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Corporate Finance

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Topics Covered

Overview and Characteristics of Current Assets

Factors influencing Working Capital Requirements

Current Asset Policy

Current Assets Financing Policy

Profit Criterion for Current Assets

Operating Cycle Analysis

Duration of the Operating CycleWorking Capital Management_10

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Working CapitalThere are two concepts of working capital:

Gross Working CapitalNet Working Capital

Gross WC = Current Assets

Net WC = Current Assets Current Liabilities

Current Assets Current Liabilities

Working Capital Management_10

Inventories Sundry creditors

* Raw material Trade advances

* Work-in-progress Borrowings

* Finished goods * Commercial banksTrade debtors Provisions

Loans & advances

Cash & bank balance

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Characteristics of Working Capital

1) Management of working capital refers to themanagement of current assets as well as current

liabilities.

2) While management of working capital, the

c aracter st cs o current assets must e ta en

into consideration. These are:

i) Short life span, and

ii) Swift transformation into other asset forms


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--Working Capital3) The life span of current assets depends upon the

time required in the activities of procurement,production, sales, collection and the degree of

synchronisation among them.

Cash Raw Materials Work-in-process

a es n s e goo s

4) Efficient management of one component depends

upon the consideration of other components.

e.g.: i) If more finished goods inventory, more liberal creditterm is required.

ii) If the firm has a cash crunch, it may have to offer

generous discounts.Working Capital Management_10

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Factors affecting Working Capital Requirements

1) Nature of business

2) Seasonality of operations

3) Production policy

4) Market conditions

5) Conditions of supply


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Working Capital Policy

For formulating the Working Capital Policy, theimportant issues are as follows:

i) Ratio of Current Assets to Sales

ii Ratio of ST-financin to LT-Financin


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Current Assets in relation to Sales--

C

ur

Conservative

Sales

r

e

n

t

A

s

s

e

t

s

o era e

Aggressive


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--Current Assets in relation to Sales--

1) If the firm pursues a very conservative currentasset policy, it would carry a high level of current

assets in relation to sales.

It tends to reduce risk. The surplus current

assets under this policy enable the firm to cope-,

procurement time comfortably.

2) If the firm adopts a moderate current asset policy,it would carry a moderate level of current assets

in relation to sales.


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--Current Assets in relation to Sales--3) If the firm follows a highly aggressive current

asset policy, it would carry a low level of currentassets in relation to sales. It minimises the

investment in current assets which exposes the

firm to greater risk.

e.g.:


Sales Rs. 10,00,000 Rs. 10,00,000

EBIT Rs. 2,00,000 Rs. 2,00,000

Current Assets Rs. 6,00,000 Rs. 4,00,000

Fixed Assets Rs. 5,00,000 Rs. 5,00,000

Total Assets Rs. 11,00,000 Rs. 9,00,000

ROI (=EBIT/TA) 18.18% 22.22%

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Ratio of ST-Financing to LT-Financing

Current Assets of a firm are supported by short-termas well as long-term sources of Finance. Thus, we

have various types of Current Asset Financing Policy.

Conservative Current Asset Financing Policy

It de ends less on short-term financin and more on

Long-term sources of Finance.

If it is highly conservative, it would rather replace

long-term debt by equity.

Aggressive Current Asset Financing Policy

It depends highly on short-term bank finance and

less on the long-term sources of finance.

It exposes the firm to a higher degree of risk.Working Capital Management_10

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Choosing the Working Capital Policy

ModerateOverall WorkingCapital Policy

AggressiveOverall WorkingCapital Policy

Aggressi

ve

an

cing

Policy

ModerateOverall WorkingCapital Policy

ConservativeOverall WorkingCapital Policy

Conservative Aggressive

Current Asset Policy

conser

vativeC

urrent

AssetFi


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Note:

1) A Conservative Overall Working Capital Policy means that

the firm has a Conservative Current Asset Policy along witha Conservative Current Asset Financing Policy. It reduces

risk and offers low return.

2) A Moderate Overall Working Capital Policy means a

combination of Aggressive Current Asset Policy andConservative Current Asset Financing Policy OR,

Conservative Current Asset Policy along with Aggressive

Current Asset Financing Policy. It offers moderate return

and moderate risk.

3) An Aggressive Overall Working Capital Policy means that the

firm has an Aggressive Current Asset Policy along with

Aggressive Current Asset Financing Policy. It provides high

return accompanied with high risk.


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Profit Criterion for Working Capital--Current assets can be easily liquidated and the value realised

on liquidation would be more or less equal to the amountinvested initially.

i.e. investment in current assets is easily reversible.

For reversible investments, the criterion of net profit per

period (which here means residual income) is equivalent

to the criterion of net present value.,

interest earned on it and k the cost of capital.

Profit per year = Pr Pk

where,

Pr = return for the yearPk = cost of funds for the year

Let us assume that the investment in current assets continue

for n years.Working Capital Management_10

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--Profit Criterion for Working CapitalNow,

NPV = - P + Pr PVIFA(k,n) + P PVIF(k,n)Where,P = Initial investments in the current assets

Pr PVIFA(k,n) = PV of the annual return of Pr for a period of n

years

P PVIF(k,n) = PV of the liquidation value of P realised at the end of

n years,

NPV = (Pr Pk) PVIFA(k,n)

It is quite obvious from the above simplification that the

criterion of profit per period is equivalent to the criterion of netpresent value.

Hence, the criterion of net profit per period may be substituted

for the criterion of net present value in analysing working

capital decisions. Working Capital Management_10

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Operating Cycle AnalysisThe operating cycle of a firm begins with the

acquisition of raw materials and ends with thecollection of receivables.

It is divided into four stages:

ii) Work-in-Process Stage

iii) Finished Goods Inventory Stage

iv) Debtor Collection StageWorking Capital Management_10

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Duration of the Operating Cycle--It is equal to the sum of the durations of each of the

above stages less the credit period allowed by thesuppliers of the firm.

We have,

O = R + W + F + D C

Where,= ura on o e opera ng cyc e

R = Raw Materials and Stores Storage Period

W = Work-in-Process Period

F = Finished Goods Storage PeriodD = Debtor Collection Period

C = Creditors Payment Period


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Now,

R =

It depends upon the regularity of supply, transportation time,

degree of perishability, price fluctuations and economies of

bulk purchases.

W =

Average stock of raw materials and stores

Average raw materials and stores consumed per day

Average work-in-process inventory

It depends upon the length of manufacturing cycle,

consistency in capacities at different stages and efficient co-

ordination of various inputs.

Average cost of production per day


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F =

It depends upon the pattern of production and sales.

D =

It de ends u on the credit eriod discount offered for rom t

Average finished goods inventory

Average cost of goods sold

Average book-debts

Average credit sales per day

payments and efficiency of collection effort.

C =Average trade creditors

Average credit purchase per day


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