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Unit11
Unit11
Structure
WorkingCapitalManagement
Introduction ComponentsofCurrentAssetsandCurrentLiabilities ConceptsofWorkingCapital ObjectiveofWorkingCapitalManagement NeedforworkingCapital OperatingCycle DeterminantsofWorkingCapital EstimationofWorkingCapital Summary TerminalQuestions AnswertoSAQsandTQs
11.1
Introduction
SoundworkingCapitalManagementhasbecomeanecessityinaneraofinformationtechnology foracompanytosucceed.ThebestexampletosupportthisargumentistheperformanceofDell computersasreportedinoneoftherecentFortunearticle. AperusalofthearticlewillgiveusaninsightintohowDellcouldusetechnologyforimprovingthe performanceofcomponentsofworkingcapital. 1. Use of internet as a tool for reducing costs of linking manufacturer with their suppliers and dealers. 2. Outsourcinganoperationsifthefirmscorecompetencedoesnotpermittheperformanceof theoperationeffectively. 3. Traintheemployeestoacceptchange. 4. Introductionofinternetbusiness 5. Releasing Capital by reduction in investment in inventory for improving the profitability of operatingcapital. Afinancialmangerspendsalargepartofhistimeinmanagingworkingcapital. Therearetwoimportantelementsofworkingcapitalmanagement.
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1. Decisionsontheamountofcurrentassetstobeheldbyafirmforefficientoperationsofits business. 2. Decisionsonfinancingworkingcapitalrequirement. Inadequacy or mismanagement of Working Capital is the leading cause of many business failures. Working Capital is that portion of asset of a business which are used in current operations. They are used in the operating cycle of the firm. It is defined as the excess of CurrentAssetsoverCurrentLiabilitiesandprovisions.
11.2
ComponentsofCurrentAssetsandCurrentLiabilities
1)Inventories 2)SundryDebtors3)BillsReceivables
11.2.1 CurrentAssetsare:
4)CashandBankBalances5)Shortterminvestments 6) Advances such as advances for purchase of raw materials, components and consumablestores,prepaidexpensesetc. 11.2.2 CurrentLiabilitiesare: 1)SundryCreditors2)BillsPayable3)Creditorsforoutstandingexpenses 4)Provisionfortax5)Otherprovisionsagainsttheliabilitiespayablewithinaperiodof 12months. Working Capital Management is concerned with managing the different components of current assets and current liabilities. A firm must have adequate Working Capital neither excess nor shortage.MaintainingadequateWorkingCapitalatthesatisfactoryleveliscrucialformaintaining thecompetitivenessofafirm. Anylapseofafirmonthisaccountmayleadafirmtothestateofinsolvency.
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SelfAssessmentQuestions1 1. Maintaining adequate working capital at the satisfactory level is crucial for ______________the_____________ofafirm. 2. Prepaidexpensesare____________. 3. Provisionfortaxis______________. 4. Afirmmust___________________neitherexcessnorshortage.
11.3
ConceptsofWorkingCapital
TherearetwoimportantconceptsofWorkingCapitalgrossandnet Gross Working Capital: Gross Working Capital refers to the amounts invested in the various componentsofcurrentassets.Thisconcepthasthefollowingpracticalrelevance. a. ManagementofcurrentassetsisthecrucialaspectofWorkingCapitalManagement. b. Itisanimportantcomponentofoperatingcapital.Therefore,forimprovingtheprofitabilityon itsinvestmentafinancemanagerofacompanymustgivetopprioritytoefficientmanagement ofcurrentassets. c. The need to plan and monitor the utilization of funds of a firm demands working capital managementasappliedtocurrentassets. d. Ithelpsinthefixationofvariousareasoffinancialresponsibility.
NetWorkingCapital NetWorkingCapitalis theexcessof current assets over currentliabilitiesand provisions. Net Working Capital is positive. when current assets exceed current liabilities and negative when currentliabilitiesexceedcurrentassets.Thisconcepthasthefollowingpracticalrelevance. 1. Itindicatestheabilityofthefirmtoeffectivelyusethespontaneousfinanceinmanagingthe firmsWorkingCapitalrequirements. 2. A firms short term solvency is measured through the net Working Capital position it commands.
