Chapter 9 Working Capital Management SSS CHAPTER CONT: 9.1. Concept of Working Capital Management. 9.2. Management of Cash. | 9,3, Accounts Payable. 9,4. Management of Accounts Receivable. 9.5 Over and Under Trading | 9.6 Management of Inventories 9.1 CONCEPT OF WORKING CAPITAL MANAGEMENT Working capital is required for the day to day working of the company. It consists of assets such as cash, marketable securities, receivables and inventory. The identity of the assets of ‘working capita is that they can be converted into cash within one year. During that period their value does not decrease. These assets are termed ‘current assets’. Working capital has to be managed efficiently for maximizing the shareholder’s wealth. Inefficient management of current assets leads to insolvency and bankruptcy. Efficient management of working capital requires that there should be a sufficient balance of current assets for carrying out business. Working capital management consists of planning of working capital, managing cash efficiently, making policies for accounts receivables and payables and inventory management. Working capital management is useful for wealth maximization of shareholders and to magnify their earnings per share. Working capital must be estimated through the company’s operating cycle, The company’s activities from production to sale both in cash and credit and receiving of finds is called an ‘operating cycle’. In other words itis the flow between cash, inventory and accounts receivable. ‘The definition of net working capital is current assets minus current liabilities or that part of the current assels which are financed by long term funds’. 9.141 Importance of Optimum Working Capital Working capital should be efficiently managed. Adequate resources Will lead to maximization9.2 Financial Management : Principles ang i “ et of shareholders funds. Optimum working capital is important for the following reaso, “ ns, 1. Ifworking capital is more than optimum level there will be a high accumulatioy This would lead to losses with unused material and tied up capital. 2. Excessive working capital leads to bad debts that decrease profitability of the f, 3. Excessive inventory leads to theft, wastage and managerial inefficiency, mm When working capital is lower than the required amount the working is inadequate, optimum working capital will have the following problems: " 1. Work is ineffective. It results into losses and it adversely affects profits of th because targets cannot be accomplished. Fim 2. Inadequate working capital creates problems in the day to day running of the busin Its goodwill will be affected it will not be able to meet its obligations in the required tine 3. Inadequacy in working capital results in production lags. The gaps will create ¢ finishing products and sales of the firm will be affected. 4. Lack of funds reduces the ability of the firm to use its fixed assets efficiently, Tis wi affect its profitability. There are two important aspects of working capital, these are investment and financing, ” Fiery Less, thay lelay in 9.1.2 Operating Cycle A firm has‘a working cycle from the production stage to sales and receipt of cash. This is called an operating cycle. The operating cycle has different stages in which the length of time is different. These stages are described below: Stage 1: Procurement of Raw Materials The first stage in a manufacturing unit is that of procurement of material. Stage 2: Work in Process The second stage is when the raw materials are used for manufacture. Different manufacturing processes are there and each of the units has a different time span of production. Cash outflows are high because goods are being produced. In service industries the company is being set and the working capital requirement is of a different nature. It is generally for routine expenses and for procuring orders. Stage 3: Conversion of Raw Materials into Finished Products In this stage the company is flushed with goods. There is a large stock of manufactured gools Stage 4: Selling Finished Products - In this stage the products must be sold by the company. Depending on the nature of the: aaa goods may be sold on cash or credit or both. The intervening period between sale on cre receipt of cash requires availability of working capital.srorking Capital Management 9.3 stage 5: Accounts receivable In this stage the company has to manage debtors ‘Until cas} vaiting pel riod. It is the gap between selli | . ing the good. service industries as well as Payment is receive a providing services and receiptof bills, h is received: It is also called the hn and receiving the cash. It exists in for services after atime Bap between that of Stage 6: Payment Received In this Stage there is an inflow of cash. There is an outflow but inflows are higher than the outflows of cash. The techniques of, ‘Working capital ‘Synchronize cash inflows and cash outflows, The operating cycle is depicted below j "Fig. 9.1.1. Itshows all the stages of a i cycle explained above, stages of the operating ——_ 1c || —_, 2. Rew Materials 16. Account 3. Work in Receivable ‘The Operating Qyde of WE process 5. Cash and 4. Finished edit Ses |} * rods Fig. 9.1.1: Operating Cycle Example 9.1: XYZ Company gives the following information, Calculate its operating cyele (in Xample 9.1: 01 lays). Rs, 6,00,000 Raw materials 8,00,000 Work in progress 6,00,000 Finished goods 2,00,000 Average creditors No. of days covered 36594 Financial Management: Principles and Prag, ‘Average period of credit allowed by suppliers 30 days Average debtor outstanding Rs)'12,00,000 Raw material consumed Rs: 10,00,000 Production cost Rs. 16,00,000 Cost of good sold 17,00,000 Credit sales for the year 44,00,000 Solution: Operating cycle of a company . ‘Average raw material 365 a> Hew msterial = Raw material consumed ~ _, $00,000, 365 = 219 days 70,00,000 LWwarklinipecas® = OO work in process. 