D sjsjajj jejwjw dbsj0 CAPITAL FINANCE.pdf

Finance

1. WORKING CAPITAL FINANCE

[SUBJECT: PROJECT FINANCE]

Learning Objectives:

% Provide a brief overview about Working Capital
Finance
Learn about the Definition of Working Capital
Learn about the Working Capital Techniques to find
the Optimal levehof Working Capital
Learn about the Methods of Analysis of Working
Capital
Provide’conceptual understanding about Fund Flow
Analysis

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2. 10.1 Introduction

Working capital financing is done by various modes such as trade credit, cash credit
/ bank overdraft, working capital loan, purchase of bills / discount of bills, bank
guarantee, letter of credit, factoring, commercial paper, inter corporate deposits
etc.

Arrangement of working capital financing forms a major part of the day to day
activities of a finance manager.

It is a very crucial activity and requires continuous attention because working capital
is the money which keeps the day to day business operations smooth.

Without appropriate and sufficienteworking capital financing, a firm may get into
troubles.

Insufficient working capital may result into non-payment of certain dues on time.
Inappropriate mode of financing would result in loss of interest which directly hits
the profits of the firm.

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3. 10.2 Definition of Working Capital

Working capital refers to Current Assets and Current liabilities.

Strictly it is not a part of project finance which deals with financing fixed assets. But

working capital has to be dealt with under project finance for two reasons:

= the margin money for working capital has to be financed by long-term sources; and

= the record of industrial sickness establishes that many a unit flounders on the
quagmire of inadequate working capital. Industrial sickness ties up national
resources and renders waste the project loan as well astthe equity of the promoter.

Promoters have to make sure that adequate working capital to.reach break-even point

and step up capacity utilization is available.

It is essential that such estimates are available and resources are tied up to meet the

working capital requirements of the project.

Net working capital is the difference between current assets and current liabilities and

is a measure of the company’s liquidity.

A survey of large-companies'shows that almost 50% of total net assets of all companies

are devoted.to current assets; and current liabilities constitute 59.1 % of total liabilities.

In the case of smaller companies, almost 63% of total net assets were devoted to

current assets.

In the case or medium companies 55% of total assets were devoted to current assets.

In the case of large companies 40% of total assets were devoted to current assets, and

current liabilities constituted almost 40 % of total liabilities.

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4. 10.3 Different types of Working Capital

1) Trade Credit:

Trade Credit is simply the credit period extended by the creditor of the business.

Trade credit is extended based on the creditworthiness of the firm which is reflected
by its earning records, liquidity position and records of payment.

Just like other sources of working capital financing, trade credit also comes with a
cost after the free credit period.

Normally, it is a costly source as a means of financingbüsiness working capital.

2) Cash Credit / Bank Overdraft:

Cash credit or Bank Overdraft"is the most Useful and appropriate type of working
capital financing extensivély used by all small and big businesses.

It is a facility offered by\commercial banks whereby the borrower is sanctioned a
particular amount whichican be utilized for making his business payments.

The borrower hasto make sure that he does not cross the sanctioned limit.

Best part is that the interest is charged to the extend the money is used and not on
the sanctioned amount which motivates him to keep depositing the amount as soon
as possible to save on interest cost.

Without a doubt, this is a cost effective working capital financing.

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5. 3) Working Capital Loans:

= Working capital loans are as good as term loan for a short period.

= These loans may be repaid in instalments or a lump sum at the end.

= The borrower should take such loans for financing permanent working capital needs.

= The cost of interest would not allow using such loans for temporary working capital.

4) Purchase / Discount of Bills:

= For a business, it is another good service provided by commercial banks for working
capital financing.

= Every firm generates bills inthe normal course of business while selling goods to
debtors.

= Ultimately, thatbillacts as a document to receive payment from the debtor.

= The seller who. requires money will approach bank with that bill and bank will apply
discount on the total amount of the bill based on the prevailing interest rates and pay
the remaining amount to the seller.

= On the date of maturity of that bill, the bank will approach the debtor and collect the
money from him.

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6. 6) Letter of Credit:

= It is also known as non fund based working capital financing.

= Letter of credit and bank guarantee has a very thin line of difference.

= Bank guarantee is revoked and bank makes payment to the holder in case of non
performance of the opposite party whereas in case of letter of credit, the bank will
pay the opposite party as soon as the party performs as per agreed terms.

