UNIT 8 PRINCIPLES OF WORKING CAPITAL MANAGEMENT MODULE - 2

Transcription

1 UNIT 8 PRINCIPLES OF WORKING CAPITAL MANAGEMENT MODULE - 2

2 UNIT 8 PRINCIPLES OF WORKING CAPITAL MANAGEMENT Structure Principles of Working Capital Management 8.0 Introduction 8.1 Unit Objectives 8.2 Concepts of Working Capital Focusing on Management of Current Assets; Focusing on Liquidity Management 8.3 Operating and Cash Conversion Cycle 8.4 Permanent and Variable Working Capital 8.5 Balanced Working Capital Position 8.6 Determinants of Working Capital Nature of Business; Market and Demand Conditions; Technology and Manufacturing Policy; Credit Policy Availability of Credit from Suppliers; Operating Efficiency Price level Changes 8.7 Issues in Working Capital Management Current Assets to Fixed Assets Ratio Liquidity vs. Profitability: Risk return trade-off The Cost Trade-off 8.8 Estimating Working Capital Needs 8.9 Policies for Financing Current Assets Matching Approach; Conservative Approach Aggressive Approach; Short-term vs. Long-term Financing: 8.10 Sources of Working Capital Trade Credit; Accrued Expenses and Deferred Income; Bank Finance for Working Capital; Commercial Paper 8.11 Let us Summarize 8.12 Key Concepts 8.13 Illustrative Solved Problems 8.14 Answers to Check Your Progress 8.15 Questions and Exercises 8.0 INTRODUCTION So far we have discussed the management of fixed assets and long-term financing. In this part, issues relating to the management of current assets will be discussed. The management of current assets is similar to that of fixed assets in the sense that in both cases a firm analyses their effects on its return and risk. The management of fixed and current assets, however, differs in three important ways: First, in managing fixed assets, time is a very important factor; consequently, discounting and compounding techniques play a significant role in capital budgeting and a minor one in the management of current assets. Second, the large holding of current assets, especially cash, strengthens the firm s liquidity position (and reduces riskiness), but also reduces the overall profitability. Thus, a risk-return trade off is involved in holding current assets. Third, levels of fixed as well as current assets depend upon expected sales, but it is only current assets which can be adjusted with sales fluctuations in the short run. Thus, the firm has a greater degree of flexibility in managing current assets. The two main sources of working capital are trade credit and bank borrowing. Commercial paper is another important source of short-term funds. Self-Instructional Material 247

3 Financial Management 8.1 UNIT OBJECTIVES Underline the need for investing in current assets, and elaborate the concept of operating cycle Highlight the necessity of managing current assets and current liabilities Explain the prinicples of current asset investment and financing Focus on the proper mix of short-term and long-term financing for current assets Discuss major sources of working capital funds including trade credit, bank finance and commercial paper. 8.2 CONCEPTS OF WORKING CAPITAL There are two concepts of working capital gross and net. Gross working capital refers to the firm s investment in current assets. Current assets are the assets which can be converted into cash within an accounting year and include cash, short-term securities, debtors, (accounts receivable or book debts) bills receivable and stock (inventory). Net working capital refers to the difference between current assets and current liabilities. Current liabilities are those claims of outsiders which are expected to mature for payment within an accounting year and include creditors (accounts payable), 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 current liabilities are in excess of current assets. The two concepts of working capital gross and net are not exclusive; rather, they have equal significance from the management viewpoint Focusing on Management of Current Assets The gross working capital concept focuses attention on two aspects of current assets management: (1) How to optimise investment in current assets? (2) How should current assets be financed? The consideration of the level of investment in current assets should avoid two danger points excessive or inadequate investment in current assets. Investment in current assets should be just adequate to the needs of the business firm. Excessive investment in current assets should be avoided because it impairs the firm s profitability, as idle investment earns nothing. On the other hand, inadequate amount of working capital can threaten solvency of the firm because of its inability to meet its current obligations. It should be realised that the working capital needs of the firm may be fluctuating with changing business activity. This may cause excess or shortage of working capital frequently. The management should be prompt to initiate an action and correct imbalances. Another aspect of the gross working capital points to the need of arranging funds to finance current assets. Whenever a need for working capital funds arises due to the increasing level of business activity or for any other reason, financing arrangement should be made quickly. Similarly, if suddenly, some surplus funds arise they should not be allowed to remain idle, but should be invested in short-term securities. Thus, the financial manager should have knowledge of the sources of working capital funds as well as investment avenues where idle funds may be temporarily invested. 248 Self-Instructional Material Focusing on Liquidity Management Net working capital is a qualitative concept. It indicates the liquidity position of the firm and suggests the extent to which working capital needs may be financed by permanent sources of funds. Current assets should be sufficiently in excess of current liabilities to constitute a margin or buffer for maturing obligations within the ordinary operating cycle of a business. In order to protect their interests, short-term creditors always like a company to maintain current assets at a higher level than current liabilities. It is a conventional rule to maintain the level of current assets twice the level of current liabilities. However, the quality of current assets should be considered

