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A measure of both a company's efficiency and its short-term financial health. The working capital ratio is
calculated as:
Positive working capital means that the company is able to pay off its short-term
liabilities. Negative working capital means that a company currently is unable to meet its short-term
liabilities with its current assets (cash, accounts receivable and inventory).
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.
Cash is the lifeline of a company. If this lifeline deteriorates, so does the company's ability to fund
operations, reinvest and meet capital requirements and payments. Understanding a company's cash flow
health is essential to making investment decisions. A good way to judge a company's cash flow prospects
is to look at its working capital management (WCM).
Working capital refers to the cash a business requires for day-to-day operations, or, more specifically, for
financing the conversion of raw materials into finished goods, which the company sells for payment.
Among the most important items of working capital are levels of inventory, accounts receivable, and
accounts payable. Analysts look at these items for signs of a company's efficiency and financial strength.
Take a simplistic case: a spaghetti sauce company uses $100 to build up its inventory of tomatoes,
onions, garlic, spices, etc. A week later, the company assembles the ingredients into sauce and ships it
out. A week after that, the checks arrive from customers. That $100, which has been tied up for two
weeks, is the company's working capital. The quicker the company sells the spaghetti sauce, the sooner
the company can go out and buy new ingredients, which will be made into more sauce sold at a profit. If
the ingredients sit in inventory for a month, company cash is tied-up and can't be used to grow the
spaghetti business. Even worse, the company can be left strapped for cash when it needs to pay its bills
and make investments. Working capital also gets trapped when customers do not pay their invoices on
time or suppliers get paid too quickly or not fast enough.
The better a company manages its working capital, the less the company needs to borrow. Even
companies with cash surpluses need to manage working capital to ensure that those surpluses are
invested in ways that will generate suitable returns for investors.
Normally, a big retailer like Wal-Mart (NYSE:WMT) has little to worry about when it comes to accounts
receivable: customers pay for goods on the spot. Inventories represent the biggest problem for retailers;
as such, they must perform rigorous inventory forecasting or they risk being out of business in a short
time.
Timing and lumpiness of payments can pose serious troubles. Manufacturing companies, for example,
incur substantial upfront costs for materials and labor before receiving payment. Much of the time they eat
more cash than they generate.
Rising DSO is a sign of trouble because it shows that a company is taking longer to collect its payments.
It suggests that the company is not going to have enough cash to fund short-term obligations because the
cash cycle is lengthening. A spike in DSO is even more worrisome, especially for companies that are
already low on cash.
The inventory turnover ratio offers another good instrument for assessing the effectiveness of WCM. The
inventory ratio shows how fast/often companies are able to get their goods completely off the shelves.
The inventory ratio looks like this:
Broadly speaking, a high inventory turnover ratio is good for business. Products that sit on the shelf are
not making money. Granted, an increase in the ratio can be a positive sign, indicating that management,
expecting sales to increase, is building up inventory ahead of time.
For investors, a company's inventory turnover ratio is best seen in light of its competitors. In a given
sector where, say, it is normal for a company to completely sell out and restock six times a year, a
company that achieves a turnover ratio of four is an underperformer.
Computer giant and stock market champion, Dell (Nasdaq:DELL), recognized early that a good way to
bolster shareholder value was to notch up working capital management. The company's world-class
supply-chain management system ensures that DSO stays low. Improvements in inventory turnover
increase cash flow, all but eliminating liquidity risk, leaving Dell with more cash on the balance sheet to
distribute to shareholders or fund growth plans.
Dell's exceptional WCM certainly exceeds those of the top executives who do not worry enough about the
nitty-gritty of working capital management. Some CEOs frequently see borrowing and raising equity as
the only way to boost cash flow. Other times, when faced with a cash crunch, instead of setting straight
inventory turnover levels and reducing DSO, these management teams pursue rampant cost cutting and
restructuring that may later aggravate problems.
Cash is king, especially at a time when fund raising is harder than ever. Letting it slip away is an oversight
that investors should not forgive. Analyzing a company's working capital can provide excellent insight into
how well a company handles its cash, and whether it is likely to have any on hand to fund growth and
contribute to shareholder value.
c c
A measurement comparing the depletion of working capital to the generation of sales over a given period.
This provides some useful information as to how effectively a company is using its working capital to
generate sales.
For example, if a company has current assets of $10 million and current liabilities of $9 million, its working
capital is $1 million. When compared to sales of $15 million, the working capital turnover ratio for the
period is 15 ($15M/$1M). When used in fundamental analysis, this ratio can be compared to that of
similar companies or to the company's own historical working capital turnovers.
c c
A managerial accounting strategy focusing on maintaining efficient levels of both components of working
capital, current assets and current liabilities, in respect to each other. Working capital management
ensures a company has sufficient cash flow in order to meet its short-term debt obligations and operating
expenses.
