Lecture notes working capital management
- 1. WORKING CAPITAL MANAGEMENT INTRODUCTION: The uses of funds of a concern can be divided into two parts namely long-term funds and short- term funds. The long – term investment may be termed as ‘fixed investment.’ A major part of the long-term funds is invested in the fixed assets. These fixed assets are retained in the business to earn profits during the life of the fixed assets. To run the business operations short–term assets are also required. The term working capital is commonly used for the capital required for day-to-day working in a business concern, such as for purchasing raw material, for meeting day-to-day expenditure on salaries, wages, rents rates, advertising etc. But there are much disagreement among various financial authorities (Financiers, accountants, businessmen and economists) as to the exact meaning of the term working capital. DEFINITION AND CLASSIFICATION OF WORKING CAPITAL: Working capital refers to the circulating capital required to meet the day to day operations of a business firm. Working capital may be defined as follows: According to Weston & Brigham - “Working capital refers to a firm’s investment in short term assets, such as cash amounts receivables, inventories etc. CONCEPTS OF WORKING CAPITAL 1. Gross Working Capital: It refers to the firm’s investment in total current or circulating assets. 2. Net Working Capital: The term “Net Working Capital” has been defined in two different ways: i. It is the excess of current assets over current liabilities. This is, as a matter of fact, the most commonly accepted definition. Some people define it as only the difference between current assets and current liabilities. The former seems to be a better definition as compared to the latter. ii. It is that portion of a firm’s current assets which is financed by long-term funds CLASSIFICATION OF WORKING CAPITAL Permanent Working Capital: This refers to that minimum amount of investment in all current assets which is required at all times to carry out minimum level of business activities. In other words, it represents the current assets required on a continuing basis over the entire year. 1. Amount of permanent working capital remains in the business in one form or another. This is particularly important from the point of view of financing. The suppliers of such working capital should not expect its return during the life-time of the firm. 2. It also grows with the size of the business. In other words, greater the size of the business, greater is the amount of such working capital and vice versa Permanent working capital is permanently needed for the business and therefore it should be financed out of long-term funds. Temporary Working Capital: The amount of such working capital keeps on fluctuating from time to time on the basis of business activities. In other words, it represents additional current
- 2. assets required at different times during the operating year. For example, extra inventory has to be maintained to support sales during peak sales period. Similarly, receivable also increase and must be financed during period of high sales. On the other hand investment in inventories, receivables, etc., will decrease in periods of depression. Suppliers of temporary working capital can expect its return during off season when it is not required by the firm. Hence, temporary working capital is generally financed from short- term sources of finance such as bank credit. Sources of Working Capital: The current assets which are used in running daily operation of a business is called working capital. Working Capital may be classified as Fixed working capital and Variable working capital. Both types of working capital help in running firm’s daily operation. Fixed working capital should be financed from long-term sources & variable working capital from short term source. So variable from the following sources are as financed: 1. Short term Bank Loan (STBC):--It is a big source of w. cap. Usually firms finance through STBL to meet the need of variable WC and need in excess of FWC. Commercial banks give bank O/D, cash credit etc. 2. Non Bank short term loan: Relatives, Bankers, Govt. Institute are the non bank S.T. Loan 3. Internal Source: One of the main sources w. Cap for a firm in Internal sources. This is also called Self-financing. 4. Long Term Sources (LTS): Sometimes W. Cap is financed through LTS. Usually fixed working capital are share, debenture LT loan etc. 5. Money Lenders: When firms can’t finance short-term need of w.cap from anywhere, they take loan form moneylenders. 6. Trade Credit: When firms purchase on credit & pay the money according to credit term, it is called Trade Credit. Normally Trade credit is used as a source of variable W. Cap. 7. Selling out Excess of Fixed asset: If any fixed asset is considered as extra than need, then that idle fixed asset is sold for working capital. 8. Other than the above sources, firms finances their working capital though paying debts in late (as much as possible) & Accrual etc.
