Management of Working Capital

Ajeet Kumar Thakur

Unit - 1
Nature, Scope and Definition of Working Capital, Working Capital Cycle, Assessment and Computation of Working Capital Requirement, ProfitabilityLiquidity trade-off, Working Capital Policy Aggressive & Defensive. Overview of Working Capital Management

Introduction
Working capital refers to the cash a company requires in order to finance its day-to-day business operations. In other words: Working capital refers to the amount of capital which is readily available to an organization.

There are two concepts of working capital for the purpose of definition:

1.Gross concept
2.Net concept

Gross concept:
Gross concept of working capital isthe investment in circulating assets, or in inventory and accounts receivable comprising the operating cycle of a manufacturing firm.

Investment in assets comprising the gross operating cycle is termed as current assets(CA).

Current assets(CA) are defined as assets which in normal course of operations are meant to be converted into cash within a period not exceeding one year. The major current assets are cash, marketable securities, accounts receivable, bills receivable and inventory. In contrast to this, fixed assets are those assets that are permanent in nature and are held for use in business activities. For example, land, building, machinery etc .

Current assets
Cash

and bank balances Temporary investments (Marketable securities) Short-term advances Prepaid expenses Receivables Inventory of raw materials, stores and spares Inventory of work-in-progress Inventory of finished goods

Current liabilities(CL) are commitments which, within a short period of time usually within a year, require cash settlement in the ordinary course of business. For example; accounts payable, bills payable, bank over-draft and outstanding expenses. Long-term liabilities, on the other hand, are obligations that can be repaid over a period greater than a single accounting period. For example; share capital, debentures, long-term loans etc.

Current liabilities
Creditors

for goods purchased Outstanding expenses Short-term borrowings Advances received against sales Taxes and dividend payable Other liabilities maturing within a year

Operating cycle
it is also known as Cash Cycle
Sales are not always converted into cash immediately, i.e., there is time-lag between the sale of a product and the realization of cash. The continuing flow from cash to suppliers, to investors, to account receivables and back in cash. The time gap is technically termed as operating cycle.

Conversion of cash into raw materials

Conversion of accounts receivable into Cash

Conversion of raw materials into work-in-progress

Conversion of finished goods into accounts receivable

Conversion of work-in-progress into finished goods.

Cash Conversion Cycle (or Net Operating Cycle) = Average Inventory Collection Period + Average Receivables Processing Period Average Payables Period

Net Concept:
Net Concept or Net Working capital refers to current assets less current liabilities. That means, working capital is the difference between resources in cash or readily convertible into cash (Current Assets) and organizational commitments for which cash will soon be required (Current Liabilities). Thus:
Working Capital = Current Assets Current Liabilities

Types of working Capital

Gross

working capital working capital working capital

Net

working capital

Permanent Temporary

Balance
Cash

Sheet working capital

working capital

Reasons for changes in working capital

Changes in the level of sales activities

Changes in the level of operating expenses Policy changes initiated by management Technological Changes Cyclical changes in the economy Changes in operating cycle
Source of change is seasonality in sales activity

Changes in the fixing the level of inventory and receivables

Dangers of excess working capital

It

leads to unnecessary purchase and accumulation of inventories. Excessive working capital results in imbalance between liquidity and profitability. It is an indication of defective credit policy. A company may not be tempted to overtrade and lose heavily.

Cont
Excessive

working capital leads to operational inefficiency because large volume of funds not being used productively. This makes management complacent which degenerates into managerial inefficiency. High liquidity may induce a firm to under take great production which may not have a matching demand.

Dangers of Too little working capital

Illiquidity

is the biggest danger of inadequate working capital. A firm, which is not able to meet its shortterm obligations, endangers its goodwill and long term survival. Inadequacy of working capital leads to frequent and stoppages in the production.

firm short of liquidity cannot in cash short-term environmental opportunities due to lack of funds. Advantages of bulk purchases are forgone. In case of emergency, the firm has to resort to external borrowings which has a very

Management of Working Capital

Nature of Working Capital Management

The goal of Working Capital Management is to manage the firm's Assets and Liabilities in such a way that a satisfactory level of working capital is maintained. The interaction between current assets and current liabilities is, therefore, the main theme of the theory of management of working capital.

