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Working Capital

Management

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WORKING CAPITAL
 Working capital refers to that part of total
capital, which is used for carrying out the
regualr business in other words its used
for financing the day-to-day operations of
the business

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Classifications of WC
Considering the objectives and scope of working capital, it can
be defined in two ways:
(i) Gross Concept
(ii) Net Concept
 (i) Gross Concept:- According to the gross concept, working
capital means total of all the current assets of a business. It is
also called gross working capital.
Gross Working Capital= Total Current Assets
 (ii) Net Concept:- According to the net concept of working
capital, net working capital means the excess of current assets
over current liabilities. If current assets are equal to current
liabilities then according to this concept working capital will be
zero and in case current liabilities are more than current assets,
the working capital will be called negative working capital.
Net Working Capital= Current Assets-Current Liabilities

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 Permanent or fixed working capital is a certain minimum
level of capital maintained on a continuous and
uninterrupted basis
 The business process does not come to an end after the
realization of cash from customers so there is a
continuous need for WC
 Any amount over and above the permanent level of WC
is temporary or fluctuating or variable WC
 So therefore temporary WC is the WC needed to meet
seasonal as well as unforeseen requirements

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Permanent Working Capital
The amount of current assets required to meet a firm’s long-term
minimum needs.
DOLLAR AMOUNT

Permanent current assets

TIME
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Temporary Working Capital
The amount of current assets that varies with seasonal requirements.

A Temporary current assets


M
O
U
N
T
Permanent current assets

TIME
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Positive and Negative Working
Capital
 The positive working capital represents the excess
of current assets over current liabilities
 Sometimes the net working capital is negative when
current liabilities are exceeding the current assets.
The ‘Negative working capital’ position will
adversely affect the operations of the firm and its
profitability. It may lead to technical insolvency.

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WORKING CAPITAL
MANAGEMENT
Working Capital Management:
It is the management of all aspects of both current assets and
current liabilities, so as to minimize the risk of insolvency while
maximizing return on assets.

The primary objective of working capital management is to ensure


that sufficient cash is available to:

 meet day-to-day cash flow needs;


 pay wages and salaries when they fall due;
 pay creditors to ensure continued supplies of goods and services;
 pay government taxation and providers of capital.. dividends; and
 ensure the long term survival of the business entity.

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 Working capital management is concerned with the
problems that arise in attempting to manage the current
assets and current liabilities and the relationship that exist
between them.

 The goal of WCM is to manage the firm’s CA and CL in


such a way that a satisfactory level of WC is maintained

 In other words WCM is concerned with maintaining


adequate amount of working capital

 adequate amount of working capital refers to optimum


amount of WC which is neither too high nor too low. Both
excess and inadequate WC are dangerous for any firm.
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 It is critical to understand that Profit is not Cash. A
company can be very profitable but it can collapse simply
because it has insufficient cash/liquidity to pay its relevant
bill (as stated above).
 Always remember that any company’s liabilities are settled
with cash and not by profit.
Importance in Optimizing Working Capital
Management:
Poor working capital management can lead to:
 over-capitalisation; and
 overtrading
 Characteristics of over-capitalisation are excessive stocks,
debtors, and cash, low return on investment with long term
funds tied up in non-earning short term assets.
 Overtrading leads to escalating debtors and creditors, and
if unchecked, ultimately to cash starvation.
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BENEFITS OF ADEQUATE WC
 Its an index of the solvency of the firm
 It enhances the credit worthiness of the firm
 It helps the firm to maintain good business relations
 It helps the firm to avail cash discounts facilities offered
by suppliers
 It improves the morale of the executives and the
employees of the firm

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DEMERITS OF EXCESS WC
 It results in idle funds and the there by lowers the profitability of the
business
 It takes the form of unnecessary accumulation of inventories, there
may be misleading wastage theft etc of the stock, which again reduces
the profits of the business
 If it takes the form of huge account receivables, the inference is that
the credit worthiness of the firm is defective and the collection of debt
is not efficient this leads to bad debts, which ll affect the firms
profitability
 It makes mgt self satisfied in their work thus contributing to managerial
inefficiency
 High liquidity may induce a company to undertake greater production,
which may not have a matching demand in the market

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DANGERS OF INADEQUATE WC
 Its not possible to utilize production facilities fully
 The company may not be able to take the advantage of cash
discount facilities
 The credit worthiness of the company is likely to jeopardize due
to lack of inadequate WC
 A company may not be able to take the advantage of profitable
business opportunities
 Its difficult to execute operating plans to achieve target profit
 Its difficult to meet day to day commitments
 A firm may not be able to enjoy the attractive credit terms from
suppliers and creditors
 It causes interruption in production

