Académique Documents
Professionnel Documents
Culture Documents
INTRODUCTION
1
NATURE OF WORKING CAPITAL
Working capital management is concerned with the problems that arise in
attempting to manage the current assets, the current liabilities and the
interrelationship that exists between them.
Current assets refer to those assets which in the ordinary course of
business can be, or will be converted into cash within one year without
undergoing a diminution in value and without disrupting the operations of the
firm. The major current assets are cash, marketable securities, accounts receivable
and inventory.
Current liabilities are those liabilities which are intended, at their
inception, to be paid in the ordinary course of business, within a year, out of the
current assets or earnings of the concern. The basic current liabilities are accounts
payable, bills payable, bank overdraft, and outstanding expenses.
The goal of working capital management is to manage the firm’s current
assets and liabilities in such a way that a satisfactory level of working capital is
maintained. This is so because if the firm cannot maintain a satisfactory level of
working capital, it is likely to become insolvent and may even be forced into
bankruptcy. The current assets should be large enough to cover its current
liabilities to ensure a reasonable margin of safety. Each of the current assets must
be managed efficiently in order to maintain the liquidity of the firm while not
keeping too high a level of any one of them. The interaction between current
assets and current liabilities is, therefore the main theme of the theory of working
management.
The sum of the current assets is the working capital of a business –JS Mill.
Any acquisition of funds which increases working. Capital also, for they are one
and same.- Bonneville.
Working capital refers to a firm’s investment in short term assess cash, short-term
securities, accounts receivable and inventories- Weston & Brigham.
2
CONCEPTS OF WORKING CAPITAL
3
TYPES OF WORKING CAPITAL
The operating cycle, thus creates the need for current assets (Working
capital). However, the need does not come to an end after the cycle is completed.
It continues to exist. To explain this continuing need of current assets, a
distinction should be dawn between permanent and temporary working capital.
Business activity does not come to an end after the realization of cash from
customers. For all practical purposes, this requirement has be met permanently as
with other fixed assets. This requirement is referred to as permanent or fixed
working capital.
Any amount over and above the permanent level of working capital is
temporary fluctuating or variable working capital.
Both kinds of working capital are necessary to facilitate the sales process
through the operating cycle. Temporary working capital is created to meet
liquidity requirements that are of a purely transient nature.
4
immediate realization of cash against goods sold, Therefore, sufficient working
capital is necessary to sustain sales activity. Technically, this is referred to as the
operating or cash cycle. The operating cycle can be said to be at the heart of the
Operating cycle need for working capital. 'The continuing flow from cash to
suppliers, to inventory, to accounts receivable and back into cash is what is called
the operating cycle in the other words, the term cash cycle refers to the length of
time necessary to complete the following cycle of events.
Cash Receivables
Inventory
5
will be in a position to meet obligations when they become due. Similarly, firms
must have adequate inventory to guard against the possibility of no! being able to
meet demand for their products. Adequate inventory, therefore, provides a cushion
against being out of stock. If firms have to be competitive, they must sell goods to
their customer.1 on credit which necessitates the holding of accounts receivable. It
is in these ways that an adequate level of working capital is absolutely necessary for
smooth sales activity which, in turn, enhances the owners wealth.
The operating cycle consists of three phases. In phase 1, cash gets
converted into inventory. This includes purchase of raw materials, conversion of
raw materials into work-in-progress, finished goods and finally the transfer of goods
to stock at the end of the manufacturing process. In the case of trading organizations,
this phase is shorter as there would be no manufacturing activity and cash is directly
converted into inventory. The phase is, of course, totally absent in the case of service
organizations.
In phase II of the cycle, the inventory is converted into receivables as
credit sales are made by customers. Firms which do not sell on credit obviously not
have phase II of the operating cycle.
The last phase, phase III, represents die stage when receivables are
collected. This phase completes the operating cycle. Thus, the firm has moved from
cash to inventory, to receivables and to cash again.