4 in determining the level of current assets vis-à-vis current liabilities. A weak liquidity position poses a threat to the solvency of the company and makes it unsafe and unsound. A negative working capital means a negative liquidity, and may prove to be harmful for the company s reputation. Excessive liquidity is also bad. It may be due to mismanagement of current assets. Therefore, prompt and timely action should be taken by management to improve and correct the imbalances in the liquidity position of the firm. Net working capital concept also covers the question of judicious mix of long-term and short-term funds for financing current assets. For every firm, there is a minimum amount of net working capital which is permanent. Therefore, a portion of the working capital should be financed with the permanent sources of funds such as equity share capital, debentures, long-term debt, preference share capital or retained earnings. Management must, therefore, decide the extent to which current assets should be financed with equity capital and/or borrowed capital. In summary, it may be emphasised that both gross and net concepts of working capital are equally important for the efficient management of working capital. There is no precise way to determine the exact amount of gross, or net working capital for any firm. The data and problems of each company should be analysed to determine the amount of working capital. There is no specific rule as to how current assets should be financed. It is not feasible in practice to finance current assets by shortterm sources only. Keeping in view the constraints of the individual company, a judicious mix of long and short-term finances should be invested in current assets. Since current assets involve cost of funds, they should be put to productive use. Principles of Working Capital Management 8.3 OPERATING AND CASH CONVERSION CYCLE The need for working capital to run the day-to-day business activities cannot be overemphasised. 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 maximising the wealth of its shareholders. In its endeavour to do so, a firm should earn sufficient return from its operations. Earning a steady amount of profit requires successful sales activity. The firm has to invest enough funds in current assets for generating sales. Current assets are needed because sales do not convert into cash instantan-eously. There is always an operating cycle involved in the conversion of sales into cash. 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 is turned over many times in a year. Investment in current assets such as inventories and debtors (accounts receivable) is realised during the firm s operating cycle that is usually less than a year. 1 What is an operating cycle? Operating cycle is the time duration required to convert sales, after the conversion of resources into inventories, into cash. The operating cycle of a manufacturing company involves three phases: Acquisition of resources such as raw material, labour, power and fuel etc. Manufacture of the product which includes conversion of raw material into work-in-progress into finished goods. Sale of the product either for cash or on credit. Credit sales create account receivable for collection. These phases affect cash flows, which most of the time, are neither synchronised nor certain. They are not synchronised 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 non-availability 1. Moyer, R.C. et. al., Contemporary Finance Management, West Publishing Co., 1984, p Check Your Progress 1. Differentiate between gross working and net working capital. 2. While deciding on the level of current assets, which are the risks that the management of the firm should avoid? 3. Why is the concept of net working capital important from a liquidity management perspective? 4. What is matching approach for financing of current assets? Self-Instructional Material 249

5 Financial Management 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. How is the length of operating cycle determined? Figure 8.1 illustrates this. 2 The length of the operating cycle of a manufacturing firm is the sum of: (i) inventory conversion period (ICP) and (ii) debtors (receivable) conversion period (DCP). 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 postpone payment of certain expenses. Payables, which the firm can defer, are spontaneous sources of capital to finance investment in current assets. The creditors (payables) deferral period (CDP) is the length of time the firm is able to defer payments on various resource purchases. The difference between (gross) operating cycle and payables deferral period is net operating cycle (NOC). If Figure 8.1 Operating cycle of a manufacturing firm Table 8.1: Statement of Cost of Sales (Rs in lakh) Items Actual Projected 19X1 19X2 1. Purchase of raw material (credit) 4,653 6, Opening raw material inventory Closing raw material inventory Raw material consumed ( ) 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 ( ) 5,212 7, Opening finished goods inventory Closing finished goods inventory Cost of goods sold ( ) 5,003 6, Selling, administrative and general expenses Cost of sales ( ) 5,307 7, Self-Instructional Material 2. Richards, V.D. and Laughlin, E.J., A Cash-Conversion Cycle Approach to Liquidity Analysis, Financial Management, (Spring, 1980), pp Also see Moyer et. al., op. cit., pp

6 depreciation is excluded from expenses in the computation of operating cycle, the net operating cycle also represents the cash conversion cycle (CCC). 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 illustrate the computation of the length of operating cycle. Consider the statement of costs of sales for a firm given in Table 8.1. The firm s data for sales and debtors and creditors are given in Table 8.2. Table 8.2: Sales and Debtors (Rs in lakh) 19X1 19X2 Principles of Working Capital Management Sales (credit) 6,087 8,006 Opening balance of debtors Closing balance of debtors 735 1,040 Opening balance of creditors Closing balance of creditors Gross Operating Cycle (GOC) The firm s gross operating cycle (GOC) can be determined as inventory conversion period (ICP) plus debtors conversion period (DCP). Thus, GOC is given as follows: Gross operating cycle = Inventory conversion period + Debtors conversion period GOC = ICP + DCP (1) Inventory conversion period What determines the inventory conversion period? 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 (2) Ram material conversion period (RMCP) The raw material conversion period (RMCP) is the average time period taken to convert material in to work-in-process. RMCP depends 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 formula can be used: Raw material inventory Raw material period = [Raw material consumption]/360 RMC RMI 360 RMCP RMI (3) 360 RMC Work-in-process conversion period (WIPCP): Work-in-process conversion period (WIPCP) is the average time taken to complete the semi-finished or work-in-process. It is given by the following formula: Work-in-process inventory Work-in-process period [Cost of production]/ 360 COP WIPI 360 WIPCP WIPI (4) 360 COP Finished goods conversion period (FGCP): Finished goods conversion period (FGCP) is the average time taken to sell the finished goods. FGCP can be calculated as follows: Self-Instructional Material 251

