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WORKING CAPITAL MANAGEMENT

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1 WORKING CAPITAL MANAGEMENT
PREPARED BY TORAN LAL VERMA

2 CONCEPTS OF WORKING CAPITAL
Gross Working Capital Concept Gross working capital is the capital invested in total current assets of the business concern. Gross Working Capital = Current Asset

3 Net Working Capital Concept
Net Working Capital is the excess of current assets over the current liability of the concern during a particular period. Net Working Capital= Current Asset – Current Liabilities

4 KINDS OF WORKING CAPITAL
FIXED/PARMANENT WORKING CAPITAL It is the capital, the business concern must maintain certain amount of capital at minimum level at all times. The level of Permanent Capital depends upon the nature of the business. Permanent or Fixed Working Capital will not change irrespective of time or volume of sales. 2. VARIABLE/TEMPORARY WORKING CAPITAL It is the amount of capital which is required to meet the Seasonal demands and some special purposes.

5 ADVERSE CONSEQUENCES OF INADEQUATE WORKING CAPITAL
Due to non-availability of funds, it may become difficult for the company to undertake profitable projects. It may become difficult to execute plans. Difficulty in meeting day to day commitments. This would further create operational inefficiency. Due to insufficient working capital fixed asset may not be efficiently utilized. Inadequacy of working capital may also prevent the company from availing attractive credit facilities.

6 DANGERS OF EXCESSIVE WORKING CAPITAL
When there is a redundant working capital, it may lead to unnecessary purchasing and accumulation of inventories causing more chances of theft, waste and losses. Excessive Working Capital means idle funds which earn no profits for the business and hence the business cannot earn a proper rate of return on its investments. Increased bad debts due to defective credit policy. Leads to managerial inefficiency. It may result into overall inefficiency in the organisation.

7 Factors determining the working capital requirement of a firm
Nature of business: A transport company maintains lesser amount of Working Capital while a construction company maintains larger amount of Working Capital. Production cycle: If the production cycle length is small, they need to maintain lesser amount of Working Capital. If it is not, they have to maintain large amount of Working Capital. Business cycle: In the booming conditions, the Working Capital requirement is larger and in the depression condition, requirement of Working Capital will reduce. Better business results lead to increase the Working Capital requirements. Production policy: If the company maintains the continues production policy, there is a need of regular Working Capital.

8 Credit policy: If the company maintains liberal credit policy to collect the payments from its customers, they have to maintain more Working Capital. If the company pays the dues on the last date it will create the cash maintenance in hand and bank. Growth and expansion: During the growth and expansion of the business concern, Working Capital requirements are higher, because it needs some additional Working Capital and incurs some extra expenses at the initial stages. Availability of raw materials: If the raw material is not readily available, it leads to production stoppage. So, the concern must maintain adequate raw material; for that purpose, they have to spend some amount of Working Capital. Earning capacity: If the business concern consists of high level of earning capacity, they can generate more Working Capital, with the help of cash from operation.

9 OPERATING CYCLE CONCEPT
The time period between purchase of inventory and conversion into cash is known as operating cycle. Operating Cycle = Material Storage period + Production/Conversion Period + Finished Goods Holding Period + Average Collection Period - Average Payment Period

10 Courtesy: Ankita Namdev

11 Operating cycle method of forecasting working capital
Estimation of total operating expenses in the year. All material, labour and overheads Number of operating cycle in the year Dividing 365 days by duration of one operating cycle.

12 1. Material Storage Period (days) = π΄π‘£π‘’π‘Ÿπ‘Žπ‘”π‘’ π‘†π‘‘π‘œπ‘π‘˜ π‘œπ‘“ π‘…π‘Žπ‘€ π‘€π‘Žπ‘‘π‘’π‘Ÿπ‘–π‘Žπ‘™ π·π‘Žπ‘–π‘™π‘¦ π΄π‘£π‘’π‘Ÿπ‘Žπ‘”π‘’ πΆπ‘œπ‘›π‘ π‘’π‘šπ‘π‘‘π‘–π‘œπ‘› Average Stock of Raw Material = 𝑂𝑝𝑒𝑛𝑖𝑛𝑔 π‘†π‘‘π‘œπ‘π‘˜+πΆπ‘™π‘œπ‘ π‘–π‘›π‘” π‘†π‘‘π‘œπ‘π‘˜ 2 Daily Average Consumption = πΆπ‘œπ‘›π‘ π‘’π‘šπ‘π‘‘π‘–π‘œπ‘› π‘“π‘œπ‘Ÿ π‘‘β„Žπ‘’ π‘¦π‘’π‘Žπ‘Ÿ 365

