STUDY -6 FTFM 1. Explain the concept of Working Capital.

Ans: The term working capital refers to the amount of capital which is readily available to an organization. Working capital finances the Cash Conversion Cycle of a business-the time required to convert raw materials into finished goods, finished goods into sales, and accounts receivable. The term working capital may be used in two different ways: A. Gross Working Capital- It refers to the firms investment in all the current assets. It is based on following premises: I. With every increase in funds, the gross working capital will increase. II. The management is more concerned with total current assets as they constitute the total funds available for operating purpose than with the sources from which the funds came Example: The ABC Limited has a cash balance of Rs.10,000 , Debtors of Rs.50,000 , Inventory of Raw material Rs.1,00,000 and Inventory of Finished goods Rs.2,00,000 then gross working capital of ABC Limited will be Rs.3,60,000. B. Net Working Capital- It refers the amount of current assets that exceeds current liabilities. It is the amount of current assets financed by long-term liabilities. It is based on following premises: I. In the long run what matters is the surplus of currents assets over current liabilities. II. The creditors and investor use this concept to judge the financial soundness of the enterprise. III. To meet the contingencies one has to rely upon the excess of current assets over current liabilities. IV. It helps to find out the correct financial position of companies.

The net working capital measures firms liquidity. The net working capital may be negative or positive. Formula Net working capital= Current Assets- Current liabilities

STUDY -6 FTFM 2. Explain the concept of negative Working Capital. Ans: A negative working capital is a sign of managerial efficiency in a business with low inventory and accounts receivable (which means they operate on an almost strictly cash basis). In any other situation, it is a sign a company may be facing bankruptcy or serious financial trouble. Excess of current liabilities over current assets is called as negative working capital. To remedy a negative working capital position, a firm has these alternatives: (1) It can convert a long-term asset into a current asset-for example, by selling a piece of equipment or a building, by liquidating a long-term investment, or by renegotiating a long-term loan receivable; (2) It can convert short-term liabilities into long-term liabilities-for example, by negotiating the substitution of a current account payable with a long-term note payable; (3) It can borrow long term; (4) It can obtain additional equity through a stock issue or other sources of paid-in capital; (5) It can retain or "plow back" profits TYPES OF WORKING CAPITAL NEEDS 3. Distinguish between Permanent Working Capital and Variable working capital. Ans: The working capital can be divided into two categories on the basis of time: A. Permanent Working Capital B. Temporary Working Capital Permanent working capital means minimum amount of investment in all current assets which is required at all times to carry out minimum level of business activities. Permanent working capital = core current assets Main features: 1. Amount of permanent working capital remains in the business in one form or other. 2. There is a positive correlation between the amount of permanent working capital and the size of the business. 3. Permanent working capital is permanently needed therefore it should be financed through long-term funds. 2

STUDY -6 FTFM Temporary working capital: The amount of temporary working capital fluctuates depending upon the changes in the production and sales. Temporary working capital = fluctuating working capital = variable working capital S. n o 1 Permanent Working Capital It refers to the minimum amount which is invested in those current assets which is constantly and continuously required by a business unit to carry on its operations. Temporary Working Capital It refers to that working capital, the requirement of which keeps on fluctuating depending on the needs of the business unit. Any amount over and above the permanent level of working capital is variable, temporary or fluctuating working capital. This type of working capital is generally financed from short term sources of finance such as bank credit because this amount is not permanently required and is usually paid back during off season or after the contingency. Its requirement depends upon the project undertaken by the company or firm. The supplier of fund can expect return during the off seasons when the WC is not required.

This type of working capital should be financed from long term sources of finance.

It grows with the size of the business and it remains in the business in one or the other form The supplier of fund should not expect return during the life time of business in one or other form.

INR AMOUNT

Temporary WC

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Permanent WC

TIME INR AMOUNT Temporary WC Permanent WC

TIME The above figure shows that the Permanent working capital may either be constant over a period of time. Further, that the permanent working capital is constant or increasing regularly while temporary working capital is fluctuating from time to time. The fund manager has to arrange fund for investment in temporary working capital needs without loss of time. 1. What are the different Approaches to financing of working capital requirements? Explain in detail. Ans: Matching approach or Hedging approachA method of financing where each asset would be offset with a financing instrument of the same approximate maturity. The hedging principle states that the financing maturity should follow the cash flow characteristics of the assets being financed. For example an asset that is expected to provide cash flows over a period of say, 6 years then it should finance with a debt having similar pattern of cash flow requirements. When the firm follows matching approach, long term financial will be used to finance permanent working capital. Temporary working capital should be financed out of short term funds. The rationale underlying matching approach is that the maturity of sources of funds should match the nature of assets to be financed.
capitalAmount of working

