UNIT FIVE MANAGEMENT OF WORKING CAPITAL

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1 UNIT FIVE MANAGEMENT OF WORKING CAPITAL

2 UNIT FIVE CHAPTER ONE WORKING CAPITAL MANAGEMENT

3 Lesson 34 Chapter-11 Working Capital Management Unit 5 Management of Working Capital After reading this lesson you will be able to: - Understand Concept, need and determinants of working capital Understand the concept of operating cycle Computation of operating cycle I will start this lesson with a question: Why should managers be familiar with working capital management? When we work in any organization, we find that most of the time managers are concerned with working capital management. What I mean is: - # Ensuring that enough cash exists to pay bills; # Ensuring that enough inventory exists to make and sell products; # Ensuring that any excess cash is invested in interest-bearing securities; # Ensuring that accounts receivable are at a level that maximizes earnings, # Ensuring that short-term borrowings such as salaries payable and trade credit are used efficiently and at the lowest cost possible.

4 What is Working capital management? You see, working capital management involves the relationship between a firm's shortterm assets and its short-term liabilities. The basic goal of working capital management is to ensure that a firm is able to continue its operations and that it has sufficient ability to satisfy both maturing short-term debt and upcoming operational expenses. The management of working capital involves managing inventories, accounts receivable, accounts payable and cash This Topic extends the discussion to the management of the firm s working capital needed. There is a trade-off between the risk of having too little working capital on hand and the reduced profitability that results from having excess working capital. What is Working capital? You can understand working capital in two different but interlinked senses. In the first sense, working capital refers to gross working capital and in second sense it is understood in terms of net working capital. We can explain both in following paragraphs: - CONCEPTS OF WORKING CAPITAL GROSS WORKING CAPITAL: It refers to the firm s investment in current assets. Current assets are the assets, which can be converted into cash within an accounting year or within an operating cycle. You can include here cash, short-term securities, debtors (accounts receivable & book debts), bills receivable and stock. NET WORKING CAPITAL: But the net working capital refers to the difference between current assets and current liabilities. Current liabilities are those claims of outsider, which are expected to mature

5 for payment within an accounting year & include creditors, bills payable & the outstanding expenses. In other words you can say that this is the excess of current assets over current liabilities. CURRENT ASSETS constitute the following: 1 Inventories: Inventories represent raw materials and components, work-inprogress and finished goods. 2 Trade Debtors: Trade Debtors comprise credit sales to customers. 3 Prepaid Expenses: These are those expenses, which have been paid for goods and services whose benefits have yet to be received. 4 Loan and Advances: They represent loans and advances given by the firm to other firms for a short period of time. 5 Investment: These assets comprise short-term surplus funds invested in government securities, shares and short-terms bonds. 6 Cash and Bank Balance: These assets represent cash in hand and at bank, which are used for meeting operational requirements. One thing you can see here is that this current asset is purely liquid but non-productive. Current liabilities form part of working capital that represent obligations which the firm has to clear to the outside parties in a short-period, generally within a year. CURRENT LIABILITIES comprise the following: I. Sundry Creditors: These liabilities stem out of purchase of raw materials on credit terms usually for a period of one to two months. II. Bank Overdrafts: These include withdrawals in excess of credit balance standing in the firm s current accounts with banks III. Short-term Loans: Short-terms borrowings by the firm from banks and others form part of current liabilities as short-term loans.

6 IV. Provisions: These include provisions for taxation, proposed dividends and contingencies. Working capital Current assets Cash Accounts receivable Notes receivable Marketable securities Inventory Prepaid expenses Total current assets Current liabilities Accounts payable Notes payable Accrued expenses Taxes payable Total current liabilities Net working capital is current assets minus current liabilities. Gross working capital concept focuses on two aspects: 1. How to optimize investment in current assets? 2. How should current assets be financed? The planning should be done keeping in mind two danger points i.e. excessive and inadequate investment in current assets. Investment in current assets needs to be adequate as it affects the profitability, solvency and liquidity. Why this issue comes up because it ultimately affects the objectives of financial management. Danger points to be kept in mind while planning 1. Excessive investment (Profitability)

