Working Capital Management PDF

FINM551: Corporate Finance Working Capital - II Management Learning outcome Assess the working capital requirement of the company Identifying working management techniques Exploring best working capital policy for management of short term financial position ...

FINM551: Corporate Finance Working Capital - II Management Learning outcome Assess the working capital requirement of the company Identifying working management techniques Exploring best working capital policy for management of short term financial position  1 Working Capital Management Meaning: A company’s short term financial decisions and how it affects current assets and current liabilities. By definition, the current assets are expected to convert to cash after appearing on the firm’s ‘Balance Sheet’  2 Current Assets In B/S, Current assets are presented in the order of liquidity  3 Current Liabilities  4 Working Capital Gross Working Capital: It represents to Investment in current assets, i.e., the assets which can be converted into cash within an accounting year.  5 Working Capital Net Working Capital: Difference between current assets and current liabilities. Generally, whenever we talk about working capital, we talk in the sense of Net Working Capital Current Assets – Current Liabilities  6 Working Capital Permanent Working Capital: Permanent or fixed working capital is the minimum level of required current assets. Depending upon the changes in production and sales, the need for working capital, over and above the permanent working capital, will fluctuate, that additional requirement is filled through Temporary Working Capital.  7 Working Capital Variable Working Capital: Variable/ temporary/ Fluctuating extra working capital needed to support the changing production and sales activities of the firm. The firm, to meet liquidity requirements that will last only temporarily, creates a temporary working capital. It is always over and above Permanent Working Capital MCQ ___________means the assets which can be converted into cash within an accounting year a. Gross working capital b. Net working capital c. Both d. None MCQ ___________means the assets which can be converted into cash within an accounting year a. Gross working capital b. Net working capital c. Both d. None MCQ Permanent or fixed working capital is the minimum level of required …. Current assets Current liabilities Fixed assets Fixed liabilities MCQ Permanent or fixed working capital is the minimum level of required …. Current assets Current liabilities Fixed assets Fixed liabilities  8 Factors affecting Working Capital 1. Nature of business 7. Turnover of working 2. Length of period of manufacture capital 3. Volume of business 8. Terms of Credit 4. The proportion of the cost of raw 9. Seasonal Variations materials to total cost 10.Requirements of Cash 5. Use of Manual Labour or 11.Other Factors Mechanization 6. Need to keep large stocks of raw materials of finished goods  9 Nature of Business Nature of the business determines the Working Capital requirements. The trading or manufacturing concerns will require more amount of working capital as compared to public utility companies. Public utilities companies with huge fixed investment usually have the lowest needs for current assets, partly because of cash, nature of their business and partly due to their selling a service instead of a commodity.  1 0 Length of period of manufacture The average length of manufacture period, i.e., the time which elapses between the commencement and end of the manufacturing process is an important factor in determining the amount of the working capital. If it takes less time to make the finished product, the working capital required will be less, e.g., a baker requires one nighttime to bake his daily quota of bread. His working capital is, therefore, much less than that of a ship­building concern which takes three to five years to build a ship.  1 1 Volume of Business The size of the company has a direct relation with the working capital needs. Big concerns must keep higher working capital for investment in current assets and for paying current liabilities as compared to small sized companies.  1 2 Proportion of cost of raw material to total cost Where the cost of raw materials to be used in manufacturing of a product is very large in proportion to the total cost, working capital required will also be more e.g., Sugar Mill. Whereas, If the importance of materials is less the need of working capital will be naturally less e.g., Oxygen Plant  1 3 Use of manual labour or mechanisation In the labour-intensive industries, larger working capital will be required than in the highly mechanized ones. The latter will have a large proportion of fixed capital.  1 4 Need to keep large stocks of raw materials, finished goods The manufacturing concerns generally have to carry stocks of raw materials and other stores and also finished goods. The larger the stocks (whether of raw materials or finished goods) more will be the needs of working capital. Whereas service industries will need less working capital compared to manufacturing concerns.  