FINANCIAL MANAGEMENT – MBA Mrs.I.

Santhilatha

FM V UNIT - WORKING CAPITAL MANAGEMENT

INTRODUCTION

Working capital may be regarded as the lifeblood of a business.The term

working capital refers to the capital for day-to-day operations of a business enterprise.
Working capital management is also one of the important parts of the financial
management it is concerned with short-term finance of the business concern which is a
closely related trade between profitability and liquidity.

DEFINITION

According to Gerstenberg, “Working capital has been defined as the excess of current
assets over current liability”.

OBJECTIVES OF WORKING CAPITAL MANGEMENT

• It is required to meet the day-to-day operating expenses.

• To hold the stock of raw materials.

• To finance operations during the time gap between sale of goods on credit and
realization of money from customers of the firm.

• To finance investments in current assets for achieving the growth target in sales.

CONCEPTS OF WORKING CAPITAL MANAGEMENT

There are two concepts of working capital:

1. Gross working capital concept.
2. Net working capital concept.
1) Gross working capital concept

Refers to the firms' investment in current assets. Current assets are the assets which can
be converted into cash with in an accounting year and include cash, short-term securities,
debtors, bills receivable and stock. The gross working capital concept focuses attention on two
aspects of current assets management.

a) Optimum investment in current assets.

b) Financing of current assets.

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2) Net working capital concept

Refers to the difference between current assets and current liabilities Current liabilities
are those claims of outsiders which are expected to mature for payment with in an accounting
year and include creditors, bills payable and outstanding expenses. Net working capital can be
positive or negative.
A positive net working capital will arise when current assets exceed Current liabilities.
A negative net working capital occurs when the current liabilities are in excess of current assets.

OPERATING CYCLE CONCEPT

The operating cycle is the amount of time it takes for a company to turn cash used to
purchase inventory into cash once again. It is a time lag between the acquisitions of raw
materials to financial realization of cash passing through various stages.

ACCOUNT
CASH
RECEIVABLE/DEBTOR

FINISHED GOODS RAW MATERIALS

WORK-IN-PROGRESS

1. Conversion of Cash into Raw Materials

This is the first step, in a manufacturing firm cash is used to buy the raw matrials. The
payment is made in the form of cash.
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2. Conversion of Raw Materials into Work-In-Progress

After the purchase of rawmaterials required by a manaufacturing firm, the next step os
to production of the product, where raw materials is converted into work-in-progress.

3. Conversion of work-in-progress into finished goods

As the work-in-progress are completed, the next step is that the product should
transferred to finished goods through production process.

4. Conversion of finished goods into account receivable/debtor

The next step after the development of finished goods is to make sale. The sale of the
product which can be in cash or credit. Credit sales usually create account receivable for
collection.

5. Conversion of account receivable into cash

This is the final phase, where all the receivables are convert into cash. Thus, the
conversion cycle is the time spend by cash in the process of conversion.

COMPONENTS OF WORKING CAPITAL MANAGEMENT

The following are the key areas of working capital management.

Current assets
Current assets are those assets which in the ordinary course of business can be
converted into cash within one year. It includes,
➢ Inventories
➢ Cash/ Bank
➢ Bills Receivables
➢ Sundry Debtors
➢ Loans& Advances
➢ Other current assets
Current liabilities
Current liabilities are those liabilities which are to be paid within a year.
➢ Bills Payable
➢ Bank Over Draft
➢ Sundry Creditors
➢ Out Standing Expense

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DETERMINANTS/ FACTORS OF WORKING CAPITAL

Following are the important factors generally influencing the working capital
requirements:
1. Nature of business: Working Capital of the business concerns largely depend upon the
nature of the business. If the business concerns follow rigid credit policy and sell goods only
for cash, they can maintain lesser amount of Working Capital. A transport company maintains
lesser amount of Working Capital while a construction company maintains larger amount of
Working Capital.

2. Production cycle: Amount of Working Capital depends upon the length of the production
cycle. If the production cycle length is small, they need to maintain lesser amount of Working
Capital. If it is not, they have to maintain large amount of Working Capital.

3. Business cycle: Business fluctuations lead to cyclical and seasonal changes in the business
condition and it will affect the requirements of the Working Capital. In the booming conditions,
the Working Capital requirement is larger and in the depression condition, requirement of
Working Capital will reduce. Better business results lead to increase the Working Capital
requirements.

