Working capital management

This presentation is an overview of Working Capital Management.
Dr. Soheli Ghose ( Ph.D (University of Calcutta), M.Phil, M.Com, M.B.A., NET (JRF), B. Ed).
Assistant Professor, Department of Commerce,St. Xavier's College, Kolkata.
Guest Faculty, M.B.A. Finance, University of Calcutta, Kolkata

1. Working Capital Management Dr. S. Ghose

2. Definition of Working Capital   Working Capital refers to that part of the firm’s capital, which is required for financing short-term or current assets such a cash marketable securities, debtors and inventories. Funds thus, invested in current assets keep revolving fast and are constantly converted into cash and this cash flow out again in exchange for other current assets. Working Capital is also known as revolving or circulating capital or short-term capital.

3. “ circulating capital means current assets of a company that are changed in the ordinary course of business from one form to another, as for example, from cash to inventories, inventories to receivables, receivable to cash” ……Genestenbreg

4. Concept of working capital There are two possible interpretations of working capital concept: Balance sheet concept Operating cycle concept Balance sheet concept There are two interpretations of working capital under the balance sheet concept. a. Excess of current assets over current liabilities b. Gross or total current assets.

5. Excess of current assets over current liabilities are called the net working capital or net current assets. Working capital is really a part of long term finance is locked in and used for supporting current activities. The balance sheet definition of working capital is meaningful only as an indication of the firm’s current solvency in repaying its creditors. When firms speak of shortage of working capital they in fact possibly imply scarcity of cash resources. In fund flow analysis an increase in working capital, as conventionally defined, represents employment or application of funds.

6. Net Working Capital Current Assets – Current Liabilities. Gross Working Capital The firm’s investment in current assets. Working Capital Management The administration of the firm’s current assets and the financing needed to support current assets. Working Capital Concepts

7. FACTORS DETERMINING WORKING CAPITAL 1 .     Nature and Demand of the Industry 2.      Cash requirements 3.      Nature of the Business 4.      Manufacturing time 5.      Volume of Sales 6.      Terms of Purchase and Sales 7.      Inventory Turnover 8.      Business Turnover and Business Cycle 9. Current Assets requirements 10. Production Cycle 11.    Credit control 12.    Inflation or Price level changes 13.    Profit planning and control 14.    Repayment ability and Cash reserves 15.    Operation efficiency 16.    Change in Technology 17.    Firm’s finance and dividend policy 18.    Attitude towards Risk contd …

8. EXCESS OR INADEQUATE WORKING CAPITAL Every business concern should have adequate working capital to run its business operations. It should have neither redundant or excess working capital nor inadequate or shortage of working capital. Both excess as well as shortage of working capital situations are bad for any business. However, out of the two, inadequacy or shortage of working capital is more dangerous from the point of view of the firm.

9. Disadvantages of Redundant or Excess Working Capital 1. Excessive Cash, Idle funds, non-profitable for business, poor ROI 2.Unnecessary purchasing & accumulation of inventories over required level 3.Excessive debtors and defective credit policy, higher incidence of B/D. 4. Overall inefficiency in the organization. 5. When there is excessive working capital, Credit worthiness suffers 6. Due to low rate of return on investments, the market value of shares may fall

10. Disadvantages or Dangers of Inadequate or Short Working Capital 1  Can’t pay off its short-term liabilities in time. 1   Economies of scale are not possible. 1   Difficult for the firm to exploit favourable market situations 1   Day-to-day liquidity worsens. 1 Adoption of Tight Credit Policy 1   Improper utilization the fixed assets and ROA/ROI falls sharply

11. Significance of Gross WC Optimum investment in CA Investment in CA must be adequate CA investment should not be inadequate or excessive inadequate WC can disturb production and can also threaten the solvency of firm , if it fails to meet its current obligation excessive investment in CA should be avoided , since it impairs firms profitability Financing of CA Need for WC arises due to increasing level of business activity & it is to provided quickly some time surplus fund may arises which should be invested in Short term securities , they should not be kept idle

12. Significance of Net Working Capital Maintaining Liquidity position For maintaining liquidity position there is a need to maintain CA sufficiently in excess of CL Judge Financial Soundness of a firm The Net working capital helps creditors and investors to judge financial soundness of a firm

13. KINDS OF WORKING CAPITAL WORKING CAPITAL BASIS OF CONCEPT BASIS OF TIME Gross Working Capital Net Working Capital Permanent / Fixed WC Temporary / Variable WC Regular WC Reserve WC Special WC Seasonal WC

