INTRODUCTION

CHAPTER 3 INTRODUCTION OF WORKING CAPITAL MANAGEMENT

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INTRODUCTION

3.1 BACKGROUND
In a perfect world, there would be no necessity for current assets and liabilities because there would be no uncertainty, no transaction cost, information search costs, scheduling costs, or production and technology constraints. The unit cost of production would not vary with the quantity produced. Borrowing and lending rates shall be same. Capital, labor, and product market shall be perfectly competitive and would reflect all available information, thus in such an environment, there would be no advantage for investing in short term assets. However the world we live is not perfect. It is characteri ed by considerable amount of uncertainty regarding the demand, market price, quality and availability of own products and those of suppliers. The real world circumstances introduce problems which require the necessity of maintaining working capital. !or e"ample, an organi ation may be faced with an uncertainty regarding availability of certain crucial inputs#raw material in future at reasonable price. This necessitates the holding of inventory, i.e. current assets. $imilarly an organi ation may be faced with an uncertainty regarding the level of its future cash flows. %oreover insufficient amount of cash may incur substantial costs. This may necessitate the reserve of short term marketable securities, again a short term capital asset.

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3.2 WORKING CAPITAL MANAGEMENT

3.2.1 What Is Wo !"#g Ca$"ta%&
&orking capital refers to the cash a business requires for day'to'day operations, or, more specifically, for financing the conversion of raw materials into finished goods, which the company sells for payment. (mong the most important items of working capital are levels of inventory, accounts receivable, and accounts payable. Cash is the lifeline of a company. If this lifeline deteriorates, so does the company)s ability to fund operations, reinvest and meet capital requirements and payments. ( good way to *udge a company)s cash flow prospects and its overall efficiency is to look at its working capital management +&C%,. In simple words &orking capital is the e"cess of Current assets and the Current -iabilities. &orking capital is the heart of the business. If it is week the business cannot prosper and survive. Therefore it is said that fate of large scale investment in fi"ed assets is often determined by a relatively small amount of current assets. The company must have adequate working capital as much as needed by the company. ."cessive working capital leads to funds lying idle with the firm without earning any profit where as inadequate working capital shows the company doesn/t have sufficient funds for financing its daily needs.

3.2.2 Nee' (o Wo !"#g )a$"ta%*

The 0rime ob*ect of the Company is to obtain ma"imum profit through its business. The amount of profit largely depends upon the magnitude of $ales. However the sale does not get converted to cash instantaneously. $ome companies are inherently better placed than others. Insurance companies, for instance, receive premium payments up front before having to make any payments1 however, insurance companies do have unpredictable outgoings as claims come in. 2ormally a big retailer like &al'%art has little to worry about when it comes to accounts receivable3 customers pay for goods on the spot. Inventories represent the biggest problem for retailers. %anufacturing companies, for e"ample, incur substantial up'front costs for materials and labor

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INTRODUCTION before receiving payment. %uch of the time they eat more cash than they generate. There is generally a time gap between sale of goods and receipt of cash. This Time gap is technically termed as 4perating Cycle# &orking capital cycle

3.2.3 Dete +"#at"o# o( Wo !"#g Ca$"ta%

The working capital needs of a firm are influenced by various factors. The important ones are3 5. 2ature of business. 6. $easonality of operations 7. 0roduction policy 8. %arket conditions 9. Conditions of supply 2ature of Business the working capital requirement of a firm are closely relate to the nature of its business. ( service firm, like an electricity undertaking or a transport corporation, which has a short operating cycle and which sells predominantly on cash basis, has modest working capital requirements. 4n the other hand, manufacturing concern like (arti Industries -td, which has a long operating cycle and which sells largely on credit, has very substantial working capital requirements. It is largely dependent on the products specifications, technology and production policy. $easonality of 4perations !irms which have marked seasonality in their operations usually has highly fluctuating working capital requirements. Their operations would be season specific and thus this increases the need of working capital during that specific 0roduction 0olicy !irms may acquire different policy of production as per their management/s decision. If their management finds the year long production to be more profitable and less risky than the seasonal specific production then the requirement of working capital will be spread all over the year than in particular period of seasonal production. (t, (arti Industries -imited the 0roduction is carried out through out the year as per the contracts won by the company. $o the &orking capital is need through out the year.