A firm should plan its operations in such a way that it should have
neither too much nor two little working capital. The total working capital
requirement is determined by a wide variety of factors. These factors, however,
affect different enterprises differently
2. Production cycle
3. Business cycle
4. Production policy
6
5. Credit policy
8. Profit level
9. Level of taxes
2. PRODUCTION CYCLE
Another factor which has a bearing on the quantum of working capital
is the production cycle. The term 'production or manufacturing cycle' refers to the
time involved in the manufacture of goods. It covers the time-span between the
procurement of raw materials and the completion of the manufacturing process
leading to the production of finished goods. Funds have to be necessarily tied up
during the process of manufacture, necessitating enhanced working capital. In
other words, there is some time gap before raw materials become finished goods.
3. BUSINESS CYCLE
7
be in two directions: (i) upward phase when boom conditions prevail and (ii)
downswing phase when economic activity is marked by a decline.
4. PRODUCTION POLICY
5. CREDIT POLICY
The credit policy relating to sales and purchases also affects the working
capital. The credit policy influences the requirement of working capital in two
ways: (i) through credit terms granted by the firm to its customers / buyers of
goods; (ii) credit terms available it the firm from its creditors.
The credit terms granted to customers have a bearing on the magnitude
of working capital by determining the level of book debts- The credit sales result
in higher book debts (receivables). Higher book debts mean more working capital.
On the other hand, if liberal credit terms are available from the suppliers of goods
(trade creditors), the need for working capital is less. The working capital
requirements of a business are, thus, affected by the terms of purchase and sale
and the role given to credit by a company in its dealings with creditors and
debtors.
8
would be a significant factor in determining the working capital needs of an
enterprise.
8. PROFIT LEVEL
9
the working capital pool. The net profit is a source of working capital to the
extent that it has been earned in cash. The cash profit can be found by adjusting
non-cash items such as depreciation, outstanding expenses and losses written
off, in the net profit. Even as the company's operations are in progress, cash is
used for augmenting stock, book debts and fixed assets. 8 It must, therefore,
be seen that cash generation has been used for furthering the interest of the
enterprise.
The availability of internal funds for working capital requirements is
determined not merely by the profit margin but also by the manner of
appropriating profits. The availability of such funds would depend upon the
profit appropriations for taxation, dividend, reserves and depreciations.
9. LEVEL OF TAXES
10
In some cases, shortage of working capital has been a powerful reason
for reducing or even skipping dividends in cash. There are occasions, on the other
hand, when dividend payments are continued In spite of inadequate earnings in a
particular year because of sound liquidity. Sometimes, the dilemma is resolved by
the payment of bonus shares. Dividend policy, is thus, a significant element in
determining the level of working capital in an organization.
11
13. OPERATING EFFICIENCY
12
ALTERNATIVE DEFINITION OF NET WORKING CAPITAL
Net working capital can alternatively be defined as that part of the
current assets which are financed with long term funds. Since current liabilities
represent sources of short term funds, as long as current assets exceed the current
liabilities, the excess must be financed with long –term funds.
HEDGING APPROACH
The term hedging, is often used in the sense of a risk reducing investment
strategy involving transactions of a simultaneous but opposing nature so that the
effect of one is likely to counterbalance the effect of the other. With reference to
an appropriate financing – mix, the term hedging can be said to refer to the
process of matching maturities of debt with the maturities of financial needs. This
approach to the financing decision to determine an appropriate financing mix is,
therefore, also called as Matching Approach.
According to this approach, the maturity of the source of funds should
match the nature of the assets to be financed. For the purpose of analysis, the
current assets can be broadly classified into two classes:
1. Those which are required in a certain amount for a given level
of operation and, hence, do not vary over time.
