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There exists two concepts of working capital, namely gross concept and net
concept. According to gross concept, working capital refers to current assets, viz. cash,
marketable securities, inventories of raw material, work-in-process, finished goods and
receivables. According to net concept, working capital refers to the difference between
current assets and current liabilities. Working capital can be classified into fixed or
permanent and variable or fluctuating parts. The minimum level of investment in current
assets regularly employed in business is called fixed or permanent working capital and
the extra working capital needed to support the changing business activities is called
variable or fluctuating working capital. Working capital management is concerned with
all aspects of managing current assets and current liabilities.
(i) Managing Investment in current assets: Determination of appropriate level of
investment in current assets is the first and foremost responsibility of working capital
manager. Although the amount of investment in any current asset ordinarily varies from
day-to-day, the average amount or level over a period of time can be used in determining
the fluctuating and permanent investment in current assets. This distinction is of great
importance in devising appropriate financing strategies. Besides the level of investment,
the type of current assets to be held are equally important decision variables. There is a
very large number of alternative levels of investment in each type of current asset.
Therefore, in principle, current asset investment is a problem of evaluating a large
number of mutually exclusive investment opportunities.
(ii) Financing of working capital: Another important dimension of working capital
management is determining the mix of finance for working capital which may be a
combination of spontaneous, short-term and long term sources. Spontaneous sources of
financing consist of trade credit and other accounts payable that arise spontaneously in
the firms day-to-day operations, such as purchase of raw materials and supplies. In
addition to trade credit, wages and salaries payable, accrued interest and accrued taxes
also provide the firm with valuable sources of spontaneous financing. Thus the credit
which arises in conjunction with the day-to-day operations of the firm provide
spontaneous source of financing of working capital. Bills payable, short term bank loans,
inter corporate loans, commercial paper are the most common examples of short term
sources of working capital finance. Term loans, debentures, equity and retained earnings
constitute long-term sources of working capital finance.
(iii) Inter-relatedness : Inter-relatedness is the most distinguishing characteristic of
working capital decisions. The desired level of inventory over a period and sales could
not be made without considering the implications for accounts receivable. Moreover
increased sales and collections for the firm is likely to mean that lower average cash
balances will be needed or that a new cash management system would be desirable.
If sales increase, an increase in inventory will be financed spontaneously with trade
credit. The amount of trade credit financing will depend on decisions regarding
payments. Inventory decisions are thus linked to trade credit decisions. Thus working
capital managers have to pay attention to the inter related nature of current assets and
current liabilities and take into account major interactions that influence the working
capital investment and financing decisions.
(iv) Volatility and Reversibility: Another significant feature of the working capital
management is that the amount of money invested in current assets can change rapidly,
and so does the financing required. The level of investment in current assets is influenced
by a variety of factors, which may be as erratic as labor unrest or flooding of the plant.
Seasonal and cyclical fluctuations in demand are a common cause of rapid changes in
investment in current assets and the financing required. Related to volatility is the
reversibility feature of current assets and current liabilities, which means that the cash
flow related to these could be readily reversed.
return on invested funds. The risk return trade off involves an increased risk of illiquidity
versus increased profitability.
Theoratically, NPV rules developed for the firms investment decisions would
apply to investment in current assets. But in practice, in view of certain unique
characteristics of current assets, two useful modifications of NPV are followed as
decision criteria in working capital decisions. They are Average Net Profit per period and
Total cost. We can use net profit per period as a criterion for choosing among alternative
reversible investments. The investment with the highest value of net profit per period is
also the investment with the highest net present value, regardless of when the investment
is reversed. Investments with positive NPVs will have positive net profits, investments
with zero NPVs will have zero net profits and investments with negative NPVs will have
negative profit. Thus, net profit per period instead of NPV can be used as a decision
criterion for working capital management.
Many current asset decisions, particularly inventory decisions can be made on the
basis of minimizing cost. There also instead of minimizing the net present value of costs,
one may minimize the total annual cost where the annual capital cost of the investment is
the discount rate times the amount invested. In sum, the current assets may be treated as
reversible and investment policies may be selected that maximize net profit or minimize
total cost per period. The choice between the profit or cost criterion will of course depend
on the particular problem being analysed.
