Working Capital

Assets/liabilities required to operate business on

day-to-day basis
CA CL

An increase in working capital indicates that the business has either increased current assets (that is received cash, or other current assets) or has decreased current liabilities, for example has paid off some shortterm creditors.

It measures how much in liquid assets a company has available to build its business.

Working Capital Management

Decisions relating to working capital and short term financing are

referred to as working capital management. Short term financial

management concerned with decisions regarding to CA and CL.
Management of Working capital refers to management of CA as well as

CL.
If current assets are less than current liabilities, an entity has a working

capital deficiency, also called a working capital deficit.

These involve managing the relationship between a firm's short-term

assets and its short-term liabilities.

Concepts of Working Capital

Gross Working Capital

Net working Capital

Gross Working Capital

Total Current assets

Where Current assets are the assets that can be

converted into cash within an accounting year & include cash , debtors etc.

Net Working Capital

CA CL

Referred as point of view of an Accountant.

It indicates liquidity position of a firm & suggests

the extent to which working capital needs may be financed by permanent sources of funds.

TYPES OF WORKING CAPITAL

PERMANENT WORKING CAPITAL

VARIABLE WORKING CAPITAL

Difference between permanent & temporary working capital

Amount of Working Capital

Variable Working Capital

Permanent Working Capital Time

Permanent and temporary working capital for Stable firm

Variable Working Capital Amount of Working Capital Permanent Working Capital

Time Permanent and temporary working capital for Growing firm

CONSTITUENTS OF WORKING CAPITAL

CURRENT ASSETS Inventory Sundry Debtors Cash and Bank Balances Advances CURRENT LIABILITIES Sundry creditors Short term loans Provisions Outstanding Expenses

Determinants of working capital

General nature of business Production cycle Business cycle Credit policy Production policy Growth and expansion Operating efficiency

Working Capital Trade-offs

Inventory
Benefit: Happy customers Few production delays (always have needed parts on hand) Cost: Expensive High storage costs Risk of obsolescence

High Levels

Cost: Shortages Dissatisfied customers Benefit: Low storage costs Less risk of obsolescence

Low Levels

Cash

High Levels
Benefit: Reduces risk Cost: Increases financing costs

Low Levels
Benefit: Reduces financing costs Cost: Increases risk

12

Working Capital Trade-offs

Accounts Receivable
High Levels (favourable credit terms)
Benefit: Happy customers High sales Cost: Expensive High collection costs Increases financing costs

Low Levels (unfavourable terms)

Cost: Dissatisfied customers Lower Sales Benefit: Less expensive

Accounts Payable and Accruals

High Levels Benefit: Reduces need for external finance--using a spontaneous financing source Cost: Unhappy suppliers 13 Low Levels Benefit: Happy suppliers/employees Cost: Not using a spontaneous financing source

Operating or Cash Cycle

1.

2.
3.

Conversion of cash into inventory Conversion of inventory into Receivables Conversion of Receivables into Cash

...begins with acquisition of raw materials and ends with collection of receivables.
Raw Materials WIP

Cash

Operating Cycle in Manufacturing firm

Finished Goods

Debtors

SALES

Operating cycle of Non Manufacturing Firm

Receivables
cash

Stock of finished goods

OPERATING CYCLE
Stages: 1) Raw materials (RM/RM consumption) 2) Work-in-process (WIP/COP) 3) Finished Goods (FG/COS) 4) Receivables (Debtors/Credit sales) Less: Creditors (creditors/purchases)

Formula for calculating Operating cycle for Manufacturing firm COGS + Selling & Distribution + Admin WC Required = Operating Expenses No of Operating Cycle Period in a year No of operating Cycle = No of days in a year / OCP

OCP = R+ WIP + F + D C R = WIP= F D = = Average Stock of Raw Materials Daily Average Consumption Average Stock of WIP Daily Average Factory Cost Average Finished Goods Cost of good sold /365 Average Account Receivable/Debtors Total Credit Sales/365 Average Account Payable/Creditors Total Credit Sales/365
Opening + Purchases Closing Opening WIP + Material , labor, Overheads - Closing WIP Opening FG + Factory Cost - Closing FG

