PRINCIPLES OF WORKING CAPITAL MANAGEMENT

LECTURE - 1

INTRODUCTION One of the most important areas in the day

to day management of the firm is the management of working capital.

Working capital refers to the funds held in current assets.

Current assets are essential to use fixed assets.

The requirements for current assets are usually greater than the amount of funds available through current liabilities.

Goal of Working capital management The goal of working capital

management is to manage the firm’s current assets and liabilities in such a way that a satisfactory level of working capital is maintained.

The interaction between current assets and current liabilities is the main theme of the theory of working capital management.

Current Assets & Current Liabilities Current Assets refers to those assets

which in the ordinary course of business, will be converted into cash within one year or operating cycle and include cash, short-term securities, debtors, bills receivable and inventory.

Current Liabilities are those liabilities which are to be paid within a year and include creditors, bills payable and outstanding expenses.

OPTIMUM INVESTMENT The importance of adequate working capital can never be over emphasized.

A firm has to be very careful in estimating its working capital. The effective management of working capital is the primary means of achieving the firm’s goal of adequate liquidity.

A very big amount of working capital would mean that the firm has idle funds. This results in over capitalization.

Over capitalization implies that the firm has too large funds for its requirements, resulting in a low rate of return, ie., profitability will be reduced.

If the firm has inadequate working capital, it is said to be under capitalized. Such a firm runs the risk of insolvency.

Shortage of working capital may lead to a situation where the firm may not be able to meet its liabilities.

Hence it is very essential to estimate the requirements of working capital carefully and determine the optimum level of investment in it.

At the optimum level of working capital the profitability will be maximum.

CONCEPTS OF WORKING CAPITAL1. Gross Working Capital :

The Gross working capital(GWC) refers to investment in all the current

Assets taken together.

2. Net working Capital :

The term ‘net working capital’ (NWC) refers to excess of total current

assets over total current liabilities(CA-CL). OR

NWC can be defined as that part of the current assets which arefinanced with long term funds. Net working capital can be positive (CA>CL) or negative (CA< CL).

Trade off between profitability and risk

To increase profitability, the firm must also increase its risk.

The trade off between these variables is regardless of how the firm increases its profitability through the manipulation of working capital, the consequence is a corresponding increase in risk as measured by the level of NWC.

NEED FOR WORKING CAPITAL MANAGEMENT

Firms differ in their requirements for the working capital.

A firm should aim at maximizing the wealth of its shareholders.

In its endeavour to do so, a firm should earn sufficient return from its operations.

Earning a steady amount of profit requires successful sales activity.

The firm has to invest enough funds in current assets for generating sales.

Current assets are needed because sales do not convert into cash instantaneously.

Similarly inventory cannot be converted into cash as and when the firm require.

All the above aspects result in the funds of the firm being blocked for a certain period. To operate the business in this period, a firm needs working capital.

IMPORTANCE OF ADEQUATE WORKING CAPITAL

A firm needs funds for its day to day running. Adequacy or inadequacy of these funds would determine the efficiency with which the daily business may be carried on. It is to be ensured that the amount of working capital available with in the firms is neither too large nor too small for its requirements.

For the following reasons working capital should be adequate.

To meet the short term obligations.

To avail the market opportunities such as purchase of raw materials at the lowest price, with discount etc.

To enable the firm to operate more efficiently and meet the raising turnover thus peak needs can be taken care off.

To enable the firm to extend favourable credit terms to the customers.

OPTIMUM WORKING CAPITAL

Current ratio has traditionally been considered the best indicator of the working capital situation.

It is considered that a current ratio of 2 for a manufacturing firm implies that the firm has an optimum account of working capital.

Optimum working capital can be determined only with reference to the particular circumstances of a specific situation.

In a firm where the inventories are easily saleable and the sundry debtors are as good as liquid cash, the current ratio may be lower than 2 and yet firm may be sound.

An optimum working capital ratio dependent upon the business situation as such, and the nature and composition of various current assets.

WORKING CAPITAL CYCLE

The working capital cycle/ Operating cycle refers to the length of time between the firms paying cash for materials etc., entering into the production process/inventory and the inflow of cash from sale of finished goods.

PHASES OF OPERATING CYCLE The operating cycle (working capital cycle) in a manufacturing firmconsists of the following events, which continues throughout the life ofbusiness.

Conversion of cash into raw materials Conversion of raw materials into work in progress Conversion of working progress into finished goods Conversion of finished goods into accounts receivable through sales

and Conversion of account receivable into cash (OR finished good into cash

in the case cash sales)

The duration of the Gross operating cycle for the purpose of estimatingworking capital is equal to the sum of the durations of each of above saidevents. Net operating cycle is calculated as Gross operating cycle less thecredit period allowed by the suppliers.

