9/22/2014

Prof. S B Mishra KIIT School of

Management,Bhubaneswar
1
Working Capital Management

LEARNING OBJECTIVES
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Prof. S B Mishra KIIT School of
Management,Bhubaneswar
2
Basic Concepts of Working Capital Management.
Significance of WCM to the organization and
different divisions.
Factors Affecting working capital requirements
Estimating Working Capital using Operating Cycle
Concepts.
Receivables Management.
What do we mean by working
capital ?
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Prof. S B Mishra KIIT School of
Management,Bhubaneswar
3
Typical Balance Sheet
Assets Financing
Fixed assets

Equity

Current assets
Debt
(financial loans)

Current liabilities

Typical Balance Sheet
Assets Financing
Fixed assets

Equity

Current assets= Gross
Working Capital
Debt
(financial loans)

Current liabilities

Figure 8.5b Net working capital
Assets Financing
Fixed assets

Equity

Net working capital
Debt
Current assets
Current liabilities

Working Capital Concepts
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Prof. S B Mishra KIIT School of
Management,Bhubaneswar
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Net Working Capital
Current Assets - Current Liabilities.
Gross Working Capital
The firms investment in current assets.
Working Capital Management
The administration of the firms current assets and the financing
needed to support current assets.
CURRENT ASSETS
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Prof. S B Mishra KIIT School of
Management,Bhubaneswar
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Inventories: Raw Materials , Semi Finished
Goods, Finished Goods.
Sundry Debtors/ Accounts Receivable
Cash and Bank Balance
Short Term Investments.
Loans and Receivable including Bills
Receivable.
Prepaid Expenses
Accrued Incomes
Characteristics of Current Assets
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Prof. S B Mishra KIIT School of
Management,Bhubaneswar
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Short Life Span
Swift Transformation into other Asset forms.
Easily convertible into cash.
Nature of repetitive and frequent
Substantial portion of total investment
Depends upon the changes in level of business
activities
Indicator of nature of financial planning.
Reveals the credit worthiness of the firm
Total current assets in nothing but gross working
capital.

Concepts- CURRENT LIABILITIES
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Prof. S B Mishra KIIT School of
Management,Bhubaneswar
10

Sundry Creditors:
Provisions
Short Term Bank Loans.
Bank Overdrafts
Outstanding Expenses.
Another way to look at it
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Prof. S B Mishra KIIT School of
Management,Bhubaneswar
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Permanent Working
Capital
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Prof. S B Mishra KIIT School of
Management,Bhubaneswar
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The amount of current assets required to
meet a firms long-term minimum needs.
Permanent current assets
TIME
A
M
O
U
N
T

Temporary Working
Capital
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Prof. S B Mishra KIIT School of
Management,Bhubaneswar
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The amount of current assets that varies with
seasonal requirements.
Permanent current assets
TIME
A
M
O
U
N
T

Temporary current assets
TYPES OF WORKING CAPITAL

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Prof. S B Mishra KIIT School of
Management,Bhubaneswar
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WORKING CAPITAL
BASIS OF
CONCEPT
BASIS OF
TIME
Gross
Working
Capital
Net
Working
Capital
Permanent
/ Fixed
WC
Temporary
/ Variable
WC
Regular
WC
Reserve
WC
Special
WC
Seasonal
WC
Now we know
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Prof. S B Mishra KIIT School of
Management,Bhubaneswar
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Gross Working Capital
Net Working capital
Permanent Working capital
Temporary Working capital
Current Assets types and their features
Current Liabilities or Sources of Short Term
Finance
What do we mean by managing
working capital ?
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Prof. S B Mishra KIIT School of
Management,Bhubaneswar
16
WCM includes
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Prof. S B Mishra KIIT School of
Management,Bhubaneswar
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Decision about the level of investments in each of
the current assets.
Arranging funds from short term and long term
sources for the investments in current assets.
In other words.WCM includes
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Prof. S B Mishra KIIT School of
Management,Bhubaneswar
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Cash Management.
Receivables Management.
Inventory Mangement.
Management of Accounts Payables
Managing other internal but short term sources of
finance.
Managing Bank financing of WC.
Why WCM is important ?
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Prof. S B Mishra KIIT School of
Management,Bhubaneswar
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Prof. S B Mishra KIIT School of
Management,Bhubaneswar
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1. Investment in CA represents a substantial
portion of total investment.
2. Investment in CA and level of CL have to be
geared quickly to changes in sales.
Significance of WCM
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Prof. S B Mishra KIIT School of
Management,Bhubaneswar
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In a typical manufacturing firm, current assets
exceed one-half of total assets.
Excessive levels can result in a substandard
Return on Investment (ROI).
Current liabilities are the principal source of
external financing for small firms.
Requires continuous, day-to-day managerial
supervision.
Working capital management affects the
companys risk, return, and share price.
Dimensions of WCM
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Prof. S B Mishra KIIT School of
Management,Bhubaneswar
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3D Nature of Working Capital Management
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Prof. S B Mishra KIIT School of
Management,Bhubaneswar
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Dimension I
Profitability,
Risk, & Liquidity
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Prof. S B Mishra KIIT School of
Management,Bhubaneswar
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Working Capital: trade-offs
Inventory of raw materials
Quantity discounts (lower unit cost)
Risk of inventory shortage (production stop)
Inventory of finished goods
Risk of inventory shortage (loss of revenue)
Delivery flexibility through high and easily accessible inventory
level (larger market share)
Receivables
Credit period as competitive sales argument
Trade payables
Credit versus lower unit price or higher product quality