14. Difference between permanent & temporary working capital Amount Variable Working Capital of Working Capital Permanent Working Capital Time Permanent and temporary working capital for Stable firm

15. Variable Working Capital Amount of Working Capital Permanent Working Capital Time Permanent and temporary working capital for Growing firm

16. Operating cycle concept Successful sales activity is necessary for earning profit but sales do not convert into cash immediately There is invisible time lap between the sale of good and receipt of cash The time taken to convert raw material into cash is known as operating cycle : Conversion of cash into raw material Conversion of raw material into work in progress Conversion of Work in progress into finished goods Conversion of finished good into Sales ( Debtors and cash )

17. 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 funds flows that are both unsynchronized and uncertain. Unsynchronized because cash disbursements (for example, payments for resource purchases) usually take place before cash receipts (for example collection of receivables). They are uncertain because future sales and costs, which generate the respective receipts and disbursements, cannot be forecasted with complete accuracy.

18. The firm has to maintain cash balance to pay the bills as they become due . In addition, the company must invest in inventories to fill customer orders promptly. And finally, the company invests in accounts receivable to extend credit to customers. Operating cycle is equal to the length of inventory and receivable conversion periods.

19. Operating Cycle in Manufacturing firm Cash Raw Materials W I P Finished Goods Debtors SALES

20. Operating cycle of Non Manufacturing Firm cash Receivables Stock of finished goods

21. Formula for calculating Operating cycle for Manufacturing firm OC = ICP+ARP OC = Operating cycle ICP = Inventory Conversion period ARP = Account Receivable Period ICP = Average Inventory Cost of good sold /365 ARP = Average Account Receivable Sales/365

22. COMPONENTS OF OPERATING CYCLE GROSS OPERATING CYCLE = Raw Material Storage Period + WIP Holding Period + Finished Goods Storage Period + Debtors Collection Period NET OPERATING CYCLE = Gross Operating Cycle – Credit Period Allowed by Supplier.

23. Particulars Actual Balance as at 1/4/14 (Rs.) Projected Balance as on 31/3/15 (Rs.) Raw Materials 45000 65356 WIP 35000 51300 Finished Goods 60181 70175 Debtors 112123 135000 Creditors 50079 70469 Annual Purchase of raw materials (all in credit) 400000 Annual Cost of Production 750000 Annual COGS 915000 Annual Operating Cost 950000 Annual Sales (all in credit) 1100000 The following information is forecasted by Z Ltd for the year ending 31/3/15. Taking 365 days in one year, calculate Net Operating Cycle period, Number of Operating Cycles in a year, Amount of Working Capital Requirement.

24. A. Raw Material Holding Period = Avg Stock of Raw Material / Avg daily consumption of raw materials = { (45000 + 65356)/2 } / { ( 45000 + 400000 – 65356) /365} = 53 days. B.WIP period = Avg WIP / Avg daily cost of production = { (35000 + 51300)/2 } / { 750000 /365} = 21 days. C.Finished Goods Holding period = Avg Stock of Finished Goods / Avg daily COGS = { (60181 + 70175)/2 } / { 915000 /365} = 26 days. D. Debtors Collection period = Avg Debtors / Avg daily credit sales = { (112123 + 135000)/2 } / { 1100000 /365} = 41 days. E. Creditor Payment period = Avg Creditors / Avg daily credit purchase = { (50079 + 70469)/2 } / { 400000 /365} = 55 days. Net Operating Cycle = A + B + C + D – E = 86 days Number of Operating Cycles = 365 / Net Operating Cycle Period = 365/86 = 4.244 = 4 cycles Amount of Working Capital = Annual Operating Cost / Number of Operating Cycle = 950000/4.2444 = 223845

25. FORECASTING / ESTIMATION OF WORKING CAPITAL REQUIREMENTS Factors to be considered Total costs incurred on materials, wages and overheads The length of time for which raw materials remain in stores before they are issued to production. The length of the production cycle or WIP, i.e., the time taken for conversion of RM into FG. The length of the Sales Cycle during which FG are to be kept waiting for sales. The average period of credit allowed to customers. The amount of cash required to pay day-to-day expenses of the business. The amount of cash required for advance payments if any. The average period of credit to be allowed by suppliers. Time – lag in the payment of wages and other overheads

