CHAPTER II: WORKING CAPITAL MANAGEMENT A CONCEPTUAL OVERVIEW

2.1 - DEFINITION OF WORKING CAPITAL

According to Bhattacharya (2006), the concept of working capital was perhaps first evolved by Karl Marx, though in a somewhat different form, and the term he used was variable capital. Guthmann and Dougall (1948) defined working capital as current assets minus current liabilities and their view was elaborated by Park and Gladson (1963). This definition is also known as net working capital. Current assets are sometimes called as gross working capital. The current assets can be divided to four primary components:(1) cash and cash equivalents; (2) marketable securities; (3) accounts receivable; and (4) inventory The three major items of current liabilities are:(1) accounts payable; (2) expenses payable, including accrued wages and taxes; and (3) notes payable. Narrower definition for working capital is:inventory + accounts receivable accounts payable. This definition emphasizes operating efficiency of a firm. Making decisions that affect to working capital is called working capital management.

2.2 - CLASSIFICATION OF WORKING CAPITAL

Working capital may be classified in two ways: o On the basis of concept. o On the basis of time. On the basis of time, working capital may be classified as: o Permanent or fixed working capital. o Temporary or variable working capital On the basis of concept working capital can be classified as:o Gross Working Capital; and o Net Working Capital. On the basis of time:-

1. 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 assets 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.

2. 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.

2.3 - CONCEPT OF WORKING CAPITAL

There are two concepts of working capital: 1) Gross Working Capital; 2) Net Working Capital.

1. Gross 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. Constituents of current assets: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: a) Raw material; b) Work in process; c) Stores and spares; d) Finished goods. Temporary investment of surplus funds. Prepaid expenses. Accrued incomes. Marketable securities.

6) 7) 8) 9)

2. Net Working Capital

In a narrow sense, the term working capital refers to the net working. Net working capital is the excess of current assets over current liability, i.e.NET WORKING CAPITAL = CURRENT ASSETS CURRENT LIABILITIES. Net working capital can be positive or negative. When the current assets exceeds the current liabilities are more than the current assets. Current liabilities are those liabilities, which are intended to be paid in the ordinary course of business within a short period of normally one accounting year out of the current assts or the income business.

Constituents of current liabilities:1) 2) 3) 4) 5) 6) 7) Accrued or outstanding expenses. Short term loans, advances and deposits. Dividends payable. Bank overdraft. Provision for taxation, if it does not amount to appropriation of profit. Bills payable. Sundry creditors.

The gross working capital concept is financial or going concern concept whereas net working capital is an accounting concept of working capital. Both the concepts have their own merits. The gross concept is sometimes preferred to the concept of working capital for the following reasons: i. ii. iii. iv. It enables the enterprise to provide correct amount of working capital at correct time. Every management is more interested in total current assets with which it has to operate than the source from where it is made available. It take into consideration of the fact every increase in the funds of the enterprise would increase its working capital. This concept is also useful in determining the rate of return on investments in working capital.

The net working capital concept, however, is also important for following reasons: i. ii. iii. iv. It is qualitative concept, which indicates the firms ability to meet to its operating expenses and short-term liabilities. IT indicates the margin of protection available to the short term creditors. It is an indicator of the financial soundness of enterprises. It suggests the need of financing a part of working capital requirement out of the permanent sources of funds.

2.4 - TOOLS FOR MEASURING WORKING CAPITAL

The most common tools used for measuring working capital size and requirement are given in table 1 Number of days inventories means how many days it takes to turn over the value of entire inventory. Number of days accounts receivable and payable tell how long in average it takes to get payment and pay invoices. Current ratio is ratio between shortterm assets and liabilities. A value under one could mean liquidity problems. Quick ratio is similar but takes account of the fact that it may take time to convert inventory into cash. Net liquid balance measures financial decisions of a firm that are irrelevant to the operation cycle. Working capital requirement comes directly from the narrower definition of working capital and measures the needed working capital. TABLE NO1.

