Unit 4 Introduction to working capital_JNTUA MBA Syllabus
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The document provides an introduction to working capital management. It defines working capital as "capital invested in current assets" which are assets that can be converted to cash within a short time. It then discusses key concepts like gross working capital, net working capital, and the operating cycle. The importance of working capital management and determining adequate working capital requirements is emphasized. Techniques for managing current assets like cash, receivables, and inventory are also summarized.
Unit 4 Introduction to working capital_JNTUA MBA Syllabus
- 2. INTRODUCTION In financial management, two important decisions are very vital and crucial. They are decision regarding fixed assets/fixed capital and decision regarding working capital/current assets. Both are important and a firm always analyses their effect to final impact upon profitability and risk. Thus, in very simple words, working capital may be defined as “capital invested in current assets.” Here current assets are those assets, which can be converted into cash within a short period of time and the cash received is again invested into these assets. Thus, it is constantly receiving or circulating. Hence, working capital is also known as circulating capital or floating capital.
- 3. DEFINITION According to Shubin, “Working Capital the amount of funds necessary to cover the cost of operating the enterprise. According to Hoagland ,” Working Capital is descriptive of that capital which is not fixed. But, the more common use of working capital is to consider it as the difference between the book value of the current assets and the current liabilities. Revolving Capital Or Circulating capital Or Short Term Capital
- 4. HOW IT WORKS (EXAMPLE): Here is some balance sheet information about XYZ Company: Using the working capital formula and the information above from Figure 1, we can calculate that XYZ Company's working capital is: $160,000 - $65,000 = $95,000
- 5. CONCEPT OF WORKING CAPITAL Gross working capital Net Working Capital There are two concepts of working capital. These are :
- 6. 1. GROSS WORKING CAPITAL: (TOTAL CURRENT ASSETS) Gross working capital (Total Current Assets) The gross working capital, simply called as 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 or operating cycle. Thus, Gross working capital, is the total of all current assets. It includes 1. Inventories (Raw materials and Components, Work-in-Progress, Finished Goods, Others) 2. Trade Debtors 3. Loans and Advance 4. Cash and Bank Balances 5. Bills Receivables. 6. Short-term Investment
- 7. 2.NET WORKING CAPITAL Net Working Capital (Total Current Assets – Total Current Liabilities) 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. Net working capital may be positive or negative. A positive net working capital will arise when current assets exceed current liabilities and a negative net working capital will arise when current liabilities exceed current assets i.e. there is no working capital, but there is a working capital deficit. It includes 1. Trade Creditors. 2. Bills Payable. 3. Accrued or Outstanding Expenses. 4. Trade Advances 5. Short Term Borrowings (Commercial Banks and Others) 6. Provisions 7. Bank Overdraft
- 8. IMPORTANCE OF WORKING CAPITAL Working capital is one of the important measurements of the financial position. The words of H. G. Guthmann clearly explain the importance of working capital. “Working Capital is the life-blood and nerve centre of the business.” In the words of Walker, “A firm’s profitability is determined in part by the way its working capital is managed.” The object of working capital management is to manage firm’s current assets and liabilities in such a way that a satisfactory level of working capital is maintained. If the firm cannot maintain a satisfactory level of working capital, it is likely to become insolvent and may even be forced into bankruptcy. Thus, need for working capital to run day-to-day business activities smoothly can’t be overemphasized.
- 9. REQUIREMENTS OF WORKING CAPITAL There are no set rules or formula to determine the working capital requirements of the firms. A large number of factors influence the working capital need of the firms. All factors are of different importance and also importance change for the firm over time. Therefore, an analysis of the relevant factors should be made in order to determine the total investment in working capital. Generally the following factors influence the working capital requirements of the firm: • Nature and size of the business • Seasonal fluctuations • Production policy • Taxation • Depreciation policy • Reserve policy • Dividend policy • Credit policy: • Growth and expansion • Price level changes • Operating efficiency • Profit margin and profit appropriation
- 10. OPERATING AND CASH CONVERSION CYCLE The time taken for the completion of the cycle of the process of conversion of raw material into finished goods, sale of goods ,realisation of sale proceeds, and receipt of cash is termed as “Operating and Cash Conversion Cycle” or Working Capital Cycle”. Operating Cycle of a company determine the requirements of working capital.