26. PROFORMA - WORKING CAPTIAL ESTIMATES 1. TRADING CONCERN STATEMENT OF WORKING CAPITAL REQUIREMENTS Amount (Rs.) Current Assets (i) Cash ---- (ii) Receivables ( For…..Month’s Sales)---- ---- (iii) Stocks ( For……Month’s Sales)----- ---- (iv)Advance Payments if any ---- Less : Current Liabilities (i) Creditors (For….. Month’s Purchases)- ---- (ii) Lag in payment of expenses -----_ WORKING CAPITAL ( CA – CL ) xxx Add : Provision / Margin for Contingencies ----- NET WORKING CAPITAL REQUIRED XXX

27. 1. MANUFACTURING CONCERN STATEMENT OF WORKING CAPITAL REQUIREMENTS Amount (Rs.) Current Assets (i) Stock of R M( for ….month’s consumption) ----- (ii)Work-in-progress (for…months) (a) Raw Materials ----- (b) Direct Labour ----- (c) Overheads ----- (iii) Stock of Finished Goods ( for …month’s sales) (a) Raw Materials ----- (b) Direct Labour ----- (c) Overheads ----- (iv) Sundry Debtors ( for …month’s sales) (a) Raw Materials ----- (b) Direct Labour ----- (c) Overheads ----- (v) Payments in Advance (if any) ----- (iv) Balance of Cash for daily expenses ----- (vii)Any other item ----- Less : Current Liabilities (i) Creditors (For….. Month’s Purchases) ----- (ii) Lag in payment of expenses ----- (iii) Any other ----- WORKING CAPITAL ( CA – CL )xxxx Add : Provision / Margin for Contingencies ----- NET WORKING CAPITAL REQUIRED XXX

28. Important Points while estimating WC (1) Profits should be ignored while calculating working capital requirements for the following reasons. (a) Profits may or may not be used as working capital (b) Even if it is used, it may be reduced by the amount of Income tax, Drawings, Dividend paid etc. (2) Calculation of WIP depends on the degree of completion as regards to materials, labour and overheads. However, if nothing is mentioned in the problem, take 100% of the value as WIP. Because in such a case, the average period of WIP must have been calculated as equivalent period of completed units. (3) Calculation of Stocks of Finished Goods and Debtors should be made at cost unless otherwise asked in the question.

29. Working Capital Financing Mix Approaches to Financing Mix The Hedging or Matching Approach The Conservative Approach The Aggressive Approach

30. Hedging approach to asset financing Fixed Assets Permanent Current Assets Total Assets Fluctuating Current Assets Time Short-term Debt Long-term Debt + Equity Capital

31. The Hedging approach Hedging approach refers to a process of matching maturities of debt with the maturities of financial need. In this approach maturity of source of fund should match the nature of asset to be financed This approach is also known as matching approach. The hedging approach suggests that the permanent working capital requirement should be financed with fund from long term sources while the temporary working capital requirement should be financed with short term funds.

32. Conservative Approach This approach suggested that the entire estimated investments in current asset should be finance from long term source and short term should be use only for emergency requirement Distinct features of this approach : Liquidity is greater Risk is minimized The cost of financing is relatively more as interest has to be paid even on seasonal requirement for the entire period

33. Conservative approach to asset financing Fixed Assets Permanent Current Assets Total Assets Fluctuating Current Assets Time Short-term Debt Long-term Debt + Equity capital

34. Trade off between Hedging and conservative approaches The hedging approaches implies low cost , high profit and high risk while the conservative approach leads to high cost , low profit , low risk. A trade off between the two will then be an acceptable approach , One way of determining the trade off is by finding the AVG of maximum and minimum requirement of current asset or working capital

35. Aggressive approach to asset financing Fixed Assets Permanent Current Assets Total Assets Fluctuating Current Assets Time Short-term Debt Long-term Debt + Equity capital

36. Aggressive approach The aggressive approach suggests that the entire estimated requirement of current asset should be financed from short-term sources and even a part of permanent current asset be financed from short - term sources. This approach makes the finance mix : More Risky Less costly More Profitable

37. Comparative Study of Aggressive, Conservative and Matching Approach Basis Aggressive Conservative Matching Permanent Current Assets Some portion financed with Short Term Sources and some with Long Term Sources of Funds All financed with Long Term Sources of Funds. All financed with Long Term Sources of Funds Temporary Current Assets All financed with Short Term Sources of Funds Some portion financed with Short Term Sources and some with Long Term Sources of Funds. In the absence of Temporary Assets, LT Finance released can be invested in Marketable Securities to build up the Liquidity Position of the firm. All financed with Short Term Sources of Funds Liquidity Lower Higher Moderate Profitability Higher Lower Moderate

