SHORT TERM DECISION MAKING IN

FINANCE

CHAPTER 1: OVERVIEW OF WOKING CAPITAL

MANAGEMENT

WORKING CAPITAL:
It refers to the investment made by the firms in current assets. It is the measure of firm’s
liquidity position. Working capital is a financial metric which represents operating
liquidity available to a business, organisation or other entity, including governmental entity.
Along with fixed assets such as plant and equipment, working capital is considered a part of
operating capital. Gross working capital is equal to current assets. Working capital is
calculated as current assets minus current liabilities. If current assets are less than current
liabilities, an entity has a working capital deficiency, also called a working capital deficit.
A company can be endowed with assets and profitability but short of liquidity if its assets
cannot readily be converted into cash. Positive working capital is required to ensure that a
firm is able to continue its operations and that it has sufficient funds to satisfy both
maturing short-term debt and upcoming operational expenses. The management of working
capital involves managing inventories, accounts receivable and payable, and cash.
CONCEPTS OF WORKING CAPITAL:

There are two concepts of working capital

a) Balance sheet concept
b) Operating cycle or circular flow concept

a) Balance sheet concept:

There are two interpretations of working capital under the balance sheet concept:

Gross working capital: in the broader sense, the term working capital refers to the gross
working capital and represents the amount of funds invested in current assets. Thus gross
working capital is the capital invested in total current assets of the enterprise.
It enables the enterprise to provide correct amount of working capital at the right time.
The gross concept takes into consideration the fact that every increase in the funds of the
enterprise would increase its working capital.

Net working capital: it is the excess of current assets over current liabilities.
Net working capital = current assets – current liabilities
It is a qualitative concept which indicates the firm’s ability to meet its operating expenses and
short term liabilities.
It is an indicator of the financial soundness of an enterprise.

b) Operating cycle concept:

The circular flow concept of working capital is based upon the working capital cycle of the
firm. The cycle starts with the purchase of raw materials and other resources and ends with
the realisation of cash from the sale of finished goods. It involves purchase of raw material
and stores, its conversion into stock of finished goods through work in progress with
progressive increscent of labour and service costs, conversion of finished stock into sales,
debtors and receivables and ultimately realisation of cash and this cycle continues again from
cash to purchase of raw materials and so on.

SCOPE OF WORKING CAPITAL

The working capital is needed for the following purposes;

 For the purpose of raw materials, components and spares.
 For the ascertainment of wages and salaries.
 To incur day to day expenses and overhead costs such as fuel, power and
office expenses etc
 To meet the selling costs as packing, advertisements etc
 To provide credit facilities to the consumers.
 To maintain the inventories of raw materials, work in progress, stores and
spares and finished goods.

PRINCIPLES OF WORKING CAPITAL MANAGEMENT:

1) Principle of risk evaluation: risk here refers to the inability of a firm to meet its
obligations as and when they become due for payment. Larger investment in CA with
less dependence on short term borrowings increases liquidity, reduces dependence on
short term borrowings increases liquidity, reduces risk and thereby decreases the
opportunity for gain or loss.
2) Principle of cost of capital: the various sources of raising working capital finance
have different cost of capital and the degree of risk involved. Generally higher the risk
lower is the cost and lower the risk higher is the cost.
3) Principe of equity position: this principle is concerned with planning the total
investment in current assets. According to this principle the amount of working
capital invested in each component should be adequately justified by a firms equity
position. Every rupee invested in the current assets should contribute to the net worth
of the firm.
4) Principle of maturity of payment: this principle is concerned with planning the
sources of finance for working capital. According to this, a firm should make every
effort to relate maturities of payment to its flow of internally generated funds.
Generally shorter the maturity schedule of current liabilities in relation to expected
cash inflows, the greater the inability to meet its obligations in time.
To sum up WCM should be considered as an integral part of overall corporate management.
In the words of Louis Brand, “we need to know when to look for working capital funds, how
to use them and how to measure, plan and control them”.

Working Capital Management

Classification or Kinds of Working Capital:
(a) On the basis of concept
(b) On the basis of time
On the basis of concept, working capital is classified as gross working capital and net
working capital as discussed earlier. This classification is important from the point of view of
the financial manager.

On the basis of time, working capital may be classified as:

1. Permanent or fixed working capital
2. Temporary or variable working capital
Permanent or fixed working capital: It is the minimum amount which is required to ensure
effective utilisation of fixed facilities and for maintaining the circulation of current assets.
There is always a minimum level of current assets which is continuously required by the
enterprise to carry out its normal business operations. This minimum level of current assets is
called permanent or fixed working capital.

