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Tuesday, October 23, 2018

Financial Management Notes: Management of Working Capital


Unit – II: Management of Working Capital
Meaning and definition of Working Capital
The capital required for a business is of two types. These are fixed capital and working capital. Fixed capital is required for the purchase of fixed assets like building, land, machinery, furniture etc. Fixed capital is invested for long period, therefore it is known as long-term capital. Similarly, the capital, which is needed for investing in current assets, is called working capital. The capital which is needed for the regular operation of business is called working capital. Working capital is also called circulating capital or revolving capital or short-term capital.
In the words of John. J Harpton “Working capital may be defined as all the short term assets used in daily operation”.
According to “Hoagland”, “Working Capital is descriptive of that capital which is not fixed. But, the more common use of Working Capital is to consider it as the difference between the book value of the current assets and the current liabilities.
From the above definitions, Working Capital means the excess of Current Assets over Current Liabilities. Working Capital is the amount of net Current Assets. It is the investments made by a business organisation in short term Current Assets like Cash, Debtors, Bills receivable etc.
Concepts of Working Capital
There are two concepts of working capital:
a)      Gross working capital
b)      Net working capital
Gross working capital refers to investment in all current assets -raw materials, work-in-progress, finished goods, book debts, bank balance and cash balance. The gross concept of working capital is significant in the context of measuring working capital needed, measuring the size of the business, continued and smooth flow of operations of the business and the like.
Net working capital refers to the excess of current assets over current liabilities. That is, value of current assets minus value of current liabilities (current liabilities include trade creditors, bills payable, outstanding expenses such as wages, salaries, dividend payable and tax payable, bank overdraft, etc.) The net concept of working capital is significant in the context of financing of working capital, the short term liquidity aspects of the business, and the like.
Classification of Working Capital
Some portion of working capital is fixed natured and some portion fluctuates for some time. In the view point working capital classified in to 2 classes,
a)      Fixed or permanent working capital
b)      Variable or temporary working capital
Fixed or permanent working capital: The fund, which is required to produce a certain amount of goods or services at a certain period of time, is called Fixed working capital. The minimum amount of cash money, A/R, which are kept to operate the business is called Fixed working capital.
Variable working capital: When extra working capital is required then a addition to fixed working capital due to seasonal causes or increased production or sales, this working capital is variable working capital. So, the working capital which fluctuates with keeping the relation between production & Sales is variable working capital.
Working capital management
The capital required for a business is of two types. These are fixed capital and working capital. Fixed capital is required for the purchase of fixed assets like building, land, machinery, furniture etc. Fixed capital is invested for long period, therefore it is known as long-term capital. Similarly, the capital, which is needed for investing in current assets, is called working capital. The capital which is needed for the regular operation of business is called working capital. Working capital is also called circulating capital or revolving capital or short-term capital.
Working capital management involves the relationship between a firm's short-term assets and its short-term liabilities. The goal of working capital management is to ensure that a firm is able to continue its operations and that it has sufficient ability 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.
Need and Importance of Working Capital
Working Capital means excess of current assets over current liabilities. Such Working Capital is required to smooth conduct of business activities. It is as important as blood to body. An organisation’s profitability depends on the quantum of Working Capital available to it. Adequate Working Capital is a source of energy to any business organisation. It is the life blood of an organisation. The following points will highlight the need of adequate working capital:
a) Enables a company to meet its obligations: Working capital helps to operate the business smoothly without any financial problem for making the payment of short-term liabilities. Purchase of raw materials and payment of salary, wages and overhead can be made without any delay. Adequate working capital helps in maintaining solvency of the business by providing uninterrupted flow of production.
b) Enhance Goodwill:  Sufficient working capital enables a business concern to make prompt payments and hence helps in creating and maintaining goodwill. Goodwill is enhanced because all current liabilities and operating expenses are paid on time.
c) Facilitates obtaining Credit from banks without any difficulty: A firm having adequate working capital, high solvency and good credit rating can arrange loans from banks and financial institutions in easy and favorable terms.
d) Regular Supply of Raw Material: Quick payment of credit purchase of raw materials ensures the regular supply of raw materials for suppliers. Suppliers are satisfied by the payment on time. It ensures regular supply of raw materials and continuous production. Prompt payments to its creditors also enable a company to take advantage of cash and quantity discounts offered by them.
e) Smooth Business Operation: Working capital is really a life blood of any business organization which maintains the firm in well condition. Any day to day financial requirement can be met without any shortage of fund. All expenses and current liabilities are paid on time.
f) Ability to Face Crisis: Adequate working capital enables a firm to face business crisis in emergencies such as depression.
g) It improves the prospects of prosperity and progress of a company.