= So, a buyer would buy a letter of credit and send it to the seller. Once the seller
sends the goods as per agreement, the bank would pay'the seller and collects that
money from buyer.

7) Factoring:

= Factoring is an arrangement whereby a business:sells all or selected accounts payables
to a third party at a price lower than the realizable value of those accounts.

= The third party here is.known as the ‘factor’ who provides factoring services to
business.

= The factor-would not only provide financing by purchasing the accounts but also
collects the amountfrom the debtors.

= Factoring is.of two types — with recourse and without recourse.

= The credit risk of non-payment by the debtor is borne by the business in case of with
recourse and it is borne by the factor in case of without recourse.

Some other sources of working capital financing used are inter-corporate deposits,

commercial paper, public deposits etc.
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7. 10.4 Working Capital Management Techniques for
finding Optimal Level of Working Capital

= Working capital management techniques such as intersection of carrying cost and shortage cost,
working capital financing policy, cash budgeting,

= EOQand JIT are applied to manage different components of working capital like cash, inventories,
debtors, financing of working capital etc.

» These effective techniques mainly manage different components of current assets.

= Working capital management techniques are very effective tools iff'managing the working capital
efficiently and effectively.

= Working capital is the difference current assets and-current liabilities of a business.
"Major focus is on current assets because current liabilitiessarise due to current assets only.
» Therefore, controlling the current assets can automatically control the current liabilities.

» Now, current assets include Inventories, Sundry Debtors or Receivables, Loans and Advances,
Cash and Bank Balance.

= All working capital management techniques attempt to find optimum level of working capital
because ‘both excess and shortage of working capital involves cost to the business.

» Excess working capital carries the ‘carrying cost’ or ‘interest cost’ on the capital lying unutilized.

= Shortage of working capital carries ‘shortage cost’ which include disturbance in production plan,
loss in revenue etc. Finding the optimum level of working capital is the main goal or winning
situation for any business manager.

There are certain techniques used for finding the optimum level of working capital or

management of different items of working capital. & h |
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8. Intersection of Carrying Cost and Shortage Cost

Level of Current Assets

One of the important methods of finding the optimum level of working capital is the point of
intersection of carrying cost and shortage cost in a graphical representation. The total of carrying and
shortage cost is minimum at this point.

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9. Working Capital Financing Policy

Working capital can be divided into two viz. Permanent and Temporary.

Permanent working capital is the level of working capital which is always required and
maintained.

Temporary working capital is the part of working capital which keeps on fluctuating.
Itis high in good seasons and low in bad seasons.

There are two types of financing available.

They are long term financing and short term financing.

Three strategies are possible with respect to financing of working capital.

Efficient financing of working capital reduces carrying éost of capital.

1) Long term financing is used for both permanent and temporary WC.

2) Long term financing is used for.permanent and:some part of temporary WC. Remaining part
of temporary WC is financed through short term financing as and when required.

3) Long term financing is used for permanent and short term financing for temporary WC.

These strategies should be chosen so as to match the maturity of source of finance with the
maturity-of the asset.

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10. Cash Budgeting

Cash budgeting is another important technique for working capital management
which helps keeping optimum level of cash in the business.

Cash budgeting involves estimating the requirements of cash by estimating all
the fore coming receipts and payments.

For effective management, a balance is needed between both excess and
shortage of cash. It is because both ends are costly.

Speeding up of collection and.getting relaxed’credit terms from the creditors can

reduce the cash requirements.

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11. Inventory Management

= Inventory is an important component of working capital or current assets.
= Optimum level of inventory can save on costs heavily.

1) E0Q:
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Economic Order Quantity (EOQ) model is a famous model for managing the inventories.

It helps the inventory manager know how to find the right quantity that should be ordered
considering other factors like cost of ordering, carrying costs, purchase price and annual
sales.

The formula used for finding EOQ is as follows:

EOQ = vi (2 xA x 0) / (P x C)]

A- Annual Sales; O— Cost per Order; P — Purchase price per unit; C— Carrying Cost

2)Just-in-Time:

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Just-in-time is another very important technique which brought about paradigm shift in the
management of inventories.

It did not reduce cost of inventory but it abolished it completely.

Just-in-time means acquiring raw*material or manufacturing product at the time when it is
required by the customer.

