INTRODUCTION

WORKING CAPITAL MANAGEMENT Working capital management is concerned with the problems arise in attempting to manage the current assets, the current liabilities and the interrelationship that exist between them. The term current assets refers to those assets which in ordinary course of business can be, or, will be, turned in to cash within one year without undergoing a diminution in value and without disrupting the operation of the firm. The major current assets are cash, marketable securities, account receivable and inventory. Current liabilities ware those liabilities which intended at there inception to be paid in ordinary course of business, within a year, out of the current assets or earnings of the concern. The basic current liabilities are account payable, bill payable, bank over-draft, and outstanding expenses. The goal of working capital management is to manage the firms current assets and current liabilities in such way that the satisfactory level of working capital is mentioned. The current should be large enough to cover its current liabilities in order to ensure a reasonable margin of the safety. DEFINITION:1. According to Guttmann & DougallExcess of current assets over current liabilities. 1. According to Park & GladsonThe excess of current assets of a business (i.e. cash, accounts receivables, inventories) over current items owned to employees and others (such as salaries & wages payable, accounts payable, taxes owned to government).
WORKING CAPITAL MANAGEMENT

Working capital refers to the firms investment in short-term assets (cash, marketable securities, accounts receivable and inventories). Net working capital is the difference between a firms current assets and its current liabilities. Working capital management involves administering to both short-term assets and short-term liabilities. Assets and liabilities must be matched and coordinated in order to keep costs to a minimum and to control risks. Generally, we want to match the firms financing with the lives of its assets. If we consider a company that is growing over time, then its assets can be decomposed into three categories fixed assets, permanent current assets and fluctuating current assets.

Short-term Fluctuating Current Assets

Permanent Current Assets Fixed Assets

Long-term

Fixed assets should be financed long-term, either equity or long-term debt, since the assets are long-lived and need financing for a long period of time. The current assets can be broken down into two portions, permanent current assets and fluctuating current assets. The permanent current assets represent base levels of inventories, receivables, etc., that will always be on hand. The fluctuating current assets represent the seasonal build-ups that occur, such as inventories before Christmas and receivables after Christmas. The fluctuating current asset levels should be financed short-term since we dont want to pay financing charges all year if we only need the money for a four-month period. While the permanent current assets are, individually, short-lived assets, as a category they are always there (hence, permanent) and will always need to be financed. Thus, the permanent current assets should also be financed long-term, just like the fixed assets. While it is possible to finance some of our permanent needs using short-term debt, it is risky to do so. (Such financing is described as an aggressive working capital financing policy in your text aggressive being associated with risky.) The risk of financing permanent needs with short-term financing is twofold: first, short-term interest rates fluctuate much more than long-term interest rates. Rolling over short-term debt year after year will subject you to greater fluctuation in your financing costs as a result. Probably a bigger risk is the inability to roll over the short-term debt every year. You may have a bad year and find that lenders are unwilling to refund the debt (forcing you to default). Of course, some companies take the opposite approach they will finance some of their seasonal needs of the fluctuating current assets with long-term financing. This is a conservative approach, but the financing is there when it is needed but it costs money during those times when it is not needed. Banks generally do not want companies to utilize them as a source of permanent financing. For this reason, many banks will require that a companys line of credit be

completely paid off for at least one month each year. This is to prevent the company from using the bank for permanent financing. Of course, banks are essentially matching their assets and liabilities as well. The difference is that a banks assets are its loans which it matches to its sources of financing while firms match their financing to their assets. Since a banks financing source is predominantly short-term deposits, it wants its loan portfolio to be predominantly short-term as well. Life insurance companies and pension funds, on the other hand, have liabilities that are many years in the future. They would prefer to make longer term loans so that there isnt the need to reinvest the money every year.

Working Capital Management

Every business needs investment to procure fixed assets, which remain in use for a longer period. Money invested in these assets is called Long term Funds or Fixed Capital. Business also needs funds for short-term purposes to finance current operations. Investment in short term assets like cash, inventories, debtors etc. is called Short-term Funds or Working Capital. The Working Capital can be categorized, as funds needed for carrying out day-to-day operations of the business smoothly. The management of the working capital is equally important as the management of long-term financial investment. Every running business needs working capital. Even a business which is fully equipped with all types of fixed assets required is bound to collapse without (i) adequate supply of raw materials for processing; (ii) cash to pay for wages, power and other costs; (iii) creating a stock of finished goods to feed the market demand regularly; and, (iv) the ability to grant credit to its customers. All these require working capital. Working capital is thus like the lifeblood of a business. The business will not be able to carry on day-today activities without the availability of adequate working capital. The diagram shown on the next page clarifies it: Working capital cycle involves conversions and rotation of various constituents/components of the working capital. Initially cash is converted into raw materials. Subsequently, with the usage of fixed assets resulting in value additions, the raw materials get converted into work in process and then into finished goods. When sold on credit, the finished goods assume the form of debtors who give the business cash on due date. Thus cash assumes its original form again at the end of one such working capital cycle but in the course it passes through various other forms of current assets too. This is how various components of current assets keep on changing their forms due to value addition. As a result,

they rotate and business operations continue. Thus, the working capital cycle involves rotation of various constituents of the working capital. While managing the working capital, two characteristics of current assets should be kept in mind viz. (i) short life span, and (ii) swift transformation into other form of current asset. Each constituent of current asset has comparatively very short life span. Investment remains in a particular form of current asset for a short period. The life span of current assets depends upon the time required in the activities of procurement; production, sales and collection and degree of synchronization among them. A very short life span of current assets results into swift transformation into other form of current assets for a running business. These characteristics have certain implications: i. Decision regarding management of the working capital has to betaken frequently and on a repeat basis. ii. The various components of the working capital are closely related and mismanagement of any one component adversely affects the other components too. iii. The difference between the present value and the book value of profit is not significant. The working capital has the following components, which are in several forms of current assets:

Stock of Cash Stock of Raw Material Stock of Finished Goods Value of Debtors Miscellaneous current assets like short term investment loans &advances

Working capital
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 Current Liabilities Net Operating Working Capital = Current Assets Non Interest-bearing 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.

WORKING CAPITAL NEEDS

Different industries have different optimum working capital profiles, reflecting their methods of doing business and what they are selling. Businesses with a lot of cash sales and few credit sales should have minimal trade debtors. Supermarkets are good examples of such businesses; Businesses that exist to trade in completed products will only have finished goods in stock. Compare this with manufacturers who will also have to maintain stocks of raw materials and work-in-progress. Some finished goods, notably foodstuffs, have to be sold within a limited period because of their perishable nature. Larger companies may be able to use their bargaining strength as customers to obtain more favorable, extended credit terms from suppliers. By contrast, smaller companies, particularly those that have recently started trading (and do not have a track record of credit worthiness) may be required to pay their suppliers immediately. Some businesses will receive their monies at certain times of the year, although they may incur expenses throughout the year at a fairly consistent level. This is often known as seasonality of cash flow. For example, travel agents have peak sales in the weeks immediately following Christmas. Working capital needs also fluctuate during the year

The amount of funds tied up in working capital would not typically be a constant figure throughout the year. Only in the most unusual of businesses would there be a constant need for working capital funding. For most businesses there would be weekly fluctuations. Many businesses operate in industries that have seasonal changes in demand. This means that sales, stocks, debtors, etc. would be at higher levels at some predictable times of the year than at others. In principle, the working capital need can be separated into two parts: A fixed part, and A fluctuating part The fixed part is probably defined in amount as the minimum working capital requirement for the year. It is widely advocated that the firm should be funded in the way shown in the diagram below:

The more permanent needs (fixed assets and the fixed element of working capital) should be financed from fairly permanent sources (e.g. equity and loan stocks); the fluctuating element should be financed from a short-term source (e.g. a bank overdraft), which can be drawn on and repaid easily and at short notice.

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.

Working capital management

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 shortterm 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. 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 interrelatedness 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.

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".

WORKING CAPITAL Current assets Current liabilities It measures how much in liquid assets a company has available to build its business.

 A short term loan which provides money to buy earning assets. Allows to avail of unexpected opportunities. 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. WORKING CAPITAL An increase in working capital indicates that the business has either increased current assets (that is received cash, or other current assets) or has decreased current liabilities, for example has paid off some short-term creditors. Working Capital Management Decisions relating to working capital and short term financing are referred to as working capital management. Short term financial management concerned with decisions regarding to CA and CL. Management of Working capital refers to management of CA as well as CL. If current assets are less than current liabilities, an entity has a working capital deficiency, also called a working capital deficit. These involve managing the relationship between a firm's short-term assets and its short-term liabilities. Working Capital Management 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. Businesses face ever increasing pressure on costs and financing requirements as a result of intensified competition on globalize markets. When trying to attain greater efficiency, it is important not to focus exclusively on income and expense items, but to also take into account the capital structure, whose improvement can free up valuable financial resources Active working capital management is an extremely effective way to increase enterprise value. Optimizing working capital results in a rapid release of liquid resources and contributes to an improvement in free cash flow and to a permanent reduction in inventory and capital costs, thereby increasing liquidity for strategic investment and debt reduction. Process optimization then helps increase profitability. The fundamental principles of working capital management are reducing the capital employed and improving efficiency in the areas of receivables, inventories, and payables.