13 2. Conversion Period (days) = π΄π‘£π‘’π‘Ÿπ‘Žπ‘”π‘’ π‘ π‘‘π‘œπ‘π‘˜ π‘œπ‘“ π‘ π‘’π‘šπ‘–βˆ’π‘“π‘–π‘›π‘–π‘ β„Žπ‘’π‘‘ π‘”π‘œπ‘œπ‘‘π‘  π΄π‘£π‘’π‘Ÿπ‘Žπ‘”π‘’ π‘‘π‘Žπ‘–π‘™π‘¦ π‘“π‘Žπ‘π‘‘π‘œπ‘Ÿπ‘¦ π‘π‘œπ‘ π‘‘ Average stock of semi-finished goods = 𝑂𝑝𝑒𝑛𝑖𝑛𝑔 π‘†π‘‘π‘œπ‘π‘˜+πΆπ‘™π‘œπ‘ π‘–π‘›π‘” π‘†π‘‘π‘œπ‘π‘˜ 2 Average daily factory cost = πΆπ‘œπ‘ π‘‘ π‘“π‘œπ‘Ÿ π‘‘β„Žπ‘’ π‘¦π‘’π‘Žπ‘Ÿ 365 Note: Conversion Period is Production Period

14 3. Finished Goods Storage Period (days)
Average stock of finished goods = 𝑂𝑝𝑒𝑛𝑖𝑛𝑔 π‘†π‘‘π‘œπ‘π‘˜+πΆπ‘™π‘œπ‘ π‘–π‘›π‘” π‘†π‘‘π‘œπ‘π‘˜ 2 Average daily cost of sales = π΄π‘£π‘’π‘Ÿπ‘Žπ‘”π‘’ π‘‘π‘Žπ‘–π‘™π‘¦ π‘“π‘œπ‘Ÿ π‘‘β„Žπ‘’ π‘¦π‘’π‘Žπ‘Ÿ 365

15 4. Average Collection Period (days) = π΄π‘£π‘’π‘Ÿπ‘Žπ‘”π‘’ π‘‘π‘’π‘π‘‘π‘œπ‘Ÿπ‘ /𝐡𝑅 𝑁𝑒𝑑 π‘π‘Ÿπ‘’π‘‘π‘–π‘‘ π‘ π‘Žπ‘™π‘’π‘  π‘π‘’π‘Ÿ π‘‘π‘Žπ‘¦ Average Debtors = 𝑂𝑝𝑒𝑛𝑖𝑛𝑔 π·π‘’π‘π‘‘π‘œπ‘Ÿπ‘ +πΆπ‘™π‘œπ‘ π‘–π‘›π‘” π·π‘’π‘π‘‘π‘œπ‘Ÿπ‘  2 Net Credit Sales per day = π‘‡π‘œπ‘‘π‘Žπ‘™ π‘π‘Ÿπ‘’π‘‘π‘–π‘‘ π‘ π‘Žπ‘™π‘’π‘  π‘“π‘œπ‘Ÿ π‘‘β„Žπ‘’ π‘¦π‘’π‘Žπ‘Ÿ 365

16 5. Average Payment Period = π΄π‘£π‘’π‘Ÿπ‘Žπ‘”π‘’ πΆπ‘Ÿπ‘’π‘‘π‘–π‘‘π‘œπ‘Ÿπ‘ /𝐡𝑃 𝑁𝑒𝑑 π‘π‘Ÿπ‘’π‘‘π‘–π‘‘ π‘π‘’π‘Ÿπ‘β„Žπ‘Žπ‘ π‘’ π‘π‘’π‘Ÿ π‘‘π‘Žπ‘¦ Average Creditors` = 𝑂𝑝𝑒𝑛𝑖𝑛𝑔 πΆπ‘Ÿπ‘’π‘‘π‘–π‘‘π‘œπ‘Ÿπ‘  +πΆπ‘™π‘œπ‘ π‘–π‘›π‘” π‘π‘Ÿπ‘’π‘‘π‘–π‘‘π‘œπ‘  2 Net Credit Purchase per day = π‘‡π‘œπ‘‘π‘Žπ‘™ π‘π‘Ÿπ‘’π‘‘π‘–π‘‘ π‘π‘’π‘Ÿπ‘β„Žπ‘Žπ‘ π‘’ π‘“π‘œπ‘Ÿ π‘‘β„Žπ‘’ π‘¦π‘’π‘Žπ‘Ÿ 365 Operating Cycle = Material Storage period+ Production/Conversion Period+ Finished Goods Holding Period+ Average Collection Period- Average Payment Period

