Working Capital Management Nature & Scope

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1 Working Capital Management Nature & Scope Introduction & Definitions Components of Working Capital Significance of Working Capital Operating Cycle Types of Working Capital Net Vs Gross Working Capital Causes of Changes in Working Capital Dangers of Excess Working Capital Dangers of Inadequate Working Capital Determinants of Working Capital Assessment of Working Capital Requirements Illustration

2 Introduction & Definitions In day to day business, working capital gets major importance. It may be define as, excess of current asset over current liabilities. According to Shubin working capital means, it is the amount of funds necessary for the cost of operating the enterprise. Thus, working capital in going concern is revolving fund. It consist of continues conversion of cash in to inventory, inventory into sales or debtors, debtors into marketable investment or cash. So in short we can say working capital is nothing but circulation of Current Assets. Which is shown in chart format on next slide

3 Introduction & Definitions Marketable Investments Cash Accounts Receivables Inventories

4 Components of Working Capital After knowing what is working capital, now let s look different components of the same. In narrow sense working capital refers to net working capital. The same is excess of current assets over current liabilities. In terms of formula it can be express as below; Net Working Capital=(C.A. C.L.) Now the question may come in to mind is that what constitute Current Assets & Current Liabilities? The same is depicted on the next slide in chart format.

5 Components of Working Capital Working Capital Components Current Assets S. Debtors Bills Receivables Cash & Bank Balance Short Term Investment Inventories Current Liabilities S. Creditors Bills Payable Advance Payments Short Term Borrowings Bank Overdraft

6 Significance of Working Capital Working capital is backbone of the enterprise, as it provides number of services, some of them are mentioned below as significance of ; a. It required for uninterrupted business operation. b. It is essential to run day to day activities. c. To ensure maximizing the wealth of the firm. d. To meet short term obligation of enterprise. e. To earn considerable profit.

7 Operating Cycle Operating cycle also known as cash cycle it is nothing but a time gap between sales and actual realisation of cash from sales proceeds. The continuing flow from cash to suppliers to WIP to F.G. to Debtors to Cash. Aforesaid is the graphical presentation of operating cycle of manufacturing concern. Accounts Receivable Into Cash Finished Goods Into Accounts Receivable Operating Cycle of Manufacturing Concern W.I.P. Into Finished Goods Cash into Raw Material Raw Material Into W.I.P.

8 Types of Working Capital Gross Working Capital : It refers to the total of all current assets. It represents short term securities, sundry debtors etc. This concept is very much suitable to those firms, where ownership is separated from management and control. Cash Gross Balance Sheet Types of Net Temporary Permanent

9 Types of Working Capital Net Working Capital : This concept is qualitative, indicating firms ability to meet its operating expenses and current liabilities. It can be presented by formula as Net = C.A. C.L. It can be further classified in to Positive & Negative. When C.A. exceeds C.L. we have Positive Net and vise versa. Cash Gross Balance Sheet Types of Net Temporary Permanent

10 Types of Working Capital Permanent Working Capital: It can be define as, the minimum amount of working capital kept by the firm to ensure uninterrupted course of operation. This amount may vary from year to year depending upon the changes in sales due to seasonal changes. Cash Gross Balance Sheet Types of Net Temporary Permanent

11 Types of Working Capital Temporary Working Capital Any amount over the permanent level of working is Temporary It is also called as Variable or Fluctuating Working Capital. Its termed as Fluctuating because requirement of C.A. changes due to seasonal variations. Cash Gross Balance Sheet Types of Net Temporary Permanent

12 Types of Working Capital Balance Sheet Working Capital : Balance Sheet working capital is one which is calculated from the items appearing in the Balance Sheet. Both Gross and Net working capital are examples of Balance Sheet working capital. Cash Gross Balance Sheet Types of Net Temporary Permanent

13 Types of Working Capital Cash Working Capital : Cash working capital refers to narrow concept of working capital, which itself is cash. This capital is required by firms to pay salaries, wages, interests and dividends etc. Items of this working capital appears in profit & loss a/c. It shows the impact of various transactions on cash position of a firm. Cash Gross Balance Sheet Types of Net Temporary Permanent

14 Net Vs Gross Working Capital Net Working Capital 1. By nature it is qualitative. 2. Its indicates firms ability to meets current liability & operating expenses. 3. It expressed as C.A. C.L. 4. Popular in accounting. 5. Suitable for Sole Traders. 6. Its useful to find out true financial position of a firm. Gross Working Capital. 1. By nature it is quantitative. 2. It points out funds available to meets current liability for financing current assets. 3. It indicates total of C.A. 4. Popular in management. 5. Suitable for companies. 6. It can t reveal true financial position of company.

15 Causes of Changes in Working Capital As we have seen earlier, working capital is not fixed and its changes according to the requirement. Following are some of the reasons which leads to same. 1. Changes in the level of Sales activities. 2. Changes in operating expenses. 3. Technological changes. 4. Cyclical changes in economy. 5. Changes in operating cycle. 6. Changes in the fixing the level of inventory.

16 Danger of Excess Working Capital Working capital is key factor for success in business. But one thing always kept in mind that it should be maintained at desired level. Because both excess or inadequate level leads to serious problem to organisation. Excessive working capital means idle funds which earn no profits. Following are some of the problems faced by company when working capital is excess.

