Working capital management

Decisions relating to working capital and short term financing are referred to
as working capital management. These involve managing the relationship between
a firm's short-term assets and its short-term liabilities. The goal of working capital
management is to ensure that the firm is able to continue its operations and that it
has sufficient cash flow to satisfy both maturing short-term debt and upcoming
operational expenses. The management of working capital involves managing
inventories, accounts receivable and payable, and cash. Working capital
management is a significant concept in financial management due to the fact that it
plays a pivotal role in keeping the wheels of the business enterprise running.
Implementing an effective working capital management system is an excellent way
for many companies to improve their earnings.

Concept of working capital:

Hoagland defines working capital as follows:

“Working capital is descriptive of that capital which is not fixed. But, the more
common use of working capital is to consider it as the difference between the book
value of the current assets and the current liabilities.”

Working capital, also known as net working capital or NWC, circulating capital
and revolving capital is a financial metric which represents operating
liquidity available to a business. Its magnitude & composition keeps on changing
continuously in the course of business. Along with fixed assets such as plant and
equipment, working capital is considered a part of operating capital. It is calculated
as current assets minus current liabilities. If current assets are less than current
liabilities, an entity has a working capital deficiency, also called a working
capital deficit.
Working Capital = Current Assets − Current Liabilities
Positive working capital means that the company is able to pay off its short-term
liabilities. Negative working capital means that a company currently is unable
to meet its short-term liabilities with its current assets
A company can be endowed with assets and profitability but short of liquidity if its
assets cannot readily be converted into cash. Positive working capital is required to
ensure that a firm is able to continue its operations and that it has sufficient funds
to satisfy both maturing short-term debt and upcoming operational expenses. The
management of working capital involves managing inventories, accounts
receivable and payable and cash.

If a company's current assets do not exceed its current liabilities, then it may run
into trouble paying back creditors in the short term. The worst-case scenario is
bankruptcy. A declining working capital ratio over a longer time period could also
be a red flag that warrants further analysis. For example, it could be that the
company's sales volumes are decreasing and, as a result, its accounts receivables
number continues to get smaller and smaller.

Working capital also gives investors an idea of the company's underlying

operational efficiency. Money that is tied up in inventory or money that customers
still owe to the company cannot be used to pay off any of the
company's obligations. So, if a company is not operating in the most efficient
manner (slow collection), it will show up as an increase in the working capital.
This can be seen by comparing the working capital from one period to
another; slow collection may signal an underlying problem in the company's
operations.

CLASSIFICATION OF WORKING CAPITAL

Working capital can be classified as follows:

• On the basis of time

• On the basis of concept

Determining the Amount of Working Capital
Working capital is the result of subtracting current liabilities from current assets.
It is a measure of a company's solvency, its capacity to make large purchases and
take advantage of bulk discounts, and its ability to attract customers by offering
advantageous credit terms.

Components of working capital:

Working capital comprises of 2 major components;
a) Current assets
b) Current liabilities
Current assets and current liabilities are..........
In accounting, a current asset is an asset on the balance sheet which is expected to
be sold or otherwise used up in the near future, usually within one year, or
one business cycle - whichever is longer.
Current assets include cash, cash equivalents, accounts receivable, inventory
including raw materials; work in progress; finished stock, the portion of prepaid
accounts which will be used within a year, short term advances, short-term
investments, sundry debtors, accrued incomes, and marketable securities.
On the balance sheet, assets will typically be classified into current assets
and long-term assets.
Current Assets = Cash + Bank + Debtors + Bills Receivable + Short Term
Investment + Inventory + Prepaid Expenses
Current liabilities are the debts a company owes which must be paid within one
year. They are the opposite of current assets.
Current liabilities includes things such as short term loans, accounts payable,
dividends and interest payable, bonds payable, consumer deposits, reserves for
Federal taxes, bank overdraft, and other liabilities maturing within one period.
Current liabilities = creditors + accounts payable + short term borrowings +
accrued expenses +dividend & taxes payable +bank overdraft.
The current ratio is calculated by dividing total current assets by total current
liabilities. It is frequently used as an indicator of a company's liquidity, its ability
to meet short-term obligations.
Why should the managers of a business pay special attention to
working capital??????
Management must ensure that a business has sufficient working capital. Too little
will result in cash flow problems highlighted by an organization exceeding its
agreed overdraft limit, failing to pay suppliers on time and being unable to claim
discounts for prompt payment. In the long run, a business with insufficient
working capital will be unable to meet its current obligations and will be forced to
cease trading even if it remains profitable on paper.
On the other hand, if an organization ties up too much of its resources in working
capital it will earn a lower than expected rate of return on capital employed. Again
this is not a desirable situation.

