Working Capital Management and Policy

Prof. Sandhya Harkawat

Content

Introduction Meaning of Working Capital Working Capital Needs of Different Types of Businesses Relationship of Working Capital Management to Business Solvency Operating Cycle and its Relevance for Working Capital Management

Working Capital policy

Estimation of Working Capital Requirements

Introduction

The number one reason most people look at a balance sheet is to find out a company's working capital (or "current") position. It reveals more about the financial condition of a business than almost any other calculation. It tells you what would be left if a company raised all of its short term resources, and used them to pay off its short term liabilities. The more working capital, the less financial strain a company experiences. By studying a company's position, you can clearly see if it has the resources necessary to expand internally or if it will have to turn to a bank and take on debt.

Working capital typically means the firms holding of current or short-term assets such as cash, receivables, inventory and marketable securities. These items are also referred to as circulating capital. Corporate executives devote a considerable amount of attention to the management of working capital. Working capital is really what a part of long term finance is locked in and used for supporting current activities

3D Nature of Working Capital Management

Dimension I Profitability, Risk, & Liquidity

TYPES OF WORKING CAPITAL

WORKING CAPITAL

BASIS OF CONCEPT Gross Working Capital Net Working Capital

BASIS OF TIME Permanent / Fixed WC Temporary / Variable WC Special WC

Seasonal WC Regular WC Reserve WC

Working Capital is the easiest of all the balance sheet calculations. Here's the formula:

Current Assets - Current Liabilities = Working Capital

Components of WCM

cash, Accounts Payables,

accounts receivable, and

inventories.

Working Capital
How much is enough?

Depends

Factors to Consider:
Accounts receivable management Inventory management Diversification of operations

Type of business
Prepayment activity Leverage Expansion plans

Working capital policy deciding the level of each type of current asset to hold, and how to finance current assets. Working capital management controlling cash, inventories, and A/R, plus short-term liability management.

PROFORMA - WORKING CAPTIAL ESTIMATES

1. TRADING CONCERN
STATEMENT OF WORKING CAPITAL REQUIREMENTS Amount (Rs.) Current Assets (i) Cash ---(ii) Receivables ( For..Months Sales)------(iii) Stocks ( ForMonths Sales)-------(iv)Advance Payments if any ---Less : Current Liabilities (i) Creditors (For.. Months Purchases)---(ii) Lag in payment of expenses -----_ WORKING CAPITAL ( CA CL ) xxx Add : Provision / Margin for Contingencies -----

NET WORKING CAPITAL REQUIRED

XXX

1. MANUFACTURING CONCERN
STATEMENT OF WORKING CAPITAL REQUIREMENTS Amount (Rs.) Current Assets (i) Stock of R M( for .months consumption) (ii)Work-in-progress (formonths) (a) Raw Materials (b) Direct Labour (c) Overheads (iii) Stock of Finished Goods ( for months sales) (a) Raw Materials (b) Direct Labour (c) Overheads (iv) Sundry Debtors ( for months sales) (a) Raw Materials (b) Direct Labour (c) Overheads (v) Payments in Advance (if any) (iv) Balance of Cash for daily expenses (vii)Any other item Less : Current Liabilities (i) Creditors (For.. Months Purchases) (ii) Lag in payment of expenses (iii) Any other WORKING CAPITAL ( CA CL )xxxx Add : Provision / Margin for Contingencies NET WORKING CAPITAL REQUIRED -----------------------------------------------------

----------------XXX

Working Capital Needs of Different Types of Businesses

Companies that have high inventory turns and do business on a cash basis (such as a grocery store) need very little working capital. if a financial crisis arises. Since cash can be raised so quickly, there is no need to have a large amount of working capital available. A company that makes heavy machinery is a completely different story. Because these types of businesses are selling expensive items on a long-term payment basis, they can't raise cash as quickly. Since the inventory on their balance sheet is normally ordered months in advance, it can rarely be sold fast enough to raise money for short-term financial crises (by the time it is sold, it may be too late). It's easy to see why companies such as this must keep enough working capital on hand to get through any unforeseen difficulties.

WORKING CAPITAL NEEDS OF DIFFERENT TYPES OF BUSINESS

Current assets to total assets ratio for different industries Industries Current assets to total assets (%) Trading 7577 Medicines 6570 Engineering 6065 Aluminium 4550 Paper 4045 Shipping 1518

GROSS WORKING CAPITAL (GWC)

Gross working capital (GWC)refers to the total investment made by a firm in current assets

It denotes the liquidity position of the firm.

Other factors remaining the same, the higher the GWC of a firm, the better its liquidity position

NET WORKING CAPITAL (NWC)

Net Working capital (NWC)refers to the difference between current assets and current liabilities (CA CL).

This differential denotes that part of current assets which is financed by long-term sources of financing

An increasing NWC indicates an improving liquidity position of the firm

Working Capital Cycle

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

Accounts Payable

Raw Materials

WIP

Cash

THE WORKING CAPITAL CYCLE (OPERATING CYCLE)

Finished Goods

Accounts Receivable

SALES

Working capital cycle is the lifeblood of the firm

Each component of working capital (namely inventory, receivables and payables) has two dimensions ........ TIME ......... and MONEY.

When it comes to managing working capital - TIME IS MONEY.

More businesses fail for lack of cash than for want of profit.

If you ....... Collect receivables (debtors) faster Collect receivables (debtors) slower Get better credit (in terms of duration or amount) from suppliers Shift inventory (stocks) faster Move inventory (stocks) slower

Then ...... You release cash from the cycle Your receivables soak up cash You increase your cash resources
You free up cash You consume more cash

Working capital policy

the risk and return tradeoffs inherent in alternative working capital policies. High risk, high return working capital investment and financing strategies are referred to as aggressive; lower risk and return strategies are called moderate or matching; still lower risk and return is called conservative

Three alternative working capital investment policies

Policy C

Policy B

Current Assets ($)

Policy A

Sales ($)

Policy C represents conservative approach Policy A represents aggressive approach Policy B represents a matching approach

Optimal level investment

of

working

capital

Risk of long-term versus short-term debt

Difference between permanent & temporary working capital

Amount of Working Capital

Variable Working Capital

Permanent Working Capital

Time

Matching approach to asset financing

Total Assets Short-term Debt Fluctuating Current Assets

Permanent Current Assets

Long-term Debt + Equity Capital

Fixed Assets

Time

Conservative approach to asset financing

Total Assets Short-term Debt Fluctuating Current Assets

Permanent Current Assets

Long-term Debt + Equity capital

Fixed Assets

Time

Aggressive approach to asset financing

Total Assets Short-term Debt Fluctuating Current Assets

Permanent Current Assets

Long-term Debt + Equity capital

Fixed Assets

Time

Estimation Of Working Capital Requirements

Estimation of working capital requirements is based on past data and future projections. It requires estimation of the duration and weights of different components of the operating cycle

ESTIMATION OF WORKING CAPITAL REQUIREMENTS

Estimation of working capital can be stated as a four step process: Step 1:Determining the duration (or conversion period) of blockage of funds. Duration of the various components of CA and CL is determined as follows:

Raw Material Inventory conversion period

= Avg. Raw Material inventory _________________ Raw Material Consumed/365 work in progress inventory = ___________________ cost of production/365

Work in - progress

Finished goods conversion period

finished good inventory = _________________ Cost of sales/365

Receivable conversion period Accounts receivable = ___________________ Annual credit sales/365 Payables deferral period Accounts payable = ___________________________ Credit Purchase / 360