7 Financial Management Finished goods conversion period Finished goods inventory [Cost of goods sold]/ 360 CGI FGI 360 FGCP FGI (5) 360 CGS Debtors (receivable) conversion period (DCP) Debtors conversion period (DCP) is the average time taken to convert debtors into cash. DCP represents the average collection period. It is calculated as follows: Debtors Debtors 360 Debtors conversion period (DCP) (6) Credit sales/ 360 Credit sales Creditors (payables) deferral period (CDP) Creditors (payables) deferral period (CDP) is the average time taken by the firm in paying its suppliers (creditors). CDP is given as follows: Creditors Creditors 360 Creditors deferral period (CDP) (7) Credit purchases/ 360 Credit purchases Cash Conversion or Net Operating Cycle Net operating cycle (NOC) is the difference between gross operating cycle and payables deferral period. Net operating cycle = Gross operating cycle Creditors deferral period NOC = GOC CDP (8) Table 8.3: Operating Cycle Calculation (Rs in lakh) Items Actual Projected 19X1 19X2 1. Raw Material Conversion Period (a) Raw material consumption 4,349 5,932 (b) Raw material consumption per day (c) Raw material inventory (d) Raw material inventory holding days 68d 60d 2. Work-in-Process Conversion Period (a) Cost of production* 5,212 7,051 (b) Cost of production per day (c) Work-in-process inventory (d) Work-in-process inventory holding days 22d 25d 3. Finished Goods Conversion Period (a) Cost of goods sold* 5,003 6,582 (b) Cost of goods sold per day (c) Finished goods inventory (d) Finished goods inventory holding days 38d 54d 4. Collection Period (a) Credit sales (at cost)** 6,087 8,006 (b) Sales per day (c) Debtors 735 1,040 (d) Debtors outstanding days 43d 47d 5. Creditors Deferral Period (a) Credit purchases 4,653 6,091 (b) Purchase per day (c) Creditors (d) Creditors outstanding days 35d 38d 252 Self-Instructional Material * Depreciation is included. ** All sales are assumed on credit. Net operating cycle is also referred to as cash conversion cycle. Some people argue that depreciation and profit should be excluded in the computation of cash conversion cycle since the firm s

8 concern is with cash flows associated with conversion at cost; depreciation is a non-cash item and profits are not costs. 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 formulae, average figures for the period may be used. For our example, Table 8.3 shows detained calculations of the components of a firm s operating cycle. Table 8.4 provides the summary of calculations. Principles of Working Capital Management During 19X1 the daily raw material consumption was Rs 12.1 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 16.5 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 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 8.3. Table 8.4: Summary of Operating Cycle Calculations (Number of Days) 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) 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 54 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 (creditors) deferral period, will have to negotiate higher working capital funds. In the case of the firm in our example, its net operating cycle is expected to increase from 136 days to 148 days (Table 8.4). 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. The operating cycle concept as shown in Figure 8.1 relates to a manufacturing firm. Nonmanufacturing firms such as wholesalers and retailers will not have the manufacturing phase. They will acquire stock of finished goods and convert them into debtors (receivable) and debtors into cash. Further, service and financial enterprises will not have inventory of goods (cash will be their inventory). Their operating cycles will be the shortest. They need to acquire cash, then lend (create debtors) and again convert lending into cash. 8.4 PERMANENT AND VARIABLE WORKING CAPITAL We know that the need for current assets arises because of the operating cycle. The operating cycle is a continuous process and, therefore, the need for current assets is felt constantly. But the magnitude of current assets needed is not always the same; it increases and decreases over time. Check Your Progress 5. Define the operating cycle of a manufacturing firm. 6. What is meant by the term net operating cycle? 7. What are major components of gross operating cycle? 8. What is the manufacturing cycle period? Self-Instructional Material 253

9 Financial Management However, there is always a minimum level of current assets which is continuously required by a firm to carry on its business operations. Permanent or fixed, working capital is the minimum level of current assets. It is permanent in the same way as the firm s fixed assets are. Depending upon the changes in production and sales, the need for working capital, over and above permanent working capital, will fluctuate. For example, extra inventory of finished goods will have to be maintained to support the peak periods of sale, and investment in debtors (receivable) may also increase during such periods. On the other hand, investment in raw material, work-in-process and finished goods will fall if the market is slack. Figure 8.2 Permanent and temporary working capital Fluctuating or variable working capital is the extra working capital needed to support the changing production and sales activities of the firm. Both kinds of working capital permanent and fluctuating (temporary) are necessary to facilitate production and sale through the operating cycle. But the firm to meet liquidity requirements that will last only temporarily creates the temporary working capital. Figure 8.2 illustrates differences between permanent and temporary working capital. It is shown that permanent working capital is stable over time, while temporary working capital is fluctuating sometimes increasing and sometimes decreasing. However, the permanent working capital line need not be horizontal if the firm s requirement for permanent capital is increasing (or decreasing) over a period. For a growing firm, the difference between permanent and temporary working capital can be depicted through Figure 8.3. Figure 8.3 Permanent and temporary working capital 8.5 BALANCED WORKING CAPITAL POSITION Check Your Progress 9. Differentiate between permanent and variable working capital. The firm should maintain a sound working capital position. It should have adequate working capital to run its business operations. Both excessive as well as inadequate working capital positions are dangerous from the firm s point of view. Excessive working capital means holding costs and idle funds which earn no profits for the firm. Paucity of working capital not only impairs the firm s profitability but also results in production interruptions and inefficiencies and sales disruptions. 254 Self-Instructional Material

