Working-Capital

Management
 Working-Capital Management

 It is concerned with the management of current

assets,current liabilitites & interaction between
them.
 The objective of Working capital mgmt. is to
maintain a satisfactory level of Working capital to
ensure sufficient liquidity in the operations of an
enterprise
 The liquidity of a firm is measured by it’s ability
to satisfy short term obligations as they become
due.
Working-Capital Management

 The extent of liquidity depends on:

 The time required to convert the asset into
money
 The degree of certainty associated with the
price realized for the asset
 Measuring liquidity

 Three basic measures:

1. Current ratio
2. Acid test ratio
3. Net working capital
 Current & acid test ratio used in inter-firm
comparison whereas NWC is useful for
internal control.
 Concept of working capital
• Gross Working capital:Total current assets

• Net working capital(NWC):

1. Current assets less current
liabilities(traditional view) or
2. The part of current assets which is financed
with long-term funds (Dynamic view)
 Concept of working capital
 Permanent (fixed) working capital:
 Required on a continuing basis over several years.
 Minimum level of W.C.- cash,inventory &
debtors- to be maintained to carry on the business
smoothly at anytime during an accounting year
 Permanent W.C. is locked in the business as long
as it continues to exist.
 The amount varies from time to time w.r.t. level of
business activities.
 Concept of working capital

Temporary(circulating) working capital:

 Additional assets required at different times
during the operating year in addition to permanent
working capital
 Goes on changing from time to time do meet
seasonal fluctuations & unforeseen eventualities.
 Factors affecting composition of
working capital
 Nature of business
 Nature of raw materials used
 Process technology used
 Nature of finished goods
 Degree of competition in the market
 Paying habit of customers
 Synchronization among cash inflows &
outflows
 Working Capital-Planning
 As there is a time-lag involved between
conversion of cash back into cash,it is necessary to
maintain sufficient level of working capital to
sustain sales activity.
 This continuing flow from cash to suppliers to
inventory to accounts receivable & back to cash is
called the operating cycle
 Operating cycle duration is the time between
acquisition of raw materials & final cash
realisation from debtors.
 Thus it consists of three phases….
 Typical Operating Cycle
Phase 3 Phase 1
FEDERAL RESERVE NOTE
THE UNITED STATES OF AMERICA
THIS NOTE IS LEGAL TENDER
L70744629F
CASH
FOR ALL DEBTS, PUBLIC AND PRIVATE

12 A 12
WASHINGTON, D.C.
FEDERAL RESERVE NOTE
THE UNITED STATES OF AMERICA
L70744629F H 293 THIS NOTE IS LEGAL TENDER
FOR ALL DEBTS, PUBLIC AND PRIVATE L70744629F
12 SERIES
12
12 12
A
ONE DOLLAR
1985
WASHINGTON, D.C.

L70744629F H 293

12 SERIES
12

ONE DOLLAR
1985

ACCTS. RECEIVABLE

Phase 2 INVENTORY
FEDERAL RESERVE NOTE
THE UNITED STATES OF AMERICA
THIS NOTE IS LEGAL TENDER
FOR ALL DEBTS, PUBLIC AND PRIVATE L70744629F

12 12
A WASHINGTON, D.C.

L70744629F H 293

12 SERIES
12

ONE DOLLAR
1985

Time it takes to go from cash back to cash

 Operating cycle approach
 This approach is very useful in controlling & forecasting working capital.
 The duration of operating cycle =
(R + W+ F + D – C)

Where: R = Avg. stock of R.M./stores Raw material storage

period
Avg. R.M. consumption per day

W = Avg. W.I.P. inventory Conversion Period

Avg. COP per day

F= Avg. F.G. inventory Finished goods storage

Avg. cost of goods sold per day period

D= Avg. Debtors Average collection period

Avg. credit sales per day

C= Avg. creditors Average payment period

Avg. credit purchases per day
 Working Capital-Planning
Forecasting working capital requirements