38. In a typical manufacturing firm, current assets exceed one-half of total assets. Excessive levels can result in a substandard Return on Investment (ROI). Current liabilities are the principal source of external financing for small firms. Requires continuous, day-to-day managerial supervision. Working capital management affects the company’s risk, return, and share price. Significance of Working Capital Management

39. Management of Working Capital Working capital in general practice refer to the excess of CA over CL. Management of working capital therefore is concerned with the problems that arise in attempting to manage the CA, the CL and the inter-relationship that exists between them. The basic goal of WCM is to manage the CA & CL of a firm in such a way that a satisfactory level of WC is maintained. Working Capital Management Policies of a firm have a great effect on its profitability, liquidity and structural health of the organization

40. 3 dimensional Nature of Working capital management Dimension I Profitability, Risk, & Liquidity Dimension II Composition & Level of CA Dimension III Composition & Level of CL

41. Working Capital Issues Assumptions 50,000 maximum units of production Continuous production Three different policies for current asset levels are possible Optimal Amount (Level) of Current Assets 0 25,000 50,000 OUTPUT (units) ASSET LEVEL Current Assets Policy C Policy A Policy B

42. Impact on Liquidity Liquidity Analysis Policy Liquidity A High B Average C Low Greater current asset levels generate more liquidity; all other factors held constant. Optimal Amount (Level) of Current Assets 0 25,000 50,000 OUTPUT (units) ASSET LEVEL Current Assets Policy C Policy A Policy B

43. Impact on Expected Profitability Return on Investment = Net Profit Total Assets Let Current Assets = (Cash + Rec. + Inv.) Return on Investment = Net Profit Current + Fixed Assets Optimal Amount (Level) of Current Assets 0 25,000 50,000 OUTPUT (units) ASSET LEVEL Current Assets Policy C Policy A Policy B

44. Impact on Expected Profitability Profitability Analysis Policy Profitability A Low B Average C High As current asset levels decline, total assets will decline and the ROI will rise. Optimal Amount (Level) of Current Assets 0 25,000 50,000 OUTPUT (units) ASSET LEVEL Current Assets Policy C Policy A Policy B

45. Impact on Risk Decreasing cash reduces the firm’s ability to meet its financial obligations. More risk! Stricter credit policies reduce receivables and possibly lose sales and customers. More risk! Lower inventory levels increase stockouts and lost sales. More risk! Optimal Amount (Level) of Current Assets 0 25,000 50,000 OUTPUT (units) ASSET LEVEL Current Assets Policy C Policy A Policy B

46. Impact on Risk Risk Analysis Policy Risk A Low B Average C High Risk increases as the level of current assets are reduced. Optimal Amount (Level) of Current Assets 0 25,000 50,000 OUTPUT (units) ASSET LEVEL Current Assets Policy C Policy A Policy B

47. Summary of the Optimal Amount of Current Assets S UMMARY O F O PTIMAL C URRENT A SSET A NALYSIS Policy Liquidity Profitability Risk A High Low Low B Average Average Average C Low High High 1. Profitability varies inversely with liquidity. 2. Profitability moves together with risk. (risk and return go hand in hand!)

48. Techniques of analysis of working capital The analysis of working capital can be conducted through a number of devices such as Ratio analysis Fund flow analysis Working capital Budgeting

49. The following ratios may be calculated for this purpose Liquidity Ratio Current Ratio Acid test ratio/quick ratio/liquid ratio Cash Position ratio/absolute liquid ratio Inventory turnover ratio Receivable turnover ratio Payable turnover ratio Working capital turnover ratio

50. Inventory turnover ratio Inventory turn over ratio = Cost of good sold Average Inventory at cost Generally , the cost of good sold may not be known from the published financials , in such circumstances Inventory turn over ratio = Net Sales Average Inventory at cost Inventory turn over ratio = Cost of good sold Average Inventory at selling price Inventory conversion period = Days in a year Inventory Turnover Ratio

