Working Capital Management a .1 INTRODUCTION TO WORKING CAPITAL Based on periodicity the capital requirements of a business organization are of two types. They are Long-term capital and short-term capital requirements. The Long-term capital also called as block capital/fixed capital. The short-term capital also called as working capital/circulating capital. As names indicate, that amount of capital required for investing in block assets or fixed assets which are in use for long duration is fixed capital or long term capital and that of amount capital required to invest in current or circulating assets is working capital. The term working capital is also called as revolving capital or circulating capital. Working capital is that part of capital, which is invested in current or circulating assets. It is the capital locked up in various current assets, such as stock of raw materials, work-in - progress, stock of finished goods, debtors, and cash and bank balances prepaid expenses, outstanding incomes. It is the capital invested in working assets. It is the amount of capital required to carry on day-to-day operations of the business. Basically there are four concepts of working capital as mentioned below; A brief not on each of the above is given below; 1, Gross Working Capital Gross working capital refers to the total amount of funds invested in current assets. a. Positive WC CONCEPT OF WC ‘Scanned with CamScanneeThe components of current assets includes, cash in hand, cash at bank, accounts receivable, stock of finished goods, work-in-progress, stock of raw materials, short-term trade investments, prepaid expenses etc, This is a broader concept of WC, indicated almost all the components of Working Capital of the Company. 2. Net Working Capital ‘The Net Working Capital concept ois « narrow concept, According to this coneePly fhe difference between current assets and current Habilties is net working capttal. In ret! Tite situation sometimes current assets are more than current liabilities or current assets are "esser than current liabilities. The gross working capital is a financial or going concer# concept. The net working capital is an accounting concept. Based on nature of difference between current assets and current liabil working capital is named as (a) positive net working capital and (b) negative Wo! (a) Positive Working Capital. Positive working capital refers to the situation where current assets are more than the current liabilities. Excess of current assets over current liabilities is called positive working capital. If current assets > current liabilities > positive working capital. The positive working capital indicates that, the company is financially sound in terms of Working capital. (b) Negative Working Capital. Negative working capital refers to a situation where the current assets are lesser than the current liabilities, When the current assets are less than current liabilities, the business organization has no working capital of its own. If current assets < current liabilities > negative working capital. The negative working capital is an indication of financial crisis of a business in terms of its working capital status. 3. Permanent Working Capital Permanent working capital refers to the minimum amount of investment in current assets required throughout the year for carrying out the business operations. It is that amount of working capital, which is required on a continuous basis to carry out business operations. It is the irreducible amount of working capital. It is somewhat similar to fixed cost concept in the total cost. It is the working capital, which remains in the business permanently in one form or another. This is the working capital, which is required for financing the stock of raw materials, finished goods, paying wages, salaries and other payments of regular nature. ies, the net rking capital, 4. Temporary Working Capital Temporary working capital is also called as fluctuating /varying working capital. Temporary working capital refers to the amount of working capital, which goes on fluctuating from time to time with changes in the volume of business activities. It is similar to variable cost. During the peak season, more amount of working capital is required and during slack season, small amount of working capital is required. ‘Scanned with CamScanneeONCEPT OF OPERATING CYCLE Q(\,, GVO ;. veasng ; ie Gai panne aa qe aoe the sales of goods and realization ses . This i called operating cycle. Therefc ir of jeis the length of time required to complete the conversion of cash in to raw materials, 7 oye jals in to work-in-process, work- in material 4 Work- in- process in to finished is nae accounts receivable, accounts receivable into cask: This ener jn to acco falowing diagrams WORK IN, REWMATERIALS <=> PROGRESS CASH/BANK FINISHED GOODS: VS ACCOUNTS EGA RECEIVABLES WORKING CAPITAL CYCLE/OPERATING CYCLE > The length of operating cycle will depend on the nature of business. The length of operating cycle of a manufacturing business is longer than the operating cycle of a trading concern. A manufacturing company has 4 component periods in its operating cycle, namely 1, Raw materials conversion period It is the length of time required for purchase of rai raw materials in to work-in-process. 