Determination of operating cycle

Operating cycle = R + W + F + D – C= Raw material + Work in progress +

Finished goods + Debtors - Creditors

TYPES OF WORKING CAPITALFrom the point of view of time, the term working capital can be divided into twocategories:

1. Permanent working capital: It is that minimum level of investment in the current assets that is carried by thefirm at all times to carry out minimum level of its activities. It also refers to theHard core working capital.

2. Temporary working capital:

It refers to that part of total working capital, which is required by a business overand above permanent working capital. It is also called as variable or

fluctuatingworking capital. Since the volume of temporary working capital keeps on fluctuating from time to time, according to the business activities it may be

financed from short- term sources.

Estimation of working capital This involves two steps

1. Estimation of Current Assets

2. Estimation of Current Liabilities

Estimated Working Capital requirement = Estimated Current Assets – Estimated

Current Liabilities

DETERMINANTS OF WORKING CAPITAL

There are no hard fast rules or formulaeto determine working capital needs of thefirms. A large number of factors influenceworking capital needs of firms. All factorsare of different importance. The relevantfactors are:

Nature & Size of business

The shorter the manufacturing process, the lower is the requirements for the working capital. This is because, in such a case, inventories have to be maintained at a low level. Longer the manufacturing process the higher would be the requirements of working capital. This is the reason why highly capital intensive industries require a large amount of working capital to run their sophisticated and long production process.

Business cycle

Business fluctuations lead to cyclical and seasonal changes in production and sales and affect the working capital requirements.

Production Policy The plan for production, has great

influence on the level of inventories. The raw material procurement varies from industry to industry. In all such cases, the need for working capital will vary in accordance with production plans. Similarly, the decision of the management regarding automation, etc., also affect working capital requirements.

Conditions of supply

If prompt and adequate supply of raw materials, spares, stores etc., is available, it is possible to manage with small investments in inventory of work on ‘Just in Time’ inventory principles. However if supply is erratic, scanty, seasonal, channelised through government agencies etc., it is essential to keep larger stocks increasing working capital requirements.

Inventory policies

Since a large amount of funds is normally locked up in inventories, the inventory policy of a company has an impact on the working capital requirements. An efficient firm may stock raw material for a smaller period and may, therefore, require lesser amount of working capital.

Credit Policy

The credit policy of the firm also determines the requirements of working capital. A firm, which allows liberal credit to its customers may have higher sales but consequently will have larger amount of funds tied up in sundry debtors. Similarly a firm, which has a very efficient debt collection machinery and offers strict credit terms, may require lesser amount of working capital than the one where debt collection system is not so efficient or where the credit terms are liberal.

The credibility of a firm in the market also has an effect on the working capital requirements. Reputed and established concerns can purchase raw material on credit and enjoy many other services also like door delivery, after sales service etc.,. This would mean that they can easily have large current liabilities. Therefore the required working capital may not be very high.

Market conditions

Working capital requirements are also affected by market conditions like degree of competition. Large inventory is essential as delivery has to be off the shelf or credit has to be extended on liberal terms when market competition is fierce or market is not very strong or is a buyer’s market.

Growth and expansion:

The growth in volume and growth in working capital go hand in hand. However, the change may not be proportionate and the increased need for working capital is felt right from the initial stages of growth.

Level of taxes/Dividend PolicyLevel of taxes: The amount of taxes paid depends on taxation

laws. These amounts usually have to be paid in advance. Thus need for working capital varies with tax rates and advance tax provisions.

Dividend policy: Payment of dividend utilizes cash, while

retaining profits acts as a source of working capital. Thus dividend policies affect working capital.

Price level changes/Operating efficiency

Price level changes: Inflationary trends in the economy

necessitate more working capital to maintain the same level of activity.

Operating efficiency: Efficient and coordinated utilization

of capital reduces the amount required to be invested in working capital.

Abnormal factors

Abnormal conditions like strikes and lockouts, also require additional working capital. Recessionary conditions, necessitate a higher amount of stock of finished goods remaining in stock. Similarly, inflationary conditions necessitate more funds for working capital to maintain the same amount of current assets.

Approach to working capital

A firm can adopt different financing policies namely long term, short term and spontaneous.

A firm should take maximum advantage of the Spontaneous finance sources such as trade credit.

The approach a firm used in mixing these sources can be matching, conservative or aggressive.

Approaches1. Matching or Hedging approach:

When the firm uses long term sources to finance fixed assets and permanent current assets, and short term financing to finance temporary current assets.

2. Conservative approach:

Under this approach a firm finances its permanent assets and also a part of temporary current assets with long term financing. It relies heavily on long term financing and is less risky so far as solvency is concerned, however, the funds may be invested in such instruments, which fetch small returns to build up liquidity. This adversely affects profitability.

3. Aggressive Approach:

The firm uses more short term financing than what is justified, in this approach. The firm finances a part of its permanent current assets with short term financing. This is more risky but may add to the return on assets.