C HAPTER - I

16

1-BACKGROUND OF THE STUDY

2-STATEMENT OF PROBLEM
3-OBJECTIVES OF THE STUDY
4-HYPOTHESIS
5-METHODOLOGY
6-LIMITATIONS OF THE STUDY
7-STRUCTURE OF THE WORKS.
 1.1
BACKGROUND OF THE STUDY.
“THE MAJOR OBJECTIVE OF THIS STUDY IS FOR THE
PROPER UNDERSTANDING OF THE WORKING
CAPITAL OF
ARABIAN INDUSTRIES LLC AND TO SUGGEST
NECESSARY MEASURES TO OVERCOME THE
SHORTFALLS IF ANY IN
THE INDUSTRY.”

The project undertaken is on “Working Capital

Management of Arabian Industries LLC.”. It
describesabout how the company manages its working
capital and the various steps that are required in
themanagement of working capital. Cash is the lifeline of
a company. If this lifeline deteriorates, so doesthe
company's ability to fund operations, reinvest and meet
capital requirements and payments.Understanding a
company's cash flow health is essential to making
investment decisions. A good wayto judge a company's
cash flow prospects is to look at its Working Capital
Management (WCM).
Working capital refers to the cash of a business requires
for day-to-day operations or, morespecifically, for
financing the conversion of raw materials into finished
goods, which the companysells for payment. Among the
most important items of working capital are levels of
inventory,accounts receivable, and accounts payable.
Analysts look at these items for signs of a
company'sefficiency and financial strength.
The working capital is an important yardstick to measure
the company’s operational and financialefficiency. Any
company should have a right amount of cash and lines of
credit for its business needsat all times. This project
describes how the management of working capital takes
place at ArabianIndustries LLC..
There are numerous instances in the history of business
world where inadequacy of working capitalhas led to
business failures when a firm finds it difficult to meetings
day to day affairs. Operatingexpenses essential out lays
may have to be postponed for want of funds, operating
plans will go out ofgear & enterprise objectives on
investment slumps the suppliers & creditors of the firm
may have towait longer to raise their dues & will hesitate
to extend further credit to the firm.
Thus efficient management of working capital in an
important prerequisite for successful working of
abusiness concern it reduces the chances of business
failure generates a felling of security andconfidence in
the minds of personnel in the organization it assurance
solvency of steady of the organization.
17
 1.2
STATEMENT OF PROBLEM
In the management of working capital, the firm is faced
with two key problems:
1. First, given the level of sales and the relevant cost
considerations, what are the optimal amounts of
cash, accounts receivable and inventories that a firm
should choose to maintain?

2. Second, given these optimal amounts, what is the most

economical way to finance these workingcapital
investments? To produce the best possible results, firms
should keep no unproductive assetsand should finance
with the cheapest available sources of funds. Why? In
general, it is quiteadvantageous for the firm to invest in
short term assets and to finance short-term liabilities.
Besides this followings are some other problem , a firm is
facing. Through this study we try to find
answer for these problems.

1.What are root causes of working

capital on business?
2.What are the major effects on accounts receivable?
3.What is the nature of relationship between working
capital and capital employed
4.What steps should be taken to ensure that it effect on
the profit of the firm will not be
 negative?
5.How can working capital be managed?
6.What make up the working capital cycle?
7.How can debtors be controlled?
1.3
NEED AND IMPORTANCE OF THE STUDY.

1.This projects is helpful in knowing the companies

position of funds maintenance and setting thestandards
for working capital inventory levels, current ratio level,
quick ratio, current asset turnoverlevel & size of current
liability etc.
2. This project is helpful to the managements for
expanding the dualism & the project viability &
present availability of funds.
3. This project is also useful as it combines the present
year data with the previous year data and there
by it show the trend analysis, i.e. increasing fund or
decreasing fund.
4. The project is done as a whole entirely. It will give
overall view of the organization and it is useful
in further expansion decision to be taken by
management.
18
 1.4
OBJECTIVES OF THE STUDY
The main objective of the study is to determine the effect
of working capital on business profitability
which has to do with:-
1.Maintenance of working capital at appropriate level,
and
2.Availability of ample funds as and when they are
needed