This strategy is very difficult to implement but if implemented can bring down inventory cost
to minimum levels.

These are some important techniques discussed here.

Theyӊre very effective in managing working capital. Managing working capital means
managing current assets.

Currenteassets like cash can be managed using cash budgeting; inventory can managed using
inventory techniques like EOQ and JIT.

Debtors and financing of working capital can be managed using appropriate sources of
finance.

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12. 10.5 Methods of Analysis of Working Capital

Analysis of working capital is significant for both management and short-term creditors.
Management can assess the efficiency of the working capital employed in the business.

Such an analysis helps management to detect trends and initiate corrective measures.

It helps the shareholders and creditors to determine prospects of payment of dividend
and interest.

The analysis of working capital helps in determining the ability of the company to repay
its current debts promptly, assess the effectiveness.of management of working capital,
adequacy of working capital and to undertake.credit rating.

Analysis of working capital relates to.an examination of circulation, liquidity, level and
structural aspects of working capital.

In the analysis of working capital the tools used are ratio analysis and funds flow
analysis of the company.

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13. Liquidity Ratios

(i) Net working capital to total assets:

= It was noted earlier that current assets are those assets which the company expects to turn
into cash in the near future and current liabilities are those which it expects to meet in the
near future.

= Net working capital is the difference between current assets and current liabilities
= Net working capital toughly measures the company’s potential reserve of cash.
= Net working capital is expressed as a proportion of total assets.
= Net working capital
Total Assets
(ii) Current Ratio:

. Current ratio serves a similar purposesand is frequently used. It is also called working capital
ratio.

= It is considered as an index.of solvency of a company.
. It indicates the ability of the company to meet its current obligations.
. Changesán current ratio can, however, be misleading.

= Ifa company raises money through Commercial paper and invests the amount in marketable
securities, nét working capital is unaffected but the current ratio changes.

" Current ratio is computed by dividing the total current assets by current liabilities. The result
shows the number of times the current assets pay off the current liabilities.

= Current ratio= Current Assets
Current Liabilities

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14. Acurrent ratio of 2:1 is generally considered satisfactory for a manufacturing company.
It constitutes a rule of thumb for measuring liquidity.

A demand for 100 % margin of current assets over current liabilities is a precaution based on the
practical knowledge of the possible shrinkage that may occur in the value of current assets.

The current ratio cannot, however, be applied as a norm for all companies because the quality
and character of current assets varies according to the type of activity.

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15. (iii) Quick (or Acid-test) ratio:
= Another ratio which measures immediate solvency is the current ratio.
= » Itincludes assets which can be quickly or immediately converted to cash.

» Such assets include only cash, marketable securities and bills customers have not yet paid
(receivables). Inventories are excluded because they cannot be sold at anything above fire-sale
prices.

Es “The liquidity arises because finished goods cannot be sold for more than production cost. Quick
ratio is computed as:

= QR = Cash +Marketable Securities + Receivables = Current Assets - Current Liabilities
Current liabilities Current liabilities

(iv) Interval Measure:

= Sometimes it may be useful to compare current assets to regular cash outgoings of a company.
The interval measure is calculatedyby,

= Cash + Marketable Securities + Receivables

Average daily expenditure from operations

“The intervakexpressed in number of days measures the ability of the company to finance its daily
expenditure with the.Current assets in its position even if it receives no further cash.

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16. Inventory turnover ratios

The inventory turnover ratios show the extent of use of work in different types of inventory
(i) Turnover of raw materials:

This ratio shows the number of times the raw materials were replaced during a year

It is obtained by dividing raw materials issued to the factory by raw materials in ending
inventory

The raw materials inventory of a manufacturing enterprise may be reduced to a number of
months in a year by the turnover of raw materials inventory

A low turnover ratio of raw materials inventory indicates that excessive raw materials have been
procured and the opposite is the condition with a high turnover ofraw materials inventory

(ii) Turnover of stores and spares:

This ratio shows utilization of funds in stores and spares inventory

This ratio is obtained by dividing stores and spare consumed in a fiscal year by the value of stock
and spares at the end of the fiscal year

The stores and spares inventory"may be reduced to number of months stores and spares
inventory by dividing number of months ina year by the turnover of stores and spares inventory
A higher turnover of stores andıspares inventory is an indication of management's efforts to
reduce investment'in this component

