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Decisions relating to working capital and short term financing are referred to
as working capital management. These involve managing the relationship between
a firm's short-term assets and its short-term liabilities. The goal of working capital
management is to ensure that the firm is able to continue its operations and that it
has sufficient cash flow to satisfy both maturing short-term debt and upcoming
operational expenses. The management of working capital involves managing
inventories, accounts receivable and payable, and cash. Working capital
management is a significant concept in financial management due to the fact that it
plays a pivotal role in keeping the wheels of the business enterprise running.
Implementing an effective working capital management system is an excellent way
for many companies to improve their earnings.
“Working capital is descriptive of that capital which is not fixed. But, the more
common use of working capital is to consider it as the difference between the book
value of the current assets and the current liabilities.”
Working capital, also known as net working capital or NWC, circulating capital
and revolving capital is a financial metric which represents operating
liquidity available to a business. Its magnitude & composition keeps on changing
continuously in the course of business. Along with fixed assets such as plant and
equipment, working capital is considered a part of operating capital. It is calculated
as current assets minus current liabilities. If current assets are less than current
liabilities, an entity has a working capital deficiency, also called a working
capital deficit.
Working Capital = Current Assets − Current Liabilities
Positive working capital means that the company is able to pay off its short-term
liabilities. Negative working capital means that a company currently is unable
to meet its short-term liabilities with its current assets
A company can be endowed with assets and profitability but short of liquidity if its
assets cannot readily be converted into cash. Positive working capital is required to
ensure that a firm is able to continue its operations and that it has sufficient funds
to satisfy both maturing short-term debt and upcoming operational expenses. The
management of working capital involves managing inventories, accounts
receivable and payable and cash.
If a company's current assets do not exceed its current liabilities, then it may run
into trouble paying back creditors in the short term. The worst-case scenario is
bankruptcy. A declining working capital ratio over a longer time period could also
be a red flag that warrants further analysis. For example, it could be that the
company's sales volumes are decreasing and, as a result, its accounts receivables
number continues to get smaller and smaller.
• Goodwill
• Easy loans
• Cash discounts
• Excessive Purchasing
• Excessive Debtors
• Due to low rate of return on investments, the market value of shares may fall
Nature of Business
Size of Business
Depreciation Policy
EXTERNAL FACTORS :
Business Fluctuations.
Technological Development
Import Policy
Taxation Policy
Ist Recommendation
The borrower has to contribute a minimum 25% of working capital gap from long
term funds.
IInd Recommendation
The borrower has to contribute a minimum of 25% of the total current assets from
long term funds.
IIIrd Recommendation
The borrower has to contribute the entire core current assets and a minimum of
25% of the balance of the current assets from long term funds.
Where;
CA = Current assets
Practical problems:
1) A proforma cost sheet of raju brothers’ private
limited provides the following particulars.
Elements of cost Amount per unit
Raw material 80
Direct labour 30
Overheads 60
Profit 30
d) Annual sales
e) Lag in payment of
Rent 6 months
“The period of time which elapses between the point at which cash begins to
be expended on the production of a product and the collection of cash from a
customer.”
The working capital cycle measures the amount of time that elapses between the
moment when your business begins investing money in a product or service, and
the moment the business receives payment for
that product or service. This doesn’t necessarily begin when you manufacture a
product—businesses often invest money in products when they hire people to
produce goods, or when they buy raw materials.
The working capital diagram should be customized to show the way capital moves
around your business.
More complex diagrams might include incoming assets such as cash payments,
interest payments, loans, and equity. Items that commonly absorb cash would be
labor, inventory, and suppliers.
The key thing to model is the time lag between each item on the diagram. For some
businesses, there may be a very long delay between making the product and
receiving cash from sales. Others may need to purchase raw materials a long time
before the product can be manufactured. Once you have this information, it is
possible to calculate your total working capital cycle, and potentially identify
where time lags within the cycle can be reduced or eliminated.
Operating Cycle:
Time duration required from procurement of raw material and ending with sales
realization.
Chronological sequence in which working capital cycle operates:
= _________________
Cost of sales/365
Accounts receivable
= ___________________
= ___________________________
The diagram below illustrates the working capital cycle for a manufacturing
firm
The upper
portion of the
diagram above
shows in a
simplified
form the chain
of events in a
manufacturing
firm. Each of
the boxes in
the upper part
of the diagram
can be seen as
a tank through
which funds
flow. These tanks, which are concerned with day-to-day activities, have funds
constantly flowing into and out of them.
• The chain starts with the firm buying raw materials on credit.
• In due course this stock will be used in production, work will be carried out on
the stock, and it will become part of the firm’s work in progress (WIP)
• Work will continue on the WIP until it eventually emerges as the finished product
• When the finished goods are sold on credit, debtors are increased
• They will eventually pay, so that cash will be injected into the firm
Each of the areas – stocks (raw materials, work in progress and finished goods),
trade debtors, cash (positive or negative) and trade creditors – can be viewed as
tanks into and from which funds flow.
Working capital is clearly not the only aspect of a business that affects the amount
of cash:
• Shareholders (existing or new) may provide new funds in the form of cash
• Long-term loan creditors (existing or new) may provide loan finance, loans will
need to be repaid from time to time, and
There are two elements in the business cycle that absorb cash
- Inventory (stocks and work-in-progress)
and Receivables (debtors owing you money). The main sources
of cash are Payables (your creditors) and Equity and Loans.
W-I-P 420
31-3-2007 31-3-2008
(Rs.Lakhs) (Rs.lakhs)
Sales 600 720
Depreciation 12 15
Less: Interest 30 40
Finished goods 30
Debtors 100
Creditors 15