Working Capital Decision

Any business firm requires two types of assetslong term and short assets. In investment decision we studied that how a firm should select the most profitable project to acquire some capital assets or long term asset.

Introduction:

In financing decision making we discussed the concepts of leverages, capital structure theories and EBIT & EPs analysis through which we can how the shareholders wealth can be increased.

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In Dividend decision we acquired little bit knowledge about the dividend policies; payout and retention ratio and how a firm can increase it market value of share at given EPS by making change in payout ratio.

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Now, all this may happen in any business if it can run smoothly. The question is what is essential to run a business or to make fixed assts operative. The answer is Working Capital.

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Working capital represents the Capital value of current assets in Theory of Working the firm. The management of short term assets is so Management: important for a firm that it can survive only after keeping adequate level of short term assets. The working capital plays a role in business firm like a lubricants and fuel in automobile. It converts an asset from non productive to productive one and vice versa. It applies for all the factors of production. In every business the receipts are uncertain where as the payments are certain.

So, to fill this gap a firm needs optimum quantity of working capital. The working capital management refers the matching of current assets and current liabilities to maintain long term assets and to pay respectable compensation to the long term funds. It establishes the relationship between current assets and current liabilities. It should be adequately supplied to increase the wealth of the organization.

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Working capital management involves two main processes. Determining the size of the working capital Arranging the sources of working capital

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It is determined on the basis of certain factors, like

Nature of Industry Size of Business Manufacturing Cycle Production Policy Volume of Sales Terms of purchase & Sales

Determining the size of the working capital:

Business Cycle Growth and Expansion Supply of Raw Materials Price Level changes Operating Efficiency Profit Margin Profit Appropriation Capital Structure Monetary Policy

Contd.

It depends mainly upon the availability of funds and different application of this working capital. Current assets or working capital includes mainly three components Inventories Cash Receivables So, in short we can also say that the working capital management means to manage all these three components in the firm.

Arranging the sources of working capital:

Types of Working Capital: There two broad classifications of the working capital.
Gross Working Capital Net Working Capital

There are two more classifications which are also very important.
Permanent Working Capital Temporary Working Capital

Contd.

It refers to the firms investment in current assets which include mainly cash, short term securities, and debtors, bills receivable and stock. The concept of the current assets is the assets which can be converted in to cash within one accounting year.

Gross Working Capital:

It refers to the difference between current assets and current liabilities. Current liabilities are those which are expected to mature for claim within one accounting year and which include trade creditors, bills payables and outstanding expenses.

Net Working Capital:

It refers to the amount of working capital which is required by the firm every time. It shows the minimum level of working capital which required maintaining day to day operations of the firm.

Permanent Working Capital:

It is required by the when while some changes in production or sales volume or change in the price level of any factors of production.

Temporary Working Capital:

The net working capital may be positive or negative. Positive working capital shows the surplus of current assets over current liabilities and negative shows deficiencies

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In working capital finance we will discuss two things Sources of Working Capital Approaches for determining the Financing Mix

Determining the Financing mix

On the basis of sources, we can classify it in to three broad categories Long Term Financing Short Term Financing Spontaneous Financing

Sources of Working Capital:

It includes the following Term loans from financial institutions Issue of Debentures Issue of Shares Accepting Public Deposit Internal Financing (Retained Earnings)

Long Term Financing:

It includes following Short term bank loan (Bank Overdraft) Commercial Papers (like bills hundies etc.)

Short Term Financing:

This source of finance is cost free sources. It includes following Trade Creditors Outstanding Expenses etc.

Spontaneous Financing:

There are following three types of approaches to finance the working capital Matching Approach or Hedge Approach Conservative Approach Aggressive Approach

Approaches for determining the Financing Mix:

In this approach of financing the working capital the firm tries to finance the permanent working capital through the long term funds and temporary working capital through short term funds. The concept behind this is that the maturity of source of funds should match the nature of assets to be financed.

Matching Approach or Hedge Approach:

According this approach the whole amount of working capital should be financed through the long term funds. In this approach the firm does not want to take any risk. It is a costly approach in comparison to matching approach.

Conservative Approach:

Under this approach the firm uses the short term funds to finance some part of permanent working capital and the whole of part of temporary working capital. But this approach is more risky for the firm, however this the cheapest approach.