- 11. OPERATING AND CASH CONVERSION CYCLE Cash Raw Material Work-in- Progress Finished Goods Account Receivable PurchaseRealization Sale Production Process
- 12. CLASSIFICATION OR TYPES OF WORKING CAPITAL Types of working capital On the basis of Concepts Gross Working Capital Net Working Capital On the basis of Time Fixed Working Capital Regular Working Capital Reserve Working Capital Variable Working Capital Seasonal Working Capital Special Working Capital
- 13. TYPES OF WORKING CAPITAL Fixed Working Capital implies the base investment amount in all types of current resources which is respected at all times to carry on business activities. The value of current assets have been increased or decreased over a period of time. Even though, there is a need of having minimum level of current assets at all times in order to carry on the business activities effectively. Features of Permanent Working Capital a) The gross value of permanent working capital remain constant but the value of components of current assets is differing from each other. b) There is a positive correlation between the size of business and the amount of permanent working capital. c) Only long term sources of funds are used for permanent working capital. 2. Temporary Working Capital: It is otherwise called as Fluctuating or Variable Working Capital. There is a close relationship prevailing between temporary working capital and the level of production and sales. There is no uniform production and sales throughout the year. If heavy order is received for production and there is a large amount of credit sales, there is a need of more amount of temporary working capital. At the same time, if production is carried on in anticipation of demand in near future, temporary working capital is required.
- 14. TYPES OF WORKING CAPITAL Reserve Working Capital: It is otherwise called as Cushion Working Capital. It refers to the short term financial arrangement made by the business units to meet uncertain changes or to meet uncertainties. A firm is always working with the expectation of some risks which may be controllable or uncontrollable. The reserve working capital can be used in order to meet the uncontrollable risks and sustain in the business world. Regular Working Capital: The minimum amount of working capital to be maintained in normal condition is called Regular Working Capital. Seasonal Working Capital: Some products have seasonal demand. Seasonal demand arises due to festival. In this way, seasonal working capital means an amount of working capital maintained to meet the seasonal demand of the product. Special Working Capital: Special programmes may be conducted for business development. The programmes may be advertisement campaign, sales promotion activities, product development activities, marketing research activities, launching of new products, expansion of markets and the like. Therefore, special working capital means an amount of working capital maintained to meet the expenses of special programmes of the company.
- 15. FACTORS DETERMINING THE WORKING CAPITAL Nature of Business Production Policy Dividend Policy Manufacturing Cycle Price Level Changes Nature of Demand Credit Policy Business Period Effect of External Business Environment Factors
- 16. CURRENT ASSETS MANAGEMENT Cash management has assumed importance because it is the most significant of all the current assets. It is required to meet business obligations and it is productive when not used. Cash management need strategies to deal with various facets of cash. Following are some of its facets: (a)Cash Planning: Cash Planning is technique to plan and control the use of cash. A projected cash flow statement may be prepared, based on the present business operations and anticipated future activities. The cash inflows from various sources may be anticipated and cash outflows will determine the possible uses of cash. (b)Cash Forecasts and Budgeting: A cash budget is the most important device for the control of receipts and payments of cash. A cash budget is an estimate of cash receipts during a future period of time. It is an analysis of flow of cash in a business over a future, short or long period of time. It is a forecast of expected cash intake and outlay.
