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Topic 01: Working Capital Management & Sources of Finance of Working Capital

Working Capital:

It is capital required for the day- to- day business of the firm.

Current Assets: Assets which can be or will be converted into cash within one year. e.g., Inventories Raw materials & components Work-in-process Finished goods Trade debtors Cash & bank balance Short term loans and advances given

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Current Liabilities: Liabilities which are intended to be paid within one year, out of the current assets or earning of the concern. e.g., Sundry creditors Accounts payables Outstanding expenses Borrowings (short term) Commercial banks

Gross working capital (GWC) GWC refers to the firms total investment in current assets.

Net working capital (NWC) NWC refers to the difference between current assets and current liabilities. It denotes the liquidity position of the firm. NWC can be positive or negative. Positive NWC = CA > CL Negative NWC = CA < CL

Working Capital Management Goal

manage CA and CL of the firms CA

Administration

Financing needed to

support CA.

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Factors influencing working capital requirements

Nature of Business Seasonality of Operations Production Policy Market Conditions Conditions of Supply

Proportions of Current Assets and Fixed Assets

Industries Current Assets (% ) Hotels & Restaurants 1020

Fixed Assets 8090

Electricity Generation and Distribution 2030

Aluminium, Shipping

3040

6070
5060 4050 3040 2030 1020

Iron and Steel, Basic Industrial Chemicals 4050 Tea Plantation Cotton Textiles, Sugar Edible Oils, Tobacco Trading, Construction 5060 6070 7080 8090

Dollars
Total cost of holding current assets Carrying costs

Minimum point

Shortage costs

CA* The optimal amount of current assets. This point minimizes costs.

Amount of current assets (CA)

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Permanent or fixed working

capital A minimum level of current assets, which is continuously required by a firm to carry on its business operations. or variable working capital The extra working capital needed to support the changing production and sales activities of the firm.

Fluctuating

The

policies of working capital financing can be categorized as:

Matching
Conservative Aggressive

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Goods Sold Inve ntory Purchased Inve ntory Pe riod

Cash Received

A/cs receivable period

A/cs payable pe riod

O perating Cycle
Cash Cycle

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Average inventory Inventory period = Average COGS / 365 Average accounts receivable

Accounts receivable period =

Raw materials period =

Av. Raw Material inventory Raw material consumed/ 365

Work in- process inventory Cost of production/ 365

Finished Goods period = Finished goods inventory COGS / 365

Operating Cycle = Inventory Period + Accounts Receivable Period

Cash Cycle

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Practice Problem Following information has been extracted from the financial statements of a manufacturing firm: (RS. in Crore). Compute the Operating Cycle if the information given is for one year. Av. Credit period allowed by suppliers (days) Av. Debtors outstanding Raw material consumed Cost of production Cost of goods sold 60 6 60 145 157.5

Sales
Inventory of raw material Work- in- progress Finished goods

200
5.75 6.75 4.8

Inventory

represents value locked up at both ends of the production system. The definition of inventory is specific to the nature of business. For a typical manufacturing firm inventory comprises of raw material, work-in-process and finished goods.
For

a trading business it refers to the finished goods stock held for sale.

Determining

and maintaining an optimal level of inventory i.e. a level that is neither inadequate nor excessive. management of inventory assumes significance in the light of the magnitude of funds blocked in them.

The

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Optimal

level of inventory involves a trade-off between carrying costs and ordering costs.

At this trade-off

point the total cost is minimum.

This

point is referred to as Economic Ordering Quantity (EOQ)

Carrying Cost The cost of maintaining inventory in a company's warehouse Alternatively referred to as holding cost. They include costs associated with physically carrying inventories, such as - warehouse rent, - insurance of inventory financial cost of funds tied up in the inventory i.e. the opportunity cost of alternative investments.

Ordering

cost The costs that are incurred at the time an order is placed. These costs are periodic and are regardless of the size of the order. Examples cost of processing orders, cost of follow up with the vendors, cost of receiving new shipment, cost incurred on handling the accounts payable invoice.

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The

EOQ model of inventory management provides answer the question How much should be ordered? refers to the lot size of inventory that is most economical to procure and hold.

EOQ

EOQ=

2DO/ C Where; D is the demand in units, O is the ordering cost per order, and C is the carrying cost per unit per period.

The

EOQ (Q) is the quantity for which both ordering costs and carrying costs are equal.
is the point of trade-off between carrying and ordering costs. the total cost of inventory shall be lowest.

This

At this,

This

is the most economical quantity that can be ordered by the firm.

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Practice Problem

A unit manufacturing plastic containers consumes 1350 units of molded plastic uniformly through the month. The current cost of acquisition is Rs. 20 per unit and the carrying cost for the firm, 30% on average based on recent data available, is not likely to change in the coming months. The firm has to bear a cost of Rs. 2400 every time it places an order. Compute the optimal inventory level for the year ahead using the EOQ model.

Assumptions of the

EOQ model:

Constant or uniform demand Constant unit price Constant carrying costs Constant ordering costs Instantaneous delivery

Management

of Accounts receivables is significant due to the amount of funds blocked in them.

Meaning:

The combined monetary value of unpaid customer invoices is termed as accounts receivables or simply receivables. They are usually due within a relatively short time period, ranging from a few days to a year. The level of sales is one of the key determinants of the size of the investment in accounts receivable. Nature of business also affects the investment in the accounts receivables.

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Cash

is the most liquid but least productive current

asset.
The

higher the cash in hand and bank balance, the stronger is the liquidity position.
determination of optimal cash balance assumes importance, as it affects the profitabilityliquidity position of the firm.

The

Two

prime objectives for the firms cash management system are:

Important aspects

Managing collections and disbursements Reliable forecasting and reporting system Maximizing the interest income by selecting the optimal mix of cash and marketable securities.

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