Capital Managements accepted purpose has been the management of a firms current assets and current liabilities in a way that achieves the optimum balance between liquidity and profitability. On the one hand, obviously, a high level of net working capital implies funds invested in current assets that increase a firms liquidity but reduces its returns, because current assets are less profitable than long-term assets.
Working

 On

the other hand, however, a low level of net working capital results in increased profitability, since funds are put to better use, but increases the firms risk of technical insolvency. The bottom line is that any suboptimal level of net working capital in the end reduces the return to shareholders by lowering the firms value.

 WC

= Equity + LTD Fixed Assets

WC

is that portion of current assets which could not be fulfilled by current liabilities.

Objectives of Working Capital Management

Availability

of adequate funds Minimum Cost Matching(Balance) between profitability & liquidity Flexibility Optimum use of funds

Sources of working capital Long Term

Issue

of shares Floating of debentures Long Term Loans Public deposits/Loans Sale of unwanted assets Private loans Lease (Land/Machinery)

Medium & Short-Term

Internal
Depreciation Taxation

Provision Accrued Expenses Private Loans Reserve & Provisions

External
Bank

Credit Trade Credit Discounting Bills Accounts Receivable Financing Government Assistance Customer Credit Loans from Directors Hire Purchase & Sale

Working Capital Management in Multinational Environment

Foreign
Tax

exchange

Regulatory
Economic

constraints

Investment in Current Assets

Flexible

Policy Policy

Large amt. of cash, marketable securities, and inventories, liberal credit policy.

Aggressive

Minimized cash, marketable securities, inventories and receivables.

Moderate Policy Mid way between two extreme approaches

Financing of Current Assets

Aggressive

financing policy Financing Policy

Ex - High proportion of short-term debt.

Conservative

Ex - Financing with long-term sources

Self

liquidity Financing Policy

Ex - Maturity matching or hedging approach

Risk-Return Trade-Off

Factors Affecting Working Capital Requirement

Nature

of Business Seasonability of operations Level of Activity Market Conditions Supply conditions

Modern Mantra Zero Working Capital

Proponents

of zero working capital concept claims that a movement toward this goal generate cash, speeds up production, and help businesses make timely deliveries and operate more efficiently.

The investment freed from inventories or receivables reduces financing requirements on a permanent basis, or at least for that level of activity. Increase in accounts payable reduces financing requirements from other sources, provided the new level can be maintained. The investment freed from working capital creates a source of financing available for another more productive purpose. Return on investment increase as the investment base decreases and inventory and receivables are insignificant investment in

 Net

operating cycle, or Cash conversion cycle, represents the time difference between cash payment for raw materials and cash collection for sales. The cash conversion cycle indicates the firm's ability to convert its resources into cash. Gross operating cycle is the same as net operating cycle except that it does not take into account the creditors deferral period.

 The

inventory conversion period is the time required to obtain materials for a product, manufacture it, and sell it. The inventory conversion period is essentially the time period during which a company must invest cash while it converts materials into a sale. The calculation is: Inventory Cost of sales / 365

Raw material conversion period is the time period between receiving the raw material and sending them for production. It is the period of stocking the raw materials for usage. Work-in-progress conversion period is the time period when the raw materials are received for production and the time for their dispatch. Finished goods conversion period is the time of storage of finished goods in the warehouse until they are sold.

Gross Operating Cycle = Inventory Conversion Period + Debtors Conversion Period Inventory conversion Period = Raw Material Conversion Period + Work-in-Progress Conversion Period + Finished Goods Conversion Period
Raw Material Conversion Period = (Raw Material Inventory/Raw Material Consumption)*360

Work-in-Progress Conversion Period = (Work in process inventory/Cost of production)*360

Finished Goods conversion Period = (Finished Goods Inventory/Cost of goods sold)*360 Debtors Conversion Period = (Debtors/Credit Sales)*360

Creditors Deferral Period = (Creditors/Credit Purchase)*360 Cash Conversion or Net Operating Cycle = Gross Operating Cycle Creditors deferral Period

