Session17
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Working capital management involves administering current assets like cash and inventory to fund day-to-day operations. It aims to balance liquidity against returns. There are conservative, moderate, and aggressive working capital policies that respectively carry more cash, less cash, and impact liquidity and returns differently. Firms must determine optimal current asset levels that minimize carrying and shortage costs. Permanent working capital funds fixed needs while temporary funds fluctuating needs like the operating cycle. Factors like the business, production, and economic environment influence working capital composition.
Session17
- 2. Working Capital Management Management of the current assets held by a firm is known as working capital management. It involves administering and controlling current assets as well as the procuring and financing of the current assets. Working capital management deals with funds involved in the day-to-day operations of the firm. Management of working capital is important for protecting the firm from liquidity problems.
- 3. Liquidity of Current Assets Liquidity simply means converting an asset into cash. Liquidity depends on the ease with which the asset can be converted into cash. Liquidity of a business firm is measured by its ability to satisfy short term obligations.
- 4. Financing of Current Assets GWC (Gross working capital) = TCA (Total current assets) NWC = TCA - TCL NWC, or net working capital, is also called the liquid surplus of the firm. Level of Cash outflow and cash inflow define the requirement of NWC. Ex. Electricity department- cash inflow predictable so little NWC required.
- 5. Need for Working Capital Operating cycle signifies the time taken by the firm to process the raw material into finished goods for earning sales revenue. Permanent Working Capital Temporary Working Capital Figure: The operating cycle
- 6. Permanent and Variable Working Capital The part of current assets, which is fixed and is the mandatory requirement of the firm is known as permanent or fixed working capital. Figure: Changes in permanent and variable working capital over time
- 7. Level of Current Assets Conservative Working Capital Policy -When the firm maintains huge investments in its current assets then its liquidity will be very high as current assets can be easily converted into cash. Aggressive Policy- The investment is current asset is low. This means that the firm keeps a small balance of cash , small amount of inventories . The Optimal level of current asset involves a trade off between costs that rise with current asset(Carrying cost) and costs that fall with current asset(Shortage cost)
- 8. Optimum level of Current Asset
- 9. Example 1 The firm has the option of three possible current asset levels of Rs. 6,00,000, 5,00,000, and 4,00,000. If the level of fixed assets and sales remains constant, what will be the effect of the three current asset policies on firm's liquidity and return on total assets (ROTA)? The following financial data relates to a firm for the current financial year:
- 10. Example 1 (contd) Solution: The return on total assets will be as follows:
- 11. Example 1 (contd) Thus, policy I (conservative) provides the firm maximum liquidity and lowest return on total assets. In contrast policy III (aggressive) provides the firm minimum liquidity and maximum return on total assets. Policy II is medium policy. It earns a return on total assets which is higher than policy I but less than policy III. Risk wise policy II is more risky than policy I but less risky than policy III.
- 12. Different Policies for Current Asset Investment The optimum policy of a firm is a trade-off between risk and return of the firm. The concept of optimum working capital is also supported by the following formula for return on investment (ROI) for a firm. Figure: Different policies for current asset investment
- 13. The Hedging Approach The hedging approach is also known as matching approach-high profit-high risk approach This approach states that permanent assets should be financed with long-term capital (long-term liabilities + equity) and temporary assets should be financed with short- term credit. Figure: The hedging/matching approach
- 14. Conservative Approach When it depends more on long term funds for financing needs. The firm finance its permanent CA and a part of temporary CA with long term financing. The released long term funds can be invested in CA, so less risk of facing problem of shortage of funds.
- 15. Aggressive Approach When firm uses it short term financing to finance its permanent current assets, even some time a part of fixed assets with short term financing. More risky as level of minimum CA is difficult to maintain.
- 16. Factors Affecting the Composition of Working Capital Nature of business Availability of raw material used Production cycle Business Cycle Production Policy Credit Policy Growth and Expansion Profit Level Price level changes Operating Efficiency