PermanentWorkingCapital PermanentWorkingCapitalistheminimumamountofinvestmentrequiredtobemadeincurrent assetsatalltimestocarryonthedaytodayoperationoffirmsbusiness.Thisminimumlevelof currentassethasbeengiven thename of corecurrentassetsby the Tandon Committee. It is alsoknownasfixedWorkingCapital.
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TemporaryWorkingCapital It is also known as Variable Working Capital orfluctuating Working Capital. The firms working capital requirementsvary depending upon theseasonaland cyclical changesindemandsfor a firms products. The extra Working Capital required as per the changing production and sales levelsofafirmisknownasTemporaryWorkingCapital.
11.4 ObjectiveofWorkingCapitalManagement Thebasicobjectiveoffinancialmanagementismaximizingthenetwealthofshareholders.Afirm mustearnsufficientreturnsfromitsoperationstoensuretherealizationofthisobjective.There exists a positive correlation between sales and firms return on its investment. The amount of earnings that a firm earns dependsupon the volume of sales achieved. There is the need to ensure adequate investment in current assets, keeping pace with accelerating sales volume. Firmsmakesalesoncredit.Thereisalwaysatimegapbetweensaleofgoodsoncreditandthe realizationofproceedsofsalesfromthefirmscustomers.Financemangerofafirmisrequired to finance the operation during this time gap. Therefore, objective of Working Capital Managementisto ensure smoothfunctioning ofthenormalbusiness operationsofafirm. The firmhastodecideontheamountofWorkingCapitaltobeemployed. The firm may have a conservative policy of holding large quantum of current assets to ensure largermarketshareandtopreventthecompetitorsfromsnatchinganymarketfortheirproducts. Butsuchapolicywillaffectthefirmsreturnonitsinvestment.Thefirmwillhavehigherthanthe requiredamountofinvestmentincurrentasset.Thisexcessfundslockedincurrentassetswill reducethefirmsprofitabilityonoperatingcapital. Ontheotherhandafirmmayhaveanaggressivepolicyofdependingonspontaneousfinanceto the maximum extent. Credit obtained by a firm from its suppliers is known as spontaneous finance.Hereafirmwilltrytoreduceitsinvestmentsincurrentassetsasmuchaspossiblebut withoutaffectingthefirmsabilitytomeetworkingcapitalneedsforsalesgrowthtargets.Sucha policy will ensure higher return on its investment as the firm will not be locking in any excess
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fundsin currentassets. However,anyerror inforecasting canaffect the operationsof thefirm unfavorablyiftheerrorisfraughtwiththedownsiderisk.Thereisalsoanotherriskoffirmlosing onmaintainingitsliquidityposition. Objective of working capital management is achieving a trade off between liquidity and profitability ofoperationsforthesmoothconductofnormalbusinessoperationsofthefirm.
SelfAssessmentsQuestions3 1. Objective of working capital management is achieving a trade off between ______ and ________. 2.Creditobtainedbyfirmfromitssuppliersisknowas_________. 3. An aggressive policy of working capital management means depending on ____________________tothemaximumextent. 4.Topreventthecompetitorsfromsnatchinganymarketfortheirproductsthefirmmayhavea ________________policyofholding__________ofcurrentassets.
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Thetimegapbetweenacquisitionofresourcesandcollectionofcashfromcustomersisknownas theoperatingcycle.Thesefivephasesoccuronacontinuousbasis.Thereisnosynchronization between the activities in operating cycle. Cashout flows occur before the occurrences of cash inflows in operating cycle cash out flows are certain. On the other hand cash in flows are uncertain because of uncertainty associated.With effecting salesasper the salesforecastand ultimatetimelycollectionofamountduefromthecustomerstowhomthefirmhassolditsgoods. Sincecashinflowsdonotmatchwithcashoutflows,firmhastoinvestinvariouscurrentassets toensuresmoothconductofdaytodaybusinessoperations.Therefore,thefirmhastoassess the operating cycle time of its operation for providing adequately for its working capital requirements. Operatingcycle=ICperiod+RCperiod ICperiod=Inventoryconversionperiod RCperiod=Receivablesconversionperiod Inventory conversion period is the average length of time required to produce and sell the product.