HEDGING PRINCIPLE
A principle which can be used as a guide to firms working capital financing
decisions is the hedging principle or matching principle. Simply speaking, the hedging
principle involves matching the cash flow generating characteristics of an asset with the
maturity of the source of financing used to finance its acquisition. For example, a
seasonal expansion in inventories, according to the hedging principle should be financed
with a short term loan or current liability. The rationale underlying the rule is straight
forward. Funds are needed for a limited period of time, and when that time has passed,
the cash needed to repay the loan will be generated by the sale of extra inventory items.
Obtaining the needed funds from a long term source (longer than one year) would mean
that the firm would still have the funds after the inventories (they helped finance) have
been sold. In this case the firm would have excess liquidity which they either hold in cash
or invest in low yielding marketable securities until the seasonal increase in inventories
occurs again and the funds are needed. This would result in an over all lowering of firm
profits.
To put it very succinctly, the hedging principle states that the firms assets not
financed by spontaneous sources should be financed in accordance with the rule:
permanent assets (including permanent working capital needs) financed with long term
sources and temporary assets (viz. fluctuating working capital need) with short term
sources of finance to ward of the liquidity risk. In practice, several modifications of the
strict hedging principle such as conservative financing strategy and the aggressive
financing strategy are followed by the firms at different times. The hedging principle
provides an important guide regarding the appropriate use of short term credit for
working capital financing.
In conservative financing strategy, the firm follows a more cautious plan, whereby
long-term sources of financing exceed permanent assets in trough period such that excess
cash is available (which must be invested in marketable securities). Note that the firm
actually has excess liquidity during the low ebb of its asset cycle and thus faces a lower
risk of being caught short of cash than a firm that follows the pure hedging approach.
However, the firm also increases its investment in relatively low-yielding assets such that
its return on investment is diminished.
In aggressive financing strategy, the firm continually finances a part of its
permanent asset needs with short term funds and thus follows a more aggressive strategy
in managing its working capital. It can be seen that even when its investment in asst
needs is lowest the firm must still rely on short term financing. Such a firm would be
subjected to increased risks of a cash short fall in that it must depend on a continual
rollover or replacement of its short term debt with more short term debt. The benefit
derived from following such a policy relates to the possible savings resulting from the use
of lower cost short-term debt as opposed to long-term debt.
RATIOS
Working capital management is concerned with maintaining an
adequate amount of working capital by proper balance of current assets vis-vis non current assets in the asset structure and a reasonable mix of shot
term and long term sources in the financial structure of the firm. Ratio
analysis can be used by management as a tool to verify the level and
composition of working capital held by management in the business as against
its operations, the extent of liquidity present in its asset structure as well
as financial structure and the efficiency with which working capital is being
used in the business. In the other words, management can employ ratios to
analyze three facets of working capital management namely efficiency,
liquidity and its structural health.
Net Sales
--------------------------------Average Net Working Capital
This ratio indicates the rate of working capital utilization in the firm. A
higher ratio of a firm when compared with that of an industry average
indicates that the amount of working capital in this firm is less than that
required by its operations i.e., sales. So the firm may have to go for
additional working capital that can be supplied to it by its owners through
reinvestment of earnings or can be obtained by selling additional shares or
debentures. Likewise if this ratio is lower than the industry average, it
indicates that the investment in net working capital is more than what is
required. This calls for either withdrawing excess amount or increasing the
sales in the market so that the relationship between the amount of working
capital financed by long term sources and sales is reasonable.
Net working capital turnover ratio can also be analyzed over a period
of five to seven years. An increasing ratio indicates that working capital has
been used more intensively over a period of time. A decreasing ratio is
indicative of relative inefficiency in the use of working capital. A variant of
this ratio is current asset turnover ratio which is cost of goods sold to
average current asset. Generally a higher ratio is considered an indicator of
better efficiency and a lower one the opposite.
EFFICIENCY OF WORKING CAPITAL ELEMENTS
Inventory constitutes an important part of the total working capital.