Fluctuating WC

short Term financing

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Permanent working capital Long Term financing

Time

Figure: Matching Long-Term and Short-Term needs If you refer to the above diagram, the fixed working capital is financed with the long-term capital& equity funds, whereas fluctuating current assets are financed with short-term debt. For example, a seasonal expansion in inventories should be financed with short term loan. The rationale of the hedging principal is straight forward. The Financing mix a suggested by the hedging approach is a desirable financing pattern. Conservative Approach- According to this approach all requirement of funds should be met from long-term sources. Shortterm sources should be used only for emergency situations only. Under a conservative plan, a firm finances its permanent current assets and a part of the temporary current assets with a long-term financing. In periods when the firm has no temporary current assets, it stores liquidity by investing surplus funds in marketable securities. Conservative approach is less risky but more costly as compared to matching approach. In other words it is low profit low risk approach.

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(Conservative Approach)
Firm can reduce risks associated with short by using a larger proportion of long u sing -term borrowing -term financing. finan cing.

AMOUNT OF WORKING CAPITAL

Short -term financing

Current assets Long -term financing Fixed assets

TIME

8-22

Figure: Using Long-term Financing for part of short-term needs The shaded area shows that a part of temporary working capital is financed by long term sources. Aggressive Approach- Under an aggressive policy the firm finances a part of its permanent current assets with short-term financing. On the other hand more use of short-term financing makes the firm more risky. This policy seeks to minimize excess liquidity while meeting the short term requirements. The firm may accept even greater risk of insolvency in order to save cost of long term financing and thus in order to earn greater return. Under Aggressive working capital policy, investment in current Assets is very low. The firm keeps less amount of cash and marketable securities, manages with less inventories and tight credit terms resulting in low level of debtors. The consequences of aggressive working capital policy are frequent production stoppages, delayed deliveries to customers and loss of sales.

The aggressive approach to financing working capital has been shown in figure

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Permanent working capital Short term financing Amount of Working capital short term financing Long term sources

Time

Figure: Aggressive Financing Plan

2. Explain the difference between Hedging Approach and Conservative Approach. Ans. Both Hedging Approach and Conservative Approach do not help much finance manager in managing the working capital needs. The Hedging Approach is more risky as short term assets are financed by short term liabilities only and firm may not have sufficient liquidity with it. On the other hand Conservative Approach is more costly as long term sources may remain idle in slack period. Hedging Approach Conservative Approach The cost of financing is reduced It is less risky and firm is able to absorb shocks. The investment in net working capital The firm does not face frequent financing is minimum problems Frequent efforts are require to arrange The cost of financing is definitely higher funds. The risk is increased as the firm is Large investment is blocked in temporary vulnerable to sudden shocks. working capital The Conservative Approach provides liquidity in excess of expected needs and thus minimizes the risk of not being able to finance spontaneous asset growth. Neither the Hedging Approach nor Conservative Approach can be used by any firm in the strict sense. Therefore financial manager should try to have trade-off between Hedging Approach and Conservative Approach.

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3. Explain the risk and return Trade-off of current asset Financing. Ans. The financing of current assets involves a trade off between risk and return. A firm can choose from short or long term sources of finance. Short term financing is less expensive than long term financing but at the same time, short term financing involves greater risk than long term financing. Depending on the mix of short term and long term financing, the approach followed by a company may be referred as matching approach, conservative approach and aggressive approach. In matching approach, long-term finance is used to finance fixed assets and permanent current assets and short term financing to finance temporary or variable current assets. Under the conservative plan, the firm finances its permanent assets and also a part of temporary current assets with long term financing and hence less risk of facing the problem of shortage of funds. An aggressive policy is said to be followed by the firm when it uses more short term financing than warranted by the matching plan and finances a part of its permanent current assets with short term financing. There are two types of risks inherent in working capital management, namely, liquidity risk and opportunity loss risk. Liquidity risk is the non availability of cash to pay a liability that falls due. Even though it may happen only on certain days, it can cause, not only a loss of reputation but also make the work condition unfavourable for getting the best terms on transaction with the trade creditors. The other risk involved in working capital management is the risk of opportunity loss i.e. risk of having two little inventory to maintain production and sales, or the risk of not granting adequate credit for releasing achievable level of sales. In other words it is a the risk of not been able to produce more or sell more or both, and therefore, not being able to earn the potential profits, because there are not enough funds to support higher inventory and book debts. thus, it would not out of place to maintain that is only theoretical that the current assets could zero values. Indeed, it is neither practicable nor advisable. In practice, all current assets take positive value, because the firm seeks to reduce working capital risk The risk return trade-off involve in managing the firms liquidity is illustrated in following example: Firm B has invested in marketable securities which has been financed with equity. Firm A has current Ratio of 2.5:1 and ROI is 10% while Firm B has current Ratio of 3:1 and ROI is 9.66% 8