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-.o/ )e0 F"#a#)"a% Ma#age+e#t1 Theo 2 3 P a)t")e -4th E'5 *.62 P asa#a Cha#' a5
C/ e#t Asset -<5 5:'6: 6:'7: 7:'8: 8:'9: 9:'A: A:'>: >:';: ;:'<: F"7e' Asset -<5 ;:'<: >:';: A:'>: 9:'A: 8:'9: 7:'8: 6:'7: 5:'6: I#'/st "es Hotel and =estaurants .lectricity ?eneration and @istribution (luminum, $hipping Iron and $teel, Basic Industrial Chemicals Tea 0lantation Cotton Te"tile, $ugar .dible 4ils, Tobacco Trading, Construction

Ta6%e0 1 D"st "6/t"o# o( C/ e#t a#' F"7e' Asset

Conditions of $upply !irms with irregular and intermittent supplies need to maintain large working capital to meet market demand. These firms will be required to maintain large inventory even at high cost if the supplies are limited or irregular. Thus the cost of working capital increases and that further place pressure to increase sales turnover. (t (arti Industries -imited, the supplies are regularly available and the working capital is maintained at the regular level. %arket Conditions !irms which face cutthroat competition from other firms in the industry need to maintain the level of the inventory at such a position that they are able to meet their customer requirement in time and with consistency. This will require the firm to maintain the working capital at the level which is most profitable but at the same time feasible. Aa t" I#'/st "es L"+"te' (a)es )o+$et"t"o# ( o+ se8e a% $%a2e s %"!e P"'"%"te+ I#'1 Tata Che+")a%s1 G/9 a%!a%"1 BOC I#'"a1 :"#at" O ga#")s

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3.2.,

CON.E=UENCE. WORKING CAPITAL

OF

UNDER

A..E..MENT

OF

?rowth may be stunted. It may become difficult for the enterprise to undertake profitable pro*ects due to non'availability of working capital. Implementation of operating plans may become difficult and consequently the profit goals may not be achieved. Cash crisis may emerge due to paucity of working funds. 4ptimum capacity utili ation of fi"ed assets may not be achieved due to non availability of the working capital. The business may fail to honour its commitment in time, thereby adversely affecting its credibility. This situation may lead to business closure. The business may be compelled to buy raw materials on credit and sell finished goods on cash. In the process it may end up with increasing cost of purchases and reducing selling prices by offering discounts. Both these situations would affect profitability adversely. 2on'availability of stocks due to non'availability of funds may result in production stoppage. &hile underassessment of working capital has disastrous implications on business, over assessment of working capital also has its own dangers.

3.2.; CON.E=UENCE. OF O:ER A..E..MENT OF WORKING CAPITAL

."cess of working capital may result in unnecessary accumulation of inventories. It may lead to offer too liberal credit terms to buyers and very poor recovery system and cash management. It may make management complacent leading to its inefficiency. 4ver'investment in working capital makes capital less productive and may reduce return on investment. &orking capital is very essential for success of a business and, therefore, needs efficient management and control. .ach of the components of the working capital needs proper management to optimi e profit.

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3.2.> The ?o !"#g )a$"ta% "# )e ta"# e#te $ "se +a2 6e )%ass"("e' "#to the (o%%o?"#g !"#'s. 1. I#"t"a% ?o !"#g )a$"ta%
The capital, which is required at the time of the commencement of business, is called initial working capital. These are the promotion e"penses incurred at the earliest stage of formation of the enterprise which include the incorporation fees. (ttorney)s fees, office e"penses and other e"penses.

2. Reg/%a ?o !"#g )a$"ta%

This type of working capital remains always in the enterprise for the successful operation. It supplies the funds necessary to meet the current working e"penses i.e. for purchasing raw material and supplies, payment of wages, salaries and other sundry e"penses.

3. F%/)t/at"#g ?o !"#g )a$"ta%

This capital is needed to meet the seasonal requirements of the business. It is used to raise the volume of production by improvement or e"tension of machinery. It may be secured from any financial institution which can, of course, be met with short term capital. It is also called variable working capital.

