Working capital management

Ashalakshmi.R.K
 Working capital
• Funds invested for short period
• Short term capital or circulating capital
• Decisions relating to working capital and short term
financing are referred to as working capital
management.
• Short term financing or financial management?
• Management of Working capital =Management of CA
&CL.
• Current assets<Current liability=Working capital
deficiency/ working capital deficit.
• Working capital management
=
• Cash flow to satisfy both maturing short-term
debt and upcoming operational expenses.
 Purpose of working capital
• Stock of raw material
• Stock of WIP
• Stock of finished goods
• Grant credit
• Hold cash balances
 Need for working capital
• Finance operating cycle
• Time between supply of raw material…………….
…………………………collection of receivables
• Cash----------finished goods
• Finished goods-----------receivables
• Receivables --------------cash
 Operating cycle of a trading firm
1. Conversion of cash into inventory
2. Conversion of inventory into Receivables
3. Conversion of Receivables into Cash

Cash Inventory of Receivables

finished goods
Operating cycle in a manufacturing firm

Inventory of Inventory
Inventory of
Cash raw of finished
WIP
materials goods

Receivables
• “Operating or Cash Cycle” .

• It is defined as “The continuing flow from cash

to suppliers, to inventory , to accounts
receivable & back into cash “.
• Gross operating cycle=R+W+F+D
• Net operating cycle=R+W+F+D-C
 COMPONENTS OF OPERATING CYCLE

• Average raw material storage period

• “ WIP holding period
• “ finished goods storage period
• “ debtors collection period
• “ creditors payment period
• “ time lag in payment of expenses
• No. of operating cycles in a year
 Concepts of Working Capital

• Gross Working Capital

• Net working Capital

 Gross Working Capital
• Total Current assets
• Current assets =Converted into cash within an
accounting year & include cash , debtors etc.
• Referred as “Economics Concept” since assets
are employed for a rate of return
• CA= SHORT LIFESPAN(cash balance), SWIFT
TRANSFORMATION INTO OTHER ASSETS
 NET WORKING CAPITAL
• NWC=CA – CL
• Referred as ‘point of view of an Accountant’.
• It indicates liquidity position of a firm
• Positive or negative

• NWC=GWC-CURRENT LIABILITIES
 CONSTITUENTS OF WORKING CAPITAL

• CURRENT ASSETS
 Inventory
 Sundry Debtors
 Cash and Bank Balances
 Loans and advances
• CURRENT LIABILITIES
 Sundry creditors
 Short term loans
 Provisions
 TYPES OF WORKING CAPITAL

• PERMANENT WORKING CAPITAL

• VARIABLE /TEMPORARY WORKING CAPITAL
• Minimum level of investment in current
assets that is required to continue the
business without interruption
---Permanent /hardcore working capital
• Investment required over and above the minimum
WC to meet seasonal fluctuations in business activity
or other temporary requirements---Temporary
/seasonal working capital
Approaches for financing current assets

• 1.Aggressive approach
• 2.Conservative approach
• 3.Matching/ hedging approach
 Aggressive approach
• Financing:
• Temporary current assets-short term source of
fund
• Portion of permanent current assets-short
term source of fund
• Portion of permanent current assets- long
term source of fund
 Conservative approach
• Financing:
• All permanent current assets-long term source
of funds
• Portion of temporary current assets-long term
source
• Portion of temporary current assets-short
term source
 Matching approach or hedging approach

• Financing:
• Permanent current assets-long term source of
funds
• Temporary current assets- short term source
•
• AA- Lower liquidity , higher profitability
• CA- Higher liquidity , lower profitability
• MA/HA- Moderate liquidity , moderate
profitability
 Factors determining working capital
Nature of business Price level changes
Size of business Operating efficiency
Manufacturing cycle Profit margin
Business cycle Taxation policy
Production policy Depreciation policy
Credit policy Dividend policy
Availability of credit Inventory policy
Growth and expansion activities Conditions of supply
Market conditions
 1.Nature of business
• Small trading concern-
• Large trading firm or departmental stores dealing in
large variety of goods-
• Manufacturing firm-
• Public utilities-
• Hotels ,restaurants and eating houses-
• Financial firms-
• Tobacco firm-
• Construction firms-
 4.Business cycle
Large
Need for requirements
investment in of working
Increase in inventory and capital
demand and receivables
Boom
sales
condition

Recessive Decrease in
condition demand and Need for
Small
sales decrease in
requirement
inventory and
of working
receivables
capital
 Sources of financing working capital
Trade credit Working capital demand loan