Permanent working capital can be further classified into

1. Regular working capital
2. Reserve working capital
Regular working capital: It ensures the circulation of current assets from cash to
inventories, from inventories to receivable and from receivables to cash and so on.

Reserve working capital: It is the excess amount over the requirement for regular working
capital which may be provided for contingencies that may arise at unstated periods such as
strikes, rise in price, depression etc.

Temporary working capital: It is the amount of working capital which is required to meet
the seasonal demands and some special exigencies.

Temporary working can be further classified as:

1. Seasonal working capital
2. Special working capital
Seasonal working capital: It is the amount of working capital required to meet the seasonal
needs of the enterprise.
Special working capital: It is that part of working capital which is required to meet special
exigencies such as launching of extensive marketing campaigns for conducting research etc.
Temporary working capital differs from permanent working capital in the sense that it is
required for short periods and cannot be permanently employed gainfully in the business.
Objectives of working capital:
 To ensure optimum investment in current assets.
 To strike a balance between the twin objectives of liquidity and profitability in the use
of funds
 To ensure adequate flow of funds for current operations
 To speed up the flow of funds or to minimize the stagnation of funds
Need of working capital
Maximisation of shareholders wealth of a firm is possible only when there is sufficient return
from their operations. But profits can be earned will naturally depend, among other things,
upon the magnitude of the sales. In other words, successful sales activity is necessary for
earning profits. Sales do not convert into cash immediately there is invisible time lag between
the sale of goods and receipts of cash. There is therefore a need for working capital. In other
words, sufficient working capital is necessary to sustain sales activity.
Working capital management

Working capital management refers to the management of short term assets. It involves
planning and controlling the level and mix of a firm’s current assets as well as the pattern of
their financing. It is alternatively referred to as current assets management.

SOURCES OF WORKING CAPITAL:

Once the estimation of current asset is over the next step in working capital management is
financing the current assets.
1. Short term financing: Generally current assets should be financed by short term
financial sources. Short term finance is obtained for a period of less than 1 year. The
source of short term finance are loans from bank, short term public deposit,
commercial paper, bills discounting, retention of profit etc..
2. Long term financing: Net current asset or working capital is supposed to be financed
by long term sources of finance. Long term finance is raised for a period of above five
years. It include share capital, preference share capital, debentures, long term loans
from banks etc.. A firm that need to finance net current assets can go for any of these
sources, but it depends on companies attitude towards risk control over the company.
3. Spontaneous financing: It refers to the automatic sources of short term fund arising
in the normal course of a business. The source includes trade credit and outstanding
expenses. Spontaneous sources of finance are available at cost free. A firm that want
to real choice of financing current assets lies between short term and long term
sources.

OPEATING CYCLE- “Operating cycle is the time duration involved in the acquisition of
resources, conversion of raw materials into work- in-process into finished goods, conversion
of finished goods into sales and collection of sales.”
Procurement of inputs, transformation of input into outputs, and distribution of output. The
total time involved in operating cycle can be broken up into the following three constituents:
 Inventory conversion period (ICP):- The total time involved from the procurement of
inputs till the conversion of inputs into outputs is called inventory conversion period.
It consists of three successive stages- raw material conversion period, work in
progress conversion period, and finished goods conversion period.
 Receivable/ debtors conversion period (RCP):- Time lag in converting credit sales
into cash is called receivable conversion period. It depends on the credit period
 offered to customers and collection efforts of the firm. It is alternatively referred to as
accounts receivable conversion period.
 Payable deferral period (PDP):- The period for which the firm can defer its payments
is referred to as payables deferred period. The longer the period, the lesser would be
the firm’s need to seek working capital financing from external sources.

