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WORKING CAPITAL MANAGEMENTWORKING CAPITAL MANAGEMENT
Gross and Net working Gross and Net working capitalcapital
CRCR QRQR CASH BUDGETCASH BUDGET WC POLICYWC POLICY WCMWCM
WORKING CAPITAL MANAGEMENTWORKING CAPITAL MANAGEMENT
OBJECTIVES OF WORKING CAPITAL OBJECTIVES OF WORKING CAPITAL
MANAGEMENT :MANAGEMENT : Optimising the investment in current assets and liabilitiesOptimising the investment in current assets and liabilities Ensuring that the company should always be in a position Ensuring that the company should always be in a position
to meet its current obligations, supported by current to meet its current obligations, supported by current assets available with the firm.assets available with the firm.
The firm should manage its current assets in such a way The firm should manage its current assets in such a way that the marginal return on investment in these assets is that the marginal return on investment in these assets is not less than the cost of capital employed to finance the not less than the cost of capital employed to finance the current assets.current assets.
2 Approaches2 Approaches
►Balance Sheet approachBalance Sheet approach►Process approachProcess approach
WORKING CAPITAL MANAGEMENTWORKING CAPITAL MANAGEMENT
Cash and Bank balancesCash and Bank balances ReceivablesReceivables InventoryInventory
Raw material, stores and Raw material, stores and sparesspares
Work - in - progressWork - in - progressFinished goods.Finished goods.
Prepaid expensesPrepaid expenses Short-term advancesShort-term advances Temporary investmentsTemporary investments
WORKING CAPITAL MANAGEMENTWORKING CAPITAL MANAGEMENT
Current Liabilities include:Current Liabilities include:
Creditors for goods purchasedCreditors for goods purchased Outstanding expenses i.e., expenses Outstanding expenses i.e., expenses
due but not paiddue but not paid Short-term borrowingsShort-term borrowings Advances received against salesAdvances received against sales Taxes and dividends payableTaxes and dividends payable Other liabilities maturing within a year.Other liabilities maturing within a year.
WORKING CAPITAL MANAGEMENTWORKING CAPITAL MANAGEMENT
►More WC – reduces liquidity risk, effect More WC – reduces liquidity risk, effect on the revenues and future growth, -ve on the revenues and future growth, -ve effect on CF, need for external fundingeffect on CF, need for external funding
►Less WC – more CF, late payment to Less WC – more CF, late payment to suppliers, lost sales due to inventory suppliers, lost sales due to inventory shortage and tight credit policyshortage and tight credit policy
►Dependent on the operations of the Dependent on the operations of the firm and make up of working capitalfirm and make up of working capital
WORKING CAPITAL MANAGEMENTWORKING CAPITAL MANAGEMENT
►Factors of WC changes on liquidity riskFactors of WC changes on liquidity risk Access to financingAccess to financing State of the economyState of the economy Uncertainty on future CFsUncertainty on future CFs
►WC should be large for firms WC should be large for firms Having more volatile revenues and CFsHaving more volatile revenues and CFs Smaller and have less access to external Smaller and have less access to external
financingfinancing
WORKING CAPITAL MANAGEMENTWORKING CAPITAL MANAGEMENT
Factors determining working capital Factors determining working capital requirement :requirement :
Nature of business Nature of business Production policyProduction policy Market conditionsMarket conditions Seasonal variationsSeasonal variations Supply conditions of materialsSupply conditions of materials
WORKING CAPITAL MANAGEMENTWORKING CAPITAL MANAGEMENT
Factors determining working Factors determining working capital requirement :capital requirement :
Credit policyCredit policy Accessibility to creditAccessibility to credit Growth and diversification of Growth and diversification of
businessbusiness
The Size of the Firm’s Investment in The Size of the Firm’s Investment in Current AssetsCurrent Assets
► The size of the firm’s investment in The size of the firm’s investment in current assets is determined by its short-current assets is determined by its short-term financial policies.term financial policies.
► FlexibleFlexible policy actions include: policy actions include: Keeping large cash and securities balancesKeeping large cash and securities balances Keeping large amounts of inventoryKeeping large amounts of inventory Granting liberal credit termsGranting liberal credit terms
► RestrictiveRestrictive policy actions include: policy actions include: Keeping low cash and securities balancesKeeping low cash and securities balances Keeping small amounts of inventoryKeeping small amounts of inventory Allowing few or no credit salesAllowing few or no credit sales
Carrying Costs and Shortage Costs Carrying Costs and Shortage Costs
Short-term financial policy: the optimal investment in current assets.