NEED OF WORKING CAPITAL MANAGEMENT

The need for working capital gross or current assets cannot be over emphasized. As already observed, the objective of financial decision making is to maximize the shareholders wealth. To achieve this, it is necessary to generate sufficient profits can be earned will naturally depend upon the magnitude of the sales among other things but sales can not convert into cash. There is a need for working capital in the form of current assets to deal with the problem arising out of lack of immediate realization of cash against goods sold. Therefore sufficient working capital is necessary to sustain sales activity. Technically this is refers to operating or cash cycle. If the company has certain amount of cash, it will be required for purchasing the raw material maybe available on credit basis. Then the company has to spend some amount for labour and factory overhead to convert the raw material in work in progress, and ultimately finished goods. These finished goods convert in to sales on credit basis in the form of sundry debtors. Sundry debtors are converting into cash after expiry of credit period. Thus some amount of cash is blocked in raw materials, WIP, finished goods, and sundry debtors and day to day cash requirements. However some part of current assets may be financed by the current liabilities also. The amount required to be invested in this current assets is always higher than the funds available from current liabilities. This is the precise reason why the needs for working capital arise GROSS WORKING CAPITAL AND NET WORKING CAPITAL There are two concepts of working capital management 1. Gross working capital Gross working capital refers to the firms investment I current assets. Current assets are the assets which can be convert in to cash within year includes cash, short term securities, debtors, bills receivable and inventory. 2. Net working capital Net working capital refers to the difference between current assets and current liabilities. Current liabilities are those claims of outsiders which are expected to mature for payment within an accounting year and include creditors, bills payable and outstanding expenses. Net working capital can be positive or negative efficient working capital management requires that firms should operate with some amount of net working capital, the exact amount varying from firm to firm and depending, among other things; on the nature of industries.net working capital is necessary because the cash outflows and inflows do not coincide. The cash outflows resulting from payment of current liabilities are relatively predictable. The cash inflow are however difficult to predict. The more predictable the cash inflows are, the less net working capital will be required. The concept of working capital was, first evolved by Karl Marx. Marx used the term variable capital means outlays for payrolls advanced to workers before the completion of work. He compared this with constant capital which according to him is nothing but dead labour. This variable capital is nothing wage fund which remains blocked in terms of financial management, in working process along with other operating expenses until it is released through sale of finished goods. Although Marx did not mentioned that workers also gave

credit to the firm by accepting periodical payment of wages which funded a portioned of W.I.P, the concept of working capital, as we understand today was embedded in his variable capital.

TYPES OF WORKING CAPITAL

The operating cycle creates the need for current assets (working capital).However the need does not come to an end after the cycle is completed to explain this continuing need of current assets a destination should be drawn between permanent and temporary working capital. 1) Permanent working capital The need for current assets arises, as already observed, because of the cash cycle. To carry on business certain minimum level of working capital is necessary on continues and uninterrupted basis. For all practical purpose, this requirement will have to be met permanent as with other fixed assets. This requirement refers to as permanent or fixed working capital 2) Temporary working capital Any amount over and above the permanent level of working capital is temporary, fluctuating or variable, working capital. This portion of the required working capital is needed to meet fluctuation in demand consequent upon changes in production and sales as result of seasonal changes Graph shows that the permanent level is fairly castanet; while temporary working capital is fluctuating in the case of an expanding firm the permanent working capital line may not be horizontal. This may be because of changes in demand for permanent current assets might be increasing to support a rising level of activity.

DETERMINANTS OF WORKING CAPITAL The amount of working capital is depends upon a following factors: 1. Nature of business Some businesses are such, due to their very nature, that their requirement of fixed capital is more rather than working capital. These businesses sell services and not the commodities and that too on cash basis. As such, no founds are blocked in piling inventories and also no funds are blocked in receivables. E.g. public utility services like railways, infrastructure oriented project etc. there requirement of working capital is less. On the other hand, there are some businesses like trading activity, where requirement of fixed capital is less but more money is blocked in inventories and debtors. 2. Length of production cycle In some business like machine tools industry, the time gap between the acquisition of raw material till the end of final production of finished products itself is quit high. As such amount may be blocked either in raw material or work in progress or finished goods or even in debtors. Naturally there need of working capital is high. 3. Size and growth of business In very small company the working capital requirement is quit high due to high overhead, higher buying and selling cost etc. as such medium size business positively has edge over the small companies. But if the business start growing after certain limit, the working capital requirements may adversely affect by the increasing size. 4. Business/ Trade cycle If the company is the operating in the time of boom, the working capital requirement may be more as the company may like to buy more raw material, may increase the production and sales to take the benefit of favorable market, due to increase in the sales, there may more and more amount of funds blocked in stock and debtors etc. similarly in the case of depressions also, working capital may be high as the sales terms of value and quantity may be reducing, there may be unnecessary piling up of stack without getting sold, the receivable may not be recovered in time etc. 5. Terms of purchase and sales Some time due to competition or custom, it may be necessary for the company to extend more and more credit to customers, as result which more and more amount is locked up in debtors or bills receivables which increase the working capital requirement. On the other hand, in the case of purchase, if the credit is offered by suppliers of goods and services, a part of working capital requirement may be financed by them, but it is necessary to purchase on cash basis, the working capital requirement will be higher.

6. Profitability The profitability of the business may be vary in each and every individual case, which is in turn its depend on numerous factors, but high profitability will positively reduce the strain on working capital requirement of the company, because the profits to the extend that they earned in cash may be used to meet the working capital requirement of the company. 7. Operating efficiency

If the business is carried on more efficiently, it can operate in profits which may reduce the strain on working capital; it may ensure proper utilization of existing resources by eliminating the waste and improved coordination etc. COMPONENTS OF WORKING CAPITAL

Cash
Cash is probably the least productive asset you can have. Not only does it not earn anything, it actually loses purchasing power as a consequence of inflation. So why do firms hold cash? The three Keynsian motives for holding cash balances are Transactions motive to conduct day-to-day business of paying for purchases, labor, etc. Precautionary motive to cover unexpected expenditures. If the delivery truck breaks down, it must be repaired or replaced if you want to stay in business. Speculative motive unusually good opportunities occasionally arise. If you have the money available, you can take advantage of these opportunities. While cash is necessary to cover the transactions motive, the precautionary and speculative motives can be covered with the near money (or near cash) of marketable securities. In order to maximize your cash balances, you can do one of two things; either accelerate the inflow of funds (ask for an advance on your salary) or delay the outflow of funds (postpone paying the phone bill until next month). But why would we want to maximize our cash holdings if it is the least productive asset? Because idle cash, either sitting in a checking account or tied-up in accounts receivable is extremely costly. For example, suppose we have a client who owes us payment of $1,000,000 that is due. The opportunity cost of not collecting is the interest we could earn on the money. $1,000,000 Receivable due

5% Treasury bill rate $ 50,000 Annual interest $50,000/365 days = $137 per day Can you invest money for one day? Absolutely. In fact, for a large enough amount of money, someone will meet you at the bank on Sunday in order to accept your deposit. This also illustrates the concept of float. Bank float is the period of time between when a check is written to pay an obligation and when the funds are actually deducted from your checking account. Within a city, it is common practice to have a local check clearing system where banks meet each day to exchange checks written on one anothers accounts. When the bank where a check is deposited is in a different city from the bank on which the check is drawn, the deposited check first goes to the regional Federal Reserve Bank, (Dallas in the case of Texas), and is then forwarded to the issuing bank. This adds a day or two to the float period. If the check is drawn on a bank account in another Federal Reserve District, then another day or so is added as the local Fed must forward the check to the Fed in the issuing banks district which then forwards the check to the bank. Exxon used to pay suppliers west of the Mississippi river with checks written on a small bank in North Carolina, while suppliers east of the Mississippi were paid with checks on a small bank in Arizona. One days worth of float to the U.S. government is worth over $1 billion (which is one reason government employees now get paid on the first of the following month rather than the last day of the month). Most of us have probably played the float on at least one occasion (and probably gotten caught!) It should be noted, however, that using float to cover up a deficit (i.e., hot check) is illegal. Another means of extending the float is through the use of drafts. A draft is like a check, but must be returned to the issuer for verification prior being deposited. This, again, adds 2-3 days to the float period. Insurance companies are most noted for using drafts within the U.S. The type of draft that insurance companies use are known as sight drafts since they are paid upon presentation. Time drafts are those which are payable upon a specific future date. Time drafts are an important financing instrument in international trade and will be discussed later. While bank float and drafts delay the outflow of funds, cash balances can also be increased by speeding up the inflow of funds. The primary means of accomplishing this is through the use of a lock-box system. A lock-box is a post office box in a local city where payments from customers in the area are sent. The lock-box is cleared daily and the checks are deposited in a local bank and then wired to the companys main bank account. Referred to as concentration banking, it cuts 2-3 days off of the time it takes the checks to cross several states and allows funds to be concentrated in one bank for investment in short-term securities. The larger amount of funds that can be invested yields higher interest rates and lower transactions costs.

The local bank will offer the lock-box system if a local office is not available or does not want to devote the personnel to tend to the system. Banks, however, charge for the services that they provide through either a direct service charge, or by requiring that a minimum compensating balance be maintained. A compensating balance is one that does not pay any interest. The minimum balance can be either an absolute minimum or an average minimum.

Marketable Securities
Marketable securities are a way of holding cash but with the attribute of earning interest. Market securities have three characteristics: 1. Short-term maturity (less than one year, or money market instruments 2. High marketability 3. Virtually no risk of default Several types of marketable securities exist, the major ones being U.S. Treasury bills Treasury bills are auctioned every Monday by the government. Most have maturities of 91 or 181 days, although some 9-month (270 days) and 12month (360 days) bills are sold. The t-bills, generally with a face value of $10,000 each, are sold at a discount to the highest bidders. The difference between the amount paid and the face value at maturity represents the interest that is earned. Anticipation notes Anticipation notes are issued by municipalities and school districts. Since their revenues come from tax sources, the notes are in anticipation of future tax receipts. Commercial paper Commercial paper is the promissory notes of a major national firms. Most of the firms that issue commercial paper sell it directly to investors (insurance companies, money market funds, pension funds) although sometimes it will be sold through investment bankers. Commercial paper is a substitute for bank debt, but at a rate of interest that is one-fourth to on-half of a percent higher than t-bills (currently about 4.3%) but significantly less than what banks would charge (prime is currently about 8.5%). Bankers Acceptances A bankers acceptance is a time draft that evolves from international export/import financing. An exporter is paid by a time draft issued by a foreign bank. Since the draft is not payable until some future date (1-3 months, typically) the company that receives it will often sell it to its local

bank at a discount. The local bank bundles the discounted drafts (bankers acceptances) and then resells them in the money markets. Accounts Receivable Accounts receivable are generated when a firm offers credit to its customers. The first thing that needs to be addressed when establishing a credit policy is to set the standards by which a firm is judged in determining whether or not credit will be extended. There is whats known as the 5 Cs of credit: 1. Character the willingness of the borrower to repay the obligation 2. Capacity the capability of the borrower to earn the money to repay the obligation 3. Capital sufficient assets available to support operations (as opposed to a firm that is undercapitalized). Sometimes capital is interpreted to mean equity capital; i.e., to make sure the owners of the firm have sufficient money at stake to give them proper incentive to repay the loan and not let the company go bankrupt. 4. Collateral assets to support the loan which can be liquidated if default occurs 5. Conditions current and future anticipated conditions of the firm and the industry. Once the credit standards have been set, the terms of credit need to be established. When must the customer pay? If they pay early, will they receive a discount? If they pay late, do they get charged a penalty? While the whole purpose of extending credit is to increase sales and, thus, gross profits, the expected increase in gross profits must be compared with the costs associated with extending credit to customers. These costs include The time value of money tied up in accounts receivable Bad debts that occur Credit checks (to minimize bad debts) Collection costs Discounts for early payment (reduces revenues) Clerical costs associated with maintaining a credit department