Accountspayablesperiodisalsoknownaspayablesdeferralperiod. 3. Accountspayablesperiod= (Payablesdeferralperiod) Purchasesperday Averagecreditors purchasesperday =TotalPurchasesforyear 365 Receivablesconversionperiodistheaveragelengthoftimerequiredtoconvertthefirms receivablesintocash.
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Example: ThefollowingdetailsareavailableforXYZLtdfortheyearended31.03.08 Sales Costofgoods 80,000 56,000 Inventory 31.03.07 31.03.08 AccountsReceivables 31.03.07 31.03.08 AccountsPayable 31.03.07 31.03.08 7,000 10,000 12,000 16,000 9,000 12,000
X365
X365
=68.4days
AverageAccountsReceivables
ReceivablesConversionPeriod=
X365
Annualsales
(12000+16000)/2x365 80000
=63.9days
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AverageAccountsPayables
ReceivablesConversionPeriod=
(7000+10000)/2x365 56000
AnnualCostofgoodssold
X365
=63.9days
8500x365 56000
=55.4days
OperatingCycle=ICP+RCP =68.4+63.9=132.3days CashConversioncycle =OCPDP =132.355.4=76.9days The Cash conversion cycle shows the time interval over which additional non spontaneous sourcesofworkingcapitalfinancingmustbeobtainedtocarryoutfirmsactivities.Anincreasein the length of operating cycle, without a corresponding increase in payables deferral period, increasesthecashconversioncycle.Anyincreaseincashconversioncycleleadstoadditional workingcapitalneedsofthefirm.
SelfAssessmentQuestion5 1. The time gap between acquisition of resources from suppliers and collection of cash from customersisknownas______. 2.__________istheaveragelengthoftimerequiredtoproduceandselltheproduct. 3. ______________ is the average lenth of time required to concept the firms receivables into cash. 4. _______________ is conversion cycle is the length of time between firms actual cash expenditureanditsownreceipt.
11.7 DeterminantsofWorkingCapital A large numberof factors influence Working Capital needs of a firm. The basic objective of a firmsWorkingCapitalmanagementistoensurethatthefirmhasadequateworkingcapitalforits operations,neithertoomuchnottoolittle.Investingheavilyincurrentassetswilldrainthefirms earningsandinadequateinvestmentincurrentassetswillreducethefirmscredibilityasitaffects
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the firms liquidity. Therefore, the need to strike a balance between liquidity and profitability cannotbeignored.Thefollowingfactorsdetermineafirmsworkingcapitalrequirements. 1. Natureofbusiness:WorkingCapitalrequirementsarebasicallyinfluencedbythenatureof businessofthefirm.Tradingorganizationsareforcedtocarrylargestocksoffinishedgoods, accounts receivables and accounts payables. Public utilities require lesser investment in workingcapital. 2. SizeofBusinessOperation:Sizeismeasuredintermsofascaleofoperation.Afirmwith largescaleofoperationnormallyrequiresmoreWorkingCapitalthanafirmwithalowscaleof operation. 3. Manufacturing Cycle: Capital intensive industries with longer manufacturing process will havehigherrequirementsofWorkingCapitalbecauseoftheneedtoruntheirsophisticated andlongproductionprocess. 4. ProductsPolicy:Productionscheduleofafirminfluencestheinvestmentsininventories.A firm,exposedtoseasonalchangesindemandwhenfollowingasteadyproductionpolicywill havetofacethecostsandrisksassociatedwithinventoryaccumulationduringtheoffseason periods. On the other hand a firm with a variable production policy will be facing different dimensions of management of working capital. Such afirmmay have to effectively handle problem of production planning and control associated with utilization of installed plant capacityunderconditionsofvaryingvolumesofproductionofproductsofseasonaldemand. 5. Volumeofsales:Thereisapositivedirectcorrelationbetweenthevolumeofsalesandthe sizeofworkingcapitalofafirm. 