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INTRODUCTIONWorking Capital is the key difference between the long term financial management and short term financial management in terms of the timing of cash. Long term finance involves the cash flow over the extended period of time i.e. 5 to 15 years, while short term financial decisions involve cash flow within a year or within operating cycle. Working capital management is a short term financial management. Working capital management is concerned with the problems that arise in attempting to manage the current assets, the current liabilities & the inter relationship that exists between them. The current assets refer to those assets which can be easily converted into cash in ordinary course of business, without disrupting the operations of the firm.
DEFINITIONS OF WORKING CAPITALThe following are the most important definitions of Working capital: -
1) Working capital is the difference between the inflow and outflow of funds.In other
words it is the net cash inflow.
2)
Working capital represents the total of all current assets. In other words it is the Gross working capital, it is also known as Circulating capital or Current capital for current assets are rotating in their nature.
3)
Working capital is defined as the excess of current assets over current liabilities and provisions. In other words it is the Net Current Assets or Net Working Capital.
Composition of working capital Major Current Assets1) 2) 3) 4) Cash Accounts Receivables Inventory
Marketable Securities
Major Current Liabilities1) Bank Overdraft 2) Outstanding Expenses 3) Accounts Payable 4) Bills Payable
2. In personal finance, current assets are all assets that a person can readily convert to cash to pay outstanding debts and cover liabilities without having to sell fixed assets. In the United Kingdom, current assets are also known as "current account
Current Assets
1. Current assets are important to businesses because they are the assets that are used to fund day-to-day operations and pay ongoing expenses. Depending on the nature of the business, current assets can range from barrels of crude oil, to baked goods, to foreign currency.
2. In personal finance, current assets include cash on hand and in the bank, and marketable securities that are not tied up in long-term investments. In other words, current assets are anything of value that is highly liquid.
Current Liabilities
Essentially, these are bills that are due to creditors and suppliers within a short period of time. Normally, companies withdraw or cash current assets in order to pay their current liabilities. Analysts and creditors will often use the current ratio, (which divides current assets by liabilities), or the quick ratio, (which divides current assets minus inventories by current liabilities), to determine whether a company has the ability to pay off its current liabilities.
The Goal of Capital Management is to manage the firm s current assets &liabilities, so that the satisfactory level of working capital is maintained. If the firm cannot maintain the satisfactory level of working capital, it is likely to become insolvent &may be forced into bankruptcy. To maintain the margin of safety current asset should belarge enough to cover its current assets. Main theme of the theory of working capital management is interaction between the current assets & current liabilities.
CONCEPT OF WORKING CAPITALThere are 2 concepts:1) Gross Working Capital 2) Net Working Capital
1) Gross working capitalIt is referred as total current assets. Focuses on, Optimum investment in current assets Excessive investments impair firm s profitability, as idle investment earns nothing. Inadequate working capital can threaten solvency of the firm because of its inability to meet its current obligations. Therefore there should be adequate investment in current assets. Financing of current assets whenever the need for working capital funds arises, agreement should be made quickly. If surplus funds are available they should be invested in short term securities.
Difference between current assets and current liabilities Net working capital is that portion of current assets which is financed with long term funds.
If the working capital is efficiently managed then liquidity and profitability both will improve. They are not components of working capital but outcome of working capital. Working capital is basically related with the question of profitability versus liquidity & related aspects of risk.
Implications of Net Working Capital:Net working capital is necessary because the cash outflows and inflows do not coincide. In general the cash outflows resulting from payments of current liability are relatively predictable. The cash inflows are however difficult to predict. More predictable the cash inflows are the less NWC will be required. But where the cash inflows are uncertain, it will be necessary to maintain current assets at level adequate to cover current liabilities that are there must be NWC.For evaluating NWC position, an important consideration is trade off between probability and risk. The term profitability is measured by profits after expenses. The term risk is defined as the profitability that a firm will become technically insolvent so that it will not be able to meet its obligations when they become due for payment. The risk of becoming technically insolvent is measured by NWC. If the firm wants to increase profitability, the risk will definitely increase. If firm wants to reduce the risk, the profitability will decrease.