4. Production policy: It is also one of the factors which affect the Working Capital requirement
of the business concern. If the company maintains the continues production policy, there is a
need of regular Working Capital. If the production policy of the company depends upon the
situation or conditions, Working Capital requirement will depend upon the conditions laid
down by the company.

5. Credit policy: Credit policy of sales and purchase also affect the Working Capital
requirements of the business concern. If the company maintains liberal credit policy to collect
the payments from its customers, they have to maintain more Working Capital. If the company
pays the dues on the last date it will create the cash maintenance in hand and bank.

6. Growth and expansion: During the growth and expansion of the business concern, Working
Capital requirements are higher, because it needs some additional Working Capital and incurs
some extra expenses at the initial stages.

7. Availability of raw materials: Major part of the Working Capital requirements are largely
depend on the availability of raw materials. Raw materials are the basic components of the
production process. If the raw material is not readily available, it leads to production stoppage.

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So, the concern must maintain adequate raw material; for that purpose, they have to spend some
amount of Working Capital.

8. Earning capacity: If the business concern consists of high level of earning capacity, they
can generate more Working Capital, with the help of cash from operation. Earning capacity is
also one of the factors which determines the Working Capital requirements of the business
concern.

9. Dividend Policy: The dividend policy of a concern also influences the requirements of its
working capital. A firm that maintains a steady high rate of cash divided irrespective of its
generation of profits needs more working capital than the firm that retains larger part of its
profits and does not pay so high rate of cash dividend.

Optimum level of current assets

A firm has to maintain an adequate level of working capital to run its operations
smoothly and effectively. It should be adequate in the sense that it shall not be more than the
requirements nor it shall be less than the requirements. Both the excessive as well as inadequate
working capital positions are dangerous from the firm’s point view.

We know that the current liabilities are met out of the current assets. So the level of
current assets shall be sufficient enough to meet the current liabilities. Excessive working
capital refers to the position where when the level of current assets is much higher to meet
current liabilities. The excessive capital has opportunity cost for the firm, as this excessive
capital remains idle in the firm, which earns no profit for the firm. If these funds shall be
invested in some profitable project, it adds the profitability of the Company.

On the other hand, inadequate working capital refers to the position where the current
assets are not sufficient enough to meet the current liabilities. Such type of position may be
harmful to the firm as it may interrupt the production and sales of the Company, which
ultimately affects the profitability of the Company. Moreover if the liquidity position of the
firm is not adequate enough to meet its current liabilities, it may affect its credibility in the
market.

Therefore an enlightened management should maintain the right amount of working

capital on a continuous basis. Only then the proper functioning of business operations can be
ensured. The amount of the working capital shall be maintained at such level, which is adequate

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for it to run its business operations, neither excessive nor inadequate. This level of working
capital is called as the “Optimum Working Capital”.

Liquidity Vs Profitability

The level of working capital affects the degree of risk and profitability both. Hence the
level of working capital should be so fixed that, on the one hand, its financial soundness is
maintained and on the other hand, its profitability is optimized.

At this point it is necessary to be clear about the meaning of solvency or insolvency of

the firm. Solvency means a situation in which a firm can easily repay its debts as and when
they mature. On the other hand, insolvency is a situation in which a firm is not able to repay its
debts as and when they become due for payment. The term risk implies the profitability that a
firm will become technically insolvent, so that it will not be able to meet its obligations as and
when they become due for payment.

Nature of Risk-Return Trade-off

If profitability is to be increased, the firm must increase its risk. If the firm wants to
decrease risk, its profitability will also decrease. If a firm wants to maintain insolvency, it must
maintain a higher level of liquidity. That is, it must hold a larger amount of current assets such
as cash, receivables, stock of goods etc., so that there would be no problem in repaying the
debts as and when they due for payment. However, if a firm holds more amount of current
assets, the prospects of profit decline due to the fact that most of its funds are locked up in idle
current assets, which earn no profit.

On the other hand, if a firm wants s to increase its profitability, it must be prepared to
increase its risk of insolvency, as it would have to reduce its investment in current assets.
However a smaller amount of liquidity increases risk of insolvency and, at the same time, it
increases profitability also.

