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Theory of working capital management

Theory of working capital management

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Chapter 26 THEORY OF WORKING CAPITAL MANAGEMENT INTRODUCTION This chapter analyses the theory of working capital management and

is divided into four section. The first section explains the nature of working capital in terms of the basic concepts, strategies and policies of working capital management. The trade-off between profitability and risk is elaborated in section 2. The determination of financing mix is explained in Section 3. The major points are .recapitulated in the last Section Section I NATURE OF WORKING CAPITAL Working capital management is concerned with the problems that arise in attempting to manage the current assets, the current liabilities and the interrelationship that exists between them. The term current assets refer to those assets which in the ordinary course of business can be, or will be, converted into cash within one year without undergoing a diminution in value and without disrupting the operations of the firm. The major current assets are cash, marketable securities, accounts receivable and inventory. Current liabilities are those liabilities which are intended, at their inception, to be paid in the ordinary course of business, with in a year, out of the current assets or earnings of the concern. The basics current liabilities are accounts payable, bills payable, bank overdraft, and outstanding expenses. The goal of working capital management is to manage the firm’s current assets and liabilities in such a way that a satisfactory level of working capital is maintained. This is so because if the firm cannot maintain a satisfactory level of working capital, it is likely to become insolvent and may even be forced into bankruptcy. The current assets should be large enough to cover its current liabilities in order to ensure a reasonable margin of safety. Each of the current assets must be managed efficiently in order to maintain the liquidity of the

firm while not keeping too high a level of any one of them. Each of the short-term sources of financing must be continuously managed to ensure that they are obtained and used in the best possible way. The interaction between current assets and current liabilities, is .therefore, the main theme of the theory of working management The basic ingredients of the theory of working capital management may be said to include its definition, need, optimum level of current assets, the trade-off between profitability and risk which is associated with he level of current assets and liabilities. Financing.mix strategies and so on Concepts and Definitions of Working Capital .There are two concepts of working capital : gross and net The term gross working capital, also referred to as working .capital, means the total current assets The term net working capital can be defined in two ways: (i) the most common definition of net working capital (NWC) is the difference between current assets and current liabilities; and ii) alternate definition of NWC is that portion of current assets which is financed with long-term funds.1 The task of the financial manger in managing working capital efficiently is to ensure sufficient liquidity in the operation of the enterprise. The liquidity of business firm is measure by its ability to satisfy short-term obligations as they become due. The three basic measures of firm’s overall liquidity are (i) the current ratio, (ii) the acid-test ratio, and (iii) the net working capital. The suitability of the first two measures has already been discussed in detail in chapter 4. In brief, they are very useful in interfirm comparisons of liquidity. Net working capital (NWC) as a measure of liquidity, is not very useful for comparing the performance of different firms, but it is quite of liquidity, is not very useful for comparing the performance of different firms, but it is quite useful for internal control. The NWC

helps in comparing the liquidity of the same firm over time. For purpose of working capital management, therefore NWC can be said to measure the liquidity of the firm. In other words, the goal of working capital management is to mange the current assets and liabilities in such a way that an acceptable level of NWC is .maintained The common Definition of NWC and its Implications NWC is commonly defined as the difference between current assets and current liabilities. Efficient working capital management requires that firms should operate with some amount of NWC, the exact amount varying fro firm to firm and depending, among other things, on the nature of industry The theoretical justification for the use of NWC to measure liquidity is based on the premise that the greater the margin by which the current assets cover the short-term obligations, the more is the ability to pay obligations when they become due for payment. The NWC is necessary because the cash outflows and inflows do not coincide. In other words, it is the non synchronous nature of cash flows that makes NWC necessary. In general, the cash outflows resulting from payment of current liabilities are relatively predictable. The cash inflows are, however difficult to predict. The more predictable the cash inflows are, the less NWC will be required. A firm, say an electricity generation company, with almost certain and predictable cash inflows can operate with little or no NWC. But where cash inflows are uncertain, it will be necessary to maintain current assets at a level adequate .to cover current liabilities, that is there must be NWC Alternative Definition of NWC NWC can alternatively be defined as that part of the current assets which are financed with long-term funds. Since current represent sources of short-term funds, as long as current assets exceed the current liabilities, the excess must be financed with long-term funds. This alternative definition, as shown