CHALLENGES in WCM
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Prof. S B Mishra KIIT School of
Management,Bhubaneswar
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WCM encompasses all departments including
finance. Cash Management, Management of
Receivables and Inventory Management etc. are the
responsibilities of finance executives and
departmental executives. This division of
responsibilities makes a coordinated approach to
WCM both necessary and difficult- particularly
when managers from different departments are
pursuing different goals.
The two main aims to be satisfied by the WC Manger
are profitability and liquidity. However the two goals of
profitability and liquidity frequently conflict with
each other .
Three alternative working capital investment
policies
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Prof. S B Mishra KIIT School of
Management,Bhubaneswar
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Sales ($)
C
u
r
r
e
n
t

A
s
s
e
t
s

(
$
)

Policy C
Policy A
Policy B
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Prof. S B Mishra KIIT School of
Management,Bhubaneswar
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Policy C represents conservative approach
Policy A represents aggressive approach
Policy B represents a moderate approach

Optimal level of working capital investment

Risk of long-term versus short-term debt
Working capital requirements is
based on what factors?
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Prof. S B Mishra KIIT School of
Management,Bhubaneswar
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Prof. S B Mishra KIIT School of
Management,Bhubaneswar
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FACTORS DETERMINING WORKING CAPITAL

1. Nature of the Industry
2. Demand of Industry
3. Cash requirements
4. Nature of the Business
5. Manufacturing time
6. Volume of Sales
7. Terms of Purchase and Sales
8. Inventory Turnover
9. Business Turnover
10. Business Cycle
11. Current Assets requirements
12. Production Cycle

contd
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Prof. S B Mishra KIIT School of
Management,Bhubaneswar
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Working Capital Determinants (Contd)

13. Credit control
14. Inflation or Price level changes
15. Profit planning and control
16. Repayment ability
17. Cash reserves
18. Operation efficiency
19. Change in Technology
20. Firms finance and dividend policy
21. Attitude towards Risk
HOW DO WE DETERMINE
WORKING CAPITAL NEEDS
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Prof. S B Mishra KIIT School of
Management,Bhubaneswar
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Different approaches in
determination of working
capital
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Prof. S B Mishra KIIT School of
Management,Bhubaneswar
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Industry norm approach
Economic modeling approach
Strategic choice approach
How to use OPERATING CYCLE
Approach to Estimate WC
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Prof. S B Mishra KIIT School of
Management,Bhubaneswar
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THE WORKING CAPITAL
CYCLE
(OPERATING CYCLE)
Accounts Payable
Cash
Raw
Materials
W I P
Finished
Goods
Value Addition
Accounts
Receivable
SALES
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Prof. S B Mishra KIIT School of
Management,Bhubaneswar
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OPERATING CYCLE AND CASH CYCLE

