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CAPITAL MANAGEMENT
LECTURE - 1
INTRODUCTION
One of the most important areas in the day
to day management of the firm is the
management of working capital.
Working capital refers to the funds held in
current assets.
Current assets are essential to use fixed
assets.
The requirements for current assets are
usually greater than the amount of funds
available through current liabilities.
OPTIMUM INVESTMENT
The importance of adequate working capital can never be over emphasized.
A firm has to be very careful in estimating its working capital. The effective management of
working capital is the primary means of achieving the firm’s goal of adequate liquidity.
A very big amount of working capital would mean that the firm has idle funds. This results
in over capitalization.
Over capitalization implies that the firm has too large funds for its requirements, resulting
in a low rate of return.
If the firm has inadequate working capital, it is said to be under capitalized. Such a firm
runs the risk of insolvency.
Shortage of working capital may lead to a situation where the firm may not be able to meet
its liabilities.
Hence it is very essential to estimate the requirements of working capital carefully and
determine the optimum level of investment in it.
The Gross working capital refers to investment in all the current assets
taken together. Current assets are the assets which can be converted
into cash within an accounting year or operating cycle and include cash,
short-term securities, debtors, bills receivable and inventory.
In its endeavour to do so, a firm should earn sufficient return from its
operations.
The firm has to invest enough funds in current assets for generating sales.
Current assets are needed because sales do not convert into cash
instantaneously.
Similarly inventory cannot be converted into cash as and when the firm require.
All the above aspects result in the funds of the firm being blocked for a certain
period. To operate the business in this period, a firm needs working capital.
IMPORTANCE OF
ADEQUATE WORKING
CAPITAL
A firm needs funds for its day to day running. Adequacy or
inadequacy of these funds would determine the efficiency with which
the daily business may be carried on. It is to be ensured that the
amount of working capital available with in the firms is neither too
large nor too small for its requirements.
To enable the firm to operate more efficiently and meet the raising
turnover thus peak needs can be taken care off.
The duration of the Gross operating cycle for the purpose of estimating
working capital is equal to the sum of the durations of each of above said
events. Net operating cycle is calculated as Gross operating cycle less the
credit period allowed by the suppliers.
Determination of
operating cycle
Operating cycle = R + W + F + D – C
Average stock of raw material
R = Raw material storage period =
Average cost of consumptio n per day
Estimated production (in units) X Estimated cost of raw material per unit X Average raw material holding period(in months/in days)
12 months/360 days
Estimation of Current
Assets
Estimated production (in units) X Estimated WIP(cost per unit) X Average holding period of WIP(in months/in days)
12 months/360 days
Estimation of Current
Assets
Estimated production (in units) X Cost of production(per unit without dep.) X Average holding period of finished goods inventory(in months/in days)
12 months/360 days
Estimation of Current
Assets
Trade Debtors =
Estimated credit sales (in units) X Cost of sales(per unit without dep.) X Average Debtors collection period(in months/in days)
12 months/360 days
Estimation of Current
Assets
Minimum desired Cash and Bank
balances to be maintained by the
firm has to be added in the current
assets for the computation of
working capital
Estimation of Current
Liabilities
Trade Creditors =
Estimated yrly production (in units) X Raw material requirement per unit X Credit period granted by suppliers(in months/in days)
12 months/360 days
Estimation of Current
Liabilities
Direct Wages =
Estimated production (in units) X Direct Labour cost per unit X Average time lag in payment of wages(in months/in days)
12 months/360 days
Estimation of Current
Liabilities
Estimated yrly production (in units) X Overhead cost per unit X Average time lag in payment of overheads(in months/in days)
12 months/360 days
DETERMINANTS OF
WORKING CAPITAL
There are no hard fast rules or
formulae
to determine working capital needs
of the
firms. A large number of factors
influence
working capital needs of firms. All
factors
are of different importance. The
Nature & Size of
business
Dividend policy:
Payment of dividend utilizes cash, while
When the firm uses long term sources to finance fixed assets and
permanent current assets, and short term financing to finance
temporary current assets.
2. Conservative approach:
Under this approach a firm finances its permanent assets and also a
part of temporary current assets with long term financing. It relies
heavily on long term financing and is less risky so far as solvency is
concerned, however, the funds may be invested in such instruments,
which fetch small returns to build up liquidity. This adversely affects
profitability.
3. Aggressive Approach:
The firm uses more short term financing than what is justified, in this
approach. The firm finances a part of its permanent current assets
with short term financing. This is more risky but may add to the return
on assets.