In actual practice, many firms face serious problems due to slow moving, out
dated inventory. But if too much amount is invested in this for too long, it
poses a serious threat to the profitability as well as solvency of the concern.
Inventory turnover ratio reflects the efficiency with which inventory is
being managed in the concern.
Total Sales
--------------------Average Receivables
CASH EFFICIENCY
Cash is considered an idle asset as it does not earn any return.
Therefore, a balance has to be struck between too much and too less an
amount of cash that a concern should have. In fact, it should be just
adequate to the needs of the concern. Efficient management of cash
requires that there should be proper relationship between cash needs of the
concern to the average balance of cash held by it during the year. This is
expressed by cash turnover ratio.
However no conclusions can be drawn if this ratio deviates from the selected
standards of comparisons.
PAYABLES EFFICIENCY
Accounts payable constitute an important source to provide
spontaneous working capital finance for the firm. To what extent
management is able to use it properly is an important area worth probing.
Payables turnover ratio expresses the number of times account payables are
converted into purchases by management during the year.
Annual purchases
-------------------Average payables
This ratio indicates the rate of utilization of raw material. A higher turnover
ratio over a period of time indicates its increasing utilization. But too high a
ratio may indicate that proportionately less raw materials were held in order
to carry out the production which may be quite risky.
Work-in-process inventory =
turnover
If the finished goods are turned over faster, the amount of locked up funds
would be less; otherwise, it will be more. Finished goods inventory turnover
ratio attempts to capture this aspect.
Current ratio =
Current assets
------------------Current liabilities
This ratio indicates the extent to which short term creditors are safe in
terms of liquidity of the current assets. Thus, higher the value of the
current ratio, more liquid the firm is and more ability it has to pay its bills. A
low value of current ratio means that the firm may find it difficult to pay
the bills. However, a current ratio of 2:1 is considered generally
satisfactory. It indicates that in the worst situation even if the value of
current assets go down by half, management would still be able to repay the
debts and meet its obligations. Thus it represents the cushion that creditors
have to protect themselves against any adverse liquid position. A relatively
very high ratio indicates slackness of management practices as reflected in
excessive holding of current assets. On the other hand, a low ratio indicates
an inadequate margin of safety between the current resources and short
term obligations.
This ratio gives clues about the liquidity of working capital. Quick asset is
defined as current assets minus inventory. Among the various elements of
working capital, inventory is relatively less liquid and hence deducted from
total current assets to give the value of quick assets in the firm. Quick
liabilities are the same as current liabilities. An acid test ratio of 1:1 is
considered satisfactory.
Cash Ratio =
This ratio is the most rigorous test of the liquidity position of the business
unit. This ratio is a stricter one to measure the liquidity position as only cash
and marketable securities have been taken into account. Thus cash ratio
measures the absolute liquidity of the business.
the operations are in fact the revenues earned from operations (as also non-operating
incomes) less all immediate costs of goods sold requiring use of funds. In other words, it
is net income or profit after taxes plus all the non-cash expenses, such as depreciation and
amortisation.
External Sources : External sources of funds are resources raised form outside the
organization to augment funds availability for any of the uses. Normally there are two
ways of doing this: by contributing or raising additional capital and by increased long
term borrowing. Short-term creditors are not included as a source of funds since we have
already defined funds as current assets less current liabilities. Thus working capital
represents long term investment in current assets and hence short term borrowing will not
increase working capital. The sources of funds, as usually presented in the fund flow
statement are given below:
Sources of Funds
Operations:
Net Profit after taxes
Add: Depreciation
Other amortizations
Funds provided by operations
New issue of share capital
New issue of debentures/bonds
Additional long-term borrowing
Sale proceeds of fixed assets
Sale of long term investments
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If the trading or business operations are unsuccessful, they may use funds rather than
provide funds. The uses of funds, as they are usually presented in the fund flow
statement, are given below:
Uses of Funds
Dividends
Non-operating losses not passed through P & L account
Redemption of redeemable preference share capital
Repayment of debentures/bonds
Repayment of long term loans
Purchase of fixed assets
Purchase of long-term-investment
Increase in working capital
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BALANCE SHEET
Balance sheet is the most significant financial statement. It indicates the financial
condition or the state of affairs of a business at a particular moment of time. In the
language of accounting, balance sheet communicates information about assets, liabilities
and owners equity for a business firm as on a specific date. It provides a snapshot of the
financial position of the firm at the close of the firms accounting period.