10 The dangers of excessive working capital are as follows: 3 It results in unnecessary accumulation of inventories. Thus, chances of inventory mishandling, waste, theft and losses increase. It is an indication of defective credit policy and slack collection period. Consequently, higher incidence of bad debts results, which adversely affects profits. Excessive working capital makes management complacent which degenerates into managerial inefficiency. Tendencies of accumulating inventories tend to make speculative profits grow. This may tend to make dividend policy liberal and difficult to cope with in future when the firm is unable to make speculative profits. Inadequate working capital is also bad and has the following dangers: 4 It stagnates growth. It becomes difficult for the firm to undertake profitable projects for nonavailability of working capital funds. It becomes difficult to implement operating plans and achieve the firm s profit target. Operating inefficiencies creep in when it becomes difficult even to meet day-to-day commitments. Fixed assets are not efficiently utilised for the lack of working capital funds. Thus, the firm s profitability would deteriorate. Paucity of working capital funds render the firm unable to avail attractive credit opportunities etc. The firm loses its reputation when it is not in a position to honour its short-term obligations. As a result, the firm faces tight credit terms. An enlightened management should, therefore, maintain the right amount of working capital on a continuous basis. Only then a proper functioning of business operations will be ensured. Sound financial and statistical techniques, supported by judgement, should be used to predict the quantum of working capital needed at different time periods. A firm s net working capital position is not only important as an index of liquidity but it is also used as a measure of the firm s risk. Risk in this regard means chances of the firm being unable to meet its obligations on due date. The lender considers a positive net working as a measure of safety. All other things being equal, the more the net working capital a firm has, the less likely that it will default in meeting its current financial obligations. Lenders such as commercial banks insist that the firm should maintain a minimum net working capital position. Principles of Working Capital Management 8.6 DETERMINANTS OF WORKING CAPITAL There are no set rules or formulae to determine the working capital requirements of firms. A large number of factors, each having a different importance, influence working capital needs of firms. The importance of factors also changes for a firm over time. Therefore, an analysis of relevant factors should be made in order to determine total investment in working capital. The following is the description of factors which generally influence the working capital requirements of firms Nature of Business Working capital requirements of a firm are basically influenced by the nature of its business. Trading and financial firms have a very small investment in fixed assets, but require a large sum of money to be invested in working capital. Retail stores, for example, must carry large stocks of a variety of goods to satisfy varied and continuous demands of their customers. A large departmental store like Wal-Mart may carry, say, over 20,000 items. Some manufacturing businesses, such as tobacco manufacturers and construction firms, also have to invest substantially in working 3. Also see, Ramamoorthy, V.E., Working Capital Management, IFMR, Chennai, 1976, p Ibid., p Ibid., pp Check Your Progress 10. Why is it important to have a balanced working capital position? Self-Instructional Material 255

11 Financial Management capital and a nominal amount in fixed assets. In contrast, public utilities may have limited need for working capital and have to invest abundantly in fixed assets. Their working capital requirements are nominal because they may have only cash sales and supply services, not products. Thus, no funds will be tied up in debtors and stock (inventories). For the working capital requirements most of the manufacturing companies will fall between the two extreme requirements of trading firms and public utilities. Such concerns have to make adequate investment in current assets depending upon the total assets structure and other variables Market and Demand Conditions The working capital needs of a firm are related to its sales. However, it is difficult to precisely determine the relationship between volume of sales and working capital needs. In practice, current assets will have to be employed before growth takes place. It is, therefore, necessary to make advance planning of working capital for a growing firm on a continuous basis. Growing firms may need to invest funds in fixed assets in order to sustain growing production and sales. This will, in turn, increase investment in current assets to support enlarged scale of operations. Growing firms need funds continuously. They use external sources as well as internal sources to meet increasing needs of funds. These firms face further problems when they retain substantial portion of profits, as they will not be able to pay dividends to shareholders. It is, therefore, imperative that such firms do proper planning to finance their increasing needs for working capital. Sales depend on demand conditions. Large number of firms experience seasonal and cyclical fluctuations in the demand for their products and services. These business variations affect the working capital requirement, specially the temporary working capital requirement of the firm. When there is an upward swing in the economy, sales will increase; correspondingly, the firm s investment in inventories and debtors will also increase. Under boom, additional investment in fixed assets may be made by some firms to increase their productive capacity. This act of firms will require further additions of working capital. To meet their requirements of funds for fixed assets and current assets under boom period, firms generally resort to substantial borrowing. On the other hand, when there is a decline in the economy, sales will fall and consequently, levels of inventories and debtors will also fall. Under recession, firms try to reduce their short-term borrowings. Seasonal fluctuations not only affect working capital requirement but also create production problems for the firm. During periods of peak demand, increasing production may be expensive for the firm. Similarly, it will be more expensive during slack periods when the firm has to sustain its working force and physical facilities without adequate production and sales. A firm may, thus, follow a policy of level production, irrespective of seasonal changes in order to utilise its resources to the fullest extent. Such a policy will mean accumulation of inventories during off-season and their quick disposal during the peak season. The increasing level of inventories during the slack season will require increasing funds to be tied up in the working capital for some months. Unlike cyclical fluctuations, seasonal fluctuations generally conform to a steady pattern. Therefore, financial arrangements for seasonal working capital requirements can be made in advance. However, the financial plan or arrangement should be flexible enough to take care of some abrupt seasonal fluctuations Technology and Manufacturing Policy 256 Self-Instructional Material The manufacturing cycle (or the inventory conversion cycle) comprises of the purchase and use of raw materials and the production of finished goods. Longer the manufacturing cycle, larger will be the firm s working capital requirements. For example, the manufacturing cycle in the case of a boiler, depending on its size, may range between six to twenty-four months. On the other hand, the manufacturing cycle of products such as detergent powder, soaps, chocolate etc. may be a few hours. An extended manufacturing time span means a larger tie-up of funds in inventories. Thus, if there are alternative technologies of manufacturing a product, the technological process