6. Term of Purchase and Sales: Afirm which allows liberal credit to its customers willneed more working capital than thatof afirm with strict creditpolicy. A firm whichenjoysliberal creditfacilitiesfromitssuppliersrequiresloweramountofworkingcapitalwhencomparedtoa firmwhichdoesnothavesuchafacility. 7. Operating efficiency: The firm with high efficiency in operation can bring down the total investmentinworkingcapitaltolowerlevels.Hereeffectiveutilizationofresourceshelpsthe firminbringingdowntheinvestmentinworkingcapital. 8. Price levelchanges: Inflation affects the working capital levelsin afirm. To maintain the operating efficiency under an inflationary set upa firm should examine the maintenance of working capital position under constant price level. The financial capital maintenance demands afirm to maintainhigheramountof working capital keeping pace with risingprice levels. Under inflationary conditions same levels of inventory will require increased
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investment.Theabilityofafirmtoreviseitsproductspriceswithrisingpricelevelswilldecide theadditionalinvestmenttobemadetomaintaintheworkingcapitalintact. 9. BusinessCycle: Duringboom,salesriseasbusinessexpands.Depressionismarkedbya decline in sale. During boom, expansion of business can be achieved only by augmenting investmentinvariousassetsthatconstituteworkingcapitalofafirm.Whenthereadeclinein business on account of depression in economy, inventory glut forces a firm to maintain workingcapitalatalevelfarinexcessoftherequirementsundernormalconditions. 10. Processing technology: Longer the manufacturing cycle the larger the investment in working capital when raw materialpasses through several stagesintheproductionprocess workinprocessinventorywillincreasecorrespondingly. 11. Fluctuationsinthesupplyofrawmaterials: Companieswhichuserawmaterialsavailable onlyfromoneortwosourcesareforcedtomaintainbufferstockofrawmaterialstomeetthe requirementsofuncertaintyinleadtime Suchfirmsnormallycarrymoreinventorythanitwouldhave,hadthematerialsbeenavailable innormalmarketconditions.
SelfAssessmentQuestions6 1.Capitalintensiveindustriesrequired___amountofworkingcapital. 2. There is a _______________between volume of sales and the size of working capital of a firm. 3.Underinflationingconditionssamelevelofinventorywillrequire____________investmentin workingcapital 4.Longerthemanufacturingcyclethe_theinvestmentinworkingcapital.
11.8 EstimationofWorkingCapital Thebestapproachtoestimateisbasedonoperatingcycle.Therefore,thetwocomponentsof working capital are current assets and current liabilities. This approach is based on the assumption that production and sales occur on a continuous basis and all costs occur accordingly. EstimationofCurrentAssets. 1. Rawmaterialsinventory:Averageinvestmentinrawmaterialisestimated. 2. Averageinvestmentinworkinprogressinventoryisestimated. 3. Averageinvestmentinfinishedgoodsinventoryisestimated.
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4. Average investment in receivables (i,e both in debtors and bills receivables) is estimated basedoncreditpolicythatthefirmwishestopursue. 5. Basedonthefirmsattitudetowardsrisk,accesstoborrowingsources,pastexperienceand natureofbusiness,firmsdecideonthepolicyofmaintainingtheminimumcashbalances.
EstimationofCurrentLiabilities: 1. Trade Creditors: Based on production budget, raw material consumption, credit period enjoyedfromsuppliersaverageamountoffinancingavailabletothefirmisestimated. 2. Directwages: Based onproductionbudget,direct labour cost perunit,average timelagin paymentofwagesestimationismadeontotalwagestobepaidonanaveragebasis. 3. Overheads: Based on production budget, overhead cost per unit and average timelag in paymentofoverheadanestimationonanaveragebasisoftheamountoutstandingtobepaid tocreditorsforoverhead.
