycle.

d. Working capital is also known as revolving or circulating capital or short-term capital. Working capital has been described as the ‘life blood of any business which is apt because it constitutes a cyclically flowing stream through the business’.

If the circulation of blood in a person stops, it may lead to paralysis, coma, or even death. In the same way, if the flow of money and conversion of assets into cash is disturbed at any stage, it may lead to sickness of the business and even death (closure) of the unit/enterprise.

CHAPTER 2

NATURE & SCOPE OF WORKING CAPITAL

Nature of working capital:

Capital, in the form of cash, is converted into another form, as already discussed, i.e. raw material or semi-finished goods, finished goods or book receivables/accounts receivables/ book debts. Capital changes form through varied business activities and ultimately, it is converted into cash in order to make the business or industry a successful venture.

In fact, working capital includes assets only, and not the liabilities on account of total working capital requirement. This working capital is called total/gross working capital and is required for a business to run uninterrupted.

A. Short Term:

The nature of working capital is short term. If working capital stays for a long term, it is not in the interest of the enterprise and may cause losses in due course of time because of obsolescence, cost of interest on holding of such goods without any such need or income thereon, etc. Even if the goods are retained beyond such a period because of anticipation of rise in prices, then this type of holding will be for the purpose of speculation and not for business needs.

Now the question arises - what is a short period? A short period is related to the effect on cost of production and profitability of the unit. Therefore, this period differs depending on various factors such as:

i. From industry to industry

Where the raw material is available at all times as per requirements, the manufacturing process is also very short. Here, the industry’s product is quickly saleable and realisable; therefore a short period of even more than 15 days could be undesirable.

ii. From person to person

If the traders/manufacturers have a good reputation, they may not require extra time to get their purchases executed in time. The sales too are realisable in time in comparison to a new entrepreneur who may have to get the raw material by making advance payment and may also have to provide a longer period of credit to the buyer of his product to establish himself in the market.

iii. Attitude of the people

Some people want to keep stock of raw material or finished goods in abundance to be on the safe side. There are others who prefer to keep only minimum capital for this purpose as they know or are confident of getting the required stock from other sources in case of an emergency. Thus the attitude of each individual plays a vital role. The first approach is conservative while the second is aggressive. Both approaches have their own risks. In the first one, there is cost to the enterprise on account of interest for excess holding. In the second, there is overt trading where the person’s own contribution is negligible or zero, which may result in not making the payment of current liability on the due date. If there is a small fluctuation downward in sale price or book debts are not realized in time, the enterprise will have no money to make payment to the creditors. Therefore, an enterprise must adopt a moderate policy in this regard.

iv. Realization/conversion period is important

The period of realization of book debts/accounts receivables/book receivables is also important. This depends on various factors like availability of the product and its competitors, the attitude of the traders/manufacturers who provide a longer credit period to boost sales, and the marketing conditions (gap in demand and supply)/ trade and practices in a particular area.

B. Long-Term Working Capital:

This is required for a long term i.e., the minimum capital required for a business at all times. In other words, the raw material, semi finished goods, finished goods, book receivables that are required to be maintained at a minimum level at all times, in the absence of which the unit /business cannot run smoothly. This capital is present in the premises at all times irrespective of other factors. This type of capital is called ‘core capital’ or long-term working capital. Further, this capital is equalant to the value of raw material which is required for the transit period from the seller’s place to buyer’s place in the factory.

CHAPTER 3

WORKING CAPITAL CYCLE

We need to understand the working capital cycle. This will help us to comprehend the basics of working capital and its requirement. It starts with cash and then moves to a cycle of diverse activities and ultimately converts into cash. This is illustrated in the diagram below.

From the above diagram we can clearly observe that the cash is to be converted into something else to produce goods or services. These goods/services are delivered against either cash or credit. If the sale is on a cash basis, then no further step is required. However if the goods/services are sold on credit then it is converted into receivable or book debts. Subsequently, these receivables need to be converted into cash. If one step is missed or the process lacks efficiency, it will affect not only the profitability of the enterprise but also its solvency. This cycle, which starts from cash and ends with cash, moving into various forms like raw material, semi-finished goods, finished goods, receivables and cash, is termed as working capital cycle. Money is needed to ensure that there is no break in this cycle at any level. The entire business cycle, at every step, requires complete efficiency so as to produce goods at a minimum cost to face a competitive market.

CHAPTER 4

COMPONENTS OF WORKING CAPITAL

There are various components of working capital. Some economists include only the current assets that are required to operate the business cycle, whereas other economists also take the current liabilities into consideration. They are of the opinion that when credit is available in the market, current assets are not a requirement in relation to capital. We will discuss both the aspects of working capital to understand its components in totality.

