Liquidity Decisions in Financial management

Liquidity Decisions

1. Unit 5 Liquidity Decisions

2. Working Capital The working capital management refers to management of the working capital, or to be more precise, the management of current assets . A firm’s working capital consists of its investment in current assets which include short term assets such as cash and bank balance, inventories, receivables (including debtors and bills), and marketable securities. Working capital management refers to the management of the level of all these individual current assets. The need for working capital management arises from two considerations. First, existence of working capital is imperative in any firm. The fixed assets which usually require a large chunk of total funds, can be used at an optimum level only if supported by sufficient working capital , and second, the working capital involves investment of funds of the firm. If the working capital level is not properly maintained and managed, then it may result in unnecessary blocking of scarce resources of the firm . The insufficient working capital, on the other hand, put different hindrances in smooth working of the firm . Therefore, the working capital management needs attention of all the financial managers.

3. Cont.. The term working capital refers to current assets which may be defined as ( i ) those which are convertible into cash or equivalents within a period of one year, and ( ii ) those which are required to meet day to day operations. The management of current assets is similar to that of fixed assets in the sense that in both cases a firm analysis their effects on its return and risk . The management of fixed and current assets, however, differs in three important ways: First, in managing fixed assets, time is a very important factor; consequently, discounting and compounding techniques play a significant role in capital budgeting and a minor one in the management of current assets. Second, the large holding of current assets, especially cash, firm’s liquidity position (and reduces riskiness), but also reduces the overall profitability. Thus, a risk-return trade-off is involved in holding current assets. Third, levels of fixed as well as current assets depend upon expected sales , but it is only the current assets which can be adjusted with sales fluctuations in the short run. Thus, the firm has a greater degree of flexibility in managing current assets.

4. CONCEPTS OF WORKING CAPITAL Gross working capital refers to the firm’s investment in current assets. Current assets are the assets which can be converted into cash within an accounting year and include cash, short-term securities, debtors (accounts receivable or book debts), bills receivable and stock (inventory). Net working capital refers to the difference between current assets and current liabilities. Current liabilities are those claims of outsiders which are expected to mature for payment within an accounting year and include creditors (accounts payable), bills payable, and outstanding expenses. Net working capital can be positive or negative. A positive net working capital will arise when current assets exceed current liabilities. A negative net working capital occurs when current liabilities are in excess of current assets. The two concepts of working capital—gross and net—are not exclusive; rather, they have equal significance from the management viewpoint.

5. Cont.. Too large an investment in current assets means tying up funds that can be productively used elsewhere (or it means added interest cost if the firm has borrowed funds to finance the investment in current assets). Excess investment may also expose the firm to undue risk e.g. , in case, the inventory cannot be sold or the receivables cannot be collected. On the other hand, too little investment also can be expensive. For example, insufficient inventory may mean that sales are lost as the goods which a customer wants are not available . The result is that the financial managers spend a large chunk of their time managing the current assets because level of these assets changes quickly and a lack of attention paid to them may result in appreciably lower profits for the firm. So, in the working capital management, a financial manager is faced with a decision involving some of the considerations as follows : 1. What should be the total investment in working capital of the firm? 2. What should be the level of individual current assets ? 3. What should be the relative proportion of different sources to finance the working capital requirements ? Thus, the working capital management may be defined as the management of firm’s sources and uses of working capital in order to maximize the wealth of the shareholders.

6. The operating Cycle and Working Capital needs The working capital requirement of a firm depends, to a great extent upon the operating cycle of the firm. The operating cycle may be defined as the time duration starting from the procurement of goods or raw materials and ending with the sales realization . The length and nature of the operating cycle may differ from one firm to another depending upon the size and nature of the firm. Thus, the operating cycle of a firm consists of the time required for the completion of the chronological sequence of some or all of the following : ( i ) Procurement of raw materials and services. ( ii ) Conversion of raw materials into work-in-progress. ( iii ) Conversion of work-in-progress into finished goods. ( iv ) Sale of finished goods (cash or credit). ( v ) Conversion of receivables into cash.

7. Cont.. Operating Cycle Period : The length or time duration of the operating cycle of any firm can be defined as the sum of its inventory conversion period (ICP) and the receivable conversion period (RCP). Inventory Conversion Period (ICP) : It is the time required for the conversion of raw materials into finished goods sales. In a manufacturing firm the ICP is consisting of Raw Material Conversion Period (RMCP), Work-in-Progress Conversion Period (WPCP), and the Finished Goods Conversion Period (FGCP). The RMCP refers to the period for which the raw material is generally kept in stores before it is issued to the production department. The WPCP refers to the period for which the raw materials remain in the production process before it is taken out as a finished unit. The FGCP refers to the period for which finished units remain in stores before being sold to the customers. Receivables Conversion Period (RCP) : It is the time required to convert the credit sales into cash realization. It refers to the period between the occurrence of credit sales and collection of debtors. The total of ICP and RCP is also known as Total Operating Cycle Period (TOCP). The firm might be getting some credit facilities from the supplier of raw materials, wage earners etc. The period for which the payments to these parties are deferred or delayed is known as Deferral Period (DP).

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