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DETERMINANTS OF WC
REQUIREMENTS
 General nature of business
 Scale of operations
 Growth and expansion length of manufacturing process
 Production policies
 Rapidity of turnover
 Seasonal fluctuations in demand
 Fluctuations in supplies
 Operating efficiency
 Credit policies
 Price level changes
 Government regulations
 Profit level
 Taxes
 Depreciation policies

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DETERMINING FINANCING MIX
 The important decision involved in WCM is how current
assets are financed
 Financing mix is the choice of financing of current assets
 The two sources from which funds can be raised for
current asset financing are
short term sources(current liability)
long term sources
(shares,debentures,borrowings,retained earnings)

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 What proportion of current assets must be
financed by current liabilities and what
proportion by long term resources?
 Decisions on such questions will determine
the financing mix..
 the 3 basic approaches to determine an
apporpriate financing mix are….
hedging or matchin approach
conservative approach
trade off between these two

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Hedging approach
 Hedging is used in sense of risk-reducing investment strategy, involving
transactions of simultaneous but opposing nature so that effect of one is likely to
counterbalance the effect of other
 Hedging approach is the process of matching the maturity of debt with maturity
of financial needs
 According to this approach maturity of sources of fund should match the nature
of asset to be financed. So CA can be classified into two
do not vary over time
fluctuate over time
 According to this approach..
Use long term funds to finance fixed portion of CA(permanent) requirement and
Use short term funds to finance temporary or seasonal requirement
 So here requirements of total funds are divided into seasonal and permanent
components, each being financed by a different source.

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 Permanent needs implies financing needs
for fixed assets plus permanent portion of
current assets which remain unchanged
over the years
 Seasonal needs implies the financing
requirements for temporary current assets
which vary over the year

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Conservative approach
 This approach suggest that the estimated
requirement of the total funds must be met
from long term sources only, and the use
of short term funds should be restricted to
only emergency situations or unexpected
outflow of cash

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A trade off between hedging and
conservative approach
 The hedging approach is associated with high
profits and high risk
 While the conservative approach is associated
with low profits and low risk.
 Obviously neither approach by itself would serve
the purpose of efficient WCM
 A trade off btwn these two extremes would give
an acceptable financing strategy

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PLANNING WORKING CAPITAL
NEED FOR WORKING CAPITAL
 Need for WC or CA cannot be overemphasized.
 The objective of financial decision making to maximize the sh/h wealth,
its necessary to generate sufficient profits.
 The extent to which the profits are earned will depend on many other
things like magnitude of sales
 Sales are necessary to earn profits.
 But sales do not convert into cast instently, there is a time lag btwn sale
of goods and receipt of cash, so therefore there is a need for WC in the
form of CA to deal with this problem and to sustain the sales activity.
 This is referred to as operating or cash cycle

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 “the continuing flow of cash to suppliers, to inventory, to account
receivables, and back into cash is called as operating cycle.
 its the length of time necessary to
complete the following cycle of events
Namely..
Conversion of cash into inventory
Conversion of inventory into receivables
Conversion of receivables into cash
Phase 3
Receivables

cash Phase 2

inventory
Phase 1

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OPERATING CYCLE

DEFINITION
The average time between purchasing or
acquiring inventory and receiving cash
proceeds from its sale.

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Cash and Operating Cycle
Operating cycle and cash cycle are two important components of working
capital management. Together they determine the efficiency of a firm
regarding working capital management.
Operating cycle refers to the delay between the buying of raw materials and
the receipt of cash from sales proceeds. In other words, operating cycle
refers to the number of days taken for the conversion of cash to inventory
through the conversion of accounts receivable to cash. It indicates towards
the time period for which cash is engaged in inventory and accounts
receivable. If an operating cycle is long, then there is lower accessibility to
cash for satisfying liabilities for the short term.
Operating cycle takes into consideration the following elements: accounts
payable, cash, accounts receivable, and inventory replacement.
The following formula is used for calculating operating cycle:
Operating cycle = age of inventory + collection period

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 Cash cycle is also termed as net operating cycle, asset conversion cycle,
working capital cycle or cash conversion cycle. Cash cycle is implemented in
the financial assessment of a commercial enterprise. The more the figure is
increased, the higher is the period for which the cash of a commercial entity
is engaged in commercial activities and is inaccessible for other functions,
for instance investments. The cash cycle is interpreted as the number of
days between the payment for inputs and getting cash by sales of
commodities manufactured from that input.
The fundamental formula that is applied for the calculation of cash
conversion cycle is as follows:
Cash cycle = (Average Stockholding Period) + (Average Receivables
Processing Period) - (Average Payables Processing Period)
Average Receivables Processing Period (in days) = Accounts
Receivable/Average Daily Credit Sales Average Stockholding Period (in
days) = Closing Stock/Average Daily Purchases Average Payable
Processing Period (in days) = Accounts Payable/Average Daily Credit
Purchases