A. CURRENT ASSETS

Current assets are those assets that are used during the period of initiating the process of purchase till the process of realization of sales. However, if the assets are used for the purpose of creating current assets, these are not treated as current assets. For example, if a person is dealing in the manufacturing or sale and purchase of cars/trucks, the cars and trucks are the current assets of the firm. But, if a firm is providing services then the same cars or trucks are not sold but utilized. Hence these cars/trucks will be classified as fixed assets and not current assets.

Current assets have academically been classified as ‘those assets which can be converted into cash within a period of 12 months’ but in practice this period depends on various factors as discussed in Chapter 3.

Generally the following assets are treated as current assets:

a. Cash in hand and balance at the bank

Cash in hand and balance at the bank means currency in hand/balance available in the account of the bank. This is kept for payment of day-to-day expenses that are incurred in a business.

.100 lakhs (defined as Bulk Deposit), the bank may stipulate not to allow premature payment at the time of acceptance of such deposits. Therefore, subject to this condition, the amount kept in a term deposit in the bank may also be treated as current assets provided it is not encumbered or if the term deposit is not under lien for any other debts as security.

b. Bills receivables/Sundry debtors

Bills receivables represent the amount of goods that have been sold on credit to a buyer. The sale on credit may be for a specific period as per terms and conditions agreed upon between the buyer and the seller of the goods. When such sales are made through bill of exchange, the amount is represented as bills receivables. If the sales are not made through bill of exchange then these sales on credit are represented as sundry debtors or book debts or book receivables. In theory, this is for a period of 12 months but in practice and as per the guidelines of the Institute of Chartered Accountants of India, all the debtors/book debts are to be classified under two subheads. One is for those book debts which are six months old or less and the other is for book debts that are outstanding for longer than six months. However, as discussed in Chapter 3, the period of credit to be considered for classification as current assets depends on various factors.

c. Short-term loans and advances

This covers the amount advanced to someone who may be related to the business or otherwise without getting any goods or services; it has to be returned in cash or as goods and services to the firm within a period 12 months. Caution is required here, specifically for the loans and advances made to allied or sister concerns or the partners of the firm. In such cases, these current assets should be treated as noncurrent assets and be deducted from the capital/net worth of the firm..

d. Inventories or stock

These include:

i. Raw material

ii. Work in process or semi-finished goods

iii. Stores and spares

iv. Finished goods.

Here the period of holding of any one type of the stock/inventory is very important. The longer the period of holding, more the interest you have to pay for investing in capital requirements. If the period of holding is shorter, it could be profitable at a given point of time as the cost of interest will be less; however, it may run into a risk of production/solvency.

In case any stock is required, the enterprise may not be in a position to meet the requirement. In that scenario, production may be hampered or dispatches could be delayed resulting in a liquidity crunch which could lead to delay in payment of creditors and affect the credibility of the firm. Therefore optimum utilization is the key to success.

e. Temporary investment of surplus funds

When there are surplus funds that are lying idle, these funds will not earn any income. Therefore, these funds are invested temporarily in various financial instruments so as to earn income and simultaneously keep liquidity intact.

f. Prepaid expenses

These expenses are on account of certain activities to be carried on after the end of financial year but the amount is already paid in the previous financial year. These expenses are sometimes huge when they are amortised in subsequent years because of the financial impact on the profitability of the firm; they are classified as intangible assets

In fact, these expenses are made with the confidence that they will yield results in the coming years; they include publicity expenses, purchase of patents and goodwill etc. However, it is pertinent to note that if such expenses are vouched or debited during one financial year, it will not be correct. This is because of disproportionate expenditure in that year in relation to the income generated in the same year from invested expenditure.

g. Accrued income

This is the income which is due but not has been received till the date of the financial statement. For example, the interest was due on 31.03.2014 but will be received in the first week of April 2014. In case financial statements are prepared as on 31.03.2014, such income will be classified as accrued income for the year ending 31.03.2014

h. Marketable securities

Securities which are tradable in the market at any point of time like Treasury Bills, Certificate of Deposit, commercial paper etc are classified as marketable securities. These securities earn income in the form of interest for the period of investment; it provides a source of liquidity to the firm.

B. CURRENT LIABILITIES

a. Bank overdraft/cash credit limits

The overdraft of bank/cash credit limits is payable on demand and is to be renewed or reviewed within 12 months. Hence this liability is also classified as current liability. These types of credit facilities are generally never adjusted but since they are renewed, reviewed, increased, decreased or recalled after 12 months - depending upon performance of the enterprise - they are classified as current liability and are payable on demand.

b. Bills payable/sundry creditors

This amount represents the purchases on credit. The period of credit depends on several factors as in the case of bills receivables. Generally these purchases are backed by bills of exchange. In fact, the bills receivable are the seller’s current assets whereas these bills are current liability for the buyer. In case the purchases are not backed by bills of exchange, then the purchases on credit are classified as sundry creditors.