2. Work-in-process conversion period It is the length of time required for goods. w materials and conversion of conversion of work-in-process in to finished t ‘Scanned with CamScannee3. Finished goods conversion period Itis the time required for selling the finished goods to the customers. The total o¢ the above period is called Inventory conversion period. Inventory conversion period = RMCP+ WIPCP+FGC 4. Book debt conversion period : It is the length of time needed for collecting cash from debtors for the credit sly made by the company. > Types of Operating Cycle There are two types of operating cycle, namely; , ‘ 1, Gross Operating Cycle [GOC]}. The total/sum of the inventory conversion period and debtors’ conversion period is called gross operating cycle. Gross Operating Cycle = RMCP+ WIPCP+FGCP + BDCP. 2, Net Operating Cycle [NOC]. NOC is the difference between the GOC & Deferral period, - Net Operating Cycle = Gross Operating Cycle - Deferral Period ] If the firm is buying raw materials from its suppliers on credit, the payment need not be made immediately. It is postponed to the future. This future payment/forward payment period is called payment deferral period. It is the period between date of | ‘purchase and date of payment. If this period is deducted from gross operating cycle, we get net operating cycle, Management of working capital is a vital function of business organization. The proper functioning of fixed assets depends on effective working of current assets. Working capital is a lubricant, which makes the fixed assets to work smoothly. Working capital management refers to the management of current assets and current liabilities, Working capital management is a managerial strategy of maintaining efficient levels of components of working capital current assets & current liabilities. The term current assets refer to those assets, which in the ordinary course of business, turns in to cash, The major component of current assets is cash, bills receivable, debtors and inventory. Current liabilities are those liabilities, which are paid, in the ordinary course of business. The basic current liabilities are bills payable, bank overdraft, and outstanding expenses. Working capital management is concerned with maintaining adequate amount of working capital, which is neither excessive nor inadequate. Both excess and inadequate working capitals are not good for proper functioning of any business concern. Both excess and inadequate working capitals are danger to business. Therefore, a business concern should maintain adequate amount of working capital. As both inadequate and excess working capitals are not good for any business organization, finance manager is required to maintain adequate amount of working capital. ‘Scanned with CamScanneeame on their d neither excessi tren AT sient to carry lay-to-da sive than their requirem yf ce of adequate working capital - erat xf a ni cae ortant advantages of adequate I gives numbe; working capi fi oF benefits to a business organisation, Ips in getting easy finan; , 1. Help’ bs 8 easy financial assistance from banks and financial insti . Ithelps to improve goodwily of the and financial institutions, . business isati _ Ithelps in smooth and uninterrupte Organisation, . d flow of busi ; " ithelps to maintain good customer andy business Operations, 2. 3. 4 plier relationshi 5. Ithelps to take advantage of favourable market conditi ips. 6. It gives business organisation the stren ote 7. igth to face the crisi i |, Through smooth and uninterrupted flow ae isis offectively, solvency of business organizations, usiness operations, i g. It improves the morale, efficiency, prod tiv eee caine Y, productivity of employees and reduces the waste \WCO Improves the § PROBLEMS OF INADEQUATE WORKING CAPITAI Doing business inadequate working capital, the business organizati i . 4 , ‘ganizations are d of the benefits of adequate working capital. The business organizations with = working capital can face the following problems- 1, With inadequate working capital, busines: favourable market conditions, 'S organizations loose the advantages of . It leads to under utilization of plant capacity. . Difficult to complete the business operations as per schedule. . Difficult to meet the customers demand in time. . Chances of loosing market are more. . It badly affects the image of the business organizations. . It affects the liquidity and solvency of the business organizations. PrADMwARYN . Due to inadequate working capital, a business organisation fails to pay the wages in time, which in turn affects the employees moral, efficiency and productivity. 