FINANCIAL MANAGEMENT (PART-7) WORKING CAPITAL MANAGEMENT PART 2

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1 FINANCIAL MANAGEMENT (PART-7) WORKING CAPITAL MANAGEMENT PART 2 1. INTRODUCTION Dear Students, Welcome to the lecture series on financial management. Today in this lecture we shall cover the topic Working Capital Management. Under working capital management we shall learn the meaning of working capital management; we shall learn the broad aspect of working capital management i.e., how much to purchase and how to purchase i.e., the decision relating to how much asset to be used in a working capital cycle and how to fund those current assets. We shall learn the various approaches for investment in the current assets and we shall also learn the major issues in using working capital, we shall learn the factor affecting the working capital management. The objective of this lecture is to understand the conceptual framework of working capital management where we have to take the decision that the investment in the current asset should not be insufficient and should not be excessive so that the proper funding can be done and it can ensure the tradeoff between risk and return by working on profitability and liquidity so that the wealth of the shareholders can be maximized.

2 2. MEANING AND FEATURES OF WORKING CAPITAL MANAGEMENT Working capital management is the process of planning, organizing, directing and controlling the working capital in an organization. Working capital and current assets and the operating cycle- these are the three terms which we have learnt in detail in our previous lecture. Working capital means it is the excess of current assets over current liabilities. CURRENT ASSETS Current assets are those assets which are used for a period of 1 year or less than 1 year. They are earning assets which are used for doing day to day business activities. We can list out the current assets as

3 Our lecture will concentrate on management of working capital into three broad categories: Cash Management Receivables Management Inventories Management They are the prime areas where we need to manage our working capital. Need of working capital: To ensure that a required level of the inventories of the cash, period of receivables are maintained properly in the business organization so that the tradeoff between risk and return can be made. Features of Working Capital Management: It gives us the answer to two prime questions i.e. 1. How much to invest in each type of Current Asset? 2. How to finance the current asset. Let us analysis the first question, I.e., how much to invest in each type of current assets. We know that the current assets which need to deal in working capital are: Current assets Cash, Marketable securities, Receivables and Inventories.

4 The inventories shall include Raw material, Work in progress and finished goods. There is a cycle where cash will generate at one point of time and again it will be used to get stock or current asset. This cycle is called operating cycle. How much to invest in an asset will depend upon the length of operating cycle. The Larger the operating cycle, the larger will be the requirement of working capital. Reason being the fund will be blocked for a longer time. How the firm will take decision on the investment in the various assets. The firm will trade off between risk and return. The risk and return will comprise of profitability and liquidity. These are the two parameters on which we will decide the requirement of the current assets.

5 Let us learn this with the help of a table. With this table, we have learned how much current assets are to be purchased or maintained under working capital management. 3. IMPORTANT ASPECT OF WORKING CAPITAL MANAGEMENT Second important question in working capital management is - How to invest in the current assets? This is very crucial question here we need to give the answers to the following question: Whether the current assets are to be financed by long- term source of finance or short- term source of finance? We will divide the current assets into two categories:- 1. Permanent current assets 2. Temporary current assets

6 Permanent current assets- They are those assets which are required to be maintained irrespective of scale of operation or level of activity. As such they are in the form of fixed assets having characteristics of current assets. Temporary Current assets- are those which are used regularly in the production and they are to be maintained over and above the permanent current assets. There are three approaches drafted which will be useful to take the decision of the source of finance out of which these current assets are to be purchased. Sources of funds 1. Long term source- comprises of Equity share capital Preference share capital Debentures Long- term loans 2. Short- term financial facilities Cash credits Bank overdrafts Short term loans Short term non banking facilities such as public deposits or short-term loans from agencies. These are the sources of funds which we have to use for investing in current assets.

7 4. ASSET FINANCING UNDER WORKING CAPITAL Three approaches of asset financing: 1. Aggressive 2. Conservative 3. Hedging/ matching approach Let us learn how the assets being used or being purchased or investment in current assets are made under these three approaches. 1. Aggressive Policy Under Aggressive Policy, all the temporary current assets and some portion of permanent current assets are financed with short-term sources of funds and some portion of permanent current assets are financed with long-term sources of finance. We can see the graph on screen.

8 2. Conservative Approach Under conservative approach, all permanent current assets and some portion of temporary current assets are financed with long term sources of fund and some portion of temporary current assets are financed with short term sources of funds. This diagram will show the position in a much clear manner.