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Balance sheets 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 Cash Marketble securities(9%) Account receivables Inventories Current assets Net fixed assets Total Current Liablities Long term debt Equity Capital Total Current Ratio( 5)/(8) Net Working capital Net Income ROI In %

A Rs. 500.00

B Rs. 500.00 5,000.00 9,500.00 15,000.00 30,000.00 50,000.00 80,000.00 10,000.00 15,000.00 55,000.00 80,000.00 3.00 20,000.00 7,725.00 9.66

9,500.00 15,000.00 25,000.00 50,000.00 75,000.00 10,000.00 15,000.00 50,000.00 75,000.00 2.50 15,000.00 7,500.00 10.00

Thus investing in current Assets and in particular in marketable securities does not have favorable effect on firms Liquidity but it has also an unfavourable effect on the firms ROI. Thus Risk return Trade-off involved in adding marketable securities is just adding one more liquidity versus reduced profitability. 4. What do you mean by Operating Cycle? Differentiate between cash conversion Cycle and Operating Cycle with the help of diagram and illustration. Ans: Operating cycle is the time period between the acquisition of inventory and when cash is collected from receivables. In a manufacturing business, operating cycle is the average time that raw material remains in stock less the period of credit taken from suppliers, plus the time taken for producing the goods, plus the time the goods remain in finished inventory, plus the time taken by customer to pay for the goods. This can be represented as under:

O = RMCP - DP + WPCP + FGCP + RCP

O is the operating cycle RMCP is raw material conversion period DP is deferral period WPCP is work in progress conversion period FGCP is finished goods conversion period 9

STUDY -6 FTFM RCP is receivable' conversion period Each stage is influenced by various factors. For example, storage of raw materials depends on regular availability of raw materials, the lead time for procurement, the level of safety stock required, possibility or perception of price fluctuations, economics of bulk purchase etc. The length of work in process depends on the type of business, consistency in capacities at various stages of production etc. The duration of finished goods depends on level of competition, pattern of production and seasonality of demands. The duration of debtors, again depends on competition, discounts offered and efficiency in collection. Material cost is partly covered by trade credit from suppliers and successive operational activities also involve cash flow. If the flow continues without any interruption, operational activities of the company will also continue smoothly. Movements of cash through the above processes are called circular flow of cash. Operating cycle concept is important for management of cash and management of working capital because the longer the operating cycle the more financial resources the company needs. Therefore, the management has to remain cautious that the operating cycle should not become too long. Operating Cycle = Inventory Payables Conversion period period

Receivables

deferral

Conversion period

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STUDY -6 FTFM

Inventory sold Inventory purchased Inventory period Accounts payable period Cash paid for inventory Accounts receivable period

Cash received

Time

Operating cycle (OC) Cash Conversion Cycle (CCC)

Cash conversion cycle is the time between cash disbursement and cash collection. An estimate of the average time between when a firm pays cash for its inventory purchases and when it receives cash for its sales; the average number of days of sales that firm must finance outside the use of trade credit. Operating cycle is long and a number of steps could be taken to shorten this operating cycle. Debtors could be cut by a quicker collection of accounts. Finished goods could be turned over more rapidly, the level of raw material inventory could be reduced or the production period shortened. The operating cycle help in assessing the needs of working capital accurately by determining the relationship between debtors and sales, creditors and sales and inventory and sales. Even requirement of extra working capital can be guessed from such estimate. The above figure would reveal that operating cycle is the time that elapses between the cash outlay and the cash realisation by the sale of finished goods and realisation of sundry debtors. Thus cash used in productive activity, often some time comes back from the operating cycle of the activity. The length of operating cycle of an enterprise is the sum of these four individual stages i.e. components of time. The operating cycle can be calculated for a period as under: 1. RMCP = Average Raw material stock Total Raw material consumption Less: Period of credit granted by supplier (DP) 11 X 360

STUDY -6 FTFM = Average level of creditors X 360 Total credit purchase 2. WPCP = Average work in progress Total cost of production X 360 X 360 ________ XXX__