FORECASTING / ESTIMATION OF WORKING CAPITAL REQUIREMENTS PROFORMA - WORKING CAPTIAL ESTIMATES

1. TRADING CONCERN
STATEMENT OF WORKING CAPITAL REQUIREMENTS Amount (Rs.)

Current Assets (i) Cash (ii) Receivables ( For..Months Sales)---(iii) Stocks ( ForMonths Sales)----(iv)Advance Payments if any Less : Current Liabilities (i) Creditors (For.. Months Purchases)(ii) Lag in payment of expenses WORKING CAPITAL ( CA CL ) Add : Provision / Margin for Contingencies

--------------------_ -----

xxx

xxx xxx

NET WORKING CAPITAL REQUIRED

XXX

1. MANUFACTURING CONCERN
STATEMENT OF WORKING CAPITAL REQUIREMENTS Amount (Rs.) Current Assets (i) Stock of R M( for .months consumption) (ii)Work-in-progress (formonths) (a) Raw Materials (b) Direct Labour (c) Overheads (iii) Stock of Finished Goods ( for months sales) (a) Raw Materials (b) Direct Labour (c) Overheads (iv) Sundry Debtors ( for months sales) (a) Raw Materials (b) Direct Labour (c) Overheads (v) Payments in Advance (if any) (iv) Balance of Cash for daily expenses (vii)Any other item Less : Current Liabilities (i) Creditors (For.. Months Purchases) (ii) Lag in payment of expenses (iii) Any other WORKING CAPITAL ( CA CL )xxxx Add : Provision / Margin for Contingencies NET WORKING CAPITAL REQUIRED -----------------------------------------------------

----------------XXX

RM = WIP =

budgeted production * RM Cost /unit * Average inventory holding Period

52/12/365
(R)= budgeted production * RM Cost /unit * Average WIP Period 52/12/365 (L)= budgeted production * Labor Cost /unit * Average WIP Period

52/12/365
(OH )= budgeted production * OH Cost /unit * Average WIP Period 52/12/365 F = (R)= budgeted production * RM Cost /unit * Average Finished goods Period

52/12/365
(L)= budgeted production * Labor Cost /unit * Average Finished goods Period 52/12/365 (OH )= budgeted production * OH Cost /unit * Average Finished goods Period

52/12/365
D = Period C= budgeted production * Total Cost/unit * Average Debtors collection 52/12/365 budgeted production * RM/unit * Average Creditors Period 52/12/365

Working Capital Management

The goal of working capital management is to ensure that the firm is able to

continue its operations and that it has sufficient cash flow to satisfy both maturing short-term debt and upcoming operational expenses.

Businesses face ever increasing pressure on costs and financing requirements

as a result of intensified competition on globalised markets. When trying to attain greater efficiency, it is important not to focus exclusively on income and expense items, but to also take into account the capital structure, whose improvement can free up valuable financial resources

Need for Working Capital

As profits earned depend upon magnitude of

sales and they donot convert into cash instantly, thus there is a need for working capital in the form of CA so as to deal with the problem arising from lack of immediate realisation of cash against goods sold. This is referred to as Operating or Cash Cycle . It is defined as The continuing flow from cash to suppliers, to inventory , to accounts receivable & back into cash .

Need for Working Capital

Thus needs for working capital arises from

cash or operating cycle of a firm. Which refers to length of time required to complete the sequence of events. Thus operating cycle creates the need for working capital & its length in terms of time span required to complete the cycle is the major determinant of the firms working capital needs.

Temporary Current Assets

Temporary current assets are an increase in current assets due to a temporary

event. An example would be seasonal demand for a product. Going back to our previous example, a toy manufacturer experiences a temporary increase in current assets around Christmas. An increase in temporary current assets will likely cause a need for short-term financing. Permanent Current Assets
Permanent current assets are an increase in current assets due to a permanent

increase in levels of accounts receivable and inventory levels. For example, if our toy manufacturer started selling toys to major toy retailer, they would experience a higher level of sales, resulting in a higher accounts receivable and the need for a new permanent level of inventory to meet demand from supplying the new retailer. To finance this increase in current assets the toy manufacturer should obtain long-term financing. The reason they would need long-term financing is the new level of current assets will be permanent (greater than one year). Because the firm has obtained long-term financing for their new permanent level of current assets, they will have more liquidity to meet the seasonal demand. If they obtained short-term financing, the company will likely find themselves short on cash when they need to increase inventory before Christmas.

