1. Introduction of Working Capital Management.pptx

Introduction of Working Capital Management

1. Working capital management Introduction to Working Capital Management

2. Concept of Working Capital Working capital means the funds available and used for day-to-day operations of an enterprise It is typically the firm’s holdings of current, or short-term, assets such as cash, receivables, inventory, and marketable securities In a retail establishment, cash is initially employed to purchase inventory which is in turn sold on credit and results in accounts receivables; once the receivables are collected, they become cash - part of which is reinvested in additional inventory and part (i.e., the amount above cost) going to profit or cash The less Working Capital used to attract sales, the higher is likely to be the return on investment Working capital provides an accurate assessment of the liquidity position of firm with the liquidity-profitability dilemma solidly authenticated in the financial scheme of obligations which mature within a twelve-month period

3. Concept of Working Capital Credit Sale There are two possible interpretations of working capital concept: 1. Balance Sheet Concept 2. Operating Cycle Concept

4. Balance Sheet Concept There are two interpretations of working capital under the balance sheet concept At times, working capital is used as a synonym for gross or total current assets At other times it is represented by the excess of current assets over current liabilities and is the amount normally available to finance current operations The excess of current assets over current liabilities is called the net working capital or net current assets; many economists feel that In the long run what matters is the surplus of current asserts over current liabilities It is this concept which helps creditors and investors to judge the financial soundness of the enterprise What can always be relied upon to meet the contingencies, is the excess of current assets over the current liabilities; and This definition helps to find out the correct financial position of companies having the same amount of current assets

5. Balance Sheet Concept Other economists feel that current assets should be considered as working capital as the whole of it helps to earn profits; and management is more concerned with the total current assets as they constitute the total funds available for operational purposes Working capital is really a part of long-term finance that is locked in and used for supporting current activities; as such, the larger the amount of working capital so derived, greater the proportion of long-term capital sources siphoned off to short-term activities

6. Operating cycle Concept A company’s operating cycle typically consists of three primary activities; purchasing resources producing the product, and distributing (selling) the product These activities create unsynchronized funds flows because cash disbursements usually take place before cash receipts, example: payments for resource purchases takes place before the collection of receivables They are also uncertain because future sales and costs, which generate the respective receipts and disbursements, cannot be forecasted with complete accuracy Firms have to maintain a cash balance to pay the bills as they come due to invest in inventories to fill customer orders promptly To invest in accounts receivable to extend credit to its customers

7. Operating cycle Concept The operating cycle is equal to the length of the inventory and receivables conversion periods

8. Operating cycle Concept The operating cycle of a typical firm is equal to the length of the inventory and receivables conversion periods: Operating cycle = Inventory conversion period + Receivables conversion period The inventory conversion period is the length of time required to produce and sell the product; it is defined as follows: Inventory conversion period = Average inventory Cost of sales / 365

9. Operating cycle Concept Finally, the cash conversion cycle represents the net time interval between the collection of cash receipts from product sales and the cash payments for the company’s various resource purchases It is calculated as follows: Cash conversion cycle = Operating cycle – Payable deferral period Payables deferral period = Accounts Payable + Salaries, benefits and Payroll taxes payable (Cost of sales + Selling, general and Administrative expense) /365 The payables deferral period is the length of time the firm is able to defer payment on its various resource purchases (for example, materials, wages, and taxes)

10. Importance of Working Capital Working capital is the life blood and nerve centre of a business; no business can run successfully without an adequate amount of working capital The main advantages of maintaining adequate amount of working capital are as follows: Solvency of the business: Adequate working capital helps in maintaining solvency of the business by providing uninterrupted flow of production Goodwill: Sufficient working capital enables a business concern to make prompt payments and hence helps in creating and maintaining goodwill. Easy Loans: A concern having adequate working capital, high solvency and good credit standing can arrange loans from banks and other on easy and favourable terms. Cash discounts: Adequate working capital also enables a concern to avail cash discounts on the purchases and hence it reduces costs Regular supply of raw materials: Sufficient working capital ensures regular supply of raw materials and continuous production

11. Importance of Working Capital Regular payment of salaries, wages and other day-to-day commitments: A company which has ample working capital can make regular payment of salaries, wages and other day-to-day commitments which raises the morale of its employees Exploitation of favourable market condition: Only concern with adequate working capital can exploit favourable market conditions such as purchasing its requirements in bulk when the prices are lower Ability to face crisis: Adequate working capital enables a concern to face business crisis in emergencies such as depression because during such periods, generally, there is much pressure on working capital. Quick and regular return on investments: Sufficiency of working capital enables a concern to pay quick and regular dividends to its investors; this gains the confidence of its investors High morale: Adequacy of working capital creates an environment of security, confidence, and high morale and creates overall efficiency in a business