Inventory

Conversion Period =
(Inventory/Cost of Sale)*360

Unit III

Management of Receivables & Inventory

Receivables: Nature & cost of maintaining receivables, objectives of receivables management, factors affecting size of receivables, policies for managing accounts receivables, determination of potential credit policy including credit analysis, credit standards, credit period, credit terms, etc; Collection Policies; Credit Management in India. Inventory: Need for monitoring & control of inventories, objectives of inventory management, Benefits of holding inventory, risks and costs associated with inventories, Inventory Management: Minimizing cost in inventory, Techniques of Inventory Management Classification, order quantity, order point etc.

Accounts Receivable or Trade Debtors

When

a firm sells its products or services on credit and does not receive cash immediately, Trade credit arises. Trade credit creates accounts receivable or trade debtors that the firm is expected to collect in the near future. The customer from whom receivables have to be collected in the future are called trade debtors or simply debtors.

Characteristics of Credit Sale

It

involves an element of risk that should be carefully analyzed. Based on economic value It implies futurity

Cont
In

India, trade debtors, after inventories, are the major components of current assets. They form about 1/3rd of current assets in India. This amount is to be financed out of working capital. As substantial amounts are tied-up in trade debtors, it needs careful analysis and proper management.

Credit Policy: Nature and Goals

Credit Policy: Nature

A firms investment in accounts receivable depends on: The

volume of credit sales Collection period

Cont
Sales

depend on market size, firms market share, product quality, intensity of competition, economic conditions etc., the financial manager hardly has any control over these variables.

The

percentage of credit sales to total sales is mostly influenced by the nature of business and industry norms.

Decision Variables of Credit Policy

Credit Credit

Standards terms efforts

Collection

Goals of Credit Policy

Lenient

vs Stringent Credit Policy

Credit Policy: A Marketing Tool

For

Sale expansion In declining market to maintain the market share To retain old customers and create new In growing market to increase market share In highly competitive situation and recessionary economic conditions credit policy is to be liberalized

Some other reasons for giving credit:

Because

of company position Buyers status and requirement Dealer relationship Transit delays Industrial practice

Why do companies in India Grant Credit?

 Competition
Company's

Bargain Power Buyers Requirement Buyers Status Relationship with Dealers Marketing Tool Industry Practice Transit Delays

Maximization of Sales vs. Incremental Profit Sales expansion comes with additional cost. A firm will have to evaluate its credit policy in terms of both return and cost of additional sales. Additional sales should add to the firms operating profit. There are 3 types of costs involved:

Production and Selling Cost

If

sales expand within the existing production capacity, then only the variable production and selling costs will increase. If capacity is added for sales expansion resulting from loosening of credit policy, then the incremental production and selling costs will include both variable and fixed costs.

Incremental Contribution = Incremental Sales Revenue Incremental Production and Selling costs CONT = SALES COST

tight credit policy means rejection of certain types of accounts whose creditworthiness is doubtful. This results into loss of sales and consequently, loss of contribution. This is an opportunity loss to the firm.

Administration Costs
Credit Investigation and Supervision Costs Collection Costs The firm is required to analyze and supervise large number of accounts when it loosens its credit policy. Similarly the firm will have to intensify its collection efforts to collect outstanding bills from financially less sound customers.

Bad-debt Losses
Bad-debt loss arises when the firm is unable to collect its accounts receivable. The size of bad debt losses depends on the quality of accounts accepted by the firm. A firm can avoid or minimize these losses by adopting a very tight credit policy, but by doing so, the firm will not be able to avail the opportunity of using credit policy as a marketing tool for sales expansion, and will incur opportunity cost

Thus the evaluation of change in a firms credit policy involves analysis of:
Opportunity

cost

of

lost

contribution Credit administration cost and bad-debt losses

Above mentioned two costs behave contrary to each other.

The

firms credit policy will be determined by the trade-off between opportunity cost and credit administration cost and baddebt losses.

