ADVANCED FINANCIAL MANAGEMENT

Module -1

ADVANCED FINANCIAL MANAGEMENT

Management
Topics to be covered.
Concept of working capital
Types of working capital
Need for working capital
Management of working capital
Determination of level of current assets
Working capital financing
Working capital leverage
Sources for financing working capital
Bank finance for working capital
Computation of working capital
What is Working Capital?

Working Capital: Funds (current assets) required by a firm to finance dayto-day operations

Working

capital is that part of the firm total capital which is required for
financing short term assets or current assets such as cash, debtors,
inventories, marketable securities. It is also known as circulating capital.
Objectives of Working Capital

To ensure optimum investment in current assets

To strike a balance between the twin objectives of liquidity and profitability
in the use of funds

To ensure adequate flow of funds for current operations

To speed up the flow of funds or to minimize the stagnation of funds.
Need for Working Capital
The basic objective of financial management is to maximize share holders
wealth.
This is possible only when the company earns sufficient profit.
The amount of such profit largely depends upon the magnitude of sales.
However, sales do not convert into cash instantaneously.
There is always a time gap between the sale of goods and receipt of cash.
Therefore, additional capital is required to have uninterrupted business
operations, the amount will be locked up in the currents assets like account
receivable, stock etc.
This, actually happens due to the Cash cycle or Operating cycle
By the time the cash is converted back to cash (Cash to stock to sales to
account receivable to cash). The firm needs extra funds and hence the need
for working capital.
If this is not provided, the business operations will be affected to a greater
extent and hence this part of finance has to managed well.
Need to Maintain Balanced WC
Problems with Excess WC:
i. Unnecessary accumulation of inventory
ii. Defective credit policy
iii. Stock collection period
iv. Increases managements inefficiency

Problems with inadequate WC:

a. Stagnates growth
b. Difficult to implement operating plans
c. Difficult to meet day-to-day commitments
d. Inefficient utilisation of fixed assets
e. Unable to avail attractive cash and trade discounts
f. Loss of reputation
Working Capital Management

Working

capital management refers to the administration of all aspects of

current assets namely, cash, debtors, inventories, and marketable securities
and current liabilities.

This

basically determines the levels and composition of current assets to

ensure that right sources are tapped to finance current assets and current
liabilities are paid in time.
Concept of Working Capital

Working

capital is the amount of funds necessary to cover the cost of

operating the enterprises.

There

are two concepts of working capital (i) Gross working capital (ii) Net
working capital.
1.Gross Working Capital
It is the sum of all current assets appear in balance sheet
According to this concept, working capital refers to the sum total of all
current assets of the enterprise employed in the business process.
Gross working capital is a broader concept which includes all the current
assets of the enterprises.
2.Net Working Capital

This concepts represents excess of current assets over current liabilities. It

can be positive or negative. It is also that proportion of a firms current
assets which is financed by long term funds.
Kinds of Working Capital
Types of Working Capital

Permanent working capital

Temporary or Variable working capital
Other types of Working capital

Gross working capital

Net working capital
Negative working capital
Balance sheet working capital
Cash working capital
1. Permanent working capital
Permanent

working capital represents current assets required on a

continuous basis over the entire year.
A

manufacturing enterprises has to carry irreducible minimum amount of

inventories necessary to ensure uninterrupted production and sales.
Likewise,

some amount of funds remain tied in receivables when the firm

sells goods on credit terms.
Some

amount of cash has also to be held by the firm so as to exploit

business opportunities, meet operational requirements and to provide
insurance against business fluctuations.
Thus,

minimum amount of current assets which the firm has to hold for all
time to come to carry an operation at any time is termed as permanent or
regular working capital.
Distinction between Permanent and Temporary WC (For non-growing
firm)

