WORKING CAPITAL FINANCE

CA. SANJAY KOTHARI

DEFINITION Working Capital refers to that part of the firms capital, which is required for financing shortterm or current assets such as cash marketable securities, debtors and inventories. Funds thus, invested in current assets keep revolving fast and are constantly converted into cash and this cash flow out again in exchange for other current assets. Working Capital is also known as revolving or circulating capital or short-term capital.

FACTORS DETERMINING WORKING CAPITAL

Nature of the Industry Demand of Industry Cash requirements Nature of the Business Manufacturing time Volume of Sales Terms of Purchase and Sales Inventory Turnover Business Turnover Business Cycle Current Assets requirements Production Cycle Credit control Inflation or Price level changes Profit planning and control Repayment ability Cash reserves Operation efficiency Change in Technology Firms finance and dividend policy Attitude towards Risk

WORKING CAPITAL CYCLE

Cash

Debtors

RM

Sales

WIP

FG

TIME AND MONEY CONCEPTS IN WORKING CAPITAL CYCLE

Each component of working capital (namely inventory, receivables and payables) has two dimensions ........TIME ......... and MONEY, when it comes to managing working capital. You can get money to move faster around the cycle or reduce the amount of money tied up. Then, business will generate more cash or it will need to borrow less money to fund working capital. As a consequence, you could reduce the cost of bank interest or you'll have additional free money available to support additional sales growth or investment. Similarly, if you can negotiate improved terms with suppliers e.g. get longer credit or an increased credit limit, you effectively create free finance to help fund future sales.

If you

Then ......

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

You release cash from the cycle Your receivables soak up cash You increase your cash resources

You free up cash

(stocks)

You consume more cash

TYPE OF WORKING CAPITAL Concept Basis

Gross WC Net WC

Time Basis
Permanent/Fixed WC
Regular WC Reserve WC

Temporary/variable WC
Seasonal WC Special WC

SOURCES OF WORKING CAPITAL Sources of working capital are:

Owned fund (Equity, Reserves, etc.) Bank borrowings(Cash Credit, Packing Credit, B/D, L/C)

Sources of additional working capital include the following:

Existing cash reserves Profits (when you secure it as cash !) Payables (credit from suppliers) New equity or loans from shareholders Bank overdrafts or lines of credit Long-term loans

METHODS OF ASSESSMENT OF WORKING CAPITAL

TURNOVER METHOD
Mainly used for small trading companies Not appropriate for manufacturing and big trading companies

CASH BUDGET SYSTEM

Mainly used for service sector companies Cash inflow Cash outflow = Bank finance in form of WC

TONDON COMMITTEE RECOMMENDATIONS

Out of 3 methods recommended, method II also known as Maximum Permissible Bank Finance (MPBF) is mainly used by the banks for assessment of WC finance

CREDIT MONITORING ARRANGEMENT (CMA) CMA data is a tool used by the bankers to assess the requirement of working capital. It is divided into six parts as follows:
Form I Form II Form III Particulars of Existing & Proposed Limits Operating Statement Analysis of Balance Sheet

Form IV Comparative Statement of Current Assets & Current Liabilities Form V Form VI Computation of Maximum Permissible Bank Finance (MPBF) Funds Flow Statement

KEY RATIO LEVELS

PARTICULARS Current Ratio TOL/TNW Interest Coverage PAT/SALES% Inventory (No. of days) Debtors (No. of days) Debt Equity Ratio DSCR (For TL) LOW RISK > 1.40 < 2.00 > 3.50 > 10.00 < 60 < 45 < 1.25 > 2.00 MEDIUM RISK 1.20 - 1.40 2.00 - 3.50 2.00 - 3.50 4.00 - 10.00 60 - 90 45 - 90 1.25 - 1.75 1.25 - 2.00 HIGH RISK < 1.20 < 3.50 < 2.00 < 4.00 > 90 > 90 > 1.75 < 1.25
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FORECASTING/ESTIMATION OF WORKING CAPITAL REQUIREMENT

Factors to be considered Total costs incurred on materials, wages and overheads The length of time for which raw materials remain in stores before they are issued to production. The length of the production cycle or WIP, i.e., the time taken for conversion of RM into FG. The length of the Sales Cycle during which FG are to be kept waiting for sales. The average period of credit allowed to customers. The amount of cash required to pay day-to-day expenses of the business. The amount of cash required for advance payments if any. The average period of credit to be allowed by suppliers. Time lag in the payment of wages and other overheads

WORKING CAPITAL Fund based

Domestic
Cash Credit Overdraft facility Bill Discounting

PRODUCTS

Export
Preshipment Credit Post shipment Credit

Non-fund based
Letter of credit Bank Guarantee

SPECIAL SITUATIONS
CYCLICAL PRODUCTION/SALES PHASED EXPANSION PROGRAMS EXPANSION PROGRAMS WITH ENHANCEMENT IN EXISTING LIMITS MAJOR ORDERS ENHANCEMENT DURING THE YEAR SHORT TERM FUND USED FOR ACQUISITION OF LONG TERM ASSETS DRAWING POWER NOT ALLIGNED TO MPBF DEVALUATION / EROSION OF CURRENT ASSETS

STRUCTURED WORKING CAPITAL PRODUCTS

Commercial Paper Corporate Loan Suppliers/ Buyers Credit Securitisation of receivables Factoring Forfeiting

IMPORTANCE OF ADEQUATE WORKING CAPITAL Every business concern should have adequate working capital to run its business operations. It should have neither redundant or excess working capital nor inadequate or shortage of working capital. Both excess as well as shortage of working capital situations are bad for any business. However, out of the two, inadequacy or shortage of working capital is more dangerous from the point of view of the firm.