12 with the shortest manufacturing cycle may be chosen. Once a manufacturing technology has been selected, it should be ensured that manufacturing cycle is completed within the specified period. This needs proper planning and coordination at all levels of activity. Any delay in manufacturing process will result in accumulation of work-in-process and waste of time. In order to minimise their investment in working capital, some firms, specifically those manufacturing industrial products, have a policy of asking for advance payments from their customers. Nonmanufacturing firms, service and financial enterprises do not have a manufacturing cycle. Principles of Working Capital Management A strategy of level or steady production may be maintained in order to resolve the working capital problems arising due to seasonal changes in the demand for the firm s product. A steady or level production policy will cause inventories to accumulate during the off-season periods and the firm will be exposed to greater inventory costs and risks. Thus, if costs and risks of maintaining a constant production schedule are high, the firm may adopt a variable production policy, varying its production schedules in accordance with changing demand. Those firms, whose productive capacities can be utilised for manufacturing varied products, can have the advantage of diversified activities and solve their working capital problems. They will manufacture the original product line during its increasing demand and when it has an off-season, other products may be manufactured to utilise physical resources and working force. Thus, production policies will differ from firm to firm, depending on the circumstances of individual firm Credit Policy The credit policy of the firm affects the working capital by influencing the level of debtors. The credit terms to be granted to customers may depend upon the norms of the industry to which the firm belongs. But a firm has the flexibility of shaping its credit policy within the constraint of industry norms and practices. The firm should use discretion in granting credit terms to its customers. Depending upon the individual case, different terms may be given to different customers. A liberal credit policy, without rating the credit-worthiness of customers, will be detrimental to the firm and will create a problem of collection later on. The firm should be prompt in making collections. A high collection period will mean tie-up of large funds in debtors. Slack collection procedures can increase the chance of bad debts. In order to ensure that unnecessary funds are not tied up in debtors, the firm should follow a rationalised credit policy based on the credit standing of customers and other relevant factors. The firm should evaluate the credit standing of new customers and periodically review the creditworthiness of the existing customers. The case of delayed payments should be thoroughly investigated Availability of Credit from Suppliers The working capital requirements of a firm are also affected by credit terms granted by its suppliers. A firm will needless working capital if liberal credit terms are available to it from suppliers. Suppliers credit finances the firm s inventories and reduces the cash conversion cycle. In the absence of suppliers credit the firm will have to borrow funds for bank. The availability of credit at reasonable cost from banks is crucial. It influences the working capital policy of a firm. A firm without the suppliers credit, but which can get bank credit easily on favourable conditions, will be able to finance its inventories and debtors without much difficulty Operating Efficiency The operating efficiency of the firm relates to the optimum utilisation of all its resources at minimum costs. The efficiency in controlling operating costs and utilising fixed and current assets leads to operating efficiency. The use of working capital is improved and pace of cash conversion cycle is accelerated with operating efficiency. Better utilisation of resources improves profitability and, thus, helps in releasing the pressure on working capital. Although it may not be possible for a firm to control prices of materials or wages of labour, it can certainly ensure efficient and effective use of its materials, labour and other resources. Self-Instructional Material 257

13 Financial Management Price Level Changes The increasing shifts in price level make functions of financial manager difficult. She should anticipate the effect of price level changes on working capital requirements of the firm. Generally, rising price levels will require a firm to maintain higher amount of working capital. Same levels of current assets will need increased investment when prices are increasing. However, companies that can immediately revise their product prices with rising price levels will not face a severe working capital problem. Further, firms will feel effects of increasing general price level differently as prices of individual products move differently. Thus, it is possible that some companies may not be affected by rising prices while others may be badly hit. 8.7 ISSUES IN WORKING CAPITAL MANAGEMENT Working capital management refers to the administration of all components of working capital cash, marketable securities, debtors (receivable) and stock (inventories) and creditors (payables). The financial manager must determine levels and composition of current assets. He must see that right sources are tapped to finance current assets, and that current liabilities are paid in time. There are many aspects of working capital management which make it an important function of the financial manager: 6 Time Working capital management requires much of the financial manager s time. Investment Working capital represents a large portion of the total investment in assets. Criticality Working capital management has great significance for all firms but it is very critical for small firms. Growth The need for working capital is directly related to the firm s growth. Empirical observations show that the financial managers have to spend much of their time to the daily internal operations, relating to current assets and current liabilities of the firms. As the largest portion of the financial manager s valuable time is devoted to working capital problems, it is necessary to manage working capital in the best possible way to get the maximum benefit. Check Your Progress 11. List some of the major determinants of working capital. 12. How does credit policy followed by the firm affect working capital requirements? 13. What are the various factors affecting the working capital requirement of any organization? 258 Self-Instructional Material Investment in current assets represents a very significant portion of the total investment in assets. For example, in the case of the large and medium public limited companies in India, current assets constitute about 60 per cent of total assets or total capital employed. 7 In a large company such as Bharat Heavy Electricals Limited (BHEL) current assets as a percentage of total assets may be as high as, say, 90 per cent. (See Exhibit 4.1 for examples of other companies). This clearly indicates that the financial manager should pay special attention to the management of current assets on a continuing basis. Actions should be taken to curtail unnecessary investment in current assets. Working capital management is critical for all firms, but particularly for small firms. A small firm may not have much investment in fixed assets, but it has to invest in current assets. Small firms in India face a severe problem of collecting their debtors (book debts or receivables). Further, the role of current liabilities in financing current assets is far more significant in case of small firms, as, unlike large firms, they face difficulties in raising long-term finances. There is a direct relationship between a firm s growth and its working capital needs. As sales grow, the firm needs to invest more in inventories and debtors. These needs become very frequent and fast when sales grow continuously. The financial manager should be aware of such needs and finance them quickly. Continuous growth in sales may also require additional investment in fixed assets. It may, thus, be concluded that all precautions should be taken for the effective and efficient management of working capital. The finance manager should pay particular attention to the levels of current assets and the financing of current assets. To decide the levels and financing of current assets, the risk return implications must be evaluated. 6. Weston, J. Fred and Eugene F. Brigham, Managerial Finance, Illinois: Dryden Press, 1975, pp Reserve Bank of India, Finance of Medium and Large Public Limited Companies, various issues of Reserve Bank of India Bulletin.