- 18. RECEIVABLE MANAGEMENT The term receivable is defined as debt owed to the concern by customers arising from sale of goods or services in the ordinary course of business. Receivables are also one of the major parts of the current assets of the business concerns. It arises only due to credit sales to customers, hence, it is also known as Account Receivables or Bills Receivables. Definition : Management of account receivable is defined as “the process of making decision resulting to the investment of funds in these assets which will result in maximizing the overall return on the investment of the firm”. The objective of receivable management is to promote sales and profit.
- 19. COSTS ASSOCIATED WITH THE EXTENSION OF CREDIT AND ACCOUNTS RECEIVABLES Collection Cost Capital Cost Administrative Cost Default Cost
- 20. 1.Collection Cost : These costs incurred in collecting the receivables from the customers, to who credit sales have been made. 2.Capital Cost : This is the cost on the use of additional capital to support credit sales which alternatively could have been employed else where. 3.Administrative Cost : This is an additional administrative cost for maintaining account receivable in the form of salaries to the staff kept for maintaining accounting records relating to customers, cost of investigation etc. 4.Default Cost : Default costs are the over dues that cannot be recovered. Business concern may not be able to recover the over dues because of the inability of the customers.
- 21. FACTORS CONSIDERING THE RECEIVABLE SIZE 1. Sales Level 2. Credit Policy 3. Credit Terms 4. Credit Period 5. Cash Discount 6. Management of Receivable
- 22. 1. Sales Level Sales level is one of the important factors which determines the size of receivable of the firm. If the firm wants to increase the sales level, they have to liberalise their credit policy and terms and conditions. When the firms maintain more sales, there will be a possibility of large size of receivable. 2. Credit Policy Credit policy is the determination of credit standards and analysis. It may vary from firm to firm or even some times product to product in the same industry. Liberal credit policy leads to increase the sales volume and also increases the size of receivable. Stringent credit policy reduces the size of the receivable. Example : Home Appliances 3. Credit Terms Credit terms specify the repayment terms required of credit receivables, depend upon the credit terms, size of the receivables may increase or decrease. Hence, credit term is one of the factors which affects the size of receivable. 4. Credit Period It is the time for which trade credit is extended to customer in the case of credit sales. Normally it is expressed in terms of ‘Net days’. For Example Credit Card facility by banks.
- 23. 5. Cash Discount Cash discount is the incentive to the customers to make early payment of the due date. A special discount will be provided to the customer for his payment before the due date. For Example : Whole Sale shops to retail shop keepers 6. Management of Receivable It is also one of the factors which affects the size of receivable in the firm. When the management involves systematic approaches to the receivable, the firm can reduce the size of receivable.
- 24. INVENTORY MANAGEMENT MEANING : The dictionary meaning of the inventory is stock of goods or a list of goods. In accounting language, inventory means stock of finished goods. In a manufacturing point of view, inventory includes, raw material, work in process, stores, etc. KINDS OF INVENTORIES Inventories can be classified into five major categories. A. Raw Material: It is basic and important part of inventories. These are goods which have not yet been committed to production in a manufacturing business concern. B. Work in Progress: These include those materials which have been committed to production process but have not yet been completed. C. Consumables: These are the materials which are needed to smooth running of the manufacturing process. D. Finished Goods: These are the final output of the production process of the business concern. It is ready for consumers. E. Spares: It is also a part of inventories, which includes small spares and parts.
- 25. OBJECTIVES OF INVENTORY MANAGEMENT Inventory occupies 30–80% of the total current assets of the business concern. It is also very essential part not only in the field of Financial Management but also it is closely associated with production management. • To efficient and smooth production process. • To maintain optimum inventory to maximize the profitability. • To meet the seasonal demand of the products.. • To ensure the level and site of inventories required. • To plan when to purchase and where to purchase • To avoid both over stock and under stock of inventory. • To avoid price increase in future.
- 26. Techniques Of Inventory Management Techniques Based on Order Quantity Determination of Stock Level Determination of Stock Economic Order Quantity Techniques Based on Classification ABC Analysis VED Analysis HML Analysis Aging Schedule Based on Records Inventory Report Inventory Budget