Working capital management

Working Capital Management

Meaning Working Capital refers to the funds invested in current assets, i.e. investment in stocks, sundry debtors, cash and other current assets. One of the most important areas in the day-to-day management of the firm is the management of Working Capital. Working Capital management is the functional area of finance that covers all the currents accounts of the firm. It is concerned with management of the level of individual current assets as well as the management of total working capital. For example: A machine is identified as working capital. It is obvious that a certain amount of funds is always tied up in raw material inventories, work in progress, finished goods, consumable stores, sundry debtors and day-today cash requirements. Broadly Working Capital can be divided in to two parts. Gross Working Capital: The gross working capital refers to investment in all the current assets taken together. The total of investments in all current assets is known as gross working capital. Net Working Capital: The term net working capital refers to excess of total current assets over total current liabilities. It may be noted that the current liabilities refers to these liabilities which are payable within a period of 1 year. From the point of view of time, the term working capital can be divided into two categories: Permanent/ Fixed Working Capital: it also refers to the Hard core Working Capital. It is that minimum level of investment in the current assets that is carried by the business at all times to carry out minimum level of its activities. Temporary Working Capital: It refers to that part of total working capital, which is required by a business over and above permanent working capital. It is also called variable working capital. Since the volume of temporary working capital keeps on fluctuating from time to time according to the business activities it may be financed from short-term sources. Importance of Working Capital: (1) Payment to creditors in time. (2) Benefit of cash discount. (3) Adequate distribution of dividend. (4) Increase in goodwill & debt power of the firm. (5) Helpful while taking loans from bank or other financial institutions. (6) Helpful in facing contingencies. (7) High efficiency. (8) Increase in productivity of fixed assets. Factors to be taken into consideration while determining the requirement of working capital: (A) Production Policies (B) Nature Of Business (C) Credit Policy (D) Inventory Policies (E) Abnormal Factors (F) Market conditions (G) Condition of Supply (H) Business Cycle (I) Growth and Expansion (J) Level of Taxes (K) Dividend Policy (L) Price level Changes (M) Operating efficiency. Please read the above points from the book (Khan & Jain) in detail.

Working capital management

Working Capital Management: Working Capital Management is usually concerned with the administration of all the current assets and current liabilities. It is basically concerned with: (A) Determining the need for working capital. (B) Determining the optimal levels of investment in various current assets. (C) Examining the salient points regarding each element of working capital. Working Capital Forecasts: Working Capital is essential for the smooth running business enterprise. The finance manager should forecast working capital requirements carefully to determine an optimum level of investment in working capital. While forecasting working capital requirements, it should be borne in mind the working capital requirements are to be determined on an average basis and not at any specific point of time. (1) Working Capital Based On Operating Cycle: The working capital cycle refers to the length of time between the firms paying cash for materials etc., entering into the production process/ stock and the inflow of cash from debtors. The determination of working capital cycle helps in the forecast, control and management of working capital. It indicates the total time lag and the relative significance of its constituent parts. The duration of working capital cycle may vary depending on the nature of the business. The operating cycle consists of the following events, which continues throughout the life of business. Conversion of Cash into Raw Materials. Conversion of Raw Materials into Work in Progress. Conversion of Work in Progress into finished products. Conversion of Finished products into accounts receivables through sales. Conversion of Account receivables into cash. The duration of the operating cycle for the purpose of estimating working capital is equal to the sum of the durations of each of the above said events, less the credit period allowed by the suppliers. Operating Cycle = R + W + F + D + C R = Raw Material storage period W = Work in progress holding period D = Debtors Collection period C = Credit period allowed The Various components of operating cycle may be calculated as shown below: (1) Raw Material Storage Period: Average Stock of Raw Material -----------------------------------------------------------------Average Cost of Raw Material Consumption per day (2) Work in progress holding Period: Average work in Progress inventory ----------------------------------------------------------------Average Cost Of Production Per Day

