WORKING CAPITAL MANAGEMENT

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1 CHAPTER 9 WORKING CAPITAL MANAGEMENT Working capital is the long term fund required to run the day to day operations of the business. The company starts with cash. It buys raw materials, employs staff and spends on expenditure like advertising and marketing and sells the goods. Even then it may not receive cash immediately if sold on credit. The company will have to have use its own cash before it gets back sales revenue and then the cycle can go on. So the money or fund required to meet the expenditure until it gets back through sales revenue is called working capital and this much fund it has to keep. Hence it is called part of long term fund. In accounting terminology, term working capital is defined as the excess of current assets over current liabilities. Eventhough working capital is defined as the excess of current assets over current liabilities, in literature, this excess has come to be called Net Working Capital and current assets are called Gross Working Capital. Insufficient or inadequate working capital will lead to delay in payment to suppliers. The concern will not only miss out on discounts and reduced prices, but also will have to be satisfied with sub standard materials/exorbitant prices. This will affect the cost and quality of its final products thus affecting sales and profits. One can see the crippling effect of inadequate working capital on the business. On the other hand surplus working capital will lead to idle funds and inefficiency. Therefore the management has a great responsibility in arranging and managing working capital in sufficient quantum. Objectives of Working Capital Management Working capital management covers all segments of current assets and current liabilities. The objectives of working capital management are: To maintain the liquidity of operations. The business should have enough funds to meet the day to day payment obligations. To keep the working capital at the optimum level, the working capital should not be too much which will result in idle funds and should not be too less which will affect the operations, sales and profits. To maintain a proper mix among different segments of current assets. Keeping raw material inventory is different from keeping finished goods or receivables. The decisions will affect not only liquidity but also volume of sales. To obtain funds from the external parties like sundry creditors, commercial banks and financial institutions at minimum cost for working capital purposes. Determinants of Working Capital There are many factors that influence the volume of current assets and working capital. Significant ones are discussed below. Size and volume of business is the basic determinant. If the business is seasonal either in the supply of raw materials like cotton or in sales like fertiliser. In such cases large quantum of inventories will have to be kept and possibly debtors could be varying. If the manufacturing time is more, more working process stock will be involved. If the products are sold for cash, there will be no outstanding debtors. Higher the credit period, higher will be the debtors and higher the requirement. Against this, larger the credits period allowed by suppliers, lower will be the requirement of working capital.

2 28 WORKING CAPITAL MANAGEMENT If the concern has got higher profit margin, it would require less working capital from outside sources. Large lead time for the suppliers to supply the materials will require more raw material to be stocked. If the sale is made ex-factory or through stockists there will be less finished goods inventory. Efficiency of management contributes to the reduced volume of working capital. Operating Cycle To appreciate the influence of factors on the working capital and also to plan for optimum working capital, it is essential that the concept of operating cycle should be understood. Operating cycle is the time taken to convert cash into raw materials, finished product, debtors and back into cash. This can be shown in a diagram as under. Debtors Cash Finished Goods Raw materials Work in Process On any particular day or time the current assets in all these forms would normally be present in the company. Cash takes the form of raw material stock in the stores for some time, then lies in the factory as work in process until it is completed, then is kept in the form of finished goods in the factory godown and depots until it is sold. If it is sold for credit, again it stays in the form of debtors until it is paid. So the total time of operating cycle could be calculated as sum total of time periods of all terms minus the credit period enjoyed by the firm for payment to creditors for supply of materials. The stock and debtors/creditors balances are taken generally from the closing balance sheet. There is also another method in which average of the opening and closing balances are used. However the former method only is used in practice and is a better method. Estimating Working Capital Requirement For proper functioning of a business the day to day payments will have to be met and so, the management should assess the funds required for working capital purposes constantly. While doing so all the factors that influence the requirement of funds will be scrutinized. It will also help in working out a plan for procuring adequate funds for working capital if necessary. Later it could be compared with actuals. A detailed illustration is given below. Illustration A co is a producing a product with a selling price of Rs. 25/unit. Annual output is 30,000 units/year. Cost structure is as follows: Cost/Units Raw material Direct labour 2.50 Overheads-factory 5.00 Adm-selling Expenses 2.50 Total cost Profit 5.00 Cost of production Cost of sales Selling price 25.00