- 3. 9. Collect money/Receivable in the earliest time, pay as late as possible. List of Current Assets and Current Liabilities: Current Assets Current Liabilities Cash, Short-Term securities, Debtors, Bill Receivable, Notes Receivable, Stock (Inventory—R/M, WIP, F/G), Prepaid expenses, etc. Creditors Outstanding expenses, Bills Payable, Bank Overdraft, Etc. Four Components: a. Conversion of cash into inventory. b. Conversion of Inventory into Finished Goods. c. Conversion of Finished goods into account receivable d. Conversion of Account Receivable into cash. DETERMINANTS OF WORKING CAPITAL The factors influencing the working capital decisions of a firm may be classified as two groups, such as internal factors and external factors. The internal factors includes, nature of business size of business, firm’s product policy, credit policy, dividend policy, and access to money and capital markets, growth and expansion of business etc. The external factors include business fluctuations, changes in the technology, infrastructural facilities, import policy and the taxation policy etc. These factors are discussed in brief in the following lines. I. INTERNAL FACTORS 1. Nature and size of the business: The working capital requirements of a firm are basically influenced by the nature and size of the business. Size may be measured in terms of the scale of operations. A firm with larger scale of operations will need more working capital than a small firm. Similarly, the nature of the business - influence the working capital decisions. Trading and financial firms have less investment in fixed assets. But require a large sum of money to be invested in working capital. Retail stores, business units require larger amount of working capital, where as, public utilities need less working capital and more funds to invest in fixed assets. 2. Firm’s production policy: The firm’s production policy (manufacturing cycle) is an important factor to decide the working capital requirement of a firm. The production cycle starts with the
- 4. purchase and use of raw material and completes with the production of finished goods. On the other hand production policy is uniform production policy or seasonal production policy etc., also influences the working capital decisions. Larger the manufacturing cycle and uniform production policy – larger will be the requirement of working capital. The working capital requirement will be higher with varying production schedules in accordance with the changing demand. 3. Firm’s credit policy: The credit policy of a firm influences credit policy of working capital. A firm following liberal credit policy to all customers requires funds. On the other hand, the firm adopting strict credit policy and grant credit facilities to few potential customers will require less amount of working capital. 4. Availability of credit: The working capital requirements of a firm are also affected by credit terms granted by its suppliers – i.e. creditors. A firm will need less working capital if liberal credit terms are available to it. Similarly, the availability of credit from banks also influences the working capital needs of the firm. A firm, which can get bank credit easily on favorable conditions, will be operated with less working capital than a firm without such a facility. 5. Growth and expansion of business: Working capital requirement of a business firm tend to increase in correspondence with growth in sales volume and fixed assets. A growing firm may need funds to invest in fixed assets in order to sustain its growing production and sales. This will, in turn, increase investment in current assets to support increased scale of operations. Thus, a growing firm needs additional funds continuously. 6. Profit margin and dividend policy: The magnitude of working capital in a firm is dependent upon its profit margin and dividend policy. A high net profit margin contributes towards the working capital pool. To the extent the net profit has been earned in cash, it becomes a source of working capital. This depends upon the dividend policy of the firm. Distribution of high proportion of profits in the form of cash dividends results in a drain on cash resources and thus reduces company’s working capital to that extent. The working capital position of the firm is strengthened if the management follows conservative dividend policy and vice versa. 7. Operating efficiency of the firm: Operating efficiency means the optimum utilisation of a firm’s resources at minimum cost. If a firm successfully controls operating cost, it will be able to improve net profit margin which, will, in turn, release greater funds for working capital purposes. 8. Co-ordinating activities in firm: The working capital requirements of a firm are depend upon the co-ordination between production and distribution activities. The greater and effective the co- ordinations, the pressure on the working capital will be minimized. In the absence of co-ordination, demand for working capital is reduced. II. EXTERNAL FACTORS 1. Business fluctuations: Most firms experience fluctuations in demand for their products and services. These business variations affect the working capital requirements. When there is an upward swing in the economy, sales will increase, correspondingly, the firm’s investment in
