Working Capital capital Management and Finance - I

Working capitalIntroduction

Working capital typically means the firm’s holding of current or short-term assets such as cash, receivables, inventory and marketable securities.

These items are also referred to as circulating capital

Corporate executives devote a considerable amount of attention to the management of working capital.

Definition Working Capital refers to that part of the firm’s Working Capital refers to that part of the firm’s

capital, which is required for financing short-capital, which is required for financing short-term or current assets such a cash marketable term or current assets such a cash marketable securities, debtors and inventories. Funds securities, debtors and inventories. Funds thus, invested in current assets keep revolving thus, invested in current assets keep revolving fast and are constantly converted into cash fast and are constantly converted into cash and this cash flow out again in exchange for and this cash flow out again in exchange for other current assets. Working Capital is also other current assets. Working Capital is also known as known as revolving or circulating capital or revolving or circulating capital or short-term capital.short-term capital.

Concept of working capital There are two possible interpretations of

working capital concept:1. Balance sheet concept2. Operating cycle concept

Balance sheet conceptThere are two interpretations of working capital under the balance sheet concept.

a. GROSS WORKING CAPITALb. NET WORKING CAPITAL

GROSS WORKING CAPITALFunds invested in current assetsConstituents of Current assets1.Cash in hand and bank balance2.Bill receivables3.Sundry debtors4.Short term loans and advances5.Inventoriesa)Raw materialb)Work-in-progressc)Stores and sparesd)Finished goods6. Temporary investment of surplus funds7. Prepaid expenses8. Accrued incomes

NET WORKING CAPITALCURRENT ASSETS – CURRENT LIABILITIESConstituents of current liabilities1.Bills payable2.Sundry creditors3.Accrued expenses4.Short term loans, advances and deposits5.Dividends payable6.Bank overdraft

Operating cycle conceptA company’s operating cycle typically

consists of three primary activities:Purchasing resources,Producing the product andDistributing (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.

“ circulating capital means current assets of a company that are changed in the ordinary course of business from one form to another, as for example, from cash to inventories, inventories to receivables, receivable to cash” …………GenestenbregGenestenbreg

OPERATING CYCLE OR CIRCULAR FLOW CONCEPT

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.

TYPES OF WORKING CAPITAL

WORKING CAPITAL

BASIS OF CONCEPT

BASIS OF TIME

Gross Working Capital

Net Working Capital

Permanent / Fixed

WC

Temporary / Variable

WC

Regular WC

Reserve WC

Special WC

Seasonal WC

Difference between permanent & Difference between permanent & temporary working capitaltemporary working capital

Amount Variable Working CapitalAmount Variable Working Capitalof of WorkingWorkingCapitalCapital

Permanent Working CapitalPermanent Working Capital

TimeTime

Variable Working CapitalAmount of WorkingCapital

Permanent Working Capital

Time

Importance or advantages of adequate working capitalSolvency of the businessGoodwillEasy loansCash discountsRegular supply of raw materialRegular payment of salaries, wages and other

day to day commitmentsExploitation of favorable market conditionsAbility to face crisisQuick and regular return on investmentHigh morale

FACTORS DETERMINING WORKING CAPITALNature of the BusinessSize of businessProduction policyLength of production cycleSeasonal variationsWorking capital cycleRate of stock turnoverCredit policyBusiness cyclesRate of growth of businessEarning capacity and dividend policyPrice level changesOther factors

Working capital investment

The size and nature of investment in current assets is a function of different factors such as type of products manufactured, the length of operating cycle, the sales level, inventory policies, unexpected demand and unanticipated delays in obtaining new inventories, credit policies and current assets.