2. Temporary or Variable Working Capital

It represents the additional assets which are required at different times
during the operating year-additional inventory, extra cash, etc.
Seasonal working capital is the additional amount of current assetsparticularly cash, receivables and inventory which is required during the
more active business seasons of the year.
It is temporarily invested in current assets and possesses the following
characteristics:
It is not always gainfully employed, though it may change from one asset to
another, as permanent working capital does;
It is particularly suited to business of a seasonal of cyclical nature.
3. Gross Working Capital:
It is the amount of funds invested in the various components of current
assets.
4.NetWorkingCapital:
It is the difference between current asset and current liabilities. The concept
net working capital enables a firm to determine the exact amount available
at its disposal for operational requirements.
5.NegativeWorkingCapital:
When current Liabilities exceed current assets negative working capital
emerges. Such a situation occurs when a firm is nearing a crisis of some
magnitude.
6.BalanceSheetWorkingCapital:
The balance sheet working capital is one which is calculated from the items
appearing in the balance sheet. Gross working capital and Net Working
Capital are examples of the balance sheet working capital.
7.CashWorkingCapital:
Cash working capital is one which is calculated from the items appearing in
the Profit and Loss account. It shows the real flow of money or value at a
particular time and is considered to be the most realistic approach in working
capital management.
Methods of estimating working capital requirements.

There

are two methods usually followed in determining working capital

requirements:

Conventional or Cash Cycle Method

Operating Cycle Method
Conventional or Cash Cycle Method

According to the conventional method, cash inflows and outflows are

matched with each other.

Greater emphasis is laid on liquidity and greater importance is attached to

current ratio, liquidity ratio etc. which pertain to the liquidity of business.
What is Cash Cycle?

It is the net time interval between cash collections from sale of the product
and cash payment for resources acquired by the firm.

It

also represents the time interval over which additional funds called
working capital, should be obtained in order to carry out the firms
operations.
Meaning of Operating Cycle Or Working Capital Cycle
The term operating cycle refers to the time duration required to complete
the following cycle of events in case of a manufacturing firm is called
operating cycle.
Conversion

of cash in to raw materials,

Conversion

of raw materials into work-in-process,

Conversion

of work in process into finished goods,

Conversion

of finished goods into debtors and bills receivables through

sales.
Conversion

of debtors and bills receivable into cash.

This cycle will be repeated again and again. The operating cycle of a
manufacturing business can be shown as given in the following chart.

Operating Cycle
The time that elapses in conversion of raw materials into cash
Cash Conversion Cycle
Cash

cycle = Operating Cycle - Time take to pay Suppliers

Principles of Working Capital

In

managing working capital the finance manager must bear in mind

certain fundamental principals which serve as useful guidelines.
Principle of Optimization
Principle of Suitability
Principle of Cost of Capital
Principle of Investment in working capital
1. Principle of Optimization
According to this principle, the finance manager must aim at selecting the
level of working capital that optimizes the firms rate of return.
This level is defined as that point at which the incremental cost associated
with a decline in working capital investment is equal to the incremental gain
associated it.
Optimization principle is based on the principle that a definite relation exists
between degree of risk that a firm assumes and the rate of return.
The more risk that a firm assumes the greater is the opportunity for gain or
loss.
2. Principle of Suitability

Principle of suitability should be followed while financing different

components of working capital.

This stipulates that each asset should be offset with a financing instrument
of the same approximate maturity.

Thus, temporary or seasonal working capital would be financed by shortterm borrowings and permanent working capital with long-term sources.
3. Principle of Cost of Capital

This principle emphasizes the different sources of finance, for each source
has a different cost of capital.

It should be remembered that the cost of capital moves inversely with risk.
Thus additional risk capital results in the decline in cost of capital.
4. Principle of Investment in WC.

This principle was evolved by professor Walker.

According to this principle, capital should be invested in each component of
working capital as long as the equity position of the enterprise increases.

This will strengthen, the financial position of the enterprise and reduce the
risk involved in it.
Management of Working Capital

The basic objective of working capital management is to manage the firms

current assets and current liabilities in such a way that a satisfactory level of
working capital is maintained i.e., it is neither inadequate nor excessive.

In order to achieve this objective the finance manager has to perform

basically following two functions:
Determinants of Working Capital requirements

In order to determine the amount of working capital needed by the firm, a

number of factors have to be considered by Finance Manager.

