UNIT NO.4 Working Capital 1. Concept of Working Capital 2. Need of Working Capital 3. Types of Working Capital 4. Adequacy of Working Capital 5. Factor affecting Working Capital 6. Financing approaches for Working Capital. 7. Methods of forecasting working Capital requirement 8. Estimating working capital 9. Cash cycle analysis 10. Working capital finance from bank

1. Concept of Working Capital There are two concept of working capital.. Gross working capital : It refers to the firms investment in total current asset i.e. cash, marketable securities, debtors and stock. Net working Capital ; The term Net Working capital has been defined in two different ways.. It is excess of current assets over current liabilities. This is as a matter of fact the most commonly accepted definition. Some people define it as only the difference between current asset and current liabilities. The former seems to be a better definition as compared to the latter.

2.Need for working capital It has already been stated in the preceding chapter that the basic objective of financial management is to maximize shareholders wealth. This is possible only when the company earns sufficient profit. The amount of such profit largely depends upon the magnitude of sales. However, sales do not convert into cash instantaneously. There is a time gap between sale of goods and receipt of cash. Working capital is required for this period in order to sustain the sales activity. In case adequate working capital is not be in a position to sustain the sales since a may not be in a position to purchase raw material, pay wages and other expenses required for manufacturing the goods to be sold.

Operating cycle From preceding slide, It is clear that working capital is required because of the time gap between the sales and their actual realization in cash. This time gap is technically termed as “operating cycle” of the business

In Manufacturing firm.. 1. Conversion of cash into raw material 2. Conversion of raw material into work in progress. 3. Conversion of work in progress into finished goods 4. Conversion of finished goods into account receivable. And 5. Conversion of account receivable into cash this cycle will be repeated again and again….

Operating cycle Account Receivable/ Debtors Finished Goods Work in Progress Raw Material Cash

In case of trading firm The operating cycle will include the length of time required to convert… 1. Cash into inventories 2. Inventories into account receivable 3. Account receivable into cash I N CASE OF F INANCING FIRM.. The operating cycle include the length of time taken for… 1. Conversion of cash into debtors and 2. Conversion of debtors into cash

3. Types of working capital 1. Permanent Working capital : This refer to that minimum amount of investment in all current assets which is required at all times to carry out minimum level of business activates. In other words it represent the current assets required on a continuing basis over the entire year. In other words certain current assets which are retained by the organization on a permanent basis is called permanent working capital.

2. Temporary working Capital : The amount of such working capital keeps on fluctuating form time to time on the basis of business activities. In other words, it represent additional current assets required at different times during the operating year. For Example : Extra Inventory has to be maintain to support sales during the peak sales period. Similarly receivable also increase and must be financed during period of high sales. On the other hand investment in inventories, receivables etc. will decrease in the period of depression. Suppliers of temporary working capital can expect its return during off season when it is not required by the firm. Hence, temporary working capital is generally financed from short term source of finance such as bank credit.

Diagram of temporary and permanent working capital Temporary Working Capital Permanent working Capital Temporary Working Capital Permanent working Capital Amt. of working capital(Rs) Time

Adequacy of working Capital A firm must have adequate working capital i.e. as much as needed by the firm. It should neither be excessive nor inadequate. Both situation are dangerous. Excessive working capital means the firm has idle fund which earn no profits for the firm. Inadequate working capital means firms does not have sufficient funds for running its operations which ultimately result in production interruption and lowering down the profitability.

Relationship between working capital, risk and return In manufacturing concern, it is generally accepted that higher levels of working capital decrease the risk and decrease the profitability too. While lower levels of working capital increase the risk but have the potentiality of increasing the profitability also. This principle is based on the following assumption … “There is direct relationship between risk and profitability –higher is the risk higher is the profitability while lower is the risk, lower is the profitability”. “Current assets are less profitable than fixed assets.”