Three alternative working capital investment policies

Sales ($)

Cur

rent

Ass

ets

($)

Policy C

Policy A

Policy B

Policy C represents conservative approachPolicy A represents aggressive approach Policy B represents a moderate approach

Optimal level of working capital investment

Risk of long-term versus short-term debt

Financing needs over time

Fixed Assets

Permanent Current Assets

Total Assets

Fluctuating Current Assets

Time

$

Matching approach to asset financing

Fixed Assets

Permanent Current Assets

Total Assets

Fluctuating Current Assets

Time

$

Short-termDebt

Long-termDebt +EquityCapital

Conservative approach to asset financing

Fixed Assets

Permanent Current Assets

Total Assets

Fluctuating Current Assets

Time

$

Short-termDebt

Long-termDebt +Equity capital

Aggressive approach to asset financing

Fixed Assets

Permanent Current Assets

Total Assets

Fluctuating Current Assets

Time

$

Short-termDebt

Long-termDebt +Equity capital

EXCESS OR INADEQUATE WORKING CAPITALEXCESS OR INADEQUATE WORKING CAPITAL

Every business concern should have Every business concern should have adequate working capital to run its business adequate working capital to run its business operations. It should have operations. It should have neither redundant neither redundant or excess working capital nor inadequate or or excess working capital nor inadequate or shortage of working capital.shortage of working capital.

Both excess as well as shortage of working Both excess as well as shortage of working capital situations are bad for any business. capital situations are bad for any business. However, out of the two, inadequacy or However, out of the two, inadequacy or shortage of working capital is more shortage of working capital is more dangerous from the point of view of the firm.dangerous from the point of view of the firm.

Disadvantages of Redundant or Excess Disadvantages of Redundant or Excess Working CapitalWorking Capital

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

Disadvantages or Dangers of Inadequate Disadvantages or Dangers of Inadequate or Short Working Capitalor Short Working Capital

 Can’t pay off its short-term liabilities in  Can’t pay off its short-term liabilities in time. time.   Economies of scale are not possible.  Economies of scale are not possible.  Difficult for the firm to exploit   Difficult for the firm to exploit favourable market situations favourable market situations   Day-to-day liquidity worsens  Day-to-day liquidity worsens  Improper utilization the fixed assets   Improper utilization the fixed assets and ROA/ROI falls sharply and ROA/ROI falls sharply

FORECASTING / ESTIMATION OF WORKING CAPITAL FORECASTING / ESTIMATION OF WORKING CAPITAL REQUIREMENTSREQUIREMENTS

Factors to be consideredFactors to be considered Total costs incurred on Total costs incurred on materials, wages and overheadsmaterials, wages and overheads The The length of timelength of time for which raw materials remain in for which raw materials remain in

stores before they are issued to production.stores before they are issued to production. The length of the production cycle or WIP, i.e., The length of the production cycle or WIP, i.e., the time the time

taken for conversion of RM into FG.taken for conversion of RM into FG. The The length of the Sales Cyclelength of the Sales Cycle during which FG are to be during which FG are to be

kept waiting for sales.kept waiting for sales. The average period of The average period of credit allowed to customers.credit allowed to customers. The The amount of cash required to pay day-to-day amount of cash required to pay day-to-day

expenses of the business.expenses of the business. The The amount of cash required for advance payments if amount of cash required for advance payments if

any.any. The average period of The average period of credit to be allowed by suppliers.credit to be allowed by suppliers. Time – lag in the payment of wages and other overheadsTime – lag in the payment of wages and other overheads

PROFORMA - WORKING CAPTIAL ESTIMATESPROFORMA - WORKING CAPTIAL ESTIMATES1. TRADING CONCERN1. TRADING CONCERN

STATEMENT OF WORKING CAPITAL REQUIREMENTS Amount (Rs.)

Current Assets(i) Cash ----(ii) Receivables ( For…..Month’s Sales)---- ----(iii) Stocks ( For……Month’s Sales)----- ----(iv)Advance Payments if any ----Less : Current Liabilities(i) Creditors (For….. Month’s Purchases)- ----(ii) Lag in payment of expenses -----_WORKING CAPITAL ( CA – CL ) xxxAdd : Provision / Margin for Contingencies -----

NET WORKING CAPITAL REQUIRED XXX

Points to be remembered while estimating WCPoints to be remembered while estimating WC

(1) Profits should be ignored while calculating working (1) Profits should be ignored while calculating working capital requirements for the following reasons.capital requirements for the following reasons.

