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PRINCIPLES

OF WORKING CAPITAL MANAGEMENT

Contents

Meaning & need for inves/ng in current assets Gross working Capital and Net Working Capital Concept of opera/ng cycle & its rela/on to Working capital Working capital nancing

Introduc;on

Tradi/onally, working capital has been dened as the rms investment in current assets. Current assets are required for day-to-day opera/ons of the rm. The assets keep changing from one form to another from viz. Stocks, Receivables and Cash. Working capital decisions are very important as they aect the liquidity of the business.

Features of Working capital decisions

Working capital decisions are typically Short-term nancial decisions, i.e., working capital decisions typically aect the cash ows of the rm for a shorter /me frame, extending normally up to a maximum of one year The concepts of risk and 3me value of money are less per0nent to working capital decision-making They are modied from 3me to 3me unlike capital budge/ng decisions, which are one-/me and irreversible Concept of working capital is dynamic as market condi/ons with respect to credit, stocking etc. change more frequently

Concepts of Working Capital


1. Gross Working Capital (GWC) 2. Net Working Capital (NWC) Gross working capital (GWC)

GWC refers to the rms total investment in current assets Current assets are the assets which can be converted into cash within an accoun/ng year (or opera/ng cycle) and include cash, debtors, (accounts receivable or book debts) bills receivable and stock (inventory). It is termed as managers concept of working capital. It denotes the liquidity posi/on of the rm. Other factors remaining the same, the higher the GWC of a rm, the bePer its liquidity posi/on. Increasing GWC aects protability adversely as more funds get /ed up in current assets that have low/zero yield.

Concepts of Working Capital


Net working capital (NWC)

NWC refers to the dierence between current assets and current liabili/es. Current liabili/es (CL) are those claims of outsiders which are expected to mature for payment within an accoun/ng year and include creditors (accounts payable), bills payable, and outstanding expenses. NWC can be posi/ve or nega/ve.

Posi/ve NWC = CA > CL Nega/ve NWC = CA < CL

Factors inuencing Working Capital decisions


Time Opera/ng & Cash conversion Cycle Ac/vity- Units produced / Sold / held & Costs Working Capital Policy of the company
Current assets to total assets ra;o for dierent industries Industries IT Trading Pharma Engineering Metals Paper Shipping Current assets to total assets (%) 80-85 7580 6570 6065 4550 4045 1520

Nature of business

Market & demand

Technology

Manufacturing policy Credit policy Opera/ng eciency Ina/on

Opera;ng Cycle
Opera/ng cycle is the /me dura/on required to convert 1. resources into inventories 2. inventories into sales (either cash or credit sales) 3. Credit sales into cash. The opera/ng cycle of a manufacturing company involves following phases:
1. 2. 3.

Acquisi;on of resources such as raw material, labour, power and fuel etc. Manufacture of the product which includes conversion of raw material into work-in-progress into nished goods. Sale of the product either for cash or on credit. Credit sales create account receivable for collec/on.

Opera;ng cycle
The length of the opera/ng cycle of a manufacturing rm is the sum of:

Inventory conversion period (ICP). Debtors (Account receivable) conversion period (DCP).

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Gross Opera;ng Cycle (GOC)

The rms gross opera/ng cycle (GOC) can be determined as inventory conversion period (ICP) plus debtors conversion period (DCP). Thus, GOC is given as follows:

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Inventory conversion period (ICP)


Inventory conversion period is the total /me needed for producing and selling the product. Typically, it includes:

Rawmaterial Inventory X 360 RMCP = Rawmaterial consumed Work In process Inventory X 360 WIPCP = Cost of production Finished Goods Inventory X 360 FGCP = Cost of goods sold

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Debtors (receivables) conversion period (DCP)

Debtors conversion period (DCP) is the average /me taken to convert debtors into cash. DCP represents the average collec/on period. It is calculated as follows:

Sundry Debtors X 360 Debtors Conversion Period ( DCP ) = Annual Credit Sales

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Creditors (payables) deferral period (CDP)

Creditors(payables) deferral period (CDP) is the average /me taken by the rm in paying its suppliers (creditors). CDP is given as follows:

SundryCreditorsX 360 Creditors Deferral Period (CDP) = Annual Credit Purchases

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Cash Conversion or Net Operating Cycle

Net opera/ng cycle (NOC) is the dierence between gross opera/ng cycle and payables deferral period.

