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Introduction Meaning of Working Capital Management Components of working capital management Objective of working capital management Nature of working capital management Management of working capital working capital management Different Aspects of Working Capital Management Steps for working capital management Aim of Working Capital Management Importance of working capital management Decision criteria Holistic Approach to Working Capital Management Working capital management current challenges Benefits from optimized working capital management Case Study Conclusion Reference or The procedure of
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Introduction
Working capital management is also known as liquidity decision. Management of working capital: A firm must have adequate working capital, i.e.; as much as needed the firm. It should be neither excessive nor inadequate. Both situations are dangerous. Excessive working capital means the firm has idle funds which earn no profits for the firm. Inadequate working capital means the firm does not have sufficient funds for running its operations. It will be interesting to understand the relationship between working capital, risk and return. The basic objective of working capital management is to manage firms current assets and current liabilities in such a way that the satisfactory level of working capital is maintained, i.e.; neither inadequate nor excessive. Working capital some times is referred to as circulating capital. Operating cycle can be said to be t the heart of the need for working capital. The flow begins with conversion of cash into raw materials which are, in turn transformed into work-in-progress and then to finished goods. With the sale finished goods turn into accounts receivable, presuming goods are sold as credit. Collection of receivables brings back the cycle to cash. The company has been effective in carrying working capital cycle with low working capital limits. It may also be observed that the PBT in absolute terms has been increasing as a year to year basis as could be seen from the above table although profit percentage turnover may be lower but in absolute terms it is increasing. In order to further increase profit margins, SSL can increase their margins by extending credit to good customers and also by paying the creditors in advance to get better rates High working capital ratios often mean that too much money is tied up in receivables and inventories. Typically, the knee-jerk reaction to this problem is to apply the big squeeze by aggressively collecting receivables, ruthlessly delaying payments to suppliers and cutting inventories across the board. But that only attacks the symptoms of working capital issues, not the root causes. A more effective approach is to
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fundamentally rethink and streamline key processes across the value chain. This will not only free up cash but lead to significant cost reductions at the same time. An accounting strategy in which a company seeks to maximize its cash flows so as to pay for its current liabilities and operating expenses Examples of working capital management include active monitoring of accounts receivable and maintaining little short-term debt. Working capital management, if done properly, can help a company improve its earnings and maintain a healthy financial state.
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Working capital management is the device of finance. It is related to manage of current assets and current liabilities .i.e. working capital. Meaning of working capital-Working capital (abbreviated WC) is a financial metric which represents operating liquidity available to a business, organization or other entity, including governmental entity. Along with fixed assets such as plant and equipment, working capital is considered a part of operating capital. Net working capital is calculated as current assets minus current liabilities. It is a derivation of working capital that is commonly used in valuation techniques such as DCFs (Discounted cash flows). If current assets are less than current liabilities, an entity has a working capital deficiency, also called a working capital deficit. If a company's current assets do not exceed its current liabilities, then it may run into trouble paying back creditors in the short term. The worst-case scenario is bankruptcy. A declining working capital ratio over a longer time period could also be a red flag that warrants further analysis. For example, it could be that the company's sales volumes are decreasing and, as a result, its accounts receivables number continues to get smaller and smaller. Working capital also gives investors an idea of the company's underlying operational efficiency. Money that is tied up in inventory or money that customers still owe to the company cannot be used to pay off any of the company's obligations. So, if a company is not operating in the most efficient manner (slow collection), it will show up as an increase in the working capital. This can be seen by comparing the working capital from one period to another; slow collection may signal an underlying problem in the company's operations. The accounting formula used to calculate the available working capital of a business is: Current Assets - Current Liabilities = Working Capital Working capital can be reflected as a positive or negative number depending on how much debt the business is carrying. The net working capital of a business is its current assets less its current liabilities Current Assets include: 1) 2) 3) 4) 5) Cash in hand and cash at bank Bills receivables Sundry debtors Short term loans and advances. Inventories of stock as:
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6. Temporary investment of surplus funds. 7. Prepaid expenses 8. Accrued incomes. 9. Marketable securities Current Liabilities include: Accrued or outstanding expenses. 2. 3. 4. 5. 6. 7. 1. 2. Short term loans, advances and deposits. Dividends payable. Bank overdraft. Provision for taxation, if it does not amt. to app. Of profit. Bills payable. Sundry creditors Gross working capital Net working capital
The gross working capital is the capital invested in the total current assets of the enterprises current assets are those Assets which can convert in to cash within a short period normally one accounting year. Working capital may be classified in to ways: 1. 2. On the basis of concept. On the basis of time.