Cost of Credit Policy

Cost of administration & bad-debt loss

Costs & Benefit s

Optimum CP A Opportunity Cost

Tight

Credit Policy

Loose

Optimum Credit Policy : A Marginal Cost-Benefit Analysis

The firms operating profit is maximized when total cost is minimized for given level of revenue. Credit policy at point A represents the maximum operating profit(Since total cost is minimum). But it is not necessarily the optimum credit policy. Optimum credit policy is one which maximizes the firms value.

 The

value of the firm is maximized when the incremental or marginal rate of return of an investment is equal to the incremental or marginal cost of funds used to finance the investment. The incremental rate of return can be calculated as incremental operating profit divided by the incremental investment in receivable. The incremental cost of funds is the rate of return required by the suppliers of funds, given the risk of investment in accounts

 The

required rate of return is not equal to the borrowing rate. Higher the risk of investment, higher the required rate of return. As the firm loosens its credit policy, its investment in accounts receivable becomes more risky because of increase in slow paying and defaulting accounts. Thus the required rate of return is upward sloping curve.

In order to maximize firms value accounts receivables should involve following 4 steps:
Estimation of incremental operating profit Estimation of incremental investment in accounts receivables Estimation of the incremental rate of return of investment Comparison of the incremental rate of return with the required rate of return.

A firms behavior of cost (As percentage of sale)

Fixed Cost Variable Cost
82.00 4.00 5.70

Total Cost
82.00 6.50 8.50

Cost of goods sold

2.50 2.80

Administrative cost
Selling Cost

Bad-debt losses
Collection cost

5.30

0.05
0.02 91.77

0.05
0.02 97.07

Optimum Level of Receivable

Marginal Cost of Capital (k)

Cost & Return (%)

Marginal Rate of Return (r)

Optimum investment in receivables

Stringent

Credit Policy

Liberal

Credit Policy Variables

Major

controllable decision variables include:

Credit Standards & Analysis Credit Terms Collection Policy & Procedures

Credit Standards
The

criteria to decide the types of customers to whom goods could be sold on credit. If a firm has more slow paying customers, its investment in accounts receivable will increase. The firm will also be exposed to higher risk of default.

Credit Terms
To

specify duration of credit and terms of payment by customers. Investment in accounts receivable will be high if the customers are allowed extended time period for making payments.

Collection Policy
To

determine the actual period. The lower the collection period, the lower the investment in accounts receivable and vice versa.

Cont.
While

making the framework for credit policy participation of executives of production, marketing and finance departments are appreciated along with the credit manager, because of its implication to these departments. And the framework should ensure that the firms value of share is maximized, by answering the following questions:

Cont
What

will be the change in sale when a decision variable is altered? What will be the cost of altering the decision variable? How would the level of receivable be affected by changing the decision variable? How are expected rate of return and cost of funds related?

Credit Standards
Credit

Analysis Credit standards influence the quality of the firms customers. There are two aspects of the quality of customers: (i) The time taken by customers to repay credit obligations (Average Collection period) (ii) The default rate

To estimate the probability of default, the financial or credit manager should consider three Cs(Regarding customer): Character
Capacity

Condition

Character refers to customers willingness to pay. The moral factor is of considerable importance in credit evaluation in practice. Capacity refers to the customers ability to pay. Ability to pay can be judged by assessing the customers capital and assets which he may offer as security. Condition refers to the prevailing economic and other conditions which may affect the customers ability to pay. Adverse economic conditions can affect the ability or willingness of a customer to pay.

Analyzing change in credit standards

Credit Term
Credit

terms are the stipulation under which the firm sells on credit to customer. This include: Period

Credit

Cash

Discount

Credit Period : Credit extension time

length
Depending

on the objective of the firm, it can tighten or lengthen its credit period, to control frequently defaulting customers and bad debt losses or to increase its operating profit through expanded sales, respectively. However, there will be net increase in operating profit only when the cost of extended credit period is less than the

There are two factors causing increase in investment in receivables, due to extended credit period:

Incremental sales result in incremental receivable Existing customer will take more time to repay credit obligation

Cash Discount
Rate The Net

of cash discount

cash discount period credit period

Collection Policy and Procedures

Collection Policy and Procedures for Individual Accounts

Collection Policy and Procedures in Indian Context

Inventory Management

 Inventories

constitute about 60 percent of current assets of public limited companies in India. Because of the large size of inventories maintained by firms, a considerable amount of funds is required to be committed to them. The reduction in excessive inventories carries a favourable impact on a companys profitability.