The other problems associated with inadequate & excessive working

capital are:
WORKING CAPITAL SHOULD BE ADEQUATE NEITHER
EXCESSIVE NOR INADEQUATE!!!!!!!!!!!!!!
Advantages Of Adequate Working Capital:
• Solvency Of the Business

• Goodwill

• Easy loans

• Cash discounts

• Regular supply of raw materials

• Regular Payments To Employees

• Favourable Policy Decisions As Per Market Trends

• Quick And Regular Return On Investment

Disadvantages Of Inadequate Working Capital:

• Difficulty In Meeting Operational Expenses

• Loss Of Favourable Business Opportunity

 • Loss Of Goodwill

• Reduction in overall efficiency of the business

• Can’t pay off its short-term liabilities in time.

• Economies of scale are not possible.

• Difficult for the firm to exploit favourable market situations

• Day-to-day liquidity worsens

• Improper utilization the fixed assets and ROA/ROI falls sharply

Disadvantages of Excessive Working Capital:

• Blockage Of Funds

• Excessive Purchasing

• Excessive Debtors

• 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

Factors affecting working capital requirement:

There is no set of universally applicable rules to ascertain working capital needs of
a business organization. A host of factors influencing of working capital needs of a
firm can be categorized into two categories viz., internal factors and external
factors.
INTERNAL FACTORS:

 Nature of Business

 Size of Business

 Firm’s production Policy

 Firm’s credit Policy

 Access to Money Market

 Growth and Expansion of Business

 Profit Margin and Dividend Policy

 Depreciation Policy

 Working capital cycle

 Operating Efficiency of Firm.

EXTERNAL FACTORS :

 Business Fluctuations.

 Technological Development

 Transport and Communication Development

 Import Policy

 Taxation Policy

MANAGEMENT OF WORKING CAPITAL

Management of working capital is concerned with the problem that arises in

attempting to manage the current assets, current liabilities. The basic goal of
working capital management is to manage the current assets and current liabilities
of a firm in such a way that a satisfactory level of working capital is maintained,
i.e. it is neither adequate nor excessive as both the situations are bad for any firm.
There should be no shortage of funds and also no working capital should be ideal.
WORKING CAPITAL MANAGEMENT POLICES of a firm has a great on its
probability, liquidity and structural health of the organization. So working capital
management is three dimensional in nature as

 1. It concerned with the formulation of policies with regard to

profitability, liquidity and risk.
 2. It is concerned with the decision about the composition and level of
current assets.
 3. It is concerned with the decision about the composition and level of
current liabilities.
TANDON COMMITTEE-
Lending Norms:

Ist Recommendation

The borrower has to contribute a minimum 25% of working capital gap from long
term funds.

IInd Recommendation

The borrower has to contribute a minimum of 25% of the total current assets from
long term funds.
IIIrd Recommendation

The borrower has to contribute the entire core current assets and a minimum of
25% of the balance of the current assets from long term funds.

Maximum Permissable Bank Finance (MPBF):

Calculation of maximum permissible bank finance (MPBF)

• Method 1 (Low Risk Category of Borrowers) 0.75(CA-CL)

• Method 2 (Medium Risk category of borrowers) 0.75CA-CL
• Method 3 (High Risk Category of borrowers) 0.75(CA-CCA)-CL

Where;

CA = Current assets

CL = Currents Liabilities excluding bank overdraft or any Short Term

Bank Borrowings

CCA = Core Current Assets

Practical problems:
1) A proforma cost sheet of raju brothers’ private
limited provides the following particulars.
Elements of cost Amount per unit
Raw material 80

Direct labour 30

Overheads 60

Total cost 170

Profit 30

Selling price 200

 The following further particulars are available:

a) Raw materials are in stock for one month

b) Credit allowed by suppliers is one month
c) Credit allowed to customers is two months
d) Lag in payment of wages 1.5 weeks
e) Lag in payment of overheads one month
f) Materials are in process for an average of half month
g) Finished goods are in stock for an average of one month
h) 1/4th of output is sold against cash

Cash in hand and at bank is expected to be Rs. 25000. You are

requested to prepare a statement showing the working capital
needed to finance a level of activity of 104000units of product.

You may assume that production is carried on evenly throughout the

year. Wages and overheads accrue similarly and a period of 4 weeks
is equivalent to a month.