OPERATING CYCLE OR CIRCULATING CASH FORMAT:Working Capital refers to that part of firms capital which is required for financing short term or current assets such as cash, marketable securities, debtors and inventories. Funds thus invested in current assets keep revolving fast and being constantly converted into cash and these cash flows out again in exchange for other current assets. Hence it is also known as revolving or circulating capital. The circular flow concept of working capital is based upon this operating or working capital cycle of a firm. The cycle starts with the purchase of raw material and other resources and ends with the realization of cash from the sales of finished goods. It involves purchase of raw material and stores, its conversion into stocks of finished goods through work in progress with progressive increment of labor and service cost, conversion of finished stocks in to sales, debtors and receivables and ultimately realization of cash and this cycle continuous again from cash to purchase of raw materials and so on. The speed/ time of duration required to complete one cycle determines the requirements of working capital longer the period of cycle, larger is the requirement of working capital.
On the basis of conceptWorking capital is classified as gross working capital and net working capital. The classification is important from the point of view of the financial manager.
y y
2. TEMPRORAY 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. Variables working capital can be further classified as second working capital and special working capital.
The capital required to meet the seasonal needs of the enterprises is called the seasonal working capital. 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.
Working capital is the life blood and nerve centre of a business. Just a circulation of a blood is essential in the human body for maintaining life, working capital is very essential to
maintain the smooth running of a business. No business can run successfully without an adequate amount of working capital. The main advantages of maintaining adequate amount of working capital are as follows:
y y y y y y y y y y
Solvency of the Business Goodwill Easy Loans Cash discounts Regular supply of Raw Materials Regular payments of salaries, wages & other day to day commitments. Exploitation of favourable market conditions Ability of crisis Quick and regular return on investments High morals
y y y
For the purchase of raw materials , components and spaces To pay wages and salaries To incur day to day expenses and overhead costs such as fuel, power andoffice expenses etc.
y y
To meet the selling costs as packing, advertising etc. To provide credit facilities to the customers.
FACTORS DETERMING THE WORKING CAPITAL REQUIRMENT: The working capital requirements of a concern depend upon a large number of factors such as nature and size of the business, the characteristics of their operations, the length of production cycle, the rate of stock turnover and the state of economic situation .However the following are the important factors generally influencing the working capital requirements.
OPERATIONS:
The requirement of working capital fluctuates for seasonal business. The working capital needs of such business may increase considerably during the busy season and decrease during the
MARKET CONDITION:
If there is a high competition in the chosen project category then one shall need to offer sops like credit, immediate delivery of goods etc for which the working capital requirement will be high. Otherwise if there is no competition or less competition in the market then the working capital requirements will be low.
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. LENTH OF PRDUCTION 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.
5. SEASONALS VARIATIONS : Generally, during the busy season, a firm requires larger
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.
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
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
The analysis of working capital can be conducted through a number of devices, such as :
1.
Ratio analysis.
2.
3.
Budgeting.
1. RATIO ANALYSIS
A ratio is a simple arithmetical expression one number to another. The technique of ratio analysis can be employed for measuring short-term liquidity or working capital position of a firm. The following ratios can be calculated for these purposes:
5. Receivables turnover. 6. Payable turnover ratio. 7. Working capital turnover ratio. 8. Working capital leverage 9. Ratio of current liabilities to tangible net worth.
Fund flow analysis is a technical device fund designated to the study the source from which additional funds were derived and the use to which these sources were put. The flow analysis consists of:
a.
b.
It is an effective management tool to study the changes in financial position (working capital) business enterprise between beginning and ending of the financial dates.
A budget is a financial and / or quantitative expression of business plans and polices to be pursued in the future period time. Working capital budget as a part of the total budge ting process of a business is prepared estimating future long term and short term working capital needs and sources to finance them, and then comparing the budgeted figures with actual performance for calculating the variances, if any, so that corrective actions may be taken in future. He objective working capital budget is to ensure availability of funds as and needed, and to ensure effective utilization of these resources. The successful implementation of working capital budget involves the preparing of separate budget for each element of working capital, such as, cash, inventories and receivables etc.
