WORKING CAPITAL MANAGEMENT
Introduction
1 Concept of working capital
2 Need of working capital policy
3 Determinants of working capital requirement
4 Issues &Estimation of working capital
requirement
Introduction
Capital required for a business can be classified
into fixed capital and working capital. Every business needs funds for two
purposes for its establishment. Working capital is required to carry out day to
day expenses. Long term funds are required to create production facilities
through purchase of fixed assets such as plant and machinery, land, building;
furniture etc. funds are also needed for short-term purpose for the purchase of
raw material, payment of wages, and other day-to-day expenses etc. These funds
are known as working capital
Long term funds are required to create production
facilities through purchase of fixed assets such as plants, machineries, lands,
buildings & etc
Short term funds are required for the purchase of
raw materials, payment of wages, and other day-to-day expenses. . It is
otherwise known as revolving or circulating capital
It is
nothing but the difference between current assets and current liabilities. i.e.
Working Capital = Current Asset –
Current Liability.
1 Concept Of Working Capital
v Balance
sheet concept
v Operating
cycle or circular flow concept
Balance sheet concept
-
Gross Working capital- It is the capital invested
in the total current asset of the enterprise
-
Net working capital- It is the excess of current
assets over over current liabilities
Net working capital = current Assets
– Current Liabilities
KINDS OF WORKING CAPITAL
v On the
basis of concept
v On the
basis of time
On the Basis of Concept
v Gross
working capital
v Net
working capital
On the Basis of time
Permanent or fixed working
capital
It is the
minimum amount which is required to ensure effective utilization of fixed
facilities and for maintaining the circulation of current assets
v Regular
working capital – circulation of current asset from cash to inventories and
from inventories to receivables and from receivable to cash and so on.
v Reserve
working capital – excess the amount of regular working capital which may be
provided for contingencies that may arise at unstated period such as strikes,
rise in
prices,
depression etc
Temporary or variable working
capital
It is the
amount of working capital which is required to meet seasonal demands. It is
classified in to seasonal and special working capital.
v Seasonal
working capital – to meet the seasonal needs of the enterprise
v Special
working capital – to meet special exigencies such as launching of extensive
marketing campaign for conducting research etc.
2 Need Of Working Capital Policy
The various working capital policies are
Liquidity policies
Under this policy, finance manager will increase the amount of
liquidity for reducing the risk of business. If business has high volume of cash and bank balance, then business can easily pays
his dues at maturity. But finance manger should not forget that the excess cash
will not produce and earning and return on investment will decrease. So
liquidity policy should be optimized.
Profitability policy
Under this policy, finance manger will keep low amount of cash
in business and try to invest maximum amount of cash and bank balance. It will
sure that profit of business will increase due to increasing of investment in
proper way but risk of business will also increase because liquidity of
business will decrease and it can create bankruptcy position of business. So,
profitability policy should make after seeing liquidity policy and after this
both policies will helpful for proper management of working capital.
Matching or hedging approach/policy
This approach or policy is a moderate policy that matches assets
and liabilities to maturities. Basically, a firm uses long term sources to
finance fixed assets and permanent current assets and short term financing to
finance temporary current assets
Example
A fixed asset/equipment which is expected to provide cash flow
for 8 years should be financed by say 8 years long-term debts .Assuming a firm needs to have
additional inventories for 2 months, it will then sought short term 2 months
bank credit to match it.
Conservative
approach/policy
v Conservative because the firm prefers to have more cash on hands
v Fixed and part of current assets are financed by long-term or
permanent funds
v As permanent or long-term sources are more expensive, this leads
to ―lo wer risk lower return‖
v Having excess cash at off-peak period hence the need to invest
the idle or excess cash to earn returns.
Aggressive approach/policy
The firm wants to take high risk where short term funds are used
to a very high degree to finance current and even fixed assets.