COMPUTATION / ESTIMATION OF WORKING CAPITAL NEEDS

Working Capital requirement depends upon number of factors, which are already
discussed in the previous parts. Now the discussion is on how to calculate the Working
Capital needs of the business concern. It may also depend upon various factors but some
of the common methods are used to estimate the Working Capital.
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Estimation of components of working capital method

Working capital consists of various current assets and current liabilities. Hence,
we have to estimate how much current assets as inventories required and how much
cash required to meet the short term obligations. Finance Manager first estimates the
assets and required Working Capital for a particular period.

Percent of sales method

Based on the past experience between Sales and Working Capital requirements,
a ratio can be determined for estimating the Working Capital requirement in future. It
is the simple and tradition method to estimate the Working Capital requirements.

Under this method, first we have to find out the sales to Working Capital ratio and based
on that we have to estimate Working Capital requirements. This method also expresses
the relationship between the Sales and Working Capital.

Operating cycle

Working Capital requirements depend upon the operating cycle of the business.
The operating cycle begins with the acquisition of raw material and ends with the
collection of receivables.

Operating cycle consists of the following important stages:

1. Raw Material and Storage Stage, (R)

2. Work in Process Stage, (W)

3. Finished Goods Stage, (F)

4. Debtors Collection Stage, (D)

5. Creditors Payment Period Stage. (C)

O = R + W + F + D–C

Each component of the operating cycle can be calculated by the following formula:

R =Average Stock of Raw Material/Average Raw Material Consumption Per Day

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W=Average Work in Process Inventory/Average Cost of Production per Day

F =Average Finished Stock Inventory/Average Cost of Goods Sold Per Day

D =Average Book Debts/Average Credit Sales per Day

C =Average Trade Creditors /Average Credit Purchase Per Day

FINANCING/SOURCES OF WORKING CAPITAL

There are different sources available for financing the working capital. They are:

SOURCES OF WORKING CAPITAL

Permanent or Fixed Temporary or Variable

Shares Commercial Banks

Debentures Indigeneous Bankers
Public Deposits Trade Credit
Ploughing Back of Profit Instalment Credit
Loans from Financial Institutions Advances
Accrued Expenses
Commercial Papers
Permanent or fixed of long term working capital
Firms must rise permanent working capital, so that it can be useful for a long period of
time. Permanent or long term working capital can be raised five sources. They are:

1. Shares: Issue of shares is the most important sorce for raising the permanent capital. A
big amount of capital required is collected through the shares issued to public. Shares
can be issued at any time generally these are issued at the time of starting of new
business expending or reorganizing the existing concern.
2. Debentures: When company desire the required finance through loans instead of scale
of share, then debenture are issued. In this way it is advantageous because debentures
holder can not claim for ownership and he is to be paid interest only.

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3. Public Deposit: Simple and convenient source of finance is public deposits, which has
recently became popular for raising long term deposits. These deposits are directly
accepted from public.
4. Ploughing Back of Profits: when a company reinvest its surplus profits in its business
it is known as ploughing back of profits. Though it is advantageous but not appropriate
for a nwely set up firm for its expansion, modernization and replacement etc.
5. Loan from Financial Institutions: There are many specialized financial institutions
esablished by the central and state governments which give long term loans at
reasonable rate of interest. Some of these institutions are
Industrial Finance Corporation of India (IFCI)
Industrial Development Bank of India (IDBI)
Industrial Credit and Investment Corporation of India (ICICI)
Temporary or Variable or short term working capital
A company can raise short term working capital from the important sources of finance
such as:
1. Indigenous Bankers: Indigenous bankers were private money lenders and other
country bankers. They were enjoying the monopoly power in the market. But after
establishment of commercial banks they are not so popular.
2. Trade Credit: Trade credit is an important source of raising short term capital. In trade
credit, supplier of goods provide goods on credit basis and buyer makes the payment in
future. It is easy and convinent way for raising funds.
3. Installment Credit: Installment credit is a short term source of finance. In this method
as asset is purchased by giving some down payment and the rest of the amount is paid
on installments over a specified period of time.
4. Advances: Advances are obtained from customers and agents against orders.
Companies use this advances as a short term source of finance.
5. Accrued Expenses: When a firm takes advantage of the services provided but not yet
paid for them are known as accrued expenses. They can be used as short term finance.
Accrued expenses of a firm are wages, salaries, taxes and interest.
6. Commercial Paper: commercial papers are issued for raising short term finance its
maturity period is between 91 to 180 days. It is an unsecured promissory note issued
by firm on discount and redeemable on face value in future date.

