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The concept of working capital

An organization needs not only the fixed assets but also the current assets. Working capital is
nothing but the capital needed to run day to day operations of a business such as wages, freight,
raw materials, etc. If all these expenses, which are to be incurred on short term or day to day
basis are put together it is called working capital.
There are gross working capital (GWC e two concepts of working capital: gross concept and net
concept, or) and net working capital (NWC).Gross working capital or gross concept of working
capital refers to the total current assets, that is, total of cash, accounts receivable, inventories,
prepaid expenses and short term investments.
GWC and TCA are therefore synonymous. Current assets are those assets, which can normally
be converted into cash within an operating cycle or an accounting year. Fixed assets have a life
of greater than a year. The net concept of working capital or net working capital is simply an
excess of current assets over current liabilities (NWC=CA-CL). Current liabilities are those
claims of outsiders, which are expected to matures for payment within an accounting year, and
include sundry creditors, bank overdraft, short-term loan, proposed dividends, taxes payable, and
outstanding expenses. The net working capital may be positive or negative. It is positive if current
assets are greater than current liabilities and it is negative if current liabilities are than current
assets.
The need for net concept of WC is due to the fact that gross concept fails to consider CL. Working
capital management is concerned with the problems that arise in attempting to manage the
current assets, the current liabilities and the inter relationship that exist between them.
Working capital is a broader term and there are chances of misunderstanding it. Both the
concepts are of equal value. Gross concept emphasizes that investment in current assets should
be adequate, not more or not less, to the needs of the business firm. Excessive investment in
current assets affects profitability ass idle investment yields nothing. Similarly, inadequate
investment in current assets makes it difficult to carry out the day to day operation of the business
smoothly. It also threatens the solvency position of the business.
The need for net working capital arises due to the fact that short term creditors want an
enterprise to maintain current assets at a higher level as compared to current liabilities. It shows
the extent of protection provided to short term liabilities. The current ratio of 2:1 and quick ratio
of 1:1 are considered being the appropriate standards but they are simply the conventional rules
or rules of thumb. The quality of current assets is more important than the current ratio of 2:1.
The illiquid firm finds it difficult to borrow from outside.
In fact, the choice of a particular concept will depend upon the propose in view. Of the two
concepts the net is more useful, if the purpose is to be find out the liquidity position of an
enterprise. If, on the other hand, the interest lies in finding out whether the total current assets of
an enterprise are being put to maximum use the gross concept is more preferable.
The concept of zero working capital
In todays world of intense competition, working capital management is receiving increasing
attention from managers. In fact, the goal of many leading companies today is zero working
capital. Proponents of the zero working capital concept claims that a movement toward this goal
not only generates cash but also speeds up production and helps businesses make more timely
deliveries and operate more efficiently. The concept has its own definition of working capital:

Inventories + Receivables payables. The rational here is that inventories and receivables are the
keys to making sales, but that inventories can be financed by suppliers. The idea is to reduce
investment in working capital. Reducing working capital forces a company to increasing
turnover. Reducing working capital forces a company to produce and deliver faster than its
competitors. As inventories disappear, warehouses can be sold off, both labor and handling
equipment needs are reduced, and obsolete and or out- of style goods are minimized. The most
important factor in moving zero working capital is increased speed. The production process has to
be fast. Achieving zero working capital requires that every order and part move at maximum
speed. Clearly, it is not possible for most firms to achieve zero working capital and infinitely
efficient production. Still, a focus on minimizing receivables and inventories while maximizing
payable will help a firm lower its investment in working capital and achieve financial and
production economies.
The working capital cash flow cycle or cash conversion cycle
Cash conversion cycle measures the length of time the firm has funds tied up in working capital.
It is the length of time between when the company makes payments and when it receives cash
payment. In other words, it is the length of time between paying for raw materials and receiving
cash from the sale of finished goods. The cash conversion cycle or cash conversion period is
inventory conversion period plus receivables conversion period minus payable deferral period.
The cycle consists of the following periods.
Cash conversion period= Inventory conversion period + Receivable
Conversion period payable deferral
Period.
We now turn attention to computation of cash conversion cycle.
Inventory conversion period (ICP): It is length of time required to convert raw materials into
finished goods and then to sell these goods. It may be computed as under.
ICP = 360 X Inventory
Sales
Inventory conversion period is simply 360 days divided by inventory turnover. If sales are Rs.
18 million and average inventories are Rs. 3 million, than inventory conversion period would be
60 days.
On average, it requires 60 days to convert taw materials into finished goods and then to sell
these goods.
Receivables conversion period (RCP): It is the length of time required to convert the firms
receivables into cash, that is, to collect cash following a sale. It is also called the days sales
outstanding (DSO).
RCP: 360 X Receivables
Sales
If receivables are Rs. 2 million, receivable conversion period is 40 days. On average, it requires
40 days to convert the firms receivable into cash. Receivables conversion period is simply 360
divided by receivables turnover. The sum of receivables ad inventory conversion periods is also
known as operating cycle.

