MODULE I

WORKING CAPITAL MANAGEMENT

TOPICS TO BE COVERED
Determination of level of current assets. Bank finance for working capital. Working capital financing: Short term financing of working capital, long term financing of working capital. Working capital leverages Sources for financing working capital.

Working capital Mgt

Working capital may be regarded as life blood of Business. WC is needed to meet the day to day operations of the business unit. WCM is not only shows the financial efficiency of business, but also its credit worthiness.

Meaning of Working capital Mgt

In Simple, WC is D/b Current Assets and Current Liabilities. CA Refer to those assets which in the Ordinary course of Business can be, or will be, converted into cash within one year. CL Are those liabilities which are payable immediately or with in a short period of time.

CURRENT ASSETS
Current assets are reasonably expected to be realized in cash, or sold or consumed, during the longer of one year or the companys operating cycle Current assets include: Cash -- ultimate liquid asset Cash equivalents -- temporary investments of excess cash Marketable securities -- debt or equity securities held as ST investments Accounts receivable -- Amounts due from credit sales Inventories -- items held for sale in the normal course of business Prepaid expenses -- advance payments for services and supplies

CURRENT LIABILITIES
Current liabilities are obligations expected to be satisfied within a relatively short period of time, usually one year Current liabilities include:

Accounts payable Short-term bank loans Tax payable Accrued expenses

Definition of WCM
Working Capital Mgt 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 goal of working capital management is to manage the firms current assets and liabilities in such a way that a satisfactory level of WC is maintained.

Types of Working Capital

Gross Working Capital it means the Total current assets. The total amount of funds which are invested in CA. Net Working Capital it 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.

Types of Working Capital

Permanent or fixed working capital A minimum level of current assets, which is continuously required by a firm to carry on its business operations, is referred to as permanent or fixed working capital. Fluctuating or variable working capital The extra working capital needed to support the changing production and sales activities of the firm is referred to as fluctuating or variable working capital.

Types of Working Capital

A m o u n t o f W C
Temporary WC

Permanent WC

Time

Types of Working Capital

Zero Working capital it means the current Assets is exactly equal to Current Liabilities. Negative Working Capital It means the Current liability is exceeds the current Assets.

Determinants of Working capital

Availability of Raw Materials Nature of Industry Manufacturing cycle Market conditions Inventory policy Collection policy/Credit policy Growth and Expansion

Cont

Determinants of working capital

Cost of Labour Seasonal Variations Profit level Dividend policy Level of Taxes Price level changes

Operating Cycle
The continuing flow from cash to suppliers, to inventory, to accounts receivable and back into cash is called Operating cycle. In other words, the term cash cycle refers to the length of time necessary to complete the following cycle of events.

 Conversion of cash into inventory Conversion of Inventory into receivables Conversion of receivables into cash Receivables Phase 3
CASH vg

Phase 2

Inventory

Phase 1

DETERMINATION OF LEVEL OF CURRENT ASSETS or DETERMINING FINANCING MIX

Financing mix is the choice of sources of financing of CA. To maximize the wealth of shareholders Firm can have different level of CA This may be Hedging or Matching Policy Conservative policy Aggressive Policy Moderate policy or Trade off

HEDGING APPROACH OR POLICY

The term Hedging is often used in the sense of a risk reducing investment strategy involving transactions of a simultaneous. According to the Hedging approach, the Permanent Portion of funds required should be financed with long term funds and the Seasonal or Temporary WC with Short term funds.

CONSERVATIVE POLICY
Conservative current assets policy indicates constant level of fixed assets, and a higher CA/FA ratio It involves greater liquidity & lower risk The high level of current assets involves high cost and in turn high liquidity PWC or TWC Financed from LTS Low risk offers low profit

AGGRESSIVE POLICY
Aggressive current assets policy indicates constant level of fixed assets, and a lower CA/FA ratio It involves higher risk & poor liquidity The low level of current assets involves low cost and in turn poor liquidity PWC or TWC Financed from the STS High risk offers high profit

MODERATE / TRADE OFF POLICY

It is the trade off between conservative and aggressive policy Here an average level of current assets is maintained It involves moderate risk and average liquidity