365 Total cost of production 8,00,000 = 300,000 365 = 182.5 d 16,00,000 * 5 = 182-3 days A ' __Average finished stock 345 3. Finished goods = = Total cost of goods sold x 365 = 128.82 days 00,000 100. _ Average debtors 4. Debtors = Avene debtors Creditsales Average creditors 5. Credit : editors Total purchases -* 365 _, 2,00,000 x 365 600,000 = 121-66 daysoptal Management pois 95 Note: , of days is rounded i Number of day %f for calcutening operating cycle, operating cycle = 219+ 18341294 199 _ 122 = 509 = 509 days, yg types of Working Capital Se are different types of working capital these nt types ‘i in aye si er) et working capital working capita (Permanent i temporary it) gross a 1, permanent Working Capital ‘The permanent working capital is the level of Current assets determined for continuous requirement bya firm in carrying Out its business e| fixed assets ofa company. In different seasons th maintains the assets although they are not required oftre of requirement will be termed as permanent sseither constant or it increases with the size Fig9.1.2. ficiently. It is used. continuously just like the 'e demand changes but the firm continuously for production. The continuous ‘uninterrupted it working capital Permanent working capital of the business or its scale of operations. Total WC 4zcoz> Permanent WC oz Time Fig. 9.1.2: Permanent Working Capital 2 Temporary Working Capital: tis also called variable capital because it fluctuates according to the demands of the firm. ‘When the requirement is high it is procured and itis liquidated when demand falls. There is not Tuch difference between temporary and permanent working capital, yet the difference is etesary because decisions have to be taken for funding from different sources. The temporary/ ‘arable working capital is depicted in fig. 9.1.3 the temporary! variable working capital is mets very quickly and decisions relatingto it have to be taken very quickly pot in situations “rising funds or in liquidating them according to the requirements of the firm. The temporary . ase |9.6 fluctuating variable capital Financial Management : Principles ang Pract ce Fis in curves and moves up and down according 0 the fgg i y requirements of the firm. Total WC Temporary WC ‘Amount of Working Capital Fig, 9.1.3 : Temporary Working Capital ‘To summarize the changes in the requirements of working capital may be due to 1. ‘A change in trend or long run changes would require changes in permanent capital, Seasonal changes require temporary working capital changes probably due to sales activities. . The long term change in prices of raw materials would be of a permanent nature buta seasonal change is temporary and brings about a change in temporary working capital A permanent increase in sales would require changes in permanent working capital sit would require a higher cash balance, more inventory and greater receivables. The need for permanent and temporary working capital would also depend upon chang® ina firm’s policy. A conservative policy will require a high level of investment incurrent asset where as in an aggressive policy fewer amounts of current assets will be required. 3. Gross Working Capital Working capital may be defined as gross working capital or net working capital. Gross and net working capital has equal significance, Gross working capital requires that a firm should have adequate investment in current ass# and proper management of these assets, There should be an optimum amount of wore capital that should be responsive to the changing requirements of business. Temporh imbalances should be corrected. Optimum investment is desired in current assets in fn" different sources for financing of short term needs.7 wivscol Management 91 i ital is the total of the i . working cap! : of the investment of all th he gr 02 explains gross working capital, Sour ase of tho fare goth : i | ae 9.2: Firm ABC has the following current assets, What is its gross working capital? Be natal = Rs, 5,00,000 ast 8008 = Rs, 2,50,000 coshbalene® = Rs, 1,50,000 pies = Rs. 2,00,000 solution? i ‘he rss working capital of the firm is Rs. 5,00,000 + Rs 2,50,000 + Rs. 1,50,000 + Tipoo= 110,000 4, Net Working Capital (NWC) Current assets minus current liabilities are equal to net working capital. To have positive NWC, current assets should be higher than current liabilities. When current liabilities exceed current assets then there will be negative NWC. Some current assets are raw materials, cash, finished ‘and debtors. The current liabilities are those which are payable within the same accounting year. Some items on the liabilities list are bills payable, creditors and outstanding expenses. Networking capital provides the liquidity position ofa firm and the requirements of working capital that should be financed by long term sources of funds. The current assets and current Iibilties should generally be in the ratio of 2:1. A firm should not have excessive or low liquidity. Tosummarize NWC is the management of financing of working capital through the long term and short term funds. There should be a proper mix of the portion of current assets to be financed through equity capital and borrowings. Determination of Working Capital for the Year: (A) Current Assets (CA): (1) Raw Materials @), Work in Progress. () Raw Materials Labour ii) Finished goods. @) Debtors © Cash and bank balance Total Current Assets ©) Current Liabilities (CL) Creditors Q Wages unpaid ) Overheads