Order placed Stock arrives Goods sold Cash received

Inventory period Accounts
receivable period

Accounts
payable period

Firm receives Cash paid for
invoice materials

Operating cycle

Cash cycle
Average inventory
Inventory period =
Average COGS / 365
Average accounts receivable
Accounts receivable period =
Annual sales / 365
Average accounts payable
Average payable period =
Average COGS / 365
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Prof. S B Mishra KIIT School of
Management,Bhubaneswar
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OC contd
OC includes the duration of time required to
complete the following sequence of events , in
case of a manufacturing firm , is called the
operating cycle.
Conversion of Cash into Raw Materials.
Conversion of Raw Materials into Work in
Progress.
Conversion of WIP into Finished Goods.
Conversion of Finished Goods into Accounts
Receivables.
Conversion of Accounts Receivables into Cash .
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Prof. S B Mishra KIIT School of
Management,Bhubaneswar
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Concepts- Dynamic View
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Prof. S B Mishra KIIT School of
Management,Bhubaneswar
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Working Capital Investment =
Investment in Raw Material
+
Investment in Work In Process
+
Investment in Finished Goods
+
Investment in Accounts Receivable
+
Investment in Minimum Cash Balance
-
Accounts Payables
Raw Material
Consumption
Period

=
Average Raw Material
Inventory
(Annual RawMaterial
Consumption ) /360
=
Average WIP
Inventory
(Cost of Production)/360
Work in Process
Conversion Period

FORMULA
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Prof. S B Mishra KIIT School of
Management,Bhubaneswar
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Finished Goods
Conversion Period

=
Average Finished Goods
Inventory
(Cost of Goods
sold) /360
=
Average Sundry
Debtors
(Credit Sales)/360
Debtors Conversion
Period

FORMULA
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Prof. S B Mishra KIIT School of
Management,Bhubaneswar
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Creditors Payment
Period
=
Average Creditors
(Credit
Purchases) /360
FORMULA
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Prof. S B Mishra KIIT School of
Management,Bhubaneswar
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FORMULA contd..
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Prof. S B Mishra KIIT School of
Management,Bhubaneswar
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Annual Consumption of Raw Material=
Opening stock of Raw Material +
Purchases Closing stock of
Raw materials
Annual Cost of Production =
Opening stock of WIP + Annual
Consumption of Raw material +
Production Cost + Depreciation
Closing WIP

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Prof. S B Mishra KIIT School of
Management,Bhubaneswar
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Cost of Sales= Opening inventory of Finished
Goods+ Annual Cost of Production +Sales and
Distrn Cost + Excise Duty -Closing stock of
Finished Goods
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Prof. S B Mishra KIIT School of
Management,Bhubaneswar
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COST OF PRODUCTION. (COP)
Add Opening Finished Goods Inventory
Add Selling and Distribution Overheads
Less Closing Finished Goods Inventory

PROFORMA - WORKING CAPTIAL ESTIMATES

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Prof. S B Mishra KIIT School of
Management,Bhubaneswar
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1. TRADING CONCERN

STATEMENT OF WORKING CAPITAL REQUIREMENTS
Amount (Rs.)
Current Assets
(i) Cash ----
(ii) Receivables ( For..Months Sales)---- ----
(iii) Stocks ( ForMonths Sales)----- ----
(iv)Advance Payments if any ----
Less : Current Liabilities
(i) Creditors (For.. Months Purchases)- ----
(ii) Lag in payment of expenses -----_
WORKING CAPITAL ( CA CL ) xxx
Add : Provision / Margin for Contingencies -----


NET WORKING CAPITAL REQUIRED XXX
1. MANUFACTURING CONCERN

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Prof. S B Mishra KIIT School of
Management,Bhubaneswar
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STATEMENT OF WORKING CAPITAL REQUIREMENTS
Amount (Rs.)
Current Assets
(i) Stock of R M( for .months consumption) -----
(ii)Work-in-progress (formonths)
(a) Raw Materials -----
(b) Direct Labour -----
(c) Overheads -----
(iii) Stock of Finished Goods ( for months sales)
(a) Raw Materials -----
(b) Direct Labour -----
(c) Overheads -----
(iv) Sundry Debtors ( for months sales)
(a) Raw Materials -----
(b) Direct Labour -----
(c) Overheads -----
(v) Payments in Advance (if any) -----
(iv) Balance of Cash for daily expenses -----
(vii)Any other item -----