To calculate days working capital, the following formula can be used: Average Working capital*365/annual sales revenue Days working capital can be used in ratio and fundamental analysis. When utilizing any ratio, it is important to consider how this company has evolved over time and how it compares to similar companies in the same industry. By comparing this ratio in a historical and relative basis, you will get a better understanding of how efficient a given company actually is.
These businesses tend to involve retail, consumer goods and technology hardware, especially if they are low-cost producers or distributors. Working capital is the difference between current assets and current liabilities:
1) Receivables Management
Receivables or debtors are the one of the most important parts of the current assets which is created if the company sells the finished goods to the customer but not receive the cash for the same immediately. Trade credit arises when firm sells its products and services on credit and dose not receive cash immediately. It is essential marketing tool, acting as bridge for the movement of goods through production and distribution stages to customers. Trade credit creates receivables or book debts which the firm is expected to collect in the near future. The receivables include three characteristics 1) It involve element of risk which should be carefully analysis. 2) It is based on economic value. To the buyer, the economic value in goods or services passes immediately at the time of sale, while seller expects an equivalent value to be received later on.
3) It implies futurity. The cash payment for goods or serves received by the buyer will be made by him in a future period.
debtors since a short collection period implies the prompt payment by debt ors. The average collection period should be compared against the firms credit terms and policy judges its credit and collection efficiency. The collection period ratio thus helps an analyst in two respects: 1. In determining the collectability of debtors and thus, the efficiency of collection efforts. 2. In ascertaining the firm s comparative strength and advantages related to its credit policy and performance.
The debtors turnover ratio can be transformed in to the number of days of holding of debtors.
Observations
The size of receivables are staidly increasing it indicates that the company was allowing more credit year to year, but it was not bad signal because as receivables were supporting to the increase in the sales. Average collection period are reducing to
present situation, but as compare with the normal collection period allowed to customer is 90 days, it was clear that the company required to increase our efficiency of collection of receivables. All the above factors directly or indirectly affects in the debtors turnover ratio, current ratio and working capital ratio. For effective management of credit, the firm should lay down clear cut guidelines and procedure for granting credit to individual customers and collecting individual accounts should involve following steps: (1) Credit information (2) Credit investigation (3) Credit limits (4) Collection procedure.
2) Inventory Management
The term inventory is used to designate the aggregate of those items of tangible assets which are 1. Finished goods ( saleable ) 2. Work-in-progress ( convertible ) 3. Material and supplies ( consumable ) In financial view, inventory defined as the sum of the value of raw material and supplies, including spares, semi processed material or work in progress and finished goods. The nature of inventory is largely depending upon the type of operation carried on. For instance, in the case of a manufacturing concern, the inventory will generally comprise all three groups mentioned above while in the case of a trading concern, it will simply be by stock- in- trade or finished goods.
objective of turning inventory as quickly as possible, it should at the same time ensure sufficient inventories to satisfy production and sales demand. The objectives of inventory management consist of two counterbalancing parts: 1. To minimize the firms investment in inventory 2. To meet a demand for the product by efficiently organizing the firms production and sales operation. This two conflicting objective of inventory management can also be expressed in term of cost and benefits associated with inventory. That the firm should minimize the investment in inventory implies that maintaining an inventory cost, such that smaller the inventory, the better the view point .obviously, the financial manager should aim at a level of inventory which will reconcile these conflicting elements. Some objective as follow
1. To have stock available as and when they are required. 2. To utilize available storage space but prevents stock levels from exceeding space available. 3. To maintain adequate accountability of inventories assets. 4. To provide, on item by- item basis, for re-order point and order such quantity as would ensure that the aggregate result confirm with the constraint and objective of inventory control. To keep low investment in inventories carrying cost an obsolesce losses to the minimum.
