FA Assignment 1: Working capital operating cycle & its relation with profitability &

liquidity
Working capital is a financial metric which represents operating liquidity available to a business, organization or other entity, including governmental entity. Along with fixed assets such as plant and equipment, working capital is considered a part of operating capital. Net working capital is calculated as current assets minus current liabilities. It is a derivation of working capital that is commonly used in valuation techniques such as DCFs (Discounted cash flows). If current assets are less than current liabilities, an entity has a working capital deficiency, also called a working capital deficit. Working capital refers to that part of the firms capital which is required for financing short term or current assets such as cash, receivables and inventories. It is essential to maintain a proper level of these assets. The scarcity of cash may adversely affect the reputation of the firm. Though sales may go up, the risk of bad debts and cost involved in it may have to be weighed against the benefits. Proper management of working capital is an important area of financial management. The two components of Working Capital Operating Cycle Management are current assets and current liabilities. There are two concepts of working capital: (i) Balance Sheet Concept: which has further two categories

Gross Working Capital It is the capital invested in total current assets of the enterprise. Current assets are those assets which in the ordinary course of business can be converted into cash within a short period of time. Net Working Capital It referred as the excess of current assets over current liabilities. Net Working Capital = Current assets Current Liabilities Net Working Capital = Current Assets Current Liabilities Net Operating Working Capital = Current Assets Non Interest-bearing Current Liabilities Equity Working Capital = Current Assets Current Liabilities Long-term Debt (ii) Operating Cycle or circular Flow Concept: Operating Cycle of cash flow in working capital management can be explained from the diagram below -

NMIMS MPE-3rd Batch

Ganesh Yanamandra

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FA Assignment 1: Working capital operating cycle & its relation with profitability &

liquidity

A company can be endowed with assets and profitability but short of liquidity if its assets cannot readily be converted into cash. Positive working capital is required to ensure that a firm is able to continue its operations and that it has sufficient funds to satisfy both maturing short-term debt and upcoming operational expenses. The management of working capital involves managing inventories, accounts receivable and payable, and cash. Current assets and current liabilities include three accounts which are of special importance. These accounts represent the areas of the business where managers have the most direct impact: Accounts receivable (current asset) Inventory (current assets), and Accounts payable (current liability)

The current portion of debt (payable within 12 months) is critical, because it represents a short-term claim to current assets and is often secured by long term assets. Common types of short-term debt are bank loans and lines of credit. An increase in working capital indicates that the business has either increased current assets (that is has increased its receivables, or other current assets) or has decreased current liabilities, for example has paid off some short-term creditors. 1. IMPORTANCE OF WORKING CAPITAL Two essential aspects of financial soundness of a firm are the financial position and economic performance. Working capital management is most crucial aspect of economic performance of a firm. Effective working capital decisions contribute to the profitability and attainment of overall objectives of an organization on one hand and provide liquidity to the firm on the other. For several reasons, capital budgeting decisions are influenced by operating managers to larger extent and the day to day management of liquidity, short term obligations, uninterrupted operations calls for effective working capital decisions that forms the domain of finance function1.

NMIMS MPE-3rd Batch

Ganesh Yanamandra

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FA Assignment 1: Working capital operating cycle & its relation with profitability &

liquidity
Theoretically, leaving other things constant, level of investment in current assets has a bearing on the profitability of the firm. Excess of investment in working capital casts a negative impact on the profitability of a firm and positive impact on the liquidity. Studies on the association of level of investment in current assets and the profitability have always claimed inverse relationship in the research on the degree of association both at micro and macro levels. Let us have a glance on the impact of investment in various current assets on the profitability theoretically through Table 1. TABLE I : THEORETICAL RELATIONSHIP BETWEEN VARIOUS CURRENT ASSETS AND PROFITABILITY CURRENT ASSET Cash EXCESS As non earning assets reduces profitability. Cost of Collection efforts, Default risks, low profitability Opportunity cost of funds, price declines, carrying costs adversely affect profits SHORTAGE Causes liquidity crisis by lagging in payments, disruption of operations, ultimately affecting the overall turnover and profits. Lower turnover, lower profitability Interrupted production schedules, limited supplies, lower turnover and profits