2. Those which are fluctuate over time.
13
The hedging approach suggests that long-term funds should be used to
finance the fixed protection of current assets requirements as spelt out in (1)
above, in a manner similar to the financing of fixed assets. The purely
temporary requirements, that is, the seasonal variations over and above the
permanent financing needs should be appropriately financed with short-term
funds(current liabilities). This approach, therefore, divides the requirements of
total funds into permanent and seasonal components, each being financed by a
different source.
According to the hedging, the permanent portion of funds required
should be financed with long-term funds and the seasonal portion with short-term
funds. With this approach, the approach, the short-term financing requirements
(Current assets) would be just equal to the short – term financing available
(Current liabilities).
CONSERVATIVE APPROACH
2. risk considerations.
The cost of these financing plans has a bearing on the profit ability of the
enterprise. We assume that the cost of short-term funds and long term funds is 3
per cent and 8 per cent respectively.
14
HEDGING PLAN
The cost of financing under the hedging plan can be estimated as follows.
RISK CONSIDERATIONS
The two approaches can be also be contrasted on the basis of the risk
involved.
HEDGING APPROACH
CONSERVATIVE APPROACH
With the conservative approach, in contrast, the company does not use
any of its short term borrowings. Therefore, the firm has sufficient short-term
borrowing capacity to cover unexpected financial needs and avoid technical
insolvency.
15
To summarize, the hedging approach is a high profit (low cost ) – high
risk (no net working capital) approach, to determine an appropriate financing mix.
In contrast, the conservative approach is low profit (high cost) – low risk (high
net working capital). The contrast between these approaches is inductive of the
need for trade off between profitability and risk.
It has been shown that the hedging approach is associated with high profits
as well as high risk, while the conservative approach provides low profits and low
risk. Obviously, neither approach by itself would serve the purpose of efficient
working capital management. A trade-off between these two extremes would give
an acceptable financing Strategy. The third approach trade-off between the two
approaches–strikes a balance and provides a financing plan that lies between these
two extremes.
The exact trade-off between risk and profitability will differ from case to
case depending on risk perception of the decision makers. One possible trade off
could be assumed to be equal to the average of the minimum and maximum
monthly requirements of funds during a given period of time. This level of
requirements of funds may be financed through long-run sources and for any
additional financing need, short-term funds may be used.
The changes in the level of working capital occur for the following three
basic reasons.
3. changes in technology.
16
Permanent and Temporary Working Capital
TECHNOLOGICAL CHANGES
17
COMPUTATION OF WORKING CAPITAL
The two components of working capital (WC) are current assets (CA)
and current liabilities (CL)-They have a bearing on the cash operating cycle.
In order to calculate the working capital needs, what is required is the
holding period of various types of inventories, the credit collection period and
the credit payment period. The calculation of working capital is based on
the assumption that the production / sales is carried on evenly throughout
the year and all costs accrue similarly. As the working capital requirements
are related to the cost excluding depreciation and not to the sale price, WC is
computed with reference to cash cost. The cash cost approach is
comprehensive and superior to the operating cycle.
12 months/365 days
18
Budgeted Estimated work- Average time span
production x in-process cost x of work-in-progress
(in units) per unit inventory (months/days)
12 months/365 days
Debtors
12 months/365 days
Apart from WC needs for financing inventories and debtors, firms also
find it useful to have some minimum cash balances with them. It is difficult to
lay down the exact procedure of determining such an amount. This would
primarily be based on the motives for holding cash balances
The working capital needs of business firms are lower to the extent such
needs are met through the current liabilities (other than bank credit") arising in the
ordinary course of business. The important current liabilities (CL), in this context arc,
trade-creditors, wages and overheads.
19
TRADE CREDITORS
Budgeted yearly Raw material Credit period
production x cost x allowed by creditors
(in units) per unit (months/days)
12 months/365 days
DIRECT WAGES
Budgeted yearly Direct labor Average time-lag in
production x cost per unit x payment of wages
(in units) (Months/days)
20
CASH MANAGEMENT
21
highlighted by the cash budget. A cash budget has normally three parts,
namely, cash collections, cash payments and cash balances. The major
sources of cash receipts and payments are operating and financial. The
operating sources are repetitive in nature, while the financial sources are
non-recurring.