ASSETS
Assets, representing economic resources are the valuable possessions owned by the firm.
Assets are the future benefits. They represent: (a) stored purchasing power (e.g. cash), (b)
money claims (e.g. receivables, stock) and (c) tangible and intangible items that can be
sold or used in the business to generate earnings. Tangible items include land, building,
plant, equipment or stocks of materials and finished goods and all such items which have
physical substance. Intangible items do not have any physical existence, but they have
value to a firm. They include patents, copy rights, trade name or goodwill.
Assets may be classified as: (1) current assets and (2) fixed (long-term) assets.
CURRENT ASSETS
Current assets, sometimes called liquid assets, are those resources of a firm which are
either held in the form of cash or are expected to be converted in cash within the
accounting period or the operating cycle of the business. Current assets include cash,
tradable (marketable) securities, book debts (accounts receivables) and stock of raw
material, work-in-process and finished goods.
CASH
Cash is the most liquid current asset. It is the current purchasing power in the hands of a
firm and can be used for the purposes of acquiring resources or paying obligations. Cash
includes actual money in hand and cash deposits in bank account.
MARKETABLE SECURITIES
Marketable securities are temporary, or short-term investments in shares, debentures,
bonds and other securities. These securities are readily marketable and can be converted
into cash within the accounting period. The inter-corporate lending is another popular
short-term investment in India.
ACCOUNTS RECEIVABLE
Accounts receivable are the amounts due from debtors (customers) to whom goods or
services have been sold on credit. These amounts are generally realizable in cash within
the accounting period. All accounts receivable (also called book debts) may not be
realized by the firm. Debts which will never be collected are called bad debts.
BILLS RECEIVABLES
Bills receivables represent the promises made in writing by the debtors to pay definite
sums of money after some specified period of time. Bills are written by the firm and
become effective when accepted by the debtors. A firm may discount its bills receivables
with a bank and realize cash immediately. The amount of discount is the banks
commission.
STOCK (or INVENTORY)
Stock or inventory includes raw materials, work-in-process and finished goods in case of
manufacturing firms. A merchandise business may not have raw material and work-inprocess inventories as it has no manufacturing activity.
PREPAID EXPENSES AND ACCRUED INCOMES
Prepaid expenses and accrued incomes are also included incurrent assets. Prepaid
expenses are the expenses of future period paid in advance. Examples of prepaid
expenses are prepaid insurance, prepaid rent or taxes paid in advance. They are current
assets because their benefits will be received within the accounting period. Accrued
incomes are the benefits which the firm has earned, but they have not been received in
cash yet. They include items such as accrued dividend, accrued commission, or accrued
interest.
LOANS AND ADVANCES
Loans and Advances are also included in current assets in India. They include dues from
employees or associates, advances for current supplies and advances against acquisition
of capital assets.
FIXED ASSETS
Fixed or long-term assets are held for periods longer than the accounting period. They are
held for use in business, and not for the purpose of sale. Fixed assets would include longterm investment and all non-current assets.
Tangible fixed assets
Tangible fixed assets include land, building, machinery, equipment, furniture etc. These
are normally recorded at cost. Costs of tangible fixed assets are allocated over their useful
lives. The amount so allocated each year is called depreciation. Costs of tangible fixed
assets are reduced every year by the amount of depreciation. Depreciating an asset is a
process of allocating cost and does not involve any cash outlay.
Intangible fixed assets
Intangible fixed assets represent the firms rights and include patents, copyrights,
franchises, trade-marks, trade names and goodwill. Patents are the exclusive rights
granted by the government enabling the holder to control the use of an invention. Copy
rights are the exclusive rights to reproduce and sell literary, musical and artistic works.