To accomplishment of these two objectives, the

management has consider the composition of
currentassets pool. The working capital position sets the
various policies in the business with respect togeneral
operations like purchasing, financing, expansion and
dividend etc,
The subsidiary Objective of Working Capital Management
is to provide adequate support for thesmooth functioning
of the normal business operations of a company. This
Objective can be sub-divided into 2 parts:-
1. Liquidity
2. Profitability
1)
Liquidity
The quantum of Investment in Current Assets has to be
made in a manner that it not only meets theneeds of the
forecasted sales but also provides a built in cushion in the
form of safety stocks to meetunforeseen contingencies
arising out of factors such as delays in arrival of Raw
Material, suddenspurts in demand etc. Consequently, the
investment in current assets for a given level of
forecastedsales will be higher if the management follows
a conservative attitude than when it follows anaggressive
attitude. Thus, a company following a conservative
approach is subject to a lower degree ofrisk than the one
following an aggressive approach. Further, in the former
situation the high amount ofInvestment in Current Assets
imparts greater liquidity to the company than under the
latter situationwherein the quantum of investment in
Current Asset is less. This aspect exclusively covers
theliquidity dimension of Working Capital.
2)
Profitability

Once we recognize the fact that the total amount of

financial resources at the disposal of a company islimited
and these can be put to alternative uses, the larger the
amount of investment in current assets,the smaller will
be the amount available for investment in other profitable
avenues at hand with thecompany. A conservative
approach in respect of Investment in Current Assets
leaves fewer amountsfor other Investments than an
aggressive approach does.
19
 1.5
HYPOTHESIS

Hypothesis is a conjectural statement of the relationships

between two or more variables. It is testable,tentative
problem explanation of the relationship between two or
more variables that create a state ofaffairs or
phenomenon.E,C, Osuola said hypothesis should always
be in declarative sentence form, andthey should relate to
them generally or specially variable to variables.
Hypothesis thus:-

1. Explain observed events in a systematic manner2.

Predict the outcome of events and relationships3.
Systematically summarized existing knowledge.
In essence, there exist null hypothesis set up only to
nullify the research hypothesis and the alternative
hypothesis, for the purpose of the study. For the
efficiency of the study, the hypothesis is as follows:
H0
1.Working capital does not help the business concern in
maintaining the goodwill
2.Working capital does not create an environment of
security, confidence, and overall efficiency
in a business
H1
 1. Working capital helps the business concern in
maintaining the goodwill.
2. Working capital creates an environment of security,
confidence, and overall efficiency in business.
1.6
METHODOLOGY

Methodology may be a description of process, or may be

expanded to include a philosophicallycoherent collection
oft heor i es, concepts or ideas as they relate to a
particular discipline or field ofinquiry. This project
requires a detailed understanding of the concept –
“Working CapitalManagement”. Therefore, firstly we need
to have a clear idea of, what is working capital, how it
ismanaged in Arabian Industries LLC, what are the
different ways in which the financing of workingcapital is
done in the organization etc.
20
 To recognize the various type of information which are
necessary for the study of working capital
management.
 The management of working capital involves
managing inventories, accounts receivable and
payable and cash. Therefore one also needs to have a
sound knowledge about cash
management, inventory management and receivables
management.
 Then comes the financing of working capital
requirement, i.e. how the working capital is
financed, what are the various sources through which it is
done.
 And, in the end, suggestions and recommendations
on ways for better management and
control of working capital are provided.
Collection of data from various department of AILLC to
analyze the working capital management of
the firm.
1.6.1
COLLECTION OF DATA
There are several ways of collecting both data-Primary
and Secondary datas,which differ
 considerably in context of money, cost, time and other
sources at the disposable of the researcher.

There are two types of data:

· Primary data
· Secondary data
1-Primary Data
Definition:-
The first handed information/Fresh data collected through
various methods is known as primary data.
In respect of primary data which the researchers are
directly collects data that have not been
previously collected.
The primary data was gathered through personal
interaction with various functional heads and other
technical personnel. Some information was also collected
by observation.
Working capital
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Domestic credit to private sector in 2005

Working capital (abbreviated WC) 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 = Current Assets
Net Working Capital = Current Assets − Current Liabilities
Equity Working Capital = Current Assets − Current Liabilities − Long-
term Debt
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.

Contents
[hide]
• 1 Calculation
• 2 Working capital management
○ 2.1 Decision criteria
○ 2.2 Management of working capital
• 3 See also

[edit] Calculation
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.
Implications on M&A: The common commercial definition of working capital for the purpose
of a working capital adjustment in an M&A transaction (i.e. for a working capital adjustment
mechanism in a sale and purchase agreement) is equal to:
Current Assets – Current Liabilities excluding deferred tax assets/liabilities, excess cash, surplus
assets and/or deposit balances.
Cash balance items often attract a one-for-one purchase price adjustment.
[edit] Working capital management
Corporate finance

Working capital
 Cash conversion cycle
Return on capital
Economic value added
Just in time
Economic order quantity
Discounts and allowances
Factoring (finance)