These factors are as explained below:

Issues in Working Capital
Levels of current assets
Current assets to fixed assets

 Liquidity Vs. profitability

Cost trade-off
HOW IS IT ESTIMATED ?
Current assets holding period
To estimate working capital requirements on the basis of average holding
period of current assets and relating them to costs based on the companys
experience in the previous years. This method is essentially based on the
operating cycle concept.
Ratio of sales
To estimate working capital requirements as a ratio of sales on the
assumption that current assets change with sales.
Ratio of fixed investment
To estimate working capital requirements as a percentage of fixed
investment.
Determination of relevant levels of current assets
Working Capital Management (WCM) refers to the admin of all components
of working capital-cash, marketable securities, debtors (receivable) and stock
(inventories) and creditors (payables).
The importance of working capital management is the determination of
relevant levels of current assets and their efficient use as well as the choice
of the finance mix.
The financial manager must determine levels and composition of current
assets. He must see that right sources are tapped to finance current assets,
and the current liabilities are paid in time.
There are many aspects of working capital management which make it an
important function of the financial manager.
Time: WCM requires much of the financial managers time.
Investment: Working capital represents a large portion of the total
investment in assets.

Critically: WCM has great significance for all firms but it is very critical is
directly related to the firms growth.
There is a direct relationship between a firms growth and its working
capital needs.
As sales grow, the firm needs to invest more in inventories and debtors.
These needs become very frequent and fast when sales grow continuously.
The financial manager should be aware of such needs and finance them
quickly.
Continuous growth in sales may also require additional investments in fixed
assets.
To decide the levels and financing of current assets, the risk return
implications must be evaluated.
Working Capital Financing

Commercial Banks play the most significant role in providing working

capital finance, particularly in the Indian context.

The balancing need has to be managed either by long term borrowings or

by issuing equity or by earning sufficient profits and retained the same for
coping with the additional working capital requirements.

The first choice before a finance manager, when a part of additional

working capital is not provided by Banks, is take the long-term sources of
finance.
Policies of Working Capital
A firm can adopt different financing policies vis--vis current assets. Three
types of financing may be distinguished.
1. Short-term financing
2. Long-term financing
3. Spontaneous financing
1. Long Term Financing: The sources of long-term financing include
ordinary share capital, preference share capital, debentures, long-term

borrowings from financial institutions and reserves and surplus (retained

earnings).
2. Short Term Financing: The short term financing obtained for a period
less than one year. It is arranged in advance from banks and other
suppliers of short term finance in the money market. Short-term finances
include working capital funds from banks, public deposits, commercial
paper, factoring of receivable etc.
3. Spontaneous Financing: It refers to the automatic sources of short-term
funds arising in the normal course of the business. Trade credit (suppliers)
and outstanding expenses are example of spontaneous financing. There is
not explicit cost of spontaneous financing. A firm is expected to utilize
these sources of finances to the fullest extent.
The real choice of financing current assets, once the spontaneous sources
of financing have been fully utilized, is between the long-term and short-term
sources of finance
What should be the mix of short-and long-term sources in financing
current assets?
Depending on the mix of short and long term financing the approach
followed by company may be referred to as:
Matching approach

Conservative approach

Aggressive approach

Approaches for Financing Current Assets

Matching Approach
Matching

or Hedging Approach: Here funds raised for a period which is

matching with the life of an asset
Conservative approach

Conservative Approach: Use of long-term funds for financing short-term

funds to finance a part of temporary current assets
Aggressive approach
Aggressive Approach: A firm is aggressive in financing working capital when
it uses short-term funds to finance a part of permanent current assets
Working Capital Leverage

Working capital leverage (WCL) measures the sensitivity of return on

investment (ROI) to the changes in the level of current assets.

