Understanding Working Capital Management and Financing

Management of current assets

Concept

A measure of both a company's efficiency and its short-term financial health.

WC is the amount of funds necessary to cover the cost of operating the enterprise.

Understanding Working Capital Management and Financing

Meaning of Working Capital

Working capital is a financial metric which represents operating liquidity (how much in liquid assets a company has available to build its business). Gross Working Capital is firms investment in Current Assets. Net Working Capital = Current Assets Current Liabilities Net working capital is the portion of current assets financed with long term funds. POSITIVE working capital The management of working capital involves managing inventories, accounts receivable and payable and cash; i.e. OPERATING CYCLE

Current Assets

Current assets are assets can be converted into cash within a short period (normally within an accounting year) Cash + Bank balance + Debtors + Bills Receivable + Short Term Investment + Inventory + Prepaid Expenses + Accrued Incomes

http://www.investopedia.com/video/play/working-capital

Current Liabilities

Current Liabilities are those which are intended, at their inception, to be paid in the ordinary course of business, within a year. Bills Payable, Sundry creditors, accounts payable, accrued or outstanding expenses, short term loans, advances, dividend payoffs, bank overdraft, provision for taxation.

Types
Gross working Capital Net normally referred to as WC

Financial concept / goingconcern concept

Accounting concept

Useful in determining the ROR

Qualitative concept indicates margin of protection available for short-term creditors.

Exercise and video

TATA MOTORS 2010 details

Balance Sheet of Canara Bank

Mar '06 Capital and Liabilities: Total Share Capital Equity Share Capital Share Application Money Preference Share Capital Reserves Revaluation Reserves Net Worth Deposits Borrowings Total Debt Other Liabilities & Provisions Total Liabilities Assets Cash & Balances with RBI Balance with Banks, Money at Call Advances Investments Gross Block Accumulated Depreciation Net Block Capital Work In Progress Other Assets Total Assets Contingent Liabilities Bills for collection Book Value (Rs) Mar '07 Mar '08 Mar '09 Mar '10 410.00 410.00 410.00 410.00 410.00 410.00 410.00 410.00 410.00 410.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 6,608.86 7,701.11 7,885.63 9,629.61 12,129.11 113.38 2,242.87 2,204.86 2,168.16 2,132.68 7,132.24 10,353.98 10,500.49 12,207.77 14,671.79 116,803.23 142,381.45 154,072.42 186,892.51 234,651.44 25.82 1,574.35 2,517.23 7,056.61 8,440.56 116,829.05 143,955.80 156,589.65 193,949.12 243,092.00 8,860.57 11,651.25 13,438.55 13,488.91 6,977.30 132,821.86 165,961.03 180,528.69 219,645.80 264,741.09 7,914.00 9,095.19 13,364.79 10,036.79 15,719.46

4,909.56 7,278.74 4,513.25 6,622.99 3,933.75 79,425.70 98,505.69 107,238.04 138,219.40 169,334.63 36,974.18 45,225.54 49,811.57 57,776.90 69,676.95 1,718.60 4,056.39 4,254.33 4,440.07 4,480.37 1,030.13 1,195.04 1,337.46 1,510.61 1,620.99 688.47 2,861.35 2,916.87 2,929.46 2,859.38 0.00 0.00 0.00 0.00 0.00 2,909.95 2,994.53 2,684.17 4,060.26 3,216.92 132,821.86 165,961.04 180,528.69 219,645.80 264,741.09 47,062.37 52,150.75 95,710.87 136,851.39 110,627.02 12,260.93 15,660.41 25,299.63 25,757.73 21,206.47 171.19 197.83 202.33 244.87 305.83

10

Types

On the basis of Concept

On the basis of Time

Gross Working Capital

Net Working Capital

Permanent or Fixed

Temporary or Variable

Regular

Reserve

Seasonal

Special

11

Understanding Working Capital Management and Financing

Permanent and Temporary WC

Permanent WC - Minimum level of current assets required by the firm always.
Temporary WC to support changing production or sales activities. Temporary or Fluctuating

Working Capital

Permanent

12

TIME

Advantages of Adequate Working Capital

Write 5 points

13

Advantages of Adequate Working Capital

Solvency of the business Goodwill Easy Loans Cash Discounts Regular supply of raw materials Regular payment of salaries, wages and other day-to-day commitments Exploitation of favorable market conditions Ability to face crisis Quick and regular return on investments High morale

14

Understanding Working Capital Management and Financing

Balanced WC Position
Both excessive and inadequate levels are dangerous.
Excessive

Inadequate

Idle inventory Poor credit policy Bad debts Higher speculative and NOT real profits

Stagnates growth Ineffective use of fixed assets Tighter credit terms

Working capital management affects the companys risk, return, and share price.