On the other hand, a falling turnover of stores and Spares inventory may be taken to mean that
excessive working funds have been deployed in this component

(iii) Turnover of goods-in-process:

This ratio is obtained by dividing the value of goods produced in a year by the value of goods in
process at the end of a fiscal year

This ratio establishes relationship between the value of goods produced and the value of goods
in process of production

A high turnover indicates less accumulation of inventory and less working finance tied up in this

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17. (iv) Turnover of finished goods:

“This ratio is computed by dividing the net sales by finished goods inventory

» The finished goods inventory may be reduced to number of months finished goods inventory by
dividing number of months in a year by turnover of finished goods. inventory

= A higher turnover of finished goods inventory indicates that a higher level of sales has been
attained with less investment in the finished goods inventory

= A falling turnover indicates that the investment in finished=goods is increasing in relation to
sales

(v) Turnover of aggregate inventory:

“This ratio is obtained by dividing the net Sales in a year by the value of aggregate inventory at
the end of the year

= The aggregate inventory of aybusiness enterprise may be reduced to a number of months'
inventory by dividing the number of months in the year by ratio of turnover of aggregate
inventory

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18. Work-in-process

Work-in-process represents investment by firm

It is the amount of semi finished products currently lying on the factory floor

In the traditional view, inventories including WIP are considered as assets and
inventory build-up is seen as value added

They are also considered as a buffer against uncertainties) arising out of delayed
supplies, machine breakdowns, absenteeism and uncertain customer orders

The desire to improve utilization of expensive equipment also contributed to
building up WIP

In recent times inventory lis considered evil and evidence of poor design, poor
foretasting, poor coordination and poor operation of the manufacturing system.
The current trend is to produce times as required

WIP should be equal to the sum obtained by multiplying the rate at which parts
flow through the factory with the length of time parts spent in the factory

The higher turnover of inventory quickens the flow of funds from inventory

A low turnover ratio indicates an over investment in inventory in relation to sales

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19. (i)

Receivables Turnover Ratios

The receivables turnover ratio is computed by dividing annual credit sales by total
customer-receivables.

When the number of days in a year is divided by the turnover of receivables, the
ratio gives average collection period.

The turnover of receivables indicates the rate at which sales are converted into cash
and the average collection period shows the number of days of sales that are
represented by the account receivables.

A declining turnover of account receivables indicates an Over investment of funds in
receivables which may raise the requirement of working capital of a firm.

Cash turnover ratio:

This ratio shows the relationship between cashtbalance plus other liquid assets and
operating costs and expenses.

It shows the adequacy of liquid assets to meet current operating needs.

A high turnover offcash indicates an insufficiency of cash to provide for
emergencies.

A low_turnover of cash shows that an excess cash balance is lying with the
enterprise.

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20. (ii) Current assets turnover ratio:

= This ratio measures the turnover of total current assets used in business operations.

= The ratio is obtained by dividing the cost of goods sold by total current assets.

= This ratio may be linked with the profitability of an enterprise.

= For this purpose two other computations are done.

= First, net income is divided into current assets which gives the rate of profit on
average current assets.

= Second, the rate of profit of current Assets is divided by the turnover of current assets
which gives the rate of profit per turnover of current assets.

= The lower turnover and profitability of current assets indicate utilization of working
capital and reverse is the case with a higher turnover and profitability.

(iii) Working capital turnover ratio:

= This ratio is obtained by dividing net sales by working capital.

= This ratio indicates the:efficiency with which the working capital has been used in the
company.

= The higher turnover of working capital represents lower investment in it and greater
profitability:

= But a very.high turnover of working capital may also indicate the efficient utilization
of working capital in the enterprise.

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21. Efficiency or Profitability Ratios

= These ratios are employed to judge how efficiently a company is using its assets.