subsequently, is more useful for the analysis of the trade-off .between profitability and risk SECTION 2, TRADE_ OFF BETWEEN PROFITABILITY AND RISK In evaluating a firms NWC position an important consideration is the trade-off between profitability and risk. IN other words, the level of NWC has a bearing on profitability as well as risk. The term profitability used in this context is measured by profits after expense. The term risk is defined as the probability that a firm will become technically insolvent so that it will not be able to meet its .obligations when they become due for payment The risk of becoming technically insolvent is measured using NWC. It is assumed that the greater the amount of NWC, the less riskprone the firm is. Or, the greater the NWC, the more liquid is the firm and, therefore, the less likely it is to become technically insolvent. Conversely, lower of NWC and liquidity are associated with increasing levels of risk. The relationship between liquidity, NWC and risk is such that if either NWC or liquidity increases, the .firm’s risk decreases Nature of Trade-off If a firm wants to increase its profitability, it must also increase its risk. If it is to decrease risk, it must decrease profitability. The tradeoff between these variables is that regardless of how the firm increases its profitability through the manipulation of working capital, the consequence is a corresponding increase is a .corresponding increase in risk as measured by the level of NWC The effects of changing current assets and current liabilities on profitability-risk trade-off are discussed first and subsequently they have been integrated into an overall theory of working capital .management

In evaluating the profitability-risk trade-off related to the level of NWC, three basic assumptions, which are generally true, are : (i) that we are dealing with a manufacturing firm; (i) that we are dealing with a manufacturing firm: (ii) that current assets are less profitable than fixed assets; and (iii) that short-term funds are less .expensive than long-term funds Effect of the level of current assets on the profitability-risk trade-off The effect of the level of current assets on profitability-risk and trade-off can be shown, using the ratio of current assets to total assets. This ration indicates the percentage of total assets that are in the form of current assets. A change in the ration will reflect a change in the amount of current assets. It may either increase or .decrease Effect of Higher Ratio An increase in the ratio increase / of current assets to total assets will leads to a decline in profitability because current assets are assumed to be less profitable than fixed assets. A second effect of the increase in the ratio will be that the risk of technical insolvency insolvency would also decrease because the increase in current assets, assuming no change in current liabilities, will increase NWC. This is shown in example 26.1 .Balance sheet of Hypothetical ltd Asset Amount (in lacks) Amount current assets Fixed assets Rs. 3,200 4,800 6,000 14,000 14,000 current liabilities Rs 5,400 Long-term debt 8,600 Equity capital Liabilities

If the company earns approximately 2 per cent on its current assets and 12 per cent on its fixed assets, it can currently earn approximately Rs. 1,140 {(0.02 x Rs 5,400) + (0.12 x Rs 8,600) on its total assets. The NWC currently is Rs 2,200 (Rs 5,400 - Rs 3,200). The current assets to total assets ratio is 0.386 (Rs. 5,400 .(Rs 14,000 Assuming the company increase the investment in current assets by investing an additional Rs 600 in current assets (and thus 600 less in fixed assets), the ratio of current assets to total assets would be 0.429 (Rs. 6,000 - Rs. 14,000). The profits on total assets would Rs 1,080 {(0.02 x Rs 6,000) + (0.12 x Rs 8,000)}. Thus, as the current-total asset ratio increases from 0.386 to 0.429, the total profits decrease from Rs 1,140 to Rs 1080. The risk measured by the amount of NWC decreases, since NWC increases from Rs .2,200 to Rs 2,800 leading to a improvement in liquidity Effect of Decrease / Lower Ratio A decrease in the ratio of current assets to total assets will result in an increase in profitability as well as risk. The increase in profitability will primarily be due to the corresponding increase in fixed assets which are likely to generate higher returns. Since the current assets decrease without a corresponding reduction in current liabilities, the amount of NWS .will decrease, thereby increasing risk To illustrate the effect of a decrease in the level of current assets, let us assume that in the case of the Hypothetical Ltd in Example 15.1, the investment in fixed assets is increased by Rs 600 (implying thereby a decrease in current assets by a similar amount). As a result, the ratio of current assets to total assets would be 0.343 (Rs. 4,800 - Rs 14000). The profits on total assets will be Rs 1,200 {(0.02 x Rs 4,800) + (0.12 x Rs 9,200)}. The NWC will be Rs 1,600 (Rs 4,800 - 3,200). It is, thus, evident that a decrease in the current total assets ratio leads to an increase in