14 EXHIBIT 8.1: LEVELS OF CURRENT ASSETS: SOME EXAMPLES OF INDIAN COMPANIES Current assets form a significant portion of total assets of many Indian companies. Consider the following examples: BHEL GNFC L&T Voltas Sales Total assets (TA) Current assets (CA) CA/TA CA/Sales Principles of Working Capital Management Note: Data for the year 2003 except in case of BHEL. Voltas Voltas is a large, well-diversified, private sector marketing-cum-manufacturing organisation. In 2003, the company s current assets are three-fourths of total assets and more than half of sales. L&T Limited L&T is also a diversified company in the private sector. In 2003, its current assets are two-thirds of total assets and about one and a third times of sales. GNFC GNFC is a joint sector (joint venture between state of Gujarat and private sector) company manufacturing fertilizers, industrial products (methanol, formic acid, nitric acid, amonium nitrate, liquid nitrogen etc.) and electronic products. Its current assets in the year 2003 are less than half of total assets and 60 per cent of sales. BHEL BHEL was started as a large public sector company. Its shares have been partly divested now. It has a dominant position in the power sector. Its manufacturing operations are spread into industrial and transportation sectors also. A large number of its products are long production cycle products. The company s main customers are State Electricity Boards who fail to pay their due on time. BHEL s current assets in 2002 are 90 per cent of total assets and 112 per cent of sales Current Assets to Fixed Assets Ratio The financial manager should determine the optimum level of current assets so that the wealth of shareholders is maximised. 8 A firm needs fixed and current assets to support a particular level of output. However, to support the same level of output, the firm can have different levels of current assets. As the firm s output and sales increase, the need for current assets increases. Generally, current assets do not increase in direct proportion to output; current assets may increase at a decreasing rate with output. This relationship is based upon the notion that it takes a greater proportional investment in current assets when only a few units of output are produced than it does later on when the firm can use its current assets more efficiently. 9 The level of the current assets can be measured by relating current assets to fixed assets. 10 Dividing current assets by fixed assets gives CA/FA ratio. Assuming a constant level of fixed assets, a higher CA/FA ratio indicates a conservative current assets policy and a lower CA/FA ratio means an aggressive current assets policy assuming other factors to be constant. A conservative policy implies greater liquidity and lower risk; while an aggressive policy indicates higher risk and poor liquidity. Moderate current assets policy fall in the middle of conservative and aggressive policies. The current assets policy of the most firms may fall between these two extreme policies. The alternative current assets policies may be shown with the help of Figure 8.4. In Figure 8.4 alternative A indicates the most conservative policy, where CA/FA ratio is greatest at every level of output. Alternative C is the most aggressive policy, as CA/FA ratio is lowest at 8. The basic principles applicable to working capital management are discussed in Walker, E.W., Towards a Theory of Working Capital, Engineering Economist, (Jan. Feb. 1964), pp Also, see Mehta, Dilip, Working Capital Management, Prentice-Hall, Van Horne, James, C., Financial Management and Policy, Prentice-Hall of India Pvt. Ltd., 1975, p Van Horne, op. cit., Weston, J.F. and Brigham, E.F., Management Financial, Holt, Rinehart and Winston, 1972, pp Self-Instructional Material 259

15 Financial Management Figure 8.4 Alternative current asset policies all levels of output. Alternative B lies between the conservative and aggressive policies and is an average policy Liquidity vs. Profitability: Risk Return Trade-off The firm would make just enough investment in current assets if it were possible to estimate working capital needs exactly. Under perfect certainty, current assets holdings would be at the minimum level. A larger investment in current assets under certainty would mean a low rate of return on investment for the firm, as excess investment in current assets will not earn enough return. A smaller investment in current assets, on the other hand, would mean interrupted production and sales, because of frequent stock-outs and inability to pay to creditors in time due to restrictive policy. As it is not possible to estimate working capital needs accurately, the firm must decide about levels of current assets to be carried. Given a firm s technology and production policy, sales and demand conditions, operating efficiency etc., its current assets holdings will depend upon its working capital policy. It may follow a conservative or an aggressive policy. These policies involve risk return trade-offs. 11 A conservative policy means lower return and risk, while an aggressive policy produces higher return and risk. The two important aims of the working capital management are: profitability and solvency. Solvency, used in the technical sense, refers to the firm s continuous ability to meet maturing obligations. Lenders and creditors expect prompt settlements of their claims as and when due. To ensure solvency, the firm should be very liquid, which means larger current assets holdings. If the firm maintains a relatively large investment in current assets, it will have no difficulty in paying claims of creditors when they become due and will be able to fill all sales orders and ensure smooth production. Thus, a liquid firm has less risk of insolvency; that is, it will hardly experience a cash shortage or a stock-out situation. However, there is a cost associated with maintaining a sound liquidity position. A considerable amount of the firm s funds will be tied up in current assets, and to the extent this investment is idle, the firm s profitability will suffer. To have higher profitability, the firm may sacrifice solvency and maintain a relatively low level of current assets. When the firm does so, its profitability will improve as fewer funds are tied up in idle current assets, but its solvency would be threatened and would be exposed to greater risk of cash shortage and stock-outs. Illustration 8.1: Explians the risk-return trade-off of the working capital management. Illustration 8.1: Working Capital Risk-return Trade-off Suppose, a firm has the following data for some future year: 260 Self-Instructional Material 11. The risk-return analysis of working capital policies are discussed in detail in Van Horne, J.C., A Risk- Return Analysis of a Firm s Working-Capital Position, Engineering Economist, (Oct. 1970), pp