Further, if the creditors are on account of purchases of goods for running the business then they are called creditors for goods whereas the creditors for expenses are classified as creditors for expenses.

Both types of creditors are treated as current liabilities.

c. Short-term loans, advances and deposits

Any loan or advance payment or deposit obtained for the purpose of business or otherwise by the firm which are repayable either on demand or within a period of 12 months from the date of raising such loans, advances or deposits, are classified as short-term/current liability. Where the loans/ advances/deposits obtained are due in the next 12 months, they will also be classified as current liability irrespective of the total repayable period of the term loan or term deposit.

d. Dividends payable

Whenever a dividend is declared by a company, it is to be paid within that financial year. Any dividend which is payable and provided for is to be treated as current liability.

e. Provision for taxation

When any tax is to be paid, a provision is to be made for that purpose out of the profits. These provisions may be for income tax, excise, custom or vat tax etc. Such statutory provisions are shown on the liability side in the balance sheet. All such statutory liabilities are to be treated as current liability. It is also pertinent to note that statutory liabilities have superiority over any other liability of the firm.

f. Accrued or outstanding expenses

These expenses are those that are incurred during the period but have not been paid till the date of the financial statement. Such expenses are vouched for in the year in which the work has been done, but could not be paid because of the terms and conditions of the contract or some other reason. They remain as ‘payable outstanding’, to be paid in the following year/years. Such unpaid expenses are classified as accrued/outstanding/sundry creditors for expenses.

g. Contingent expenses

These are the expenses which may be incurred in unexpected situations. A contingent expense is a potential expenditure. This means that the contingent expenses might become actual expense only in the future. The provision for such expenses is to mitigate and deal with situations which are not under the control of the organization like natural calamities, the political environment etc. Prudent managers make provisions for such expenses so as to avert a huge risk at a single point of time.

CHAPTER 5

RELATIONSHIP BETWEEN CURRENT ASSETS AND CURRENT LIABILITIES

IMPORTANCE

To understand the relationship between current assets and current liabilities we need to understand the importance of both these aspects. Current assets are the backbone of any business or industry. No business or industry can be run smoothly in the absence of current assets. Further, the quantity of current assets and its value play a vital role and have a major impact on the profitability and solvency of the enterprise. The more current assets a business or industry has, the more capital they have to arrange for acquiring the current assets. This results in the payment of more interest, which will affect the profitability of the firm. However, if current assets levels are low, the continuity of the business may suffer as it could be adversely affected by break in continuity in production, payment of creditors or wages, or other operating expenses.

In fact, when a firm requires current assets, it requires money to acquire these assets. The partners/promoters have three alternatives to meet their financial requirements.

a. Own funds in the shape of capital

b. Purchase of goods on credit from the market

c. Finance from financial institutions like banks.

In case the funds are arranged as capital, although no interest is to be paid, the return on this capital will satisfy the shareholders by making payment of dividends on the shares out of profit earned. The firm will have to pay interest on the borrowings from financial institutions/banks but the credit available in the market may be a cheap source of financing its current assets. This depends on various factors, i.e. trade and practices in the particular trade being practiced in a geographical area, the reputation of the seller and buyer, the competition, etc.

However, it is not easy to obtain credit from the market and financial institutions. Additional arrangement of capital is also not an easy task. Creditors are interested in their profitability and liquidity; hence the credit from the market is available on strict terms.

As a result, the relationship between current assets and current liabilities is very important in any business or industry. Attempts have been made to quantify this by setting certain standard ratios between current assets and current liabilities. This ratio is called Current Ratio.

CURRENT RATIO:

Current Ratio is the relationship between current assets and current liabilities. It may represent in terms of percentage or in proportion. By and large, this ratio is represented in proportionate form where the value of current assets is represented in proportion to the value of current liability.

For example:

5,000

4,000

Current Ratio is calculated as below :

Current Assets: Current liabilities = 5,000:4,000 = 5:4 = 1.25:1

Here you will observe that if the current liability is 1 then the current assets are 1.25 meaning that current assets are 1.25 times more than the current liabilities.

Though this ratio depends on the attitude of the promoter/partners/financial managers keeping in view various factors, it was derived with the experience of financial managers that the standard ratio of 2:1 is the ideal ratio where there is no risk of default while making the payment of current liabilities. It is presumed that the assets will definitely be realized for half of its book value in the shortest period or on demand.

