WORKING
CAPITAL MANAGEMENT (Syllabus-MGU)
Module I
Concept and meaning of working capital – Liquidity
and profitability – identification of factors
affecting working capital requirements – theories of working capital
Module II
Approaches to estimation of working capital –
operating cycle approach.
Management of inventories – determination of optimum
inventory – lead time – Safety stock – EOQ approach
Module III
Management of receivables – credit and Collection
policy – Credit standards – Credit terms – Credit analysis – management of
payables – Maturity matching.
Module IV
Management of cash – Accelerating cash inflows –
Managing collections – Concentration banking – lock box system – Control of
disbursements – models for determining optimum level of cash – inventory model,
stochastic – Cash budgeting – Investment of surplus cash.
Module V
Sources of working capital finance – Approaches to
optimum mix of funds – trade credit, accrual accounts – money market
instruments, commercial paper, Certificate of deposits – Bill discounting and
factoring – Inter corporate loans – short term bank loans.
WORKING CAPITAL MANAGEMENT
Module-1
Meaning
and Types of Finance:
Finance-
Finance is the
Art & Science of Managing Money . It is the Art of passing currency from
hand to hand until it finally disappears
Types
& Sources of Finance
Long
Term Sources of Finance
-
Finance required to meet Capital Expenditure. Also, known as Fixed Capital
Finance
Short
Term Sources of Finance
- Finance required to meet day-to-day Business
requirements. Also, known as Working Capital
Meaning
of Working capital
-
Working
Capital is the amount of Capital that a Business has available to meet the
day-to-day cash requirements of its operations
-
Working
Capital is the difference between resources in cash or readily convertible into
cash (Current Assets) and organizational commitments for which cash will soon
be required (Current Liabilities) .It refers to the amount of Current Assets
that exceeds Current Liabilities (i.e. CA - CL)
-
Working Capital refers to that part of the firm’s Capital, which is required
for Financing Short-Term or Current Assets such as Cash, Marketable Securities,
Debtors and Inventories.
-Working Capital is also known as Revolving or
Circulating Capital or Short-Term Capital
Concepts of Working Capital:-
There
are two concepts of working capital-
(1)
Gross Working Capital Concept
(2) Net
Working Capital Concept.
(1)
Gross working capital:
Gross
working capital; refers to firm's investment in currentassets. Current
assets are the assets
which can be
converted into cash
within an accounting year and include cash, short-term securities,
debtors, bill receivables and stock.
According
to this concept, working capital means Gross working Capital which is the total
of all current assets of a business. It can be represented by the following equation:
Gross
Working Capital = Total Current Assets
Definitions
favoring this concept are:-
According
to Mead, Mallot and Field :
"Working
Capital means total of Current Assets".
(2)
Net Working Capital Concept:
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, bills payables,
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.
Net
Working Capital = Current Assets - Current Liabilities
Definitions
Favoring Net Working Capital Concept:-
According
to C.W.Gestenbergh
"It
has ordinarily been defined as the excess of current assets over current
liabilities".
According
to Lawrence. J. Gitmen
"
The most common definition of net working capital is the difference of firm's
current assets and current liabilities".
Classification of Working Capital
(1) On the Basis of Concept:
-
(i)
Gross Working Capital
(ii)
Net Working Capital
(2) On the Basis of time
or Need:-
(i) Permanent Working Capital
(ii) Temporary Working
Capital
II.
On the basis of time or need
(1)
Permanent or Fixed Working Capital:-
The need
for working capital fluctuates from time to time. However,
to carry on
day-to-day operations of the business
without any obstacles, a certain
minimum level of raw materials, work-in-progress, finished goods and cash must
be maintained on a continuous basis. The amount needed to maintain current
assets on this minimum level is called permanent or regular working capital.
The amount
involved as permanent
working capital has
to be meet
from long-term sources of
finance, e.g.
(i)
Capital
(ii)
Debentures
(iii)
Long-term loans.
(2) Temporary or Variable or Fluctuating Working Capital:-
Depending
upon the changes in production and sales, the need for working capital, over
and above the permanent level of working capital is called temporary,
fluctuating or variable working capital.
It may be two types:-
(a)Seasonal-Due to seasonal changes, level of business activities
is higher than normal during some months of year and therefore additional
working capital will be required along with the permanent working capital. It is so because during peak season, demand
rises and more stock is to be maintained to meet the demand .
(b) Special- Additional doses of working
capital may be required to face cut throat competition in the market or other
contingencies like strikes, lock outs, theft etc.
ADEQUATE
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 firm's point of
view. Excessive working capital means holding costs and idle funds which earn
no profit for the firm. Paucity of working capital not only impairs the firm's
profitability but also results in production interruptions and inefficiencies
and sales disruption
Importance/Need/Advantage of Adequate
Working Capital:
(1) Availability
of Raw Materials Regularly:-
Adequacy of
working capital makes
it possible for a firm to
pay the suppliers
of raw materials on
time. As a result it will continue to
receive regular supplies
of raw materials
and thus there
will be no disruption in production process.