(2) Calculate the working capital of royal industries from the

following particular:
a) Annual expenses:

Wages Rs. 52000

Stores and materials Rs. 9600

Office salaries Rs. 12480

Rent Rs. 2000

Other expenses Rs. 9600

b) Average amount of stocks to be maintained

Finished goods stock Rs. 1000

Material/stores stock Rs. 1600

 c) Expenses paid in advance

(Quarterly advance) Rs. 1600 p.a.

d) Annual sales

Home market Rs. 62400

Foreign market Rs. 15600

e) Lag in payment of

Wages 1.5 weeks

Stores and material 1.5 months

Office salaries 0.5 months

Rent 6 months

Other expenses 1.5 months

f) Credit allowed to customers

Home market 6 months

Foreign market 1.5 months

Concept of operating cycle………

Proper and Effective working capital forecasting and control on working capital
will lead to efficient working capital management. The effectiveness in the above
twin can be achieved if the complete information about the operating cycle is
known.
The working capital cycle can be defined as:

“The period of time which elapses between the point at which cash begins to
be expended on the production of a product and the collection of cash from a
customer.”

The working capital cycle measures the amount of time that elapses between the
moment when your business begins investing money in a product or service, and
the moment the business receives payment for
that product or service. This doesn’t necessarily begin when you manufacture a
product—businesses often invest money in products when they hire people to
produce goods, or when they buy raw materials.

It is important to measure working capital because…………..

A good working capital cycle balances incoming and outgoing payments to
maximize working capital. Simply put, you need to know you can afford to
research, produce, and sell your product.
A short working capital cycle suggests a business has good cash flow. For
example, a company that pays contractors in 7 days but takes 30 days to collect
payments has 23 days of working capital to fund—also
known as having a working capital cycle of 23 days. Amazon.com, in contrast,
collects money before it pays for goods. This means the company has a negative
working capital cycle and has more capital available
to fund growth. For a business to grow, it needs access to cash—and being able to
free up cash from the working capital cycle is cheaper than other sources of
finance, such as loans.

How It Works in Practice???????

The key to understanding a company’s working capital cycle is to know where
payments are collected and made, and to identify areas where the cycle is stretched
—and can potentially be reduced.
The working capital cycle is a diagram rather than a mathematical calculation. The
cycle shows all the cash coming in to the business, what it is used for, and how it
leaves the business (i.e., what it is spent on).
A simple working capital cycle diagram is shown in Figure 1. The arrows in the
diagram show the movement of assets through the business—including cash, but
also other assets such as raw materials and finished
goods. Each item represents a reservoir of assets—for example, cash into the
business is converted into labor. The working capital cycle will break down if there
is not a supply of assets moving continually through
the cycle (known as a liquidity crisis).

Figure 1. A simple working capital cycle diagram

The working capital diagram should be customized to show the way capital moves
around your business.
More complex diagrams might include incoming assets such as cash payments,
interest payments, loans, and equity. Items that commonly absorb cash would be
labor, inventory, and suppliers.
The key thing to model is the time lag between each item on the diagram. For some
businesses, there may be a very long delay between making the product and
receiving cash from sales. Others may need to purchase raw materials a long time
before the product can be manufactured. Once you have this information, it is
possible to calculate your total working capital cycle, and potentially identify
where time lags within the cycle can be reduced or eliminated.

Operating Cycle:
Time duration required from procurement of raw material and ending with sales
realization.
Chronological sequence in which working capital cycle operates:

1. Procurement of raw material.

2. Conversion of raw material to WIP

3. Conversion of WIP to Finished goods

4. Sale of Finished Goods (Cash or Credit)

5. Conversion of receivables into cash

Operating Cycle Period:

1. Inventory conversion Period: It is the time required for conversion of raw
material to finished goods.

Inventory conversion period

 Avg. inventory

= _________________

Cost of sales/365

2. Receivables Conversion Period: It is the time required to convert the credit

sales to sales realization.

Receivable conversion period

Accounts receivable

= ___________________

Annual credit sales/365

1. Payables deferral period

Accounts payable + Salaries, etc

= ___________________________

(Cost of sales + selling, general and admn. Expenses)/365

Net operating Cycle= Inventory conversion period+ Receivables conversion

period – deferral period (Credit period allowed by suppliers)

Cash conversion cycle = operating cycle – payables deferral period.

The diagram below illustrates the working capital cycle for a manufacturing
firm
 The upper
portion of the
diagram above
shows in a
simplified
form the chain
of events in a
manufacturing
firm. Each of
the boxes in
the upper part
of the diagram
can be seen as
a tank through
which funds
flow. These tanks, which are concerned with day-to-day activities, have funds
constantly flowing into and out of them.

• The chain starts with the firm buying raw materials on credit.