Net opera/ng cycle is also referred to as cash conversion cycle.

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Operating & Cash conversion cycle


Example: Following information has been extracted from the financial statement of a manufacturing firm. Compute the operating cycle for the firm assuming that the information given is for one full year period
(gures in Rs. Crore) Average Creditors outstanding Raw material purchases Average debtors outstanding Raw material consumed Cost of produc/on Cost of goods sold Sales Inventory of raw material Work in - progress Finished goods 15 90 6 60 145 157.5 200 5.75 6.75 4.80

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Solu;on: a) RMCP = b) WIPCP = c) FGCP = d) DCP =


Raw material Inventory X 360 Raw material consumed WIP Inventory X 360 Cost of produc;on Finished goods Inventory X 360 Cost of Goods Sold Ave. Sundry Debtors X 360 Credit sales 5.75 X 360 60 6.75 X 360 145 4.80 X 360 157.50 6 X 360 200 = 34.50 days

= 16.76 days

= 10.97 days

= 10.80 days = 73.03 days = 60 days = 13.03 days

Gross Opera;ng Cycle e) CDF =


Ave. Sundry Creditors X 360 Credit purchases 15 X 360 90

Net Opera;ng Cycle or Cash Conversion Cycle

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Cash conversion cycle of some companies


Company ACC ( 2007) Ambuja Cements (2007) Tata Motors (2008) Ashok Leyland (2008) Wipro (2008) TCS (2008) Infosys (2008) HUL (2008) Colgate (2008) SAIL (2008) Tata Steel (2008)
Source: FM text book by Jonathan Berk

Industry
Cement Cement Auto Auto Comp. Sojware Comp. Sojware Comp. Sojware Personal care Personal care Steel Steel

DCP (days) 15.35 9.50 14.47 17.32 75.37 73.78 72.15 11.83 2.27 27.98 10.09

ICP (days) 50.65 61.63 36.76 61.93 12.14 0.47 0.00 79.29 23.91 87.80 87.98

CDP (days) 99.39 93.25 70.36 65.41 0.00 34.15 13.97 116.83 88.81 37.23 109.54

CCC or NOC -33.39 -22.12 -19.13 13.84 87.51 40.10 58.18 -25.71 -62.63 78.55 -11.47

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Es;ma;ng Working capital

Current assets holding period

To es/mate working capital requirements on the basis of average holding period of current assets and rela/ng them to costs based on the companys experience in the previous years. This method is essen/ally based on the opera/ng cycle concept. To es/mate working capital requirements as a ra/o of sales on the assump/on that current assets change with sales. To es/mate working capital requirements as a percentage of xed

Ra3o of sales

Ra3o of xed investment

investment.

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Permanent and variable Working capital

Permanent or xed working capital A minimum level of current assets, which is con/nuously required by a rm to carry on its business opera/ons, is referred to as permanent or xed working capital. F l u c t u a ; n g o r v a r i a b l e working capital The extra working capital needed to support the changing produc/on and sales ac/vi/es of the rm is referred to as uctua/ng or variable working capital.

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Key decisions in Working Capital Management


Current Assets to Fixed Assets Ra;o Liquidity vs. Protability: RiskReturn Trade-o The Cost Trade-o

Alterna3ve current asset policies

Cost Trade-o

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Working Capital Finance Policies

The working capital nancing policy may have a signicant impact on the protabilityliquidity posi/on of the rm. These policies could be

Long term Short term Spontaneous

Theore/cally, the policies of working capital nancing can be categorized as:


Matching Conserva/ve Aggressive

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Working Capital Finance Policies


Expected Financing requirement: - Permanent long term requirement: Rs 100 crores ( Fixed & Current asset) - Expected uctua/on + or 15% - To use combination of long term and short term finances

Matching Long term nances Poten/al Short term nances Rs. 100 Cr

Aggressive Rs. 85 Cr

Conserva;ve Rs 115 Cr Nil. However, any requirement over and above Rs 115 cr will need short term funding