DISADVANTAGE OF INADEQUATE WORKING CAPITAL

Idle funds, non-profitable for business, poor ROI. Unnecessary purchasing & accumulation of inventories over required level. Excessive debtors and defective credit policy, higher incidence of B/D. Overall inefficiency in the organization. When there is excessive working capital, Credit worthiness suffers. Cant pay off its short-term liabilities in time. Economies of scale are not possible. Difficult for the firm to exploit favourable market situations. Day-to-day liquidity worsens . Improper utilization the fixed assets and ROA/ROI falls sharply. Due to low rate of return on investments, the market value of shares may fall.

OVERTRADING
Trying to operate without adequate working capital. It is often caused by an expansion in credit sales, and thus in trade receivables. This causes a shortage of cash. Early warning sign of overtrading include: Pressure on existing cash Exceptional cash generating activities e.g. offering high discounts for early cash payment Bank overdraft exceeds authorized limit Seeking greater overdrafts or lines of credit Part-paying suppliers or other creditors Paying bills in cash to secure additional supplies Management pre-occupation with surviving rather than managing Frequent short-term emergency requests to the bank (to help pay wages, pending receipt of a cheque Declining liquidity ratio

CURING OVERTRADING Overtrading may be cured or reduced by:

Borrowing or increasing in capital to increase current assets Sale of non-trading assets Tightening terms of credit granted to customers Negotiating longer credit terms from major suppliers.

CASH FLOW STATEMENT BACKBONE OF GROWTH

Regular cash flow are the backbone of long-term growth and sustainability. It highlight the strength of the companys business model in meeting its working capital and capex requirements, coupled with its ability to ensure orderly operations even during a cyclical downturn. A company with healthy operating cash flow is in a position to plough this cash into its projects/wc cycle. It can thus grow at a steady space, compared to the companies that mostly rely on external sources to fund their growth. This was on display during the credit crisis last year, which put the future of companies with poor cash flows in doubt. It may be possible that company reports very good earnings but it may not be generating sufficient cash. Cash flow can be negative while profitability is positive. Income statement and cash flow statement should be analyzed to assess the operational efficiency of the company

SIGN OF POTENTIAL LIQUIDITY PROBLEMS

Buildup of inventories and declining inventory turnover. Increases in debt and debt ratios. Increases in costs that cannot be passed on. Increases in accounts receivables and collection periods. Decline in net working capital and daily cash flows.

NECESSITY TO EFFECTIVELY MANAGE WORKING CAPITAL

Working capital doesn't come free -- there is an opportunity cost (returns that it could have generated from any other avenue) besides the interest burden due to the short-term bank borrowings. This cost can be substantial during an economic slowdown, when a company's inventories and receivables rise, bloating current assets. But current liabilities do not rise in proportion to current assets, since creditors tend to shy away at such times. It becomes more expensive to finance working capital, and profits are hit to that extent.

ADVANTAGE OF EFFECTIVE MANAGEMENT OF WORKING CAPITAL The important thing for a shareholder is how well the working capital is managed. Though measured at a point of time, it still says a lot about how healthy a company's revenues are. In last 2 years, companies that managed their working capital well have reported relatively strong profits, and their shareholders have been rewarded with capital appreciation despite an overall trend of declining share prices. Others, especially commodity producers and companies whose products face cyclical demand, have floundered.

IMPACT ON STOCK VALUATIONS

As there is a cost associated with working capital, a company that can generate more revenues from a specified amount of working capital than others will eventually be more profitable, with better cash flows and will command superior valuation. Most commodity-based companies are capital-intensive and have high working capital requirements. Their business is cyclical in nature, which puts an additional burden on the working capital when the chips are down. That explains why these companies are not able to extract a higher valuation from the stock markets. Also, with piling receivables and inventories, cash inflows are affected. This can lead to problems in paying large cash outflows like interest and dividend. Many companies can do nothing other than use their long-term funds to finance this shortfall -- which can also lead to falling profits. Companies that prefer to maintain low levels of working capital score well on working capital turnover ratio (Net sales / Net working capital).Though this level varies with the nature and scale of operations, the stock market attaches a premium to companies with low working capital requirements. Likewise, a company with a high working capital turnover ratio vis-a-vis its peers tends to get a higher price to earnings (PE) ratio.

CONCLUSION Any change in the working capital will have an effect on a business's cash flows. A positive change in working capital indicates that the business has paid out cash, for example in purchasing or converting inventory, paying creditors etc. Hence, an increase in working capital will have a negative effect on the business's cash holding. However, a negative change in working capital indicates lower funds to pay off short term liabilities (current liabilities), which may have bad repercussions to the future of the company.