- 5. inventories and book debts will also increase. Under boom, additional investment in fixed assets may be made by some firms to increase their productive capacity. This act of the firm will require additional funds. On the other hand when, there is a decline in economy, sales will come down and consequently the conditions, the firm try to reduce their short-term borrowings. Similarly the seasonal fluctuations may also affect the requirement of working capital of a firm. 2. Changes in the technology: The technological changes and developments in the area of production can have immediate effects on the need for working capital. If the firm wish to install a new machine in the place of old system, the new system can utilise less expensive raw materials, the inventory needs may be reduced there by working capital needs. 3. Import policy: Import policy of the Government may also effect the levels of working capital of a firm since they have to arrange funds for importing goods at specified times. 4. Infrastructural facilities: The firms may require additional funds to maintain the levels of inventory and other current assets, when there is a good infrastructural facility in the company like transportation and communications. 5. Taxation policy: The tax policies of the Government will influence the working capital decisions. If the Government follows regressive taxation policy, i.e. imposing heavy tax burdens on business firms, they are left with very little profits for distribution and retention purpose. Consequently the firm has to borrow additional funds to meet their increased working capital needs. When there is a liberalized tax policy, the pressure on working capital requirement is minimized. Thus the working capital requirements of a firm are influenced by the internal and external factors. IMPORTANCE OR ADVANTAGES OF ADEQUATE WORKING CAPITAL Working capital is the life blood and nerve centre of a business. Just as circulation of blood is essential in the human body for maintaining life, working capital is very essential to maintain the smooth running 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: 1. Solvency of the business: Adequate working capital helps in maintaining solvency of the business by providing uninterrupted flow of production. 2. Goodwill: Sufficient working capital enables a business concern to make prompt payments and hence helps in creating and maintaining goodwill. 3. 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. 4. Cash discounts: Adequate working capital also enables a concern to avail cash discounts on the purchases and hence it reduces costs.
- 6. 5. Regular supply of raw materials: Sufficient working capital ensures regular supply of raw materials and continuous production. 6. 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, increases their efficiency, reduces wastages and costs and enhances production and profits. 7. Exploitation of favourable market conditions: Only concerns with adequate working capital can exploit favourable market conditions such as purchasing its requirements in bulk when the prices are lower and by holding its inventories for higher prices. 8. 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. 9. Quick and regular return on investments: Every Investor wants a quick and regular return on his investments. Sufficiency of working capital enables a concern to pay quick and regular dividends to its investors as there may not be much pressure to plough back profits. This gains the confidence of its investors and creates a favourable market to raise additional funds i.e., the future. 10. High morale: Adequacy of working capital creates an environment of security, confidence, and high morale and creates overall efficiency in a business. Disadvantages Of Redundant Or Excessive Working Capital 1. Excessive Working Capital means ideal funds which earn no profits for the business and hence the business cannot earn a proper rate of return on its investments. 2. When there is a redundant working capital, it may lead to unnecessary purchasing and accumulation of inventories causing more chances of theft, waste and losses. 3. Excessive working capital implies excessive debtors and defective credit policy which may cause higher incidence of bad debts. 4. It may result into overall inefficiency in the organization. 5. When there is excessive working capital, relations with banks and other financial institutions may not be maintained. 6. Due to low rate of return on investments, the value of shares may also fall. 7. The redundant working capital gives rise to speculative transactions. Disadvantages Or Dangers Of Inadequate Working Capital