Working capital leverage may be defined as the percentage change in ROI

with the given percentage change in current assets. Symbolically:
WAC = % Change in ROI / % change in CA
Sources of Working Capital
Trade Credit
Trade credit is an arrangement made by the firm with their suppliers,
wherein the suppliers agree to supply the goods to the firm on credit basis
with an agreement, to pay the amount in a future date.
Trade credit as a source of short term finance is easy and convenient
method of finance and also flexible as the credit increases with growth of the
firm.
Accrued Expenses and Deferred Income
Accrued expenses are the expenses which have been incurred but not yet
due and hence not yet paid also.
These represents a liability that a firm has to pay for the services already
received by it. Wages, Salaries, Interest and taxes are the most important
components of accrued expenses.
Deferred incomes are incomes received in advance before supplying
goods or services. However, firms having great demand for its products and
services, and those having good reputation in the market can demand
deferred incomes.
Commercial Papers (CPs)

CP: A short-term unsecured promissory note issued by firm with highly

credit rating
Features:
The

maturity period of CP ranges from 15 to 365 day (but in India it ranges

between 91 to 180 days).
It

is sold at a discount from its face value and redeemed at its face value.

Return
It

on CP is the difference between par value and redeemable value.

may be sold directly to investors or indirectly through dealers.

There

is no developed secondary market for CP.

Eligibility to Issue CPs

Latest tangible networth should be not less than Rs.5 crore
Company should be eligible to sanction fund based bank finance
Can be issued CPs for 75% of bank credit
Minimum credit rating should be: P2 from CRISK A-2 from ICRA
Minimum size of each CP Rs.5 lakhs
Issue size should not be less than one crore
Evaluation of CPs
Advantages:

Alternative source of finance during the period of tight bank credit

Cheaper source when compared to bank credit
Disadvantages:

Available only for large and financially sound companies

Can not be redeemed before maturity date
Public Deposits [Regulations]

Public deposits can not be issued more than 25% of share capital and free
resources
Can be issued for a period ranging from 6 months to 3 years period
Maximum period is 5 years for NBFCs
Need to set aside 10% of maturity value of public deposit every year by
31st March
Need to disclose relevant, true, fair, vital facts of financial performance
Evaluation of Public Deposits
Advantages:

Simple procedure involved in issuing PDs.

No restrictive covenants are involved.
No security is offered against public deposits
Cheaper source (post tax cost is fairly reasonable)
Disadvantages:

Limited funds can be raised

Funds available only for short-period
Inter-corporate Deposits

Inter-corporate Deposits (ICDs): A deposit make by one firm with another

firm is known as inter corporate deposits.

Generally, these deposits are usually made for a period up to six months.
Such deposits may be the following three types:
Inter-corporate Deposits
Types:
Call Deposits

Three months deposits

Six months deposits

Features:
No legal regulations

Given and taken in secrecy

Available on personal contacts

Factoring
A factor is a financial institution which offers services relating to
management and financing of debts arising out of credit sales.
Factors render services varying from bill discounting to a total take over a
administration of credit sales including maintenance of sales ledger,
collection of accounts receivable, credit control and protection from bad
debts, provision of finance and rendering of advisory services to their clients.
Factoring may be on a recourse basis, where the risk of bad debt is bone by
the client, or on a non recourse basis, where the risk of credit is borne by the
factor.
Factoring (concise)

Factor:

A financial institution which render services relating to the

management and financing of debtors.

Factor selects accounts receivables of their client

Factor takes responsibility of collecting accounts receivables selected by it
Forms of Bank Finance

Banks provide different types of tailor made loans that are suitable for
specific needs of a firm. The different forms of loans are:
Loans

Overdrafts

Cash credit

Bills discounting

Bills purchase

Letter of credit (L/C)

Security required in Bank Finance

Hypothecation
Pledge
Mortgage
Regulation of Bank Finance

Dehejia Committee (1968)

Tandon Committee (1974)
Chore Committee (1979)
In

the deregulated economic environment in India recently, banks have

considerably relaxed their criteria of lending. In fact, each bank can develop
its own criteria for the working capital finance.

Financing of Long Term WC

Permanent working capital should be financed by long term sources
like shares (equity & preference share), debentures, long term public
deposits and retained earnings and loan from FIs.