,. Rese 8e +a g"# ?o !"#g )a$"ta%.

It represents the amount utili ed at the time of contingencies. These unpleasant events may occur at any time in the running life of the business such as inflation, depression, slump, flood, fire, earthquakes, strike, lay off and unavoidable competition etc. In this case greater amount of capital is required

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INTRODUCTION

D"((e e#)e "# Wo !"#g Ca$"ta% (o D"((e e#t I#'/st "es

Ma#/(a)t/ "#g High volume of &I0 and finished goods. High level of trade receivables, as they tend be dependent on a few customers. -ow to medium levels of trade payables. Reta"% ?oods for re' sale only and usually low volume. Bery low levels as most goods are bought in cash. .e 8")e 2one or very little inventories.

I#8e#to "es

T a'e e)e"8a6%es

Csually low levels s services are paid for immediately.

T a'e $a2a6%es

Bery high levels -ow levels of of trade payables. payables due to huge purchases of inventory.

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3.3 WORKING CAPITAL CACLE

The ?o !"#g )a$"ta% )2)%e )a# 6e 'e("#e' as0
The period of time which elapses between the point at which cash begins to be e"pended on the production of a product and the collection of cash from a customer.

( firm requires many years to recover initial investment in fi"ed assets. 4n contrary the investment in current asset is turned over many times a year. Investment in such current assets is reali ed during the operating cycle of the firm. .ach component of working capital +namely inventory, receivables and payables, has two dimensions ... TI%. ......... and %42.D. &hen it comes to managing working capital ' TI%. I$ %42.D. If you can get money to move faster around the cycle +e.g. collect dues from debtors more quickly, or reduce the amount of money tied up +e.g. reduce inventory levels relative to sales,, the business will generate more cash or it will need to borrow less money to fund working capital. (s a consequence, you could reduce the cost of bank interest or you)ll have additional free money available to support additional sales growth or investment. $imilarly, if you can negotiate improved terms with suppliers e.g. get longer credit or an increased credit limit1 you effectively create free finance to help fund future sales. It can be tempting to pay cash, if available, for fi"ed assets e.g. computers, plant, vehicles etc. If you do pay cash, remember that this

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is now longer available for working capital. Therefore, if cash is tight, consider other ways of financing capital investment ' loans, equity, leasing etc. $imilarly, if you pay dividends or increase drawings, these are cash outflows and, like water flowing downs a plughole, they remove liquidity from the business.

I( 2o/ ... Collect receivables +debtors, faster. Collect receivables +debtors, slower. ?et better credit +in terms of duration or amount, from suppliers. $hift inventory +stocks, faster. %ove inventory +stocks, slower.

The# ... Dou release cash from the cycle. Dour receivables soak up cash. Dou increase your cash resources. Dou free up cash. Dou consume more cash.

The '"ag a+ 6e%o? "%%/st ates the ?o !"#g )a$"ta% )2)%e (o Ma#/(a)t/ "#g F" +.

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INTRODUCTION .ach component of working capital +namely inventory, receivables and payables, has two dimensions TI%. and %42.D. &hen managing &orking capital, ETI%. I$ %42.DF. If you can get money to move faster around the cycle +collect monies due from the debtors more quickly, or reduce the money tied up +reduce inventory level relative to sales,. The business will generate more cash or it will need to borrow less money to fund working capital. (s a result the cost of Bank interest can be reduced or additional money will be available to support additional sales or investment. $imilarly if one negotiates improved terms with suppliers e.g. getting longer credit or an increased credit limit, one festively create freed finance to fund future sales. F"g 3

=%C0 &I0C0 !?C0 IC0 =C0 0ayables +0@0, 24C ?4C

' =aw %aterial Conversion 0eriod ' &ork in 0rogress Conversion 0eriod ' !inished ?oods Conversion 0eriod ' Inventory Conversion 0eriod ' =eceivables Conversion 0eriod ' 0ayables @eferral 0eriod ' 2et 4perating Cycle ' ?ross 4perating Cycle

( perusal of 4perating cycle reveals that the cash invested in operations are recycled back into cash. However it takes some time to get converted and this leads to need of &orking capital. Cash being the lifeblood of a Company, the manager/s primary task is to keep the cash flowing and use this cash flow to generate profits. The shorter the period of operating cycle, larger will be the turnover of funds invested in the operations.