Dollars
Amount ofcurrent assets (CA)
Total cost ofholding current assets
Carrying costs increase with the level of investment in CA.
Shortage costs decrease with the level of investment in CA.
Minimum point
CA*The optimal amount of current assets. This point minimizes total costs.
A. Flexible policy- is most appropriate when carrying costs are low relative to shortage costs.
Dollars
Amount ofcurrent assets (CA)
Total cost
Carrying costs
Shortage costs
Minimum point
CA*
B. Restrictive policy- is most appropriate when carrying costs are high relative to shortage costs.
Dollars
Amount ofcurrent assets (CA)
Total cost
Carrying costs
Shortage costs
Minimum point
CA*
Financing Policy for an “Ideal” Financing Policy for an “Ideal” EconomyEconomy
In an ideal world, net working capital is always zero because In an ideal world, net working capital is always zero because short-term assets are financed by short-term debt.short-term assets are financed by short-term debt.
Dollars
Time
Long-term debtplus common stock
Current assets = Short-term debt
Fixed assets
0 1 2 3 4
Alternative Asset Financing PoliciesAlternative Asset Financing Policies
Policy F Policy F always implies a short-term cash surplus and a always implies a short-term cash surplus and a large investment in cash and marketable securities.large investment in cash and marketable securities.
Policy F
Dollars
Time
Long-termfinancing
Total assetrequirement
Fixed assets
Marketablesecurities
Policy R Policy R uses long-term financing for permanent asset uses long-term financing for permanent asset requirements only and short-term borrowing for seasonal requirements only and short-term borrowing for seasonal variations.variations.
Policy R
Dollars
Time
Total assetrequirement
Long-termfinancing
Short-termfinancing
With a With a compromise policycompromise policy, the firm keeps a reserve of liquidity which it , the firm keeps a reserve of liquidity which it uses to initially finance seasonal variations in current asset needs. uses to initially finance seasonal variations in current asset needs. Short-term borrowing is used when the reserve is exhausted.Short-term borrowing is used when the reserve is exhausted.
Dollars
Time
Short-termfinancing
Total seasonalvariation
Flexible policy (F)
Compromise policy (C)
Restrictive policy (R)
Marketablesecurities
General growth in fixed assets and permanent current assets
Matching Principle
• The most common way to finance a temporary cash deficit to arrange a short-term loan.
• Accruals• Trade credit• Banks and FIs• Public deposits• ICDs• CPs• Factoring/ forfaiting• RE/ SC/ Debentures/ TL – Long-term
Operating and Cash CyclesOperating and Cash Cycles
►Operating Cycle -Operating Cycle - the time the time period from inventory purchase period from inventory purchase until the receipt of cash. until the receipt of cash.
►Cash Cycle - Cash Cycle - the time period from the time period from when cash is paid out, to when cash is when cash is paid out, to when cash is received.received.
cash
Purchase of raw materials
Collection of receivables
sales
Collection of receivables
Issue of materials toproduction and incurring expenses
cash
Raw material inventory
Work-in-processFinished goods
Accounts Receivable
OPERATING CYCLE
TimeAccounts payable period
Cash cycle
Operating cycle
Cash received
Accounts receivable periodInventory period
Finished goods sold
Firm receives invoice Cash paid for materials
Order Placed
Stock Arrives
Raw material purchased
Operating CycleOperating Cycle►The operating cycle-time to acquire The operating cycle-time to acquire
and sell inventory.and sell inventory.
a)a) Finding the inventory periodFinding the inventory period Inventory turnover = COGS/ Avg Inventory turnover = COGS/ Avg inventoryinventory
Inventory period =365/ Inventory Inventory period =365/ Inventory turnover turnover
b)b) Finding the accounts receivable period- Finding the accounts receivable period- time to collect on sale.time to collect on sale. Receivables turnover = Credit sales / Avg Receivables turnover = Credit sales / Avg receivablesreceivables
Receivables period =365/ Receivables Receivables period =365/ Receivables
turnover turnover
Operating cycle Operating cycle = Inventory period + = Inventory period +
Receivables periodReceivables period
Cash CycleCash Cycle►The cash cycle= Operating cycle - Accounts The cash cycle= Operating cycle - Accounts
payable period.payable period. Payable period = the time between receipt of Payable period = the time between receipt of
inventory and payment for it.inventory and payment for it.