unpaidTheinventoriesneed not beviewed asanidlenssel these are aw integral part of Firm's operations. But the tion usually 10 how much inventories be maintained by. a firm? If the inventories are too big, they become a strait on there however they are toostnal, he irmamy Tose the sale the firma rmust have a optinnuns level of inventories Managingthe levelof inventories islike maintain ing the level of water in a bath tub with an open drain, The waters lowing out continuously. Ifwateris et in tooslowy, the tub is soon empty, it waters Ft in too fast, the tu over flows, Like the water in the tub, the item in the inventory keeps changing, but the level may remain the same; The basic financial problem is to determine the proper level of investment in the inventories and to decide how much inventory must be acquired during each period to maintain that level. The present chapter attempts to discuss different aspects of inventory management. ques: TYPES OF INVENTORIES ‘The inventory means and includes the goods and services being sold by the firm and the raw materials or other compo- nents being used in the manufacturing of such goods and services, A retail shopkeeper keeps an inventory of finished goods to be offered to customers whenever demanded by them. On the other hand, a manufacturing concern has to keepa stockpile of not only the finished goods itis producing, but also of all physical ingredients being used in the produe- tion process. ‘The common types of inventories for most of the business firms may be classified as finished goods, work-in-progress, and raw materials Finished Goods: These are the goods which are either being purchased by the firm or are being produced or processed in the firm, These are just ready for sale to customers, Invento- ries of finished goods arise because of the time involved in production process nd the need to meet customer’s demand promptly. Ifthe firms do not maintain a sufficient finished ‘goods inventory, they run the risk of losing sales, as the customers whoare unwilling o wait may turnto competitors. ‘The purpose of finished goods inventory is to uncouple the production and sales function so that itis not necessary to produce the goods before a sales can occur and therefore sales can be made directly out of inventory. Work-in-Progress: It refers to the raw materials engaged in various phases of productionschedlule. Thedegreeof comple- tionmay be varying fordifferent units. Some units mighthave been just introduced, whilesomeothersmay be 40% complete or others may be 90% complete, The work-in-progress refers to partially produced goods. The value of work-in-progress includes the raw material costs, the direct wages and ex- penses already incurred and the overheads, if any. So, the work-in-progress inventory containspartially produced /com- pleted goods. ‘The quantity and the valueof work-in-progress depend! on the length of the production eycle. In case of shorter production PART V: MANAGEMENT OF cur ay be small but i th p, sorkein-progress yl een rake firm will be having a lange ee tion evel rerinore complex and lengthy the proget® progress Piper investment in worksinsprogreg proces purpose of workeineprogress inventory i gS tory Te ats operations inthe prodction prog couple the that machine f affect the otf Raw Materials: res and stoppages in one operation yay operations he ‘The raw materials include the mats vid inthe production processand every many mn has to ct stock of raw materi hese units of raw materials are regulary ise ‘I to production department, Inventories ofp ara alsare held tocnsure thatthe production procesisnr erupted by a shortage of these materials. The amoung an materials to be kept by a firm depends on a numberg: factors including the speed with which raw materials can. Eidlered and procured (the greater the speed, the lover fequired inventory for raw material) and the uncertain thesupply ofthese raw materials (he larger the uncertain thegreater the need forraw materials inventory. Iispurre isto uncouple the production function from the purchasing function ie, tomake these two functions independent ofeach other so that delay in procurement of raw materials dom cause production delays and the firm can satisfy its ned er raw materials out of the inventory lying in the stores. ‘The classification of a particular item as a finished goods or rawmaterial depends on the kind of business being discussed For a coal mining firm, coal is finished good but itisarav material fora steel mill asthe coal is used in the productin of steel. Similarly, steel is finished good for a stee mill bu it is a raw material for an automobile firm. turing fi stores. Th transl INVENTORY MANAGEMENT Itisalready noted that the purpose of carrying inventoryisto uuncouple the operations ofthe firm ie, tomake each function of the firm independent of other functions so that deaysia one area do not affect the production and sales activities AS the production shut down results in increased costs because the delays in delivery can result in loosing the cs tomers, the management and control of inventory is st important dimension of the duties of the financial manage Inventory management assumes significancein any fiemand itis of great concern to any financial manager. Though tht inventory is more directly related to production and markt ing departments, still the financial managers has to play * active role in the management of inventory. He in fact ith coma maker in the whole process of inventory manag Any firm will ke to hold higher levels of inventory. This gnable the firm to be more flexible in supplying '0 customers and will ind easein its production schedule Not of the customers