Implementing an effective working capital management system is an excellent way for many companies
to improve their earnings. The two main aspects of working capital management are ratio analysis and
management of individual components of working capital.
A few key performance ratios of a working capital management system are the working capital ratio,
inventory turnover and the collection ratio. Ratio analysis will lead management to identify areas of focus
such as inventory management, cash management, accounts receivable and payable management.
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The diagram below illustrates the working capital cycle for a manufacturing firm
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aapital required for a business can be classified under two main categories via,
1) Fixed aapital
2) Working aapital
Every business needs funds for two purposes for its establishment and to carry out its day-
to-day operations. Long terms funds are required to create production facilities through purchase
of fixed assets such as p&m, land, building, furniture, etc. Investments in these assets represent
that part of firm¶s capital which is blocked on permanent or fixed basis and is called fixed
capital. Funds are also needed for short-term purposes for the purchase of raw material, payment
of wages and other day ± to- day expenses etc.
These funds are known as working capital. In simple words, working capital refers to that
part of the firm¶s capital which is required for financing short- term or current assets such as
cash, marketable securities, debtors & inventories. Funds, thus, invested in current assts keep
revolving fast and are being constantly converted in to cash and this cash flows out again in
exchange for other current assets. Hence, it is also known as revolving or circulating capital or
short term capital.
a a
a
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.
a
a
2) Bills receivables
3) Sundry debtors
a. Raw material
b. Work in process
d. Finished goods
7. Prepaid expenses
8. Accrued incomes.
9. Marketable securities.
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, or, say:
Net working capital can be positive or negative. When the current assets
exceeds the current liabilities are more than the current assets. aurrent 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.
a
a
3. Dividends payable.
4. Bank overdraft.
6. Bills payable.
7. 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:
3. It take into consideration of the fact every increase in the funds of the
enterprise would increase its working capital.
a
a
a
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 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.
! Adequate working capital leads to high solvency and credit
standing can arrange loans from banks and other on easy and favorable terms.
/% #& a(& A concern can face the situation during the
depression.
a
a
Every business concern should have adequate amount of working capital to run its
business operations. It should have neither redundant or excess working capital nor
inadequate nor shortages of working capital. Both excess as well as short working
capital positions are bad for any business. However, it is the inadequate working
capital which is more dangerous from the point of view of the firm.
a
a
a
Every business needs some amounts of working capital. The need for working capital arises due
to the time gap between production and realization of cash from sales. There is an operating
cycle involved in sales and realization of cash. There are time gaps in purchase of raw material
and production; production and sales; and realization of cash.
For studying the need of working capital in a business, one has to study the business
under varying circumstances such as a new concern requires a lot of funds to meet its
initial requirements such as promotion and formation etc. These expenses are called
preliminary expenses and are capitalized. The amount needed for working capital
depends upon the size of the company and ambitions of its promoters. Greater the
size of the business unit, generally larger will be the requirements of the working
capital.
The requirement of the working capital goes on increasing with the growth and
expensing of the business till it gains maturity. At maturity the amount of working
capital required is called normal working capital.
There are others factors also influence the need of working capital in a business.
a
a
12
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.
32
4
Greater the size of the business,
greater is the requirement of working capital.
2 a
a If the policy is to keep production
steady by accumulating inventories it will require higher working capital.
52
a
aa
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.
62
Generally, during the busy
72
a
aa
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.
a
8. a
a 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.
aa
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.
11.
aa
a 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.
a
a ahanges in the price level also affect the
working capital requirements. Generally rise in prices leads to increase in
working capital.
Operating efficiency.
Management ability.
Irregularities of supply.
Import policy.
Asset structure.
Importance of labor.
a
As we know working capital is the life blood and the centre of a business.
Adequate amount of working capital is very much essential for the smooth
running of the business. And the most important part is the efficient management
of working capital in right time. The liquidity position of the firm is totally
effected by the management of working capital. So, a study of changes in the uses
and sources of working capital is necessary to evaluate the efficiency with which
the working capital is employed in a business. This involves the need of working
capital analysis.
1. Ratio analysis.
3. Budgeting.
12
1. aurrent ratio.
2. Quick ratio
4. Inventory turnover.
·. Receivables turnover.
32
Fund flow analysis is a technical device designated to the study the source from
which additional funds were derived and the use to which these sources were put.
The fund flow analysis consists of:
8
a
The short ±term creditors of a company such as suppliers of goods of credit and
commercial banks short-term loans are primarily interested to know the ability
of a firm to meet its obligations in time. The short term obligations of a firm can
be met in time only when it is having sufficient liquid assets. So to with the
confidence of investors, creditors, the smooth functioning of the firm and the
efficient use of fixed assets the liquid position of the firm must be strong. But a
very high degree of liquidity of the firm being tied ± up in current assets.