Payable deferral period (PDP): It is the length of time between the purchase of raw materials and
labor and the payment of cash for them. The firm might have on average 30 days to pay for labor
and materials. In that case, payable deferral period is 30 days. In other words, it simply 360 days
divided by payables turnover. It means it can be computed by dividing accounts payable by sales
per day by sales per day. Suppose that the company has payables for Rs. 1.5 million, other
information remaining the same, what is the payables deferral period?
PDP = Accounts payable
Sales per day
PDP = Rs. 1.5 million
Rs. 18 mil/360

= 30 days.

Cash conversion period/Cycle (CCC) ; We may now compute cash conversion cycle as under;
CCC = ICP + RCP PDP
= 60 + 40 30
= 70 days.
Dividend policy
Dividend policy determines the division of earnings between payments to stockholders and
reinvestment in the firm. Retained earnings are one of the most significant sources of funds for
financing corporate growth, but dividends constitute the cash flow that accrues to stockholders.
Dividend payments
The companies generally do not increase level of dividends to shareholders unless it is sure that
it can be maintained in the future as well. A firms cash flows and investment needs are too
volatile for it to set a very high regular dividend. In such a case, the directors can set a relatively
low regular dividend low enough that it can be maintained even in low profit years or in years
when a considerable amount of reinvestment in needed and supplement it with an extra
dividend in years when excess funds are available.
Payments procedure
There are some actual dividend payment procedures, which the firms normally follow. The
outline of the payment sequence is as under.
Declaration date: This is the date of the Board of Directors` Meeting when regular dividend is
declared. If the directors meet, say, on October 15 and declare the regular dividend on this date,
the date is known as declaration date. The company also declares holder of the record date,
ex dividend date, and payment date.
Holder of record date: If this date is not stated, then there will be confusion as to whether
new or old shareholder should receive dividend because shares keep on trading in the market. If
the holder of record date is set as November 15, then we should understand that it is a date of
making a list of shareholders who are entitled to receive dividends. On this date,