9 3. Matching Approach/ Hedging Approach: All permanent current assets are financed with long-term funds and all the temporary current assets are financed with shortterm sources of funds.

10 Now we have capsulated all the three approaches in a diagram. Let us see the diagram of Aggressive Approach- Here we have used the column as permanent current asset and temporary current and fund is shown in second column that is long term fund and short term. Permanent current assets are financed some of them are financed by long term fund and some of them are financed by short term fund. All temporary current assets are financed by short term funds See the effect of liquidity and profitability under aggressive approach. The liquidity will be low because much pressure is on short term funds while the profitability will be on higher side. Under hedging approach, we have financed all the permanent current assets by long term funds and all the temporary current assets by short term funds So both liquidity and profitability will be on moderate basis.

11 Third one is conservative approach; here all the permanent current assets are being financed by long term fund and while temporary current assets are by long term fund as well as short term fund. Liquidity will be higher, and profitability will be lower under conservative approach. With these we have learned how the financing of the current assets can be made using different sources of fund as per the requirement of the organization and as per the management policies. 5. MAJOR ISSUES IN WORKING CAPITAL MANAGEMENT Working capital management is nothing but the administration of all aspects of current assets and current liabilities. Under working capital management, we have to monitor the current assets, their operating cycle, and the credit period allowed and the credit period received from suppliers, they need to be adjusted so, that the liquidity can be maintained properly which will result in higher profitability.

12 So that the wealth of the shareholders can be maximized. So what are the issues in working capital management? There are certain parameters which we need to follow while doing the management of working capital. 1. First of all, we need to ensure the need of working capital. That means how much working capital is needed in our organization, for that we need to find out operating cycle. Large the operating cycle, the larger will be the requirement of working capital. Similarly, smaller the operating cycle, the smaller will be the need of working capital. So we have to rationally analysis using the set formula to ascertain the period for each class of current asset and have to take the decision. 2. Determining the optimum level of investment in the current assetsthe investment should not be excessive nor should it be inadequate. There should be a proper tradeoff between return and risk. We have already read in our previous lecture that there should be a proper tradeoff between liquidity and profitability. That is what working capital management has to ensure. 3. Determining the appropriate sources of financing- so that our funds are not blocked neither the liquidity is being hampered. 4. Ensuring the payments to the creditors on time- we should be in a position to pay off our current liabilities as and when the need to pay them arises. With this we have learnt all the important issues which we have to take up while evaluating the management of working capital in our organization. 6. FACTORS AFFECTING WORKING CAPITAL REQUIREMENT IN AN ORGANISATION There can be various factors which will decide the requirement of working capital in an organization.

13 Some of them may increase the requirement of working capital and some of them may contribute in the reduction of the working capital. Now these factors can be internal factors, depending upon management policies like dividend payment, depreciation policy while some can be external factors like inflation, rise in the price level and taxation policies formed by the government. These all factors we need to consider while evaluating the need of working capital in our organization. we cannot block the fund excessively in current assets nor it can be lesser than requirement if current assets are not maintained adequately it will result in the adverse impact on production process so ultimately it will be going to affect the profitability. To ensure both profitability and liquidity we have to look into these factors. Let us see the list of these factors in the diagram. FACTORS DETERMINING WORKING CAPITAL - 1. Nature of the Business 2. Size of the business 3. Manufacturing cycle 4. Business Cycle 5. Production Policy 6. Credit Policy 7. Availability of Credit 8. Growth and Expansion Activity 9. Price Level Changes 10. Operating Efficiency 11. Profit Margin 12. Taxation Policy 13. Depreciation Policy 14. Dividend Policy 15. Inventory Policies 16. Condition of Supply 17. Market Conditions

14 We need to learn them one by one. 1. Nature of Business- Nature of business is going to affect the requirement of working capital. In case of small business the requirement of working capital will be small because they will do the cash transactions, there will be cash sales, the inventories will be lesser in amount as well as in quantity and there will be a purchase on credit but sale on cash. For that working capital will be needed less. In case of large business, the requirement will be large, because the receivables will be higher, the credit sales will be higher, the inventory needs to be maintained at higher end and the goods are to be purchased on credit as well as receivables will be redeemed after lapse of time. In case of manufacturing unit, the requirement of working capital will be higher. It will be larger as comparison to trading concern because there is a full cycle where cash will be utilized for purchasing raw material again there will be a time lag where work in progress is to be transformed into finished goods and finished goods are sold on credit and receivables will be generated and from these receivables there will be a time lag by which cash will come. The recovery of cash and the use of cash has a full operating cycle which we need to comply in a manufacturing unit. So the need of working capital will be on very higher side. Examples let us take the examples of (size) nature of business. a. Hotels and restaurants - They need small working capital because they do not need to maintain inventories at higher side. b. Financial firm need large working capital- their debtors are very high.

