Working capital management

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. Gross working capital means the current assets which represent the proportion of investment that circulates within a firm, in the ordinary conduct of business. Net working capital is the difference between CA and CL or alternatively the portion of current assets financed with long-term funds.

That current assets are less profitable than fixed assets. That short-term funds are less expensive than longterm funds . In evaluating the profitability-risk trade-off related to the level of NWC. 3 basic assumptions which are generally true are: 1.Trade-off between profitability and risk Profitability implies the relationship between revenues and costs generated by using both fixed and current assets in productive activities Risk (of technical insolvency) is the probability that a firm will be unable to meet its obligations as they become due. That we are dealing with a manufacturing firm 2. and 3. Technically insolvent describes a firm that is unable to pay its bills as they become due.

2. 1. A decrease in the ratio will result in an increase in profitability as well as risk. The decrease in the ratio will lead to a decrease in profitability as well as risk. the increase in CA/TA ratio would decrease profitability.2 ratios in evaluating profitability-risk trade-off CA/TA: since CA for a business firm are likely to be less profitable than FA. assuming no change in CA). CL/TA: an increase in the ratio will yield higher profitability (due to decrease in costs) and higher risk (due to decrease in NWC. increase liquidity (assuming no change in CL) and reduce the risk of technical insolvency. .

Short-term sources (current liabilities) 2. retained earnings. long term borrowings. such as share capital. etc. Long-term sources. There are two sources from which funds can be raised: 1. .Determining financing mix Financing mix is the choice of sources of financing of current assets.

also known as hedging. with long-term funds and uses short-term funds for emergencies or unexpected outflows. . Matching approach to financing is the process of matching maturities of debt with the maturities of financial needs. Permanent needs implies financing needs for fixed assets plus the permanent portion of current assets which remain unchanged over the year. 2. Conservative financing approach is a strategy by which the firm finances all funds requirement.3 basic approaches to determine appropriate financing mix 1. Seasonal portion implies the financing requirements for temporary current assets which vary over the year.

and 2. the higher is the risk present. The higher the risk of insolvency.3. the higher is the expected profits. . Trade-off between hedging and conservative approaches : acceptable financing strategy Generalizations: 1. The lower the NWC.

Temporary (fluctuating/variable) working capital is the working capital needed to meet seasonal as well as unforeseen requirements. .Planning for working capital Need for working capital Operating cycle implies the continuing flow from cash to suppliers. to inventory to accounts receivables and back into cash. Permanent and temporary working capital – permanent (fixed) working capital is a certain minimum level of working capital on a continuous and uninterrupted basis.

3. dividend policy. Policy changes – eg. Production cycle 3. Price level changes 10. Operating efficiency . Growth and expansion 7. Technological changes Determinants of working capital 1. Production policy 5. Changes in sales and operating expenses 2.Changes in working capital 1. Profit level – level of taxes. Business cycle 4. Vagaries in the availability of raw material 8.. Credit policy 6. depreciation policy 9. General nature of business 2. current assets policy is the relationship between CA and sales volume.

Computation of working capital Estimation of CA: A. Minimum desired cash and bank balances B. Debtors Total current assets (I) . Inventories Raw material Work in progress Finished goods c.

Wages payable c. Creditors b.(II) Estimation of CL: a. Overheads payable Total CL (III) Net working capital (I-II) Add: Margin for contingency (IV) Net working capital required .

Trade credit period is the number of days until full payment of an account payable is required. . Trade credit: is the credit extended by suppliers of goods and services in the normal course of business. Cash discount period implies the number of days after the beginning of the credit period during which the discount is available. Advantage:informal and spontaneous source of finance. Cost of trade credit: is the implicit cost of not availing cash discount. Cash discount implies a percentage deduction from the purchase price if the buyer pays within a specified time that is shorter than the credit period.Working capital financing 1.

2. 4. Cash credit/overdrafts: Line of credit is an agreement between a bank and a firm specifying the amount of short-term borrowing the bank would make available to the firm over a given period of time. Bills purchased or discounted – relatively new in India. Loans 3.Forms of credit 1. 2. Bank credit . Term loans for working capital (3-7 years) 5. Letter of credit is a letter written by a bank stating that the bank guarantees payment of an invoiced amount if all the underlying agreements are met.


Refers to the right of a party to retain goods until a debt due to him is paid. 4. made security for payment of money to another and the transaction does not amount to mortgage.Mode of security 1. by the act of parties or by the operation of law. . Can be particular or general. 5. Mortgage is the additional security of immovable property to obtain short-term loan. 3. 2. Charge: where immovable property of one person is. Hypothecation is the use of movable property (inventory) as a security/collateral to obtain a shortterm loan. Pledge is the use of movable property (goods) as security/collateral to obtain a s-t loan (the possession changes unlike hypothecation) Lien is a publicly disclosed legal claim on collateral.

. A charge need not be made in writing but a mortgage must be attested. Mortgage is a transfer of interest in the property. A charge may be created by the act of parties or by the operation of law but a mortgage can be created only by the act of parties.Provisions of a charge A charge is not the transfer of interest in the property though it is security for payment.

Factor is a financial institution that specializes in purchasing accounts receivables from business firms. 4. Relatively new in India. Factoring involves the outright sale of receivables at a discount to a factor to obtain funds. With recourse: is the basis on which receivables are sold to the factor with the understanding that all the credit risks would be borne by the firm. . Commercial paper CP is a form of financing consisting of s-t unsecured promissory notes used by firms with a high credit standing/rating. Without recourse is the basis on which accounts receivables are sold to a factor with the understanding that the factor accepts all credit risks on the purchase accounts.3.

Discount charge is the interest charge for s-t financing by the factor for the period between the date of advance payment and the date of guaranteed payment/collection. .

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