Forms of Inventory
Raw

Materials Work-in-process Finished goods

A manufacturing firm will have substantially high levels of all the three kinds of inventories, while a retail or wholesale firm will have a very high level of finished goods inventories and no raw material and work-in-process

Need to Hold Inventories

Transaction Motive emphasizes the need to maintain inventories to facilitate smooth production and sales operations. Precautionary motive necessitates holding of inventories to guard against the risk of unpredictable changes in demand and supply forces and other factors. Speculative motive influences the decision to increase or reduce inventory levels to take advantage of price fluctuations.

Objective of Inventory Management

To

maintain a large size of inventories of raw material and work-in-process for efficient and smooth production and of finished goods for uninterrupted sales operations. To maintain a minimum investment in inventories to maximize profitability.

 Excessive

or inadequate inventory are not desirable. The firm should always avoid a situation of over-investment or under-investment in inventories.

Dangers of over-investment in inventories

tie-up of the firms fund and loss of profit Excessive carrying costs Risk of liquidity
Unnecessary

Dangers of under-investment in inventories

Production

hold-ups Failure to meet delivery commitments

An effective inventory management should:

Ensure a continuous supply of raw materials to facilitate uninterrupted production. Maintain sufficient stocks of raw materials in periods of short supply and anticipate price changes. Maintain sufficient finished goods inventory for smooth sales operation, efficient customer service. Minimize the carrying cost and time. Control investment in inventories and keep it at an optimum level.

Inventory Management Techniques

To

manage inventories efficiently, answer should be sought to the following two questions: How much should be ordered? When should it be ordered?

Economic Order Quantity

(How much should be ordered?)
One

of the major inventory management problems to be resolved is how much inventory should be added when inventory is replenished. Determining an optimum inventory level involves two types of costs:
Ordering

Cost

Ordering & Carrying Costs

Ordering Cost
Requisitioning
Order Placing Transportation Carrying Cost

Warehousing
Handling Clerical & Staff Handling

Receiving, Inspecting & Storing Clerical & Staff

Insurance
Deterioration & Obsolesence

Ordering & Carrying costs tradeoff

There

are 3 approaches to determine Economic Order Quantity: Trial & Error approach Order-formula approach
EOQ = (2AO/C)

A=Annual requirement, O=Ordering Cost, C=Carrying Cost

Graphic

approach

Reorder Point
(When it should be ordered?)
The

Reorder point is that inventory level at which an order should be placed to replenish the inventory. To determine the reorder point under certainty, we should know: Lead Time Average Usage Economic Order Quantity

Cont
Lead

time is the time normally taken in replenishing the inventory after the order has been placed. Reorder Point = Lead Time * Average Usage For ex. EOQ=500 Units, Lead Time = 3 Weeks, Average Usage = 50 Unit per week Reorder Point = 3* 50 = 150 Units Or

Safety stock or Buffer stock

It is difficult to predict usage and lead time accurately. The demand for material may fluctuate periodically and actual delivery time may be different fro the normal lead time. Both may cause stock-out, in order to guard against it the firm may maintain a safety-stock or buffer inventory. Assuming in the above example the reasonable expected stock-out is 25 units per week.

Re-order point = Lead Time * Average Usage + Safety Stock

= 150 + 75 = 250 Units

Analysis of Investment in Inventory

The goal of the inventory policy should be maximization of the firms value. The inventory policy will maximize the firms value at a point at which incremental or marginal return from the investment in inventory equals the incremental or marginal cost of funds used to finance the investment in inventory. Cost of fund is the required rate of return to the suppliers of funds, and it depends on the risk of the investment opportunity.