9. It affects the profitability of the business organizations. ‘Scanned with CamScanneeaeeuuins 1eUgvaUICD. CAPITAL OR 6:10 FACTORS AFFECTING TH A PITAL DETERMINANTS OF W: Number of factors affects/ leads to change in th requirements of a concern. The various such factors, W! requirements of a concern, are: 1. Nature of Business 2. Scale of operations 3. Length of the operating cycle 4. Growth and expansion of business 5. Length of manufacturing process 6. Production policies 7. 8. 9, e quantum of working capital hich affect the working capital . Rapidity of turnover - Seasonal fluctuation in demand . Reliability of supply 10. Operating efficiency 11. Credit Policy 12. Credit facilities enjoyed by the Creditors 13. Nature of Competition in the Market 14. Dividend Policy A brief explanation of each of the above factor is given below; 1. Nature of business The nature of business is one of the important factors determining the working capital requirements of a concern. Service rendering and public utility concerns business or industries like railways, electricity supply companies require small amount of working capital. However, manufacturing and trading concerns like steel industry, cement industry requires require large sums of working capital. 2. Scale of operations Size of operations is also an important factor affecting the working capital requirements. Large-size business organizations require large amount of working capital. Small size business organizations require small amount of working capital. 3. Length of the operating cycle The length of the operating cycle influences the size working capital. Longer the length of operating cycle greater is the amount working capital. For example in case of ship building ‘Scanned with CamScanneeSi 7 1 facturing industy;, < 69 , airoraft-manufacturing industries require . cane cycle smaller is the amount Working capitan” Working capital, Shorter the length of growth and expansion of business, f and expansion Of business also aff as & expanding business firms re Sets Working ing capital Tequirements of, ‘i Quire relatiy of aconcem, ibs ered to the firms, which are not Stowing and pm Amount of working capital . pength of manufacturing Proc, 5 ‘i fh of manufacturing Process also influ ve otring Process, the higher ences the am ess unt of working capital, Lo ; {re amount of working eeacptal Longer \ in} nce, 10 manufacturing process 'S involved so small amount of working eran required. : 6 production policies i licies are one of the fy i i Production policies are 0 Sctors affecting working ¢ example, capital-intensive industries require more fixed capital and - capital. The labour intensive industries Tequire more working capital ipital requirements, For mall amount of working 1 Rapidity of turnover The rapidity of turnover of invent business concern. If goods are sold hand, if tumover is very low a concey industries requires less worki Jewelers industries require more wo, tories has influence on working capital Tequirements of a Quickly, it requires less working capital. On the other m requires more working capital, For example consumer ing capital because of high rate of tumover. However, king capital because of low Tate of turnover. 8, Seasonal fluctuation in demand Seasonal fluctuation in demand also influences the amount of working capital. If the demand is fluctuating, then amount of is i highly fluctuating as in of working capital is required. 9. Reliability of supply The nature of supply of raw material decides the size of workin, variation in supply of raw materials, source of supply is not reliable, large amount of working capital is required to maintain more qu other hand, if supply is constant, regular and reliable small am enough, 8 capital. If there is, supply is irregular then iantity of inventories, On unt of working capital is 10, Operating efficiency The operating efficiency of a firm affects its working capital requirements. High e com, fficient ip anies use its resources efficiently and require less. working capital. On the other hand, a hich does not enjoy operating efficiency, needs more working capital. ‘Scanned with CamScannee11. Creait : . it policy A . it uirements. When The credit policy of a firm determines its size of working capi dit, requires ted firm follows liberal credit policy and sells goods and Service® Te i then the ge working capital. On the other hand, if the firm follows stricter Tequires relatively small amount of working capital. 12. Credit facilities enjoyed from creditors eT aie catalage The credit facilities enjoyed from creditors will affect is a Ss vvorking capital ‘ha which enjoys liberal credit facilities from its suppliers needs = firm, which does not enjoy liberal credit facilities from its SUPP a 13. Nature of competition in the market Competitive conditions prevailing in the market influ “de Ii a business concern. The fim facing stiff competition in the market Lae bd rae credit facilities to their customers to retain them and to face the competition My require keeping large quantity of inventories to meet customer 's orders a Fi * ino a reasons, the firm requires large amount of working capital. On the other hand, mel firm needs small amount of working capital. . 