Ex Dividend Date: In this case, the ex- dividend date is four days prior to November 15, or
November 11. It means any sale or purchase of stocks
Should be informed to the company 4 days before holder of date.
Payment date: On this date the company actually pays the dividends or mails the cheques to the
stockholders. If this date is set as December 2, the payment will be mailed on this date.
Factor influence dividend policy
Legal rules: The legal rules provide that dividends must be paid from earnings either from the
current years earnings or from past years earnings as reflected in the balance sheet account
retained earnings. If there are no earnings, then dividends cannot be paid.
Liquidity position: The distribution of dividends depends upon the liquidity position. If the
liquidity position of the company is bad, it may not be able to pay cash dividends. It will try to
retain earnings into the business to improve its liquidity position.
Restriction in debt contracts: There may be various restrictions in the debt contracts such as (1)
future dividends can be paid only out of earnings generated after the signing of the loan
agreement (2) that dividend cannot be paid when net working capital is below a specified amount.
Similarly, preferred stock agreements generally state that no cash dividends can be paid on the
common stock until all accrued preferred dividends have been paid. If there are such types of
restrictions, the firm is bound to follow conservative dividend policy.
Need to repay loan: If the firm has a need to repay the debt, it will not be able pay higher
dividends. If it pays dividends then it will not be able to repay loan.
Rate of asset expansion: If the rate of asset expansion or growth is high, the firm would retain
more earnings into the business thus following a conservative dividend policy. It is because the
more rapidly a firm grows, the greater would be its needs for financing asset expansion. If it pays
out dividends in such cases, the firm is required to raise funds externally.
Profit rate: If profit rate is increasing in the company, the firm may follow liberal dividend
policy, other things remaining the same. On the other hand, if profit rate is declining, the firm is
forced to follow conservative dividend policy.
Stability of earnings: Along with the rate of profit, stability of profit is also equally important.
The firm can raise dividend payment only if earnings are stable. The firms with stable earnings
are likely to pay higher dividends.
Access to the capital markets: If the firm has a good access to capital market, it can follow a
liberal dividend policy. It may distribute higher dividends because if a good project emerges in
the very neat future, the firm can raise the required capital from the market. Thus, a wellestablished firm is likely to have a higher dividend payout rate than is a new or small firm.
Control: If the shareholders are not willing to loose their control or ownership, the firm follows
conservative dividend policy. It will try to rely on internal financing if the profitable project
emerges. It is because raising funds by selling additional common stock dilutes the control
reduces the dividend payout.

Tax position of stockholders: The dividend policy also depends upon the tax position of the
shareholders. If the firm is closely held by a few shareholders in high income tax brackets, then it
is likely to pay a relatively low dividend. On the other hand, if the firm is very large and its stocks
are widely held, the firm might prefer a high dividend payout.
Types of dividend payout schemes:
Stable rupee amount per share: It refers to the payment of rupee of dividends. The
firms following this policy attempts to stabilize the payment of stable rupee amount per
share over a period of time.
Constant payout ratio: Many firms do not follow this type of policy that is, paying out a
constant percentage of earnings. As per this scheme, rupee amount of dividends fluctuate
with earnings.
Low regular dividend plus extras: This policy is the compromise the two policies
mentioned above. Here, the firm attempts to pay a low dividends but on regular basis. If
the firm has good earnings in some years, it pays extra dividends. This policy thus gives
the firm flexibility in payments of dividends.
Dividends as a residual:
We know that each period the company must decide whether to retain its earnings or to
distribute part or all of them to stockholders as cash dividends. The firm may treat dividend
policy as a residual decision.
It
means to say that if the firm has retained earnings left over after financing all acceptable
investment opportunities, these earnings then will be distributed to stockholders in the form of
cash dividends. If nothing is left after financing, there will be no dividends. It is also known as
treating dividend policy as a financing decision.
If the dividend policy is treated as a financing decision, the payment cash dividend becomes a
passive residual. The amount payout will fluctuate from period in keeping with fluctuations in the
amount of acceptable investment opportunities. If these opportunities are more than after tax
earnings, the dividend payment may be zero. On the other hand, if the firm has no profitable
investment opportunities, dividend payout will be 100 percent. For situations between these two
extremes, the payout will fluctuate between zero and one.
The treatment of dividend policy as a passive residual implies that dividends are irrelevant. If
investment opportunities of the company promise a higher return higher than shareholders
required return, the shareholders are happy to see the company retaining earnings. A residual
theory of dividend policy does not necessarily mean that dividends need fluctuate from period to
period in keeping with fluctuations in investment opportunities. A firm may smooth out actual
payments by saving some funds in surplus years, in anticipation of deficit years.
Modigliani and Miller (MM) position
MM`s 1961 article is the most comprehensive argument for dividend policy. They made a
comprehensive argument for irrelevance of dividends. According to them, given the investment
decision of the firm, the dividend are simply residual decisions. It does hot affect the wealth of
shareholders. MM argue that the value of the firm is determined by the earning power of the firms
assets or its investment policy and that the manner in which the earnings stream is split between
dividends and retained earnings does not affect this value. The critical assumptions are : (a)
perfect capital markets in which all investors are rational. Information available to all no cost,
instantaneous transactions without cost, infinitely divisible securities, and no investor is large
enough to affect the market price of a security (b) an absence of floatation costs on securities