Competitors will respond very quickly to a change in price. How many times have we seen the claims that We will meet or beat any advertised price? A change in credit policy, on the other hand, is a more subtle means of competing for customers and one that the competition will not necessarily respond to. In fact, many firms base their business on easy credit. How many times have we seen the advertisements where they tell us Good credit? Bad credit? No credit? We dont care! Of course, these firms

will have larger bad debt expenses and larger financing costs, etc. Obviously, they will also need to have higher prices (higher gross profit margins) in order to cover these costs. Inventories Inventories (raw materials, work-in-process, finished goods) make up a large portion of most firms current assets, and for many, total assets. As such, the extent to which a firm efficiently manages its inventories can have a large influence on its profitability. Thus, keeping abreast of inventory policy is critical to the profitability (and value) of the firm. Several factors influence the amount of inventory that a firm maintains. The most important of these include Level of sales typically, the more sales a firm has, the more inventory it holds Length of time and technical nature of the production process The longer it takes to produce finished goods inventories from raw materials, the larger the amount of finished goods that a firm will typically hold (a safety stock). Also, if the production process is highly technical, requiring that retooling be performed prior to each production run in order to assure that production is meeting specifications, larger amounts of inventory will be produced with each production run in order to minimize the set-up costs associated with retooling. Durability vs. Perishability If an inventory item is highly perishable, such as fresh vegetables, a small amount will be held. Similarly, fashions of clothes and car styles are perishable and will result in smaller inventories than durable goods such as tools and hardware. Costs Cost of holding inventories as well as costs of obtaining inventories will influence inventory sizes.

Inventory costs can be broken down into three major categories: A. Ordering Costs 1. Fixed costs stocking, clerical 2. Shipping costs often fixed 3. Missed quantity discounts an opportunity cost Carrying Costs 1. Time value of money tied-up in inventories 2. Warehousing costs 3. Insurance 4. Handling 5. Obsolescence, breakage, shrinkage

B.

C.

Stock-out Costs 1. Lost sales 2. Loss of goodwill 3. Special shipping costs

Ideally, we want to balance these costs against each other so that our total costs are minimized. Short-term Financing Trade Credit The major source of short-term financing for firms is that of trade credit. While it is an account payable on our balance sheet, it is an account receivable on the balance sheet of our supplier. The terms of credit can vary quite a bit: 1. Cash on Delivery (i.e., no credit) 2. Net amount due within a certain period of time 3. Net amount with a discount if paid within a certain period of time, net amount within another period. For example, 2/10 net 30 means that if you pay within the first ten days, you can deduct 2% from the bill; otherwise the full amount of the bill is due within 30 days. Discounts are offered by suppliers to keep their A/R balances down and minimize the funds that are tied-up. Not taking the discount can be a very expensive means of financing. For example, suppose we do not pay within the first ten days. Then, if we pay on the thirtieth day, we have paid 2% (approximately) for an additional twenty days use of the funds (the first ten days were free anyway). Since there are 18 twenty-day periods in a year, this is approximately 2% * 18 = 36% Actually, the cost is a little higher since we are paying 2% on top of the 98% we would otherwise have to pay: 2% 360days * = 36. 7% 98% 20days Of course, if you miss payment by day 10 for taking the discount, dont pay the full amount of day 11 or you have paid

2%*360 = 720% Do banks charge 36% interest on loans? Not in Texas or most states. It is a violation of the usury laws. Then why do many companies forego the discounts if the cost is so high? It is the only source of funding that they can get. To reduce the effective cost, firms will often stretch payment out past the due date. Of course, this subjects the firm to risk of its credit being completely cut off by the supplier and possibly damages the credit reputation since other suppliers will often request references before extending credit themselves. Some firms will offer post-dated billing, typically in a seasonal industry. For example, if a manufacturers primary sales are to retailers for the Christmas season they may encourage retailers to order in June and July rather than waiting until September. The encouragement is that if an order is placed in June or July, the manufacturer will not bill them until September and even then regular credit terms will apply. The advantage here is that it allows the manufacturer to smooth out sale and thus production. The manufacturer can then save on overtime with employees as well as not incur many of the carrying costs associated with holding the inventories since the retailer takes possession and ownership earlier. Commercial Banks The second major source of short-term financing for firms is commercial banks. A firm wants to establish a close relationship with its bank and obtain a line of credit. In order to get a credit line, you will want to show them your income statements, balance sheets, financial ratios, etc. The bank will then allow a certain amount of credit with a set rate of interest (usually prime plus). This can be renegotiated every year. In fact, commercial banks bread and butter is their business accounts and they are very competitive with one another in trying to attract corporate clients. The amount of the credit line is typically tied to the amount of accounts receivable that the firm has and sometimes to the amount of inventories that it holds. Another type of credit line is referred to as a revolving line of credit. With a revolving line of credit, the bank provides a written agreement guaranteeing loans up to a certain amount. The firm will pay a normal rate of interest on the amounts of funds that it borrows plus a commitment fee of one-half to one percent on any unborrowed funds. Unlike a regular line of credit which can be changed, a revolving line of credit guarantees that the bank will always make the amount available if needed. Additionally, a revolving line of credit will often be extended jointly by several banks when the amounts used are larger than a single bank can (or wants to) handle alone. Types of Loans Loans come in a variety of shapes. A simple loan requires that the firm maintain a non-interest-bearing account at the bank. While compensating balances are not used as much as they have been in the past, they are still encountered frequently.

Suppose a bank offers a one-year loan for $100,000 at an 8% rate of interest with a compensating balance of 20%. Then, Less: $100,000 loan 20,000 compensating balance $ 80,000 net proceeds

At the end of one year, the firm repays the bank $88,000. $8,000 is interest on the loan and the other $80,000 (with the $20,000 in the compensating balance for a total of $100,000) is the principal. Thus, the firm has effectively paid $8,000 interest on the use of $80,000 for an annual rate of interest of 10%. Alternatively, the bank may offer a discounted loan where the interest is deducted up-front. Using our same example, $100,000 loan Less: 8,000 interest $ 92,000 net proceeds At the end of the year, the firm repays the $100,000 of principal (since the interest was paid up-front). Effectively, the firm paid $8,000 of interest for the use of $92,000 of funds for a rate of interest of 8.7% on the loan. Of course, your banker is there to help you and may express concern that the need to come up with $100,000 at the end of the year could be difficult. He/she may suggest, instead, an interest add-on loan where the amount of interest is added to the principal and then repaid in a series of installments. Our example loan would then required that monthly payments of $9,000 be made ($100,000 principal + $8,000 interest = $108,000/12 months = $9,000 per month).

$100,000 Average Owed

12 months

As an approximation, the amount of the loan that was outstanding during the year was, on average, only $50,000. The $8,000 of interest thus represents an approximately 16% rate of interest on the average amount of the loan. More precisely, this loan appears as 0 100,000 1 - - - - - - - - - - - - - - - - - 11 (9,000) - - - - - - - - - - - - - - (9,000) 12 (9,000)

Of course, if you were the bank, the cash flows would be the same, only the signs would be reversed. So as a bank officer, how would you determine the rate of interest that you were earning on this investment? The true cost of debt of any loan is the internal rate of return between what you receive and what you have to pay back. Suppose we use our calculators and determine the IRR of this interest add-on loan. We determine that the IRR is 1.2%. But remember that his is 1.2% per month. Using simple interest, 1.2%*12 = 14.4% annual rate of interest. Security for Bank Loans Banks like some sort of collateral for loans to ensure repayment of the loan, at least in part. The preferred collateral for bank loans is accounts receivable. The reason, of course, is that collecting money is what banks do. Typically, a bank will loan up to 75-80% of the receivables that are not over 60 days. There are two ways to obtain financing with receivables: Pledging of Accounts Receivable This is the most common form. A lender will loan up to 80% of the amount of the invoice. Upon payment, the borrower has pledged to use the proceeds to reduce the amount of the loan. If the customer does not pay the invoice, the borrower is still obligated to repay the loan. Factoring of Accounts Receivable The receivable is sold to a factoring institution. Typically, this is used prior to making a sale on credit. The seller will go to a factor who will run a credit check on the potential buyer. If the buyer has a good credit rating, the factor will give the go-ahead to sell on credit and then buy the receivable (at a discount) from the seller. The buyer is notified in writing to pay the factor directly for the receivable. Then, if the invoice is not paid, it is up to the factor to collect from the buyer and the factor takes the risk of bad debt. Sometimes, the factor may withhold 10% from the seller to make them share in the risk of non-payment. Then, when payment is received, the 10% reserve will be refunded to the seller. The use of factoring is considerably more expensive than the pledging of accounts receivable. This is due to the fact that, in addition to lending money for a period of 30-90

days, the factor also must run a credit check, incur the cost of collection, and undertake the risk of nonpayment. Banks will also use inventories as collateral for short-term loans. A blanket lien (or floating lien) is one that covers all inventories. Even then, the lender will only loan 40-50% of the cost of those goods. This is because, if default occurs, the lender will have to hire someone to sell the inventories as well as substantially discounting them in order to liquidate the inventories. A warehouse receipts loan is where a third party holds the inventory as collateral for the lender. A warehouse receipts loan is most commonly used in the canning industry or where production of inventory is seasonal. For example, the cotton season runs from June to October. Denim jeans, on the other hand, are purchased year-round. Thus, a denim manufacturer might buy cotton in June and produce denim but not have enough for the estimated annual demand. The producer could then go to a bank and borrow against the bolts of denim that have been produced. These bolts of denim would then be stored in a public warehouse as collateral and funds would be made available for the producer to purchase more cotton and produce more denim. As inventories are sold, the loan could be paid down, in which case the lender would notify the public warehousing company to release X number of bolts of denim to the producer and the process reverses itself. If the inventories are too bulky to transport to a public warehouse, a field warehouse arrangement may be set up where the public warehousing company goes to the producers place of business and physically segregates the inventories that are being held as collateral for the lender. Only the public warehousing company would have access to the collateral and would only release it upon notification by the lender. Securities Loans A borrower can pledge their inventories of securities of another company (bonds, notes payable) as collateral for a loan as well. Thus, if you hold a note payable from a creditworthy firm, many lenders will loan money against it. (This is similar, in a sense, to what happens with a margin purchase.) In short, if a firm has assets of virtually any kind, it can use them as collateral for short-term loans to meet its short-term cash needs.