6. Concentration banking, as a system of decentralized billing and multiple
collection points, is a useful technique to expedite the collection of
accounts receivable by reducing the mailing time. The mailing time is
saved both in respect of sending the bill to the customers as well as in the
receipt of payment.
RECEIVABLES MANAGEMENT
22
or not to extend credit to a customer and how much credit to extend.
The two broad dimensions of credit policy decision of a firm are credit
standards and credit analysis.
4. Credit standards represent the basic criterion for the extension of credit to
customers. These can be either tight/restrictive or liberal/non-restrictive.
The trade-off with reference to credit standards cover: (i) collection cost,
(ii) cost of investment in debtors, (iii) bad debts and (iv) level of sales
profit/contribution.
INVENTARY MANAGEMENT
1. Inventory refers to the stockpile of the products a firm would sell in
future in die normal course of business operations and the components
that make up the product. The firm stores three types of inventories,
namely, raw materials, work-in-process/semi-finished goods and finished
good.
2. The objectives of inventory management consists of two counterbalancing
parts: (i) to minimize investments in inventory and (ii) to meet the
demand for products by efficiently organizing the production and sales
3. The ABC system is a widely-used classification technique to identify
various items of inventory for purposes of inventory control. On the basis
of the cost involved, the various items are classified into three categories:
(i) A, consisting of items with the large investment, (ii) C, with relatively
small investments but fairly large number of items and (iii) B, which
stands mid-way between category A and C. Category A needs the most
rigorous control, C requires minimum attention and B deserves less
attention than A but more than C.
4. The order quantity problem relates to the determination of the quantity of
inventory which should be ordered. The economic order quantity
(EOQ) is that level of inventory order which minimizes the total cost
associated with inventory management. Symbolically, EOQ = 2 AB/C .
5. The re-order point is that level of inventory when a fresh order should
be placed with suppliers to procure additional inventory equal to the EOQ.
It is that inventory level which is equal to the consumption during the lead
23
time plus safety stock.
6. Safety stocks are the minimum additional inventory which serve as a
safety margin to meet an unanticipated increase in usage resulting from
an unusually high demand and/or an uncontrollable late receipt of
incoming inventory.
24
5. Paucity of working capital in the non utilization of attractive credit
opportunities by the firm.
6. The firm losses its reputation when it is not in position to honor its short-
term obligation. As a result ,the firm light credits terms.
25
7. RESEARCH AND INNOVATION PROGRAMMES
No research program me of a firm is highly successful, if it is financed
through own working capital.
8. EXPANSION FACILITATED
The expansion programmed of a firm is highly successful; if it is
financed through own working capital.
9. PROFITABILITY INCREASED
The profitability of a firm also depends, no small measure on the right
proportion of fixed assets and current assets. Every activity of the business
directly or indirectly affects the current positions of the firm hence its needs
should be properly estimated and calculated.
Thus the need for maintaining an adequate working capital can hardly be
questioned. Just as circulation of blood is very necessary in the human body to
maintain life, smooth flow of funds is very necessary to maintain the health of the
firm. The importance of working capital can be very well explained in the words
of Husband and Dockery: “The prime object of management is to make a profit.
Whether or not this accomplished in most business depends largely on the manner
in which the working capital is administered.
Internal External
Public deposits
Customers credit
Govt. Assistance
Employees security
Factoring
27
2. Share of debentures
Debentures are also important sources of long term working capital
because they are fixed cost sources. Right debentures have also been very popular
in India since 1978.
3. Plugging back of profits
A part of the earned profits may be ploughed back by the firm in meeting
their working capital requirements. It is a regular and cheapest source of working
capital as it does not involves any explicit cost of capital.
4. Sale of fixed assets
Any idle fixed assets can be sold out and sale proceeds can be utilized for
financing the working capital requirements.