both profitability and risk. The effect of changes (increase as well .as decrease) in current assets are tabulated in Table 26.1 Effect of change in current liabilities on profitability-risk tradeoff As in the case of current assets, the effect of a change in current liabilities can also be demonstrated by using the ratio for current liabilities to total assets. This ratio will indicate the .percentage of total assets financed by current liabilities The effect of a change in the level of current liabilities would be that the current liabilities-total asset ratio will either (i) increase, or (ii) .decrease Effect of an increase in the ratio one effect of an increase in the ratio of current liabilities to total assets would be that profitability will increase. The reason for the increased profitability lies in the fact that current liabilities, which are a short-term source of finance, will increase, whereas the long-term sources of finance will be reduce. As short-term sources of finance are less expensive than long-run sources, increase in the ratio will, in effect, mean substituting less expensive sources for more expensive sources of financing. There will, therefore, therefore be a decline in cost and a corresponding .rise in profitability The increased ratio will also increase the risk. Any increase in the current liabilities, assuming no change in current assets, would adversely affect the NWC. A decrease in NWC leads to an increase in risk. Thus, as the current liabilities-total assets ratio .increase, profitability increases, but so does risk For the Hypothetical Ltd in Example 15.1 let us assume that the current liabilities cost approximately 3 percent, while the average cost of long-term funds is 8 per cent. The cost would be Rs. 960 {(0.03 x Rs 3,200) + (0.08 x Rs 10800)}. The NWC will be Rs. 2,200. The initial ratio of current liabilities to total assets is 0.229 .((Rs. 3,200 - Rs 14,000

Further assume that the company shifts Rs 600 from long-term funds to current liabilities so that the forme will decline, while the latter will increase by the amount. As an result, the ratio of current liabilities to total assets will increase to 0.271 (Rs 3,800 - Rs 14,000); the cost will decline to Rs 930 {0.03 x Rs 3,800) + (0.08 x Rs 10800)} and the NWC will be lower at the leave of Rs 1,600 (Rs 5,400 - 3,800). These figures amply demonstrate that the increase in the ratio of current liabilities to total assets causes a decline in cost and, therefore, a rise in profitability. At the same time, risk measured by the level of NWC increases, since the NWC, or .liquidity, decreases Effect of a decrease in the ratio The consequences of a decrease in the ratio are exactly opposite to the results of an increase. That is, it will lead to a decrease in profitability as well as risk. The use of more long-term funds which, by definition, are more expensive will increase the cost; by implication, profits will also decline. Similarly, risk will decrease because of the lower level of current liabilities on .the assumption that current assets remain unchanged Suppose the Hypothetical Ltd of Example 26.1 reduces its current liabilities by Rs 600 as compared to the initial level of Rs 3,200. The reduction in the current liabilities is naturally associated with an increase in the long-term funds by a similar amount. The resulting ratio will be 0.186, that is, slightly lower than the initial ratio of 0.229 (Rs 3,200 - Rs 14,000). A reduction in the ratio causes a rise in cost which will now be Rs 990 (0.03 x Rs 2,600) + (0.08 x Rs 11,400)}; the NWC will also rise to Rs 2,800 (Rs 5,400 - Rs 2,600). While the increase in cost logically denotes a decline in profitability, the increase in NWC reflects an improvement in liquidity and .reduction inrisk

The effect of changes in the current liabilities -to a assets ratio may .be summarized in Table 26.2 Effect of changes in current liabilities of Hypothetical Ltd

Combined Effect of Changes in Current Assets and Current Liabilities on Profitability-Risk Trade off The combined effects of changes in current assets and current liabilities can be measured by considering them simultaneously. We have shown in the preceding sections the effects of a decrease in the current assetstotal assets ratio and the effects of an increase in the current liabilities - total assets ratio. These changes, when considered independently, lead to an increased profitability coupled with a corresponding increase in risk. The combined effect of these changes should, logically, be to increase over all profitability as also risk at the same time decrease NWC. This is depicted in Table .26.3 Combined Effects of Changes in Current Assets and Liabilities .on Hypothetical Ltd on Profits and NWC