Inventory components
The manufacturing firm s inventory consist following components I) Raw material ii) Work- in-progress iii) Finished goods To analyze the level of raw material inventory and work in progress inventory held by the firm on an average it is necessary to examine the efficiency with which the firm converts raw material inventory and work in progress into finished goods.
3) Management of Cash
Cash is common purchasing power or medium of exchange. As such, it forms the most important component of working capital. The term cash with reference to cash management is used in two senses, in narrow sense it is used broadly to cover cash and generally accepted equivalent of cash such as cheques, draft and demand deposits in banks. The broader view of cash also induce hear- cash assets, such as marketable sense as marketable securities and time deposits in banks. The main characteristics of this deposits that they can be really sold and convert in to cash in short term. They also provide short term investment outlet for excess and are also useful for meeting planned outflow of funds. We employ the term cash management in the broader sense. Irrespective of the form in which it is held, a distinguishing feature of cash as assets is that it was no earing power. Company have to always maintain the cash balance to fulfill the dally requirement of expenses. There are four primary motive for maintain the cash a follow Motive of holding cash there are four motives for holding cash as follow 1. Transaction motive 2. Precautionary motive 3. Speculative motive 4. Compensating motive
Transaction motive
Cash balance is necessary to meet day-to-day transaction for carrying on with the operation of firms. Ordinarily, these transactions include payment for material, wages, expenses, dividends, taxation etc. there is a regular inflow of cash from operating sources, thus in case of JISL there will be two-way flow of cash- receipts and payments. But since they do not perfectly synchronize, a minimum cash balance is necessary to uphold the operations for the firm if cash payments exceed receipts. a major part of transaction balances is held in cash, a part may be held in the form of marketable securities whose maturity conforms to the timing of anticipated payments of certain items, such as taxation, dividend etc.
Precautionary Motive
Cash flows are somewhat unpredictable, with the degree of predictability varying among firms and industries. Unexpected cash needs at short notice may also be the result of following: 1. Uncontrollable circumstances such as strike and natural calamities. 2. Unexpected delay in collection of trade dues. 3. Cancellation of some order for goods due unsatisfactory quality. 4. Increase in cost of raw material, rise in wages, etc.
The higher the predictability of firm s cash flows, the lower will be the necessity of holding this balance and vice versa. The need for holding the precautionary cash balance is also influence d by the firm s capacity to have short term borrowed funds and also to convert short term marketable securities into cash.
Speculative motive
Speculative cash balances may be defined as cash balances that are held to enable the firm to take advantages of any bargain purchases that might arise. While the precautionary marketable securities portfolios than on actual cash holdings for speculative purposes.
Efficiency ratio
The ratios compounded under this group indicate the efficiency of the organization to use the various kinds of assets b y converting them the form of sale. This ratio also called as activity ratio or assets management ratio. As the
assets basically cate gorized as fixed assets and current assets and the current assets further classified according to in dividual components of current assets viz. investment and receivables or debtors or as net current assets, the important of efficiency ratio as follow: 1. Working capital turnover ratio 2. Inventory turnover ratio 3. Receivable turnover ratio
Liquidity ratio
The ratios compounded under this group indicate the short term position of the organization and also indicate the efficiency with which the working capital is being used. The most important ratio under this group is follows 1. Current ratio 2. Quick ratio
1) Efficiency Ratio
Year
Sales
Working Capital
WCTR
2.44
1.5
0.5
0
FY2005-06 FY2006-07 FY2007-08
Inference:
The Working Capital Turnover Ratio was 3.08 in 2005-2006 and decreased to 2.44.The decreasing trend was due to slow paying debtors. The working capital turnover ratio suggests that the working capital is being efficiently utilized.