issued by the firm, (c) a world of no taxes, (d) a given investment policy for the firm, not subject
to change, and (e)perfect certainty by every, investor as to future investments and profits of the
firm, MM drop this assumptions later Van Horne and Wachowicz.
According to MM, the effect of dividend payments on shareholders wealth is offset exactly by
other means of financing. MM suggest that the sum of the discounted value per share after
financing and dividends paid is equal to the market value per share before the payment of
dividends. The stocks decline in market price because of external financing offsets exactly by the
payment of the dividend. Thus, the stockholder is said to be indifferent between dividends and the
retained earnings and subsequent capital gains.
Irrelevance under uncertainty
The dividend payout would be a matter of irrelevance even with uncertainty in a world of perfect
capital markets and the absence of taxation. If dividends are less than desired, investors can sell
portions of their stock to obtain the desired cash distribution. If dividends are more than desired,
investors can use dividends to purchase additional shares in the company. Thus, investors are able
to manufacture homemade dividends. Because investors can manufacture homemade
dividends, which are perfect substitutes for corporate dividends, dividend policy is irrelevant. As
a result, one dividend policy is as good as the next. The firm is unable to create value simply by
altering the mix of dividends and retained earnings.
Share Repurchase
In recent years, the repurchase of share by corporpation has grown dramatically. Stock
repurchase often is used as part of an overall corporate restructuring. There are three methods of
repurchasing the shares by the company. (a) a fixed price tender offer, (b) a Dutch auction tender
offer and (c) open market repurchases. With a fixed price tender offer, the company makes a
formal offer to stockholders to purchase so many shares, typically, at a set price. This bid price is
above the current market price, stockholders can elect either to ell their stock at the specified
price or continue to hold it. Typically, the tender offer period is between two and three weeks. In
general, the transaction costs to the firm in making a tender offer are much higher than those
incurred in the purchase of stock in the open market.
With a dutch auction tender offer, each shareholder is given the opportunity to the submit to the
company the number of shares he or she is willing to sell at a particular price. In advance, the
company specifies the number of shares it wishes to repurchase as well as a minimum and a
maximum price it will entertain. Typically, the minimum price is slightly above the current
market price. It then determines the lowest price that will result in the full repurchase of shares
specified.
Unlike a fixed price tender offer, the company does not know the eventual repurchase price. The
dutch auction tender offer has recently become popular means of repurchase, sometimes
exceeding the number of fixed price tender offers in a given year. Larger companies tend to use
the dutch auction, versus the fixed price tender offer more than smaller companies do.
In open market purchase, a company buys its stock as any other investor does through a
brokerage house. Usually, the brokerage fee is negotiated. If the repurchase program is gradual,
its effect is to drive up the price of the stock. For these reasons, the tender offer is more suitable
when the company seeks a large amount of stock.
Stock dividend and Stock splits
Stock dividends