1. Sound & realistic forecast of the sales is the first step.

2. Forecast of debtors,production,raw materials,labour &
other operating expenses follow sales forecast
3. The operating cycle is then determined to decide upon the
Net working capital requirement by:
(i) Adding the amounts required to be invested in the current
assets-inventory,receivables & cash - depending on the
holding period &
(ii) Deducting current liabilities – creditors, outstanding
expenses- depending on time lag in payment.
 Financing of W.C.
Liquidity v/s Profitability
 The level of NWC has a bearing on the profitability & risk.
 Profitability is measured by profits after deducting
expenses
 Risk is the probability that a firm will not be able to make
payments as they become due(technically insolvent)
 Greater the amount of NWC the more liquid (less risky)
the firm is.
 The goal of WC management is trade-off between
profitability & risk
 Balance Sheet
Current Assets Current Liabilities

Fixed Assets Long-Term Debt

Preferred Stock
Common Stock

Suppose we use long-term financing to

finance some of our current assets.
This strategy would be less risky, but more
expensive!
 Balance Sheet
Current Assets Current Liabilities

Fixed Assets Long-Term Debt

Preferred Stock
Common Stock

Suppose we use current liabilities to

finance some of our fixed assets.
This strategy would be less expensive, but
more risky!
 Determining the financing mix
 The basic question is what proportion of
current assets should be financed by current
liabilities and how much by long term
resources?
 3 basic approaches:
 Hedging
 Conservative
 Trade-off
 The Hedging Principle

Hedging approach suggests :

– Long term funds should be used to finance the
fixed(permanent) part of current asset
requirements &
– Seasonal(temporary) requirements over & above
the permanent financing needs should be financed
with short term funds i.e.current liabilities
– Thus short-term financing requirements (current
assets)= short-term financing available(current
liabilities)
 Conservative approach

 Conservative approach suggests:

 Estimated requirements of total funds
should be financed from long-term
sources
 Short term funds should be used only in
emergency situations involving
unexpected outflow of funds.
 Hedging V/S Conservative

 Conservative approach is more expensive as

the available funds may not be fully utilised
in certain periods but interest has to be paid
on it.
 Hedging is more risky as there is no NWC
& no provision for emergency short-term
needs.
 Trade-off approach
 It attempts to strike a balance between hedging &
conservative approach.
 Actual trade-off differs from case to case depending on
risk-taking ability of the decision maker.
 E.g. :
 Average of minimum & maximum monthly requirements
will be financed through long term funds,
 Any additional requirement to be financed using short-
term funds.
 Financing of working capital
 After estimating the level of working capital needed the
firm has to decide on how to finance it.
 The main sources are:
 Accruals
 Trade credit
 Bank Finance
 Public deposits
 Inter-corporate deposits
 Short-term loans from financial institutions
 Commercial paper
 Factoring
 Working capital financing
Accruals
 Outstanding wages & taxes
 No explicit tax burden
 Less control by management,dictated by
industry practices & legal provisions
Trade credit
 Credit allowed by suppliers of goods & services
 Important source of W.C. financing (20-50%)
 Credit-worthiness is an important factor in
availing trade credit
 Working capital financing(contd.)
Bank Finance
Overdraft
 Facility to overdraw current account upto
specified limit during a given period
 Interest charged on the amount actually overdrawn
Cash credit
 Facility to borrow upto certain limit called cash
credit limit based on security margin
 Usually allowed against pledge or hypothecation
of goods
 1 % commitment charges on unutilised balance
 Working capital financing(contd.)
Purchasing & discounting of bills:
 Discounting of bill covered under cash
credit/overdraft limit
 Bill is discounted after the bank is satisfied about
the credit-worthiness of the drawer & authenticity
of the bill.
Public deposits
 These are unsecured deposits from public ranging
from 6 months to 3 years.
 It is governed by The Companies (Acceptance of
Deposits)Amendment Rules 1978.
 Working capital financing(contd.)
Inter-corporate Deposits
These are deposits made by one company with
another & are of 3 types:
 Call deposits: Withdrawable by the lender on a
days notice,interest rate around 14 %
 Three month deposits: Popular for short term
financing carrying interest rate around 18 %
 Six month deposits: Usually made with first-class
borrowers,interest rate around 20%
 Working capital financing(contd.)
Short term loans from financial institutions
 The LIC,GIC & UTI provide short term
loans to eligible companies satisfying
certain criteria.
 Given as a demand promissory note
 Totally unsecured given for 1 year but can
be renewed for two consecutive years
 Carries interest rate of 18 % with quarterly
rest(effectively around 19 %) allowing 1%
rebate for prompt payment
 Working capital financing(contd.)