COMPARISION
Approach Conservative Trade off Aggressive Degree of Risk Lowest Moderate Highest Degree of Liquidity Highest Moderate Lowest

COST INVOLVED IN MAINTAINING A LEVEL OF CURRENT ASSETS

Costs of liquidity: if the firms level of current assets is very high, it has excessive liquidity. Its return on assets will be low as funds ties up in idle cash and stocks earn nothing & high level of debtors produces nothing. Costs of illiquidity: is the cost of holding insufficient current assets. The firm will not be able to honour its obligations if it carries too little cash. This may force firm to borrow at high rate of interest.

WORKING CAPITAL LEVERAGES

C.A. = Current Assets T.A. = Total Assets (Net Fixed Assets + Current Assets) CA = Change in Current Assets

WORKING CAPITAL FINANCING

Spontaneous Financing Factoring Accounts Receivable Bank Finance Public Deposits Commercial papers Inter corporate deposits Short tem loans from financial institutions

SPONTANEOUS FINANCING
Types of spontaneous financing are Trade Credit and Accrued expenses Stretching Accounts payable is also known as a type of spontaneous financing

TRADE CREDIT
Customer gets credit from supplier of goods in normal course of business. An informal arrangement, granted on an open account basis, not formally acknowledge as a debt. Trade credit may also take the form of bills payable. Credit Terms refers to the conditions of due date and cash discount.

TRADE CREDIT
Advantages Easy Availability. Flexibility. Informality. Disadvantages Implicit Cost. Stretching A/P can prove to be very costly.

COST OF TRADE CREDIT

Cost of trade credit is the approximate annual cost to forgo cash discount and paying on the last day of credit period. It is
% discount =
(100% - % discount)

365 days X
(payment date discount period)

ACCRUED EXPENSES
Accrued expenses means the expenses incurred but not paid Examples Accrued Wages and Salaries. Accrued taxes and Interest. It is regarded as short term finance because some services are enjoyed by the concern without making any payment for a short period

S-t-r-e-t-c-h-i-n-g Account Payables

Postponing payment beyond the end of the net (credit) period is known as stretching accounts payable or leaning on the trade. Possible costs of stretching accounts payable are 1. Cost of the cash discount (if any) forgone 2. Late payment penalties or interest

FACTORING ACCOUNTS RECEIVABLE

Factoring is selling of receivables to a financial institution, the factor, usually without recourse. It is an ongoing arrangement between the exporter and factor. The exporter sells invoiced receivables at a discount to the factor to raise finance for working capital requirement. It bridges the gap between raising an invoice and getting that invoice paid. Factoring is a service that covers the financing and collection of account receivables in domestic and international trade.

Functions

1. Collection of A/R 2. Administration of A/R 3. Credit protection against bad debts 4. Credit control. Advantage of Factoring

It provides credit protection for the receivables. It helps the business to meet increasing sales demand and expand. Factoring helps in saving time as the invoice financing company collects the money itself. especially if factor engages in aggressive or unprofessional practices when collecting accounts. Cost is another disadvantage cost involved in factoring agreement may be more than the cost of other methods of financing available in the business.

Disadvantage It may lead to ruined relations with the customers

BANK FINANCE
Overdraft Invoice Discounting Term Loans Advances of fixed amount which are credited to the current Account of the borrower or released to him in cash. Charged with interest on the entire amount irrespective of how much he withdraws.

Secured Loan, and Unsecured loan

 Overdraft
it is an agreement by a bank to allow a company to borrow up to a certain limit without the need for further discussion. An Overdraft is a flexible source of finance in that a company only uses it when the need arises. The bank will charge daily interest at a variable rate on the debt outstanding. The bank may also require security or collateral as protection against the risk of non payment by the company.

 Invoice Discounting
It is a form of short term borrowing often used to improve a companys working capital and cash flow position. Invoice discounting allows a business to draw money against its sales invoices before the customer has actually paid. A borrower can obtain credit from a bank against its bills. The bank become owner of the bills, in practice bank holds bills as security for the credit.