On the basis of concept working capital can be classified as gross working capital and net working capital. On the basis of time, working capital may be classified as: 1. 2. Permanent or fixed working capital. Temporary or variable working capital
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Permanent or fixed working capital-Permanent or fixed working capital is minimum amount which is required to ensure effective utilization of fixed facilities and for maintaining the circulation of current assets. Every firm has to maintain a minimum level of raw material, work- in-process, finished goods and cash balance. This minimum level of current assts is called permanent or fixed working capital as this part of working is permanently blocked in current assets. As the business grow the requirements of working capital also increases due to increase in current assets. Temporary or variable working capital-Temporary or variable working capital is the amount of working capital which is required to meet the seasonal demands and some special exigencies. Variable working capital can further be classified as seasonal working capital and special working capital. The capital required to meet the seasonal need of the enterprise is called seasonal working capital. Special working capital is that part of working capital which is required to meet special exigencies such as launching of extensive marketing for conducting research, etc. Temporary working capital differs from permanent working capital in the sense that is required for short periods and cannot be permanently employed gainfully in the business. Factors determine the working capital requirements 1. nature of business: The requirements of working is very limited in public utility undertakings such as electricity, water supply and railways because they offer cash sale only and supply services not products, and no funds are tied up in inventories and receivables. On the other hand the trading and financial firms requires less investment in fixed assets but have to invest large amt. of working capital along with fixed investments. 2. Size of the business: Greater the size of the business, greater is the requirement of working capital. 3. Production policy: If the policy is to keep production steady by accumulating inventories it will require higher working capital. 4. Length of production cycle: The longer the manufacturing time the raw material and other supplies have to be carried for a longer in the process with progressive increment of labor and service costs before the final product is obtained. So working capital is directly proportional to the length of the manufacturing process.
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5. Seasonal variations: Generally, during the busy season, a firm requires larger working capital than in slack season. 6. Working capital cycle: The speed with which the working cycle completes one cycle determines the requirements of working capital. Longer the cycle larger is the requirement of working capital. 7. Rate of stock turnover: There is an inverse co-relationship between the question of working capital and the velocity or speed with which the sales are affected. A firm having a high rate of stock turnover will needs lower amt. of working capital as compared to a firm having a low rate of turnover. 8. Credit policy: A concern that purchases its requirements on credit and sales its product / services on cash requires lesser amt. of working capital and vice-versa. 9. Business cycle: In period of boom, when the business is prosperous, there is need for larger amt. of working capital due to rise in sales, rise in prices, optimistic expansion of business, etc. On the contrary in time of depression, the business contracts, sales decline, difficulties are faced in collection from debtor and the firm may have a large amt. of working capital. 10. Rate of growth of business: In faster growing concern, we shall require large amt. of working capital. 11. Earning capacity and dividend policy: Some firms have more earning capacity than other due to quality of their products, monopoly conditions, etc. Such firms may generate cash profits from operations and contribute to their working capital. The dividend policy also affects the requirement of working capital. A firm maintaining a steady high rate of cash dividend irrespective of its profits needs working capital than the firm that retains larger part of its profits and does not pay so high rate of cash dividend. 12. Price level changes: Changes in the price level also affect the working capital requirements. Generally rise in prices leads to increase in working capital. Others FACTORS: These are: 1 Operating efficiency. 3. Irregularities of supply 5. Asset structure. 2. Management ability. 4. Import policy.
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Thus, Working capital management is the tool used in fund flow analysis. Working capital is very significant for paying day to day expenses and long term liabilities. A method to release tied up working capital which includes inventory, accounts receivable and accounts payable. A way to identify improvement potentials and includes also concrete suggested activities for improvement. The methods foundation is a special designed training and a workshop before the implementation phase starts in order to secure the level of knowledge regarding working capital and cash flow but also engagement from the involved personnel.
Tools of inventory management Fixation of levels Fixation of EOQ ABC analysis VED analysis FSN / FSD analysis Perpetual inventory system Periodic inventory system Inventory turnover ratios
cash management
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Receivables management
Cost of receivables
Carrying cost Defaulting cost
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Management of receivables
Forming of credit policy Executing credit policy Formulating & executing policy Collection policy
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Identify the level of inventory which allows for uninterrupted production but reduces the investment in raw materials - and minimizes reordering costs - and hence increases cash flow. Besides this, the lead times in production should be lowered to reduce Work in Progress (WIP) and similarly, the Finished Goods should be kept on as low level as
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possible to avoid over production - see Supply chain management; Just In Time (JIT); Economic order quantity (EOQ); Economic quantity Debtors management.