Importance of working capital management?

The term working capital refers to the amount of capital which is readily available to a company. That is, working capital is the difference between resources in cash or readily convertible into cash (Current Assets) and organizational commitments for which cash will soon be required (Current Liabilities). Current Assets are resources which are in cash or will soon be converted into cash in "the ordinary course of business".

Current Liabilities are commitments which will soon require cash settlement in "the ordinary course of business". Thus: WORKING CAPITAL = CURRENT ASSETS - CURRENT LIABILITIES In a company's balance sheet components of working capital are reported under the following headings: Current Assets: Liquid Assets (cash and bank Inventory Debtors and Receivables Current Liabilities: Bank Overdraft Creditors and Payables Other Short Term Liabilities deposits)

The Importance of Good Working Capital Management

From a company's point of view, excess working capital means operating inefficiencies. Money that is tied up in inventory or money that customers still owe to the company cannot be used to pay off any of the company's obligations. So, if a company is not operating in the most efficient manner (slow collection), it will show up as an increase in the working capital. This can be seen by comparing the working capital from one period to another; slow collection may signal an underlying problem in the company's operations. Approaches to Working Capital Management The objective of working capital management is to maintain the optimum balance of each of the working capital components. This includes making sure that funds are held as cash in bank deposits for as long as and in the largest amounts possible, thereby maximizing the interest earned. However, such cash may more appropriately be "invested" in other assets or in reducing other liabilities. In recent years there has been an increased focus on Dynamic Discounting as a means of optimizing Working Capital. This methods involves the early payment for goods and services bought in return for a discounted price. Operated properly, this can give a significant return on working capital. Working capital management takes place on two levels: * Ratio analysis can be used to monitor overall trends in working capital and to identify areas requiring closer management

* The individual components of working capital can be effectively managed by using various techniques and strategies When considering these techniques and strategies, companies need to recognize that each department has a unique mix of working capital components. The emphasis that needs to be placed on each component varies according to department. For example, some departments have significant inventory levels; others have little if any inventory. Furthermore, working capital management is not an end in itself. It is an integral part of the department's overall management. The needs of efficient working capital management must be considered in relation to other aspects of the department's financial and non-financial performance.

The working capital needs of a business are influenced by numerous factors.

The important ones are discussed in brief as given below: i. Nature of Enterprise The nature and the working capital requirements of an enterprise are interlinked. While a manufacturing industry has a long cycle of operation of the working capital, the same would be short in an enterprise involved in providing services. The amount required also varies as per the nature; an enterprise involved in production would require more working capital than a service sector enterprise. ii. Manufacturing/Production Policy Each enterprise in the manufacturing sector has its own production policy, some follow the policy of uniform production even if the demand varies from time to time, and others may follow the principle of 'demand-based production in which production is based on the demand during that particular phase of time. Accordingly, the working capital requirements vary for both of them. iii. Operations The requirement of working capital fluctuates for seasonal business. The working capital needs of such businesses may increase considerably during the busy season and decrease during the slack season. Ice creams and cold drinks have a great demand during summers, while in winters the sales are negligible. iv. Market Condition If there is high competition in the chosen product category, then one shall need to offer sops like credit, immediate delivery of goods etc. for which the working capital requirement will be high. Otherwise, if there is no competition or less competition in the market then the working capital requirements will be low. v. Availability of Raw Material

If raw material is readily available then one need not maintain a large stock of the same, thereby reducing the working capital investment in raw material stock. On the other hand, if raw material is not readily available then a large. Inventory/stock needs to be maintained, thereby calling for substantial investment in the same. vi. Growth and Expansion Growth and expansion in the volume of business results in enhancement of the working capital requirement. As business grows and expands, it needs a larger amount of working capital. Normally, the need for increased working capital funds precedes growth in business activities. vii. Price Level Changes Generally, rising price level requires a higher investment in the working capital. With increasing prices, the same level of current assets needs enhanced investment. viii. Manufacturing Cycle The manufacturing cycle starts with the purchase of raw material and is completed with the production of finished goods. If the manufacturing cycle involves a longer period, the need for working capital would be more. At times, business needs to estimate the requirement of working capital in advance for proper control and management. The factors discussed above influence the quantum of working capital in the business. The assessment of working capital requirement is made keeping these factors in view. Each constituent of working capital retains its form for a certain period and that holding period is determined by the factors discussed above. So for correct assessment of the working capital requirement, the duration at various stages of the working capital cycle is estimated. Thereafter, proper value is assigned to the respective current assets, depending on its level of completion. The basis for assigning value to each component is given below:

Each constituent of the working capital is valued on the basis of valuation enumerated above for the holding period estimated. The total of all such valuation becomes the total

estimated working capital requirement. The assessment of the working capital should be accurate even in the case of small and micro enterprises where business operation is not very large. We know that working capital has a very close relationship with day-to-day operations of a business. Negligence in proper assessment of the working capital, therefore, can affect the day-to-day operations severely. It may lead to cash crisis and ultimately to liquidation. An inaccurate assessment of the working capital may cause either under-assessment or over-assessment of the working capital and both of them are dangerous. CONSEQUENCES OF UNDER ASSESSMENT OF WORKING CAPITAL Growth may be stunted. It may become difficult for the enterprise to undertake profitable projects due to non-availability of working capital. Implementation of operating plans may become difficult and consequently the profit goals may not be achieved. Cash crisis may emerge due to paucity of working funds. Optimum capacity utilization of fixed assets may not be achieved due to nonavailability of the working capital. The business may fail to honour its commitment in time, thereby adversely affecting its credibility. This situation may lead to business closure. The business may be compelled to buy raw materials on credit and sell finished goods on cash. In the process it may end up with increasing cost of purchases and reducing selling prices by offering discounts. Both these situations would affect profitability adversely. Non-availability of stocks due to non-availability of funds may result in production stoppage. While underassessment of working capital has disastrous implications on business, over assessment of working capital also has its own dangers.

CONSEQUENCES OF OVER ASSESSMENT OF WORKING CAPITAL Excess of working capital may result in unnecessary accumulation of inventories. It may lead to offer too liberal credit terms to buyers and very poor recovery system and cash management. It may make management complacent leading to its inefficiency. Over-investment in working capital makes capital less productive and may reduce return on investment. Working capital is very essential for success of a business and, therefore, needs efficient management and control. Each of the components of the working capital needs proper management to optimize profit. Inventory Management Inventory includes all types of stocks. For effective working capital management, inventory needs to be managed effectively. The level of inventory should be such that the total cost of ordering and holding inventory is the least. Simultaneously, stock out costs

should also be minimized. Business, therefore, should fix the minimum safety stock level, re-order level and ordering quantity so that the inventory cost is reduced and its management becomes efficient. Receivables Management Given a choice, every business would prefer selling its produce on cash basis. However, due to factors like trade policies, prevailing marketing conditions, etc., businesses are compelled to sell their goods on credit. In certain circumstances, a business may deliberately extend credit as a strategy of increasing sales. Extending credit means creating a current asset in the form of Debtors or Accounts Receivable. Investment in this type of current assets needs proper and effective management as it gives rise to costs such as: i. Cost of carrying receivable (payment of interest etc.) ii. Cost of bad debt losses Thus the objective of any management policy pertaining to accounts receivables would be to ensure that the benefits arising due to the receivables are more than the cost incurred for receivables and the gap between benefit and cost increases resulting in increased profits. An effective control of receivables helps a great deal in properly managing it. Each business should, therefore, try to find out average credit extended to its client using the below given formula:

Each business should project expected sales and expected investment in receivables based on various factors, which influence the working capital requirement. From this it would be possible to find out the average credit days using the above given formula. A business should continuously try to monitor the credit days and see that the average credit offered to clients is not crossing the budgeted period. Otherwise, the requirement of investment in the working capital would increase and, as a result, activities may get squeezed. This may lead to cash crisis. Cash Management Cash is the most liquid current asset. It is of vital importance to the daily operations of business. While the proportion of assets held in the form of cash is very small, its efficient management is crucial to the solvency of the business. Therefore, planning cash and controlling its use are very important tasks. Cash budgeting is a useful device for this purpose. Cash Budget Cash budget basically incorporates estimates of future inflows and outflows of cash over a projected short period of time which may usually be a year, a half or a quarter year.

Effective cash management is facilitated if the cash budget is further broken down into month, week or even on daily basis. There are two components of cash budget (i) cash inflows and (ii) cash outflows. The main sources for these flows are given hereunder: Cash Inflows (a) Cash sales (b) Cash received from debtors (c) Cash received from loans, deposits, etc. (d) Cash receipt of other revenue income (e) Cash received from sale of investments or assets. Cash Outflows (a) Cash purchases (b) Cash payment to creditors (c) Cash payment for other revenue expenditure (d) Cash payment for assets creation (e) Cash payment for withdrawals, taxes (f) Repayment of loans, etc. A suggestive format for Cash Budget is given below

Financing Working Capital

Now let us understand the means to finance the working capital. Working capital or current assets are those assets, which unlike fixed assets change their forms rapidly. Due to this nature, they need to be financed through short-term funds. Short-term funds are also called current liabilities. The following are the major sources of raising short-term funds: i. Suppliers Credit At times, business gets raw material on credit from the suppliers. The cost of raw material is paid after some time, i.e. upon completion of the credit period. Thus, without having an outflow of cash the business is in a position to use raw material and continue the activities. The credit given by the suppliers of raw materials is for a short period and

is considered current liabilities. These funds should be used for creating current assets like stock of raw material, work in process, finished goods, etc. ii. Bank Loan for Working Capital This is a major source for raising short-term funds. Banks extend loans to businesses to help them create necessary current assets so as to achieve the required business level. The loans are available for creating the following current assets: Stock of Raw Materials Stock of Work in Process Stock of Finished Goods Debtors Banks give short-term loans against these assets, keeping some security margin. The advances given by banks against current assets are short-term in nature and banks have the right to ask for immediate repayment if they consider doing so. Thus bank loans for creation of current assets are also current liabilities. iii. Promoters Fund It is advisable to finance a portion of current assets from the promoters funds. They are long-term funds and, therefore do not require immediate repayment. These funds increase the liquidity of the business.