12. Factors Affecting Working Capital Requirements Nature or Character of Business: The working capital requirement of a firm basically depends upon the nature of this business; for example, public utility undertakings like electricity water supply and railways need very limited working capital because they offer cash sales only and supply services Size of Business/Scale of Operations: The working capital requirement of a concern is directly influenced by the size of its business which may be measured in terms of scale of operations. Production Policy: In certain industries the demand is subject to wide fluctuations due to seasonal variations; the requirements of working capital in such cases depend upon the production policy Manufacturing Process/Length of Production Cycle: In manufacturing business the requirement of working capital increases in direct proportion of length of manufacturing process

13. Factors Affecting Working Capital Requirements Seasonal Variation: In certain industries raw material is not available through out the year; they have to buy raw materials in bulk during the season to ensure and uninterrupted flow and process them during the entire year Rate of Stock Turnover: A firm having a high rate of stock turnover will need lower amount of working capital as compared to a firm, having a low rate of turnover Credit Policy: The credit policy of a concern in its dealing with debtors and creditors influence considerably the requirement of working capital

14. Factors Affecting Working Capital Requirements Business Cycle: Business cycle refers to alternate expansion and contraction in general business activity; in a period of boom i.e., when the business is prosperous, there is a need of larger amount of working capital due to increase in sales, rise in prices, optimistic expansion of business contracts sales decline, difficulties are faced in collection from debtors and firms may have a large amount of working capital lying idle Rate of Growth of Business: The working capital requirement of a concern increase with the growth and expansion of its business activities Price Level Changes: Changes in the price level also effect the working capital requirement; generally the rising prices will require the firm to maintain larger amount of working capital as more funds will be required to maintain the same current assets.

15. Optimal Level of Working Capital Investment The optimal level of working capital investment is the level expected to maximize shareholder wealth A trade off between two costs namely carrying cost and shortage cost determines the optimal level of current assets Costs that rise with current assets i.e. that cost of financing a higher level of current assets form carrying costs; shortage costs are in the form of disruption in production schedule, loss of Sales and loss of goodwill The optimal level of working capital investment is a function of several factors Proportions of Short-term Financing Not only a firm have to be concerned about the level of current assets; it also has to determine the proportions of short-and long-term debt to use in financing use in these assets. The decision also involves trade-offs between profitability and risk

16. Optimal Level of Working Capital Investment Cost of Short-term versus Long-term Debt With long-term debt, a firm incurs the interest expense even during times when it has no immediate need for the funds With short-term debt, in contrast, the firm can avoid the interest costs on unneeded funds by not renewing the debt Risk of Long-term versus Short-term Debt Borrowing companies have different attitudes toward the relative risk of long-term versus short-term debt then lenders Borrowers feel that there is more risk associated with short-term debt The reasons for this are two fold

17. Optimal Level of Working Capital Investment First, there is always the chance that a firm will not be able to refund its short-term debt When a firm’s debt matures, it is either paid off or new financing is arranged; at the time of maturity, however, the firm could faced with financial problems resulting from such events as strikes, natural disasters, or recessions that cause sales and cash inflows to decline Under these circumstances the firm may find it very difficult or even impossible to obtain the needed funds, this could lead to operating and financial difficulties Second, short-term interest rates tend to fluctuate more over time than long-term interest rates; as a result, a firm’s interest expenses and expected earnings after interest and taxes are subject to more variation (risk) over time with short-term debt than with long-term

18. Overall Working Capital policy Working capital management involves decisions with regard to levels of cash, receivables, and inventory Too much working capital is costly, reducing profitability and return on capital However, too little can also be costly in terms of lost opportunities and the company may suffer increases in cost of capital due to too little cash if it cannot pay bills on time A business firm can adapt any of the following working capital policies 1. Conservative working capital policy Under conservative approach, the firm carries high investment in current assets and carries large amount of inventories and grants generous terms of credit to customers resulting in a high level of debtors The consequences of conservative working capital policy are quick deliveries to customers and more sales due to generous credit terms

19. Overall Working Capital policy 2. Aggressive working capital policy Under aggressive working capital policy, investment in current assets is very low The firm keeps less amount of cash and marketable securities, manages with less inventories and tight credit terms resulting in low level of debtors The consequences of aggressive working capital policy are frequent production stoppages, delayed deliveries to customers and loss of sales 3. Moderate working capital policy Moderate approach is always maintaining required amount of current assets depending upon sales The optimum level of current assets (minimized at that level) is denoted by total costs = carrying costs + shortage costs

20. Q & A

21. Practice Questions “There are two interpretations of working capital under the balance sheet concept” – what are the two concepts, elaborate. Illustrate the operating cycle concept of working capital management. Assess the importance of working capital management. List the factors affecting working capital requirements. “The optimal level of working capital investment is a function of several factors” - what are the factors, elaborate.