14. Dividend policy Dividend policy also affects working capital requirements of a firm. A firm following liberal cash dividend policy requires more working capital. On the other hand, a firm following strict dividend policy requires small amount of working capital. As discussed earlier, organizations require two types of working capital- permanent working capital and temporary working capital. The business organizations have to meet their permanent/ fixed working capital requirements out of permanent sources i.e. from long-term source of finance and temporary working capital requirements out of short term sources of finance. Hence for clarity and convenience sake, we can classify the working capital requirements into types as under; ‘ences the size of working capital of (a) Sources of Permanent Working | (b) Sources of Temporary or Varying Capital Working Capital 1_| Equity Shares 1_| Trade Credit 2_| Retained Earnings 2__| Bank Credit/ Loan from Bank 3_| Preferences Shares 3__| Account Receivables collections 4 _| Debentures 4_| Factoring 5_| Term Loans from financial institutions 5__| Inventory/Stock financing 6_| Public Deposits 6 | Inter-Corporate Deposits 7_| Commercial papers 8 _| Bill Discounting 9 | Customer advances 10_| Accrued expenses | Each of the above sources has been explained in detail in the following paragraphs; ‘Scanned with CamScannersources of Permanent Working Capital permanent/fixed working capital is Somewhat similar to fixed cost concept in the total of production. This working capital remains in the business ‘permanently in one form or other which is required for financing the stock of raw materials, finished goods, paying wages salaries and other Payments of regular nature. Tendon committee on working capital gement has referred to this type of working capital as ‘core current assets’. This working capital should be financed from Permanent source / long-term source of finance. The following are the important long-term source working capital Long-term sources of financing are those sources, capital for the purposes of meeting the fixed assets beyond five years, which are used to raise permanent Permanent working capital requirements and to acquire The long-term funds are raised through the following sources and instruments, namely; . 1__| Equity Shares 2098 | 2 | Retained Eamings eags 3_| Preferences Shares Se g = 4 | Debentures S3e5 5__| Term Loans from financial institutions a 6 Public Deposits 1, Equity shares: Equity shares are the main source of fixed or block capital of the companies. They are also called as ordinary shares or owners shares. Equity share is share that gives equal right to holders who invest in equity share. Equity share holder has to share the rewards and bear the risks associated with the ownership of a company. They have no right to claim dividend and have to share the losses if any. 2, Retained Earnings: Retained earnings are also called as plough back of profits. These are the profits or earnings left after dividends and taxes are paid. They are the important internal source of funds. Retained earings are the profits accumulated regularly over the years and are used for investment purpose. Retained earnings are the free sources of funds, in the sense that no out of pocket costs are involved (companies need not pay any interest to outsiders) but they have opportunity costs. 3. Preference Shares: Preference shares are those shares which enjoys preferential right as to payment of dividend and repayment of capital at the time of winding up of the company over equity shares. There are eight types of preference share (four combinations) are issued by the companies; such as Redeemable and Irredeemable preference shares, participative and non- Participative preference shares, cumulative and non-cumulative preference shares and convertible and non-convertible preference shares. Compared to equity shares, preference shares are least cost source of capital. A Preference share brings flexibility in capital structure. Through preference issue, the benefit of financial leverage is possible. Preference shares are not free from demerits. Their issue results fixed financial burden to the company in the form of fixed dividend payments particularly in case of cumulative Preference shares. The preference share dividend is not allowed as a deductable expense for income tax purpose. In this sense it is costlier than debt capital. ° —_ ‘Scanned with CamScanner4. Debentures/Bonds: Debts and Bonds are the important source of tong term finan, wtnres 2° the creditorship securities issued to ereditors for ralsiiB Oi tie: A debenture instrument issued by the company under its common seal ar jowledging a debt and setting forth the terms under which they are issued and are to be repaid. a A distinction can be made between Bond and Debentures, where beat ed toa Security that has secured by tangible fixed assets of a corporate entity an not Secured by assets, but secured by credit worthiness ofa corporate body. Debentures are guaranteed and assured sources of funds like equity or preference shares, 8 : i f equity and preference shares, he cost of debenture is comparatively lower than the Sri aaa u Say alia But the main demerit is that, it increases the financial ris Payment of interest. 