2.5 COMMON MISTAKES MADE BY FIRMS

Six common mistakes firms make in working capital management. 1. The first mistake is managing income statement. For example tightening terms of payment will result fever sales but frees capital. If cost for the freed capital is more than reduced profit tightening terms is profitable. 2. Second mistake is rewarding the sales force for growth alone. This results salespeople granting customers long terms of payment and are unwilling to chase down late payments. They also insist larger finished goods inventories than necessary in fear of stock-outs. 3. Third common mistake is overemphasizing quality in production. It tends to slow down the production cycle, locking up capital in work-in-process inventory. Reducing quality small amount could make a notable improvement in efficiency. 4. Fourth mistake is tying receivables to payables. If a supplier tightens payment terms many firms try to cover the resulting cash needs by tightening their own credit policies. However receivables and payables should be managed according to their own conditions and imperatives. Relative bargaining power, the nature of competition, industry structure, and switching costs all must be taken into account. 5. Fifth common mistake is applying current and quick ratios. Bankers use these ratios in making credit decisions and many firms try to maximize those numbers. But using these ratios can result bad working capital management. 6. Sixth mistake is benchmarking competitors. Many managers become complacent when their metrics show that they are above industry norms. It is better to look outside your industry for benchmarks to improve radically. Authors also point out that creating a culture where all employees feel responsible for creating value should be target.

3.2 - 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. CASH DEBTORS FINISHED GOODS

RAW MATERIAL

WORK IN PROGRESS

Working capital cycle can be determined by adding the number of days required for each stage in the cycle. For example, company holds raw material on average for 60 days, it gets credit from the supplier for 15 days, finished goods are held for 30 days & 30 days credit is extended to debtors. The total days are 120, i.e., 60 15 + 15 + 15 + 30 + 30 days is the total of working capital. Thus the working capital cycle helps in the forecast, control & management of working capital. It indicates the total time lag & the relative significance of its constituent parts. The duration may vary depending upon the business policies. In light of the facts discusses above we can broadly classify the operating cycle of a firm into three phases viz. 1. Acquisition of resources. 2. Manufacture of the product and 3. Sales of the product (cash / credit). First and second phase of the operating cycle result in cash outflows, and be predicted with reliability once the production targets and cost of inputs are known. However, the third phase results in cash inflows which are not certain because sales and collection which give rise to cash inflows are difficult to forecast accurately. Operating cycle consists of the following: Conversion of cash into raw-materials; Conversion of raw-material into work-in-progress; Conversion of work-in-progress into finished stock; Conversion of finished stock into accounts receivable through sales; and Conversion of accounts-receivable into cash.

In the form of an equation, the operating cycle process can be expressed as follows:

Operating cycle = R + W + F + D - C R = Raw material storage period W = Work in progress holding period F = Finished goods storage period D = Debtors collection period C = Credit period availed

Some factors to be considered: RMCP - Raw Material Conversion Period WIPCP - Work in Progress Conversion Period FGCP - Finished Goods Conversion Period DSI/ICP - Inventory Conversion Period DSO/RCP - Receivables Conversion Period DPO/Payables (PDP) - Payables Deferral Period NOC - Net Operating Cycle GOC - Gross Operating Cycle Here, the length of GOC is the sum of DSI/ICP and DSO/RCP. DSI/ICP is the total time needed for producing and selling the products. Hence it is the sum total of RMCP, WIPCP and FGCP. On the other hand, DSO/RCP is the total time required to collect the outstanding amount from customers. Usually, firm acquires resources on credit basis. DPO/PAYABLES (PDP) is the result of such an incidence and it represents the length of time the firm is able to defer payments on various resources purchased. The difference between GOC and DPO/PAYABLES (PDP) is known as Net Operating Cycle and if Depreciation is excluded from the expenses in computation of operating cycle, the NOC also represents the cash collection from sale and cash payments for resources acquired by the firm and during such time interval between cash collection from sale and cash payments for resources acquired by the firm and during such time interval over which additional funds called working capital should be obtained in order to carry out the firms operations. In short, the working capital position is directly proportional to the Net Operating Cycle.