16 Sales (100,000 Rs 15) 1,500,000 Earnings before interest and taxes 150,000 Fixed assets 500,000 The three possible current assets holdings of the firm are: Rs 500,000, Rs 400,000 and Rs 300,000. It is assumed that fixed assets level is constant and profits do not vary with current assets levels. The effect of the three alternative current assets policies is shown in Table 8.5. Rs Principles of Working Capital Management Table 8.5: Effect of Alternative Working Capital Policies Working Capital Policy Conservative A Moderate B Aggressive B Rs Rs Rs Sales 1,500,000 15,00,000 1,500,000 Earnings before interest & taxes (EBIT) 150, , ,000 Current assets 500, , ,000 Fixed assets 500, , ,000 Total assets 1,000, , ,000 Return on total assets (EBIT/Total assets) 15% 16.67% 18.75% Current assets/fixed assets The calculations in Table 8.5 indicate that alternative. A, the most conservative policy, provides greatest liquidity (solvency) to the firm, but also the lowest return on total assets. On the other hand, alternative C, the most aggressive policy, yields highest return but provides lowest liquidity and thus, is very risky to the firm. Alternative B demonstrates a moderate policy and generates a return higher than alternative A but lower than alternative C and is less risky than alternative C but more risky than alternative A. Illustration 8.1 is a simple example of risk return trade-off. 12 The calculation of risk-return trade-off is difficult in practice. Risk and returns are affected differently by different assets, and generalisation is not possible The Cost Trade-off A different way of looking into the risk-return trade-off is in terms of the cost of maintaining a particular level of current assets. There are two types of costs involved: cost of liquidity and cost of illiquidity. If the firm s level of current assets is very high, it has excessive liquidity. Its return on assets will be low, as funds tied up in idle cash and stocks earn nothing and high levels of debtors reduce profitability. Thus, the cost of liquidity (through low rates of return) increases with the level of current assets. The cost of illiquidity is the cost of holding insufficient current assets. The firm will not be in a position to honour its obligations if it carries too little cash. This may force the firm to borrow at high rates of interest. This will also adversely affect the credit-worthiness of the firm and it will face difficulties in obtaining funds in the future. All this may force the firm into insolvency. Similarly, the low level of stocks will result in loss of sales and customers may shift to competitors. Also, low level of debtors may be due to tight credit policy, which would impair sales further. Thus, the low level of current assets involves costs that increase as this level falls. In determining the optimum level of current assets, the firm should balance the profitabilitysolvency tangle by minimising total costs cost of liquidity and cost of illiquidity. This is illustrated in Figure 8.5. It is indicated in the figure that with the level of current assets the cost of liquidity increases while the cost of illiquidity decreases and vice versa. The firm should maintain its current assets at that level where the sum of these two costs is minimised. The minimum cost point indicates the optimum level of current assets in Figure See Weston and Brigham, op. cit., pp Self-Instructional Material 261

17 Financial Management Figure 8.5 Cost Trade-off 8.8 ESTIMATING WORKING CAPITAL NEEDS The most appropriate method of calculating the working capital needs of a firm is the concept of operating cycle. However, a number of other methods may be used to determine working capital needs in practice. We shall illustrate here three approaches which have been successfully applied in practice: Current assets holding period To estimate working capital requirements on the basis of average holding period of current assets and relating them to costs based on the company s experience in the previous years. This method is essentially based on the operating cycle concept. Ratio of sales To estimate working capital requirements as a ratio of sales on the assumption that current assets change with sales. Ratio of fixed investment To estimate working capital requirements as a percentage of fixed investment. To illustrate the above methods of estimating working capital requirements and their impact on rate of return we shall take examples of two hypothetical firms (as given in Table 8.6). Table 8.6: Data for Two Firms Check Your Progress 14. What are some of the important issues that the finance manager has to keep in mind while managing a firm s working capital requirements? 15. What are various aspects of working capital management? 16. Write down two main aims of working capital management? 262 Self-Instructional Material Firm A Rs Firm B Rs Material cost: Raw material consumed 248, ,000 Less: By-product 68,800 68,800 Net material cost 179, ,200 Manufacturing cost Labour 171, ,200 Maintenance 160, ,000 Power and fuel 57,600 57,600 Factory overheads 240, ,000 Depreciation 160, ,000 Total manufacturing cost 788, ,800 Total product cost 968,000 1,128,000 Annual sales 1,448,000 1,448,000 PBIT 480, ,000 Investment 1,600,000 3,200,000 Period 1 year 1 year Plant life 10 year 10 year PBDIT 640, ,000 ROI [PBIT/(investment depreciation)] 33.3% 11.1%