3. FGCP = Average stock of finished goods Total cost of good sold 4. RCP = Average debtors Total Credit sales X 360

Total Net operating cycle

ILLUSTRATIONS Example No. 1 Using the following data, calculate operating cycle for Urvi International Limited: (360 days assumed) Particulars Sales Total cost of production Purchases Average Stock of raw material Average Work in progress Average Stock of Finished goods Average creditors Average debtors Solution Operating cycle for Urvi International Limited 12 Rs. 36,00,000 24,00,000 7,20,000 72,000 1,08,000 2,16,000 90,000 3,60,000

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1. RMCP = Average Raw material stock = 36 days Total Raw material consumption

X 360 = 72,000 X 360 7,20,000

Less: Period of credit granted by supplier (DP) = Average level of creditors X 360 = 90,000 X 360 (= 45 days) Total credit purchase 7,20,000 2. WPCP = Average work in progress X 360 = 1,08,000 X 360 = 16 days Total cost of production 24,00,000 3. FGCP = Average stock of finished goods X 360 = 2,16,000 X 360 = 32 days Total cost of good sold 24,00,000 4. RCP = Average debtors X 360 = 2,16,000 X 360 22 days Total Credit sales 36,00,000 =

Net operating cycle = 36 days 45 days +16 days +32 days + 22 days Net operating cycle = 61 days. 5. What are the factors which influences the determination of working capital? Ans: Factors Influencing Working Capital
In addition to the working parameters peculiar to a company that determine the quantum of required working capital, the following factors are also equally important:

1. Nature of Business: A companys working capital requirements are directly related to the types of business operations. A company that sells a service primarily on a cash basis can carry there business with less amount of working capital. Public utility service (like railway companies) as compared to manufacturing concerns requires a lesser amount of working capital. A larger amount of working capital is required for trading or merchandising institutions. 2. Seasonal Fluctuations: A number of industries manufactures and sell goods only during seasons. For example sugar industry manufactures sugar between December and April, therefore the working capital requirement will be more during this period as compared to any other period. 3. Production Policies: The quantum of working capital is determined by production policy. If the firm is using labour intensive techniques working capital requirement will be more. Suppose a firm is making a

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STUDY -6 FTFM product for which demand is seasonal, what kind of policy should followed in such cases? As a matter of policy, the choice will rest on the one hand, and maintaining a steady rate of production and permitting stocks of inventories to build up during off season periods, on the other. In the first instance, inventories are kept to minimum levels but the production manager must shoulder the burden of constantly adjusting his working staff; in the second, the uniform manufacturing rate avoids fluctuations of production schedules, but enlarged inventory stocks create special risks and costs. In case of highly automatic plant requirement of working capital will be more. 4. Credit Policy: A business unit, making purchase on credit basis and selling its finished products on cash basis, will require lower amount of working capital than a concern having no credit facilities and which may further be forced to grant credit to its customers. 5. Growth: As a company expands, it is logical to expect that larger amounts of working capital will be required to avoid interruptions to the production sequence.

6. Position of the Business Cycle: In addition to the long-term secular trend, the recurring movements of the business cycle influence working capital changes. In periods of the boom and depression, more working capital is needed than during the other stages of cyclical fluctuations. For arriving at a satisfactory working capital position in time of prosperity the firm should conserve current capital by avoiding wasteful expenditure. When inflationary pressure has been created during a period of emergency like a war, unnecessary hoarding should be avoided because such periods of rising prizes are temporary. During a period of recession, production is disturbed due to scarcity of materials. The current assets should be converted into cash without creating new financial obligations by borrowing at a high rate of interest. During periods of long lasting depression, excessive stocks are accumulated and fund of the companies are locked up. As a result, any addition to working capital by way of borrowing is undesirable. Attempts should be directed to convert current assets into cash. 7. Size of business unit: It is an important factor for determining the proportion of working capital. The general principal in this connection is that the bigger the size of the unit, the more will be the amount of working capital required. But it is quite likely that the bigger sized business unit, i.e., a consumers goods industry may require a larger amount of fixed capital than working capital.

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STUDY -6 FTFM 8. Dividend Policy: A desire to maintain an established dividend policy may affect the volume of working capital, or changes in working capital may bring about an adjustment of dividend policy. In either event, the relationship between dividend policy and working capital is well established, and very few companies ever declare a dividend without giving consideration to its effect on cash and their needs for cash. 9. Operating Efficiency of the company: Operating efficiency of a company plays
a major role in working capital management. An efficient company will have a shorter manufacturing period, long credit terms available from suppliers and minimal customers credit outstanding. If this is achieved then the quantum of working capital required will be naturally reduced. Rapidity of Turnover: A company having high rate of turnover will need

10.

less amount of working capital as compared to company which has low turnover. For example; in case of jewelers the turnover is very slow, therefore his working capital requirement will be more.

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