Franchises are the contracts giving exclusive rights to perform certain functions or to sell
certain services or products. Trade marks and trade names are the exclusive rights granted
by the government to use certain names, symbols, labels, designs etc. Goodwill
represents the excessive earning power of a firm due to special advantages that it
possesses. Costs of intangible fixed assets are amortized over their useful lives.
Gross block
Gross block represents the original cost of total fixed assets. When accumulated
depreciation is subtracted from the gross block, the difference is called the net block.
Long-term investments
Long-term investments represent the firms in shares, debentures and bonds of other
firms or government bodies for profits and control. These investments are held for a
period of time greater than the accounting period.
Other non-current assets
Other non-current assets include assets that cannot be included in any of the above
categories. Usually they represent deferred charges. Prepayments for services or benefits
for a period longer than the accounting period are referred to as deferred charges and
include advertising, preliminary expenses etc.
LIABILITIES
Liabilities are debts payable in the future by the firm to its creditors. They represent
economic obligations to pay cash or to provide goods or services in some future period.
Generally, liabilities are created by borrowing money or purchasing goods or services on
credit. Examples of liabilities are creditors, bills payable, wages and salaries payable,
interest payable, taxes payable, bonds, debentures, borrowing from banks and financial
institutions, public deposits etc.
Liabilities are of two types: (1) current liabilities and (2) long-term (fixed) liabilities.
CURRENT LIABILITES
Current liabilities are debts payable within an accounting period. Current assets are
converted into cash to pay current liabilities. Sometimes new current liabilities may be
incurred to liquidate the existing ones. The typical examples of current liabilities are
creditors, bills payable, bank overdraft, tax payable, outstanding expenses and incomes
received in advance.
Sundry creditors or accounts payable
Sundry creditors or accounts payable represent the current liability towards suppliers
from whom the firm has purchased the raw materials on credit.
Bills payable
Bills payable are the promises made in writing by the firm to make payment of a
specified sum to creditors at some specific date. Bills are written by creditors over the
firm and become bills payable once they are accepted by the firm. Bills payable have a
life of less than a year.
Bank borrowings
Bank borrowings form a substantial part of current liabilities. Commercial banks advance
short-term credit to firms for financing their current assets.
Provisions
Provisions are other types of current liabilities. They include provision for taxes and
dividends. Generally, the amount of tax is estimated and shown as provision for taxes or
tax liability. Similarly, provision for paying dividends to shareholders may be created and
shown as current liability.
Expenses payable or outstanding expenses
Expenses payable or outstanding expenses are also current liabilities. The firm may owe
payments to its employees and others at the end of the accounting period for the services
received in the current year. These payments are payable within a very short period.
Examples of outstanding expenses are wages payable, rent payable, or commission
payable.
Income received in advance
Income received in advance is yet another example of current liability. A firm can
sometimes receive income for goods or services to be supplied in future. As goods or
services have to be provided within the accounting period, such receipts are shown as
current liabilities.
Instalments of long-term loans
Instalments of long-term loans are payable periodically. That portion of the long term
loan which is payable in the current year will form part of current liabilities.
Deposits from public
Deposits from public may be raised by a firm for financing its current assets. These may
therefore be classified under current liabilities.
LONG-TERM LIABILITIES
Long-term liabilities are the obligations or debts payable in a period of time greater than
the accounting period. Long-term liabilities usually represent borrowing for a long period
of time. They include debentures, bonds and secured long term loans from banks and
financial institutions.
Debentures or bonds
Debentures or bonds are issued by a firm to the public to raise debt. A debenture or a
bond is a general obligation of the firm to pay interest and return the principal sum as per
the agreement. Loan raised through issue of debentures or bonds may be secured or
unsecured.
Secured loans
Secured loans are the long-term borrowings with fixed assets pledged as security. Term
loans from financial institutions and commercial banks are secured against the assets of
the firm.
EQUITY
The financial interests of the owners are called owners equity. The owners interest is
residual in nature, reflecting the excess of the firms assets over its liabilities. As
liabilities are the claims of outside parties, equity represents owners claim against the
business entity as of the balance sheet date. But the nature of the owners claim is not the
same as that of the creditors. Creditors claims are defined and have to be met within the
specified period. The claim of the owners change and the amount payable to them can be
determined only when the firm is liquidated. Since assets are recorded at cost, there can
be considerable difference between the owners book claim and the real claim.