Capital budgeting
Capital investment decisions
The investment decision
The financing decision

Sections
Managerial finance
Financial accounting
Management accounting
Mergers and acquisitions
Balance sheet analysis
Business plan
Corporate action

Societal components
Financial market
Financial market participants
Corporate finance
Personal finance
Public finance
Banks and Banking
Financial regulation
Clawback

This box: view · talk · edit

Decisions relating to working capital and short term financing are referred to as working capital
management. These involve managing the relationship between a firm's short-term assets and its
short-term liabilities. The goal of working capital management is to ensure that the firm is able to
continue its operations and that it has sufficient cash flow to satisfy both maturing short-term
debt and upcoming operational expenses.
[edit] Decision criteria
By definition, working capital management entails short term decisions - generally, relating to
the next one year period - which are "reversible". These decisions are therefore not taken on the
same basis as Capital Investment Decisions (NPV or related, as above) rather they will be based
on cash flows and / or profitability.
• One measure of cash flow is provided by the cash conversion cycle - the net number of
days from the outlay of cash for raw material to receiving payment from the customer. As
a management tool, this metric makes explicit the inter-relatedness of decisions relating
 to inventories, accounts receivable and payable, and cash. Because this number
effectively corresponds to the time that the firm's cash is tied up in operations and
unavailable for other activities, management generally aims at a low net count.
• In this context, the most useful measure of profitability is Return on capital (ROC). The
result is shown as a percentage, determined by dividing relevant income for the 12
months by capital employed; Return on equity (ROE) shows this result for the firm's
shareholders. Firm value is enhanced when, and if, the return on capital, which results
from working capital management, exceeds the cost of capital, which results from capital
investment decisions as above. ROC measures are therefore useful as a management tool,
in that they link short-term policy with long-term decision making. See Economic value
added (EVA).
• Credit policy of the firm: Another factor affecting working capital management is credit
policy of the firm. It includes buying of raw material and selling of finished goods either
in cash or on credit. This affects the cash conversion cycle.
[edit] Management of working capital
Guided by the above criteria, management will use a combination of policies and techniques for
the management of working capital. These policies aim at managing the current assets (generally
cash and cash equivalents, inventories and debtors) and the short term financing, such that cash
flows and returns are acceptable.
• Cash management. Identify the cash balance which allows for the business to meet day
to day expenses, but reduces cash holding costs.
• Inventory management. Identify the level of inventory which allows for uninterrupted
production but reduces the investment in raw materials - and minimizes reordering costs -
and hence increases cash flow. Besides this, the lead times in production should be
lowered to reduce Work in Progress (WIP) and similarly, the Finished Goods should be
kept on as low level as possible to avoid over production - see Supply chain management;
Just In Time (JIT); Economic order quantity (EOQ); Economic quantity
• Debtors management. Identify the appropriate credit policy, i.e. credit terms which will
attract customers, such that any impact on cash flows and the cash conversion cycle will
be offset by increased revenue and hence Return on Capital (or vice versa); see Discounts
and allowances.
• Short term financing. Identify the appropriate source of financing, given the cash
conversion cycle: the inventory is ideally financed by credit granted by the supplier;
however, it may be necessary to utilize a bank loan (or overdraft), or to "convert debtors
to cash" through "factoring".
[edit] See also
• Cash conversion cycle
• Working capital management
• Overtrading
• Quick ratio analysis
• Sustainable growth rate
 [hide]v · d · eTypes of capital

Circulating/Floating · Cultural · Cross-cultural · Educational · Financial (Venture) ·

Human/Individual (Academic · Knowledge)
Information · Infrastructural · Instructional · Intellectual · Natural · Organizational · Physical
(Fixed) · Social · Spiritual · Symbolic · Working

Term Liquid (short) vs. Patient (long)

Marxist
Constant · Variable · Fictitious
analytical

Marxist historical Monopoly

See also: Five Capitals

Retrieved from "http://en.wikipedia.org/wiki/Working_capital"
Categories: Financial accounting | Capital
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Understanding Working Capital Management

By

Dr. Sorab Sadri

Research Professor & Director
Rai Business School
Navi Mumbai
&
Dr. Sharukh N Tara
Senior Faculty in Finance and Governance
 Allana Institute of Management Studies & Research, Mumbai
Visiting Faculty in Finance
Rai Business School, Navi Mumbai