51. Debtor/Receivable turnover ratio/Debtor velocity Debtor(Receivable) = Net credit Annual sales Average Trade debtors Trade debtors = Sundry debtor + Bill Receivable and account receivable s Average Trade Debtors = Opening Trade debtor + Closing Trade Debtor /2 Note : Debtor should always be taken at gross value , No provision for doubtful debt be deducted from them but when the information about opening and closing balance of trade debtor and credit sales is not available , then the debtors turnover ratio calculated by dividing the total sales by the balance of debtors(inclusive of Bills receivables) given Debtors turn over Ratio = Total sales Debtors

52. Average Collection Period The average collection period represent the average number of days for which a firm has to wait before its receivable are converted into cash Average Collection period = Average Trade Debtors (Drs + B/R) Sales per day Sales Per day = Net Sales No of working days

53. Or Average collection period = Average trade debtors Net Sales No of working days If the period is in months: Average collection period = No of working days Debtors turnover ratio The two basis component of the ratio are debtors and sales per day

54. Creditor/Payable turnover ratio The analysis for credit turnover is basically the same as of debtors turnover ratio except that in place of trade debtor, the trade creditor are taken and in place of sales , average daily purchase are taken as the other component of the ratio. Creditors turnover ratio = Net credit annual purchase Average Trade creditors

55. Average Payment period Ratio = Average Trade Creditors( Creditors+ Bills payable)/Average Daily purchases. Average daily purchase = Annual Purchase /No of working days in a year. Average Payment Period = Trade creditor * No of working days / Net annual purchase. Average Payment Period = No of working days / Credit turnover Ratio.

56. Working capital turnover ratio Working capital of a concern is directly related to sales and current asset like debtors , bills receivable , cash , stock etc . Working capital turnover ratio = Cost of Sales / Average working capital Average working capital = Opening working capital + Closing Working capital/2 ** If cost of sales is not given , then the figure of sale can be used . O n the other hand if opening working capital is not disclosed then working capital at the end of the year will be used. Cost of sale /Net working capital

57. Fund flow analysis : Fund flow analysis is a technical device designated to study the sources from which additional fund were derived and the use to which these sources were put . It is an effective management tool to study change in the financial position of business The fund flow analysis consists of Preparing schedule of change in working capital Statement of sources and application of funds

58. Working capital Budgeting : Working capital budget as a part of total budgeting process of a business , is prepared estimating future long term and short term working capital need and the sources of finance them . The objective of a working capital budget is to ensure availability of fund as and when needed and to ensure effective utilization of these resources .

59. Purchase of Sale of Goods Collection of Raw Material on Credit Account Receivables On credit Average age of Account receivable Inventory (AII) period (ARP) Account Payable Period (APP) Payment to suppliers Receipt of Invoice Operating Cycle (OC) Cash Conversion cycle

60. Resource flows for a manufacturing firm Fixed Assets Production Process Generates Inventory Via Sales Generator Accounts receivable Used in Accrued Direct Labour and materials Accrued Fixed Operating expenses Cash and Marketable Securities Suppliers Of Capital External Financing Return on Capital Collection process Used to purchase Used to purchase Used in Working Capital cycle

61. Credit Policy Increase in Credit Period (Days) Increase in sales (Rs) Bad Debt % of Total Sales B 15 35000 1.5 C 30 40000 1.8 A Company currently has annual sales of Rs. 500000 and an average collection period of 30 days. It is considering a more liberal credit policy. If credit policy is extended, the company expects sales and bad debt losses to increase as follows: The S.P. p.u . is Rs.2. V.C. p.u . is Rs. 1.20. If the current bad debt loss is 1% of sales and the required ROI is 20%, which credit policy should be undertaken? Ignore tax and assume 360 days in a year.

62. Particulars Existing 15 days 30 days Credit Period (days) 30 45 60 B. Annual Sales (Rs.) 500000 535000 540000 C. Levels of Receivables (on existing sales value) [(A*5000000/360] 41667 62500 83333 D. Incremental investment on increase in Sales (B – 500000)* (1.2/2)* A/360 - 2625 4000 E. Additional Investment in Receivables ( C – 41667) + D - 23458 45666 F . Opportunity Cost @ 20% ( 0.2*E) - 4692 9133 G. Incremental Contribution on additional sales @ 40% 5000 14000 16000 H . Bad Debt Losses (B* Bad Debt %) 5000 8025 9720 Incremental Bad Debt Losses ( H – 5000) - 3025 4720 J. Incremental Expected Profit (G – I) - 10975 11280 K, Net Gain - 6283 2147 The firm will maximize the shareholders value if it extends its credit period by additional 15 days for the highest net gain.