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INVENTORY MANAGEMENT
Meaning:
Inventory refers to the stock of the product that a firm is offering for sale to produce
final product.
Definition:
According to American Institute of Certified Public Accountant (AICPA), “Inventory
in the sense of tangible goods, which are held for sale, in process of production and available
for ready consumption”.
Components of Inventory
Inventories are classified into three categories:
Raw Material: These are the basic material i.e., input which are converted into finished
product through manufacturing process.
Work-in-Process: These are the material which are committed to production process, but have
yet been completed. If the process of production is not yet been completed then they are called
as semifinished product or work-in-progress.
Finished Goods: These are completed product awaiting sales. They are the final output of the
production process in a manufacturing firm.
Inventory Management
Inventory management is refers to a proper planning of purchasing, handling, storing
and accounting.

TECHNIQUES OF INVENTORY MANAGEMENT

Some of the important techniques and tools of inventory management and control are:
• ABC Analysis (Always Better Control)
• EOQ Analysis (Economic Order Quantity)
• JIT Analysis (Just-In-Time)
• VED Analysis (Vital,Essential,Desirable)
• SDE Analysis (Scarce, Difficult, Easily)
• SOS Analysis (Seasonal and Off-seasonal)
• HML Analysis (High, Medium, Low)

ABC Analysis (Always Better Control)

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In ABC analysis, a selective approach is adopted and materials are divided into three
categories i.e., A, B, C.
Category ‟A” items - More costly and valuable consumption items are classified as A
items. But the “A” category items are very less in volume (generally 10%) when ompared
to the total volume of inventory.
Category “B” items - The items having average consumption value items are
classified as B items. But the “B” category items are very average in volume (generally
20%) when compared to the total volume of inventory.

Category “C” items - The items having less consumption value items are classified as
C items. But the “C” category items are very high in volume (generally 70%) when
compared to the total volume of inventory.

EOQ Analysis (Economic Order Quantity)

EOQ is the amount of quantity of raw material to be purchased for production. It
is an importane decision of inventory management in which economic order quantity must
be adequate as it involves ordering and carrying cost also.

Ordering costs are incurred by the firm at the time of placing an order or
purchasing the materials.Carrying cost are incurred by the firm, only when stock is
maintained. It involves cost of storage, interest on investment, obsolesence, insurance, etc.

EOQ = 2AO / C

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

JIT Analysis (Just-In-Time)

Just – In – Time was first introduced by Toyoto Company in Japan. It mainly focuses
on reducing wastage and increasing productivity. In this technique, raw materials are purchased
just beforeproducing the product. It reduces the storage cost and invesement in inventory.

VED Analysis (Vital, Essential, Desirable)

VED – Vital, Essential and Desirable classification is applicable largely to spare parts.
Stocking of spare parts is based on strategies different from those of raw materials because
of there consumption pattern is different. Here the spare parts are classified in to three
categories.

Vital - The spares, the stock out of which even for a short time will stop the production.

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Essential - The spares, the absence of which cannot be tolerated for more than a few
hours or a day.
Desirable - The desirable spares are those spares which are needed but this absence for
even a week or so will not stop the production.
SDE Analysis (Scarce, Difficult, Easily)
The SDE analysis is based upon the availability of items and is very useful in the context
of scarcity of supply. In this analysis, „S‟ refers to „scarce‟ items, generally imported, and
those which are in short supply. „D‟ refers to difficult items which are available
indigenously but are difficult items to procure. Items which have to come from distant places
or for which reliable suppliers are difficult to come by fall into „D‟ category. „E‟ refers to
items which are easy to acquire and which are available in the local markets.

SOS Analysis (Seasonal and Off-seasonal)

In this analysis, materials are classified as seasonal and off – seasonal. The items which
are seasonal are stored for rest of the year, and off – seasonal items are not stored as they
are available in all seasons.

HML Analysis (High, Medium, Low)

In order to maintain an effective control over inventory, it is classified as HML. It
indicates High (H), Medium (M), and Low (L) valued items depending on their price and
consumption.

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