7 a. It results in unnecessary accumulation of inventories. Thus, chances of inventory mishandling, waste, theft & losses increase. b. It is an indication of defective credit policy & slack collection period. c. Excessive WC makes management complacent, which degenerates into managerial inefficiency. d. Tendencies of accumulating inventories tend to make speculative profits grow. 2. Inadequate investment (Liquidity) a. It stagnates growth. b. It become difficult to implement operating plans and achieve the firm s operating profit target. c. Operating inefficiencies creep in when it becomes difficult even to meet day-to-day commitments. d. Fixed assets are not efficiently utilized for the lack of working capital funds. Thus, the firm s profitability would deteriorate. e. Paucity of WC funds render the firm unable to avail attractive credit opportunities. f. The firm loses its reputation when it is not in a position to honour its short-term obligations. Kinds of Working Capital 1. Permanent working capital: This component represents the value of the current assets required on a continuing basis over the entire year, and for several years. Permanent working capital is the minimum amount of current assets, which is needed to conduct a business even during the dullest season of the year. The minimum level of current assets is called permanent or fixed working capital as this part is permanently blocked in current

8 assets. This amount varies from year to year, depending upon the growth of the company and the stage of the business cycle in which it operates. It is the amount of funds required to produce the goods and services, which are necessary to satisfy demand at a particular point of time. It represents the current assets, which are required on a continuing basis over the entire year. It is maintained as the medium as to continue the operations at any time. Characteristics of Permanent working capital It is classified on the basis of the time period It constantly changes from one asset to another and continues to remain in the business process. Its size increase with the growth of business operations. 2. Temporary working capital: Contrary to the above you will find that temporary working capital represents a certain amount of fluctuations in the total current assets during a short period. These fluctuations are increased or decreased and are generally cyclical in nature. Additional current assets are required at different times during the operating year. Variable working capital is the amount of additional current asset that are required to meet the seasonal needs of a firm, so is also called as the seasonal working capital. For example: additional inventory will be required for meeting the demand during the period of high sales When the peak period is over variable working capital starts decreasing or very little during the normal period. It is temporarily invested in current assets. Say for an example a shopkeeper invests more money during winter season because he/ she requires to keep more amount of stock of woolen cloths. The same happens in a sugar factory how: the factory manager buys more quantity of sugarcane during the harvesting season and they continuously stops for some time. Characteristics of Temporary working capital

9 It is not always gainfully employed, though it may change from one asset to another asset, as permanent working capital does. It is particularly suited to business of a seasonal or cyclical nature. Diagrammatic representation of temporary and permanent working capital Permanent or temporary working capital in case of stable firm Amount of WC Temporary or fluctuating WC Permanent WC Time

10 Permanent & temporary working capital in case of growing firm Amount of WC Temporary or fluctuating WC Permanent WC Determinants of WC Time We can explain the determinants of working capital as follows: Nature of business: The working capital requirements of an enterprise are basically related to the conduct of the business. Public utility undertakings like Electricity, Water supply, Railways, etc. need very limited working capital because they offer cash sales only and supply services, not products and as such no funds are ties up in inventories and receivables. But at the same time have to invest fewer amounts in fixed assets. The manufacturing concerns on the other hand require sizable working capital along with fixed investments, as they have to build up the inventories. Terms of sales and purchases: Credit sales granted by the concerns too its customers as well as credit terms granted by the suppliers also affect the working capital. If the credit terms of the purchases are more

11 favorable and at the same time those of sales less liberal, less cash will be invested in the inventory. With more favorable credit terms, working capital requirements can be reduced. Manufacturing cycle: The length of manufacturing cycle influences the quantum of working capital needed. Manufacturing process always involves a time lag between the time when raw materials are fed into the production line and finished goods are finally turned out by it. The length of the period of manufacture in turn depends o the nature of product as well as production technology used by a concern. Shorter the manufacturing cycle; lesser the working capital required. Rapidity of turnover: If the inventory turnover is high, the working capital requirements will be low. With a better inventory control, a firm is able to reduce its working capital requirements. When a firm has to carry on a large slow moving stock, it needs a larger working capital as against another whose turnover is rapid. A firm should determine the minimum level of stock, which it will have to maintain throughout the period of its operation. Business cycle: Cyclical changes in the economy also influence quantum of working capital. In a period of boom i.e., when the business ism prosperous, there is s need of larger amount of working capital due to increases in sales, rise in price etc and vice-a-versa during period of depression. Changes in technology: Changes in technology may lead to improvements in processing of raw materials, savings in wastage, greater productivity, and more speedy production. All these improvements may enable the firm to reduce investments in inventory. Seasonal variation:

12 The inventory of raw materials, spares and stores depends on the condition of supply. If the supply is prompt and adequate the firm can manage with small inventory. However, if the supply were unpredictable and scant then the firm, to ensure the continuity of production, would have to acquire stocks as and when they are available and carry larger inventory on an average. Market conditions: The degree of competition prevailing in the market place has an important bearing on working capital needs. When competition is keen, a larger inventory of finished goods is required to promptly serve customers who may not be inclined to wait because other manufacturers are ready to meet their needs. Seasonality of operation: Firms, which have marked seasonality in their operations usually, have highly fluctuating working requirements. Let us take an example to illustrate this point. Consider a firm manufacturing fans. The sale of fans reaches a peak during the summer months and drops sharply during the winter period. The working capital need of such a firm is likely to increase considerably in summer months and decrease significantly during winter season. Dividend policy: It has a dominant influence on the working capital position of a firm. If the firm is following a conservative dividend policy, the need for working capital can be met with retained earnings. Working capital cycle: Larger the working capital cycle, more is the requirement of working capital. NEED FOR WORKING CAPITAL

13 The need for working capital to run the day-to-day business activities cannot be overemphasized. We will hardly find a business firm, which does not require any amount of working capital. Indeed, firms differ in their requirements of the working capital. We know that a firm should aim at maximizing the wealth of its shareholders. In its endeavor to do so, a firm should earn sufficient return from its operations. Earning a steady amount of profit requires successful sales activities. The firm has to invest enough founds in current for generating sales. Current assets are needed because sales do not convert into cash instantaneously. There is always an operating cycle involved in the conversion of sales into cash. Operating Cycle There is a difference between current and fixed assets in terms of their liquidity. A firm requires many years to recover the initial investment in fixed assets such as plant and machinery or land and buildings. On the contrary, investment in current assets in turned over many times in a year. Investment in current assets such as inventories and debtors (accounts receivable) is realized during the firm s operating cycle, which is usually less than a year. Then can you tell me what an operating cycle is? Operating Cycle is the time duration required to convert resources or inventories into sales and then into cash. The operating cycle of a manufacturing company involves three phases: Acquisition of resources: such as raw material, labor, power and fuel etc. Manufacture of the product: which includes conversion of raw material into work-inprogress into finished goods. Sales of the product: either for cash or on credit. Credit sales create account receivable for collection.

14 In any of your business these phases affect cash flows, which most of the time, are neither synchronized because cash outflows usually occur before cash inflows. Cash inflows are not certain because sales and collections, which give rise to cash inflows, are difficult to forecast accurately. Cash outflows, on the other hand, are relatively certain. The firm is, therefore, required to invest in current assets for a smooth, uninterrupted functioning. It needs to maintain liquidity to purchase raw materials and pay expenses such as wages and salaries, other manufacturing, administrative and selling expenses and taxes as there is hardly a matching between cash inflows and outflows. Cash is also held to meet any future exigencies. Stocks of raw material and work-in-process are kept to ensure smooth production and to guard against nonavailability of raw material and other components. The firm holds stock of finished goods to meet the demands of customers on continuous basis and sudden demand from some customers. Debtors (accounts receivable) are created because goods are sold on credit for marketing and competitive reasons. Thus, a firm makes adequate investment in inventories, and debtors, for smooth, uninterrupted production and sale. Purchases Payment Credit sale Collection RMCP + WIPCP + FGCP Inventory conversion period Receivables conversion price Payables Net operating cycle Gross operating cycle How is the length of an operating cycle determined? The length of the operating cycle of a manufacturing firm is the sum of: (i) Inventory conversion period (ICP) and

