WORKING CAPITAL

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

Concept of Working Capital

There are two possible interpretations of working capital concept: Balance sheet concept Operating cycle concept Balance sheet concept There are two interpretations of working capital under the balance sheet concept. Excess of current assets over current liabilities gross or total current assets.

Concept of Working Capital

Excess of current assets over current liabilities are called the net working capital or net current assets. Working capital is really what a part of long term finance is locked in and used for supporting current activities. The balance sheet definition of working capital is meaningful only as an indication of the firms current solvency in repaying its creditors. When firms speak of shortage of working capital they in fact possibly imply scarcity of cash resources. In fund flow analysis an increase in working capital, as conventionally defined, represents employment or application of funds.

Concept of Working Capital

Operating cycle concept A companys operating cycle typically consists of three primary activities: Purchasing resources, Producing the product and Distributing (selling) the product. These activities create funds flows that are both unsynchronized and uncertain. Unsynchronized because cash disbursements (for example, payments for resource purchases) usually take place before cash receipts (for example collection of receivables). They are uncertain because future sales and costs, which generate the respective receipts and disbursements, cannot be forecasted with complete accuracy.

Concept of Working Capital

The firm has to maintain cash balance to pay the bills as they come due. In addition, the company must invest in inventories to fill customer orders promptly. And finally, the company invests in accounts receivable to extend credit to customers. Operating cycle is equal to the length of inventory and receivable conversion periods.

Concept of Working Capital

Inventory conversion period Avg. inventory = _________________ Cost of sales/365 Receivable conversion period Accounts receivable = ___________________ Annual credit sales/365 Payables deferral period Accounts payable + Salaries, etc = ___________________________ (Cost of sales + selling, general Expenses)/365

and

admn.

Concept of Working Capital

Cash conversion cycle = operating cycle payables deferral period. Importance of working capital
Risk and uncertainty involved in managing the cash flows Uncertainty in demand and supply of goods, escalation in cost both operating and financing costs.

Strategies to overcome the problem

Manage working capital investment or financing such as

Concept of Working Capital

Holding additional cash balances beyond expected needs Holding a reserve of short term marketable securities Arrange for availability of additional short-term borrowing capacity One of the ways to address the problem of fixed set-up cost may be to hold inventory. One or combination of the above strategies will target the problem

Working capital cycle is the life-blood of the firm

Concept of Working Capital

FACTORS DETERMINING WORKING CAPITAL
1. Nature of the Industry 2. Demand of Industry 3. Cash requirements 4. Nature of the Business 5. Manufacturing time 6. Volume of Sales 7. Terms of Purchase and Sales 8. Inventory Turnover 9. Business Turnover 10. Business Cycle 11. Current Assets requirements 12. Production Cycle

Concept of Working Capital

13. 14. 15. 16. 17. 18. 19. 20. 21. Credit control Inflation or Price level changes Profit planning and control Repayment ability Cash reserves Operation efficiency Change in Technology Firms finance and dividend policy Attitude towards Risk

Concept of Working Capital

EXCESS OR INADEQUATE WORKING CAPITAL

Every business concern should have adequate working capital to run its business operations. It should have neither redundant or excess working capital nor inadequate or shortage of working capital.
Both excess as well as shortage of working capital situations are bad for any business. However, out of the two, inadequacy or shortage of working capital is more dangerous from the point of view of the firm.

Concept of Working Capital

Disadvantages of Excess Working Capital 1. Idle funds, non-profitable for business, poor ROI 2. Unnecessary purchasing & accumulation of inventories over required level 3. Excessive debtors and defective credit policy, higher incidence of B/D. 4. Overall inefficiency in the organization. 5. When there is excessive working capital, Credit worthiness suffers 6. Due to low rate of return on investments, the market value of shares may fall

Concept of Working Capital

Disadvantages of Inadequate Working Capital 1. Cant pay off its short-term liabilities in time. 2. Economies of scale are not possible. 3. Difficult for the firm to exploit favourable market situations 4. Day-to-day liquidity worsens 5. Improper utilization the fixed assets and ROA/ROI falls sharply

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 management of CA as well as CL. refers to

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 globalised 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

Working Capital Management

Active working capital management is an extremely effective way to increase enterprise value. Optimising 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 optimisation then helps increase profitability.

Working Capital Management

The fundamental principles of working capital management are reducing the capital employed and improving efficiency in the areas of receivables, inventories, and payables.

Working Capital Management

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.