Receivables Inventory

Table I reflects the epitome of business literature on role and importance of working capital decisions and an effective financial management function calls for trade-off between the costs and benefits on each of them. One more important aspect here is that the decision on any one of current assets will have impact on others and the financial manager is constrained with the availability of funds to be risk conservative. Risk Conservativeness refers to marinating high liquidity to minimize the risk. That means when the available funds are limited, a decision to buy more stocks for example, may limit the cash balances to be maintained and the investment in receivables. RELATIONSHIP BETWEEN WORKING CAPITAL AND PROFITABILITY - A STATISTICAL APPROACH Working capital is one of the vital decisions of financial management function. Profitability and working capital relationship is frequently emphasized for deciding on the level of investment in working capital. All manufacturing firms need to understand the association between these two variables to arrive at optimal financial decisions. Though theories exist on the topic, empirical methods are inadequately focused in arriving at conclusions. Use of statistical methods in understanding the relationship is systematic and scientific, which may provide better insight for decision making. This paper is an endeavor to understand the relationship between working capital and profitability in a detailed manner. Keywords: Working Capital, Operating Cycle, Profitability, Long-term funds, Short term funds, Statistical Analysis, correlation coefficient between profitability and working capital, Test of Significance for Level of working capital on Profitability. The level of working capital needed by a firm is a function of nature of the industry, size of the firm, availability of raw materials, production cycle of the firm, Production policy of the firm, nature of demand for the products, competition in the industry etc., ) f (WL)= {N, Q, R, Pc, Pp, D, and C.n}

NMIMS MPE-3rd Batch

Ganesh Yanamandra

Page 3

FA Assignment 1: Working capital operating cycle & its relation with profitability &

liquidity
Where WL is the level of working capital Q = Size of firm R= Availability of Raw-material Pc= Production Cycle of the firm Pp= Production policy of the firm D= Nature of demand for the products of the firm C= competition in the industry The list of factors is exemplary but not exhaustive. There can be differences in the investment in various types of current assets. For example, firms in services industry have negligible size of investment in stores but considerable size of investment in cash and receivables where as manufacturing firms invest comparatively large sums in inventories. Optimum level of working capital is investment decision in current assets that varies with the risk-return preferences of firms. Conservative firms are risk averse and satisfy with the available profitability at lowest risk and aggressive firms prefer high profitability even for higher risk. Once the level of investment in current assets is determined, firms need to make decision on financing the current assets either from long term or short term sources. Long term sources of finance offer flexibility to the firms as the funds are available over a period of time beyond the normal accounting cycle, but attract higher cost. Short term sources are comparatively cheaper but not flexible in the sense that firms should oblige the short- run payment schedules. The need for working capital to run the day-to-day business activities cannot be overemphasized. We hardly find a business firm that does not require working capital and indeed, firms differ in their requirements of the working capital. In endeavoring to maximize shareholders wealth, firms need sufficient earnings from its operations. Earning a steady amount of profit requires successful sales activity. The firm has to invest enough of available funds in current assets (Liquidity) for the success of sales activity. Current assets are required because sales do not get converted into cash instantaneously as there is always a time lag involved in the conversion of sales into cash. Thus, there is always a time gap between the sale of goods and receipt of cash. The significance of working capital is felt for this period in order to sustain the level of sales activity. The time lag varies with the nature of industry. RELATIONSHIP BETWEEN WORKING CAPITAL AND LIQUIDITY Liquidity is closely related to the concept of working capital, but it is not exactly the same. A business may have adequate working capital as represented by a large inventory and big dollar amounts of accounts receivable, but still may not be able to pay their current liabilities. Creditors do not accept inventories and accounts receivable. They need cash to keep their own businesses viable.

NMIMS MPE-3rd Batch

Ganesh Yanamandra

Page 4

FA Assignment 1: Working capital operating cycle & its relation with profitability &

liquidity
Effective working capital (liquidity) management is critical in all stages of the business life cycle. When the business establishes operations, there are dozens of start up expenses such as: legal and professional advisers' fees accountant's set up charges, lease deposits and rent in advance cost of initial inventory for firms reselling merchandise initial advertising and promotion costs stationery and printing shop fitting and office equipment purchases wages and on costs for employees license and registration fees insurance premiums, always payable in advance telephone and fax connection charges equipment leasing payments utility deposits (e.g. water, gas, electricity) bank charges or loan set up costs Owner's personal living expenses while the business is becoming established.

These up front charges can and often do amount to thousands of dollars and are frequently dramatically under estimated by many intending business owners. In most cases the business will not produce enough initial revenue to meet these start-up expenses until the business begins to grow. The proprietor needs to plan for and to provide enough working capital to see the business through the establishment stage. As the business grows, revenue increases, but so do variable costs. Expanding businesses need bigger premises, more employees and updated equipment. Additionally there is the nightmare of credit or account customers. Costs are incurred as the business gets the products or services out, but there may be a wait of 30, 60 or even 90 days or more before the business receives payment. The amount of cash a business has tied up in accounts receivable reduces the amount the managers have to pay their own bills. If necessary funds are blocked (tied up) in overdue accounts, the owner may be forced to increase the size of the business' overdraft in order to meet current business commitments. The necessity of having adequate working capital never does completely "go away". As the business enters the maturity and post maturity stages of the business life cycle, owners and managers constantly need to remain aware of working capital management. Businesses in the later stages of the business life cycle and the product life cycle often face the situation of having to "write off" obsolete inventory.

NMIMS MPE-3rd Batch

Ganesh Yanamandra

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