3 Determinants of Working Capital Requirement
Nature or characteristics of Business
v Working
capital requirement depends upon the nature o f its business
v Public
utility undertaking like electricity, water supply and railways need very
limited working capital because they offer cash sales only supply services not
products.
v Trading
and financial firm require less investment in fixed asset but invest large
amount in current asset like inventories, receivables and cash.
v Manufacturing
undertaking require working capital along with fixed investment
Size of Business / Scale of Operation
v Working
capital requirement of a concern influenced by size of its business which is
measured in term s of scale of operation
v Size of
business unit large- require more working capital
v Size of
business unit small – require less working capital
Production Policy
v Production
is based on seasonal variation.
v Requirement
of working capital depends on production policy.
v Production
is seasonal less working capital
v Production
is carried out throughout the year the
working capital requirement is more
Manufacturing Process / Length of Production cycle
v Longer
the process or period of manufacture, larger the amount of working capital is
required
v Short
the length of production cycle, smaller the amount of working capital
requirement
Seasonal Variation
v For
certain industries raw material is not available throughout the year.
v They have
to buy raw material in bulk during the season and process them during the
entire year
v A huge
amount is blocked in the form of inventories during such season which give rise
to more working capital requirement.
v During
busy season a firm requires larger working capital than in the slack season.
Working capital cycle
v In
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.
Business Cycle
v It refers
to alternate expansion and contraction in general business activity.
v Boom
period when business is prosperous – larger amount of working capital due to
increase in sales
v Depression
– sales decline, difficulties are faced in collection from debtors and firms
may have larger amount of working capital requirement.
Earning capacity of the Firm
v Some
firms have more earning capacity than others due to quality of their products,
monopoly condition etc.
v Such
firms with high earning capacity may generate cash profit from operation and to
contribute to their working capital.
v Dividend
policy influences the requirement of working capital.
4 Issues & Estimation Of Working Capital
Requirement
v Components
such as cash, marketable securities, receivables and inventory
v Working
capital management requires much of the financial managers time.
v It has
greater signifivcance for all firms but it is very critical for small firms
v The need
for working capital is directly related to the firms growth.
Performa of the Working Capital Require ment
Curre nt Assets:
i) Cash XXXX
ii) Debtors XXXX
iii)
Stocks XXXX
iv)
Advanced payments XXXX
v) Others XXXX
Less:
Curre nt
liabilities
i)
Creditors XXXX
ii) Lag
in payment of expenses XXXX
iii)
Outstanding expenses if any XXXX
Working
capital (Current assets-Current liabilities) XXXX
Add:
Provision for contingencies XXXX
Net
working capital required XXXX
Sources
Of Working Capital
Working
Capital require me nt can be normalized from short- term and long-term sources.
Each source will have both merits and limitations up to certain extract. Uses
of Working Capital may be differing from stage to stage.
Internal
sources
•
Retained Earnings
• Reserve
and Surplus
•
Depreciation Funds etc.
External
sources Public
Deposits
• Loans
from Banks and Financial Institutions
•
Advances and Credit
•
Financial arrangements like Factoring, etc.
Determining
the Finance Mix
Determining
the finance mix is an important part of working capital manage me nt.
Under
this decision, the relations hip among risk, return and liquidity are measured
and also which type of financing is suitable to meet the Working Capital
requirements of the business concern. There are three basic approaches for
deter mining an appropriate Working Capital finance mix.
1.
Hedging or matching approach
2.
Conservative approach
3.
Aggressive approach.
Hedging Approach
Hedging
approach is also known as matching approach. Under this approach,
the
business concern can adopt a financial plan which matches the expected life of
assets
with the expected life of the sources of funds raised to finance assets.
When the
business follows matching approach, long-term finance shall be used to
fixed
assets and permanent cur re nt assets and short- term financing to finance
temporary
or variable assets.
Temporary Current Assets
Short-term
Conservative Approach
Under
this approach, the entire estimated finance in current assets should be
financed from long- term sources and the short- term sources should be used
only for emergency requirements. This approach is called as ―Low Profit – Low
Risk ‖ concept.
Aggressive Approach
Under
this approach, the entire estimated requirement of current assets should be
financed from short- term sources and even a part of fixed assets financing be
financed from short- term sources. This approach makes the finance mix more
risky, less costly and more profitable.
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