,.3.1 Ma#age+e#t o( I#8e#to 2

Inventories constitute the most significant part of current assets of a large ma*ority of companies in India. 4n an average, inventories are appro"imately A: G of current assets in public limited companies in India. Because of the large si e of inventories maintained by firms maintained by firms, a considerable amount of funds is required to be committed to them. It is, therefore

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INTRODUCTION very necessary to manage inventories efficiently and effectively in order to avoid unnecessary investments. ( firm neglecting a firm the management of inventories will be *eopardi ing its long run profitability and may fail ultimately. The purpose of inventory management is to ensure availability of materials in sufficient quantity as and when required and also to minimi e investment in inventories at considerable degrees, without any adverse effect on production and sales, by using simple inventory planning and control techniques.

Nee's to ho%' "#8e#to "es0D

There are three general motives for holding inventories3' Transaction motive emphasi es the need to maintain inventories to facilitate smooth production and sales operation. 0recautionary motive necessities holding of inventories to guard against the risk of unpredictable changes in demand and supply forces and other factors. $peculative motive influences the decision to increases or reduce inventory levels to take advantage of price fluctuations and also for saving in reordering costs and quantity discounts etc.

O69e)t"8e o( I#8e#to 2 Ma#age+e#t0D

The main ob*ectives of inventory management are operational and financial. The operational mean that means that the materials and spares should be available in sufficient quantity so that work is not disrupted for want of inventory. The financial ob*ective means that investments in inventories should not remain ideal and minimum working capital should be locked in it.

The (o%%o?"#g a e the o69e)t"8es o( "#8e#to 2 +a#age+e#t0D

To ensure continuous supply of materials, spares and finished goods. To avoid both over'stocking of inventory. To maintain investments in inventories at the optimum level as required by the operational and sale activities. To keep material cost under control so that they contribute in reducing cost of production and overall purchases. To eliminate duplication in ordering or replenishing stocks. This is possible with the help of centrali ing purchases.

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INTRODUCTION To minimi e losses through deterioration, pilferage, wastages and damages. To design proper organi ation for inventory control so that management. Clear cut account ability should be fi"ed at various levels of the organi ation. To ensure perpetual inventory control so that materials shown in stock ledgers should be actually lying in the stores. To ensure right quality of goods at reasonable prices. To facilitate furnishing of data for short'term and long term planning and control of inventory

,.3.2 Ma#age+e#t o( )ash

Cash is the important current asset for the operation of the business. Cash is the basic input needed to keep the business running in the continuous basis, it is also the ultimate output e"pected to be reali ed by selling or product manufactured by the firm. The firm should keep sufficient cash neither more nor less. Cash shortage will disrupt the firm/s manufacturing operations while e"cessive cash will simply remain ideal without contributing anything towards the firm/s profitability. Thus a ma*or function of the financial manager is to maintain a sound cash position. Cash is the money, which a firm can disburse immediately without any restriction. The term cash includes coins, currency and cheques held by the firm and balances in its bank account. $ometimes near cash items such as marketing securities or bank term deposits are also included in cash. ?enerally when a firm has e"cess cash, it invests it is marketable securities. This kind of investment contributes some profit to the firm.

Nee' to ho%' )ash

The firm/s need to hold cash may be attributed to the following three motives3' The T a#sa)t"o# Mot"8e0 The transaction motive requires a firm to hold cash to conduct its business in the ordinary course. The firm needs cash primarily to make payments for purchases, wages and salaries, other operating e"penses, ta"es, dividends, etc. The P e)a/t"o#a 2 Mot"8e0

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INTRODUCTION ( firm is required to keep cash for meeting various contingencies. Though cash inflows and outflows are anticipated but there may be variations in these estimates. !or e"ample a debtor who pays after > days may inform of his inability to pay, on the other hand a supplier who used to give credit for 59 days may not have the stock to supply or he may not be in opposition to give credit at present. .$e)/%at"8e Mot"8e0 D The speculative motive relates to the holding of cash for investing in profit making opportunities as and when they arise. The opportunities to make profit changes. The firm will hold cash, when it is e"pected that interest rates will rise and security price will fall.