15 (ii) Debtors conversion period (DCP). Here the inventory conversion period is the total time needed for producing and selling the product. Typically, it includes: (a) Raw material conversion period (RMCP), (b) Work-in-process conversion period (WIPCP), and (c) Finished goods conversion period (FGCP). The debtors conversion period is the time required to collect the outstanding amount from the customers. The total of inventory conversion period and debtors conversion period is referred to as gross operating cycle (GOC) In practice, a firm may acquire resources (such as raw materials) on credit and temporarily post-phone payment of certain expenses. Payables, which the firm can defer, are spontaneous sources of capital to finance investment in current assets. The payables deferral period (PDP) is the length of time the firm is able to defer payments on various resource purchases. The difference between (gross) operating cycle and payable deferral period is net operating cycle (NOC). If depreciation is excluded from expenses in the commutation of operating cycle, the net operating cycle also represents the cash conversion cycle. It is net time interval between cash collections from sale of the product and cash payments for resources acquired by the firm. It also represents the time interval over which additional funds, called working capital, should be obtained in order to carry out the firm s operations. The firm has to negotiate working capital from sources such as commercial banks. The negotiated sources of working capital financing are called nonspontaneous sources. If net operating cycle of a firm increases, it means further need for negotiated working capital. Let us now understand the computation of the length of operating cycle. Consider the statement of costs of sales for a firm given in Table

16 Table STATEMENT OF COST OF SALES Items Actual (Rs. Lakh) 19x1 19x2 1. Purchase of aw material (credit) 4,653 6, Opening raw material inventory Closing raw material inventory Raw material consumed (1+2-3) 4,349 5, Direct labour Depreciation Other mfg. Expenses Total cost ( ) 5,352 7, Opening work-in process inventory Closing work-in-process inventory Cost of production ( ) , Opening finished goods inventory Closing finished goods inventory Cost of goods sold ( ) 5,003 6, Selling, administrative and general exp Cost of sales (14+15) 5,307 7,039 The firm s data for sales and book debts and creditors are given as under SALES AND DEBTORS (Rs. Lakhs) 19x1 19x2 Sales (credit) 6,087 8,006 Opening debtors Closing debtors 735 1,040 Opening creditors

17 Closing creditors The firm s gross operating cycle (GOC) can be determined as inventory conversion period (ICP) plus debtors conversion period (DCP). Gross operating cycle = Inventory conversion period + Debtors conversion period GOC=ICP+ DCP The inventory conversion (ICP) is the sum of raw material conversion period (RMCP), work-in-process conversion period (WIPCP) and finished goods conversion period (FGCP): ICP=RMCP+WIPCP+FGCP What determines the inventory conversion period? The raw material conversion period should depend on: (a) raw material consumption per day, and (b) raw material inventory. Raw material consumption per day is given by the total raw material consumption divided by the number of days in the year ( say, 360). The raw material conversion period is obtained when raw material inventory is divided by raw material consumption per day. Similar calculations can be made for other inventories, debtors and creditors. The following formulate can be used: = Raw material Raw material consumption (RMC) Inventory (RMI) RMC RMI x 360 =RMI 360 = RMC Work-in-process conversion period (WIPCP) = Work in-process Cost of production (COP) Inventory (WIPI)

18 COP WIPI x 360 =WIPI 360 = COP Finished goods conversion period ( FGCP) Finished goods Cost of goods sold (CGS) Inventory (FGI) CGC FGI x 360 =FGI 360 = CGS Debtors conversion period (DCP) = Debtors (D) Credit sales at cost (CR SALES) 360 CRSALES D x 360 =D 360 = CR SALES Payables deferral period (PDP) = Creditors (CRS) Credit purchase (CR PUR) 360 CRPUR CRS x 360 =CRS 360 = CRPUR

19 Net Operating cycle (NOC) is the difference between gross operating cycle and payables deferral period. Net operating cycle = Gross operating cycle payables deferral period NOC = GOC PDP Net operating cycle is also referred to as cash conversion cycle. Depreciation and profit should be excluded in the computation of cash conversion cycle since the firm s concern is with cash flows associated with conversion at cost. A contrary view is that a firm has to ultimately recover total costs and make profits; therefore, the calculation of operating cycle should include depreciation, and even the profits. Also, in using the above mentioned formulate, average figures for the period may be used. Table 22.3 shows detained calculations of the components of a firm s operating cycle. Table 22.4 provides the summary of calculations. Table 22.3 OPERATING CYCLE CALCULATIONS (Rs. Lakh) Items Actual Projected 19x1 19x2 1. Raw Material Conversion Period (a) Raw material consumption (b) Raw material consumption per day Raw material inventory (d) Raw material inventory bolding days 68d 60d 2. Work-in-Process Conversion Period (a) Cost of production* (b) Cost of production per day Work-in-process inventory (d) Work-in-process inventory holding days 23d 26d