On the account of the above principle, an increase in the ratio of current assets to total assets will result in declining in the profitability of the firm. This because investment in current assets, as stated above, is less profitable than the fixed assets. However increasing in this ratio would decrease the risk of the firm becoming technically insolvent. On the other hand, a decrease the ratio of current assets to total asset would increase the profitability of the firm because investment in fixed asset is more profitable than the investment in current assets. However, this will increase the risk of the firm becoming technically insolvent on account of its possible inability of meeting its commitments in time due to shortage of fund.

Factor affecting working capital Nature of business Production policies Growth and expansion Capital structure of the company Policies of RBI Terms of purchase and Sales Profitability. Dividend policy Irregularities of supplies Sales Volume.

Nature of Business The proportion of working capital requirement of the organization is depend of upon the nature of the business. In trading and manufacturing organization require huge working capital then the service unit. Public utility concern like railway, Electricity etc would need only small amount capital for their operation

Production Policies Production policy makes an important impact on the amount of working capital requirement. In labor intensive industries require more amount of working capital. But inductor automatic machine the amount of working capital will be less. At such time such concern require huge amount of long term funds.

Growth and expansion When the firm is decided to expand its operation the requirement of working capital will also be more, because additional requirement of working capital will also be more, because additional amount of requirement to invest in raw material, finished goods and debtors. Hence growth and expansion program of a firm is an important factor to influencing the requirement of working capital.

Capital structure of the company In accompany having a policy to that the shareholders contribute certain amount of funds towards the working capital needs as and when required. So the firm will easy to meet out the working capital needs and at the same time it need not arrange funds from outside sources.

Policies of RBI When RBI announces the stringent credit policies it will affect the companies intending to raise funds outside sources of working capital requirement in this situation, it may have to pay huge interest. Suppose the RBI announces liberal credit policies, the concern may rise the money for the working capital purpose.

Terms of purchase and Sales A organization allows liberal credit facilities to its customer, huge amount of working capital required because of more amount locked up on debtors and bills receivable. If the firm follow a stringent credit terms it could required only small amount of working capital.

Profitability. Profitability position also determines the Quantum of working capital purpose. Where as any other concern could lower amount of profit, it may not be position to meet out the working capital requirements.

Dividend policy If the companies wish to distribute the dividend is will influence on the working capital position of the company.

Irregularities of supplies Industries required regular supply of raw material for their continuous flow of production. if the suppliers supplies raw material on regular basis only small amount of working capital be required. Suppose the supplies are irregularities the concern is required huge amount of working capital in order ensure regular flow of production through of the maintenance of adequate working capital

Sales Volume. The sales volume and the proportion of working capital related to each other. As the volume a sales increases automatically it requires more amount of investment in working capital.

Financing Approaches of Working capital The hedging approach The conservative approach Trade of between hedging and conservative approaches

The 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 current assets and short-term financing to finance temporary or variable assets.

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.

Methods of working capital. Estimation of components of Working capital Method Percent of sales approach Operating cycle approach

Estimation of components of Working capital Method Since working capital is the excess of current assets over current liabilities. An assessment of working capital requirement can be made by estimating the amounts of different constituents of working capital. E.g. inventories, account receivable, cash account payable etc.

Percent of sales approach This is traditional and simple method of estimating working capital requirement. According to this method, on the basis of the past experience between sales and working capital requirements a ratio can be determined for estimating working capital in future. For example, if the past experience shows that the working capital has been 30 % of sales and it is estimated that the sales for the next year would (1 lac), the amount of working capital requirement can be assessed

Operating Cycle Approach According to this approach, the requirement of working capital depend upon the operating cycle of the business. The operating cycle begins with the acquisition raw material and ends with the collection of receivable. It may be broadly classified into four stages.

Statement of Working Capital Requirement... t ParticularsAmount Current Assets :- Stock of Raw Material Stock of Work in Progress Stock of Finished Goods Sundry Debtors Undeceived Income Cash at Bank/in hand TOTAL CURRENT ASSETS :- Less :- Current Liabilities :- Creditors Unpaid Payment TOTAL CURRENT LIABILITIES:- Working Capital (CA-CL) Add :- Provision /Margin for Contingency NET WORKING CAPITAL REQUIRED