Commercial Paper
 These are short term unsecured promissory notes
issued by large firms with considerable financial
strength
 Period – 90 to 180 days
 Are sold at a discount redeemable at face value
 Working capital financing(contd.)
Factoring
 A factor is a financial institution offering services
relating to management & financing of debts
arising from credit sales
 It selects & assumes responsibility of collecting
the debt accounts ,sales ledger administration &
credit information services.
 It advances money to the client against not yet due
debts,the amount being 70-80% of the debt
carrying interest rate marginally higher than
bank’s lending rate.
 Besides interest,commission at the rate of 1-2%
of the face value of the debt factored may be
charged.
 Factoring may be on a recourse or on a non-
recourse basis.
 MPBF
Tondon committee recommendations
 Revolutionary devt. In the sphere of
distribution of bank credit in accordance
with planning priorities
 Rationing of bank credit to prevent wasteful
utilisation of credit.
 Tondon committee was constituted by RBI
in 1975 to remove shortcomings of the
system
 Objectives
 To make recommendations :
 For commercial banks follow-up of credit & also the
periodical operational/other information to be
obtained from banks
 For obtaining periodical forecasts from borrowers of
their business plans & credit needs
 Inventory norms
 Criteria for satisfactory satisfactory capital structure
& sound financial basis
 Pattern of financing for working capital requirements
 Recommendations

Covers all aspects of lending:

 Norms for inventory & lending
 Style of credit for better financial discipline
& planning
 Information system for better monitoring &
ensuring end use of the credit for intended
purpose
 Norms
 Inventory Norms: Suggested inventory & receivable
norms for 15 industries based on
 Company finance studies by RBI
 Process period,availability of R.M.,seasonality etc.
 General discussion with industry experts
 Flexibility allowed in certain specified circumstances
e.g.bunched receipt of R.M. including imports,power
cuts,strikes etc.
 Initially to all borrowers in excess of credit limit of
10 lakhs,gradually extending to small borrowers.
 Lending Norms
 Identifies bank’s role as a lender to supplement
borrowers resources
 A part of working capital gap to be financed by
bank finance & the balance should be financed
through equity & long term borrowings
 Three alternative methods have been suggested for
calculating the maximum permissible bank
finance(MPBF);each method progressively
reducing the MPBF
 Lending Norms
Method I
 MPBF = 0.75 * (Current assets – current liabilities)
 It ensures a minimum current ratio of 1:1

Method II
 MPBF = (0.75 * Current assets) – current liabilities
 It ensures a minimum current ratio of 1.33.

Method III
 MPBF = 0.75 *( Current assets – core current assets) –
current liabilities
 It ensures a higher current ratio compared to the first two methods
 Style of credit
 The committee suggested :
 Bifurcation of credit limit into loan & demand
cash credit
 Loan to be used for financing irreducible
minimum level while fluctuating to be funded by
cash credit component
 Rate of loan to be lower than cash credit for better
financial discipline
 Information system
The committee recommended a quarterly budgeting –cum-
reporting system for the borrower comprising of:
 Quarterly P/L statements with previous quarter’s actuals &
next quarter projections
 Quarterly statements of current assets & current liabilities
including inventory details
 Half-yearly proforma balance sheets within two months
 Annual audited accounts within three months
 Monthly stock statements in required detail