(i) Sales to Total Assets:
The ratio shows how hard the company’s assets are being to put to use. The ratio is
represented by

= Sales
Average total assets

= This reveals how close a company is operating to capacity. A high ratio would imply
that sales cannot be stepped up without an increase in capital invested in the
company

(ii) Sales to Net Working Capital:
The ratio would help focus on how efficient working capital is being used. The ratio
is represented by

= Sales
Average net working capital

(iii) Net Profit.Margin (NPM):
The ratio helps:in establishing the proportion of sales that finds its way into profits.
It is computed by
= NPM = Earnings before interest and taxes (pa) -Tax
Sales

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22. (iv) Inventory turnover:
The ratio which tells about the rate at which companies turnover their inventories is
obtained by

= Cost of goods
Average inventory

= Ahigh inventory ratio could mean efficiency or hand to mouth existence

(v) Return on Total Assets:
= The ratio of income (earnings before interest and after taxes) to total assets (original
cost - depreciation) is used to measure the performance of a company
= Return on Total Assets = EBIT —Tax
Average total assets (average of assets at
the beginning and end/of the year)

(vi) Payout ratio: The ratio measures theearnings paid out as dividends.
= Payout ratio = Dividend
Earnings per share
= Companies follow.a low average payout ratio if earnings are not stable. Earnings not
paid out are retained in business
= Retained earnings =1 - payout ratio
= = Earnings = Dividend
Earnings
= The impact of retained earnings in the growth of shareholders investment can be
measured by multiplying retained earnings by the return on equity (earnings/equity).
= Growth in Equity = Earnings - Dividends x Earnings

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23. (i)

Market Value Ratios

Price earning ratio (P/E ratio):
It is a common measure of the investors' estimate of the company. It is obtained by,
P/E Ratio = Stock price
Earnings per share

The stock price is arrived at by assuming that dividends are at steady rate
P= DY,

r-8
where DIV, measures the expected dividend next year, r is the required rate of return
and g is the expected rate of dividend growth.
To find the P/E ratio, divide current stock price formula with expected earnings, per
share
Po = DIV, x 1
EPS, EPS, rg
Normally, P/E ratios are in.mid teens. In the Indian stock market, PE ratios are quite
high. High P/E ratios normally indicate that

1) investors expecthigh dividend growth (g)
2) the share.has low risk and therefore investors accept a low prospective return (r)
3) the company»is’ expected to achieve average growth while paying out a high

proportion of earnings (DIV,/EPS). But in the Indian context high PE ratios are a
demand phenomenon. Excess demand for shares has driven up prices and high P/E
ratios have been registered.

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24. (ii) Dividend yield:
Dividend yield measures dividends as a proportion of the share price
= Dividend yield = Dividend yield per share
Share price
= Inthe case of a company with a steady expected growth in dividends,
Dividend yield = DIV, = r- g
P
= High yield is indicative of investors' expectation_of\low dividend growth or
requirement of a high return

25. (i) Market to book ratio:

The ratio of market price per share to book value per share reveals the
Market worth of the company as compared to what past and present
shareholders have put into it
Book value per share is net worth (paid-up capital + free reserves) divided by
the number of shares outstanding
Market to Book Ratio = Stock price
Book value per share

Market value (assets, debt and equity) to replacement:cost or Tobin's q. The
ratio q is obtained by
q= Market value of assets

Estimated replacement cost
Assets in the ratio include all assets, debtyand equity; and replacement cost
is current cost estimated after adjusting historic cost for inflation
When capital equipment is.worth more than it costs to replace, q is greater
than one and;companies have an incentive to invest; and when equipment is
worth lessithan its replacement cost, q is less than one companies will stop
investing
The merger route is preferred for acquisition of assets than purchase new
assets when q is less than 1
High market values may exist even when existing assets are worth much
more than their cost because investors believe that the company has good

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26. Level of Working Capital

The analysis of level of working capital throws light on the size of working
capital.

It shows whether the size of working capital of an enterprise is excessive or
adequate or inadequate to its needs.

The most important ratio-tests in this regard are the amount of working
capital in terms of months' cost of production or months’ average sales
turnover.

The results of these ratio-tests when compared with the norm for the
industry indicates whether the size of working capital maintained by the
enterprise is excessive or adequate or inadequate to its requirements.

A comparison of working capital with other variables such as output and
sales over a period of time may also indicate the trend in the growth of

working capital.

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27. 8.6 Funds Flow Analysis

Funds flow analysis shows the sources and uses of funds of a company

This technique helps to analyze changes in working capital components
between two dates

A comparative analysis of current assets and liabilities, as shown in the
balance sheet at the beginning and the end of year, indicates changes in
each type of current assets as well as the sources from which working
capital has been obtained

However, the technique of funds flow analysis fails to clarify the significance

of movements inithe working capital structure

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