a)a) Finding the payables turnoverFinding the payables turnover
Payables turnover = COGS/ Avg payablesPayables turnover = COGS/ Avg payables Payables period = 365/ Payables turnoverPayables period = 365/ Payables turnover
Cash cycle = Operating cycle - Payables Cash cycle = Operating cycle - Payables periodperiod
WORKING CAPITAL MANAGEMENTWORKING CAPITAL MANAGEMENT
Reasons for prolonged operating Reasons for prolonged operating cycle:cycle:
Purchase of materials in excess / short of Purchase of materials in excess / short of requirementsrequirements
Buying inferior, defective materialsBuying inferior, defective materials Failure to get trade discount, cash discountFailure to get trade discount, cash discount Inability to purchase during seasonsInability to purchase during seasons Defective inventory policyDefective inventory policy Lack of production planning, coordination Lack of production planning, coordination
and controland control
WORKING CAPITAL MANAGEMENTWORKING CAPITAL MANAGEMENT
Reasons for prolonged operating Reasons for prolonged operating cycle:cycle:
Poor maintenance and upkeep of plant, Poor maintenance and upkeep of plant, equipment and infrastructural facilitiesequipment and infrastructural facilities
Defective credit policy and slack Defective credit policy and slack collection policycollection policy
Inability to get credit from suppliers, Inability to get credit from suppliers, employeesemployees
Lack of proper monitoring of external Lack of proper monitoring of external environment etc.,environment etc.,
Use ofUse of outdated machinery, technologyoutdated machinery, technology
WORKING CAPITAL MANAGEMENTWORKING CAPITAL MANAGEMENT
How to reduce operating cycle ?How to reduce operating cycle ?
Purchase ManagementPurchase Management Production ManagementProduction Management Marketing ManagementMarketing Management Sound Credit and Collection PoliciesSound Credit and Collection Policies Proper monitoring of External EnvironmentProper monitoring of External Environment
Process ApproachProcess Approach
► All processes surrounding accounts payable, All processes surrounding accounts payable, accounts receivable and inventoryaccounts receivable and inventory
► Strategic drivers for action on working Strategic drivers for action on working capitalcapital Unlocking internal cash is the cheapest way to Unlocking internal cash is the cheapest way to
fund strategic projectsfund strategic projects Improving key ratios make the equity analyst to Improving key ratios make the equity analyst to
better value the companybetter value the company Help secure access to capital market and bolster Help secure access to capital market and bolster
credit ratingcredit rating
Customer to CashCustomer to Cash
► Consistent policy throughout the firm – Consistent policy throughout the firm – cooperation withincooperation within
► Ongoing vigilance over the people-process-Ongoing vigilance over the people-process-technology in the customer-cash cycletechnology in the customer-cash cycle
► Spotting inefficiencies – reactive collection Spotting inefficiencies – reactive collection process – pricing errors – ambiguous terms – process – pricing errors – ambiguous terms – product issuesproduct issues
► When planning strategy – 2 principles – When planning strategy – 2 principles – concentrate resources on the clients that concentrate resources on the clients that matters – build responsibility in policies and matters – build responsibility in policies and procedures procedures
Customer – cash cycleCustomer – cash cycle
►Customer negotiationsCustomer negotiations►Billing delaysBilling delays►Collections – establish a system of Collections – establish a system of
prioritized, proactive, event-driven prioritized, proactive, event-driven collection procedurecollection procedure
Purchase to PayPurchase to Pay
►Structural problemsStructural problems FragmentationFragmentation Lack of focusLack of focus Control and disciplineControl and discipline
►Payment problemsPayment problems Early payment – input errorsEarly payment – input errors Default terms - automated Default terms - automated
►Solution – approved channelsSolution – approved channels►E-procurementE-procurement
Forecast to fulfilmentForecast to fulfilment
► What inventory do you have What inventory do you have ► Where is inventory locatedWhere is inventory located► How do you maintain its valueHow do you maintain its value► Why do you have these quantitiesWhy do you have these quantities► Service level to customersService level to customers► Understanding of the staff of their actions on Understanding of the staff of their actions on
inventory and serviceinventory and service► Capabilities and requirements your suppliers Capabilities and requirements your suppliers
and customers have or deemandand customers have or deemand