Therefore, it is important proper balance in regard to the liquidity of the firm.
Two types of ratios can be calculated for measuring short-term financial
position or short-term solvency position of the firm.
1. Liquidity ratios.
Liquidity refers to the ability of a firm to meet its current obligations as and
when these become due. The short-term obligations are met by realizing
amounts from current, floating or circulating assts. The current assets should
either be liquid or near about liquidity. These should be convertible in cash for
paying obligations of short-term nature. The sufficiency or insufficiency of
current assets should be assessed by comparing them with short-term liabilities.
If current assets can pay off the current liabilities then the liquidity position is
satisfactory. On the other hand, if the current liabilities cannot be met out of the
current assets then the liquidity position is bad. To measure the liquidity of a
firm, the following ratios can be calculated:
1. a RRENT RATIO
2. Q IaK RATIO
12 a
a RRENT LIABILITES
The two components of this ratio are:
1) a RRENT ASSETS
2) a RRENT LIABILITES
A relatively high current ratio is an indication that the firm is liquid and has the
ability to pay its current obligations in time. On the hand a low current ratio
represents that the liquidity position of the firm is not good and the firm shall
not be able to pay its current liabilities in time. A ratio equal or near to the rule
of thumb of 2:1 i.e. current assets double the current liabilities is considered to
be satisfactory.
a
a
a
(Rupees in crore)
e.g.
½
As we know that ideal current ratio for any firm is 2:1. If we see the current
ratio of the company for last three years it has increased from 2006 to 2008. The
current ratio of company is more than the ideal ratio. This depicts that
company¶s liquidity position is sound. Its current assets are more than its current
liabilities.
32
a
Quick ratio is a more rigorous test of liquidity than current ratio. Quick ratio
may be defined as the relationship between quick/liquid assets and current or
liquid liabilities. An asset is said to be liquid if it can be converted into cash
with a short period without loss of value. It measures the firms¶ capacity to pay
off current obligations immediately.
a RRENT LIABILITES
1) Marketable Securities
3) Debtors.
A high ratio is an indication that the firm is liquid and has the ability to meet its
current liabilities in time and on the other hand a low quick ratio represents that
the firms¶ liquidity position is not good.
½
A quick ratio is an indication that the firm is liquid and has the ability to
meet its current liabilities in time. The ideal quick ratio is 1:1. aompany¶s
quick ratio is more than ideal ratio. This shows company has no liquidity
problem.
2
Although receivables, debtors and bills receivable are generally more liquid
than inventories, yet there may be doubts regarding their realization into cash
immediately or in time. So absolute liquid ratio should be calculated together
with current ratio and acid test ratio so as to exclude even receivables from the
current assets and find out the absolute liquid assets. Absolute Liquid Assets
includes :
a RRENT LIABILITES
½
These ratio shows that company carries a small amount of cash. But there is
nothing to be worried about the lack of cash because company has reserve,
borrowing power & long term investment. In India, firms have credit limits
sanctioned from banks and can easily draw cash.
Funds are invested in various assets in business to make sales and earn
profits. The efficiency with which assets are managed directly affects the
volume of sales. The better the management of assets, large is the amount of
sales and profits. aurrent assets movement ratios measure the efficiency with
which a firm manages its resources. These ratios are called turnover ratios
because they indicate the speed with which assets are converted or turned over
into sales. Depending upon the purpose, a number of turnover ratios can be
calculated. These are :
The current ratio and quick ratio give misleading results if current assets include
high amount of debtors due to slow credit collections and moreover if the assets
include high amount of slow moving inventories. As both the ratios ignore the
movement of current assets, it is important to calculate the turnover ratio.
AVERAGE INVENTORY
Inventory turnover ratio measures the speed with which the stock is
converted into sales. sually a high inventory ratio indicates an efficient
management of inventory because more frequently the stocks are sold ; the
lesser amount of money is required to finance the inventory. Where as low
inventory turnover ratio indicates the inefficient management of inventory.
A low inventory turnover implies over investment in inventories, dull
business, poor quality of goods, stock accumulations and slow moving
goods and low profits as compared to total investment.
(Rupees in arore)
½
These ratio shows how rapidly the inventory is turning into receivable
through sales. In 2007 the company has high inventory turnover ratio but in
2008 it has reduced to 1.7· times. This shows that the company¶s inventory
management technique is less efficient as compare to last year.
e.g.
½
Inventory conversion period shows that how many days inventories takes to
convert from raw material to finished goods. In the company inventory
conversion period is decreasing. This shows the efficiency of management to
convert the inventory into cash.