Working capital management (3) Finished Goods Storage Period: Average Stock of Finished Goods -------------------------------------------------------------Average Cost Of Goods Sold Per Day (4) Debtors Collection Period: Average Book Debts -----------------------------------------------Average Credit Sales Per Day (5) Credit Period Availed: Average Trade Creditors - ---------------------------------------------Average Credit Purchases Per Day (2) Estimate of future Working Capital based on Current Assets and Current Liabilities (Forecasting Method) The estimate of future working capital can be made if the amount of current assets and current liabilities can be estimated as follows: The various constitute of current assets and current liabilities have a direct bearing on the computation of working capital and the operating cycle. The holding period of various constitutes of operating cycle may either contract or expand the net operating cycle period. Shorter the operating cycle period, lower will be the requirement of working capital and vice-versa. Estimation of Current Assets The estimates of various components of working capital may be made as follows: (1) Raw Material Inventory: The funds to be invested in raw materials inventory may be estimated on the basis of production budget, the estimated cost per unit and average holding period of raw material inventory by using the following formula: Annual Raw Material Consumption * Raw Material Storage Period --------------------------12 Months/360 Days Note: 360 days in a year are generally assumed to facilitate calculation. (2) Work in Progress inventory: The funds to be invested in work in progress can be estimated by the following formula: Annual Cost of Production * Production time ------------------------------------------------------------12 Months/360 Days Cost Of Production = R.M. + Wages + Overheads (excluding depreciation)

Working capital management Note:- If wages and overheads are accrue evenly during the year then these costs will be made Half (1/2) while calculation W.I.P. (3) Finished Goods: The funds to be invested in finished goods inventory can be estimated with the help of following formula: Annual Cost of Sales * Finished goods Conversion Period ------------------------------------------------------12 Months/360 Days Cost of Sales = RM + wages+ overheads+ administration exp. (4) Debtors: Funds to be invested in trade debtors may be estimated with the help of following formula: Estimated annual Credit Sales Or * Debtors Collection Annual Cost of Sales Period (Excluding depreciation) ------------------------------------------------------------12 Months/360 Days Cost of Sales = RM + wages+ overheads+ administration exp.+ selling exp. (5) 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 Current liabilities generally affect computation of working capital. Hence, the amount of working capital is lowered to the extent of current liabilities (other than bank credit) arising in the normal course of business. The important current liabilities like trade creditors, wages and overheads can be estimated as follows: (1) Trade Creditors: Annual Credit Purchases * Creditors payment Period ------------------------------------------------------------12 Months/360 Days (2) Direct Wages: Annual Wages * Time Lag in payment of wages -------------------------------------------------------------

Working capital management 12 Months/360 Days

(3) Overheads (Other than depreciation and amortization) Annual Overheads * Time Lag in payment Between overheads. ------------------------------------------------------------12 Months/360 Days

Tandon Committee Recommendations:

( Credit Financing By Banks) The Reserve Bank Of India appointed a study group in July 1974, under the chairmanship of Shri Prakash Tandon to suggest guidelines for the rational allocation and optimum use of bank credit in view of the number of weakness in the bank lending at that time. Recommendations: (1) Inventory and Receivable norms: The study group recommended norms for inventory/ receivable for 15 major industries. The banker should finance only the genuine production needs of the borrower. The borrower should maintain the reasonable levels of inventory and receivables. He should hold just enough inventories to carry on his target production. Efficient management of resources should be ensured to eliminate slow-moving and flabby inventories. Flabby, profit-making or excessive inventory should not be permitted under any circumstances. Similarly the banker should finance only those receivables, which are in tune with the practices of the borrowers firm and industry. It has also emphasized those industries not convered should not be exempt from the discipline of norms. In a company making engineering goods, it has been seen that the following holding of current assets is normal: Raw Materials Imported : 6 Months Consumption Raw Materials Indigenous: 2.5 Months Consumption Stores & Components : 1.5 Months Consumption Work in Progress : 2.5 Months Cost Of Production Finished Goods : 1 Months Cost Of Production Debtors : 3 Months Sales However, such holding would vary from industry to industry. The Tandon Committee, while making its recommendations, formulated norms for various industries as a guideline to follow. (3) Lending Norms: The working capital needs of the borrower cannot be entirely financed by the bankers. The level of current assets must be reasonable and based on norms. Hence the committee felt that the main function of a banker as a lender should be to supplement the borrowers resources to carry an acceptable level of current assets. The banker will finance only a part of working capital gap: the other part to be financed by the borrower from the long-term resources. The working capital gap is defined as current assets minus current liabilities excluding bank borrowings.