As we move from HR Strategy to Strategic HR, there is a growing need felt that people managers of the
future are going to be increasingly called upon to understand financial management, information
technology and production systems. There is no denying this contention since every manager has to thrive
on the cutting edge of global competition in the new world order and the WTO regime. And so his
knowledge has to be well rounded. This short paper is based on the authors interaction with the
management teacher's fraternity in India ever since 1991 and the experience based conviction that both
accountancy and mathematics remains a chimera that the average HR Manager is only too happy to side
step. It is a well-documented fact that as more and more senior managers are expected to be multi-skilled
and multi-functional it has been observed that H R Managers are the ones usually left behind. They speak
of benchmarking but seldom practice it themselves. They talk of funds management but there is invariably
a blind spot about this in their mind's eye. Yet assessing the impact of HR interventions and also balancing
the training budget needs at least a rudimentary knowledge of working capital management.
On the other hand going through some of the assignments submitted by students specialising in HR at the
MBA level convinces me of their abject ignorance of Finance. How can these students ever go in for
successful Strategic HR interventions in the corporate world remains a major worry for teachers like us?
That is what got us thinking and hence this paper is addressed to these managers in waiting as well. To
begin with let the HR Manager (in practice or in waiting) appreciate that the dark and dismal science of
economics is certainly not dark neither is it dismal. It is fairly exact and very exciting provided the tools
are in the hands of the right craftsman and the teacher knows his subject. We have always opined that
people who are ill schooled in this fine subject should have sufficient self-respect and refrain from teaching
it. The younger generation deserves this. We shall therefore begin with understanding some Economics
(which we consider the jewel in the crown of social sciences) and move through common sense into one
aspect of Financial Management (which is a specialisation we consider to be bedrock of all managerial
sciences). In both instances mathematics is a language that the craftsman must understand and learn to
use judiciously. From a teacher's viewpoint the author's advice to HR Managers (in practice and in waiting)
is to get their theory right since once theory is perfected reality would be unable to hold out. Case studies
are an excellent tool for teaching a subject provided the theory has been understood. If not, they
degenerate into story telling sessions where the mouth starts to function long before the brain is engaged
into gear. This paper merely attempts to simplify the theory behind working capital management for HR
Managers in particular and non-Finance Managers in general.

Some basic definitions in Economics must first of all be understood.

* Production is the creation of value.

* Consumption is the destruction/conversion of the state of that value.
* Distribution is the process that links the above two.
Some basic premises of the Economic science also need to be cited

* All value is created by labour

* Capital is man made aid to production
* Investment is the process of capital creation.
So you cannot say "I am investing two years of my time and Rs 2 Lakhs as fees in getting an MBA
Degree." What you are doing is making a financial outlay in the hope that the piece of paper (Diploma
/Degree) that you get at the end of the two-year period can be traded for a job in the labour market. What
you get by way of knowledge is abstract commodity and it can well be argued that both the teacher and
the taught are partners in the expansion of knowledge. Machinery, goods in process, inventory and
buildings on the other hand are capital. Money is not capital. In fact Crowther's famous poem is very
helpful to recall at this stage.

Money is a matter of functions four,

A medium, a measure, a standard, a store.
So the question rises as to what is working capital? Imagine a four-legged table with a glass top. This is
the euphemistic structure of working capital. The first leg symbolizes cash and bank balances, the second
leg symbolizes Inventories, the third leg symbolizes Receivables and the fourth leg symbolizes
Investments. The glass top symbolizes the allocation and utilization of scarce available resources so that
corporate objectives are met. The tabletop made of brittle glass has to support some very heavy iron
weights and to top it all there is a glass of whisky on it. The glass of whisky is stable so long as the four
legs are equal and the top is even in surface. If any leg were to be longer than the rest or shorter than
them the whisky would spill. If the table were weak and cannot support the weights then also the whole
structure would collapse.