Initially, owners equity arises on account of the funds invested by them. But it changes
due to the earnings of the firm and their distribution. The firms earnings (or losses) do
not effect the creditors claims. Owners equity will increase when the firm makes
earnings and retains whole or part. If losses are incurred by the firm, owners claim will
be reduced.
Share capital
In case of a company, owners are called shareholders (or stockholders). Therefore,
owners equity is referred to as shareholders equity of shareholders funds. Shareholders
equity has two parts (i) paid-up share capital and (ii) reserves and surplus (retained
earnings) representing undistributed profits. Paid-up share capital is the amount of funds
directly contributed by the shareholders. If the shareholders are actually required to pay
more than the stated or par value per share, the amount is separately shown as share
premium.
Reserves and surplus
The second part of the owners equity is referred to as retained earnings or reserves and
surplus. The difference between the total earnings to date and the total amount of
dividends to date is reserves and surplus. It represents total undistributed earnings. (The
term deficit is used to represent excess of total dividends over total earnings or losses
incurred by the firm). Undistributed profits (reserve) may be earmarked for some specific
purpose, such as replacement or debenture redemption. Reserves that are not earmarked
are called free reserves.
Net worth
The term net worth is used for the sum of share capital and reserves and surplus, i.e., the
owners equity.
Relationship Between Assets, Liabilities and Owners Equity
Assets are resources of the firm that are acquired from funds provided by outsiders,
known as liabilities and funds provided by owners, known as owners equity. In other
words, assets represent the outsiders and owners investments. The relationship is:
Total Assets (TA) = Total Liabilities (TL) + Owners Equity (OE)
Or
TA TL = OE i.e., owners equity is the firms remaining resources
(assets) after the obligations of outsiders (liabilities) have been taken care of. Thus
changes in assets and liabilities will cause a change in owners equity. Change in owners
equity in the case of companies, will be reflected in retained earnings or reserves and
surplus. The paid-up share capital will not normally decrease in the life time of a
company; but it can increase whenever funds are raised by issuing new shares.
Total Assets (TA) = Net fixed assets (NFA) + Current assets (CA)
Total Liabilities (TL) = Long-term liabilities (LTL) + Current liabilities (CL)
i.e., NFA + CA = LTL + CL + OE
i.e., NFA + (CA CL) = LTL + OE
i.e., NFA + NCA = LTL + OE, NCA net current assets
Net working capital gap
The difference between current assets (CA) and current liabilities (CL) is called net
working capital (NWC) or net current assets (NCA). NWC or NCA is that portion of
current assets that is not financed from current liabilities; therefore, it must necessarily be
financed from long-term funds. Bank credit is an important component of current
liabilities that finances current assets. But it is a current liability that does not arise
directly from the firms operations. Accounts payable and bills payable and various types
of accruals arise spontaneously out of the firms operations and are therefore called
spontaneous current liabilities (SCL). The difference between current assets and
spontaneous current liabilities (that is, current liabilities less bank credit) may be referred
to as net working capital gap (NWCG), or operating capital (OC). NWCG must of
necessity be financed by bank borrowing (BB) and long-term funds.
NFA + CA ( SCL + BB ) = LTL + OE
NFA + NWCG BB = LTL + OE
NFA + NWCG = BB + LTL + OE
Where BB is bank borrowing for financing current assets not covered by spontaneous
current liabilities (SCL).
Capital employed
It may be defined as a net fixed assets plus net current assets
CE = NFA + NCA
Since NFA + NCA = LTL + OE, it implies that capital employed equals long-term funds:
CE = LTL + OE
The alternative definition of capital employed is total interest bearing debt or loan funds
(i.e., long-term debt plus bank borrowing) plus owners equity or shareholders funds (net
worth). From asset side, it means net fixed assets plus net working capital gap:
CE = NFA + NWCG
Since bank borrowing does not arise directly from the operations of the firm, and that it
has to be raised externally at a cost, it is more logical to use the second definition of
capital employed for analytical purposes.