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A (2011-13)
PROJECT ON WORKING CAPITAL AND FINANCING MIX
SUBMITTED TO: Meenakshi Rohella, Lecturar(WISDOM), Finance. SUBMITTED BY: Aakanksha Chaudhary(7451), Anupriya(7474), Manu Chaudhary() Nisha Jain()
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Neha()
Every business needs funds for two purposes for its establishment and to carry out its day- to-day operations. Long terms funds are required to create production facilities through purchase of fixed assets such as p & m, land, building, furniture, etc. Investments in these assets represent that part of firms capital which is blocked on permanent or fixed basis and is called fixed capital. Funds are also needed for short-term purposes for the purchase of raw material, payment of wages and other day today expenses etc. These funds are known as working capital. In simple words, working capital refers to that part of the firms capital which is required for financing short- term or current assets such as cash, marketable securities, debtors & inventories. Funds, thus, invested in current assts keep revolving fast and are being constantly converted in to cash and this cash flows out again in exchange for other current assets. Hence, it is also known as revolving or circulating capital or short term capital.
1. Gross Working Capital: The gross working capital is the capital invested in the total current assets of the enterprises current assets are those Assets which can convert in to cash within a short period normally one accounting year. 2. Net Working Capital: The term working capital refers to the net working. Net working capital is the excess of current assets over current liability, or, say: NET WORKING LIABILITIES. CAPITAL = CURRENT ASSETS CURRENT
Net working capital can be positive or negative. When the current assets exceeds the current liabilities are more than the current assets. Current
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liabilities are those liabilities, which are intended to be paid in the ordinary course of business within a short period of normally one accounting year out of the current assts or the income business.
On the basis of concept working capital can be classified as gross working capital and net working capital. On the basis of time, working capital may be classified as:
SOLVENCY OF THE BUSINESS: Adequate working capital helps in maintaining the solvency of the business by providing uninterrupted of production.
GOODWILL: Sufficient amount of working capital enables a firm to make prompt payments and makes and maintain the goodwill.
EASY LOANS: Adequate working capital leads to high solvency and credit standing can arrange loans from banks and other on easy and favorable terms CASH DISCOUNTS: Adequate working capital also enables a concern to avail cash discounts on the purchases and hence reduces cost.
REGULAR SUPPLY OF RAW MATERIAL:Sufficient working capital ensures regular supply of raw material and continuous production. REGULAR PAYMENT OF SALARIES, WAGES AND OTHER DAY TO DAY COMMITMENTS:It leads to the satisfaction of the employees and raises the morale of its employees, increases their efficiency, reduces wastage and costs and enhances production and profits. EXPLOITATION OF FAVORABLE MARKET CONDITIONS:If a firm is having adequate working capital then it can exploit the favorable market conditions such as purchasing its requirements in bulk when the prices are lower and holdings its inventories for higher prices.
QUICK AND REGULAR RETURN ON INVESTMENTS:Sufficient working capital enables a concern to pay quick and regular of dividends to its investors and gains confidence of the investors and can raise more funds in future.
REDUNDANT
OR
EXCESSIVE
Excessive working capital means ideal funds which earn no profit for the firm and business cannot earn the required rate of return on its investments. Redundant working capital leads to unnecessary purchasing and accumulation of inventories.
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Excessive working capital implies excessive debtors and defective credit policy which causes higher incidence of bad debts. It may reduce the overall efficiency of the business. If a firm is having excessive working capital then the relations with banks and other financial institution may not be maintained. Due to lower rate of return n investments, the values of shares may also fall. The redundant working capital gives rise to speculative transactions
For the purpose of raw material, components and spares. To pay wages and salaries.
To meet the selling costs as packing, advertising, etc. To provide credit facilities to the customer.
To maintain the inventories of the raw material, work-in-progress, stores and spares and finished stock. For studying the need of working capital in a business, one has to study the business under varying circumstances such as a new concern requires a lot of funds to meet its initial requirements such as promotion and formation etc. These expenses are called preliminary expenses and are capitalized. The amount needed for working capital depends upon the size of the company and ambitions of its promoters. Greater the size of the business unit, generally larger will be the requirements of the working capital. The requirement of the working capital goes on increasing with the growth and expensing of the business till it gains maturity. At maturity the amount of working capital required is called normal working capital.
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PRODUCTION POLICY:
If the policy is to keep production steady by accumulating inventories it will require higher working capital.
SEASONALS VARIATIONS:
Generally, during the busy season, a firm requires larger working capital than in slack season.