Example:AProformacostsheetofacompanyprovidesthefollowingdata CostsperUnit RawMaterial DirectLabout Overheads TotalCost Profit SellingPrice 19.50 39.00 110.50 19.50 130.00 52.00
Thefollowingadditionalinformationisavailable: a. Averagerawmaterialinstock:Onemonth b. Averagematerialsinprocess:Halfamonth c. CreditallowedbySuppliers:Onemonth d. Creditallowedtodebtors:Twomonths e. Timelaginpaymentofwages:oneandahalfweeks f. Timelaginpaymentofoverheadsonemonth g. Onefourthofsalesoncashbasis h. CashbalanceexpectedtobemaintainedisRs.1,20,000 Youarerequiredtoprepareastatementshowingtheworkingcapitalrequiredtofinancealevelof activityof70,000unitsofoutput.Youmayassume thatproductioniscarriedonevenlythrough
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out the year and wages and overheads occur similarly. Assume 360 days in a year (MBA adapted) Solution: EstimationofWorkingCapital a. Investmentininventory 1. Rawmaterial RMC = 70000x52
XRMCP
X30=303333.33
= 70000x110.5
XWIPCP
360
X15=322291.67
3603601270208.33
XFGCP
XDCP
360
X60=966875.00
c. Cashbalance d. TotalcurrentAsset(A+B+C) e. CurrentLiabilities 1. Creditors PurchaseofrawmaterialsxPDP 360 70000x52x30=303333.33 360 2. Wages 70000x19.5x10=37916.67 360 3. Overheads 70000x39x30=227500.00 360
120000 2357083.33
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f. TotalCurrentLiabilities568750.00 g. NetworkingCapital(DF)1788958.33
Examples2:ThefollowingannualfiguresrelatetoXYZ: Sales(attwomonthscredit) Materialsconsumed (Suppliersextendtwomonthscredit) 900000 WagesPaid(monthlyinarrears) Manufacturingexpensesoutstanding attheendoftheyear (Cashexpensesarepaidone monthinarrears) Totaladministrativeexpenses paid,asabove Salespromotionexpenses, Paidquarterlyinadvance 120000 240000 80000 720000 3600000
Thecompanysellsitsproductsongrossprofitof25%countingdepreciationaspartofthecostof production. It keeps one months stock each of raw materials and finished goods, and a cash balanceofRs.100000. Assumea20percentsafetymargin.Calculatetheworkingcapitalrequirementsofthecompany oncashcostbasis.Ignoreworkinprocess. [CAFinalAdapted]
Solution WorkingNotes: Computationofmanufacturingexpenses Sales Less:grossprofitat25% Totalmanufacturingcost Less:Materials900000 Wages720000 1620000 3600000 900000 2700000
Manufacturingexpenses
1080000
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Cashmanufacturingexpenses Depreciation:
960000
Totalmanufacturingexpenses Cashmanufacturingexpenses 1080000960000=Rs.120000 Totalcashcost Totalmanufacturingcost Less:Depreciation Cashmanufacturingcost Totalmanufacturingexpenses SalesPromotionexpenses Totalcashcost 2700000 120000 2580000 240000 120000 2940000
Statementofworkingcapitalrequiredcurrentassets:
RawMaterialsstock MaterialCost 12 Finishedgoodsstock Cashmanufacturingcost x 1 12 2580000x=215000 Debtors: Totalcashcostofsalesx2/12 =2940000x2/12= Salespromotionexpenses =120000x1/4 Cashrequired (A)TotalAssets CurrentLiabilities 100000 910000 490000 30000 90000x1=75000
X1
12
SundryCreditors MaterialCost 12
X2
90000x2=150000 12
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Wagesoutstanding=720000x1/12=60000 Manufacturingexpensesoutstanding=80000 Totaladministrativeexpenses Outstanding 240000/12= (B)TotalcurrentLiabilities WorkingCapital AB Add20%safetymargin WorkingCapitalrequired 600000 120000 720000 20000 310000
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SelfAssessmentQuestions2 1. Grossworkingcapital 2. Plan,utilizationoffundsofafirmworkingcapitalmanagementasapplied. 3. Positive 4. Fixed SelfAssessmentQuestions3 1. Liquidity,Profitability. 2. Spontaneousfinance. 3. Spontaneousfinance. 4. Conservative,Largequantum. SelfAssessmentQuestions4 1.Operatingcycle 2.Salesofgoodsoncredit,realizationofmoneyfromcustomers. SelfAssessmentQuestions5 1. Operatingcycle 2. Inventoryconversionperiod 3. Receivables conversionperiod 4. CashConversioncycle SelfAssessmentQuestions6 1. Higher 2. Positivedirectcorrelation. 3. Increased 4. Larger SelfAssessmentQuestions7 1. Operatingcycle 2. Continuousbases AnswerforTerminalQuestions 1. Refertounit11.2 2. Refertounit11.3 3. Refertounit11.4 4. Refertounit11.6
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