Debt rs T r
2.7
ver Rati
2.65
2.65 2.6
2.55
2.53
2.5 2.45
2.4
2.41
2.35
2.3
Inferences:
Debtor's turnover ratio throws light on the credit and collection policies of the business and thus related to liquidity. This table shows that the Debtors turnover ratio is 2.41 in 2005-2006 and in 2006-07 there is a increase in the ratio as 2.53. In the year 2007-08there is a futher increase in the ratio as 2.65. The Debtors turnover ratio shows that the firm is not utilizing its resources effectively. Debtors turnover ratio of 2.65 for 2008 is not satisfactory for a manufacturing company. The low Debtor's turnover ratio for indicates that the company is having a significant portion of slow paying Debtors.
No. of Months 12 12 12
Inferences:
From the above we can understand that, in 2005-2006 the ratio was 4.9 and by the year 2007-2008 it was 4.5. For a company like AFCIL industries, the average collection period should be between 1.5-2 months. The average collection period of 4.5 months for 2008 indicates that the collection policy of the company is not satisfactory.
Year
Credit Purchase
CTR
Inferences:
Creditors turnover ratio indicates the velocity with which the creditors are turned over in relation to purchases. Higher the creditors velocity better it is or lower the creditors velocity , less favorable the results are. This table shows that the Creditors turnover ratio is 2.42 in 2005-2006 and in 2006-07 there is a decrease in the ratio as 2.24 and a further increases in 2007-08 to 2.39.
Average Payment Period = No. of wor king days / Creditors Turnover Ratio
No.of Months 12 12 12
Inferences:
The average payment period ratio represents the average number of days taken by the firm to pay its creditors. Generally lower the ratio, the better is the liquidity position and higher the ratio, less liquid is the position of the firm. In 2005-06 the average payment period was 4.95 which increased to 5.02 in 2007-08 showing a constant change. The average payment period of the company is around five months which is satisfactory.
2) Liquidity Ratio
CURRENT RATIO
Current ratio may be defined as the relationship between current assets and current liabilities. This ratio is also known as working capital ratio, is a measure of general liquidity and is most widely used to make the analysis of the short-term position or liquidity of a firm. It is calculated by dividing the total of current assets by total of the current liabilities.
CURRENT RATIO
Current Ratio
3
2.5
2.41
2
1.52 1.5
1.7
Current Ratio
1
0.5
0
FY2005-06 FY2006-07 FY2007-08
Inferences:
The Current ratio represents a margin of safety for creditors. The higher the ratio, the greater the margin of safety; the larger the amount of current assets in relation to current liabilities, the more the firms ability to meet its current obligations. The ratio is1.52 in the year 2005 2006 and 1.70 in the year 2006-2007 and it increased to 2.19 in the year 2007-2008. The main reason for increase of ratio was increase in the current assets.
Ideal Ratio is 2:1. Current ratio exceeding 1.5 is satisfactory for the business. Since the current ratio is higher than the normal benchmark, the short-term solvency of the firm is satisfactory.
QUICK RATIO
Quick Ratio, also known as acid test or Liquid Ratio is more rigorous test of liquidity than the 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 within a short period without loss of value. In that sense, cash in hand and cash at bank are most liquid assets. The other assets, which can be included in the liquid assets and sundry debtors, marketable securities and short-term or temporary investments. Inventories cannot be termed to be liquid asset because they cannot be converted into cash immediately without a sufficient
loss of value. In the same manner, prepaid expense is also excluded from the list of quick/liquid assets because they are not expected to be converted into cash
Quick Ratio = Quick Assets/Quick Liabilities Quick Assets = Current Assets (Inventories + Prepaid expenses)
QUICK RATIO
Quick Ratio
2.5
1.95 1.8
1.49 1.5
Quick Ratio 1
0.5
0
FY2005-06 FY2006 -07 FY2007-08
Inferences:
As the quick ratio is higher than the normal benchmark of 1:1, the liquidity of the firm is good. In 2005 2006 the ratio was 1.95,in 2006-2007 it was 1.802 which then reduced to 1.498 in 2007-2008 showing that the ratios are within the acceptable limits. As the Current ratio and Quick ratio are within the acceptable limits, company's liquidity position and short term solvency is satisfactory.