15 c. Tobacco firm- Large working capital- They require large quantities of stocks to be maintained. d. Construction firm- large working capital- the work in progress is higher in comparison to other industries. 2. Size of business- Size of business means scale of operations. Scale of operations means how much the firm is producing. In crores it can be there. The turnover is required to be analyzed. 3. Manufacturing Cycle- Manufacturing cycle means the time lag between the purchase of raw material and the production of finished goods. Larger the manufacturing cycle, the larger will be the requirement of working capital and vice versa. 4. Business cycle- The need of working capital will depend upon demand and sale of goods. In the case of boom, the demand of goods will be higher, so will the sales of goods in that case there will be increase in inventory and receivables which in turn will increase the requirement of working capital.

16 In the case of recession, there will be lower demand of goods and sales of goods which will result in lesser amount of inventory and receivable in the organization which in turn will reduce the need of working capital. In the case of seasonal industry we should adopt the policy of steady production so that a moderate requirement of working capital can be met as in the case of seasonal fluctuation at the time of seasonal rise there will be higher need of working capital and in the time of slack period we need very less working capital so in order to maintain the consistency the production can be made for the whole period. We can produce those articles which are lesser in demand in slack period and again in the boom extra production can be done. So the working capital will vary as per the demand and supply of the goods. 5. Production policy- Production policy of an organization affects the need of working capital requirement because the type of production policy an organization is following ultimately put its impact up on working capital management. See the types of production policies an organization can follow.

17 6. Credit policy- The Liberal Credit policy will ensure higher sales And if there will be higher credit sales there will be higher receivables and the operating cycle will be on higher side so the requirement working capital will rise. In the case of tight Credit policy, there will be less credit sales, there will be less receivable, the working capital requirement will be small. 7. Availability of the credit I f the credit allowed by the suppliers is higher than what we are allowing to the customers then we will need smaller fund. And if credit given by the supplier is less than credit we are allowing to our customer we will need larger fund. 8. Growth and expansion- Where there is growth there is much requirement of working capital as expansion project can be there. There can additional line of business, there can be diversification of product line, so in that case the requirement of working capital automatically enhances. 9. Price Level Changes- As and when the price level changes there is a need of increase in inventory to maintain the supply of material because there will be rise in price so we need to use more fund to maintain the level of stock as required and those firm who can raise the price of their product can combat with this price rise in much better fashion. 10. Operating efficiency- operating efficiency means how effectively the funds and resources are utilized in an organization. The proper the utilization of resources, the better will be the profits and if the profits are on higher side, it will result in reduction of working capital.

18 11. Profit margin- if they are higher they will reduce the pressure of working capital. 12. Taxation policy- Taxation policy should be such where the benefits of exemptions and incentives can be taken by the organization. The organization should work on the features which will help them to reduce their taxation. So this will reduce the need of working capital and if the burden of taxes is more on organization it will result in higher need of working capital. 13. Depreciation Policy- Depreciation policy has same impact as of the dividend policy. If the depreciation is higher, the profit will be less and that will result in the burden on working capital. 14. Dividend Policy- The more the dividend is paid by the management; it will reduce the cash availability of the organization in that amount. If 100/- is the earning and Rs. 50/- is paid as Dividend,

19 So the organization is getting short by Rs. 50/- by paying off this dividend so we will need more working capital in that case. 15. Condition of Supplies- It will also result in the requirement of working capital. If the supply conditions are difficult or they are not as liberal that they provide a credit period more as required by the organization we will be required more working capital. 16. Market Condition- Market conditions are going to effect the requirement of working capital. On the basis of demand and supply we can ensure the need of working capital. If market conditions are such that current assets cannot be materialized into cash as early as possible, it will again put a pressure on the need of working capital. With this, we have learnt all the factors which are going to affect the need of working capital in an organization.

20 7. SUMMARY We have learnt the meaning of working capital and how to invest in the current assets, how much to invest in current assets looking into the risk and return factor. We have learnt major issues coming in maintaining working capital and the various factors which will decide the need of working capital in an organization. THANK YOU.

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