5. Term Loans
The loans raised for a period varying from 3 to 5-7 years are also
important sources for working capital. This type of finance is ordinarily repayable
in installments. Such loans usually increase the working capital of the enterprise.
B. Short term sources of working capital
This category of funds covers the need of working capital for financing
day to day business requirements. Normally the duration of such requirements
does not exceed beyond a year. The sources of short term working capital may be
internal as well as external.
a) Internal sources
1) Depreciation funds
The depreciation funds constitute important source for working capital.
Some authors of business finance do not accept them as a source of funds but it is
not reasonable.
2) Provision for taxation
The provision for taxation can also be used by the companies as a source
of working capital during the intermittent period.
3) Accrued Expenses (current provisions)
The firm postpones the payment of expenses for short periods. Hence these
accrued expenses also constitute an important source of working capital.
Current provisions or accruals arise in the normal course of business
operation, such as for wages, taxation, dividends etc., and mature for payment
within a short period of a few months. For a bride while they serve as a source of
28
working capital funds. Since the accruals expand or contract in tune changes in the
level of business activity they are regarded as part of ‘spontaneous financing’. As
no interest is paid on these dues they are also considered as ’free’ sources of
financing.
b) External Sources
1. Trade credit
Once of the most important forms of short-term finance is the trade credit
extended by one business enterprise to another on the purchase and sale of goods
and equipment. The use of trade credit has increased in the recent years. The
credit may also assume three forms.
1. Purchase on open account
2. Purchasing on furnishing a promote for specified period
3. Purchase on trade acceptance (i.e. bill payable)
2. Bank Credit
Commercial banks are also principal source of working capital. They
provide working capital in a number of way such as overdraft, cash credit, line of
credit, short term loans etc..compared with other methods of borrowing this is the
most flexible source because when the debt is no longer it can be quickly and
early reduced. It is also comparatively cheap.
3. Credit Papers
In the category of credit paper, bill of exchange and promissory note of
shorter duration varying between a month and six months are used . These papers
are discounted with a bank and capital can be arranged ; Accommodation bills are
an important of such finance.
4. Public deposits
Public Deposits are also an important source of short-term and medium-
term finance. Due to shortages of bank credit in recent past, the importance of
public deposits has increased. They have been very popular among Indian
companies during last three years.
5. Customers Credit
Advance may also be obtained on contracts entered into the enterprise.
The customers, are often asked to makes some advance payment in cash in lieu of
a contract to purchase. Such advances can be utilized in purchasing raw material
paying wages and son on.
29
6. Government Assistance
Sometimes, Central and State Governments also provide short-term
finance on easy terms.
7. Security of employees
If employees are required to make deposits with their employer
companies such companies can utilize those amounts to meeting their working
capital needs.
8. Factoring
Factoring involves raising funds on the security of the company’s debts.
So that cash is received earlier than if the company waited of the debtors to pay.
Thus the factors help in improving the company’s liquidity position. But this
finance is not cheap in not cheap in comparison to bank credit etc.
9. Inter corporate Deposits
This refers to deposit made by one company with another, normally for a
period up to 6 months. Such deposits can be:
1. Call deposit, which is withdraw able by the lender on giving a day’s notice.
The lender may, in fact, have to wait for three day’s these will bear higher rates
of interest.
2. Three months deposits are more popular. When temporary cash crunch arises
due to operational problems or external factors, companies resorts to this handy
source. The interest rate will be higher than that for all call deposits.
3. Six months deposits are time span beyond which companies do not extend to
deposits other companies. These will carry even higher rate of interest than that
for three months deposits.
In the absence of legal restriction of short term corporate deposits,
these have become a convenient source of funds. These transactions are also kept
secret by brokers and do not get publicized.