may require immediate delivery and high inventories mayhelp meeting theirdemands, and hencethe™ Yul be less and less chances of sales being disruptet Be theres always a cost involved in the inventories. This eludes the capital cost of the stock and the costs of 0%"“ints et. On the cartyinBs 6 OM the other hang joy Aan reared may regu ee Holding ower level of 8 Satay DESAIES ans gr yg a ulstaV Oren Ck-outs. The cost of S dissatisfaction, The ee "¥Sorhold-upsinthepredas jon “ the beneils of holding inye om wl be tangas an cos of dock to hold maxi ‘ Maximum possible oa ries. BUL this is costly set against its pPortunity costs, While ce ee tine financial manager W Poi oduct iment. arksting department an he reNo doubt, mos ofthe decisions relating toinea en, | setsken by purchase department in consultation wile ucton department, sil the financial manager showra seta the inventories are properly controlled snd fo shuld sress the need for the consideration of finenenl ‘plications of inventory management, ths theobjective of inventory managementisto determine snoptmum level of inventory ie, the level at which the irs ofall the departments are taken care of, The ive ‘uymanagement seeks to maximize the wealth ofthe shore, ils by designing and implementing such policies which ‘tempt to minimize the cost of procuring and maintaining inventories, dunes firms keep inventories for different purposes. Every {im,big or small trading or manufacturing has to maintain ‘sneminimum level of inventories, There are different mo- ‘esfor maintaining inventories, and these are more or less tsame as the motives for holding cash, The motives for hung inventory may be enumerated as follows: | Transactionary MotiverEvery firm has tomaintainsome ‘eelof inventory to meet the day to day requirements of sks, production process, customer demand etc. This ‘Motive makes the firm to keep the inventory of finished ‘Pods as well as raw materials. The inventory level will Frovide a smoothness to the operations of the firm. A business firm exists for business transactions which re- ‘ire stock of goods and raw materials. * Precautionary Motive: A firm should keep som \21 for unforeseen circumstances also. For example, the 14 supply of raw material may not reach the factory “ttostrike by the transporters or due to natural calami- G2 aricular area, There may be abou problem in ftlztory and the production process tony bal So he fy MUS have inventories of Faw mate 1 ght eoods for meeting such emergencies. ‘eeulative Motive: The firm may be tempted to keep 'nventory in order to capitalize an opportunity fo tens Poft eg, sufficient evel ofinventory may hep the allocamextra prfitincaseof expected shortageinthe Marke en CH. 16: CHS IVENORY mane 3i7 ee iscussed as Reasons and Benefits of Inventories: The motives di above make the firm to hold the inventors. However already said the inventory has costs as well as Benste associated with it, While determining the optimal level oF inventories, the financial manager must consider the neces: sityofholdinginventory andcosts hereof. The optimum level of inventory is a subjective matter and depends upon the features ofa particular firm. The following are some of the benefits or reasons for holding inventories: 1. Trading Firm: In case of a trading firm, there may be several reasons why it will maintain inventory. Ifthe firm hhas some stock of goods then the sales activity can be undertaken even if the procurement has stopped due to one reason or the other. Otherwise, if stock is not there, thereisalikelihood that thesales willstopassoonasthere is an interruption in procurement. Moreover, it is not always possible to procure the goods whenever thereisa sales opportunity, as there is always. time gap required between the purchase and sale of goods. Thus, a tra concern should have some stock of finished goods in order to undertake sales activities independent of the procurement schedule. Similarly, a firm may have several incentives being of- feredin terms of quantity discount orlower price, etc, by the supplier of goods. The benefits can be availed and goods may be purchased even if there is no immediate sales order, The inventory so purchased, ata discount/ lower cost, wil result in lowering the total cost resulting in higher profit for the firm. So, in case of trading concern, theinventory helpsin de-linking the sales activi- ties from purchase activity and also to capitalize a profit of opportunity. TL, Manufacturing Firm: A manufacturing firm should have inventory of not only the finished goods, but also of raw materials and work-in-progress for obvious reasons as follows: (9 Uninterrupted Production Schedule: Every manu- facturing firm must have sufficient stock of raw materials in order to have the regular and uninter- rupted production schedule. If there is stock-out of rawmaterialatany stage of production process,then the whole production process may come to a halt. This may result in customer dissatisfaction as the goods cannot be delivered in time. Moreover, the fixed costs will continue to be incurred even if there {s not production. The firm may also have to incur heavy cost to restart the production schedule: Further, sufficient work-in-progress would let the production process run smoothly. In most of the manufacturing concerns, the work-in-progress is natural outcome of the production schedule. The work-in-progress helps in fulfilment of some sales ordersevenif the supply of rawmaterialhas stopped. (i Independent Sales Activity : Inventory of finished goods is required not only in a trading concern, but manufacturing firms should also have sufficient stock of finished goods. The production schedule is