Rs. 15 Cr

Rs. 30 Cr

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Short vs. Long term finances


Short term Cost advantage Flexibility Liquid but risky Long term Less risky Long process Predictability Conserva3ve nancing plan

Aggressive nancing plan

Matching nancing plan

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Case Study
Strong Cement Company Ltd has an installed capacity of producing 1.25 lakh tons of cement per annum; its present capacity u;lisa;on is 80 per cent. The major raw material to manufacture cement is limestone which is obtained from the company's own mechanised mine located near the plant. The company produces cement in 200 kg bags. From the informa;on given below, determine the net working capital (NWC) requirement of the company for the current year. Cost structure per bag of cement (es;mated) Gypsum Limestone Coal Packing material Direct labour Factory overheads (including deprecia;on of Rs 10) Administra;ve overheads Selling overheads Total cost Prot margin Selling price Add: Sale tax (10 per cent of selling price) Invoice price to consumers
Rs 25 15 30 10 50 30 20 25 205 45 250 25 275

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Addi;onal informa;on: 1) Desired holding period of raw materials: Gypsum - 3months; Limestone - 1month; Coal - 2.5 months and Packing material - 1.5 months 2) The product is in process for a period of 0.5 month (assume full units of materials, namely gypsum limestone and coal are required in the beginning; other conversion costs are to be taken at 50 per cent). 3) Finished goods are in stock for a period of 1 month before they are sold. 4) Debtors are extended credit for a period 3 months. 5) Average ;me lag in payment of wages is approximately 0.5 month and of overheads, 1 month. 6) Average ;me lag in payment of sales tax is 1.5 months. 7) The credit period extended by various suppliers are: Gypsum - 2 months; Coal - 1 month and Packing material - 0.5 month 1) Minimum desired cash balance is Rs. 25 lakh.

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SOLUTION Statement showing determina;on of net working capital of Strong Cement Company Ltd Current assets: Minimum desired cash balance Raw materials: Gypsum (5 lakh bags* Rs 25 3/12) Limestone (5 lakh bags* Rs 15 1/12) Coal (5 lakh bags Rs 30 2.5/12) Packing material (5 lakh bags Rs 10 1.5/12) Work-in-process: (5 lakh bags Rs 105 0.5/12) Raw material cost 100 per cent (Rs 25 + Rs 15 + Rs 30) Other conversion costs (Rs 50 + Rs 20 cash factory overheads) 0.5 Finished goods (5 lakh bags Rs 170** 1/12) Debtors (5 lakh bags Rs 220** 3/12) Total Rs 70 35 105 Rs 25,00,000 31,25,000 6,25,000 31,25,000 6,25,000 21,87,500 70,83,333 2,75,00,000 4,67,70,833

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Current liabili;es: Creditors: Gypsum (5 lakh bags Rs 25 2/12) Coal (5 lakh bags Rs 30 1/12) Packing material (5 lakh bags Rs 10 1/24) Wages (5 lakh bags Rs 50 1/24) Overheads (5 lakh bags Rs 65 1/12) Sales tax (5 lakh bags Rs 25 1.5/12) Total NWC

20,83,333 12,50,000 2,08,333 10,41,667 27,08,333 15,62,500 88,54,166 3,79,16,667

*1.25 lakh tons 0.8 = 1 lakh ton/200 kgs = 5,00,000 bags **(Total cost, Rs 205 Deprecia;on, Rs 10 selling overheads, Rs 25) ***(Cash cost, Rs 195 + sale tax, Rs 25)

RECEIVABLES MANAGEMENT

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LEARNING OBJECTIVES

Establishing a sound credit policy Op/mum credit policy Explain the credit policy variables The nature and costs / benets of factoring

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INTRODUCTION

Trade credit happens when a rm sells its products or services on credit and does not receive cash immediately

Impact of Credit sale


Increase in sales - Marke/ng tool Maximisa/on of sales Vs. incremental prot


produc/on and selling costs administra/on costs bad-debt losses

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Purpose & features of Credit Policy


Purpose of Credit policy is to determine Features Credit policy Credit standards:

Basis & type of corpora/ons to whom credit will be allowed Credit sales as a % of total sales Average days of credit Maximum amount of exposure to a single customer /client 80-20 principle

Investment in receivables to op;mise returns, which includes volume of credit sales, collec/on period, type of customer

Credit terms:
Credit terms for specic customers

Collec/on eorts:
Process for collec/on Provisioning policy for aged debts

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Op;mum Credit Policy


Credit policy aims at maximising the value of the rm. Credit policy is op/mum when, IRR = RRR Steps in achieving op/mum credit policy are: Es/ma/on of incremental prot ( contribu/on) Es/ma/on of incremental investment in receivable Es/ma/on of incremental rate of return (IRR) Comparison of incremental rate of return with required rate of return (RRR)

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Illustration: Delta Company has current sales of Rs 30 Crore (or 3000 lakh). To increase the sales, the company is considering a more liberal credit policy. The current average collection period of the company is 25 days. If the collection period is extended, sales increase in the following manner. The company is selling its product at Credit Increase in Increase in Rs 10 each. Average cost per unit at policy collec;on period sales the current level is Rs 8 and variable X 15 days Rs. 12 lakh cost per unit Rs 6. If the company Y 25 days Rs. 27 lakh required a return of 12 per cent on its investment. Which credit policy is Z 35 days Rs. 47 lakh desirable? Solution: Need to find out a) Incremental investment in Receivables b) Incremental rate of return (contribution / Incremental investment In AR)

Cost calcula3ons: Average cost (Rs) Unit variable cost (Rs) Price (Rs) Total cost of sales (Rs lakh) Total variable cost (Rs lakh) Total xed cost (Rs lakh)

8 6 10 2,400 1,800 600

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Current policy Exis/ng Credit period Add: Change to the exis;ng credit period (days) A. New Credit period (days) B. Annual sales (Rs lakh) C. Inc. sales (Rs lakh), [B - 3,000] D. Inc. contribu;on (Rs lakh), [C x (10-6)/10] E. Cost of sales (Rs lakh), [B/10 x 6 + 600] F. Investment in receivables at cost (Rs lakh), [E/360 x A] G. Inc. receivable invt. at cost (Rs lakh), [F - 167] H. Incremental rate of return (%), [D/G] I. Required rate of return (%) 25 3,000 - - 2,400 167 - - - 25

Policy X 25 15 40 3,012 12 4.8 2,407 267 100 4.8% 12%

Policy Y 25 25 50 3,027 27 10.8 2,416 336 168 6.4% 12%

Policy Z 25 35 60 3,047 47

2,428 405 238 7.9% 12%

Conclusion: The revised credit policy would be acceptable if the IRR = or > RRR.

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Current policy Exis/ng Credit period Add: Change to the exis;ng credit period (days) A. New Credit period (days) B. Annual sales (Rs lakh) C. Inc. sales (Rs lakh), [B - 3,000] D. Inc. contribu;on (Rs lakh), [C x (10-6)/10] E. Cost of sales (Rs lakh), [B/10 x 6 + 600] F. Investment in receivables at cost (Rs lakh), [E/360 x A] G. Inc. receivable invt. at cost (Rs lakh), [F - 167] H. Incremental rate of return (%), [D/G] I. Required rate of return (%) 25 3,000 - - 2,400 167 - - - 25

Policy X 25 15 40 3,012 12 4.8 2,407 267 100 4.8% 12%

Policy Y 25 25 50 3,027 27 10.8 2,416 336 168 6.4% 12%

Policy Z 25 35 60 3,047 47 18.8 2,428 405 238 7.9% 12%

Conclusion: The revised credit policy would be acceptable if the IRR = or > RRR.

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Factoring

Factoring can be dened as a contract between the suppliers of goods/services and the Factor. Under this contract the Factor takes over ( or buys) the debtors of the suppliers. The main feature of Factoring are:

Factor performs a few or all of the following func/ons


Finance the supplier, including loans and advance payments Maintenance of receivables accounts of the supplier Collec/on of receivables which he has taken over Protec/on against default in payment by debtors

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Factoring and Bills Discoun;ng


1.