1 5 Turnover of working capital Turnover means the speed with which the working capital is recovered by the sale of goods. In certain businesses, sales are made quickly, and the stocks are soon exhausted, in such cases, a small amount of money invested in stocks will result in sales of much larger volume, e.g., textile industry. Whereas in some businesses, sales are made irregularly e.g., jewellery, in such cases, large sums of money have to be kept invested in stocks.  1 6 Terms of Credit A company purchasing all raw-materials for cash and selling on credit will be requiring more amount of working capital compared to an enterprise buying on credit and selling on cash. The length of the period of credit has a direct bearing on working capital.  1 7 Seasonal Variations Seasonal industries producing or selling largely based on season will have seasonally, higher working capital requirement, e.g., sugar industry producing sugar in winter will have more working capital requirement in the months of winter whereas a hosiery industry will have more working capital requirement 2-3 months before the start of winter season for increasing the production. Once the season is off, working capital requirement will gradually decline.  1 8 Requirements of Cash The need to have cash in hand to meet various requirements e.g., payment of salaries, rents, rates etc., has an effect on the working capital. The more the cash requirements the higher will be working capital needs of the company and vice versa.  1 9 Other Factors In addition to the above-mentioned considerations there are multiple other factors which affect the requirements of working capital such as:  Degree of co-ordination between production and distribution policies.  Specialization in the field of distribution.  Developments of means of transportation and communications.  The hazards and contingencies inherent in the type of Solution of working capital problem https://yourstory.com/video/india-msme-s ummit-solving-working-capital-problem  2 4 Working Capital Policies Conservative Policy Average Policy Aggressive Policy  2 5 Working Capital Policies A. Conservative Policy Level of Current B. Average Policy C. Aggressive Policy Assets Fixed Asset Level Output  2 6 Conservative Policy A Conservative Working Capital Policy believes in higher investment in Working Capital. The policy strives on the fact that liquidity is more important for a company. The company must not face liquidity crunch. However, higher liquidity leads to compromise with profitability  2 8 Aggressive Policy An Aggressive Working Capital Policy believes in lower investment in Working Capital. The policy strives on the fact that Profitability is more important for a company. The must maintain minimum level of working capital and must not compromise with profitability. It assumes lower liquidity, higher risk and higher profitability.  2 7 Average Policy An Average Working Capital Policy believes in moderate investment in Working Capital. The policy strives on the fact that both liquidity and profitability important for a company. The company must not face liquidity crunch while maintaining the level of profits. It strikes a good tradeoff between liquidity and profitability.  2 9 Liquidity vs Profitability: Risk Return Tradeoff Firms two main objectives are SOLVENCY and PROFITABILITY. For solvency more investment in working capital is inevitable; however, it leads to compromise with PROFITABILITY. So, a company trades off between liquidity and profitability to ensure solvency and good profitability. Statement of Working capital requirement A) Current Assets B) Current liabilities Net working capital =A-B Add-10% for contingencies Total working capital required  2 0 Operating Cycle Operating cycle is the time duration required to convert sales into cash. The operating cycle of a manufacturing company involves three phases: Acquisition of resources such as raw material, labour, power and fuel, etc. Manufacture of the product which includes conversion of raw material into work-in-progress and then into finished goods. Sale of the product either for cash or on credit. Credit sales create accounts receivable for collection. Collection of cash from account receivable  2 1 Cas h Collection of Holding Purchase Accounts Receivable Period s Collection Period Sale Production Operating Cycle Various Components of Operating Cycle A) Raw material shortage period = Average stock of raw material Average cost of raw material consumed per day B) WIP holding period = Average WIP inventory Average cost of production per day C) Finished goods storage period = Estimated production (in units) * direct lab permit 12 months / 360 days OR Average stock of finished goods Average cost of goods sold per day D) Debtors collection period = Average goods debtors Average credit sale per day E) Credit period available to suppliers = Average rate credit Average credit purchase per day  Operating Cycle = R+W+F+D-C  2 2 Gross Operating Cycle GOC= Inventory Conversion Period (ICP) + Debtor Conversion Period (DCP)  2 3 Net Operating Cycle Net Operating Cycle (NOC)= Gross Operating Cycle (GOC) – Creditor Deferral Period (CDP)