Aggressive Approach:

Every firm must maintain a sound working capital otherwise; its business activities may be adversely affected. The objective of financial management i.e. to maximize the wealth of the shareholder cannot be attained if operations the firm are not optimized. Thus, every firm has to maintain adequate working capital. It should have neither the excessive working capital nor inadequate working capital.

Planning of working capital

To increase operating profit, the firm should increase its sales. In practical life it has been seen that when firm increases its sales the profit may increase but it is not necessary that the cash profit may increase, because sales include the cash and credit sales. Cash sales increase the cash position whereas credit sales increase the Needreceivables.

The collection of cash from receivables require some times span. So, to meet out day to day expenses the firm needs some sort of funds to run uninterrupted business operations, the amount will be locked up in the current assets. It happens due to operating cycles. The need of working capital is based on the length of operating cycles. The length of operating cycle depends mainly on the nature of business it self.

Cash

Raw material Finished

Operating Cycle Work in progress

Goods Debtors Cash Sales

Bills receivables

The operating cycle concept refers to the time lag, which is required to convert the raw material in to finished products and finished product to cash again.

Concept and Computation of Operating Cycle:

Computation of Operating Cycle

The Total Operating Cycle Period (TOCP) will be equal to Inventory Conversion Period (ICP) + Receivable Conversion Period (RCP). The firm might get some credit form supplier of raw material, wages earners etc.

The period for which the payments to these parties are delayed or deferred is known as Deferred Period (DP). The Net Operating Cycle (NOC) of the firm may be calculated by deducting Deferred Period (DP) from the Total Operating Cycle Period (TOCP).

NOC = TOCP DP or NOC = ICP + RCP DP For calculation of TOCP and NOC, various conversion periods may be calculated as follows:

Average Raw Material Stock RMCP = Total Raw Material Consumption X 365

Average Work in Progress

WPCP = Total Cost of Production X 365

Average Finished Goods FGCP = Total Cost of Goods Sold Average Receivables RCP = Total Credit Sales Average Creditors DP = Total Credit Purchase X 365 X 365 X 365

On the basis of above conversion periods, TOCP and NOC may be ascertained as follows.

Particulars
RMCP

Numbers of Days ..Days ..Days ..Days

..Days ..Days ..Days ..Days

+ WMCP + FGCP
+ RCP TOCP -DP NOC

RMCP
+ WMCP + FGCP + RCP TOCP

Raw Material Conversion Period

Work in Progress Conversion Period Finished Goods Conversion Period Receivables Conversion Period Total Operating Cycle Period

-DP
NOC

Deferred Period
Net Operating Cycle

Example
Rs, In 000
Sales Cost of Production Purchase Average Raw Material Average Work in Progress Average Finished Goods Average Creditor Average Debtors 3,000 2,100 600 80 85 180 90 350

Solution:
Particulars Numbers of Days
RMCP + WMCP 49 Days 15 Days

+ FGCP
+ RCP TOCP

31 Days
43 Days 138 Days

-DP NOC

55 Days 83 Days

This is very important aspect of working capital management that excessive as well as inadequate working capital both are harmful to the organization. Excess working capital creates idle funds, which cannot earn any return, whereas shortages of working capital will hamper the production process and other business operations. In both the situations firm Problems Associated with has to suffer loss.

Excess and Inadequate Working Capital:

Demerits of Excessive Working Capital

There may be following problems It can accumulate unnecessary inventories. Thus chance of mishandling, theft, wastage of inventories may occur. It also indicates poor collection of receivable and very liberal credit policy regarding sales. The bad debts will increase it such situation continues for long time. It allows to the management to inefficiently Accumulation of excessive inventories also leads to speculative profit. This may tend to make dividend policy liberal, which may create serious problems in future. Excessive availability of cash tempts the executive to spend more.

Demerits of Inadequate Working Capital:

There may be following problemsIt becomes difficult for the firms to undertake profitable projects due to shortage of working capital. The firm may face problems in implementing the operating plans and achieve the firms profit target. It also creates problem in meeting out day-to-day or routine expenses. Fixed assets can be utilized more effectively, thus the overall return may go down. Due to inadequate working capital firm may loose some good credit opportunities The firm may spoil its fame and reputation if it fails to honour short-term obligations. As a result, the firm faces tight credit terms. It directly affects the liquidity positions of the business firms.

Management of cash

Objectives

Factors determining Cash needs,

Motive for holding Cash

Cash Budgeting as a tool

Cash Reports for monitoring

Receivable Management

Objectives

Credit Policies

Terms and Collection Policies