Working Capital Management

Concepts of Working Capital Gross Working Capital Net working Capital

Working Capital Management

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 & finlly 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.

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 realisation 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 .

Need for Working Capital

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

TYPES OF WORKING CAPITAL

permanent working capital variable working capital

PERMANENT WORKING CAPITAL

There is always a minimum level of ca which is continuously 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 current assets , variable is expected to take care for peak in business activity.

DISTINCTION
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,

Monetary and Credit Policies

Monetary policy is the process by which the govt.,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

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 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

RESERVE REQUIREMENTS
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

CASH RESERVE RATIO

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) 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 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 Bank of Ghana 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 Ghana.

INTEREST RATES
This is generally done by stipulating min. rates of interest for extending credit against commodities under selective credit control. Also, concessive or ceiling rates of interest are made applicable to advances for certain purposes also to certain sectors to reduce the interest burden and thus facilitate their development. Further obj. 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.

Selective Credit Controls

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.

Selective Credit Controls

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.

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 strategy in 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 behavior 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

FORECASTING / ESTIMATION OF WORKING CAPITAL REQUIREMENTS

Factors to be considered Total costs incurred on materials, wages and overheads The length of time for which raw materials remain in stores before they are issued to production. The length of the production cycle or WIP, i.e., the time taken for conversion of RM into FG. The length of the Sales Cycle during which FG are to be kept waiting for sales. The average period of credit allowed to customers. The amount of cash required to pay day-to-day expenses of the business. The amount of cash required for advance payments if any. The average period of credit to be allowed by suppliers. Time lag in the payment of wages and other overheads

POINTS TO BE REMEMBERED WHILE ESTIMATING WC

(1) Profits should be ignored while calculating working capital requirements for the following reasons. (a) Profits may or may not be used as working capital (b) Even if it is used, it may be reduced by the amount of Income tax, Drawings, Dividend paid etc. (2) Calculation of WIP depends on the degree of completion as regards to materials, labour and overheads. However, if nothing is mentioned in the problem, take 100% of the value as WIP. Because in such a case, the average period of WIP must have been calculated as equivalent period of completed units. (3) Calculation of Stocks of Finished Goods and Debtors should be made at cost unless otherwise asked in the question.

Time & Money Concepts in Working Capital Cycle

Each component of working capital (namely inventory, receivables and payables) has two dimensions ........TIME ......... and MONEY, when it comes to managing working capital

TIME IS MONEY
You can get money to move faster around the cycle or reduce the amount of money tied up. Then, business will generate more cash or it will need to borrow less money to fund working capital. As a consequence, you could reduce the cost of bank interest or you'll have additional free money available to support additional sales growth or investment. Similarly, if you can negotiate improved terms with suppliers e.g. get longer credit or an increased credit limit, you effectively create free finance to help fund future sales.

If you
Collect receivables (debtors) faster Collect receivables (debtors) slower Get better credit (in terms of duration or amount) from suppliers Shift inventory (stocks) faster Move inventory slower (stocks)

Then ......
You release cash from the cycle Your receivables soak up cash You increase resources You free up cash You consume more cash your cash

MANAGEMENT OF CASH
1. Importance of Cash When planning the short or long-term funding requirements of a business, it is more important to forecast the likely cash requirements than to project profitability etc. Bear in mind that more businesses fail for lack of cash than for want of profit.

Cash vs Profit
Sales and costs and, therefore, profits do not necessarily coincide with their associated cash inflows and outflows. The net result is that cash receipts often lag cash payments and, whilst profits may be reported, the business may experience a short-term cash shortfall.

For this reason it is essential to forecast cash flows as well as project likely profits.

Methods of ACCELERATING CASH INFLOWS

Prompt payment from customers (Debtors) Quick conversion of payment into cash Decentralized collections Lock Box System (collecting centers at different locations)

Methods of DECELERATING CASH OUTFLOWS

Paying on the last date Payment through Cheques and Drafts Adjusting Payroll Funds (Reducing frequency of payments) Centralization of Payments Inter-bank transfers Making use of Float (Difference between balance in Bank Pass Book and Bank Column of Cash Book)

MANAGEMENT OF RECEVABLES
Receivables ( Sundry Debtors ) result from CREDIT SALES. A concern is required to allow credit in order to expand its sales volume. Receivables contribute a significant portion of current assets. But for investment in receivables the firm has to incur certain costs (opportunity cost and time value ) Further, there is a risk of BAD DEBTS also. It is, therefore very necessary to have a proper control and management of receivables.