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 A short cash cycle reflects sound management of working capital. On the other
hand, a long cash cycle denotes that capital is occupied when the commercial
entity is expecting its clients to make payments.
There is always a probability that a commercial enterprise can face negative cash
conversion cycle, in which case they are getting payments from the clients before
any payment is made to the suppliers. Instances of such business entities are
commonly those companies, which apply JIT or Just in Time techniques, for
example Dell, as well as commercial enterprises, which purchase on terms and
conditions of longer duration credits and perform sales against cash, for instance
Tesco.
The more the manufacturing procedure is extended, the higher the amount of cash
should be kept engaged in inventories by the company. Likewise, the more time is
taken for the clients for the purpose of bill payment, the more is the accounts
receivable amount. From another viewpoint, if a company is able to detain the
payment for its internal inputs, it can decrease the amount of money required. Put
differently, the net working capital is diminished by accounts payable.

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Sources of Working Capital
Finance
Sources for Financing Working Capital
 (i) Permanent or Fixed
 (ii) Temporary or variable

Long Term Sources:


 1.Shares
 2.Debentures
 3.Public deposits
 4.Ploughing back of profits
 5.Loans from Financial Institutions

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Short term sources

 Trade credit
 Bank credit-
Cash ODs
Cash credits
Loans
Bills purchased/discounted
Term loans for working capital
Letter of credit

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 Shares-the total capital of the company will divided
into equal number of units called as shares and will
be offered for public subscription
 Debentures-its an acknowledgement of debt. these
are long term debt instrument used by business
firms to raise a large sum of money.

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 Trade credit- it refers to the credit extended by the supplier
of goods and services in the normal course of business.
Cash is not paid immediately for the purchase but aft an
agreed period of time thus trade credit represents a sourse of
finance for credit purchase.
There is no formal negotiation for trade credit its just an
informal agreement btwn the buyer and the seller.

 Cash discount- it implies a percentage deduction from the


purchase price, if the buyer pays within a specified time that
is shorter than the credit period.
cash discount is for prompt payment.

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Bank credit
 Overdraft-it’s the facility extended to current account holders where in the
customers are allowed to draw cash more than the balance in his account. so
therefore the interest charged is high.
 Loans-here the entire amount of borrowings is credited to the loan account of the
borrower. The borrower has to pay interest on the total amount and the loans are
repayable on demand or in periodic installments
 Bills discounted-here the seller of the goods draws the bill on the purchaser of the
goods, payable on demand or aft a period not exceeding 90 days. on acceptance of
the bill, the seller offers it to the bank for discount or purchase on discounting the
bank releases the fund to the seller.
 term loans-under this arrangement, banks advance loans for 3-7 years repayable
in yearly or half yearly installment
 Letter of credit-it’s a letter written by a bank stating that the bank guarantees
payment of an invoiced amount if all the under laying agreements are met.

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Mode of security
Banks provide credit on the basis of the following mode of security
 Hypothecation
 Pledge
 Lien
 Mortgage
 Charge
 Certificate of deposits
 Commercial Papers
 Factoring

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 Hypothecation-the bank provides credit to the borrower against the security of
movable property, usually inventory of goods. The goods hypothecated
continue to be in the possession of the owner of these goods but the bank has
the legal rights to sell the goods to realise the outstanding amount.
 Pledge-here the goods offered as security are transferred to the physical
possession of the lender of money. the goods are in the custody of the bank the
borrower who offers the security is called pledger while the bank is called as
pledgee. The bank must take reasonable care of the pledged goods and in case
of non payment of the loan the bank enjoys the right to sell the goods.
 Lien-it refers to the right of a party to retain goods belonging to another party
until a debt to him is paid. Particular lein is a right to retain goods until a claim
pertaining to these goods is fully paid.
and general lien can be applied until all dues are paid.
 Mortgage-it is the transfer of a legal interest in specific immovable property for
securing the payment of debt the mortgage interest in the property is
terminated as soon as the debt is paid.mortagage is an additional security for
WC credit by banks.

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 Charge-a charge is not the transfer of interest in the immovable property though
it is a security for payment of money to another.its created by the act of parties
or by the operation of law.
 Commercial papers-its an unsecured negotiable instrument it’s a form of
financing consisting of short term unsecured promissory notes issued by a firm
with high credit rating for fixed maturity period. the issuer promises the buyer a
fixed amt at a future period but pledges no asset his liquidity and earnings are
the only guarantee.
 Certificate of deposits-CDs are a marketable receipt of funds deposited in a
bank for a fixed period at a specific rate of interest. before the period expires
the depositor cannot encash from his banker but he can sell it in secondary
market. therefore the instrument has liquidity and is easily marketable.
 Factoring-factoring involves sale of account receivables to a factor who charges
a commission( he is a middle man), here the factor bears the credit risk
associated with the accounts receivable purchased by it and provides funds in
advance of collection and thus, finances receivables

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Thank you

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