5. Long-term loans from financial institutions: Long-term loans from Sear banks, specialized financial institutions like IDBI, IFCI, SIDBI, ICICI, and i te are raised for long-term investments beyond five years for expansion, modernization, diversification etc, This finance is also known as Project financing. Long-term loans are 100 Percent secured, negotiable and having definite maturity period may be multi-currency status, 6. Public deposits. Public deposits are the unsecured deposits from the public in large and small companies, to meet working capital requirements beyond one year up to three Years interval at an interest rate of 10 to 15 percent. In the Recent years the acceptance of public deposits is gaining popularity. The Government has framed number of rules and imposes certain conditions as to interest rates, quantum of acceptance and renewal of deposits from Public. In India public deposits accepted by the companies are governed by non-banking companies (Acceptance of deposits) rules. /NBFC as defined in clause (f) of section 45-1 of the RBI Act, 1934 (clause (73) of section 65) (b) Sources of Temporary / varying working capital Temporary working capital refers to the amount of working capital, which goes on fluctuating from time to time with changes in the volume of business activities. It is similar to variable cost. During the peak season, more amount of working capital is required and during slack season, small amount of working capital is required. This working capital should be financed from temporary/ short-term source of finance. The following are the important sources of temporary working capital — Components of Short-term Sources of finance 1__| Trade Credit : s 2 | Bank Credit/ Loan from Bank £3 | 3 | Account Receivables collections 5s 4 _| Factoring i Bo 5__| Inventory/Stock financing E 3 6 | Inter-Corporate Deposits 45 [7 | Commercial papers = [—s_[pinDiscounting a 9 | Customer advances 10 | Accrued expenses Each of the above factors is explained in detail as below; ‘Scanned with CamScanneer, Pde credit dit refers to the credit ext Ie Crret ., fended by th : Were on the basis of deferred payment, a ig wbblier of goods and services to the itt ‘rises in normal course of transactions of the firm isa Spontaneous source of finance. This Ws ee source of finance, pon on without Specific negotiations; hence is iers- 7h term financing. eof erm of of supplier over thi is confidence © earings record of ‘ 4 i ae i nd the prompt sod regular repayment resord or nee ae eee time, liquidity rs in granting credit by the supplier, in past are the key > Merits of trade credit : The trade credit has the following advantages- urce of finance easy & fl (a) Easy 801 i sy & convenient mod 4 separate arrangement is required to avail the credit feelin oeincumerunce| as a0 | thi hi | ) From this source, here lesser procedural no ir . - | byc ompanies. ms are involved to use retained earnings terest free source t i t i oO eae rade creditors don’t charge interest on the amount | | > Demerits of trade credit (a) Not reliable it is not reliable source o finance; in the sense that trade credit facili can be enjoyed only by reputed companies. . eve faolty (b) High prices generally the suppliers will charge higher prices when concern sought credit facility, so it is one of the major drawback trade credits, (©) Costly when business concerns regularly avail credit from their suppliers, they will lose cash discount and other favorable considerations. — 2, Bank Credit/Loans or Term Credit. Commercial banks are the specialized financial institutions whose primary objective is to lend money for business. Commercial banks normally provide the following types of credit; (i) Cash credit (ii) Overdraft (ii) Short -term loans (iv) Purchasing /discounting bill (¥) Letters of Credit. A brief not on each of the above is given below; () Cash credit (CC). Cash credit is an arrangement where the borrower can draw as oflen as required, a predetermined limit of borrowing, which is specified by the banker Brovided the drawing does not exceed given limit. The borrower enjoys the repayment fxility of the amount partially or fully as and when the firm desires. Interest is charged on credit amount sanctioned. (ii) Overdraft (OD). Overdraft is a temporary financial arrangement made between the | and customer, where the customer is allowed to draw over and above the balance in | customer account. Usually this facility is often taken by the firms, whenever there is an ° ‘Samed wth CamScanerUrge be repayable within a sh, ent need of funds for emergen: yments. Overdraft can ort duration as agreed with the banker Interest is chargeable on the amount actually drawn by the customer. ‘ch (iii) Bank Loans. Loans are the advances of fixed amounts perro to Customer account, The borrower is charged with interest on te ren amount imespective of how much he draws. Loans are payable either on demand & 0” Periodca installments. This makes loans facility is different from OD OR CC, Test ig Payable only on the amount actually drawn. , . Pent Gv) Discounting/Purchase of bills (BD). A bill i a promissory note ates OM Of ere transactions where the seller of goods draws the bill on the purchasers BN Setvplines of bill by the purchaser, the seller presents the bill to the banker for a ein re lasing. When the bank discounts/purchases the bill, it releases the cash to the seller. 