Analysis of investment in inventory involves following four steps: Estimation of operating profit Estimation of investment in inventory Estimation of the rate of return on investment in inventory Comparison of the rate of return on investment with the cost of fund

Inventory Control Systems

ABC Inventory Control Systems

According to ABC analysis inventory items should get emphasis as per their value. The high value items are classified as A Items and would be under the tightest control, and B and C categories in diminishing order. The ABC analysis concentrates on important items as per their value, it is also known as control by importance and exceptions(CIE) and proportional value analysis(PVA).

Steps in ABC Analysis

Classify the items of inventories, determining the expected use in units and the price per unit for each item. Determining the total value of each item by multiplying the expected units by its units price. Rank the items in accordance with the total value, giving first rank to the item with the highest value and so on.
Compute the ratio(percentage) of number of units of each item to total units of all items and the ratio of total value of each item to total value of all items.

Combine items on the basis of their related value to form three categories A, B, & C.

ABC Analysis
Item Units % of Total Cumula tive % Unit price (Rs.) 30.40 15 2 3 4 5 6 7 Total 5,000 16,000 14,000 30,000 15,000 10,000 1,00,000 5 16 51.2 5.5 2,56,000 88,000 72,000 51,000 22,500 6,500 8,00,000 32 11.00 Total Cost (Rs.) 304,000 % of Total Cumul ative %

10,000

10

38 70

45
14 30 15 10 100 5.14 1.7 1.5 0.65 9.00 6.38 2.81 0.81

90

100

Just-in-Time (JIT) Systems

Japanese

firms popularized the Just-inTime (JIT) system in the world. In a JIT system material or the manufactured components and parts arrive to the manufacturing sites or stores just few hours before they are put to use. The delivery of material is synchronized with manufacturing cycle and speed.

Cont..
The

system requires perfect understanding and coordination between the manufacturer and suppliers in terms of timing of delivery and quality of the material. Poor quality material or components could halt the production. The JIT Inventory system complements the Total Quality Management.

Outsourcing

Computerized Inventory Control Systems

Unit II
Management of Cash and Marketable Securities

 Meaning

of Cash, Motives for holding cash, objectives of cash management, factors determining cash needs, Cash Management Models, Cash Budget, Cash Management: basic strategies, techniques and processes, compensating balances ; Marketable Securities: Concept, types, reasons for holding marketable securities, alternative strategies, choice of securities; Cash Management Practices in India.

Introduction
firm should keep sufficient cash, neither more nor less. Cash shortage will disrupt the firms manufacturing operations while excessive cash will simply remain idle, without contributing anything towards the firms profitability. Thus a major function of the financial manager is to maintain a sound cash position.
The

Cont..
The

term cash includes coins, currency and cheques held by the firm, and balances in its bank accounts. Sometimes near-cash items, such as marketable securities or bank time deposits, are also included in cash.

Facets of Cash Management

 Cash

management is concerned with the managing of:

Cash flows into and out of the firm

(i)

(ii)
(iii)

Cash flows within the firm

Cash balances held by the firm at a point of time by financing deficit or investing surplus cash.

Cont..
Cash

Management assumes more importance than other current assets because cash is the most significant and least productive asset that a firm holds.

Cash Management Cycle

Business Operations
Cash Collection

Deficit

Borrow Invest

Information & Control

Cash Payment

Surplus

 In

order to resolve the uncertainty about cash flow prediction and lack of synchronization between cash receipts and payments, the firm should develop appropriate strategies for cash management. The firm should evolve strategies regarding the following four facets of cash management:

Cash Planning Cash inflows and outflows should be planned to project cash surplus or deficit for each planning period. Managing the cash flows The flow of cash should be properly managed. The cash inflows should be accelerated while, as for as possible, the cash outflows should be decelerated. Optimum Cash level The firm should decide about the appropriate level of cash balances. The cost of excess cash and danger of cash deficiency should be matched to determine the optimum level of

 Investing

surplus cash The surplus cash balances should be properly invested to earn profits. The firm should decide about the division of such cash balance between alternative short-term investment opportunities such as bank deposits, marketable securities, or intercorporate lending.

Motives for Holding Cash

Transaction

Motive Motive

Precautionary Speculative

Motive