Working Capital Policy

.1. AGGRESSIVE WORKING CAPITAL POLICY; Low level of investment in current assets More short-term financing is used to finance current assets. Support low level of production & sales Borrowing short-term is considered more risky than borrowing long-term. Firm risk increases, due to the risk of fluctuating interest rates, but the potential for higher returns increases because of the generally low-cost financing. This approach involves the use of short-term debt to finance at least the firm's temporaryassets, some or all of its permanent current assets, and possibly some of its long-term fixed assets. (Heavy reliance on short term debt) The firm has very little net working capital. It is more risky. May be a negative net working capital. It is very risky

2. Conservative policy A large inventory is maintained under the conservative policy and therefore the return is lower than under an aggressive policy. In terms of risk and return, a moderate policy falls somewhere between the two extremes. Under a conservative working capital financing policy, the organizations non-current assets, permanent current assets as well as a part of the fluctuating current assets are financed with permanent financing (equity and long term debt). Therefore the conservative financing policy is the least risky policy but it gives lowest return to the company

CONSERVATIVE WORKING CAPITAL POLICY; high level of investment in current assets support any level of sales and production high liquidity level Avoid short-term financing to reduce risk, but decreases the potential for maximum value creation because of the high cost of longterm debt and equity financing. Borrowing long-term is considered less risky than borrowing short-term. This approach involves the use of long-term debt and equity to finance all long-term fixed assets and permanent assets, in addition to some part of temporary current assets. The firm has a large amount of net working capital. It is a relatively lowrisk position. The safety of conservative approach has a cost. Long-term financing is generally more expensive than short-term financing

3. MODERATE WORKING CAPITAL POLICY This approach tries to balance risk and return concerns. Temporary current assets that are only going to be on the balance sheet for a short time should be financed with short-term debt, current liabilities. And, permanent current assets and long-term fixed assets that are going to be on the balance sheet for a long time should be financed from long-term debt and equity sources. The firm has a moderate amount of net working capital. It is a relatively amount of risk balanced by a relatively moderate amount of expected return. In the real world, each firm must decide on its balance of financing source s and its approach to working capital management based on its particular industry and the firm's risk and return strategy

 Risk and Return of Current Liabilities The goal of the return management process is

to maximize earnings in the context of an acceptable level of risk. Firm's working capital is financed from shortterm borrowing, long-term borrowing, equity financing, or some mixture of all three. The choice of.the firm's working capital financing dep ends on manager's desire for profit versus their degree of risk aversion. The balance between the.risk and return of financing o ptions depends onthe firm, its financial managers,and i

Working Capital Issues

Optimal Amount (Level) of Current Assets Assumptions 50,000 maximum units of production Continuous production Three different policies for current asset levels are possible
Policy A Policy B Policy C

ASSET LEVEL ($)

Current Assets

25,000 OUTPUT (units)

50,000

Impact on Liquidity
Optimal Amount (Level) of Current Assets
Liquidity Analysis Policy Liquidity A High B Average C Low
Policy A Policy B Policy C

ASSET LEVEL ($)

Greater current asset levels generate more liquidity; all other factors held constant.

Current Assets

25,000 OUTPUT (units)

50,000

Impact on Expected Profitability

Optimal Amount (Level) of Current Assets
Return on Investment =
ASSET LEVEL ($) Policy A Policy B Policy C

Net Profit Total Assets Let Current Assets = (Cash + Rec. + Inv.) Return on Investment = Net Profit Current + Fixed Assets

Current Assets

25,000 OUTPUT (units)

50,000

Impact on Expected Profitability

Optimal Amount (Level) of Current Assets Profitability Analysis Policy Profitability A Low B Average C High
As current asset levels decline, total assets will decline and the ROI will rise.
Policy A Policy B Policy C

ASSET LEVEL ($)

Current Assets

25,000 OUTPUT (units)

50,000

Impact on Risk
Optimal Amount (Level) of Current Assets
Decreasing cash reduces

the firms ability to meet its financial obligations. More risk! Stricter credit policies reduce receivables and possibly lose sales and customers. More risk! Lower inventory levels increase stockouts and lost sales. More risk!