Let us assume that the glass top supports all this weight and in addition your wife brings a heavy steel
dish full of grilled chicken. The dish is inordinately heavy so the glass top would shatter. Then you will
surely lose the chicken, break the tabletop and more importantly waste the good whisky. To add it all you
have to listen to your wife's admonishments.
Now replace the wife with the shareholders and the iron weights with your short-term liabilities. The dish
of chicken with additional business you never expected but now has to be financed and which the four legs
which stand for your assets would have to support. The glass of whisky is replaced with profits. Now very
simply, putting the right weight, having a balanced table and enjoying your whisky and chicken in peace is
what working capital management amounts to. Keeping the wife pleased is a bonus.
In short, it boils down to the management of funds in the short term as opposed to managing long-term
capital such as shares and debentures.
The HR Manager must appreciate that short-term capital has to be repaid within a short period such as a
year so its management is volatile. Working capital is after all the sum total of current assets, which are
used to pay back current liabilities and generate profits. The goal of proper working management is to see
that the current assets and current liabilities are maintained in such a way that a satisfactory level of
working capital is maintained. It relates to funds in the short term or a period normally one year and it is
always transformed from cash into other assets and back into cash within a business cycle.
Now let us see what the cash we need has to do with the normal operating time often called the process
cycle time. Some types of businesses may have a longer operating cycle and this could be well more than
a year or even a decade as in the case of distilleries. Other businesses may have a short operating cycle as
a fast food store.
Working capital could be either in terms of gross or net value. Whereas Gross working capital is the total of
current assets, Net working capital is the total of current assets minus current liabilities. As a rule of
thumb the best possible practice is to see that there is sufficient liquidity to pay back current liabilities
without blocking too much funds. The trade off between profitability and risk is the key to working capital
management. Anyone working with a fixed training budget would find this easy to understand. Too little
working capital increases profit but reduces liquidity, as current assets are more expensive than fixed
assets. For instance if a management feels that worker training is a cost they will apportion less funds for
it. If on the other hand a management sees it as an investment in manpower, the funds allocated would
increase substantially.

If at a point of time the organisation does not have sufficient funds to meet its short-term debts such as
creditors and salaries as well as day-to-day expenses it may become technically insolvent. On the other
hand, if it is very conservative it will have a surplus of working capital, which will adversely affect profits.
So it is easy to appreciate that the ratio of fixed assets to current assets is a good measure of the balance
to be maintained.
There is no specific thumb rule. It varies from industry to industry and the nature of business. Some
industry norms are given below.

Proportion of current assets to fixed assets

INDUSTRY PROPORTION
HOTELS 10-20%
ELECTRITY DISTRIBUTION 20-30%
ALUMINIUM & SHIPPING 30-40%
IRON STEEL & CHEMICALS 40-50%
COTTON TEXTILES 60-70%
TRADING 80-90%
The ideal mix thus depends on the nature of the industry. Now we shall very briefly take each component
of working capital and see what are the best practises adopted by industry in managing them.
Inventory is one of the most important components of working capital and its proper management cannot
be under stressed. Fundamentally, inventory consists of raw material, work in progress and finished
goods. The proportion of inventories to fixed assets is quite high ranging from 25% to 45% in the
manufacturing sector (in cement it is around 25%). Hence inventory management is crucial for all
managers irrespective of functional specialization. Since a number of industrial relations disputes in
manufacturing industries are linked to production bonus and incentives relating to inventory irrespective of
the market need for inventory, the HR Manager must understand this point well. Every member of the
organization feels its impact and yet scant respect is paid to it. This is most unfortunate. A serious study of
sick companies will support this contention. Hence those managers who are involved with Strategic HR
should take note of some of these important criteria for insuring proper management.

1. Maintaining a proper level of stock

2. ABC analysis to control high value items more intensively as compared to low value items.
3. Proper ordering policies.
4. Pricing of raw material work in progress and finished goods.
5. Control over wastage and obsolescence.
Further research by industrial economists sheds light on some practises adopted by various industries,
which are shown through extracts from their balance sheets. Let us quickly glance at some of these
important indicators.
Accounts receivable : This also forms an important part of working capital and depends on the credit
policy adopted by the firm namely

1. How much credit to be given

2. For how long is it given
3. Discounts for early payment
4. Collection and recovery efforts
Cash management: This as mentioned is the most liquid of all assets and is required to

1. Meet day to day expenses

2. As a hedge against uncertainties.
Too much cash is not good nor is having too little a healthy practice. Good companies usually have a
practise to plant surplus cash in risk free securities or inter company deposits. On the other hand,
companies with a deficit tend to borrow at a high rate of interest indicating a lack of planning. A sudden
surge in business may spur the need of working capital and this may also require additional interest to be
paid and again planning is important.
The key to all management and especially working capital management is to plan your work and then work
to your plan. This also is an important aspect of working capital management and good companies have
the practise of planning their needs well in advance.
Here is piece of advice to all those colleagues within the HR fraternity. The next time your wife makes
chicken and you invite your colleagues over to your house for dinner and drinks, please remember that
this is all about working capital management. If they have a fun time you are a damned good manager. If
someone drops the glass or breaks your table or slips and breaks his head then you know what to think of
your self.

Dr. Sorab Sadri

Research Professor & Director
Rai Business School
Navi Mumbai
&
Dr. Sharukh N Tara
Senior Faculty in Finance and Governance
 Allana Institute of Management Studies & Research, Mumbai
Visiting Faculty in Finance
Rai Business School, Navi Mumbai

Source: E-mail March 25, 2006

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