3 WORKING CAPITAL MANAGEMENT 29 Other details Raw material requirement 3 months = = WIP 1/2 month cost of production = = Finished good 1 month cost of production = = Sundry Debtors 2 month sales = = Cash 5 days expenditure = = = Less suppliers credit 1 month raw materials = = Inventory Control Major part of current assets comprise of inventories which are made up of raw material and store, Working process and finished goods. Inventories are controlled by keeping optimum stock and by also spending minimum expenditure. There are two techniques developed to ensure this objective. These are Economic order quantity (EOQ) and Recorder level. EOQ is the quantity that should be ordered in each order so that if it is followed, the total expenditure of running the purchase and stores sections will be minimum. The logic is that if there are more orders in a year, then purchase expenditure will be more and storage expense less since the quantity in each order will be more and storage expense less since the quantity in each order will be lower. If the number of orders is less and quantity to be ordered in each order will be more and to purchase expense will be less but storage expense more. Therefore there should be a point at which the total expense of purchasing or ordering and storage or carrying will be minimum. This is sought to be achieved though the following formula: EOQ = 2as ie Where EOQ = Economic Order Quantity a = Annual consumption of the particular materials in units. s = Ordering cost per order. i = % of storage expenses on the average stock. e = Price of the material per unit. As indicated earlier, material management cost is divided into ordering cost and carrying cost. Carrying cost cover the interest on the investment in stocks, expenses related to manning of the stores and handling, rent and manpower of stores, losses due to pilferage, obsolescence and other running expenses of stores office. This expense is proportional to the stock levels. Ordering cost relates to the purchase office, wages & salaries, rent, maintenance, depreciation, running expenses, travelling expenses & hospital expenses incurred by buyers. These expenses relate directly to the number of orders placed during a period. Illustration A company predicts an annual requirement of 3000 units of material a costing Rs per unit. Past experience shows that 10% is the storage cost and cost of placing one order is Rs Determine the economic order quantity and the number of orders required to be placed in a year. EOQ = = = 300 units No. of orders = 3000/300 = 10 orders Let us see the position of the sum of ordering cost and storage costs for different quantities per order. Half of economic order quantity will decide the average investment in inventories. From the above table the sum of ordering and cost i.e total material management cost is minimum when each order contains 300 units is EOQ. Recorder Level Recorder level (ROL) recorder point in terms of stock consists of two components, lead time