Working capital management In this connection, the committee suggested three methods of determining the permissible level of bank borrowings: (a) In the first method, the borrower will contribute 25% of the working capital gap; the remaining 75% can be financed from bank borrowings. This method will give a minimum current ratio of 1 : 1 and maximum current ratio of 1.18 : 1. (b) In the second method, the borrower will contribute 25% of the total current assets. The remaining of the working capital gap can be bridged from the bank borrowings. This method will give a current ratio of 1.33 : 1. (c) In the third method, the borrower will contribute 100% of core assets representing the irreducible technological minimum of assets and 25% of the balance of current assets. The remaining of the working capital gap can be met from the bank borrowings. This method will further strengthen the current ratio. The recommendations will apply to all the borrowers having credit limits in excess of Rs. 20 lakhs from the banking system. Reserve Bank Of India only has accepted the first two methods for implementation. Style Of Credit: The committee suggested a change in the style of bank lending and recommended the bifurcation of total credit limit into fixed and fluctuating parts. The fixed component shall be treated as a demand loan for the year representing the minimum level of borrowings, which the borrower expects to use throughout the year. The fluctuating component will be taken care of by demand cash credit. The cash credit portion may be partly used by way of bills. New cash credit limit should be placed on a quarterly budgeting-reporting system. The committee has also recommended the interest differentials. As an incentive to switch over to the new style of credit, interest rate on the loan component should be changed lower than on the cash credit account. Reserve Bank stipulated the differential at 1%. (4) Information System: The committee has advocated for the greater flow of information both for operational purpose and for the purpose of supervision and follow-up of credit by way of three forms operating statement, Quarterly budget and funds flow statement. As a first step, borrowers with credit limits of more than Rs. 1 crore are required to supply the quarterly information. The statements will indicate estimates and actuals. The borrowers should indicate the likely demand for credit. This procedure will facilitate credit planning at bankers level. This will also help the banker in evaluating the borrowers credit needs in a realistic manner and in the periodic follow-up during the ensuing year. A + 10% variance between estimates and actuals may be considered as normal. The variance beyond this limit should be investigated and discussed by the banker and borrower. The information should be shared freely and frankly with the banker so that he is in constant touch with the operations of the borrower to whom the scarce bank credit has been allocated. Banker should be treated as partners in the business. .

Working capital management TRADE-OFF BETWEEN PROFITABILITY AND RISK: In evaluating a firms NWC position, an important consideration is the trade-off between profitability and risks it. In other words, the level of NWC has a bearing on profitability as well as risk. The term profitability used in this context is measured by profits after expenses. The term risk is defined as the probability that a firm will become technically insolvent so that it will not be able to meet its obligations when they become due for payment. Effect of the level of Current Assets on the Profitability Risk Trade- Off: The effect of the level of current assets on profitability- risk and trade-off can be shown, using the ratio of current assets to total assets. This ratio indicates the percentage of total assets that are in the form of current assets. A change in the ratio will reflect a change in the amount of current assets. It may either increase or decrease. DETERMINING FINANCING MIX: Apart from the profitability trade-off, another important ingredient of the theory of working capital management is determining the financing mix. One of the most important decisions, in other words, involved in the management of working capital is how current assets will be financed. There are, broadly speaking, two sources from which funds can be raised for current assets financing; (1) short- term sources (Current Liabilities), and (2) Long-term sources, such as share capital, Long-term borrowings, internally generated resources like retained earnings and so on. Hedging Approach: According to this approach, the maturity of the source of funds should match the nature of the assets to be financed. For the purpose of analysis, the current assets can be broadly classified into two classes: (1) Those, which are required in a certain, amount for given level of operation and, hence, do not vary over time. (2) Those, which are, fluctuate over time. The Hedging approach suggests that long-term funds should be used to finance the fixed portion of current assets requirements, in a manner similar to the financing of fixed assets. The purely temporary requirements, that is, the seasonal variations over and above the permanent financing needs should be appropriately financed with short-term funds (Current liabilities). Conservative Approach: This approach suggests that the estimated requirement of total funds should be met from long-term sources; the use of short-term funds should be restricted to only emergency situations or when there is an unexpected outflow of funds. Comparison of hedging approach with conservative approach: The comparison of the two approaches can be made on the basis (1) Cost considerations, (2) Risk Consideration. Cost consideration: Here we can assume that the cost of short funds and Long-term funds is 3% and 9% respectively. Hedging Plan: the cost of financing under the hedging plan can be estimated as follows: Cost of short term funds= Average annual short term loan * Interest rate