Since the cycle of production and frequent movement of current assets and current liabilities have gained importance during the last few decades, this ratio of 2:1 has been treated as conservative, resulting in profitability being affected. Even if the ratio is less then 2:1, the chances of failure in meeting the commitment are very minimal. Furthermore, this ratio is important for Micro Small and Medium Enterprises (MSME) units as their cost of production is very important in view of the tough competition they face. Hence this ratio has gained more importance and bankers have given benefit to the industry by keeping it at a lower level so that the capital invested by them is utilized at the optimum level.

Keeping this in view, while financing units, bankers have fixed their own standard ratios gained from their experience, and from guidelines issued by Reserve Bank of India from time to time as given below. (This is the minimum ratio that is required while considering the liquidity of a unit.)

5 crores, the standard current ratio should be 1.17:1

5 crores, the standard current ratio should be 1.33:1

c. In the case of seasonal industries like the sugar industry, the current ratio may be accepted at the level of 1:1 keeping in view the fact that the goods will not be kept for a long period and will be sold out within the year. The government wants to boost such industries because of its national policies, i.e. to ensure that the payment to farmers be made as quick as possible. The Minimum Support Price (MSP) of sugarcane is fixed by the government to protect the interest of the growers on one side and the industry’s demand for low realization in relation to its cost on the other. Therefore more leverage is provided to such industries.

d. In case of annuity income, this ratio can be accepted at the level of 1.2:1, provided the lessee is of high repute and there is a tripartite agreement between the borrower (lessor/owner of property), bank and the lessee (tenant).

Although there may be several companies or enterprises where the ratio is not at this level, keeping in view the past track record of the borrower, chances of improvement of current ratio on the basis of projected profits or induction of additional capital or quasi capital, the lower ratio is entertained for existing borrowers subject to the condition that projections of sales/purchases/profit/required capital for the next year are realistic and achievable so as to ensure that the current ratio will reach the desired level.

CHAPTER 6

CONCEPT/CLASSIFICATION OF WORKING CAPITAL

CONCEPT OF WORKING CAPITAL:

There are two possible interpretations of working capital concepts:

A. BALANCE SHEET CONCEPT

B. OPERATING CYCLE CONCEPT/ON THE BASIS OF TIME CONCEPT

It is understood that the pattern of management will be highly influenced by the approach taken in defining the concept. Therefore, these concepts have been discussed separately but in a nutshell.

A. BALANCE SHEET CONCEPT:

There are two concepts under balance sheet: (i) Gross Working Capital (ii) Net Working Capital. Some economists like Lincoln & Saliers define the excess of current assets over current liabilities as net working capital requirement which is available for finance. ICAI (Institute of Chartered Accountant of India) adheres to this definition as well.

a. Gross Working Capital

Some economists like Mead, Malott, Baker and Field define working capital as ‘total current assets required for the operation of the business’. Per se, working capital means the total requirement of current assets without any impact on current liabilities, i.e. Gross Working Capital. The Gross Working Capital concept is useful in determining the rate of return on investments in working capital.

b. Net Working Capital

The earlier view, i.e. excess of current assets over current liabilities is significant since it is defined by the ICAI, a recognized financial institute in India and treated as a qualitative concept. Consequently, net working capital (Total Current Assets – Total Current Liabilities) is an important concept. The efficacy of this concept is summarized below:

i. It indicates the ability of the firm/unit to meet its operating expenses and short-term liabilities.

ii. It indicates the margin of protection available with the firm for the purpose of meeting creditors’ requirements.

iii. It suggests that a part of the working capital should be financed from the capital or permanent source of funds of the unit/firm.

iv. It is an indicator of the financial soundness of enterprises.

B. OPERATING CYCLE CONCEPT/ON THE BASIS OF TIME

This concept is based on the operating cycle of the product of the unit. It is based on many factors like:

i. For how many days is the raw material required. What is the quantity and value?

ii. For how many days are the semi-finished goods required. What is the quantity and value?

iii. For how many days are the finished goods required. What is the quantity and value?

iv. For how many days is credit to be provided to the buyer of the product or how much sales should be made on credit? What is the period required for realisation of these credit sales?

v. For how many days is credit available from the supplier of raw materials of the product? What quantity of purchases will be available on credit and how much time (number of days/months) is available for payment of these purchases on credit?

vi. Keeping in view the above factors, it is evident that certain parts of capital will always remain in the business; these may be called core working capital or permanent or fixed working capital. The other component is variable working capital which will depend on special purposes/special activities and seasonal