A stock dividend simply is the payment of additional stock holders. With stock dividend, a
stockholders proportional ownership remains unchanged. If Mr. A has 100 shares, and if 10%
stock dividend is declared, after stock dividend Mr. A will have 110 shares. Earning per share and
market price per share would also decrease after stock dividends. Stock dividend represents
nothing more than a recapitalization of the company.
Thus, the stock dividend doesnot represent a thing a value. We merely have an additional stock
certificate evidencing ownership. We may sometimes take the stock dividend as a windfall gain.
We can sell them and still retain original share holdings. There is a favorable psychological effect
only. In efficient markets, we would not expect a favorable impact of stock dividend on share
price. However we may point out some of the advantage and disadvantage of stock dividends as
under:
Advantage
(a) Conservation of cash
(b) Tax benefit as stock dividend is not taxable.
(c) Sometimes only means to pay dividends under financial difficulties.
(d) To keep market price of a share within popular trading range.
(e) Favorable psychological effect.
Disadvantages
(a) Costly to administer.
(b) Stock dividend does not affect shareholders wealth. Many people fail to realize it.
(c) Stock dividend simply represents a division of a corporate pie into a number of share
certificates. It divides ownership into a large number of share certificates, nothing more.
Stock Splits
With a stock split, the number of shares is increased through a proportionate reduction in the
par value of the stock. Suppose, the capital structure of Nepal Brick Industries before a 2 to 1
stock split was:
Common Stock (Rs. 100 par, 40,000 Shares)
4000000
Additional paid up capital
1000000
Retained earnings
5000000
Shareholders equity
10000000
After the split, the capital structure is
Common stock ( Rs. 50 par, 80000 shares)
4000000
Additional paid up capital
1000000
Retained earnings
5000000
Share holders equity
10000000
With the stock dividend, the par value is not reduced, whereas with the split, it is. As a result,
the common stock, paid up capital, and retained earnings accounts remain unchanged. Except in
accounting treatment, the stock dividend and stock split are very similar. A stock split, however, is
usually reserved for occasions when a company wishes to achieve a substantial reduction in the
marker price per share.
Reverse Stock Splits

Rather than increase the number of shares of stock outstanding, a company may want to reduce
the number. It can accomplish it with a reverse split. In our stock split example before, the firm
may undertake a 1 to 4 reverse split instead of the 2 to 1 stock split. With reverse split, the par
value per share would become Rs. 400, and there would be 10000 shares outstanding. Reverse
stock splits are employed to increase the market price per share when the stock is considered to
be selling at too low a price. If financial difficulty lowers the price drastically below the popular
trading range, it can be increased with a reverse split.
Reverse split has a negative signaling effect. It is an admission by a company that it is in
financial difficulty.
Convertible Securities
A conversion feature is an option that is included as part of a bond or a preferred stock issue and
allows its holder to change the security into a stated number of shares of common stock. The
conversion feature typically the marketability of an issue.
Types of Convertible Securities
Corporate bonds and preferred stock may be convertible into common stock. The most common
type of convertible security is the bond. Convertibles normally have an accompanying call
feature. This feature permits the issuer to retire or encourage conversion of outstanding
convertibles when appropriate.
Convertible Bonds
A convertible bond can be changed into a specified number of shares of common stock. It is
nearly always a debenture an unsecured bond with a call feature. Because the conversion feature
provides the purchase with the possibility of becoming a stockholder on favorable terms,
convertible bonds are generally a less expensive form of financing than similar risk
nonconvertible or straight bonds. The conversion feature adds a degree of speculation to a bon
issue, although the issue still maintains its value as a bond.
Convertible preferred stock
Convertible preferred stock is preferred stock that can be changed into a specified number of
shares of common stock. It can normally be sold with a lower stated dividend than a similar risk
nonconvertible or straight preferred stock. The reason is that the convertible preferred holder is
assured of the fixed dividend payment associated with a preferred stock and also may receive the
appreciation resulting from increases inn the market price of the underlying common stock.
Convertible preferred stock behaves much like convertible bond.
Stock Purchase Warrants
A stock purchase warrant gives the holder the right to purchase a certain number of shares of
common stock at a specified price over a certain period of time. Of course, holders of warrants
earn no income from them until the warrants are exercised or sold. Warrants also bear some
similarity to convertibles in that they provide for the injection of additional equity capital into the
firm at some future date.
Basic Characteristics