ASSET LEVEL ($)

Policy A Policy B Policy C

Current Assets

25,000 OUTPUT (units)

50,000

Impact on Risk
Optimal Amount (Level) of Current Assets Risk Analysis Policy Risk A Low B Average C High
Risk increases as the level of current assets are reduced.
Policy A Policy B Policy C

ASSET LEVEL ($)

Current Assets

25,000 OUTPUT (units)

50,000

 A firm is currently selling a product @ Rs. 10 per

unit. Variable cost Rs. 6 per unit for the given level of 30000 units output. Fixed cost 60000 Rs. Average cost Rs 8 per unit , Average collection period 30 days.
If is contemplating a relaxation in credit policy

average credit period will increase to 45 days , sales will increase by 15 % . required rate of return is 15 %

Present Sales less: VC Contribution less: Fixed Cost Profit Incremental Profit ( A) Total Cost DTO Ratio Average investment in debtors 300000 180000 120000 60000 60000 240000 12 20000

Proposed 345000 207000 138000 60000 78000 18000 267000 8 33375

Additional / Saving Cost

Cost of Additional Investment / Return on Saving ( B) Net profit = A-B

13375
13375 X .15 = 2006.25 15935.75

( Accepted)

 If firm is contemplating to allow 2 % discount for

payment with in 10 days then collection period dropped to 15 days sales will increase by 15 % and 60 % of total sales are on credit

Present Sales less: VC Contribution less: Fixed Cost Profit Incremental Profit ( A) Total Cost DTO Ratio Average investment in debtors 300000 180000 120000 60000 60000 240000 12 20000

Proposed 345000 207000 138000 60000 78000 18000 267000 24 11125

Additional / Saving Cost

Cost of Additional Investment / Return on Saving ( B) Net profit = A+B

8875
8875 X .15 = 1331.25 19331.25

( Accepted)

 If collection period is increased from 45 to 75

days bad debts will increase from 1 % current level to 3 % and sales will increased by 15 %

Present
Sales less: VC Contribution 300000 180000 120000

Proposed
345000 207000 138000

less: Fixed Cost

Profit Incremental Profit ( A) Total Cost

60000
30000 240000

60000
78000 18000 267000

DTO Ratio
Average investment in debtors Additional / Saving Cost Cost of Additional Investment / Return on Saving ( B) Bed Debts Additional Bed debts Net profit = A-B -C

8
30000 -

4.8
55625 25625 25625 X .15 = 3843.75

3000 -

10350 7350 6806.25

( Accepted)

Unit IV

Cash and Liquidity Management Appendix

 Meaning of cash

Motives for Holding cash

objectives of cash management factors affecting level of cash

Dimensions of Cash Management

Cash planning and forecasting

Managing the cash flows

Determining the optimum level of

cash Investing surplus cash

20A-50

The size of the minimum cash balance depends on:

How quickly and cheaply a organization can

raise cash when needed.

How accurately managers can predict cash

requirements.
(Cash Budget helpful)

How much precautionary cash the managers

need for emergencies.

The organizations maximum cash balance depends on:

Available (short-term) investment opportunities e.g. money market funds,, commercial paper Expected return on investment opportunities. e.g. If expected returns are high, organizations should be quick to invest

excess cash
Transaction cost of withdrawing cash and making an investment Demand for Cash for daily transactions

(Cash Budget helpful)

20A-53

20A-54

20A-55

20A-56

20A-57

Example: Baumol Model

Your

firm will have Rs. 5 million in cash expenditures over the next year. The interest rate is 4% and the fixed trading cost is Rs 25 per transaction.
What is the optimal cash balance?

What is the average cash balance?

What is the opportunity cost? What is the shortage cost? What is the total cost?

20A-58

The Miller - Orr Model

The Miller-Orr Model provides a formula for

determining the optimum cash balance (Z), the point at which to sell securities to raise cash (lower limit L) and when to invest excess cash by buying securities and lowering cash holdings (upper limit H).
Depends on: transaction costs of buying or selling securities variability of daily cash (incorporates uncertainty) return on short-term investments

The Miller - Orr Model

Upper Limit Buy Securities

Z
Lower Limit

L
Sell Securities Days of the Month

The Miller-Orr Model - Target Cash Balance (Z)

Z=

3 TC x V 4 r

where: TC = transaction cost of buying or selling securities V = variance of daily cash flows r = daily return on short-term investments Z= spread between upper and lower limit

 Return point = lower limit + spread

Upper limit = lower limit + spread

20A-62

The Miller - Orr Model

Upper Limit Buy Securities

10,000

4000 1000
Lower Limit Sell Securities

Days of the Month

20A-64

20A-65

20A-66