AVERAGE COLLECTION PERIOD AND AGEING SCHEDULE

The collection of BOOK DEBTS can be monitored with the use of average collection period and ageing schedule. The ACTUAL AVERAGE COLLECTION PERIOD IS COMPARED WITH THE STANDARD COLLECTION PERIOD to evaluate the efficiency of collection so that necessary corrective action can be initiated and taken.

Guidelines for Effective Receivables Management

1. Have the right mental attitude to the control of credit and make sure that it gets the priority it deserves. Establish clear credit practices as a matter of company policy. Make sure that these practices are clearly understood by staff, suppliers and customers. Be professional when accepting new accounts, and especially larger ones. Check out each customer thoroughly before you offer credit. Use credit agencies, bank references, industry sources etc. Establish credit limits for each customer... and stick to them.

2. 3. 4. 5.

6.

Guidelines for Effective Receivables Management

7. Continuously review these limits when you suspect tough times are coming or if operating in a volatile sector. 8. Keep very close to your larger customers. 9. Invoice promptly and clearly. 10. Consider charging penalties on overdue accounts. 11. Consider accepting credit /debit cards as a payment option. 12. Monitor your debtor balances and ageing schedules, and don't let any debts get too large or too old.

MANAGEMENT OF INVENTORIES Managing inventory is a juggling act.

Excessive stocks can place a heavy burden on the cash resources of a business.
Insufficient stocks can result in lost sales, delays for customers etc. INVENTORIES INCLUDE RAW MATERIALS, WIP & FINISHED GOODS

FACTORS INFLUENCING INVENTORY MANAGEMENT

Lead Time Cost of Holding Inventory Material Costs Ordering Costs Carrying Costs Cost of tying-up of Funds Cost of Under stocking Cost of Overstocking

FACTORS INFLUENCING INVENTORY MANAGEMENT

Stock Levels Reorder Level Maximum Level Minimum Level Safety Level / Danger Level Variety Reduction Materials Planning Service Levels Obsolete Inventory and Scrap Quantity Discounts

INVENTORY MANAGEMENT TECHNIQUES

MANAGING INVENTORIES EFFICIENTLY DEPENDS ON TWO QUESTIONS 1. How much should be ordered? 2. When it should be ordered? The first question how much to order relates to ECONOMIC ORDER QUANTITY and The second question when to orderarises because of uncertainty and relates to determining the REORDER POINT

ECONOMIC ORDER QUANTITY [ EOQ ]

The ordering quantity problems are solved by the firm by determining the EOQ ( or the Economic Lot Size ) that is the optimum level of inventory. There are two types of costs involved in this model. ordering costs carrying costs The EOQ is that level of inventory which MINIMIZES the total of ordering and carrying costs.

ORDERING COSTS Requisitioning

CARRYING COSTS Warehousing

Order Placing
Transportation Receiving, Inspecting & Storing Clerical & Staff

Handling
Clerical Staff Insurance

Deterioration & Obsolescence

AN EYE-OPENER TO INVENTORY MANAGEMENT

For better stock/inventory control, try the following: Review the effectiveness of existing purchasing and inventory systems. Know the stock turn for all major items of inventory. Apply tight controls to the significant few items and simplify controls for the trivial many. Sell off outdated or slow moving merchandise - it gets more difficult to sell the longer you keep it. Consider having part of your product outsourced to another manufacturer rather than make it yourself. Review your security procedures to ensure that no stock "is going out the back door !"

MANAGEMENT OF ACCOUNTS PAYABLE

Creditors are a vital part of effective cash management and should be managed carefully to enhance the cash position. Purchasing initiates cash outflows and an over-zealous purchasing function can create liquidity problems. Guidelines for effective management of Accounts Payable

MANAGEMENT OF ACCOUNTS PAYABLE

Who authorizes purchasing in your company - is it tightly managed or spread among a number of (junior) people? Are purchase quantities geared to demand forecasts? Do you use order quantities which take account of stockholding and purchasing costs? Do you know the cost to the company of carrying stock ? Do you have alternative sources of supply ? If not, get quotes from major suppliers and shop around for the best discounts, credit terms, and reduce dependence on a single supplier. How many of your suppliers have a returns policy ? Are you in a position to pass on cost increases quickly through price increases to your customers ? If a supplier of goods or services lets you down can you charge back the cost of the delay ? Can you arrange (with confidence !) to have delivery of supplies staggered or on a just-in-time basis ?