Operating cycle can be subdivided into the gross operating cycle and net operating cycle. The
gross operating cycle refers to the total time involved from the procurement of inputs to the
realization of cash on account of sales. It can be referred as an equation of:
GOC=ICP+RCP
The net operating cycle (NOC) implies the net time for which the working capital need to be
arranged. It ignores the period for which the firm is able to defer its payables as it is getting
financed indirectly by those deferrals.
NOC=GOC-PDP
NET OPERATING CYCLE:
Net operating cycle is the difference between gross operating cycle and payables deferral
period.
Net operating cycle =Gross operating cycle – Creditors deferral period
Net operating cycle is also referred to as cash conversion cycle. Some people argue that
depreciation and profit should be excluded in the computation of cash conversion cycle since
the firms concern is with cash flows associated with conversion at cost; depreciation is a non-
cash item and profits are not costs.
IMPORTANCE OR ADVANTAGES OF ADEQUATE WORKING CAPITAL:
Working capital is the life blood and nerve centre of a business. Just as circulation of
blood is essential in the human body for maintaining life, working capital is very essential to
maintain the smooth running of a business. No business can run successfully without an
adequate amount of working capital.
The main advantages of maintaining adequate amount of working capital are as follows:
1. Solvency of the business: Adequate working capital helps in maintaining solvency of the
business by providing uninterrupted flow of production
2. Goodwill: Sufficient working capital enables a business concern to make prompt payments
and hence helps in creating and maintain goodwill.
3. Easy loans: A concern having adequate having adequate working capital, high solvency
and good credit standing can arrange loans from banks and others on easy and favourable
terms.
4. Cash discounts: Adequate working capital also enables a concern to avail cash discounts
on the purchases and hence it reduces costs.
5. Regular supply of raw materials: Sufficient working capital ensures regular supply of
raw materials and continuous production.
6. Regular payments of salaries, wages and other day-to-day commitments: A company
which has ample working capital can make regular payments of salaries, wages and other
day-to-day commitments which raises the morale of its employees, increases their efficiency,
reduces wastages and costs and enhances production and profits.
7. Exploitation of favourable market conditions: Only concerns with adequate working
capital can exploit favourable market conditions such as purchasing its requirements in bulk
when the prices are lower and by holding its inventories for higher prices
8. Ability to face crisis: Adequate working capital enables a concern to business crisis in
emergencies such as depression because during such periods, generally, there is much
pressure on working capital.
9. Quick and regular return on investments: Every investor wants a quick and regular
return on his investments. Sufficiency of working capital enables a concern to pay quick and
regular dividends to its investors as there may not be much pressure to plough profits. This
gains the confidence of its investors and creates a favourable market to raise additional funds
in the future,
10. High morale: Adequacy of working capital creates an environment of security ,
confidence, high morale and creates overall efficiency in a business.
EXCESS OR INADEQUATE WORKING CAPITAL:
Every business concern should have adequate working capital to run its business operations.
It should have either redundant or excess working capital nor inadequate or shortage of
working capital.
Disadvantages of Excessive Working Capital:
1. Excessive working capital means idle funds which earn no profits for the business and
hence the business cannot earn a proper rate of return on its investments.
2. When there is a redundant working capital, it may lead to unnecessary purchasing and
accumulation of inventories causing more chances of theft, waste and losses.
3. Excessive working capital implies excessive debtors and defective credit policy which may
cause higher incidence of bad debts.
4. It may result into overall inefficiency in the organization.
5. When there is excessive working capital, relations with banks and other financial
institutions may not be maintained.
6. Due to low rate of return on investments, the values of shares may also fall.
7. The redundant working capital gives rise to speculative transactions.
Disadvantages or Dangers of Inadequate Working Capital:
1. A concern which has inadequate working capital cannot pay its short-term liabilities in
time.
2. It cannot buy its requirements in bulk and cannot avail of discounts, etc.
3. Its becomes difficult for the firm to exploit favourable market conditions and undertake
profitable projects due to lack of working capital.
4. The firm cannot pay day-to-day expenses of its operations and it creates inefficiencies,
increases costs and reduces the profits of the business.
5. It becomes impossible to utilise efficiently the fixed assets due to non-availability of liquid
funds.
6. The rate of return on investments also falls with the shortage of working capital.
FACTORS IN DETERMINING WORKING CAPITAL REQUIREMENT
The working capital requirement of a concern depends upon a large number of factors such as
nature and size of business, the character of their operations, the length of production cycles,
the rate of stock turnover and the state of economic situation
However, the following are important factors generally influencing the working capital
requirement of any organisation.
Determinants of working capital
 Nature or character of business:
The working capital requirements of a firm basically depend upon the nature of its
business. Public utility undertakings like electricity, water supply and railways require
small amount of working capital, and the trading and financial firms require relatively
very large amount, whereas manufacturing undertaking require sizable working
capital between these two extremes.

 Size of business/ scale of operations:

The working capital requirement of a concern is directly influenced by the size of its
business which may be measured in terms of scale of operations. Greater size of
business unit, generally larger will be the requirements of working capital.
 Production policy:
In certain industries, the demand is subject to wide fluctuations due to seasonal
variation. The requirement of working capital, in such cases depend upon the
production policy. If the policy is to keep production steady by accumulating
inventories it will require higher working capital.