Thus, adequate Working Capital is an important factor for prosperity and smooth running of a business organisation. It is rightly called as the “backbone” of the financial structure of a business organisation.
Factors Affecting Working Capital Requirement
The level of working capital is influenced by several factors which are given below:
a)      Nature of Business: Nature of business is one of the factors. Usually in trading businesses the working capital needs are higher as most of their investment is found concentrated in stock. On the other hand, manufacturing/processing business needs a relatively lower level of working capital.
b)      Size of Business: Size of business is also an influencing factor. As size increases, an absolute increase in working capital is imminent and vice versa.
c)       Production Policies: Production policies of a business organisation exert considerable influence on the requirement of Working Capital. But production policies depend on the nature of product. The level of production, decides the investment in current assets which in turn decides the quantum of working capital required.
d)      Terms of Purchase and Sale: A business organisation making purchases of goods on credit and selling the goods on cash terms would require less Working Capital whereas an organisation selling the goods on credit basis would require more Working Capital. If the payment is to be made in advance to suppliers, then large amount of Working Capital would be required. 286
e)      Production Process: If the production process requires a long period of time, greater amount of Working Capital will be required. But, simple and short production process requires less amount of Working Capital. If production process in an industry entails high cost because of its complex nature, more Working Capital will be required to finance that process and also for other expenses which vary with the cost of production whereas if production process is simple requiring less cost, less Working Capital will be required.
f)       Turnover of Circulating Capital: Turnover of circulating capital plays an important and decisive role in judging the adequacy of Working Capital. The speed with which circulating capital completes its cycle i.e. conversion of cash into inventory of raw materials, raw materials into finished goods, finished goods into debts and debts into cash decides the Working Capital requirements of an organization. Slow movement of Working Capital cycle requires large provision of Working Capital.
g)      Dividend Policies: Dividend policies of a business organisation also influence the requirement of Working Capital. If a business is following a liberal dividend policy, it requires high Working Capital to pay cash dividends where as a firm following a conservative dividend policy will require less amount of Working Capital.
h)      Seasonal Variations: In case of seasonal industries like Sugar, Oil mills etc. More Working Capital is required during peak seasons as compared to slack seasons.
i)        Business Cycle: Business expands during the period of prosperity and declines during the period of depression. More Working Capital is required during the period of prosperity and less Working Capital is required during the period of depression.
j)        Change in Technology: Changes in Technology as regards production have impact on the need of Working Capital. A firm using labour oriented technology will require more Working Capital to pay labour wages regularly.
k)      Inflation: During inflation a business concern requires more Working Capital to pay for raw materials, labour and other expenses. This may be compensated to some extent later due to possible rise in the selling price. 287
l)        Turnover of Inventories: A business organisation having low inventory turnover would require more Working Capital where as a business having high inventory turnover would require limited or less Working Capital.
m)    Taxation Policies: Government taxation policy affects the quantum of Working Capital requirements. High tax rate demands more amount of Working Capital.
n)      Degree of Co-ordination: Co-ordination between production and distribution policies is important in determining Working Capital requirements. In the absence of co-ordination between production and distribution policies more Working Capital may be required.
Methods for Estimating Working Capital Requirement
There are broadly three methods of estimating the requirement of working capital of a company viz. percentage of revenue or sales, regression analysis, and operating cycle method. Estimating working capital means calculating future working capital. It should be as accurate as possible because planning of working capital would be based on these estimates and bank and other financial institutes finances the working capital needs based on such estimates only.
a) Percentage of Sales Method: It is the easiest of the methods for calculating the working capital requirement of a company. This method is based on the principle of ‘history repeats itself’. For estimating, relationship of sales and working capital is worked out for say last 5 years. If it is constantly coming near say 40% i.e. working capital level is 40% of sales, the next year estimation is done based on this estimate. If the expected sales is 500 million dollars, 200 million dollars would be required as working capital.
Advantage of this method is that it is simple to understand and calculate also. Disadvantage includes its assumption which is difficult to be true for many organizations. So, where there is no linear relationship between the revenue and working capital, this method is not useful. In new startup projects also this method is not applicable because there is no past.
b) Regression Analysis Method: This statistical estimation tool is utilized by mass for various types of estimation. It tries to establish trend relationship. We will use it for working capital estimation. This method expresses the relationship between revenue & working capital in the form of an equation (Working Capital = Intercept + Slope * Revenue). Slope is the rate of change of working capital with one unit change in revenue. Intercept is the point where regression line and working capital axis meets.
c) Operating cycle method: Operating cycle is the time duration required to convert sales, after the conversion of resources into inventories and cash.  The operating  cycle of a manufacturing co involves 3 segments:
i)  Acquisition of resources like  raw labor, material, fuel and power 
ii) Manufacture of the product that includes conversion of raw material into  work  in  process  and into finished goods, and
iii) sales of the product either for cash or credit.  Credit sales create book debts for collection (debtors).