Advances from customers Factoring

Discounting bills of exchange Commercial paper

Bank overdraft Cash credit

Bills finance Letter of credit
 1.Trade credit
• Suppliers allow the customers to pay their o/s
balances with in the credit period allowed for
them
• Time -3 to 6 months
• Ready availability
• No issue formalities
Merits : Limitations :

Flexible Supplier charge increased

price

Adjust time of dealings Legal action

No flotation cost
 2.Advance from customers
• Type of goods
• Elasticity of demand
• Creditworthiness of supplier
 3.Discounting bills of exchange
• Term -3 to 6 months
• Before maturity discounting with banks
• “an act of selling of a bill to obtain payment
for it before its maturity”
• Bank charges interest for the same
• Payment not received –dishonour of bill
 4.Bank overdraft
• Over and above the account balance
• Specified limit
• Granted against-assets, personal security
• Charge interest
 5.Cash credit
• Bank is the lender
• Installment lending
• Specified limit-cash credit limit
• Granted against –pledge or hypothecation,
personal security
• Flexibility
• Charge –interest
 6.Letter of credit
• Guarantee provided by bank
• Arrangement between buyer’s bank and
seller’s bank
• Default -bank shall make payment
 7. Bills finance
• Objective:
• Finance actual sales transaction
• Three forms of financing:
• A. Purchase of bills by the bank
• B. Discounting of bills by bank-Usance bills
• C. Advance against bills under collection from
the drawees
 8.Working capital demand loan
• Applicable to borrowers having 10 crore or
more working capital
• Granted for a fixed term
 9.Factoring
• Converting non-productive assets into
productive assets(cash)
• Factor makes conversion
• “a contract between the supplier of
goods/services and the factor ,under which
the factor agrees to perform at least two of
the following functions:-
• Finance the assigned book debts
• Maintain account relating to receivables
• Collect book debt
• Protection against default in payment by
debtors
• Credit administration services
• Factor charges commission
• Ranges between 2.5-3%
• Low commission –recourse factoring
• Parties to factoring:
• Buyer
• Seller
• Factor
 Types of factoring
1.Non recourse factoring(old line factoring)
• Risk of bad debts
• Higher commission
• Advance cash up to 80/90%
• 2.Recourse factoring
• No risk of bad debts
• Lower commission
• Cash up to 70/80%
• 3.Advance factoring-
• Advances cash immediately

• 4.Maturity factoring-
• Payment on maturity
• 5.Finance factoring(bulk/agency)-
• Finance book debt in bulk
• Client administer and operates sales ledger
• 6.Non-notification factoring-
• Notice of assignment of receivables is not
given to the debtors
Advantages Disadvantages

Eliminating trade discounts Image of the client may suffer

Prompt payment and credit Not of much use if companies have many
branches

Improves scope for operating leverage Financial evaluation may not be accurate
Reduction of administrative cost burden If client have cheaper source of finance
and credit factoring is not useful

Increase in return to the client

Improvement in liquidity

It is neither a loan nor a deposit but

facilitates liquidity

Provide insurance against bad debts

 10.Commercial papers

• Short term issuance promissory note

• Issued at discount/interest on face value
• Negotiable by endorsement and delivery
• Highly liquid
 Features
• Short term money market instrument
• Used by corporate enterprise
• Financing working capital requirements
• Fixed maturity value
• Certificate evidencing an unsecured corporate
debt
• Issued at discount /interest on face value
• Promise to pay some fixed amount on future
period
• Issuer does not pledge any asset
• Issued directly by a company to investors or
through banks or merchant bankers
 Eligibility criteria
• Minimum tangible net worth
• Fund based working capital
• Minimum current ratio
• Minimum credit rating
• Classification of account by financial bank
• Age of rating
• Listed requirements
• Issue expenses
 Guidelines for issue of CP
• Minimum maturity -3 months
• Maximum maturity-6 months
• Grace period of maturity-nil
• Denomination-multiple of 10 lakhs
• Minimum -50 lakhs
• Maximum – up to 20% of the issue’s fund
based working capital limit
 UNIT 2
CASH MANAGEMENT
• Planning ,organising, directing and controlling
of cash
• How much to maintain as cash balance?
• How to finance deficit?
• How to invest cash surplus?
 Need for cash
• 1.Transaction motive:
• Hold cash to make routine payments
• 2.Speculative motive:
• Hold cash take advantage of profitable
opportunities
• 3.Precautionary motive:
 Cash planning
• Timings and amount of expected cash inflows
• Timings and amount of expected cash
outflows
• Timings and amount of cash deficit
• Timings and amount of surplus cash
 Cash Budget
• “Statement showing estimated cash inflows ,
cash outflows and the resultant cash balance
over a given budget period”
• Utility of cash budget:
• 1.Helps to determine the timings
• 2.Helps to determine the quantity
• 3.Helps to determine the time period
• 4.Prepare the borrowing schedule
• 5.Prepare repayment schedule in advance
• 6.Plan for dividend payment in advance
• 7.Plan for financing expansion and
modernisation
• 8.Plan for financing new project
• 9.Takes the advantage of cash discount
 Methods of cash forecasting
• a. Receipts and payments method
• b. Adjusted net income method
• Receipts and payment method:
• 1.Ascertain the operating balance
• 2.Identify ,analyze and estimate inflows-
• A. operating inflows
• B. investing cash inflows
• C. Financing inflows
• 3.Identify ,analyze and estimate outflows-
• 4.Estimate deficit /surplus make necessary
arrangements
 Cash management control
• Reason :
• Projected cash flow =actual cash flows
• Objective :
• To accelerate cash collection
• To decelerate disbursement
• Note :Deposit float or collection-amount of
cheque sent by customer
Methods of accelerating cash collection