Why working Capital is important?

Investment in CA represents a substantial portion of total investment. Investment in CA and level of CL have to be geared quickly to changes in sales

Concepts of Working Capital Gross Working Capital Net working Capital Gross Working Capital Total Current assets Where Current assets are the assets that can be converted into cash within an accounting year & include cash , debtors etc. Referred as Economics Concept since assets are employed to derive a rate of return . Net Working Capital CA CL Referred as point of view of an Accountant. It indicates liquidity position of a firm & suggests the extent to which working capital needs may be financed by permanent sources of funds. CONSTITUENTS OF WORKING CAPITAL CURRENT ASSETS Inventory Sundry Debtors Cash and Bank Balances

Loans and advances CURRENT LIABILITIES Sundry creditors Short term loans Provisions

Characteristics of Current Assets

Short Life Span I.e. cash balances may be held idle for a week or two , thus a/c may have a life span of 30-60 days etc. Swift Transformation into other Asset forms I.e. each CA is swiftly transformed into other asset forms like cash is used for acquiring raw materials , raw materials are transformed into finished goods and these sold on credit are convertible into A/R & finally into cash.

Matching Principle
If a firm finances a long term asset(like machinery) with a S-T Debt then it will have to be periodically finance the asset which will be risky as well as inconvenient. i.e. maturity of sources of financing should be properly matched with maturity of assets being financed. Thus Fixed Assets & permanent CA should be supported with L-T sources of finance & fluctuating CA by S-T sources. MATCHING PRINCIPLE

Need for Working Capital

As profits earned depend upon magnitude of sales and they do not convert into cash instantly, thus there is a need for working capital in the form of CA so as to deal with the problem arising from lack of immediate realization of cash against goods sold. This is referred to as Operating or Cash Cycle. It is defined as The continuing flow from cash to suppliers, to inventory , to accounts receivable & back into cash . Thus needs for working capital arises from cash or operating cycle of a firm. Which refers to length of time required to complete the sequence of events. Thus operating cycle creates the need for working capital & its length in terms of time span required to complete the cycle is the major determinant of the firms working capital needs.

Operating or Cash Cycle 1. Conversion of cash into inventory 2. Conversion of inventory into Receivables 3. Conversion of Receivables into Cash OPERATING CYCLE Phase 3
RECEIVABLES

CASH

Phase 2
INVENTORY

Phase 1

TYPES OF WORKING CAPITAL PERMANENT WORKING CAPITAL VARIABLE WORKING CAPITAL PERMANENT WORKING CAPITAL THERE IS ALWAYS A MINIMUM LEVEL OF CA WHICH IS CONTINOUSLY REQUIRED BY A FIRM TO CARRY ON ITS BUSINESS OPERATIONS. THUS , THE MINIMUM LEVEL OF INVESTMENT IN CURRENT ASSETS THAT IS REQUIRED TO CONTINUE THE BUSINESS WITHOUT INTERRUPTION IS REFERRED AS PERMANENT WORKING CAPITAL. VARIABLE WORKING CAPITAL

 THIS IS THE AMOUNT OF INVESTMENT REQUIRED TO TAKE CARE OF FLUCTUATIONS IN BUSINESS ACTIVITY OR NEEDED TO MEET FLUCTUATIONS IN DEMAND CONSEQUENT UPON CHANGES IN PRODUCTION & SALES AS A RESULT OF SEASONAL CHANGES. DISTINCTION PERMANENT IS STABLE OVER TIME WHEREAS VARIABLE IS FLUCTUATING ACCORDING TO SEASONAL DEMANDS. INVESTMENT IN PERMANENT PORTION CAN BE PREDICTED WITH SOME PROFITABILITY WHEREAS INVESTMENT IN VARIABLE CANNOT BE PREDICTED EASILY. WHILE PERMANENT IS MINIMUM INVESTMENT IN VARIOUS CA , VARIABLE IS EXPECTED TO TAKE CARE FOR PEAK IN BUSINESS ACTIVITY. WHILE PERMANENT COMPONENT REFLECTS THE NEED FOR A CERTAIN IRREDUCIBLE LEVEL OF CURRENT ASSETS ON A CONTINOUS AND UNINTERRUPTED BASIS , THE TEMPORARY PORTION IS NEEDED TO MEET SEASONAL & OTHER TEMPORARY REQUIREMENTS. ALSO PERMANENT CAPITAL REQUIREMENTS SHOULD BE FINANCED FROM L-T SOURCES , S-TFUNDS SHOULD BE USED TO FINANCE TEMPORARY WORKING CAPITAL NEEDS OF A FIRM, OPERATING ENVIRONMENT OF WORKING CAPITAL Monetary and Credit Policies Monetary policy is the process by which the government, central bank, or monetary authority of a country controls (i) the supply of money, (ii) availability of money, and (iii) cost of money or rate of interest, in order to attain a set of objectives oriented towards the growth and stability of the economy. Monetary policy is the process by which the government, central bank, or monetary authority of a country controls (i) the supply of money, (ii) availability of money, and (iii) cost of money or rate of interest, in order to attain a set of objectives oriented towards the growth and stability of the economy. Monetary theory provides insight into how to craft optimal monetary policy. Monetary policy involves variations in money supply , interest rates , lending by commercial banks etc. Credit Policy Credit gives the customer the opportunity to buy goods and services, and pay for them at a later date. Clear, written guidelines that set (1) the terms and conditions for supplying goods on credit , (2) customer qualification criteria (3) procedure for making collections , and

(4) steps to be taken in case of customer delinquency . Also called collection policy. Where delinquency means Failure to repay an obligation when due or as agreed. Thus in consumer installment loans, missing two successive payments will normally make the account delinquent Advantages of credit trade Usually results in more customers than cash trade. Can charge more for goods to cover the risk of bad debt. Gain goodwill and loyalty of customers. People can buy goods and pay for them at a later date. Farmers can buy seeds and implements, and pay for them only after the harvest. Stimulates agricultural and industrial production and commerce. Can be used as a promotional tool. Increase the sales. Disadvantages of credit trade Risk of bad debt. High administration expenses. People can buy more than they can afford. More working capital needed. Risk of Bankruptcy

Instruments of Monetary Policy in India

Money Supply Bank Rate Reserve Ratios Interest Rates Selective Credit Controls Flow of Credit Money Supply This is the sum total of money public funds and can be used for settling transactions to buy and sell things and make other payments constitutes the money supply of a nation. Money supply = Notes and coins with public + Demand deposits with Commercial papers Bank Rate Standard rate at which bank is prepared to buy or rediscount bills of exchange or other commercial papers eligible for purchase under Reserve bank of India Act, 1934. The rate of interest charged by central bank on their loans to commercial banks is called bank rate (Discount rate). An increase in bank rate makes it more expensive for commercial banks to borrow . This exerts pressure to bring about the rise in interest rates (lending

rates) charged by commercial banks on their lending to public. This leads to a general tightening in economy. Whereas decrease in bank rate has the opposite effect and leads to general easing of credit in the economy. RESERVE REQUIREMENTS The reserve requirement (or required reserve ratio) is a bank regulation that sets the minimum reserves each bank must hold to customer deposits and notes. These reserves are designed to satisfy withdrawal demands, and would normally be in the form of fiat currency stored in a bank vault(vault cash), or with a central bank. The reserve ratio is sometimes used as a tool in the monetary policy, influencing the country's economy, borrowing, and interest rates .Western central banks rarely alter the reserve requirements because it would cause immediate liquidity problems for banks with low excess reserves; they prefer to use open market operations to implement their monetary policy Thus central bank makes it legally obligatory for commercial banks to keep a certain minimum percentage of deposits in reserve. These are of 2 types:1. Cash reserves 2. Liquidity reserves CRR CASH RESERVE RATIO THIS IS DEFINED AS A cash reserve ratio (or CRR) is the percentage of bank reserves to deposits and notes. The cash reserve ratio is also known as the cash asset ratio or liquidity ratio. STATUTORY LIQUIDITY RATIO Statutory Liquidity Ratio (SLR) is a term used in the regulation of banking in India. It is the amount which a bank has to maintain in the form: Cash Gold valued at a price not exceeding the current market price, Unencumbered approved securities (G Secs or Gilts come under this) valued at a price as specified by the RBI from time to time. STATUTORY LIQUIDITY RATIO The quantum is specified as some percentage of the total demand and time liabilities ( i.e. the liabilities of the bank which are payable on demand anytime, and those liabilities which are accruing in one months time due to maturity) of a bank. This percentage is fixed by the Reserve Bank of India. The maximum and minimum limits for the SLR are 40% and 25% respectively. Following the amendment of the Banking regulation Act (1949) in January 2007, the floor rate of 25% for SLR was removed. Presently the SLR is 24% with effect from 8 November, 2008. The objectives of SLR are:

 To restrict the expansion of bank credit. To augment the investment of the banks in Government securities. To ensure solvency of banks. A reduction of SLR rates looks eminent to support the credit growth in India. INTEREST RATES This is generally done by stipulating min. rates of interest for extending credit against commodities covered under selective credit control. Also, concessive or ceiling rates of interest are made applicable to advances for certain purposes is to certain sectors to reduce the interest burden and thus facilitate their development. Further objective behind fixing rates on deposits are to avoid unhealthy competition amongst the banks for deposits and keep the level of deposit rates in alignment with lending rates of banks for deposits. Selective Credit Controls These are Qualitative instruments which are aimed at affecting changes in the availability of credit with respect to particular sectors of the economy. Thus selective controls are called selective because they are aimed at movement of credit towards selective sectors of the economy The general instruments such as Reserve ratios, Bank rate and open market operations. They are called so because they influence the nations money supply and general availability of credit. Quantitative instruments are called quantitative because they affect the total volume(quantity) of money supply and credit in the country. The most widely used qualitative techniques are selective control and moral suasion. While the general credit controls operate on the cost and total volume of credit, selective credit controls relate to tools available with the monetary authority for regulating the distribution or direction of bank resources to particular sectors of economy in accordance with broad national priorities considered necessary for achieving the set. MORAL SUASION IT IMPLIES THE CENTRAL BANK EXERTING PRESSURE ON BANKS BY USING ORAL AND WRITTEN APPEALS TO EXPAND OR RESTRICT CREDIT IN LINE WITH ITS CREDIT POLICY. DETERMINATION OF WORKING CAPITAL NEEDS Different approaches in determination of working capital Industry norm approach Economic modeling approach Strategic choice approach