Less : Current Liabilities
(i) Creditors (For.. Months Purchases) -----
(ii) Lag in payment of expenses -----
(iii) Any other -----
WORKING CAPITAL ( CA CL )xxxx
Add : Provision / Margin for Contingencies -----

NET WORKING CAPITAL REQUIRED XXX
SESSION 2
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Prof. S B Mishra KIIT School of
Management,Bhubaneswar
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HOW TO MANAGE RECEIVABLES
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Prof. S B Mishra KIIT School of
Management,Bhubaneswar
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Receivables ( Sundry Debtors ) result from
CREDIT SALES.
A concern is required to allow credit in order to
expand its sales volume.
Receivables contribute a significant portion of
current assets.
But for investment in receivables the firm has to
incur certain costs (opportunity cost and time value
)
Further, there is a risk of BAD DEBTS also.
It is, therefore very necessary to have a proper
control and management of receivables.


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Prof. S B Mishra KIIT School of
Management,Bhubaneswar
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MANAGEMENT OF RECEVABLES
OBJECTIVES

The objective of Receivables Management is to
take sound decision as regards to investment
in Debtors. In the words of BOLTON S E., the
objective of receivables management is

to promote sales and profits until that point
is reached where the return on investment in
further funding of receivables is less than the
cost of funds raised to finance that additional
credit
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Prof. S B Mishra KIIT School of
Management,Bhubaneswar
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DIMENSIONS OF RECEIVABLES MANAGEMENT

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Prof. S B Mishra KIIT School of
Management,Bhubaneswar
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OPTIMUM LEVEL OF INVESTMENT IN TRADE RECEIVABLES


Profitability



Costs &
Profitability Optimum Level



Liquidity

Stringent Liberal

TERMS OF PAYMENT
Cash Terms
Open Account
Consignment
Bill of Exchange
Letter of Credit
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Prof. S B Mishra KIIT School of
Management,Bhubaneswar
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CREDIT POLICY VARIABLES
The important dimensions of a firms credit policy
are:
Credit standards
Credit period
Cash discount
Collection effort
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Prof. S B Mishra KIIT School of
Management,Bhubaneswar
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Cost Benefit Analysis of change
in credit policy variables
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Prof. S B Mishra KIIT School of
Management,Bhubaneswar
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Cost and Benefits associated with
changes in Credit Policy
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Prof. S B Mishra KIIT School of
Management,Bhubaneswar
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COSTS
Increase in interest
payment on
additional investment
in receivables.
Increase in Discount
Cost
Increase in Bad Debt
Loss
BENEFITS
Increase in Sales
Decrease in interest
payment on LESS
investment in
receivables.
Rule of Acceptance
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Prof. S B Mishra KIIT School of
Management,Bhubaneswar
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We accept a change in credit policy variable if
Benefits are more over cost.

In other words we accept if RESIDUAL INCOME (
Benefits Cost is More)
IMPACT ON RESIDUAL
INCOME OF LONGER CREDIT PERIOD


RI = [S(1 V) - Sb
n
] (1 t ) k I

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Prof. S B Mishra KIIT School of
Management,Bhubaneswar
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INCREASE IN RECEIVABLES
INVESTMENT

S
0
S
I = (ACP
n
ACP
0
) + V (ACP
n
)
360 360

where: I = increase in receivables investment
ACP
n
= new average collection period (after lengthening
the credit period)
ACP
0
= old average collection period
V = ratio of variable cost to sales
S = increase in sales
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Prof. S B Mishra KIIT School of
Management,Bhubaneswar
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CONTROL OF ACCOUNTS
RECEIVABLES
Days Sales Outstanding
Ageing Schedule
Collection Matrix
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Prof. S B Mishra KIIT School of
Management,Bhubaneswar
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AVERAGE COLLECTION PERIOD AND AGEING
SCHEDULE

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Prof. S B Mishra KIIT School of
Management,Bhubaneswar
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The collection of BOOK DEBTS can be
monitored with the use of average collection
period and ageing schedule.
The ACTUAL AVERAGE COLLECTION
PERIOD IS COMPARED WITH THE
STANDARD COLLECTION PERIOD to
evaluate the efficiency of collection so that
necessary corrective action can be initiated and
taken.



THE AGEING SCHEDULE HIGHLIGHTS THE DEBTORS
ACCORDING TO THE AGE OR LENGTH OF TIME OF THE
OUTSTANDING DEBTORS.