7 1e bank Presents the bill to the purchaser (i.e. .the acceptor of the bill) on the due date and gets the payment. (v) Letter of Credit (LOC). Letter of Credit is an arrangement whereby a bank helps its Customers to obtain a credit from its customers’ supplier (seller). When the buyer bank opens a letter of credit in favour of its buyer customer for some specific purchase, the bank undertakes the responsibility to honors the obligation of its customer when the customer fails to pay the credit. It is an indirect form of financing as against OD/CC/BD, which are direct forms of financing. Note that in direct financing, bank assumes a risk as well provides financing facility, 3. Account Receivables Account Receivables financing is an arrangement where Account Receivables are pledged as collateral to raise the loan or sold to a financing agency, which is called factoring, Factors purchases Account Receivables out rightly. Apart from loan and cash credit, a part of the total credit requirement within the overall eligibility could also be provided by way of bill limits to finance seller’s receivable, since Account Receivables are the sellers” most liquid asset after cash in borrower’s Balance sheet. 4. Factoring A factor is a financial institution, which offers services relating to management and financing of debts arising from credit sales. Factoring is an arrangement between a factor and his clients for finance or maintenance of accounts or collection of debts or protection against credit risks. 3 Under Factoring, receivables arising out of credit sales are sold to the factor , as a result of which the title to the goods or services represented by the said receivable passes on to the factor. Hence forth the factor becomes responsible for all credit control, sales accounting and debt collection from the buyers. In full service factoring concept (without recourse facility), if any of the debtor is failed to pay the dues as a result of his financial inability or insolvency or bankruptcy the factor has to absorb the losses. 5. Inventory or Stock financing An advance given against inventory which is in the form of raw material/work-in progress / finished goods is called Inventory or Stock financing. The borrower can pledge the ‘Scanned with CamScannertock of inventory or the banker may take a letter of hypothecation from the borrower while granting the advance against stock or inventory, 6. Inter-Corporate Deposits (ICDs) 3, A deposit made by one company with another company normally for a period*ap to six months. ICDS are of three types; * (@) Call deposits/ three days deposit: a deposit withdrawable by the lender on days notice (normally 3 days). This type of deposits will fetch 12 percent per annum. (b) 3 months deposits are more Popular in short term cash inadequacy that may be caused due to disruptions in production, excessive” import of raw materials, tax payment, and delay in collections, dividend payments and unpaid * capital expenditure. The interest rate on this deposit is 15 Percent per annum. (©) 6 months deposit: this type of deposits is extended by lending companies to the maximum of six months to the first class borrowers at 18 percent per annum. Practice are taken by borrower to tide 0} 7. Commercial papers * Commercial papers re - Present the short term unsecured promissory notes issued by firms, which enjoy a fairly y high credit rating (large firms) with a maturity period of 90 to 180 days, placed directly with investors who intend to hold it t a discount and redeeme ill maturity. Commercial is sold at d at its face value. 8. Bill discounting A bill is a promissory note arises out of credit transactions where the seller of goods draws the bill on the purchaser; on the acceptance of bill by the purchaser, the seller presents the bill to the banker for discounting or purchasing. When the bank discounts/purchases the bill, it releases the cash to the-seller. The banks Present the bill to the purchaser (i.e. .the acceptor of the bill) on the due date and get the payment. 9. Customer advances These are the advance payments made by the customer in advance of purchasing of goods and services to the suppliers of goods and services. These are the easiest and cheapest sources of short-term finance. 10, Accrued expenses It is one of the spontaneous sources of finance. Expenses which are incurred but not yet id are accrued expenses or outstanding expenses. These simply represent liabilities thers es has to pay for the benefits already receive by firm examples are outstanding wages outstanding rent ete. ee ‘Scanned with CamScannee