FINANCIAL MANAGEMENT

ITM-XMBA

Financial Management

Financial Management

Working Capital Management & Financing

Financial Management

Topics to be covered
Theory of Working Capital Management
Nature for Working Capital Trade-off between Profitability & Risk Determining Financing Mix

Planning of Working Capital

Need for Working Capital Determinants of Working Capital Computation of Working Capital

Working Capital Financing

Trade Credit Bank Credit Commercial Papers Factoring
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Theory of Working Capital Management

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Nature of Working Capital

Working Capital Management is concerned with the problems that arise in attempting to manage
the current assets, the current liabilities and the interrelationship that exists between them

Current Assets are those assets

Which in ordinary course of business can be or will be converted into cash within one year. Without any diminution in value and without disturbing the operations of the firm. Examples Sundry Debtors / Accounts Receivable , Inventory/Stock

Current Liabilities are those liabilities

Which are intended, at their inception, to be paid in the ordinary course of business, within a year, out of the current assets or the earnings of the business. Example Sundry Creditors / Accounts Payable , bank overdraft
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 The goal of W.C. Management is to manage the firms current assets and liabilities in such a way that a satisfactory level of working capital is maintained. This is so because if the firm cannot maintain a satisfactory level of Working Capital, it is likely to become insolvent and may even be forced into bankruptcy.
In order to maintain a reasonable margin of safety the current assets should be large enough to cover its current liabilities. Each of the current assets must be managed efficiently in order to maintain the liquidity of the firm while not keeping too high a level of any one of them.

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Some important definitions Gross Working Capital means total current assets Net Working Capital means the difference between current asstes and current liabilities

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 Net Working Capital is used as an indicator of the firms liquidity. While analysing a companys financial strength, its Net Working Capital is seen to understand the liquidity position of the company.
The greater the margin by which the current assets cover the short term obligations (i.e. current liabilities), the more is the ability to pay obligations when they become due for payment. NWC is necessary because the cash outflows and inflows do not coincide. Cash outflows resulting from payment of current liabilities are relatively predictable. However the cash inflows are difficult to predict.
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 The more predictable the cash inflows are, the less NWC is required. A firm, say an electricity generation company, with almost certain and predictable cash inflows can operate with little or no NWC.
But where cash inflows are uncertain, it will be necessary to maintain current assets at a level adequate to cover current liabilities.

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Trade-off between Profitability & Risk

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Trade-off b/w Profitability & Risk

While evaluating a firms NWC position, an important consideration is the trade-off between profitability & risk.
In other words, the level of NWC has a bearing on profitability as well as risk.

Profitability means profits after expenses Risk defined as 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.
This trade-off between profitability and risk is an important element in evaluation of the level at which the firm should maintain its NWC.
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 The greater the NWC, the less risk prone the firm is since the firm is more liquid.
The relationship between liquidity, NWC and risk is such that if either NWC or liquidity increases, the firms risk decreases.

There are three assumptions to be noted here:

1) That we are dealing with a manufacturing firm;
2) That current assets are less profitable than fixed assets 3) That short-term funds are less expensive than long-term funds

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Nature of trade-off
In evaluating the profitability risk trade-off related to the level of NWC, two ratios are used:
1) Current Assets to Total Assets ratio (CA / TA) 2) Current Liabilities to Total Assets ratio (CL / TA)

Current Assets to Total Assets ratio indicates the percentage of CA in the total assets of the firm.
Since CA for a business firm is likely to be less than fixed assets, the increase in CA/TA ratio would decrease profitability but on the other hand would reduce the risk of technical insolvency. A decrease in the ratio will result in an increase in profitability as well as risk.
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 The CL/TA ratio indicates the percentage of total assets financed by current liabilities.
An increase in the ratio will yield higher profitability (due to decrease in costs) and higher risk (due to decrease on NWC, assuming no change in CA). The decrease in profitability as well as risk. The combined effects of change in CA and CL on profitability-risk trade-off can be evaluated by considering them simultaneously also.

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Determining Financing Mix

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 Apart from the profitability-risk trade-off, another important ingredient of the theory of working capital management is determining the financing mix. Financing mix means as to how the current asset will be financed. There are broadly two sources for this: 1) Short-term sources (Current liabilties) 2) Long-term sources
share capital, long-term borrowing, internally generated resources like retained earnings and so on.

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 There are three approaches to determine an appropriate financing mix :

1) Hedging or Matching Approach 2) Conservative Approach 3) Trade-off between Hedging & Conservative Approach

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Hedging Approach: According to Hedging approach, long term funds should be used to finance the permanent / core part of CA.
And the purely temporary and seasonal requirements (over and above the permanent needs) should be met out of short-term funds i.e. out of CL. As a result, the short term financing (CL) would be just equal to current assets (i.e NWC = Zero) This approach is a high profit high risk financing mix.

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Conservative Approach: According to this approach, the estimated total requirements of the CA should be financed from long-term sources.
The short-term sources of finance should be used only in emergency situations.

The firm has NWC equal to excess of long term financing over the permanent requirement.
This approach is a low-profit, low-risk combination.

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THANK YOU

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