17 6. No. of Operating Cycle = 365 π·π‘’π‘Ÿπ‘Žπ‘‘π‘–π‘œπ‘› π‘œπ‘“ π‘œπ‘›π‘’ π‘œπ‘π‘’π‘Ÿπ‘Žπ‘‘π‘–π‘›π‘” 𝑐𝑦𝑐𝑙𝑒 7
6. No. of Operating Cycle = 365 π·π‘’π‘Ÿπ‘Žπ‘‘π‘–π‘œπ‘› π‘œπ‘“ π‘œπ‘›π‘’ π‘œπ‘π‘’π‘Ÿπ‘Žπ‘‘π‘–π‘›π‘” 𝑐𝑦𝑐𝑙𝑒 7. Working Capital = π‘‡π‘œπ‘‘π‘Žπ‘™ π‘‚π‘π‘’π‘Ÿπ‘Žπ‘‘π‘–π‘›π‘” 𝐸π‘₯𝑝𝑒𝑛𝑠𝑒𝑠 π‘π‘’π‘šπ‘π‘’π‘Ÿ π‘œπ‘“ π‘‚π‘π‘’π‘Ÿπ‘Žπ‘‘π‘–π‘›π‘” 𝐢𝑦𝑐𝑙𝑒𝑠

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19 Solution Material Storage Period (days) = π΄π‘£π‘’π‘Ÿπ‘Žπ‘”π‘’ π‘†π‘‘π‘œπ‘π‘˜ π‘œπ‘“ π‘…π‘Žπ‘€ π‘€π‘Žπ‘‘π‘’π‘Ÿπ‘–π‘Žπ‘™ π·π‘Žπ‘–π‘™π‘¦ π΄π‘£π‘’π‘Ÿπ‘Žπ‘”π‘’ πΆπ‘œπ‘›π‘ π‘’π‘šπ‘π‘‘π‘–π‘œπ‘› Average Collection Period (days) = π΄π‘£π‘’π‘Ÿπ‘Žπ‘”π‘’ π‘‘π‘’π‘π‘‘π‘œπ‘Ÿπ‘ /𝐡𝑅 𝑁𝑒𝑑 π‘π‘Ÿπ‘’π‘‘π‘–π‘‘ π‘ π‘Žπ‘™π‘’π‘  π‘π‘’π‘Ÿ π‘‘π‘Žπ‘¦ Finished Goods Storage Period (days) = π΄π‘£π‘’π‘Ÿπ‘Žπ‘”π‘’ π‘ π‘‘π‘œπ‘π‘˜ π‘œπ‘“ π‘“π‘–π‘›π‘–π‘ β„Žπ‘’π‘‘ π‘”π‘œπ‘œπ‘‘π‘  π‘Žπ‘£π‘’π‘Ÿπ‘Žπ‘”π‘’ π‘‘π‘Žπ‘–π‘™π‘¦ π‘π‘œπ‘ π‘‘ π‘œπ‘“ π‘ π‘Žπ‘™π‘’π‘  Conversion Period (days) = π΄π‘£π‘’π‘Ÿπ‘Žπ‘”π‘’ π‘ π‘‘π‘œπ‘π‘˜ π‘œπ‘“ π‘ π‘’π‘šπ‘–βˆ’π‘“π‘–π‘›π‘–π‘ β„Žπ‘’π‘‘ π‘”π‘œπ‘œπ‘‘π‘  π΄π‘£π‘’π‘Ÿπ‘Žπ‘”π‘’ π‘‘π‘Žπ‘–π‘™π‘¦ π‘“π‘Žπ‘π‘‘π‘œπ‘Ÿπ‘¦ π‘π‘œπ‘ π‘‘ Payment period = 100 days