18 The calculations are based on the following assumptions regarding each of the three methods: Method 1: Inventory: one month s supply of each of raw material, semifinished goods and finished material. Debtors: one month s sales. Operating cash: one month s total cost. Method 2: 25 35% of annual sales. Method 3: 10 20% of fixed capital investment. Principles of Working Capital Management The following calculations based on data of firm A are made to show how three methods work. You may complete calculations for firm B. Method 1: Current Assets Holding Period Let us first compute inventory requirements as shown below: Raw material: one month s supply: Rs 248, = Rs 20,667 Semi-finished material: one month s supply (based on raw material plus assume one-half of normal conversion cost): Rs 20,667 + (Rs 171,200 + Rs 160,000 + Rs 57,600) 1/2 12 = Rs 20, ,200 = Rs 36,867 Finished material: one month s supply: The total inventory needs are: Rs 968, = Rs 80,666 Rs 20,667 + Rs 36,867 + Rs 80,666 = Rs138,200 After determining the inventory requirements, projection for debtors and operating cash should be made. Debtors: One month s sales: Rs1,448,00012 Rs120,667 Operating cash: One month s total cost: Rs 968, Rs 80,667 Thus the total working capital required is: Rs138,200 + Rs120,667 + Rs 80,666 = Rs 339,533 Method 2: Ratio of Sales The average ratio is 30 per cent. Therefore, 30 per cent of annual sales, Rs 1,448,000 is Rs 434,400. Method 3: Ratio of Fixed Investment The ratio of current assets to fixed investment ranges between 10 to 20 per cent. We shall use the average rate of 15 per centages. The 15 per cent of fixed investment, Rs 1,600,000 is Rs 240,000. The first method gives details of the working capital items. This approach is subject to error if markets are seasonal. As per the first method the working capital requirement is Rs 339,533. If this figure is considered in calculating the rate of return, it is lowered from 33.3 per cent to 27 per cent. On the other hand, the return of Firm B drops from 11.1 per cent to 9.9 per cent. The estimated working capital for firm B as per the first method is Rs 366,200. Rates of return are calculated as follows: PBIT Rate of return = Net fixed investment+ Workingcapital 480,000 Firm A = 27% [(1,600, ,000) 339,533] 320,000 Firm B = 9.9% [(3,200, ,000) 366,200] Self-Instructional Material 263

19 Financial Management You may notice that investments have been taken net of depreciation. The second method has a limited reliability. Its accuracy is dependent upon the accuracy of sales estimates. The rate of return of Firm A drops to 25.6 per cent and that of Firm B to 9.7 per cent when the working capital computed by this method is incorporated. Third method relates working capital to investment. If estimate of investment is inaccurate, this method cannot be relied upon. This method is not generally used in practice to estimate working capital needs. The rates of return from Firms A and B are respectively 28.6 per cent and 9.5 per cent when the working capital computed by this method is considered. A number of factors will govern the choice of methods of estimating working capital. Factors such as seasonal variations in operations, accuracy of sales forecasts, investment cost and variability in sales price would generally be considered. The production cycle and credit and collection policy of the firm would have an impact on working capital requirements. Therefore, they should be given due weightage in projecting working capital requirements. Example 8.1. From the following projects of ABC Ltd. for the coming year, your are asked to determine the working capital needs of the company. Annuals Sales: Rs. 15,60,000 Cost of production (including depreciation of Rs. 1,30,000): Rs. 12,50,000 Raw material purchases: Rs. 7,00,000 Opening Stock of raw materials: Rs. 1,50,000 Using stock of raw materials: Rs. 1,30,000 Inventory Norms: Raw materials: 2 months Work-in-process: 1/2 month Finished goods: 1 month The firm enjoys credit of 1 month or its purchases and also extends credit of 1 month an its supplier. It may be assumed that production is carried out evenly cash balance the year and the minimum cash balance to be maintained is Rs 50,000. Solution: Determination of net working capital (I) Current Assets: (Rs) Cash Balance 50,000 Inventories: Raw materials Opening Stock 1,50,000 Add: Purchase 7,00,000 Less: Closing Stock 1,30,000 Annual Consumption 7,20,000 Two months requirement (7,20,000 2/12) 1,20,000 Work-in-process (11,20,000 1/24) 46,667 Finished goods (11,20,000 1/12) 93,333 Debtors (11,20,000 1/12) 93,333 Check Your Progress 17. What are the main methods for estimating working capital needs? Total Current Assets 4,03,333 (II) Current liabilities: Trade creditors (7,00,000 1/12) 58,333 (III) Net working capital (I II) Rs. 3,45,000 Note: Depreciation is excluded from the cost of production. 264 Self-Instructional Material

20 Example 8.2. Determination of operating cycle from the information provided below, calculate the operating cycle of the manufacturing company in days: Period Covered: Average period of credit allowed by suppliers: 365 days 15 days Average debtors outstanding Rs 4,50,000 Raw material consumption Rs 45,00,000 Total production cost Rs 110,00,000 Total cost of sales Rs 120,00,000 Sales for the year Rs 170,00,000 Value of average stock maintained: Raw materials Rs 3,30,000 Work-in-process Rs 3,60,000 Finished goods Rs 3,80,000 Principles of Working Capital Management Solution: (Days) (a) Raw material holding period 27 (365 days 330/4500) (b) Less creditors payment period 15 (c) Work-in-process holding period (365 days 380/11000) 13 (d) Finished goods holding period (365 days 450/17000) 10 Duration of operating cycle 47 Example 8.3. DEF Co. wants to purchase a business and has consulted year. The company wants you to advise them regarding the average amount of working capital. Which will be required in the first year s working. You are given the following estimates and are instructed to add 10% to your computed figure to allow for contiguities: (i) Average amount backed up for stocks: Data for the year (Rs in 000s) Stocks of finished product 6,000 Stocks of stores material, etc. 7,000 (ii) Average credit given: Inland sales 4 weeks credit 3,20,000 Export sales 2 week credit 90,000 (iii) Lag in payment of wages and other outgoings: Wages 1 week 1,80,000 Stock, row materials etc. 1/2 months 50,000 Rent, royalties, etc. 3 months 5,000 Clerical staff 1/2 month 65,000 Managers 1/2 month 15,000 Miscellaneous expenses 1 month 30,000 (iv) Payment in advance: Sundry expenses (quarterly) 9,000 The calculations have to be made for the average amount of working capital required. Self-Instructional Material 265