Secured loan
In a secured loan, the borrower pledges assets as collateral for the loan. For short-term loans, the most commonly pledged assets are receivables and inventories. Securities are great collateral, but generally not available

Unsecured Loan
It is a loan obtained without collateral. A person obtaining an unsecured loan agrees to pay back the loan within a set term and signs documents attesting to such. Another common type of unsecured loan is a purchase made on a credit card. Each time a person makes a credit card purchase, he or she signs a form which authorizes the payment and stands as an agreement to pay the money borrowed.

Security required in Bank Finance

Hypothecation Under Hypothecation, the borrower is provided with working capital finance by the bank against the security of the moveable property, generally inventories. The borrower does not transfer the property to the bank and the possession remains with the owner itself.

 Pledge Under this arrangement, the borrower is required to transfer the physical possession of the property offered as a security to the bank to obtain credit the banker has a right of lien and can retain possession of the goods pledged unless payment of interest, principal and any other expenses is made.

 Mortgage
It is the transfer of legal or equitable interest in a specific immovable property for the payment of debt. In this case, the possession of the asset will remain with the borrower and the lender getting full legal title. The borrower is called as mortgagor, the bank is called the mortgagee, and the instrument of transfer is called the mortgage deed.

Public Deposits
The term public deposit implies any money received by a company through the deposits or loans collected from the public. The Public includes the general public, employees and shareholders of the company but excludes the money received in the form of shares and debenture. The public deposits are generally solicited by the firms in order to finance the working capital requirement of the firm. Public deposits are an important source of financing the medium term and long term requirements of a company. The Max maturity period is 3 years and Min is 6 months.

 Lien Means right of the lender to retain property belonging to the borrower until he repays credit.

Commercial Paper
It refers to short term unsecued promisory note sold by large business firms to raise cash. It can be sold either directly or through dealers.

Intercorporate deposits
It is also one type of short term deposits with other companies is a fairly attractive form of investment of short term funds in terms of rate of return which currently ranges between 12 to 15 percent.

Sources of Long term Finance

Shares Debentures These are also issued to the general public. The holders of debentures are the creditors of the company. Public deposits General public also like to deposit their savings with a popular and well established company which can pay interest periodically and payback the deposit when due.

 Retained earnings The co may not distribute the whole of its profits among its shareholders. It may retain a part of the profits and utilize it as capital. Term loans from banks. Many industrial dvt banks, cooperative banks and commercial banks grant loans for a period of 3 to 5 years.

 Loan from financial institutions

There are many specialised financial institutions established by the central and state govts which gave long term loans at reasonable rate of interest. Some of the these institutions are Industrial Finance corp of india (IFCI) Industrial Dvt bank of India (IDBI) Industrial credit and investment corp of India (ICICI) Unit Trust of India (UTI)

MPBF
Maximum Permissible Bank Finance Recommended by Tandon committee The group (headed by Sh. Prakash Tandon) was appointed in July 1974 which was to frame guidelines for follow-up of bank credit and submitted its final report during 1975

MPBF
According to Tandon committee Method I : 0.75 (Current Assets Current Liabilities) Method II : (0.75 *Current Assets) Current Liabilities Method III: 0.75 (Current Assets CCA) Current Liabilities

Method I
Total Current Assets Less: Total Current Liabilities (#) Working Capital Gap Less: 25% from Long Term Sources MPBF xxx xx xxx xx xxx

# Note: Total Current Liabilities means Liabilities excluding Bank Borrowings to be taken into account for Calculation

Method II
Total Current Assets Less: 25% from Long Term Sources xxx xx

Net Current Assets

Less: Total Current Liabilities (#) MPBF

xxx
xx xxx

# Note: Total Current Liabilities means Liabilities excluding Bank Borrowings to be taken into account for Calculation

Method III
Total Current Assets xxx

Less: Core current Assets (CCA)

Net WC Current Assets Less: 25% from Long Term Sources Net Current Assets Less: Total Current Liabilities (#) MPBF

xx
xxx xx xxx xx xxx

# Note: Total Current Liabilities means Liabilities excluding Bank Borrowings to be taken into account for Calculation