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21

22 SOURCES OF FINANCING WORKING CAPITAL
Long Term Sources Owned Sources Issue of Shares Retained Earnings Reserves Sale of fixed assets Borrowed Sources Debentures Long-term loans

23 Short-term sources Trade Credit Bank loans Certificate of Deposit
Advance from customers

24 New Sources Factoring Convertible Debentures Commercial Papers

25 STRATEGIES FOR FINANCING WORKING CAPITAL

26 CONSERVATIVE STRATEGY
In this strategy, apart from the fixed assets and permanentΒ current assets, a part of temporary working capital is also financed by long-term financing sources.Β  Long Term Funds will Finance >>Β FA + PWC + Part of TWC Short Term Funds will Finance >>Β Remaining Part of TWC

27 AGGRESSIVE STRATEGY The complete focus of the strategy is in profitability. It is a high-risk high profitability strategy. In this strategy, the dearer funds i.e. long term funds are utilized only to finance fixed assets and a part of the permanent working capital. Complete temporary working capital and a part of permanent working capital also are financed by the short-term funds. Long Term Funds will Finance >>Β FA + Part of PWC Short Term Funds will Finance >>Β Remaining Part of PWC + TWC

28 HEDGING (MATURITY MATCHING) STRATEGY
This is a meticulous strategy of financing the working capital with moderate risk and profitability.Β  Hedging strategy works on the cardinal principle of financing i.e. utilizing long- term sources for financing long-term assets i.e. fixed assets and a part of permanent working capital and temporary working capital are financed by short- termΒ sources of finance.Β  Long Term Funds will Finance >> FA + PWC Short Term Funds will Finance >>Β TWC

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30 TONDON COMMITTEE REPORT

31 TONDON COMMITTEE REPORT 1975
RBI formed constituted a committee in July, 1974 under the chairmanship of Mr. Prakash Tondon. The committee was formed with an aim to formulate guidelines for bank credit. These are To issue guidelines for banks for ensuring proper use of funds, improving the safety of credit system. To suggest the type of operational data and other information that may be obtained by banks periodically from borrowers. To make suggestions for prescribing inventory norms for different industries both in private and public sectors. To suggest criteria regarding satisfactory capital structure and sound financial basis in relation to borrowings. To make recommendations regarding sources of financing the minimum working capital requirement To review nd suggest modification in the existing system of financing working capital.

32 FINDING OF THE COMMITTEE
Borrowers decide as to how much to borrow. Bankers could not provide any credit plan because they don’t have knowledge as how much they would lend. Bank credit has been considered as first source of loan. Bank credit has been granted on the basis of collateral rather than on the basis of business plans and operations.

33 RECOMMENDATIONS OF THE COMMITTEE:
Recommendations are based on 3 principles: Borrowers has to maintain a strict financial discipline. The borrower has to furnish complete information of the business plan to the banker for getting loan. The prime function of a bank as a lender is to maintain the borrowers current asset at an acceptable level The banker should have knowledge about the end use of bank credit.

34 Major Recommendations
Norms for inventory and receivables: Borrowers Should maintain a reasonable level of current asset, particularly inventory and receivables to ensure rational allocation of resources and to avoid unwanted financing of current asset. The banker should finance only reasonable inventory based on production plan and should not finance any excessive inventory Only those receivables should be financed which are in tune with borrower’s firms. Lending Norms: the recommendation is related to lending by commercial banks to borrowers. The current asset to be financed by banks must be reasonable and based o norms. A pat of current asset must be financed by long term funds and the banker is required to finance only the remaining pat. Style of Credit: the committee recommended the decomposition of credit into two parts- fixed and fluctuating. The information provided by bank was required to be appropriately used by banks to follow up and supervise the uuse of credit.

35 5. Maximum Permissible Bank Finance: the committee suggested the following three methods of determining the level of working capital to be financed by bank borrowings: First Method: The borrower has to finance 25% of the working capital gap through long –term sources. The remaining 75% will be financed from bank. Formula = 0.75(CA-CL) Second Method: According to this method at least 25% of the current asset should be arranged through long term sources. The remaining gap will be provided by bank Formula = (0.75CA)-CL Third Method: the borrower has to contribute the entire hard core current asset and a minimum of 25% of the balance of the current asset of the firm. Formula = 0.75(CA-CCA)-CL

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39 COMMERCESTUDYGUIDE.COM Detailed explanations and fekology is expected from students Source: S.P. Gupta

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