Working capital management Here short term loan = Temporary working capital For example temporary working capital = Rs 12000 Therefore cost will be 12000* 3% = 360 Cost of Long term Funds= Long term funds * interest rate. Here long term funds = Fixed working capital. Suppose fixed working capital = Rs. 50000 Therefore cost will be = 50000* 9% = 4500 Total cost in hedging plan = 4500+360= 4860 Conservative Plan The cost of financing under the conservative plan is equal to the cost of the long-term funds, that is, annual average loan, multiplied by the long-term rate of interest. As in this approach both fixed as well as temporary working capital has been financed by the long-term loans therefore in the above example the cost of financing will be: (50000+12000) * 9% = 5580 Therefore the conservative plan for financing is more expensive because the available funds are not fully utilized during certain periods, moreover, interest has to be paid for funds, which are not actually needed. Risk Consideration: the two approaches can also be contrasted on the basis of the risk involved. Hedging Approach: The hedging approach is more risky in comparison to the conservative approach. There are two reasons for this. First, there is, as already observed, no NWC with the hedging approach because no long-term funds are used to finance short-term funds are used to finance short-term seasonal needs, that is, current assets are just equal to current liabilities. Secondly, the hedging plan is risky because it involves almost full utilization of the capacity to use short-term funds and in emergency situations. It may be difficult to satisfy the short-term needs. Conservative Approach: With the conservative approach, in contrast, the company does not use any of its shortterm borrowings. Therefore, the firm has sufficient short-term borrowing capacity to cover unexpected financial needs and avoid technical insolvency. To summarize, the hedging approach is a high profit (low cost) high risk (no NWC), approach to determine an appropriate financing mix. In contrast, the conservative approach is low profit (high cost)- low risk (high NWC). A Trade Off Between the Hedging and Conservative Approaches: It has been shown that the hedging approach is associated with the high profits as well as high risk, while the conservative approach provides low profits and low risk. Obviously, neither approach by itself would serve the purpose of efficient working capital management. A trade-off between these two extremes would give an acceptable financing strategy. The exact trade-off between risk and profitability will differ from case to case depending on risk perception of the decision makers. One possible trade-off could be assumed to be equal to the average of the minimum and maximum monthly requirements of funds during a given period of time. This level of requirement of funds may be financed through long- run sources and for any additional financing need; short-term funds may be used.

Working capital management

. Q. How would you assess the working capital requirements for seasonal industries? Give example in support of your answer. Also state in brief the norms to be observed in sick industries. How would you assess the working capital requirements for a seasonal industry? Illustrate with an example. Answer: for seasonal industry, the working capital requirement depends upon the availability of raw materials. Raw materials will not be available throughout the year. For example: sugar industry. Raw material (sugar cane) will be available for 4 or 5 months in a year. Hence, working capital requirement should be assessed on the basis of purchase programmed of raw material for 4 or 5 months. This should meet the requirement of raw materials for the whole year. Hence, finance manager has to plan for it in a suitable manner. Sick industries: according to sick industrial companies (special provisions) act 1995, sick industrial company means, an industrial company registered for not less than 5 years which has at the end of financial year accumulated losses equal or exceeding its entire net worth and has also suffered cash losses in such financial year and the financial year immediately preceding such financial year. There are no specific norms for sick units. Tandon committee recommended inventory and receivable norms and lending norm. These norms are applicable to both for a healthy and sick unit. (These norms have been discussed separately in this chapter). Sick units also can follow the above norms with some modifications depending upon circumstance.