,.3.3 Ma#age+e#t o( Re)e"8a6%es

( sound managerial control requires proper management of liquid assets and inventory. These assets are a part of working capital of the business. (n efficient use of financial resources is necessary to avoid financial distress. =eceivables result from credit sales. ( concern is required to allow credit sales in order to e"pand its sales volume. It is not always possible to sell goods on cash basis only. $ometimes other concern in that line might have established a practice of selling goods on credit basis. Cnder these circumstances, it is not possible to avoid credit sales without adversely affecting sales. The increase in sales is also essential to increases profitability. (fter a certain level of sales the increase in sales will not proportionately increase production costs. The increase in sales will bring in more profits. Thus, receivables constitute a significant portion of current assets of a firm. But for investment in receivables, a firm has to insure certain costs. !urther, there is a risk of bad debts also. It is therefore, very necessary to have a proper control and management of receivables.

Nee's to ho%' )ash0

=eceivables management is the process of making decisions relating to investment in trade debtors. Certain investments in receivables are necessary to increase the sales

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INTRODUCTION and the profits of a firm. But at the same time investment in this asset involves cost consideration also. !urther, there is always a risk of bad debts too. Thus, the ob*ective of receivable management is to take a sound decision as regards investments in debtors. In the words of Bolton, $..., the need of receivables %anagement is Eto promote sales and profits until that point is reached where the return of investment in further funding of receivables is less than the cost of funds raised to finance that additional credit.F

,.3., .o/ )es o( A''"t"o#a% Wo !"#g Ca$"ta%

$ources of additional working capital include the following3 ."isting cash reserves 0rofits +when you secure it as cashH, 0ayables +credit from suppliers, 2ew equity or loans from shareholders Bank overdrafts or lines of credit -ong'term loans

If you have insufficient working capital and try to increase sales, you can easily over' stretch the financial resources of the business. This is called overtrading. Ea %2 ?a #"#g s"g#s "#)%/'e0 0ressure on e"isting cash ."ceptional cash generating activities e.g. offering high discounts for early cash payment Bank overdraft e"ceeds authori ed limit $eeking greater overdrafts or lines of credit 0art'paying suppliers or other creditors 0aying bills in cash to secure additional supplies %anagement pre'occupation with surviving rather than managing !requent short'term emergency requests to the bank +to help pay wages, pending receipt of a cheque,.

,.3.; Ha#'%"#g Re)e"8a6%es -De6to s5

Cash flow can be significantly enhanced if the amounts owing to a business are

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INTRODUCTION collected faster. .very business needs to know.... who owes them money.... how much is owed.... how long it is owing.... for what it is owed. Late payments erode profits and can lead to bad debts. $low payment has a crippling effect on business1 in particular on small businesses who can least afford it. If you don)t manage debtors, they will begin to manage your business as you will gradually lose control due to reduced cash flow and, of course, you could e"perience an increased incidence of bad debt. The following measures will help manage your debtors3 5. Have the right mental attitude to the control of credit and make sure that it gets the priority it deserves. 6. .stablish clear credit practices as a matter of company policy. 7. %ake sure that these practices are clearly understood by staff, suppliers and customers. 8. Be professional when accepting new accounts, and especially larger ones. 9. Check out each customer thoroughly before you offer credit. Cse credit agencies, bank references, industry sources etc. A. .stablish credit limits for each customer and stick to them. >. Continuously review these limits when you suspect tough times are coming or if operating in a volatile sector. ;. Ieep very close to your larger customers. <. Invoice promptly and clearly. 5:. Consider charging penalties on overdue accounts. 55. Consider accepting credit #debit cards as a payment option. 56. %onitor your debtor balances and ageing schedules, and don)t let any debts get too large or too old. =ecogni e that the longer someone owes you, the greater the chance you will never get paid. If the average age of your debtors is getting longer, or is already very long, you may need to look for the following possible defects3 &eak Credit Judgment 0oor Collection 0rocedures -a" .nforcement 4f Credit Terms $low Issue 4f Invoices 4r $tatements .rrors In Invoices 4r $tatements

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INTRODUCTION Customer @issatisfaction.