(a) Profits may or may not be used as working capital(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 (b) Even if it is used, it may be reduced by the amount of

Income tax, Drawings, Dividend paid etc.Income tax, Drawings, Dividend paid etc. (2) Calculation of WIP depends on the degree of completion (2) Calculation of WIP depends on the degree of completion

as regards to materials, labour and overheads. However, if as regards to materials, labour and overheads. However, if nothing is mentioned in the problem, take 100% of the value nothing is mentioned in the problem, take 100% of the value as WIP. Because in such a case, the average period of WIP as WIP. Because in such a case, the average period of WIP must have been calculated as equivalent period of completed must have been calculated as equivalent period of completed units.units.

(3) Calculation of Stocks of Finished Goods and Debtors (3) Calculation of Stocks of Finished Goods and Debtors should be made at cost unless otherwise asked in the should be made at cost unless otherwise asked in the question.question.

Forecast/Estimate WC requirementsPercentage of sales methodRegression analysis methodCash forecasting methodOperating cycle method

Tondon Committee ReportThe study group headed by Shri Prakash Tandon, the

then Chairman of Punjab National Bank, was constituted by the RBI in July 1974 with eminent personalities drawn from leading banks, financial institutions and a wide cross-section of the Industry with a view to study the entire gamut of Bank's finance for working capital and suggest ways for optimum utilisation of Bank credit. This was the first elaborate attempt by the central bank to organise the Bank credit. The report of this group is widely known as Tandon Committee report. Most banks in India even today continue to look at the needs of the corporates in the light of methodology recommended by the Group.

Terms of reference of committeeTo suggest guidelines for commercial banks to follow up

and supervise creditTo suggest type of operational data and other

information that can be obtained from borrowers by RBITo suggest prescribing inventory norms for different

industries; both public and privateTo make recommendations regarding resources for

financing the minimum working capital requirementsTo suggest criteria regarding satisfactory capital

structureTo make recommendations as to whether exiting

pattern of financing working capital requirements to be modified.

First Method of Lending:Banks can work out the working capital gap, i.e. total current assets less current liabilities other than bank borrowings (called Maximum Permissible Bank Finance or MPBF) and finance a maximum of 75 per cent of the gap; the balance to come out of long-term funds, i.e., owned funds and term borrowings. This approach was considered suitable only for very small borrowers i.e. where the requirements of credit were less than Rs.10 lacs

Second Method of Lending:Under this method, it was thought that the borrower should provide for a minimum of 25% of total current assets out of long-term funds i.e., owned funds plus term borrowings. A certain level of credit for purchases and other current liabilities will be available to fund the build up of current assets and the bank will provide the balance (MPBF). Consequently, total current liabilities inclusive of bank borrowings could not exceed 75% of current assets. RBI stipulated that the working capital needs of all borrowers enjoying fund based credit facilities of more than Rs. 10 lacs should be appraised (calculated) under this method.

Third Method of Lending: Under this method, the borrower's contribution from long term funds will be to the extent of the entire CORE CURRENT ASSETS, which has been defined by the Study Group as representing the absolute minimum level of raw materials, process stock, finished goods and stores which are in the pipeline to ensure continuity of production and a minimum of 25% of the balance current assets should be financed out of the long term funds plus term borrowings.(This method was not accepted for implementation and hence is of only academic interest).

CHORE COMMITTEE REPORTThe quality of lending improved considerably but

the cash credit system continued to pose few difficulties. Bifurcation of working capital limit in two parts as demand loan and a fluctuating cash credit component, as suggested by Tandon Group, was not done by many banks. It was, therefore, considered necessary by Reserve Bank to review the system of cash credit in all its aspects and for this purpose a 'Working Group' headed by Sh. K. B. Chore was appointed in 1979. The terms of reference to the 'Group' were as follows:

Important recommendationsThe bank should obtain quarterly statements in

prescribed format from all borrowers having working capital credit limits of rs.50 lacs and above

The banks should undertake a periodical review of limits of rs.10 lacs and above

The bank should not bifurcate cash credit accounts into demand loan and cash credit components

If a borrower does not submit the quarterly returns in time, the banks may penal interest of one percent on total amount outstanding

Banks should discourage sanction of temporary limits by charging additional one percent interest over the normal rate of interest

Bank should fix separate credit limits for peak and non-peak levels ; if possible

Banks should take steps to convert cash credit limits into bill limits for financing sales.`

THANKS…..