INDUSTRY NORM APPROACH THIS APPROACH IS BASED ON THE PREMISE THAT EVERY COMPANY IS GUIDED BY THE INDUSTRY PRACTICE. LIKE IF MAJORITY OF FIRMS HAVE BEEN GRANTING 3 MONTHS CREDIT TO A CUSTOMER THEN OTHERS WILL HAVE TO ALSO FOLLOW THE MAJORITY DUE TO FEAR OF LOSING CUSTOMERS. ECONOMIC MODELLING APPROACH TO ESTIMATE OPTIMUM INVENTORY IS DECIDED WITH THE HELP OF EOQ MODEL. STRATEGIC CHOICE APPROACH THIS APPROACH RECOGNISES THE VARIATIONS IN BUSINESS PRACTICE AND ADVOCATES USE OF STRATEGYIN TAKING WORKING CAPITAL DECISIONS. THE PURPOSE BEHIND THIS APPROACH IS TO PREPARE THE UNIT TO FACE CHALLENGES OF COMPETITION & TAKE A STRATEGIC POSITION IN THE MARKET PLACE. STRATEGIC CHOICE APPROACH THE EMPHASIS IS ON STRATEGIC BEHAVIOUR OF BUSINESS UNIT.THUS THE FIRM IS INDEPENDENT IN CHOOSING ITS OWN COURSE OF ACTION WHICH IS NOT GUIDED BY THE RULES OF INDUSTRY,

Determinants of working capital

General nature of business Production cycle Business cycle Credit policy Production policy Growth and expansion Profit level Operating efficiency

FACTORS AFFECTING WORKING CAPITAL The need of working capital is not always the same. It varies from year to year or even month to month depending upon a number of factors. There are no set rules or formulae to determine working capital needs of the firm. Each factor has its own importance and the importance of factor changes for a firm over time. In order to determine the proper amount of working capital of a concern, the following factors should be considered carefully:-

Nature of business: The amount of working capital is basically related to the nature and volume of the business. In concerns where the cost of raw materials to be used in the manufacture of a product is very large in proportion to its total cost of manufacture, the requirements of working capital will be large. On the contrary, concerns having large investments in fixed assets require lesser amount of working capital. Size of the business unit: Size of the business unit is also a determining factor in estimating the total amount of working capital. The general principle in this regard is that the bigger the size, the larger will be the amount of working capital required since the larger business units are required to maintain larger inventories for the flow of the business. Seasonal Variations: Strong seasonal movements create special problems of working capital in controlling the financial swings. A great many companies have to carry out seasonal business such as sugar mills, oil mills or woolen mills, etc. and therefore they require larger amount of working capital in the season to purchase the raw materials in large quantities and utilize them throughout the year. Time Consumed in Manufacture: The average time taken in the process of manufacture is also an important factor in determining the amount of working capital. The longer the period of manufacture, the larger the inventory required. Though capital goods industries manage to minimize their investment in inventories or working capital by asking advances from the customers as work proceeds on their orders. Turnover of Circulating Capital: Turnover means the ratio of gross annual sales to average working assets. In simple words, it means the speed with which circulating capital completes its rounds or the number of times the amount invested in working assets have been converted into cash by sale of the finished goods and re-invested in working assets during a year. The faster the sales, the larger the turnover. Conversely, the greater the turnover, the larger the volume of business to be done with given working capital. Labour v/s Capital Intensive Industries: In labour intensive industries, larger working capital is required because of regular payment of heavy wage bills and more time taken in completing the manufacturing process. The capital intensive industries require lesser amount of working capital because of the heavy investment in fixed assets and shorter period in manufacturing process. Need to Stockpile Raw Material and Finished Goods: In industries, where it is necessary to stockpile the raw materials and finished goods, it increases the amount of working capital tied up in stocks and stores. In certain lines of business where the materials are bulky and best purchased in large quantities such as cement, stockpiling is usual. Such concerns require larger working capital. Terms of Purchase and Sale: Terms (cash or credit) of purchase and sales also affect the amount of working capital. If a company purchases all goods in cash and sells its finished product on credit also naturally, it will require larger amount of working capital.

On the contrary, a concern having credit facilities and allowing no credit to its customers, will require lesser amount of working capital. Terms and conditions of purchase and sale are generally governed by prevailing trade practices and by changing economic conditions. Conversion of Current Assets into Cash: The need of having cash in hand to meet the day-to-day requirements, e.g. payment of wages and salaries, rents, rates, etc. has an important bearing in deciding the adequate amount of working capital. The greater the cash requirements, the higher will be the need of working capital. Growth and Expansion: Growing concerns require more working capital than those which are static. It is logical to expect larger amount of working capital in a growing concern to meet its growing needs of funds for its expansion and/or diversification programs though it varies with economic conditions and corporate practices. Business Cycle Fluctuations: Business cycles affect the requirement of working capital. At times, when the prices are going up and boom conditions prevail, the tendency is to pile up a large stock of materials and to maintain a large stock of finished goods with an expectation to earn more profits. The other type of business cycle, i.e. depression involves in locking up of a big amount in working capital as the inventories remain unsold and book debts uncollected. Profit Appropriation: Some firms enjoy dominant position in the market due to quality product or good marketing. On the other hand, a firm facing extremely tough competition may earn low margins of profits. A high net profit margin contributes towards working capital provided it is earned in cash. The working capital requirement will be estimated on how the cash available is used rightfully. The contribution towards working capital is affected by the way in which profits are appropriated and therefore it is affected by taxation, depreciation, reserve policy, etc. Price Level Changes: The financial manager should also anticipate the effect of price level changes on working capital requirements of the firm. Generally, rising price levels will require higher amount of working capital since to maintain the same level of current assets, higher investment will be required. The effects of rising price levels will be different for different firms depending upon their price policies, nature of the product, ability to pass on the increase to the customer, etc. Dividend Policy: There is a well established relationship between dividend and working capital in companies where conservative dividend policy is followed. The changes in working capital position bring about an adjustment in the dividend policy. A shortage of cash may induce the management for reducing cash dividend. On the other hand, strong cash position may justify higher cash dividend. Other Factors: In addition to the above, there are a number of other factors which affect the requirement of working capital. Some of them are the production and distribution policies, absence of specialization in the distribution of products, means of transportation

and communication infrastructure, hazards and contingencies inherent in a particular business, etc.
THE ADVANTAGES OF WORKING CAPITAL TO FINANCE A BUSINESS

Working capital is the money that a business actually has at hand to pay its immediate costs. Though a business may have many valuable assets in terms of its facilities and knowledge base, if it does not have a good working capital flow it is liable to run into many problems. Working capital is the lifeblood of the economic system, allowing businesses to launch new ventures and create new wealth.
Security

One of the greatest advantages for a business of having a positive working capital flow is the stability and security that it ensures. It is in the nature of the free market that unexpected costs and events will eventually occur. Having capital at hand available to pay any unexpected costs gives a business a great deal more security. Many businesses fail when they run into unexpected costs and do not have enough working capital. Debt Having a ready supply of working capital will allow a business to launch new ventures without having to take on a significant amount of debt. The costs of debt payment can be a major drag on any business. Many businesses get in a vicious cycle where, because of the costs of previous debt, they have limited working capital, which forces them to take on even more debt. Gaining working capital is a major budget priority.
Investment

Many investors evaluate a business by looking at the working capital that it has on hand at any moment. A company that wishes to attract more investment will have gone a long way in establishing confidence in its business model and management by creating a positive flow of working capital. Working capital is a sign of competence in the business world and the most successful companies are those that have created reliable streams of income.
Evaluation

Having a supply of working capital is one of the better ways for a business to evaluate its own model. There are many unknown variables that a business must keep in mind when attempting to predict its own future. Having a supply of capital at hand to use in whatever way is necessary is one sure hedge against the unknown. The ultimate success of any business model is how much working capital it brings in.

ADVANTAGES OF WORKING CAPITAL:

Is being able to foresee any financial difficulties that may arise. Even a business that has billions of dollars in fixed assets will quickly find itself in bankruptcy court if it can't pay

its monthly bills. Under the best circumstances, poor working capital leads to financial pressure on a company, increased borrowing, and late payments to creditor - all of which result in a lower credit rating. A lower credit rating means banks charge a higher interest rate, which can cost a corporation a lot of money over time. Companies that have high inventory turns and do business on a cash basis (such as a grocery store) need very little working capital. These types of businesses raise money every time they open their doors, then turn around and plow that money back into inventory to increase sales. Since cash is generated so quickly, managements can simply stock pile the proceeds from their daily sales for a short period of time if a financial crisis arises. Since cash can be raised so quickly, there is no need to have a large amount of working capital available. A company that makes heavy machinery is a completely different story. Because these types of businesses are selling expensive items on a long-term payment basis, they can't raise cash as quickly. Since the inventory on their balance sheet is normally ordered months in advance, it can rarely be sold fast enough to raise money for short-term financial crises (by the time it is sold, it may be too late). It's easy to see why companies such as this must keep enough working capital on hand to get through any unforeseen difficulties. It reveals more about the financial condition of a business than almost any other calculation. It tells you what would be left if a company raised all of its short term resources, and used them to pay off its short term liabilities. The more working capital, the less financial strain a company experiences. By studying a company's position, you can clearly see if it has the resources necessary to expand internally or if it will have to turn to a bank and take on debt. You can pay your suppliers, pay your staff, and pay yourself a wage, and can expand your business.