The length  of  the  operating  cycle  of a  manufacturing co  is  the  sum  of - i)   inventory conversion period (ICP) and ii)   Book debts conversion period (BDCP) collectively, they are sometimes called as gross operating cycle (GOC).
GOC = ICP + DCP
The Inventory conversion period is the entire time needed for producing and selling the product and includes:
(a) Raw material conversion time (RMCP)
(b) Work in process conversion period (WIPCP) and
(c)  Finished good conversion period (FGCP).
ICP = RMCP + WIPCP + FGCP
The payables deferral period (PDP) is the length of time the firm is capable to defer payments on various resource purchases. The variation between the gross operating cycle and payables deferrals period is the net operating cycle (NOC).
NOC = GOC- Payables deferral period.
Various Sources of Working Capital
Sources of working capital are many. There are both external and internal sources. The external sources are both short-term and long-term. Trade credit, commercial banks, finance companies, indigenous bankers, public deposits, advances from customers, accrual accounts, loans and advances from directors and group companies etc. are external short-term sources. Companies can also issue debentures and invite public deposits for working capital which are external long term sources. Equity funds may also be used for working capital. A brief discussion of each source is attempted below.
1) Trade credit is a short term credit facility extended by suppliers of raw materials and other suppliers. It is a common source. It is an important source. Trade credit is an informal and readily available credit facility. It is unsecured. It is flexible too; that is advance retirement or extension of credit period can be negotiated. Trade credit might be costlier as the supplier may inflate the price to account for the loss of interest for delayed payment.
2) Commercial banks are the next important source of working capital finance commercial banking system in the country is broad based and fairly developed. Straight loans, cash credits, hypothecation loans, pledge loans, overdrafts and bill purchase and discounting are the principal forms of working capital finance provided by commercial banks.  They provide loan in the following form:
a)      Straight loans are given with or without security. A onetime lump-sum payment is made, while repayments may be periodical or one time.
b)      Cash credit is an arrangement by which the customers (business concerns) are given borrowing facility upto certain limit, the limit being subjected to examination and revision year after year. Interest is charged on actual borrowings, though a commitment charge for utilization may be charged.
c)       Hypothecation advance is granted on the hypothecation of stock or other asset It is a secured loan. The borrower can deal with the goods.
d)      Pledge loans are made against physical deposit of security in the bank's custody. Here the borrower cannot deal with the goods until the loan is settled.
e)      Overdraft facility is given to current account holding customers t^ overdraw the account upto certain limit. It is a very common form of extending working capital assistance.
f)       Bill financing by purchasing or discounting bills of exchange is another common form of financing. Here, the seller of goods on credit draws a bill on the buyer and the latter accepts the same. The bill is discounted per cash will the banker. This is a popular form.
3) Finance companies abound in the country. About 50000 companies exist at present. They provide services almost similar to banks, though not they are banks. They provide need based loans and sometimes arrange loans from others for customers. Interest rate is higher. But timely assistance may be obtained.
4) Indigenous bankers also abound and provide financial assistance to small business and trades. They change exorbitant rates of interest by very much understanding.
5) Public deposits are unsecured deposits raised by businesses for periods exceeding a year but not more than 3 years by manufacturing concerns and not more than 5 years by non-banking finance companies. The RBI is regulating deposit taking by these companies in order to protect the depositors. Quantity restriction is placed at 25% of paid up capital + free services for deposits solicited from public is prescribed for non-banking manufacturing concerns. The rate of interest ceiling is also fixed. This form of working capital financing is resorted to by well established companies.
6) Advances from customers are normally demanded by producers of costly goods at the time of accepting orders for supply of goods. Contractors might also demand advance from customers. Where sellers* market prevail advances from customers may be insisted. In certain cases to ensure performance of contract in advance may be insisted.
7) Accrual accounts are simply outstanding dues to workers, suppliers of overhead service requirements and the like. Outstanding wages, taxes due, dividend provision, etc. are accrual accounts providing working capital finance for short period on a regular basis.
8) Loans from directors, loans from group companies etc. constitute another source of working capital. Cash rich companies lend to liquidity crunch companies of the group.
9) Commercial papers can be used to raise funds. It is a promissory note carrying the undertaking to repay the amount on or after a particular date. Normally it is an unsecured means of borrowing and the companies are allowed to issue commercial papers as per the regulations issued by SEBI and Company’s Act.
10) Debentures and equity fund can be issued to finance working capital so that the permanent working capital can be matchingly financed through long term funds.

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