It can, thus, be seen from these figures that the net effect of the two changes taken together is that profits have increased by Rs 90 and NWC (liquidity) has decreased by Rs 1,200. The trade-off is clear; the company has increased its profitability by increasing its risk. The NWC has been reduced from its initial level of Rs 2,200 to Rs 1,000. The initial net profit of the company (i.e. the difference between initial profits on total assets and the initial cost of financing) was Rs. 180 (Rs. 1,140 - Rs 960). After the change in the current assets and liabilities, the profits on total assets

increased to Rs 1,200 while the cost of financing decreased to Rs 930; its net profits, therefore, increased to Rs 270 (Rs. 1,200 - Rs .(930 Section 3 Determining Financing Mix Apart from the profitability-risk trade-off, another important ingredient of the theory of working capital management is determining the financing is. One of the most important decisions, in other words, involved in the management of working capital is how current assets will be financed. There are, broadly speaking, two sources from which funds can be raised for current asset financing; (i) short-term sources (current liabilities), and (ii) longterm sources, such as share capital, long-term borrowings, internally generated resources like retained earning and so on. What proportion of current assets should be financed by current liabilities and how much by long-term resources? Decisions on .such questions will determine the financing mix There are three basic approaches to determine an appropriate financing mix; (a) Heading approach, also called the Matching approach; (b) Conservative approach, and (c) Trade-off between .these two Hedging Approach There term ‘hedging’ is often used in the sense of a risk-reducing investment strategy involving transactions of a simultaneous but opposing nature so that the effect of one is likely to counterbalance the effect of the other. With reference to an appropriate financingmix, the term hedging can be said to refer to the process of matching maturities of debt with the maturities of financial needs. This approach to the financing decision to determine an appropriate .financing mix is, therefore, also called as matching approach

according to this approach, the maturity of the sources of funds should match the nature of the assets to be financed. For the purpose of analysis, the current assets can be broadly classified ;into two classes Those which are required in a certain amount for a .1

.given level of operation and, hence, do not vary over time .Those which fluctuate over time .2

The hedging approach suggests that long-term funds should be used to finance the fixed portion of current assets requirements as spelt out in (1) above, in a manner similar to the financing of fixed assets. The purely temporary requirements, that is the seasonal variations over and above the permanent financing needs should be appropriately financed with short-term funds (current liabilities). This approach, therefore, divides the requirements of total funds into permanent and seasonal components, each being financed by a different source. This has been illustrated in Table 26.4 Estimated total funds requirements of Hypothetical Ltd

According to the hedging approach, the permanent portion of funds required (col.3) should be financed with long-term funds and the seasonal portion (col.4) with short-term funds. With this approach, the short-term financing requirements (current assets) would be .(just equal to the short-term financing available (current liabilities Conservation approach This approach suggest that the estimated requirement of total funds should be met from long-term sources; the use of short-term funds should be restricted to only emergency situation or when

there is an unexpected outflow of funds. In the case of the Hypothecate Ltd in Table 26. 4 the total requirements, including the entire Rs 9,000 needed in October, will be financed by long-run sources. The short-term funds will be used only to meet conductances. The amounts given in column 4 of Table 26.4 represent the extent to which short-term financial needs are being financed by long-term funds, that is, the NWC. The NWC reaches the highest level (Rs 2,100) in October (Rs. 9,000 - Rs 6,900). Any long-term financing in excess of Rs 6,900 in permanent financing .the needs of the company represents NWC Comparison of Hedging approach with conservative approach A comparison of the two approaches can be made on the basis of .(i) cost considerations, and (ii) risk consideration Cost considerations The cost of these financing plans has a bearing on the profitability of the enterprise. We assume that the cost of short-term funds and long-term funds, as in the preceding Section dealing with profitability-risk trade-off, is 3 per cent and 8 .per cent respectively Hedging Plan The cost of financing under the digging plan can be estimated as follows : (i) Cost of short-term funds: The cost of .short-term funds = average annual short-term loan x interest rate Average annual shorterm loan = total of monthly seasonal .requirements (Col.4) divided by the number of months Average annual short-term loan = Rs 11,600 - 12 = Rs 966.67 .Short-term cost = Rs 966.67 x 0.03 = Rs 29 ii) Cost of long-term funds = ( Average annual long - term fund) requirement ) X ( annual interest rate) .Rs 6,900 X 0,08 = Rs 552 =

iii) Total cost under hedging plan = total of (i) + (ii)