15

Determinants of Working Capital

Write 5 points

16

Determinants of Working Capital

Nature of business Sales and demand Conditions Credit Policy Availability of Credit Operating Efficiency Price level changes Scale of operations Production policy Seasonal Variations Length of WC cycle Business Cycle

17

Principles of Working Capital Management

Principle of Risk Variation Principle of Maturity of payments

Principle of Cost of Capital

Principle of Equity position

18

Principle of Risk Variation

Larger investment in Current Assets with less dependence on short-term borrowings increases liquidity, reduces risk TRADE OFF has to be made.

Cost of Assets

19

Sales

Next Class.

Operating cycle Cash cycle Levels of working capital investment Planning of working capital investment

introduction need computation of working capital

W.C. & banking policy (Tandon, Chore, Marathe committee reports.)

20

Operating cycles
TASK Draw operating cycle of RADIO station ADVERTISING Co Insurance Co.

21

DANISH REZA

MANUFACTURING CONCERN

22

Understanding Working Capital Management and Financing

Operating Cycle
1. Acquisition of resources 2. Manufacture of the product 3. Sale of the product
Gross Operating Cycle

Oh ! Thats why we need working capital

Inventory Conversion Period

RMCP + WIPCP + FGCP

Debtors Conversion Period

Credit Sale

Payables
Purchases Payment

Net Operating cycle

Collection

23

Gross Operating Cycle

GOC = ICP + DCP Inventory Conversion period

RMCP WIPCP FGCP

RMCP = RM inventory x 360 RM Consumption

24

Gross Operating Cycle

WIP period = WIP Inventory x 360 Cost of production FGCP = FG Inventory x 360 Cost of Goods sold

25

Gross Operating Cycle

Debtors Conversion period

Debtors x 360 Credit Sales

Creditors deferral period

Creditors x 360 Credit purchases

26

Looking back

Cash Conversion Cycle or NOC = GOC - CDP

Gross Operating Cycle

Inventory Conversion Period

RMCP + WIPCP + FGCP

Debtors Conversion Period

Credit Sale

Payables
Purchases Payment

Net Operating cycle

Collection

27

Question

from the book.

28

Understanding Working Capital Management and Financing

Hedging (or Maturity Matching) Approach

A method of financing where each asset would be offset with a financing instrument of the same approximate maturity
Short-term financing

Assets

Long-term financing Fixed assets

29

TIME

Understanding Working Capital Management and Financing

Conservative Approach
Firm can reduce risks associated with short-term borrowing by using a larger proportion of long-term financing. Short-term financing

Assets

Long-term financing Fixed assets

30

TIME

Issues in WC Management

Time Investment Critically Growth

31

Liquidity Vs Profitability Risk Return Trade Off

Working Capital Policy Sales EBIT Current Asset Fixed Asset Conservative 1500000 150000 500000 500000 Moderate 1500000 150000 400000 500000 Aggressive 1500000 150000 300000 500000

Total Asset

1000000

900000

800000

32

Calculate Return on Total Asset CA/FA ratio

Solution
Conservative Sales EBIT CA 1500000 150000 500000 Moderate 1500000 150000 400000 Aggressive 1500000 150000 300000

FA
TA

500000
1000000

500000
900000

500000
800000

Return on TA
CA/FA

15%
1

16.67%
0.8

18.75%
0.6

33

Working Capital Levels

Level of Current Asset

Current Asset to Fixed Asset Ratio = CA/FA Higher CA/FA ratio indicates

Conservative Policy Average Policy Aggressive Policy

High liquidity Lower risk

Profitability and Solvency (Risk- return trade off)

Current Assets Fixed Assets

Output

34

Cost Trade-off

Cost of Liquidity Cost of Illiquidity

Total Cost Cost of liquidity Minimum Cost

Cost of illiquidity

35

Optimum level of Current Asset

Estimating WC needs

Current Assets holding period Ratio of Sales Ratio of Fixed Investment

36

TANDON Committee Report (July 1974) CHORE Committee Report (March 1979) MARATHE Committee Report (1982)

37

Next Class

Financing and control of working capital Sources of finance

Accruals Trade credit, W.C. advance by commercial banks, Regulation of bank finance, public deposits, ICDs, short term loans from FIs, right debentures for W.C., commercial papers factoring

38

Financing Working Capital

Trade Credit deferral of payment

Cash discount Easy availability, Flexibility and Informality.

39

Understanding Working Capital Management and Financing

Financing Working Capital

Trade Credit deferral of payment

Cash discount Easy availability, Flexibility and Informality.

Bank Credit

Overdraft or Cash credit Bill Discounting Term Loan Letter of Credit Hypothecation against movable property (inventories) without the transfer of ownership or possession Pledge transfer of physical possession Lien Mortgage

Secured and unsecured lending

40

Understanding Working Capital Management and Financing

Financing Working Capital (Cont.)

Commercial Papers Unsecured money market instrument with fixed maturity of 15 to a year Issued by large corporations with good credit ratings Sold at a discount with a promise to pay the face value at maturity.

Factoring Sale of receivables at a discount to a factor to obtain funds.

41

Understanding Working Capital Management and Financing

Looking Back..

Meaning of Working Capital Operating Cycle Permanent and Temporary working Capital Financing mix Financing alternatives

42