(2)
Full Utilization of Fixed Assets:-
Adequacy
of working capital makes it possible for a firm to utilize its fixed assets
fully and continuously. For example, if there is inadequate stock of raw
material, the machines will not be utilized in full and their productivity will
be reduced.
(3) Cash
Discount:-
A firm
having the adequate
working capital can
avail the cash discount by purchasing the goods for
cash or by making the payment before the due date.
(4)
Increase in Credit Rating:-
Paying
its short-term obligations in time leads to a strong credit rating which
enables the firm to purchase goods on credit on favorable terms and to maintain
its line of credit with banks etc. it facilities the taking of loan in case of need.
5) Exploitation
of Favorable Market conditions:-
Whenever there
are chances of increase
in prices of
raw materials, the
firm can purchase
sufficient quantity if it has adequate of working capital. Similarly, if
a firm receives a bulk order for the
supply of goods
it can take
advantage of such
opportunity if it
has sufficient working capital.
(6) Facility
in Obtaining Bank Loans:-
Banks do
not hesitate to advance even the unsecured loan to a firm which has the
sufficient working capital. This is because the excess of current assets over
current liabilities itself is a good security.
(7)
Increase in Efficiency of Management:-
Adequacy
of working capital has a favorable psychological effect on the managers. This
is because no obstacle arises in the day-to-day business operations. Creditors,
wages and all other expenses are paid on time and hence it keeps the morale of manager’s
high
(8) Ability to face crisis:-
Adequate
working capital enables a concern to face business crisis in emergencies such
as depression. Because during such periods, generally, there is much pressure
on working capital.
(9) Solvency of the business:-
Adequate
working capital helps in maintaining solvency of the business by providing uninterrupted
flow of production.
(10) Good will
Sufficient
working capital enables a business concern to male prompt payments and hence
helps in creating and maintaining good will.
EXCESSIVE
AND INADEQUATE WORKING CAPITAL:
A
business enterprise should maintain adequate working capital according to the
needs of its business operations. The amount of working capital should neither
be excessive nor inadequate. If the working capital is in excess if its
requirements it means idle funds adding to the cost of capital but which earn
nom profits for the firm. On the
contrary, if the working capital is short of its requirements, it will result
in production interruptions and reduction of sales and, in turn, will affect
the profitability of the business adversely.
Disadvantage of Excessive Working
Capital:-
(1)
Excessive Inventory:-
Excessive
working capital results in unnecessary accumulation of large inventory. It
increases the chances of misuse, waste, theft etc.
(2)
Excessive Debtors:-
Excessive
working capital will results in liberal
credit policy which, in turn,
will results in higher amount tied up in debtors and higher incidence of bad
debts.
(3)
Adverse Effect on Profitability:-
Excessive
working capital means idle funds in the business which adds to the cost of
capital but earns no profits for the firm. Hence it has a bad effect on
profitability of the firm.
(4)
Inefficiency of Management:-
Management
becomes careless due to excessive resources at their command. It results in laxity of control on expenses
and cash resources.
Disadvantage of Inadequate Working
Capital:
(1)
Difficulty in Availability of Raw-Material:-
Adequacy
of working capital results in non-payment of creditors on time. As a result the credit purchase of goods on
favorable terms becomes increasingly difficult. Also, the firm cannot avail the
cash discount.
(2)
Full Utilization of Fixed Assets not Possible:
Due to
the frequent interruption in the supply of raw materials and paucity of stock,
the firm cannot make full utilization of its machines etc.
(3)
Difficulty in the
Maintenance of Machinery:
Due to
the inadequacy of
working capital, machines are not cared and maintained properly which
results in the closure of production on many occasions.
(4)
Decrease in Credit Rating:
Because
of inadequacy of working capital, firm is unable to pay its short-term
obligations on time. It decays the firm's relations with its bankers and it becomes
difficult for the firm to borrow in case of need.
(5) Non Utilization of Favorable
Opportunities:
For
example, a firm cannot purchase sufficient quantity of raw materials in case of
sudden decrease in the prices. Similarly, if the firm receives a big order, it
cannot execute it due to shortage of working capital.
(6)
Decrease in Sales:
Due to
the shortage of
working capital, the
firm cannot keep sufficient stock of finished goods. It
results in the decrease in sales. Also, the firm will be forced to restrict its
credit sales. This will further reduce the sales.
(7)
Difficulty in the Distribution of Dividends:
Because
of paucity of cash resources, firm will not be able to pay the dividend to its
shareholders.
(8)
Decrease in the Efficiency of Management:
It will
become increasingly difficult for the management to pay its creditors on time
and pay its day-to-day expenses. It will also be difficult to pay the wages
regularly which will have an adverse
effect on the morale of managers.