@ebtors due over <: days +unless within agreed credit terms, should generally demand immediate attention. -ook for the warning signs of a future bad debt. Fo e7a+$%e......... -onger credit terms taken with approval, particularly for smaller orders Cse of post'dated checks by debtors who normally settle within agreed terms .vidence of customers switching to additional suppliers for the same goods 2ew customers who are reluctant to give credit references =eceiving part payments from debtors. Profits only come from paid sales. The act of collecting money is one which most people dislike for many reasons and therefore put on the long finger because they convince themselves there is something more urgent or important that demands their attention now. The e "s #oth"#g +o e "+$o ta#t tha# gett"#g $a"' (o 2o/ $ o'/)t o se 8")e. A )/sto+e ?ho 'oes #ot $a2 "s #ot a )/sto+e .

,.3.> Ma#ag"#g Pa2a6%es -C e'"to s5

Creditors are a vital part of effective cash management and should be managed carefully to enhance the cash position. 0urchasing initiates cash outflows and an over' ealous purchasing function can create liquidity problems. Co#s"'e the (o%%o?"#g0 &ho authori es purchasing in your company ' is it tightly managed or spread among a number of +*unior, peopleK (re purchase quantities geared to demand forecastsK @o you use order quantities which take account of stock'holding and purchasing costsK @o you know the cost to the company of carrying stockK @o you have alternative sources of supplyK If not, get quotes from ma*or suppliers and shop around for the best discounts, credit terms, and reduce dependence on a single supplier.

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INTRODUCTION How many of your suppliers have a returns policyK (re you in a position to pass on cost increases quickly through price increases to your customersK If a supplier of goods or services lets you down can you charge back the cost of the delayK Can you arrange +with confidenceH, to have delivery of supplies staggered or on a *ust'in'time basisK There is an old adage in business that if you can buy well then you can sell well . %anagement of your creditors and suppliers is *ust as important as the management of your debtors. It is important to look after your creditors ' slow payment by you may create ill'feeling and can signal that your company is inefficient +or in troubleH,. Re+e+6e 1 a goo' s/$$%"e "s so+eo#e ?ho ?"%% ?o ! ?"th 2o/ to e#ha#)e the (/t/ e 8"a6"%"t2 a#' $ o("ta6"%"t2 o( 2o/ )o+$a#2.

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,., FINANCING WORKING CAPITAL

2ow let us understand the means to finance the working capital. &orking capital or current assets are those assets, which unlike fi"ed assets change their forms rapidly. @ue to this nature, they need to be financed through short'term funds. $hort'term funds are also called current liabilities. The following are the ma*or sources of raising short'term funds3 I. ./$$%"e Es C e'"t (t times, business gets raw material on credit from the suppliers. The cost of raw material is paid after some time, i.e. upon completion of the credit period. Thus, without having an outflow of cash the business is in a position to use raw material and continue the activities. The credit given by the suppliers of raw materials is for a short period and is considered current liabilities. These funds should be used for creating current assets like stock of raw material, work in process, finished goods, etc. "". Ba#! Loa# (o Wo !"#g Ca$"ta% This is a ma*or source for raising short'term funds. Banks e"tend loans to businesses to help them create necessary current assets so as to achieve the required business level. The loans are available for creating the following current (ssets3 .to)! o( Ra? Mate "a%s .to)! o( Wo ! "# P o)ess .to)! o( F"#"she' Goo's De6to s

Banks give short'term loans against these assets, keeping some security margin. The advances given by banks against current assets are short'term in nature and banks have the right to ask for immediate repayment if they consider doing so. Thus bank loans for creation of current assets are also current liabilities. """. P o+ote Es F/#' It is advisable to finance a portion of current assets from the promoter/s funds. They are long'term funds and, therefore do not require immediate repayment. These funds increase the liquidity of the business.

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