 Manufacturing process length of production cycle:

In manufacturing business, the requirement of working capital increase in direct
proportion to length of manufacturing process. Longer the process period of
manufacturing, larger amount of working capital required.
 Seasonal variations:
In certain industries, raw material is not available throughout the year. They have to
buy raw material in bulk during the season. a huge amount is thus, blocked in the
form of material inventories during such season. Generally, during the busy seasons, a
firm requires larger working capital than in the slack season.

 Working capital cycle:

In a manufacturing concern, the working capital cycle starts with the purchase of raw
material and ends with the realization of cash from the sale of finished products. The
speed with which the working capital completes one cycle determines the
requirements of working capital longer the period of the cycle larger is the
requirement of working capital.

 Rate of stock turnover:

There is a high degree of inverse co- relationships between the quantum of working
capital and the sales. A firm having a high rate of stock turnover will need lower
amount of working capital as compared to a firm having a low rate of turnover.

 Credit policy:
A concern buying its requirements for cash and allowing credit to its customers, shall
need larger amount of working capital as very huge amount of fund are bound to be
tied up in debtors or bill receivables.

 Business cycle:
Business cycle refers to alternate expansion and contraction in general business
activity. In a period of boom that is when the business is prosperous, there is a need
for larger amount of working capital due to increase in sales, rise in prices optimistic
expansion of business, etc.

 Rate of growth of business;

The working capital requirements of a concern increase with the growth and
expansion of its business activities. Although, it is difficult to determine the
relationship between the growth to the volume of business and the growth in the
working capital of a business.

 Earning capacity and dividend policy:

some firms have more earning capacity than others due to quality of their products,
monopoly conditions etc. such firms with high earning capacity may generate cash
profits from operations and contribute to their working capital. The dividend policy of
a concern also influences the requirements of its working capital.

 Price level changes:

 Changes in the price level also affect the working capital requirement. Generally, the
rising prices will require the firm to maintain larger amount of working capital as
more funds will be required to maintain the same current assets.

 Market and demand conditions:

The working capital needs of a firm are related to its sales. However, it is difficult to
precisely determine the relationship between volume of sales and working capital
needs. Sales depend upon demand conditions. Larger number of firm experience
seasonal and cyclical fluctuations in the demand for their products and services.

 Availability of credit from suppliers:

The working capital requirements of a firm are also affected by credit term granted by
its suppliers. A firm will need ls working capital if liberal Credit terms are available to
it from the suppliers.

 Operating efficiency:
The operating efficiency of the firm relates to the optimum utilization of all its
resources at minimum costs. The efficiency in controlling operating costs and
utilizing fixed and current assets leads to operating efficiency.

 Other factor:
Certain other factors such as operating efficiency, management ability, irregularities
of supply, import policy, asset structure, banking facilities etc. also influence the
requirements of working capital.

WORKING CAPITAL FINANCING POLICIES

A firm can adopt different financing policies vis-à-vis current assets. Three types of financing
may be distinguished as:

 Long term financing: The sources of long- term financing include ordinary share
capital, preference share capital, debentures, long-term borrowings from financial
institutions and reserves and surplus (retained earnings).

 Short-term financing: The short-term financing is obtained for a period less than one
year. It is arranged in advance from banks and other suppliers of short-term finance in
the money market. Short-term finances include working capital funds from banks,
public deposits, commercial paper, factoring of receivables, etc.

 Spontaneous financing: Spontaneous financing refers to the automatic sources of

short-term funds arising in the normal course of a business. Trade (suppliers’) credit
and outstanding expenses are examples of spontaneous financing. There is no explicit
cost of spontaneous financing. A firm is expected to utilize these sources of finance to
the fullest extent. The real choice of financing current assets, once the spontaneous
 sources of financing have been fully utilized, is between the long-term and short-term
sources of finances.

Short-term vs. Long-term financing:

Firm should decide whether or not it should use short-term financing. If short-term financing
has to be used, the firm must determine its portion in total financing.

The decision of the firm will be guided by the risk –return trade-off. Short-term financing
may be preferred over long-term financing for two reasons: (1) the cost advantage and (2)
flexibility. But short-term financing is more risky than long-term financing.
Cost: Short term financing should generally be less costly than long-term financing. It has
been found in developed countries, like USA, that the rate of interest is related to the maturity
of debt. The relationship between the maturity of debt and its cost is called the term structure
of interest rates. The curve, relating to the maturity of debt and interest rates, is called the
yield curve. The Yield curve may assume any shape, but it is generally upward sloping.

This figure indicates that more the maturity greater the interest rate.