4 30 WORKING CAPITAL MANAGEMENT consumption and safety stock. Lead time is the time duration between placement of order till the receipt of material fit for use. Therefore while placing the order i.e at ROL, there should enough stock to meet the consumption during the time taken by the supplier to supply the materials. Further as there can be variation in the lead time and also the consumption rate, the concern should also have a cushion of additional stock to meet this unfavorable eventuality. This is called safety stock. It can found out through statistical analysis or simply taken as % addition to the lead time consumption. Therefore ROL = Lead time consumption + safety stock. ABC Analysis The analysis required for inventory control will be involved and enormous if one wants to fix the EOQ and ROL for each item of inventory. It is not practical to carry out the analysis for each item. It may not be also necessary. Through a technique called ABC analysis, important and significant but limited number of items are identified for which only, the detailed analysis could be carried out. In any organisation when the annual consumption of various items is analyzed in financial terms, it will be noticed that only a small number of items account for major portion of the total value. These are obviously the items that are most important calling for a high degree of control. Hence these items are classified as A items. There would be a large number of items at the latter part of the list accounting only a small portion of consumption. These are termed C items. In between A and C groups lie the items whose % both in value and number are about the same. These are called B items. The following may be the likely pattern of items. % of total % of value of Group inventories inventories A B C The items under each group are obtained from a list prepared will all items listed in the descending order of consumption values. First 10% of the items would probably account for 70% of consumption in value. Similarly the other groups also could be found out. There could be light variation in the % but over all picture will be showing these distinct groups. Indicators of Efficiency Efficiency of inventory management can be judged on the basis of a few indicators. The volume of stock expressed in terms of number of days consumption, work in process in terms equivalent to full production and finished goods in terms of number of days sales are some of the effective indicators. When there is shortage of raw materials or finished goods the concern loses its production or sales. It has to incur additional expenses to procure the material on emergency basis. Therefore on account of lack of stock, the concern could incur some losses. This is called stock out cost. Management could watch out the extent of the stock out cost as an additional measure of efficiency. Receivables or Debtors The volume of receivables the concern would be having at any time is dependent upon the credit terms or policy of the company and efficiency of the collection machinery. The credit terms normally in practice are credit period allowed, cash discount for prompt payment, penalty for later payment, bank security etc. There are many factors which are considered before deciding on the specific credit policy. The industry practice, status of the buyer, status of the product, new area, new products, availability of funds and interest rates, volume of business and competition are important factors. However it is ultimately that the gains should exceed the costs of following a particular credit policy. If the management wants to change the credit terms from cash sales to one month credit, the likely

5 WORKING CAPITAL MANAGEMENT 31 benefit will be the additional profit due to additional sales minus additional expenses in the form of cost of additional investment in debtors, cost of collection and likely bad debts. If the gain is more than expenses, it is worthwhile to change the policy from cash payment to one month credit. Similarly there will be specific gains and expenses for every decision relating to credit policy relating to other credit terms. The objective of receivables management is to keep the investment in receivables to the optimum level with minimum expenditure. Besides deciding on the credit policy, another important decision is choice of debtors for extending credit. The credit worthiness of the parties could be checked through industry and bank references. Proper credit analysis of the parties business is also important by which the paying capacity and habits can be scrutinized. Profitability and Liquidity ratios should be studied. In case of existing parties the behavior of their accounts with the concern should be verified and the opinion of the sales personal be sought. A very important statement useful to the management for controlling is Age analysis in which the outstanding amounts against each party are listed together with the date from when it has been outstanding. Alternately they can be grouped under those due for a month, for 3 months or 6 months or more with a customerwise statement for 2nd and 3rd categories. The overall measure of effectiveness of the collection machinery is the collection period or debtors/receivables turnover which is calculated as under. Outstanding debtors balance Collection period = Average credit sales/day This ratio can be calculated only by internal executive as break up of sales into cash and credit sales will not be available to outside analysis. In that case average total sales per day should be used. Cash Management Cash management is involved primarily with planning the cash requirement through a technique called Cash forecast in which the receipts from sales revenue and other sources including loans are forecast for a period and listed together with the various cash payment that should be made during the period. The aim is to find the cash surplus or deficit arising during that period. In case of deficit, steps should have to be taken to find the funds required in time or adjust payments and expedite receipts from different sources. In case of surplus action will be taken to use it beneficially. Illustration The accountant of a company is preparing the cash budget for the first six months of 1993 and obtains the following information: Sales on credit, variable costs and wages are budgeted as follows (the November and December of the previous year being the actual figures for those months): Credit Variable Sales cost Wages Rs. Rs. Rs. November 10,000 7,000 1,000 December 12,000 7,500 1,100 January 14,000 8,000 1,200 February 13,000 7,700 1,000 March 10,000 7,000 1,000 April 12,000 7,500 1,100 May 13,000 7,750 1,200 June 16,000 8,750 1,300 Fixed expenses amount to Rs. 15,000 net per month and the half year s preference dividend of Rs. 1,400 net is due on June 30. Corporation tax amounting to Rs. 8,000 is payable in January and progress payment under a building contract are due as follows: March 31st Rs. 5,000 and May 31st Rs. 6,000. The terms on which goods are sold are net cash in the month following delivery. Variable costs are payable in the month following that in which they are incurred and are as to 50% subject to 2.5% discount, and the balance net. It is found that 75% of debtors to whom sales are made pay within the period of credit and the remainder do not pay until the following month. The company pays all its accounts promptly.