Identify the appropriate credit policy, i.e. credit terms which will attract customers, such that any impact on cash flows and the cash conversion cycle will be offset by increased revenue and hence Return on Capital (or vice versa); see Discounts and allowances. Short term financing.
Identify the appropriate source of financing, given the cash conversion cycle: the inventory is ideally financed by credit granted by the supplier; however, it may be necessary to utilize a bank loan (or overdraft), or to "convert debtors to cash" through "factoring".
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Decision criteria
Decisions relating to working capital and short term financing are referred to as working capital management. These involve managing the relationship between a firm's shortterm assets and its short-term liabilities. The goal of working capital management is to ensure that the firm is able to continue its operations and that it has sufficient cash flow to satisfy both maturing short-term debt and upcoming operational expenses. By definition, working capital management entails short term decisions - generally, relating to the next one year period - which is "reversible". These decisions are therefore not taken on the same basis as Capital Investment Decisions (NPV or related, as above) rather they will be based on cash flows and / or profitability. 1) One measure of cash flow is provided by the cash conversion cycle - the net number of days from the outlay of cash for raw material to receiving payment from the customer. As a management tool, this metric makes explicit the inter-relatedness of decisions relating to inventories, accounts receivable and payable, and cash. Because this number effectively corresponds to the time that the firm's cash is tied up in operations and unavailable for other activities, management generally aims at a low net count. In this context, the most useful result is shown as a percentage, determined by dividing relevant income for the 12 months by capital employed; Return on equity (ROE) shows this result for the firm's shareholders. Firm value is enhanced when, and if, the return on capital, which results from working capital management, exceeds the cost of capital, which results from capital investment decisions as above. ROC
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measures are therefore useful as a management tool, in that they link short-term policy with long-term decision making. See Economic value added (EVA). Credit policy of the firm: Another factor affecting working capital management is credit policy of the firm. It includes buying of raw material and selling of finished goods either in cash or on credit. This affects the cash conversion cycle.
Doubts about ability to make serious capital repayments on loan within the next measure of profitability are Return on capital (ROC). The six or seven months.
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Case Study
A leading industrial conglomerate with worldwide sales presence in all of its divisions recently conducted a comprehensive, group-wide working capital program with a strong commitment of top management levels. Critical success factors were a holistic approach to the entire value chain and the definition of clear and practicable measures, together with employees responsible for implementation on the operational level. Improvement measures ranged from more easily implemented quick wins, such as optimizing payment processes, to complete restructuring of production processes. Quick wins not only paid off the initiative after a few months, but also served as a beacon for the initiative and proof of concept. The overall NWC reduction added up to more than 40%. Roughly half of the improvement potential was already realized within one year from start of the implementation. In order to anchor working capital management in the organization, a pragmatic controlling tool was set up and regular reporting cycles were established. Working capital goals were integrated into budgets and incentive programs to further foster sustainability. Before the program brought the change, a number of initiatives had fallen short of expectations. The main reasons had been an undifferentiated top-down approach, and the lack of a comprehensive perspective on working capital. Thus, the symptoms rather than the root causes of excess accounts receivable and inventory or low positions in payables had been approached and no sustainable results had been achieved.
Conclusion
Many companies still underestimate the importance of working capital management as a lever for freeing up cash from inventory, accounts receivable, and accounts payable. By effectively managing these components, companies can sharply reduce their dependence on outside funding and can use the released cash for further investments or acquisitions. This will not only lead to more financial flexibility, but also create value and have a strong impact on a companys enterprise value by reducing capital employed and thus
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increasing asset productivity. Thus working capital management is very important for all type of organization irrespective of their some limitations
Reference
en.wikipedia.org/wiki/Working_capital www.investorwords.com/5334/working_capital.html financial-dictionary.thefreedictionary.com/working+capital www.qfinance.com Home QFINANCE Dictionary www.caalley.com/art/WorkingCapitalManagement.pdf womeninbusiness.about.com/od/.../a/def-workingcap.html www.advfn.com/money-words_term_9827_Working_capital_manag... www.allprojectreports.com/.../working_capital_management/working... http://www.investopedia.com/terms/w/workingcapital.asp#ixzz1hwk2CnNZ
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