• 1.Concentration banking:
• System of operating through a number of
collection centers in different regions
• Purpose :
• Minimize the gap between customers sending
and fund available for use
• Functions :
• Collect cheques from customers
• Deposit the collected cheques
• Transfer surplus fund to concentration bank
• Concentration bank: The company has its
major bank account and is usually located at
the head office
• 2.Lock Box System:
• Purpose :eliminate the time gap between the
receipt of cheque and its deposit into the bank
• Playing the float-
• Difference between the total amount of
cheques drawn and the bank balance as per
bank book .
• Period during which cheque issued are expected
to be presented for encashment -float period
Billing float –
• time between the sale and mailing the invoice
to the customer
Mail float-
• time between customer sends cheque and
received by the firm
Cheque processing float-
• time between the cheque is received and
deposited
Banking processing float-
• time between the cheque is deposited and
credited to firm’s account
 Determinants of optimal cash balance

• 1.BAUMOL’S MODEL
• 2.MILLER-ORR MODEL
• Purpose-
• Avoid the situation of excessive and
inadequate cash
 Baumol’s model
• Application :
• Determining optimum cash balance-demand of
cash is certain
• Optimum cash balance:
• Total of carrying cost and transactions cost is
minimum
• Economic lot size:
• Total of transaction costs and carrying cost is
minimum
• ELS:-TTC=TCC
• Factors to be considered:
• 1.Transaction costs:
• Converting the marketable securities into cash
• Situation :
• Firm falls short of cash
• Sell securities resulting in clerical , brokerage,
registration and other costs
• Transaction cost per transaction is assumed to
be constant
• TTC=Total no. of transaction x per transaction
cost
• Inverse relationship between ELS and TC
• Larger LS & Smaller LS
• 2.Holding /carrying /opportunity cost:

• Return foregone on marketable securities/

• Costs for maintaining an average cash balance
• Positive relationship between ELS and holding
costs
• LLS-Higher the HC
• SLS-Lower the HC
• THC= average cash balance x holding cost
• 3.Annual requirements of cash
• Importance –eliminating lot size problem
• “How much marketable securities should be
sold at a particular point of time”?
• Assumptions :
• Constant annual requirements of cash
• Constant rate of demand for cash
• Constant transaction cost
• Constant holding costs
• Zero conversion period
• Economic Lot Size- three methods
• Graphical
• Tabular/trial & error
• Formula method
• Limitations :
• Annual cash requirements may not be
constant
• Rate of demand for cash may not be constant
• Transactions and holding costs may not be
constant
• Conversion period may not be constant
 Miller-Orr Model
• Application :
• Determining the optimum cash balance
• The demand for cash is uncertain
• Control limits:
• Upper limit(h)
• Return point(z)
• Lower limit(o)
• Upper limit:
• Marketable securities are purchased
• Lower limit:
• Marketable securities are sold
• Return point:
• Attained after purchase or sale
 Unit -3

• Capital structure decisions

 Patterns of capital structure
• Capital structure with:
• Equity shares only
• Both equity and preference shares
• Equity shares and debentures

• Equity shares ,preference shares and

debentures
 POINT OF INDIFFERENCE
• (X-I1)(1-T)-PD/S1=(X-I2)(1-T)-PD/S2
• X=point of indifference or breakeven EBIT
level
• I1=interest under alternative 1
• T= tax rate
• PD=preference dividend
• S1 = no.of equity shares /amount of equity
shares under alternative 1