As discussed earlier, the justification for the higher cost of long-term financing can be found
in the liquidity preference theory. This theory says that since lenders are risk averse, and risk
generally increases with the length of lending time, most lenders would prefer to make short-
term loans. The only way to induce these lenders to lend for longer periods is to offer them
higher rates of interest.

The cost of financing has an impact on the firm’s return. Both short and long- term
financing have a leveraging effect on shareholders’ return. But the short-term financing ought
to cost less than the long-term financing; therefore, it gives relatively higher return to
shareholders.

It is noticeable that in India short-term loans cost more than long term loans. Banks are the
major suppliers of the working capital finance in India. Their rates of interest on working
capital finance are quite high. The main source of long-term loans is financial institutions
which till recently were not charging interest at differential rates. The prime rate of interest
charged by financial institutional is lower than the rate charged by banks.

Flexibility: It is relatively easy to refund short-term funds when the need for funds
diminishes. Long term funds such as debentures loan or preference capital cannot be refunded
before time. Thus, if a firm anticipates that its requirements for funds will diminish in near
future, it would choose short-term funds.

Risk: Although short-term financing may involve less cost, it is more risky than long-term
financing. If the firm uses short-term financing to finance its current assets, it runs the risk of
renewing borrowings again and again. This is particularly so in the case of permanent assets.
As discussed earlier, permanent current assets refer to the minimum level of current assets
which a firm should always maintain. If the firm finances its permanent current assets with
short-term debt, it will have to raise new short-term funds as debt matures. This continued
financing exposes the firm to certain risks. It may be difficult for the firm to borrow during
stringent credit periods. At times, the firms may be unable to raise any funds and
consequently, its operating activities may be disrupted. In order to avoid failure, the firm may
have to borrow at most inconvenient terms. These problems are much less when the firm
finances with long-term funds. There is less risk of failure when the log-term financing is
used

Risks return trade-off: There is a conflict between long- term and short-term financing.
Short-term financing is less expensive than long-term financing, but, at the same time, short-
term financing involves greater risk than long-term financing. The choice between long-term
and short-term financing involves a trade-off between risk and return.

Depending on the mix of short and long-term financing, the approach followed by a
company may be referred to as / approaches for financing current assets/ Financing mix
of current assets or
Approaches of financing Current Assets
 Matching Approach
 Conservative Approach
 Aggressive Approach

 Matching Approach: The firm can adopt a financial plan which matches the
expected life of assets with the expected life of the source of funds raised to finance
assets. Thus, a ten-year loan may be raised to finance a plant with an expected life of
ten years: stock of goods to be sold in thirty days may be financed with a thirty-day
commercial paper or a bank loan. The justification for the exact matching is that,
since the purpose of financing is to pay for assets, the sources of financing and the
asset should be relinquished simultaneously. Using long-term financing for short-term
assets is expensive as funds will not be utilized for the full period. Similarly,
financing long term assets with short-term financing is costly as well as inconvenient,
 as arrangement for the new short-term financing will have to be made on a continuing
basis.

When the firm follows a matching approach (also known as hedging approach), long-
term financing will be used to finance fixed assets and permanent current assets and
short-term financing to finance temporary or variable current assets. However, it
should be realized that exact matching is not possible because of the uncertainty about
the expected lives of assets.

The firm fixed assets and permanent current assets are financed with long-term funds
and as the level of these assets increases, the long term funds and as the level of these
assets increases, the long-term financing level also increases. The temporary or
variable current assets are financed with short-term funds and as their level increases,
the level of short-term financing also increases. Under a matching plan, no short-term
financing will be used if the firm has a fixed current assets need only.

 Conservative Approach: A firm in practice may adopt a conservative approach in

financing its current its current and fixed assets. The financing policy of the firm is
said to be conservative when it depends more on long –term funds forfinancing needs.
Under a conservative plan, the firm finance its permanent assets and also a part of
temporary current assets with long-term financing. In the period when the firm has no
need for temporary current assets, the idle long-term funds can be invested in the
tradable securities to conserve liquidity. The conservative plan relies heavily on long-
term financing and, therefore, the firm has less risk of facing the problem of shortage
of funds. Note that when the firm has no temporary current assets, the released long-
term funds can be invested in marketable securities to build up the liquidity position
of the firm.

 Aggressive Approach: A firm may be aggressive in financing its assets. An

aggressive policy is said to be followed by the firm when it uses more short-term
financing than warranted by the matching plan. Under an aggressive policy, the
firm finances a part of its permanent current assets with short-term financing.
Some extremely aggressive firms may even finance a part of their fixed assets
with short-term financing. The relatively large use of short –term financing makes
the firm more risky.