20 3. Finished Goods Conversion Period (a) Cost of goods sold* (b) Cost of production per day Finished goods inventory (d) Finished goods inventory holding days 38d 55d 4. Collection Period (a) Credit sales (at cost)** (b) Sales per day Book debts (d) Book debts outstanding days 50d 53d 5. Payment Deferral periods (a) Credit purchase (b) Purchase per day Creditors (d) Creditors outstanding 35d 28d *Depreciation is excluded on the assumption that the firm is interested in cash conversion period. Depreciation is a non-cash item. ** All sales are assumed on credit. Cost of sales figure should be used for calculation of collection period. During 19x1 the daily raw material consumption was Rs lakh and the company held an ending raw material inventory of Rs. 827 lakh. If we assume that this is the average inventory held by the company, the raw material consumption period works out to be 68 days. You may notice that for 19x2, the projected raw material conversion period is 60 days. This has happened because both consumption (Rs lakh per day) and level of inventory (Rs. 986 lakh) have increased, but the consumption rate has increased (by 36.4 per cent) much more than the increase in inventory holding (by 19.2 per cent). Thus, the raw material conversion period has declined by 8 days. Raw material is the result of daily raw material consumption and total raw material consumption during

21 a period given the company s production targets. Thus, raw material inventory is controlled through control over purchases and production. We can similarly interpret other calculations in Table 22.3 Table 22.4 SUMMARY OF OPERATING CYCLE CALCULATIONS Actual Projected GROSS OPERATING CYCLE 1. Inventory Conversion Period (i) Raw material (ii) Work-in-process (iii) Finished goods Debtors Conversion Period Gross Operating Cycle ( 1+2) Net Operating Cycle 4. Payment Deferral Period Net Operating Cycle ( 3-4) We note a significant change in the company s policy for 19x2 with regard to finished goods inventory. It is expected to increase to 55 days holding from 38 days in the previous year. One reason could be a conscious policy decision to avoid stock-out situations and carry more finished goods inventory to expand sales. But this policy has a cost; the company, in the absence of a significant increase in payables deferral period, will have to negotiate higher working capital funds. In the case of the firm in or example, its net operating (cash conversion) cycle is expected to increase from 144 days to 156 days (Table 22.4), How does a company manage its inventories, debtors and suppliers credit? How can it reduce its operating cycle? We shall attempt to answer these questions in the next four chapters.

22 The operating cycle concept as shown in Figure 22.1 relates to a manufacturing firm. Non-manufacturing firms such as wholesalers and retailers will not have the manufacturing phase. They will acquire stock of finished goods and convert them into debtors (book debts) and debtors into cash. Further, service and financial enterprises will not have inventory of goods (cash will e their inventory). Their operating cycles will be the shortest. They need to acquire cash, then lend (create debtors) and again convert lending into cash. COMPUTATION OF OPEARTING CYCLE Formulae: RMCP = (RMI*360) / RMC WIPCP = (WIPI*360) / COP FGCP = (FGI*360) / COGS DCP = (DRS *360) / Cr.Sales PDP = (CRS*360) / Cr. purchases GROSS OP. CYCLE = ICP+DCP ICP = RMCP + WIPCP +FGCP NET OP. CYCLE = GOC-PDP Where: RMC is the consumption of raw material RMI is the closing stock of raw material inventory WIPI is the closing stock of work-in process inventory FGI is the closing stock of finished goods inventory COP is the cost of production COGS is the cost of goods sold

23 The important points to be considered Time value of money not important Liquidity position of a firm is dependent on investment in current assets Any short run, immediate need of the company whether it be cash or adjustments in sales can be made only through adjusting the levels of the various components of the current assets. This calls for efficient management of current assets, which form part of management of working capital. We will cover more exercises in next session

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