Gives a company the ability to meet its current liabilities. Expand its volume of business. Take advantage of financial opportunities as they arise.

DISADVANTAGE OF WORKING CAPITAL:

You can't expand, can't pay your staff, can't pay yourself, and can't pay your suppliers. So in a nutshell, no cash flow, or working capital, no viable business. Lack of sufficient working capital and inability to liquidate current assets are frequent causes of business failure.

COUNTING THE BENEFITS OF WORKING CAPITAL MANAGEMENT

Even though interest rates are low, companies that can squeeze cash out of the order-to-receipt process see big advantages over competitors with inefficient processes. Cash may be worth less than 2 percent in today's anemic marketplace, but shrewd finance executives are treating it like a treasure. They're searching for ways to shrink their investment in working capital, and they're using the cash they gain to pay down debt or build their investment portfolio. "In the go-go days of the 1990s, cash was considered a drag on earnings," notes Lee Epstein, president and CEO of Money Market One, a San Francisco-based institutional broker dealer, and Decision Analytics, a treasury investment consultancy. "Today cash is earnings. Cash is king again. It's certainly worth more than inventory. Financial managers try to maximize it whenever possible." Eric Wright, president for the Americas of REL Consultancy Group in Purchase, N.Y., agrees. "The interest in maximizing cash flow is way up due to the economy," he reports. "That's a top priority in the minds of financial executives. One of the best ways to do that is to reduce working capital." Whenever the economy is tough, companies want to free up cash that is trapped in their business processes, points out Maria D'Alessandro, senior vice president and working capital practice leader in Wachovia's treasury and financial consulting group in Atlanta. "It's not just accounts receivable but the whole order-to-receipt process. And it's not just manufacturers; even service companies and not-for-profits are going after working capital," she says. Michael Gallanis, principal of Treasury Strategies Inc. in Chicago, just finished a working capital reduction project for a $2.5 billion company that freed up $1 million of cash through tighter management of inventory and payment terms, especially A/R collections, he says. The company has now invested this found money. REL specializes in working capital reduction, so Wright makes his living helping large and middle-market corporations find ways to wring out cash that's absorbed in business operations, primarily in inventory and A/R. An organization can access that cash, he advises, by making everything work faster. "Always look for ways to accelerate your business," he recommends. For companies that are relatively unsophisticated, that means overhauling operations to speed up processes and eliminate mistakes that lead to delays. Improvements can be as basic as reengineering billing procedures so that accurate bills go out the same day orders are shipped, with all pertinent information included, in ways that fit smoothly into the customer's A/P system -- which can reduce the number of payments that have to be processed as exceptions, suggests Wright. Sophisticated companies that have mastered the fundamentals of working capital should take a broader approach; they should look for ways to speed up the whole supply chain, Wright says. "Working capital is money the business process consumes. The longer the process takes, the more money is consumed," he notes.

Contrasts between companies that use best practices in working capital management and those that don't are dramatic, Wright observes. Working capital at Barnes & Noble averages 56 days, while Amazon.com has reduced that number to minus 28 days. At Hewlett-Packard, working capital is 69 days; Dell has it down to negative 32 days. "Dell, Amazon and some others ... turn everything around very quickly," Wright explains. "When you configure order and pay for a computer from Dell, you trigger a production process that operates on no inventory and carries no receivable."
Sales Trade-off

That's not to say the best companies always have the least working capital, of course. In theory, it's easy to eliminate working capital by requiring customers to pay in advance, but that's not how business works in many sectors. Extended payment terms may be necessary to retain customers or may be a shrewd way to increase sales. "Working capital balloons on the balance sheet when you let customers pay later, but if that's a deliberate strategy that works, carrying a lot of working capital can be a good thing," Wright observes. Some organizations that have historically had trouble shrinking A/R are finding that technology is now on their side. The more automated the order and settlement system -and the stronger the company's track record for always delivering the right merchandise at the right time in the right way -- the more the buyer will be willing to settle on the spot. Buyers who used to fight for every last penny of float are starting to realize that the benefits of paying slowly may be worth less than the savings they could gain from a more efficient process. Automation reduces the demands on the buyer's A/P operation and shrinks overhead, Wright notes. Sending documents back and forth is expensive for both parties, so interest in electronic invoice presentment and payment (EIPP) projects that expedite settlement is growing among both buyers and sellers, he points out. Companies whose customers are not interested in process efficiencies can still shrink working capital to near zero by securitizing receivables, Wright explains. Receivablesbased financing traditionally has been considered expensive, but it doesn't have to be when the receivables are high-quality. "If the receivables are very clean and you can demonstrate strong controls and discipline, securitization can be a quite efficient way to reduce working capital," he says. "You have to give up a little margin, but it can be worth it."
Inventory Wars

Of course, managing working capital requires oversight of inventory as well as A/R. The less time a company holds inventory, the lower its working capital investment will be. There is a magic threshold, Wright notes, beyond which the length of time the seller needs to acquire materials and make and ship a product is less than the length of time between order placements and when the customer expects to receive the product. If a business can cross that line, as Dell has, it can completely eliminate inventory and acquire exactly the right materials after each sale has been made. But many companies can't operate under this model. Those that sell time-sensitive items have to have materials, if not finished products, on hand to satisfy the expectations of the customer who needs an order right away, Wright points out. Still, every organization can

find value by shrinking the production cycle and reducing the size of inventory or the length of time it is held, Wright says. "Lean on your suppliers to deliver quicker," he advises.
The Payables Card

Ironically, some companies looking to take working capital off the balance sheet nurture slow, inefficient or even obstructive A/P processes. "It's one case where negligence can improve your financial performance," Wright observes. "But squeezing your vendors is a short-sighted policy," he insists. A better strategy is to shrink your vendor base radi-cally, then use your clout to negotiate longer terms with the vendors you keep. "Vendor rationalization is a process that can pay off in a big way," he says. Wright concedes that if he's helping one client improve A/R and, at the same time, helping another optimize A/P, "what we recommend can come back and bite us" if they do business with each other. "Everyone looks at the equation for their own benefit," he adds. The working capital equation clearly favors dominant businesses like Microsoft and WalMart. "Wal-Mart can get away with telling its suppliers, 'You carry my inventory for me, and then let me pay you in 90 days,' " Wright explains.It's a cost of doing business with Wal-Mart. When we have a client who sells to Wal-Mart, we concentrate on execution -delivering a perfect invoice so that nothing will slow down its processing. If you can't get paid for 60 days, you make sure you don't have to wait 61 days." Today's low interest rates bleed away some of the urgency in tightening working capital management, Wright concedes. "The value is reflected in the opportunity cost of money, and lower interest rates reduce the reward." In Japan, where rates have been very low for a long time, there is little incentive to reduce working capital. But reducing working capital will always be your cheapest source of capital. "It's the only money that is free," he insists. Plus, when low rates accompany a weak economy, lower revenue and tighter credit standards supply the incentive to conserve cash by shrinking working capital, he points out.

How WPP Almost Eliminates Working Capital

WPP, the global collection of ad agencies and other media service firms, lives or dies by the size of its working capital. Altogether, the company collects $30 billion a year in gross revenue from its clients, usually well before it pays the media on their behalf. "We have to collect fast and pay slow," summarizes John A. Forster, treasurer of WPP Group USA in New York City. "We live and breathe payment timing -- not paying until we get paid." As a result, the company keeps working capital very low; it's even negative during some parts of the year. WPP is highly decentralized, but corporate sets and monitors working capital targets for each business unit, Forster explains. "Every unit has its target. They know that we watch it closely and will be all over them if they're off by much. So they hit their targets consistently, and we let them run their businesses their way," he says. The company's business units know that they must measure up in three areas: they must hit a very low target of average working capital divided by annualized revenue; they must hit a very low target for receivables due more than 90 days after the invoice date; and they must hit a high target for positive cash flow. "All it takes is the discipline to set targets, monitor them monthly and send the right message -- that if you miss your targets, you go on the problem list, and that is not a good thing," Forster emphasizes. Its careful working capital management makes WPP ambivalent about electronic payments. The business collects electronically whenever it can but almost always pays by check, and the slower the better. "To disburse electronically could hurt our working capital, and we can't afford to do that," Forster explains. While WPP keeps its working capital investment very lean, it remains a net debtor for much of a typical year. Investable cash accumulates seasonally, usually around the end of the year, and is invested "very short and very safe," Forster notes. Summer (TV rerun season) often finds the company drawing on its working capital lines of credit. Later in the year, it uses the cash squeezed out by its tight working capital management to pay down debt.
The Investor's Challenge

Companies that are able to accumulate cash face a real challenge in making the most of that money in today's low-interest-rate environment. Some finance departments are just taking low yields and waiting for rates to rise, but others are taking an active approach to getting all they can in the current market, Money Market One's Epstein reports. They're more likely than the average company to segment their portfolio and go medium-term with their strategic reserves. (See LSI Logic Goes for High Returns below.) They're more likely to allocate some of their cash to an outside investment manager who will work fulltime to maximize returns. And they're more likely to move to lower-rated credits with their highly liquid investments. Does this strategy work? "Generally, it has paid off, although medium-term, fixedincome investors had their heads handed to them last July, when rates shot up and market

value went down," Epstein concedes. "Some lost principal, although the true working capital buy-and-hold investors only had paper losses. Their principal was safe as long as they didn't sell the securities." Corporate investors who insist on AAA short-term paper are overpaying for their comfort, Epstein suggests. "The more savvy investors know that they don't need AAA, which is a very limiting criterion. They will buy split-rated commercial paper or A or even BBB corporate paper." Dutch-auction products also produce relatively good yield for minimal risk, he notes. A recent survey conducted by Treasury Strategies reveals that many companies are lengthening the maturities of investments they buy in order to increase returns without taking on more credit risk, Gallanis reports. They're also using more vendors and rateshopping more aggressively, he says. However, Derek Chauvette, national sales manager of corporate investment services with Cleveland-based McDonald Investments, a subsidiary of KeyCorp. has found that businesses are staying short with their liquidity reserves. They're investing heavily in institutional money-market funds and tax-free floaters, he reports. On longer-term strategic funds, they're picking up yield with instruments such as four- to five-year callable agencies, Chauvette adds. Some short-term investors are surprised to discover that their best investment may be their bank's earnings credit rate (ECR) on funds left on deposit. An above-market bank ECR is "an anomaly, an arbitrage opportunity in this market when that rate doesn't fall as fast as the rest of the cash market," Epstein explains. "The world is upside down right now. Rates are so low that what usually makes sense doesn't necessarily make sense anymore. When we come out of it -- and we will -- and rates go back up to 3 to 4 percent, things will return to normal." The returns corporate investors are currently seeing do not reflect the full value of cash, Wachovia's D'Alessandro insists. "Look at the savings as an investment in your business," she advises. Cash gained today from better working capital management can be used to profitably reinvest in the business once the economy starts to recover. As long as banks are cautious about whom they lend to, companies will appreciate having some cash of their own to protect them from trouble and to help them capitalize on opportunities, she says. That's why although cash may be cheap, it's priceless.