The following table presents the ageing schedule

AGEING SCHEDULE

Outstanding Period O/s Amount of Debtors % of Debtors

0 30 Days 5,00,000 50
31 40 Days 1,00,000 10
41 60 Days 2,00,000 20
61 90 Days 1,00,000 10
Over 60 Days 1,00,000 10

Total 10,00,000 100

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1. Have the right mental attitude to the control of credit
and make sure that it gets the priority it deserves.
2. Establish clear credit practices as a matter of
company policy.
3. Make sure that these practices are clearly
understood by staff, suppliers and customers.
4. Be professional when accepting new accounts, and
especially larger ones.
5. Check out each customer thoroughly before you offer
credit. Use credit agencies, bank references, industry
sources etc.
6. Establish credit limits for each customer... and stick
to them.

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Prof. S B Mishra KIIT School of
Management,Bhubaneswar
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Guidelines for Effective Receivables Management
7. Continuously review these limits when you
suspect tough times are coming or if
operating in a volatile sector.
8. Keep very close to your larger customers.
9. Invoice promptly and clearly.
10. Consider charging penalties on overdue
accounts.
11. Consider accepting credit /debit cards as a
payment option.
12. Monitor your debtor balances and ageing
schedules, and don't let any debts get too large
or too old.

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Prof. S B Mishra KIIT School of
Management,Bhubaneswar
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WORKING CAPITAL FINANCING
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Prof. S B Mishra KIIT School of
Management,Bhubaneswar
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ACCRUALS
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Management,Bhubaneswar
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The major accrual items are wages and
provisions.


Accruals vary with the level of activity of
the firm.


While accruals are a welcome source of
financing, they are typically not amenable
to control by management.
TRADE CREDIT
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Prof. S B Mishra KIIT School of
Management,Bhubaneswar
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Trade credit represents the credit extended by
the suppliers of goods and services.
It is a spontaneous source of finance.

The confidence of suppliers is the key to
securing trade credit.
WORKING CAPITAL ADVANCE BY
COMMERCIAL BANKS

Application and processing
Sanction, terms and conditions
Forms of bank finance
Cash credits/Overdrafts
Loans
Purchase/Discount of Bills
Letter of credit
Security
Hypothecation
Pledge
Margin amount
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Prof. S B Mishra KIIT School of
Management,Bhubaneswar
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MAXIMUM PERMISSIBLE
BANK FINANCE (MPBF)
Tandon Committee had suggested three methods for
determining the MPBF
Method 1 : MPBF = 0.75 (CA CL)
Method 2 : MPBF = 0.75 (CA) CL
Method 3 : MPBF = 0.75 (CA CCA) CL
CA = current assets
CL = non-banking current liabilities
CCA = core current assets
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Prof. S B Mishra KIIT School of
Management,Bhubaneswar
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9/22/2014
Prof. S B Mishra KIIT School of
Management,Bhubaneswar
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CASH CREDIT / OVERDRAFT
A predetermined limit for borrowing is specified by
the bank.

The borrower can draw as often as required.

Repayment as and when desired.

Interest is charged on running balance subject to a
minimum amount to be paid.

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Prof. S B Mishra KIIT School of
Management,Bhubaneswar
69
LOANS
For the portion of permanent working capital.

Like a term loan .

Interest is payable on the whole portion.

Backed by a demand promissory note.
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Prof. S B Mishra KIIT School of
Management,Bhubaneswar
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Purchase/ Discount of Bills
For financing sundry creditors.

Against trade bills.

Can be demand or usance bill.

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Prof. S B Mishra KIIT School of
Management,Bhubaneswar
71
Letter of Credit ( LOC)
Through this the bank helps the customer to
obtain credit from its suppliers.

Through this the bank undertakes the
responsibility to honor the obligation of its
customer, should the customer fail to do so.

Its a indirect form of financing.

SUMMING UP

Typically, the current assets of the firm are
supported by a combination of long-term and short-
term sources of financing.

The following sources of finance more or less
exclusively support current assets: accruals, trade
credit, working capital advance by commercial
banks, public deposits, inter-corporate deposits,
shot-term loans from financial institutions, rights
debentures for working capital,commercial paper,
and factoring.
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Prof. S B Mishra KIIT School of
Management,Bhubaneswar
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