• In due course this stock will be used in production, work will be carried out on
the stock, and it will become part of the firm’s work in progress (WIP)

• Work will continue on the WIP until it eventually emerges as the finished product

• As production progresses, labour costs and overheads will need to be met

• Of course at some stage trade creditors will need to be paid

• When the finished goods are sold on credit, debtors are increased

• They will eventually pay, so that cash will be injected into the firm

Each of the areas – stocks (raw materials, work in progress and finished goods),
trade debtors, cash (positive or negative) and trade creditors – can be viewed as
tanks into and from which funds flow.
Working capital is clearly not the only aspect of a business that affects the amount
of cash:

• The business will have to make payments to government for taxation

• Fixed assets will be purchased and sold

• Lessors of fixed assets will be paid their rent

• Shareholders (existing or new) may provide new funds in the form of cash

• Some shares may be redeemed for cash

• Dividends may be paid

• Long-term loan creditors (existing or new) may provide loan finance, loans will
need to be repaid from time to time, and

• Interest obligations will have to be met by the business.

Unlike movements in the working capital items, most of these ‘non-working

capital’ cash transactions are not every day events. Some of them are annual events
(e.g. tax payments, lease payments, dividends, interest and, possibly, fixed asset
purchases and sales). Others (e.g. new equity and loan finance and redemption of
old equity and loan finance) would typically be rarer events.

Importance & use of working capital

Working capital management is very essential as most of the

business falls due to lack of cash than of profits. It is the
business's life blood and every manager's primary task is to help
keep it flowing and to use the cash flow to generate profits. The
faster a business expands, the more cash it will need for working
capital and investment. Good management of working capital
will generate cash, will help improve profits and reduce risks.

For investors, the working capital cycle is most relevant when

analyzing capital-intensive businesses where cash flow is used
to buy inventory. Typically, the working capital cycle of
retailers, consumer goods, and consumer goods manufacturers is
critical to their success.
The working capital cycle should be considered alongside the
cash conversion cycle—a measure of working capital efficiency
that gives clues about the average number of days that working
capital is invested in the operating cycle.

There are two elements in the business cycle that absorb cash
- Inventory (stocks and work-in-progress)
and Receivables (debtors owing you money). The main sources
of cash are Payables (your creditors) and Equity and Loans.

Time & Money Concepts in Working Capital Cycle

Each component of working capital (namely inventory,
receivables and payables) has two dimensions ........TIME .........
and MONEY. When it comes to managing working capital
- TIME IS MONEY. If you can get money to move faster
around the cycle (e.g. collect monies due from debtors more
quickly) or reduce the amount of money tied up (e.g. reduce
inventory levels relative to sales), the business will generate
more cash or it will need to borrow less money to fund working
capital. As a consequence, you could reduce the cost of bank
interest or you'll have additional free money available to support
additional sales growth or investment. Similarly, if you can
negotiate improved terms with suppliers e.g. get longer credit or
an increased credit limit, you effectively create free finance to
help fund future sales.

If you ....... Then ......

• Collect receivables You release cash from the cycle
(debtors) faster
• Collect receivables Your receivables soak up cash
(debtors) slower
• Get better credit (in You increase your cash resources
terms of duration or
amount) from
suppliers
• Shift inventory You free up cash
(stocks) faster
• Move inventory You consume more cash
(stocks) slower

Sources of Additional Working Capital

Sources of additional working capital include the following:

• Existing cash reserves

• Profits (when you secure it as cash !)
• Payables (credit from suppliers)
• New equity or loans from shareholders
• Bank overdrafts or lines of credit
• Long-term loan.
 (I)From the following information of X & Co , compute the
operating cycle in days and working capital requirements:

Period covered 365 days

Average period of credit showed by suppliers 6 days
Amount
(Rs.’000)
Average Total Debtors Outstanding 420

Raw material consumption 5840

Total Production cost 10220

Total cost of sales 10950

Sales for the year (credit) 12775

Value for average stock maintained:

Raw material 480

W-I-P 420

Finished goods 660

(II) Given below are the summarized income statements of

infinity limited for the year ended 31st march 2007 and the
projected year 31st march 2008:

31-3-2007 31-3-2008
(Rs.Lakhs) (Rs.lakhs)
Sales 600 720

Less: Consumption of raw materials 180 240

Depreciation 12 15

Other manufacturing expenses 174 186

Adjustment of opening & closing stock (6) (9)

Cost of goods sold 360 432

Gross profit 240 288

Less: Interest 30 40

General selling expenses 150 200

Profit before tax 60 48

The company’s average inventory, debtors & creditors levels for

the year 2006-2007 were as follows:
Rs. In lakhs
Raw materials 15

Semi finished goods 15

Finished goods 30

Debtors 100
Creditors 15

Based on the projected income statement estimate the working capital

requirement for the year.