6 32 WORKING CAPITAL MANAGEMENT Prepare cash budget: Solution A) Cash inflows Collection from credit sales i) First month following sales ii) Second month following sales (25% of sales) Total cash receipts B) Cash outflows Jan Feb March April May June 9, , , , , , , , , , , , , , , , , , Fixed expenses 1, , , , , , Preference dividend 1, Corporation tax 8, Payments under a building contract Variable cost (VC) i) 2.5% discount on 50% VC ii) No discount on 50% VC (Wages assumed to have been paid same month) Total cash payments C) Surplus (deficiency) (A-B) 5, , , , , , , , , , , , , , , , , , , , , , , , , , (6,606.25) 3, (1,853.75) 1, (4,606.25)

7 WORKING CAPITAL MANAGEMENT 33 Issues Connected with Cash Management When the payments are made by cheques, in many cases considerable time elapses before the cheques are realized. It could be due to delay in the concern itself in recording before handing over to the bank for collection or delay in bank. This delay should be curtailed through proper supervision and follow up. When the sales occur in various parts of the country one should have bank accounts dispersed and the customers should be asked to send the cheques to those nearest collection centres. While collection is better decentralized in the above manner, centralized payments are found to be beneficial to the concern. Only then payments could be made according to the overall priority. However in case of centralized payment practice, branches often find that their payments even though very critical are not paid in time. So it is very important that the priority list for payment in the central office is made by a very senior person, taking into consideration the needs of all sections. Payment to suppliers will be the first to suffer in case of cash crisis. Proper policy of obtaining cash discount should have been formulated taking into consideration the bank interest and also the benefits in times of quality and lower price accruing from prompt payment. One should not ignore the effect on the image of the concern and the resultant higher prices for material or lower quality. All these factors may better be quantified so that benefit cost analysis can be made and decisions are taken on that basis. In case of profit earning concerns, there will be gradual build up of surplus cash and management should use it to the full advantage of the company. Timely payment to the suppliers would greatly enhance the image of the organization and bring many benefits to the concern. Temporary surplus cash can also be invested in short term deposits so that interest could earned. While investing, certain aspects like maturity date, liquidity of investment, rate of interest and safety of the investment will have to be considered. The most important criteria to measure the efficiency of cash management is the ability of the management to meet its liabilities. In short it should not have any over due liability at any time. In a running company it is not possible to have nil liability overdue. There will be some. However it should possess cash or cash equivalent to the extent of the overdue liabilities. Therefore this ratio, which may be called overdue liability ratio, should be around one. Much less is dangerous to the organisation. Much more means idle funds. Working Capital Financing From a study of a balance sheet of a concern, one can see that the current assets are financed by three groups of parties. Trade creditors and provisions forming part of current liability is one group. Commercial banks provide funds for working capital. Normally the current assets will be in excess of these two groups. The excess is financed by the long time funds of the company. If the concern does not require bank finance for working capital purposes, it can manage with composition of current liability and long term funds. In case the concern has to approach a commercial bank for financing its current assets, it has to follow certain conditions laid down by the bank. Even through only medium and large organisations are strictly governed by these stipulations, the bank could also follow the same logic in case of small organisations. The main stipulations are as belows: 1. The concern is expected to provide a plan of action in a detailed statement in which full requirement of funds is spelt out by drawing a projected profits and loss account and balance sheet for the ensuing year indicating its requirement of bank finance which forms the basis for fixing working capital finance granted by the banks. 2. The concern is expected to keep inventories and receivables within the norms set by the bank for the industry to which the concern belongs.

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