Bills discoun/ng is a sort of borrowing while factoring is the ecient and specialized management of book debts along with enhancement of the clients liquidity. The client has to undertake the collec/on of book debt. Bill discoun/ng is always with recourse, and as such, the client is not protected from bad-debts. Bills discoun/ng is not a convenient method for companies having large number of buyers with small amounts since it is quite inconvenient to draw a large number of bills.

2.

3.

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Types of Factoring

Full service non-recourse Full service recourse factoring Bulk/agency factoring Non-no/ca/on factoring

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Benets of Factoring

Factoring provides specialized service in credit management, and thus, helps the rm s management to concentrate on its core competencies viz. manufacturing and marke/ng. Factoring helps the rm to save cost of credit administra/on due to the scale of economics and specializa/on.

CASH MANAGEMENT

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Contents

Need for cash management Cash planning - budgets & Forecasts

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Cash Management

Cash management is concerned with the managing of:


cash ows into and out of the rm, cash ows within the rm, and Financing decit or inves/ng surplus cash

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Facets of Cash Management


Cash planning Op/mum cash level Inves/ng surplus cash

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Cash Planning

Cash planning is a technique to plan and control the use of cash. Cash Forecas0ng and Budge0ng

Cash budget is the most signicant device to plan for and control cash receipts and payments. Cash forecasts are needed to prepare cash budgets.

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Short term Cash Forecasts

The important func/ons of short-term cash forecasts


To determine opera/ng cash requirements To an/cipate short-term nancing To manage investment of surplus cash. The receipt and disbursements method The adjusted net income method

Short-term Forecas/ng Methods


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Long-term Cash Forecas;ng

The major uses of the long-term cash forecasts are:

It indicates as companys future nancial needs, especially for its working capital requirements. It helps to evaluate proposed capital projects. It pinpoints the cash required to nance these projects as well as the cash to be generated by the company to support them. It helps to improve corporate planning. Long-term cash forecasts compel each division to plan for future and to formulate projects carefully.

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Op;mum Cash Balance


Op/mum Cash Balance under Certainty: Baumols Model Op/mum Cash Balance under Uncertainty: The Miller Orr Model

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Baumols ModelAssump;ons:

The rm is able to forecast its cash needs with certainty. The rms cash payments occur uniformly over a period of /me. From 1 and 2 therefore, rm knows how much of cash it has to hold at any one point of /me. The opportunity cost of holding cash is known and it does not change over /me. The rm will incur the same transac/on cost whenever it converts securi/es to cash.

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Baumols Model

The rm incurs a holding cost for keeping the cash balance. It is an opportunity cost; that is, the return foregone on the marketable securi/es. If the opportunity cost is k, then the rms holding cost for maintaining an average cash balance is as follows: Holding cost = k (C / 2) The rm incurs a conversion or transac;on cost whenever it converts its marketable securi/es to cash. Total number of transac/ons during the year will be total funds requirement, T, divided by the cash balance, C, i.e., T/C. The per transac/on cost is assumed to be constant. If per transac/on cost is c, then the total transac/on cost will be:

Transaction cost = c(T / C ) The total annual cost of the demand for cash will be: Total cost = k (C / 2) + c(T / C ) The op/mum cash balance, C*, is obtained when the total cost is minimum. The formula for the op/mum cash balance is as follows: 2cT C* = k

Illustra;on: Baumols Model

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ABC limited es/mates its total cash requirement as Rs 20 cr. next year. The companys opportunity cost of funds is 16% per annum. The company will have to incur Rs 150 per transac/on when it converts its short-term securi/es to cash. Determine the op/mum cash balance. How much is the total annual cost of the demand for the op/mum cash balance? How many deposits will have to be made during the year? Given, T = total cash requirement for the yr = Rs 20 cr C= cost of conversion = Rs 150 per transac/on k = Holding cost = 16% per annum Therefore, the op/mum cash balance C* =

C* =
C*= C* =

2cT k
2(150)(200000000) 0.16

2(150)(200000000) 0.16 C * = 612,372

Total Cost = Rs 97980 made up of a. Cost of conversion = T / C* X c = 20,00,00,000 / 612372 X 150 = Rs. 48990 b. Holding cost = (C* / 2) X k = 612372/2 X 0.16 = Rs 48990

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The MillerOrr Model

The MO model provides for

two control limitsthe upper control limit and the lower control limit a return point

If the rms cash ows uctuate randomly and hit the upper limit, then it buys sucient marketable securi/es to come back to a normal level of cash balance (the return point). Similarly, when the rms cash ows hit the lower limit, it sells sucient marketable securi/es to bring the cash balance back to the normal level (the return point).