Warrants are often attached to debt issue as sweeteners. When a firm makes a large bond issue,
the attachment of stock purchase warrants may add to the marketability of the issue and lower the
required interest rate. As sweeteners, warrants are similar to conversion features. Often, when a
new firm is raising its initial capital, suppliers of debt will require warrants to permit them to
share in whatever success the firm achieves. In addition, established companies sometimes offer
warrants with debt to compensate for risk and thereby lower the interest rate and provide for
fewer restrictive covenants.
Options
In the most general sense, an option can be viewed as an instrument that provides its holder with
an opportunity to purchase or sell a specified asset at a stated price on or before a set expiration
date. Options are probably the most popular type of derivative security. Today, the interest in
options centers on options on common stock. The development of organized options exchanges
has created markets in which to trade these options, which themselves are securities. Three basic
forms of options are rights, warrants, and calls and puts.
Rights
The right allows common stockholders to maintain their proportionate ownership in the
corporation when new shares are issued. It allows existing shareholders to maintain voting
control and protects them against the dilution of their ownership. Dilution of ownership usually
results in the dilution of earnings, because each present shareholder has a claim on a smaller part
of the firms earnings than previously.
In a rights offering, the firm grants rights to its shareholders. These financial instruments
permit stockholders to purchase additional shares at a price below the market price, in direct
proportion to their number of owned shares. Rights are used primarily by smaller corporations
whose shares are either closely owned or publicly owned and not actively traded. In these
situations, rights are an important financing tool without which shareholders would run the risk of
losing their proportionate control of the corporation. From the firms viewpoint, the use of rights
offering to raise new equity capital may be less costly and may generate more interest than a
public offering of stock.
Warrants
Explain in earlier.
Calls and puts
The two most types of options are calls and puts. A call option is an option to purchase a specified
number of shares of a stock (Typically 100) on or before a specified future date at a stated price.
Call options usually have initial lives of 1 to 9 month, occasionally 1 year. The striking price is
the price at which the holder of the option can buy the stock at any time prior to the options
expiration date; it is generally set at or near the prevailing market price of the stock at the time the
option is issued. For example, if a firms stock is currently selling for 50 per share, a call option on
the stock initiated today will probably have a striking price set at 50 per share. One most pay a
specified price (normally a few hundred rupees) to purchase a call option.
A put option is an option to sell a specified number of shares of a stock (typically 100) on or
before a specified future date at a stated striking price. Like the call option, the striking price of
the put is set close of puts are similar to those of calls.
Options Markets
There are two ways of making options transactions. The first involves making a transaction
through on of 20 or so call and put options dealers with the help of a stockbroker. The other,
popular mechanism is the organized options exchanges. The dominant exchange is the Chicago
board options exchange (CBOE) which was established in 1973. Other exchanges on which

options are trade include the American Stock Exchange, the Philadelphia Stock Exchange, and
the Pacific Stock Exchange. The options traded on these exchanges are standardized and thus are
considered registered securities. Each option is for 100 shares of the underlying stock. The price
at which options transactions can be made is determined by the forces of supply and demand.
The Role Of Call and Put Options in Fund Raising
Although call and put options are extremely popular investment vehicles, they play no direct role
in the fund raising activities of the financial manager. These options are issued by investors, not
business. They are not a source of financing to the firm. Corporate pension managers, whose job
it is to invest and manage corporate pension funds, may use call and put options as part of their
investment activities to earn a return or to protect of lock in returns already earned on securities.
The presence of options trading in the firms stock could by increasing trading activity stabilize
the firms share price in the marketplace, but the financial manager has no direct control over this.
Buyers of options have neither any say in the firms management not any voting rights; only
stockholders are given these privileges. Despites the popularity of call and put options as an
investment vehicle, the financial manager has very little need to deal with them, especially as part
of fund raising activities.