LSI Logic Goes for High Returns

LSI Logic Corp., the $1.8 billion Milpitas, Calif., supplier of specialty semiconductors, used to invest extensively in expensive equipment. However, since the company changed its business strategy and began outsourcing manufacturing, the amount of cash in its corporate coffers has increased by $1.1 billion. Now that it's a big investor, LSI Logic has split its portfolio, keeping just 10 percent in highly liquid money market instruments and putting the rest in a strategic portfolio invested for longer durations, explains Anita Prasad, vice president of treasury and tax. The reward: A stunning return between 7 percent and 9 percent on the strategic portfolio. "Until early 2001, we were a capital-intensive company with small cash balances, a buyand-hold investor that kept maturities short -- nothing beyond the 90- to 180-day range," she explains. "Now we have a real incentive to maximize our investment returns." Solid working capital management has helped LSI build its cash hoard. "We're reasonably efficient at managing our receivables and payables," Prasad explains. "We benchmark favorably to our peers. And about half our business is in customized products we can't prebuild, so that helps us keep our inventory fairly lean."

IMPORTANCE OF WORKING CAPITAL DURING RECESSION

The economic and credit crisis of 2008 has forced many companies into cash flow problems due to non availability of working capital and credit facilities which in turn have led to retrenchment of staff, shrinkage of operations, curtailment of plans for capital expansion into different markets and downsizing. For most of these companies such a curtailment of operations and credit crunch threatens their very existence. To overcome this problem companies look up to finance professionals who can manage the working capital requirements through planning, obtaining additional facilities and restructuring their operations. Working capital management is one of the cornerstones of business continuity and acts as a hedge against tightening credit and access to additional capital. Companies which manage their working capital optimally during times of recessions come out stronger post the recession period. During times of double digit growth and expansions it is easy to forecast working capital needs and manage liquidity. The real test however comes during periods of recession and credit crisis as witnessed by the world during 2008 and 2009. During these times the management and finance professionals need to devote themselves to reassessing the organizations working capital sources and needs, such as how to finance the working capital, what is the level of financing required in downturn and what are the costs of obtaining the working capital.

What is working capital?

Working capital, also known as net working capital, represents operating liquidity available to a business. Along with fixed assets such as plant and equipment, working capital is considered a part of operating capital. It is calculated as current assets minus

current liabilities. If current assets are less than current liabilities, an entity has a working capital deficiency.

Working Capital = Current Assets Current Liabilities

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, payable and cash. These components provide the sources of income for the business, whether in the form of profit from the sale of products and services, or interest earned from securities. The current liabilities consist mainly of accounts payable which is of prime importance as management of payables can significantly affect cash flows of the company. Effective working capital management is ensuring sufficient cash flow to fund operations while reducing debt. Working capital management is the responsibility of all the departments in the organization i.e. finance, sales, purchasing, planning, manufacturing etc., also known as the cash conversion cycle.

THE IMPORTANT ASPECTS OF WORKING CAPITAL MANAGEMENT ARE:

1) Planning - Companies should begin by determining what their working capital requirements should be and tune the working capital model accordingly. The model could be aggressive or moderate based on the market situation affecting the company. Assessing the risks present and future, also plays an important part in planning for the working capital requirements. 2) Reassess internal working capital policies such as credit periods for customers, suppliers, short term finance, long term finance, equity participation, inventory, securities etc. 3) Benchmarking-Companies should benchmark their requirements against similar companies in their industries to have information on working capital requirements. 4) Balance growth and profitability- Companies should balance growth with profitability with sound working capital policies. To be successful, working capital and cash management initiatives require buy-in and support from senior levels of management and logically, should be led by the Chief Financial Officer, or in some cases, the Chief Executive Officer. Dramatic improvements in working capital are possible. The best organizations are shifting their focus to a more strategic approach to the finance function, by taking responsibility for performance improvement initiatives that have a direct link to enhancing the economic value of the organization.

Improving your businesss cash-flow management system is critical to freeing up your capital and using it to your advantage. These operational improvements can contribute to strategic success and help sustain your competitive advantage.

PRINCIPLES OF WORKING CAPITAL MANAGEMENT

The financial manager must keep in mind following principles of working capital management: (1) Principle of Optimization: The level of working capital must be so kept that the rate of return on investment is optimized. In other words, the working capital should be maintained at an optimum level. This is the point at which the increase in cost due to decline in working capital is equal to the increase in gain associated with it. To determine the optimum level of working capital, the financial manager will have to make a study of the forces that influence the amount of funds required for different components of the working capital. A study of the state of the economy of the country will also be fruitful. According to the principle of optimization, the magnitude of working capital should be such that each rupee invested ads to its net value. As E. W. Walker had stated, "Capital should be invested in each component of working capital as long as the equity position of the firm increases. (2) Principle of Risk Variation: This principle is based on the assumption that the rate of return on investment is linked with the degree of risk in the business. The greater the risk the business assumes, the greater is the opportunity for gain or loss. As stated by E. W. Walker, "If working capital is varied relative to sales, the amounts of risk that a firm assumes is also varied and the opportunity for gain or loss is increased. If the level of working capital is increased, the amount of risk is decreased and the opportunity for gain or loss likewise decreases. On the other hand, if the level of working capital is decreased, the amount of risk increases and prospects of gain and loss also increases. The level of working capital maintained depends on the attitude of management towards risk. The level of sales remaining same, more amount of working capital will be employed if the management is conservative but the amount of working capital will be less for the same volume of sales if the management is willing to assume more risk. (3) Principle of Cost of Capital: Each source of working capital has different cost capital. The degree of risk also differs from one source to another. As E. W. Walker has remarked, "The type of capital used to finance working capital directly affects the amount of risk that a firm assumes as well as the opportunity for gain or loss and cost of capital." For example, if capital is raised through equity shares, the risk involved is less, while the prospect of higher return is more. But if capital is raised through debentures, or bank loans, the risk is less for the investors, but it is more for the firm. Also, the investors expect a lower return on investment in debentures. Hence, a firm should raise capital in

such

manner

that

balance

is

maintained

between

risk

and

profit.

(4) Principle of Maturity of Payment: This principle suggests that working capital should be so raised from different sources that the firm is able to repay them on maturity out of its inflow of funds. Otherwise, the firm would fail to repay on maturity and ultimately, it would find itself on the brink of liquidation despite high profits. For this reason, many times, the investors who provide short term funds to the firm ask from it its reports of expected cash flows to get an idea of the timing of the inflow of cast to the firm and also to judge whether the firm would be in a position to repay its short term debts on maturity. This implies that the firm's ability to repay its short term debts depends not on its earnings, but on the flow of cash into it.

SIGNIFICANCE OF WORKING CAPITAL MANAGEMENT

The current assets of a typical manufacturing firm account for over half of its total assets. For a distribution company, they account for even more. Excessive levels of current assets can easily result in a firm realizing a substandard return on investment. However, firms with too few current assets may incur shortage and difficulties in maintaining smooth operations. For small companies, current liabilities are the principal source of external financing. These do not have access to the longer term capital markets capital markets, other than to acquire a mortgage on a building. The fast growing but larger company also makes use of current liability financing. For these reasons, the financial manager and staff devote a considerable portion of their time to working capital matters. The management of cash, marketable securities, accounts receivable, accounts payable, accruals, and other means of short-term financing is the direct responsibility of the financial manager; only the management of inventories is not. Moreover, these management responsibilities require continuous day-to-day supervision. Unlike dividend and capital structure decisions, you cannot study the issue, reach a decision, and set the matter aside for many months to come. Thus, working capital management is important, if for no other reason than the proportion of the financial managers time that must be devoted to it. More fundamental, however, is the effect that working capital decisions have on the companys risk, return, and share price. Profitability and Risk: Underlying sound working capital management lie two fundamental decision issues for the firm. They are the determination of, 1. The optimal level of investment in current assets. 2. The appropriate mix of short-term and long-term financing used to support this investment in current assets. In turn, these decisions are influenced by the trade-off that must be made between profitability and risk. Lowering the level of investment in current assets, while still being

able to support sales, would lead to an increase in the forms return on the total assets. To the extent that the explicit costs of short-term financing are less than those of intermediate and the long-term financing, the greater the proportional of short-term debt to total debt, the higher is the profitability of the firm. Although short-term interest rates sometimes exceed long term rates, generally they are less. Even when short-term rates are higher, the situation is likely to be only temporary. Over an extended period of time, we would expect to pay more in interest cost with longterm debt than we would with short-term borrowings, which are continually rolled over (refinanced) at maturity. Moreover, the use of short-term debt as opposed to longer-term debt is likely to result in higher profits because debt will be paid off during periods when it is not needed. DANGER OF INADEQUATE WORKING CAPITAL When working capital is inadequate, a firm faces the following problems. Fixed Assets cannot efficiently and effectively be utilized on account of lack of sufficient working capital. Low liquidity position may lead to liquidation of firm. When a firm is unable to meets its debts at maturity, there is an unsound position. Credit worthiness of the firm may be damaged because of lack of liquidity. Thus it will lose its reputation. There by, a firm may not be able to get credit facilities. It may not be able to take advantages of cash discount. CONCLUSION Any change in the working capital will have an effect on a business's cash flows. A positive change in working capital indicates that the business has paid out cash, for example in purchasing or converting inventory, paying creditors etc. Hence, an increase in working capital will have a negative effect on the business's cash holding. However, a negative change in working capital indicates lower funds to pay off short term liabilities (current liabilities), which may have bad repercussions to the future of the company.