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Miller-Orr model

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The Miller-Orr Model

The dierence between the upper limit and the lower limit depends on the following factors:

the transac/on cost (c) the interest rate, (i) the standard devia/on (s) of net cash ows.

The formula for determining the distance between upper and lower control limits (called Z) is as follows:
1/ 3

(Upper Limit Lower Limit) = (3/4 Transaction Cost Cash Flow Variance/Interest Rate)
Upper Limit = Lower Limit + 3Z Return Point = Lower Limit + Z The net effect is that the firms hold the average the cash balance equal to: Average Cash Balance = Lower Limit + 4/3Z

Illustra;on: Miller -Orr Model

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XYZ company has a policy of maintaining a minimum cash balance of Rs 50 lakh. The standard devia/on of the companys daily cash ows is Rs 20 lakh. The annual interest rate is 15 per cent. The transac/on cost of buying and selling securi/es is Rs 150 per transac/on. Determine XYZs upper control limit, return point and average cash balance as per the Miller-Orr model. Solu/on: Upper Control Limit = Lower limit + 3Z Data given Lower limit = Rs 50 lakh 3Z = to be found out Z = dierence (in Rs or $) between upper control limit and lower control limit Formula to nd out Z = (3/ 4 X Transaction Cost X Cash Flow Variance / Interest Rate)1/3 = [3/4 X 150 X 20,00,0002 / (0.15 /365)]1/3 = 10,30,714 Upper limit = 50,00,000+(3 X 10,30,714) = Rs 80,92,141 Return point = Lower limit + z = 50,00,000 + 10,30,714 = Rs 60,30,714 Average cash balance = Lower limit + 4/3 Z = 50,00,000 + (4/3 X 10,30,714) = 63,74,285

Inves;ng surplus cash in Marketable securi;es

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Selec/ng Investment Opportuni/es:


Safety Time to maturity Marketability

Short-term Investment Opportuni;es:


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Treasury bills Commercial papers Cer/cates of deposits Bank deposits Inter-corporate deposits Money market mutual funds

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Appendix

Features of Instruments of Collec;on in India

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Clearing

The clearing process refers to the exchange by banks of instruments drawn on them, through a clearinghouse. Instruments like cheques, demand drajs, interest and dividend warrants and refund orders can go through clearing. Documentary bills, or promissory notes do not go through clearing. The clearing process has been highly automated in a number of countries.

The Receipt and Disbursements Method

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The virtues of the receipt and payment methods are:


It gives a complete picture of all the items of expected cash ows. It is a sound tool of managing daily cash opera/ons. Its reliability is reduced because of the uncertainty of cash forecasts. For example, collec/ons may be delayed, or unan/cipated demands may cause large disbursements. It fails to highlight the signicant movements in the working capital items.

This method, however, suers from the following limita/ons:

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The Adjusted Net Income Method

The benets of the adjusted net income method are:

It highlights the movements in the working capital items, and thus helps to keep a control on a rms working capital. It helps in an/cipa/ng a rms nancial requirements.

The major limita/on of this method is:

It fails to trace cash ows, and therefore, its u/lity in controlling daily cash opera/ons is limited.

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Managing Cash Collec;ons and Disbursements

Accelera/ng Cash Collec/ons


Decentralised Collec/ons Lock-box System Disbursement or Payment Float

Controlling Disbursements

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Controlling Disbursements

Delaying disbursement results in maximum availability of funds. However, the rms that delay in making payments may endanger its credit standing. While, for accelerated collec/ons a decentralized collec/on procedure may be followed, for a proper control of disbursements, a centralized system may be advantageous. Some rms use the technique of playing the oat to maximize the availability of funds. When the rms actual bank balance is greater than the balance shown in the rms books, the dierence is called disbursement or payment oat.