30
1. CURRENT RATIO
2. QUICK RATIO
3. SUPER QUICK RATIO
4. INVENTORY TURNOVER RATIO
5. WORKING CAPITAL TURN OVER RATIO
6 .CURRENT ASSESTS TURN OVER RATIO
7. CURRENT ASSETS TO TOTAL CURRENT ASSETS
8. QUICK ASSETS TO TOTAL SALES RATIO
9. QUICK ASSETS TO TOTAL ASSETS
1. CURRENT RATIO
Current ratio is the ratio of current assets and current liabilities current
assets are the assets which can be converted into cash with in one year and
include cash in hand and at the bank, bills receivables, Sundry debtors, stock,
prepaid expenses, outstanding and occurred income And short term
investments current liabilities are to be repaid with one year and include bills
payable, sundry creditors, bank over draft, outstanding expenses, income
received in advances, purposed and dividends provisions for taxation,
unclaimed dividends and short term loans and advances.
Current ratio = Current assets / current liabilities
A current ratio of 2:1 is considered ideal if current ratio is less than 2, it
includes that the business does not enjoy adequate liquidity how ever a high
ratio of more than 3 indicated that the firm is having ideal funds and has not
invested them properly.
2. QUICK RATIO
Quick ratio is the ratio of quick assets to liabilities, quick assets are
assets, which can be easily convertible into cash very quickly without much
loss, and quick liabilities have to be necessarily paid with in one year. Cash
and bank, bills receivables, sundry debtors, short term investment, are quick
assets.
Quick ratio = quick assets / current liabilities.
A quick ratio of 1:1 is considered as ideal. A ratio of less than is an
indication of inadequate liquidity of the business. A very high ratio is also not
advisable. As funds can be more profitable employed.
31
3. SUPER QUICK RATIO
Although receivables, debtors and bills receivables are generally
More liquidity than inventories. Yet there may be doubts regarding their
realization into cash immediately or in time. Hence some authorities are of the
opinion that the absolute liquid ratio should also be calculated together with
current ratio and acid test so as to exclude even receivables from the current
assets and find out absolute liquid assets.
Super Quick ratio = (Cash+ investment) / current liabilities
Absolute liquid assets include cash in hand and at bank and investments
or temporary investments. The acceptable norm for this ratio is 0.51% or 1:2
i.e., debt rate 1 worth super quick assets or considered adequate to pay 2 with
current liabilities in time has all the creditors or not expected to demand cash
at the same time and then cash may also be realized firm debtors and
inventories.
4. INVENTORY TURN OVER RATIO
Every firm has to maintain a certain level of finished goods as to be
able to meet the requirement of the business, but the level should not be too
high or too low. As a high level indicates block of capital more go down spare.
slow recovery of cash etc. the purpose this ratio is to see whether only the
required minimum funds have been lackeyed in the inventory. A low indicates
efficient management of inventory because more frequently the stocks or sold
a higher ratio indicates in efficient management of inventory dull business
stock accumulation.
Inventory turnover ratio =sales/ inventory.
5. WORKING CAPITAL TURN OVER RATIO
The working capital turn over indicates the velocity of utilization of net
Working capital or the efficiency with which the working capital is being used a
low ratio indicates efficient utilization of working capital and high ratio indicates
otherwise.
Working capital ratio = sales/ working capital.
32
6. CURRENT ASSETS TURN OVER RATIO
The current assets turn over ratio indicates the velocity of utilization of
total current assets with the sales of the current years.
Current assets turn over ratio = Sales / Current assets.
7. CURRENT ASSETS TO TOTAL CURRENT ASSETS
The current assets to total current assets indicates the utilization of total
assets with the current assets of the current years.
Current assets to total current assets = Current assets / Total assets.
8. QUICK ASSETS TO TOTAL SALES
The quick assets to total sales indicates the utilization of total sales
with the quick assets of the current years.
Quick assets to total sales = Quick assets / Total sales.
9. QUICK ASSETS TO TOTAL ASSETS
The quick assets to total sales indicates the utilization of total assets
with the quick assets of the current years.
Quick assets to total sales = Quick assets / Total assets.
33