17 Danger of Excess Working Capital a. It leads to unnecessary accumulation of inventory. b. Results in imbalance between liquidity & profitability. c. It is an indication of defective credit policy. d. This makes management complacent which degenerates into managerial inefficiency.

18 Danger of Inadequate Working Capital In contras to excessive working capital, inadequate working capital impairs firm s profitability and liquidity. Following are some problems faces by firms when working capital is inadequate. a. It causes growth and expansion of firm. b. It may not able to utilise production facilities. c. It may not able to meet short term liabilities. d. Firm may not take cash discount facilities. e. It may not able to efficiently utilised fixed assets, this leads to low profitability.

19 Determinants of Working Capital Working capital requirements are determined by variety of factors. These factors affect different enterprises differently. The determinants of working capital can be classify broadly in to two. 1] Internal Factors. 2] External Factors. Both Internal and External factors are further depends on several other factors. Those are listed in next slides.

20 Determinants of Working Capital Internal Factors 1. Nature of Enterprise 2. Size of Business 3. Firms Credit Policy 4. Access to Money Market. 5. Manufacturing Cycle. 6. Expansion & Growth of Business 7. Depreciation Policy 8. Profit Margin & Dividend Policy 9. Operating Efficiency of Firm. 10.Co-ordination Activities of Firm.

21 Determinants of Working Capital External Factors 1. Business cycle Fluctuations. 2. Technological Development. 3. Seasonal Fluctuations. 4. Environment Factor. 5. Taxation Policy.

22 Assessments of Working Capital Requirements The working capital means excess of current assets over current liabilities. It reality such excess may be more or less than organisations requirement. So the question arise is how one can judge the requirement? There are three techniques, which determine the working capital requirement. Those are ; 1] Percentage Sales Method 2] Estimation of Components of Working Capital 3] Cash Working Capital Method.

23 Assessments of Working Capital Requirements Percentage Sales Method : This is simple and traditional method for calculating working capital requirements. In this method working capital is calculated and presented as a percentage to sales. This method is useful for planning short term working capital needs. The basic criticism on this method is that it assumes a linear relationship between sales and working capital. Hence it is not universally accepted.

24 Assessments of Working Capital Requirements Estimation of components of Working Capital Method : This is a second method and it is calculated after considering components of current assets and current liabilities. These components include inventories, Debtors, Short Term Obligations etc. It is particularly suitable for long term forecasting. Symbolically it presented as below; Working Capital=Current Assets Current Liabilities

25 Assessments of Working Capital Requirements Cash Working Capital Method : This method is also known as operating cycle method. This method suggest that operating cycle refers to the period that firms takes from acquisition of raw material and ends with the collection of receivables. Following formula may be used to express the duration of operating cycle. O = (R + W + F + D) C

26 Assessments of Working Capital Requirements O = (R + W + F + D) C Where, O = Total Period of Operating Cycle R = Number of days for holding raw material W = Number of days for holding stock of W.I.P. F = Number of days for holding stock of F.G. D = Debtors Collection Period C = Creditors Payment Period

27 Assessments of Working Capital Requirements Factors to be Considered : Following are some of the factors, which has to be taken into account while making an estimation of working capital requirement by manufacturing concern. 1. Total units of output made by a firm throughout the year 2. The length of time to issue material for production 3. The average credit period allowed to debtors. 4. The average credit period allowed by suppliers. 5. The amount of cash required for making advance payment. If any.

28 Illustration Pavan Industries Ltd. Plans to sell units next year. The expected cost of goods sold is as below; Raw Materials 200 Manufacturing Expenses 60 Operating Expenses including selling & distribution 40 Selling Price 400 The duration at various stages of the operating cycle is expected to be as below; Raw material stage 2 months Work-in-progress stage 1 month Finished goods stage 1/2 month Debtors stage 1 month Assuming the monthly sales level of 2500 units: 1] Calculate the investment in various current assets 2] Estimate working capital requirement if the desired cash balance is 5% of working capital requirements.

29 Calculation of profitability : Proposed Sale = units Selling Price per unit = Rs. 400 Sales for the year = 1,20,00,000 Less: Raw Material = 60,00,000 Mfg. Expenses = 18,00,000 Operating Exp. = 12,00,000 Net Profit : 30,00,000 Solution Calculation of Investment in Various current Assets : (a) Raw Material (1/6 of Rs. 60,000) 10,00,000 (b) Work-in-progress (Taken to be complete 25% as to Mfg. Expenses): Raw Material 60,00,000 Mfg. Expenses 25% of 18,00,000 4,50,000 64,50,000 Stage of Work-in-progress for one month (64,50,000/12) 5,37,500

30 Solution ( c ) Finished Goods : Raw Materials 60,00,000 Mfg. Expenses 18,00,000 78,00,000 Stage of finished goods for half of (1/2/12 x 78,00,000) = 3,25,000 ( d ) Debtors one month of Rs. 1,20,00,000 (1,20,00,000 x ½) = 10,00,000 Total Current Assets ( a +b +c + d ) = 28,62,500 Estimation of Working Capital Requirement : Stock of Raw Material 10,00,000 Stock of Work-in-progress 5,37,000 Finished Goods 3,25,000 Debtors 10,00,000 Cash Balance (5/95 x 28,62,500) 1,50,658 Working Capital Required : 30,13,158

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