DETERMINANTS
OF WORKING CAPITAL:
A
firm should have neither too much nor too little working capital. A large
number of factors, each has a different importance, influencing 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. The working capital requirement is determined by a
large number of factors but,
in general, the
following factors influence
the working capital needs of an
enterprise:
(1)
Nature of Business
:-
Working capital
requirements of an
enterprise are largely influenced by the nature of its
business. For instance, public utilities such as railways, transport, water,
electricity etc. have a very limited need for working capital because they have
invested fairly large amounts in fixed assets. Their working capital need is
minimal because they get immediate
payment for their services
and do not have to maintain big
inventories. On the
other extreme are
the trading and
financial enterprises which have to invest fewer amounts in fixed assets
and a large amount in working capital. This is so because the nature of their
business is such that they have to
maintain a sufficient
amount of cash,
inventories and debtors.
Working capital needs of most of
the manufacturing enterprises fall between these two extremes, that is, between
public utilities and trading concerns.
(2)
Size of Business:-
Larger
the size of the business enterprise, greater would be the need for working
capital. The size of a business may be measured in terms of scale of its
business operations.
(3)
Growth and Expansion:-
As
a business enterprise grows, it is logical to expect that a larger amount of
working capital will be
required. Growing industries
require more working capital than
those that are static.
(4)
Production cycle:-
Production
cycle means the time-span between the purchase of raw materials and its
conversion into finished goods. The longer the production cycle, the larger
will be the need for working capital because the funds will be tied up for a
longer period in work in process. If the production cycle is small, the need
for working capital will also be small.
(5)
Business Fluctuations:-
Business
fluctuations may be in the direction of boom and depression. During boom period
the firm will have to operate at full capacity to meet the increased demand
which in turn, leads to increase in the level of inventories and book debts.
Hence, the need
for working capital
in boom conditions
is bound to increase.
The depression phase
of business fluctuations
has exactly an
opposite effect on the level of working capital requirement.
(6)
Production Policy:-
The
need for working capital is also determined by production policy. The demand
for certain products (such as woolen garments) is seasonal. Two types of
production policies may be adopted for such products. Firstly, the goods may be
produced in the
months of demand and
secondly, the goods may be
produces throughout the year. If the second alternative is adopted, the
stock of finished goods will
accumulate progressively upto
the season of
demand which requires
an increasing amount of working capital that remains tied up in the
stock of finished goods for some months.
(7)
Credit Policy Relating to Sales:-
If
a firm adopts liberal credit policy
in respect of sales, the amount tied up in debtors will also be higher.
Obviously, higher book debts mean more working capital. On the other hand, if
the firm follows tight credit policy, the magnitude of working capital will
decrease
(8)
Credit Policy Relating to Purchase:-
If
a firm purchases more goods on credit, the requirement for working capital will
be less. In other words, if liberal credit terms are available from
the suppliers of
goods (i.e., creditors),
the requirement for
working capital will be reduced and vice versa.
(9)
Availability of Raw Material:-
If the
raw material required
by the firm
is available easily on a continuous basis, there will be no need to keep
a large inventory of such materials and hence the requirement of working
capital will be less. On the other hand,
if the supply of raw material is irregular, the firm will be compelled
to keep an excessive inventory of such raw materials which will result in high
level of working capital. Also, some raw materials are available only during a
particular season such as oil seeds,
cotton, etc. They would have to be necessarily purchased in that season and
have to be kept in stock for a period when
supplies are lean. This will require
more working capital.
(10)
Availability of Credit from Banks:-
If
a firm can get easy bank facility in case of need, it will
operate with less
working capital. On the other
hand, if such
facility is not available, it will have to keep large
amount of working capital.
(11)
Volume of Profit:-
The
net profit is a source of working capital to the extent it has been earned in
cash. Higher net
profit would generate
more internal funds
thereby contributing the working capital pool.
(12)
Level of Taxes:-
Full
amount of cash profit is not available for working capital purpose. Taxes have
to be paid out of profits. Higher the amount of taxes less will be the profits
for working capital.
(13)
Dividend Policy:-
Dividend
policy is a significant element in determining the level of working capital
in an enterprise.
The payment of
dividend reduces the
cash and thereby, affects the
working capital to that extent. On the contrary, if the company does not pay
dividend but retains
the profits, more
would be the
contribution of profits towards capital pool.
(14)
Depreciation Policy:-
Although depreciation
does not result
in outflow of cash, it affects the working capital indirectly. In
the first place, since depreciation is allowable expenditure in calculating
net profits, it affects the
tax liability. In the second
place, higher depreciation also means lower disposable profits and, in
turn, a lower dividend payment. Thus, outgo of cash is restricted to that
extent.
(15)
Price Level Changes:-
Changes in
price level also
affect the working
capital requirements. If the price level is rising, more funds will be
required to maintain the existing
level of production.
Same level of
current assets will
need increased investment
when prices are increasing. However,
companies that can immediately
their product prices with rising price levels will not face a severe working
capital problem. Thus, it is possible that some companies may not be affected
by rising prices while others may be badly hit.
(16)
Efficiency of Management:-
Efficiency
of management is also a significant factor to determine the level of working capital.
Management can reduce the need for working capital by the efficient utilization
of resources. It can accelerate the pace of cash cycle and thereby use the same
amount working capital again and again very quickly.