- 7. 1. A concern which has inadequate working capital cannot pay its short-term liabilities in time. Thus, it will lose its reputation and shall not be able to get good credit facilities. 2. It cannot buy its requirements in bulk and cannot avail of discounts, etc. 3. It becomes difficult for the firm to exploit favourable market conditions and undertake profitable projects due to lack of working capital. 4. The firm cannot pay day-to-day expenses of its operations and it creates inefficiencies, increases costs and reduces the profits of the business. 5. It becomes impossible to utilize efficiently the fixed assets due to non-availability of liquid funds. 6. The rate of return on investments also falls with the shortage of working capital. DETERMINATION OF WORKING CAPITAL REQUIREMENTS Determination of Net Working Capital: Particulars Amount Rs. Total Rs. A. Current Assets: 1. Cash in Hand/at Bank 2. Raw Materials 3. Work-In-Progress: i. Raw Materials ii. Direct Labour iii. Overhead 4. Finished Goods 5. Debtors 6. Prepaid Expenses 7. Others xxx xxx xxx xxx xxx xxx xxx xxx xxx Xxx Total Current Assets (TCA) Xxx B. Current Liabilities: 1. Creditors 2. Accounts Payables 3. Advance Income xxx xxx xxx xxx Xxx Total Current Liabilities (TCL) Xxx Net Working Capital (A-B)(TCA-TCL) Xxx Problem No: 1 The board of Directors of XYZ Co requests to prepare statement showing the working capital management for a level of activity at 1,56,000 units of production, The following information is available for your calculation:
- 8. Details Per Unit (Rs) Raw Materials 90 Direct Labour 40 Overhead 75 Total 205 Profit 60 Selling price 265 i) Raw material are stock on average for 1 month ii) Materials are in process WIP, which is 50%,completed on average for 4 weeks. iii) Finished goods are in stock, on average, for 1 month. iv) Time lag in payment from debtors is 2 months. v) Credit allowed by Suppliers is 1 month. vi) Average lag in payment of wages is 1.5 weeks. vii) Average lag in payment of overhead is 1 month. Assume that all the sales are credit sales. Cash is hand and in Bank is expected to be Rs. 60,000. It is to be assumed that production is carried on evenly throughout the year, wages & overhead accrue similarly. Add 10% for contingency Particulars Amount (Rs) Total (Rs) A. Current Assets: Stock Raw materials (156000 x 90 x 1/2) WIP (156000 x 205 x 4/52 x 0.5) Finished goods (156000 x 205 x 1/12) Sundry Debtors (156000 x 205 x 2/12) Cash at Bank 70,20,000 12,30,000 26,65,000 53,30,000 60,000 16,30,5000 Total Current Assets (TCA) 16,30,5000 B. Current Liabilities: Creditors (156000 x 90 x 1/2) Outstanding salaries (156000 x 40 x 1.5/52) Outstanding expenses (156000 x 75 x 1/12) 70,20,000 1,80,000 9,75000 81,75,000 Total Current Liabilities (TCL) 81,75,000
- 9. Net Working Capital (A-B)(TCA-TCL) Add: 10% for contingency 81,30,000 8,13,000 Required working capital 89,43,000.00 Problem No :2 (Home Work) While preparing a project report on behalf of a client, you have to collect the following facts. Estimate the net working capital required for the project. Add 10% to your computed figure to allow for contingencies: Estimated cost per unit of production: (Amount per unit (Rs)) Raw material 80 Direct Labour 30 Overhead (including depreciation Tk 5) 65 Total Cost 175 Additional Information: Selling price Rs. 200 per unit Level of activity 1,04,000 units of production p.a. Raw material in stock Average 4 weeks Work in progress (assume full unit of R/M required in the beginning of manufacturing; other conversion cost are 50%)---------Average 2 weeks Finished goods in stock -------- Average 4 weeks Credit allowed to debtors ---------Average 8 weeks Credit allowed to Suppliers ---------Average 4 weeks Lag in payment of wages ---------Average 1.5 weeks Cash at Bank (desired to be maintained) --------- Rs. 25,000 You may assume that the production is carried on evenly throughout the year (52 weeks) and wages/overheads accrue similarly. All sales are on a credit basis only.