CREDIT POLICY:
A concern that purchases its requirements on credit and sales its product / services on cash requires lesser amt. of working capital and vice-versa.
BUSINESS CYCLE:
In period of boom, when the business is prosperous, there is need for larger amt. of working capital due to rise in sales, rise in prices, optimistic expansion of business, etc. On the contrary in time of depression, the business contracts, sales decline, difficulties are faced in collection from debtor and the firm may have a large amt. of working capital.
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charge of the finances must be certain that they know what they are doing if they are going to adjust the financial mix. Determining the financial mix can be considered the same as the firms capital structure. Every firm needs money to operate and start up which is called capital. The main decision to be taken is to determine how this capital will be generated.the resultant capital structure of the firm is called the financial mix. In simple word, it is the amount of capital generated from debt and equity. This represents the money the company generated by issuing bonds and issuing stocks. Keeping in mind the objective of the firm, the firm decides how the financial mix is to be designed. It is also the maximum amount of capital that can be generated at the lowest cost. Apart from the profitabilty- risk, another important ingredient of the theory of working capital management is determining the financing mix. One of the most important decisions involved in the management of the working capital is how current assets will be financed. There are, broadly speaking, two sources from which the funds can be raised for current asset financing: i. Short term sources ( current liabilities) and ii. Long term sources , such as share capital, long term borrowings, internally generated resources like retained earnings and so on.
to
determine
an
appropriate
sources of funds are matched. The general rule is that the length of the finance should match with the life duration of the assets. That is why the fixed assets are always financed by long term sources only. So, the permanent working capital needs are financed by long term sources. On the other hand, the temporary working capital needs are financed by short term sources only. In other words, the core or fixed working capital is financed by long term sources of funds while the additional or fluctuating working capital needs the financed by the short term sources. For example, a seasonal expansion in inventories should be financed with short term loan or liabilities. The rationale of the hedging principle is straight forward. Funds are needed for a limited period say for purchase of additional inventory, and when that period is over, the cash needed to repay the loan will be generated by the sale of extra inventory items. Obtaining the needed funds from a long terms source would mean that the firm would still have the fund after the inventories had already been sold. In this case, the firm would have excess liquidity, which it either holds in cash or marketable securities until the seasonal increase in inventories occurs again. The result of all this would be lowers the profits of the firm. The financing mix as suggested by the hedging approach is a desirable financing pattern. However, it may be noted that the exact match of maturity period of current assets and sources of finance is always not possible because of uncertainty involved.
CONSERVATIVE APPROACH
As the name itself suggests, under the approach the finance manager does not undertake risk. As a result, all the working capital needs are primarily financed by long term sources and the use of short term sources may be restricted to unexpected and emergency situation only. The working capital policy of a firm is called a conservative policy when all or most of the working capital needs are met by the long term sources and thus the firm avoids the risk of insolvency. So, under the conservative approach, the working capital is primarily financed by long term sources. The larger the portion of long term sources used for financing the working capital, the more conservative is said to be the working capital policy of the firm. In case, the firm has no temporary working capital need then the idle long term funds can be invested in marketable securities. This will help the firm to earn some income. The firm uses a small amount of short term sources to meet its peak level working capital needs. It also stores liquidity in the form of marketable securities in slack season.
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An aggressive finance approach allows a business to decrease the time necessary to earn cash, the asset with the highest liquidity. One method is to factor accounts receivable. Companies will sell open accounts receivable to a third party, receiving 80 to 90 percent cash for these assets. This eliminates the need to wait for customers to pay off money owed to the business. Another option is to obtain a credit line, increasing draws taken on a bank account to pay for daily operations.
CONSIDERATIONS
The use of budgets often helps a company determine its cash needs. Companies can estimate their cash receipts based on historical records. The expected cash receipts -- which add to a company's current assets -then go against a company's expected cash payments. If a deficit exists, a company will need to adopt an aggressive approach to finance working capital to meet this expected cash shortage.
DISADVANTAGES
Aggressive approaches to financing working capital can have serious disadvantages for a business. Factoring receivables, for example, often releases the collection techniques and styles to another company. Customers may be unhappy with receiving numerous phone calls from an individual attempting to collect receivables. Using short-term credit lines increases risk. If operations suddenly become unprofitable, the credit line remains unpaid and incurring interest until its paid off. The following chart gives a summary of the relative costs and benefits of the three different approaches:
Factors Liquidity Profitability Risk Hedging Approach Moderate Moderate Moderate Conservative Approach More Less Less Aggressive Approach Less More More
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