AVERAGE DEBTORS
Debtor¶s velocity indicates the number of times the debtors are turned
over during a year. Generally higher the value of debtor¶s turnover ratio the
more efficient is the management of debtors/sales or more liquid are the debtors.
Whereas a low debtors turnover ratio indicates poor management of
debtors/sales and less liquid debtors. This ratio should be compared with ratios
of other firms doing the same business and a trend may be found to make a
better interpretation of the ratio.
e.g.
½
This ratio indicates the speed with which debtors are being converted or
turnover into sales. The higher the values or turnover into sales. The higher the
values of debtors turnover, the more efficient is the management of credit. But
in the company the debtor turnover ratio is decreasing year to year. This shows
that company is not utilizing its debtors efficiency. Now their credit policy
become liberal as compare to previous year.
The average collection period ratio represents the average number of days
for which a firm has to wait before its receivables are converted into cash. It
measures the quality of debtors. Generally, shorter the average collection period
the better is the quality of debtors as a short collection period implies quick
payment by debtors and vice-versa.
½
The average collection period measures the quality of debtors and it
helps in analyzing the efficiency of collection efforts. It also helps to analysis
the credit policy adopted by company. In the firm average collection period
increasing year to year. It shows that the firm has Liberal aredit policy. These
changes in policy are due to competitor¶s credit policy.
·. c
½
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Networking aapital
e.g.
This ratio indicates low much net working capital requires for sales.
In 2008, the reciprocal of this ratio (1/1.64 = .609) shows that for sales of Rs. 1
the company requires 60 paisa as working capital. Thus this ratio is helpful to
forecast the working capital requirement on the basis of sale.
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½
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This graph shows that there is 64 increase in current assets in 2008. This
increase is arise because there is approx. ·0 increase in inventories. Increase
in current assets shows the liquidity soundness of company.
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The above parameters are used for critical analysis of financial position. With the evaluation of
each component, the financial position from different angles is tried to be presented in well and
systematic manner. By critical analysis with the help of different tools, it becomes clear how the
financial manager handles the finance matters in profitable manner in the critical challenging
atmosphere, the recommendation are made which would suggest the organization in formulation
of a healthy and strong position financially with proper management system.
FINANaIAL STATEMENTS:
2. To provide other needed information about charges in such economic resources and
obligation.
3. To provide reliable information about change in net resources (recourses less obligations)
missing out of business activities.
4. To provide financial information that assets in estimating the learning potential of the
business.
Though financial statements are relevant and useful for a concern, still they do not present a final
picture a final picture of a concern. The utility of these statements is dependent upon a number of
factors. The analysis and interpretation of these statements must be done carefully otherwise
misleading conclusion may be drawn.
1. Financial statements do not given a final picture of the concern. The data given in these
statements is only approximate. The actual value can only be determined when the business is
sold or liquidated.
2. Financial statements have been prepared for different accounting periods, generally one year,
during the life of a concern. The costs and incomes are apportioned to different periods with a
view to determine profits etc. The allocation of expenses and income depends upon the personal
judgment of the accountant. The existence of contingent assets and liabilities also make the
statements imprecise. So financial statement are at the most interim reports rather than the final
picture of the firm.
3. The financial statements are expressed in monetary value, so they appear to give final and
accurate position. The value of fixed assets in the balance sheet neither represent the value for
which fixed assets can be sold nor the amount which will be required to replace these assets. The
balance sheet is prepared on the presumption of a going concern. The concern is expected to
continue in future. So fixed assets are shown at cost less accumulated deprecation. Moreover,
there are certain assets in the balance sheet which will realize nothing at the time of liquidation
but they are shown in the balance sheets.
4. The financial statements are prepared on the basis of historical costs Or original costs. The
value of assets decreases with the passage of time current price changes are not taken into
account. The statement are not prepared with the keeping in view the economic conditions. the
balance sheet loses the significance of being an index of current economics realities. Similarly,
the profitability shown by the income statements may be represent the earning capacity of the
concern.
·. There are certain factors which have a bearing on the financial position and operating result of
the business but they do not become a part of these statements because they cannot be measured
in monetary terms. The basic limitation of the traditional financial statements comprising the
balance sheet, profit & loss A/c is that they do not give all the information regarding the financial
operation of the firm. Nevertheless, they provide some extremely useful information to the extent
the balance sheet mirrors the financial position on a particular data in lines of the structure of
assets, liabilities etc. and the profit & loss A/c shows the result of operation during a certain
period in terms revenue obtained and cost incurred during the year. Thus, the financial position
and operation of the firm.
It is the process of identifying the financial strength and weakness of a firm from the available
accounting data and financial statements. The analysis is done
Ratios can be classified in to different categories depending upon the basis of classification
The traditional classification has been on the basis of the financial statement to which the
determination of ratios belongs.
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