= Rs 29 + Rs) 552 = Rs 581

Conservative plan The cost of financing under the conservative plan is equal to the cost of the long - term fund, that is, annual average loan, multiplied by the long -term rate of interest = Rs 9,000 X 0.08 = Rs 720 Thus, the of financing under the conservative approach (Rs 720 ) is higher than the cost using the hedging approach (Rs 581). The conservative plan for financing is more expensive because the available funds are not fully utilized during certain periods; moreover, interest has to be paid for funds which are not actually .( needed (i.e. the period when there is NWC Risk considerations The two approaches can also be contrasted .on the basis of the risk involved Hedging Approach The hedging approach is more risky in comparison to the to the conservative approach. There are two reasons for this. First, there is, as already observed, no NWC with the hedging approach because no long-term funds are used to finance short-term seasonal needs, that is, current assets are just equal to current liabilities. One the other hand, the conservative approach has a fairly high level of NWC. Secondly, the hedging plan is risky because it involves almost full utilization of the capacity to use short-term funds and in emergency situations it may be .difficult to satisfy the short-term needs Conservative approach with the conservative approach, in contrast, the company does not use any of its short-term borrowings. Therefore, the firm has sufficient short-term borrowing capacity to cover unexpected financial needs and avoid technical .insolvency To summaries, the hedging approach is a high profit (low cost)high risk (no NWC) approach to determine an appropriate financing-mix.

In contrast, the conservative approach is low profit (high cost) low risk (high NWC). The contrast between these approaches is .indicative of the need for trade-off between profitability and risk A trade-off between the hedging and conservative approaches It has been shown that the hedging approach is associated with high profits as well as high risk, while the conservative approach provides low profits and low risk. Obviously, neither approach by itself would serve the purpose of efficient working capital managemental. A trade-off between these two extremes would give an acceptable financing strategy. The third approach -trade-off between the two approaches-strikes a balance and provides a .financing plan that lies between these two extremes The exact trade-off between risk and profitability will differ from case depending on risk perception of the decision makers. One possible trade-off could be assumed to be equal to the average of the minimum and maximum monthly requirements of funds during a given period of time. This level of requirements of funds may be financed through long-run sources and for any additional financing need, short-term funds may be used. The breakdown of the requirement of funds of the Hypothetical Ltd between long-term and short-term sources under the trade-off plans is shown in Table .26.5

The figures in Table 26.5 reveal that the maximum fund required is Rs 9,000 (october) and the minimum is Rs 6,900 (May). The average (Rs. 9000 + 6,900)/2 = Rs 7,950. In other words, the company should use Rs 7,950 each month (Col. 3) in the form of long-term funds and raise additional funds, if needed, thorough short-term resources (Current Liabilities). IT is clear from the table

that no short-term funds are required during 5 months, namely, March, APril, May, June an December, because long-term funds available exceed the total requirements for funds. In the remaining 7 months, the company will have to use short-term funds totalling (Rs. Rs 2,700 (Col 4 i) Cost of short-term funds: = (average annual short-term funds ) required) x (rate of short-tern interest ) = Rs 2,700/12 = Rs 225 x 0.03 = Rs 6.75 ii) Cost of long-term funds = (Average long-term funds required ) x) (Rate of interest on long-term funds ) = Rs. 7,950 x 0.08 = Rs 636 iii) Total cost of the trade -off plan = Rs 6.75 + 636 = Rs. 642.75) Risk consideration The NWC under this plan would be Rs. 1,050 ((Rs 7,950 - Rs 6,900 Comparison of the Trade-off plan with the hedging and conservative approaches For a comparison of the three approaches to determine an approaches on profitability and risk is give in Table. 26.6 Comparison of Trade-off plan Interpretation From the summary of results in Table 26.6. It can be seen clearly that the hedging approach is the most risky while the conservative approach is the least risky. The trade-off plan stands midway; less risky than the hedging approach by more risky than the conservative approach. The measure of risk is the level of NWC. From the point of view of profitability (as reflected in the level of total cost of financing plan) a similar kind of relationship is found to exist, the trade-off plan lying between the other two approaches. The preceding analysis, thus established the trade-off between profitability and risk. In this connection two generalizations are warranted; (i)

appropriate financing -mix, the summary of the result of these

the lower the NWC, the higher is the risk present, and (ii) the higher the risk of .insolvency, the higher is the expected profits

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