Working capital management

 

1.1 CONCEPT OF WORKING CAPITAL

 

There are two concepts of working capital. These are:

 

1. Gross working capital: (Total Current Assets) : The gross working capital, simply called as working capital refers to the firm’s investment in current assets. Current assets are the assets, which can be converted into cash within an accounting year or operating cycle. Thus, Gross working capital, is the total of all current assets. It includes

 1. Inventories (Raw materials and Components, Work-in-Progress, Finished Goods, Others)

 2. Trade Debtors

3. Loans and Advance

 4. Cash and Bank Balances

 5. Bills Receivables.

 6. Short-term Investment

 

2. Net Working Capital: (Total Current Assets – Total Current Liabilities)

Net working capital refers to the difference between current assets and

current liabilities. Current liabilities are those claims of outsiders, which are

expected to mature for payment within an accounting year. Net working

capital may be positive or negative. A positive net working capital will arise

when current assets exceed current liabilities and a negative net working

capital will arise when current liabilities exceed current assets i.e. there is no

working capital, but there is a working capital deficit. It includes

1. Trade Creditors.

2. Bills Payable.

3. Accrued or Outstanding Expenses.

4. Trade Advances

5. Short Term Borrowings (Commercial Banks and Others)

6. Provisions

7. Bank Overdraft

“Working Capital represents the amount of current assets that have not been

supplied by current, short term creditors.”10

 

“Gross working capital refers to the amount of funds invested in current assets

that are employed in the business process while, Net Working Capital refers

to the difference between current assets and current liabilities.” 11

“Working Capital is the excess of current assets that has been supplied by the

long-term creditors and the stockholders.”12

 

The two concepts of working capital, gross working capital and net working

capital are exclusive. Both are equally important for the efficient management

of working capital. The gross working capital focuses attention on two aspects

How to optimize investment in current assets? and How should current assets

be financed? While, net working capital concept is qualitative. It indicates the liquidity position of the firm and suggests the extent to which working capital needs may be financed by permanent sources of funds.

 

 

 

 

 

1.2 IMPORTANCE OF WORKING CAPITAL

 

Working capital is one of the important measurements of the financial position. The words of H. G. Guthmann clearly explain the importance of working capital. “Working Capital is the life-blood and nerve centre of the business.” In the words of Walker, “A firm’s profitability is determined in part by the way its working capital is managed.” The object of working capital management is to manage firm’s current assets and liabilities in such a way that a satisfactory level of working capital is maintained. If the firm cannot maintain a satisfactory level of working capital, it is likely to become insolvent

and may even be forced into bankruptcy. Thus, need for working capital to run day-to-day business activities smoothly can’t be overemphasized.

 

 

                        1.3 REQUIREMENTS OF WORKING CAPITAL

There are no set rules or formula to determine the working capital

requirements of the firms. A large number of factors influence the working

capital need of the firms. All factors are of different importance and also

importance change for the firm over time. Therefore, an analysis of the

relevant factors should be made in order to determine the total investment in

working capital. Generally the following factors influence the working capital

requirements of the firm:

• Nature and size of the business

• Seasonal fluctuations

• Production policy

• Taxation

• Depreciation policy

• Reserve policy

• Dividend policy

• Credit policy:

• Growth and expansion

• Price level changes

• Operating efficiency

• Profit margin and profit appropriation

 

 

Alternative current assest financing policies

Most businesses experience cyclical fluctuations Similarly, virtually all businesses must build up current assets when the business economy is strong, but they then see off inventories and reduce receivables when the economy slacks off, still, current assets rarely drop to zero . companies have some permanent current assets, which are the current assets on hand at the low point of the cycle. Then, as sales increase during the upswing, current assets must be increased and these additional current assets are defined as temporary current assets. The manner in which the permanent and temporary current assets are financed is called the firm’s current asset financing policy.

 

 

1.      Self-Liquidating  Approach :  Self-liquidating approach calls for matching asset and liability maturities. This strategy minimizes the risk that the firm will be unable to pay off its maturing obligations.

 

2.       Aggressive Approach

The situation for a relatively aggressive firm which finances all of its fixed assets with long-term capital and part of its permanent current assets with short-term, no spontaneous credit. Note that we used the term “relatively” in the title for panel b because there can be different degrees of aggressiveness. For example, the dashed line in panel b could have been drawn below the line designating fixed assets, indicating that all of the permanent current assets and part of the fixed assets were financed with short-term credit; this would be a highly aggressive, extremely no conservative position and the firm would be very much subject to dangers from rising interest rates as well as to loan renewal problems. However, short-term debt is often cheaper than long-term debt, and some firms are willing to sacrifice safety for the chance of higher profits.

 

3.       Conservative Approach

The dashed line above the line designating permanent current assets indicating that permanent capital is being used to finance all permanent asset requirements and also to meet some of the seasonal needs. In this situation, the firm uses a small amount of short-term, non-spontaneous credit to meet its peak requirements, but it also meets a part of its seasonal needs by “storing liquidity” in the form of marketable securities.

 

The humps above the dashed line represent short-term financing, while the troughs below the dashed line represent short-term security holdings. Panel c represents a very safe, conservative current asset financing policy.

 

Unit 2

Short term financial management

 

Some of the short-term sources of finance are:-

1. Trade Credit

 2. Accrual

 3. Deferred Income

 4. Commercial Paper (CPs)

 5. Public Deposits

 6. Inter-Corporate Deposits (ICDs)

7. Commercial Banks

8. Factoring

9. Installment Credit.

 

Trade credit refers to the credit extended by the supplier of goods or services to his/her customer in the course of business. It occupies a important position in shortterm financing due to the competition. Almost all the traders , manufacturers are required to extend credit facility . In order to get this source of finance, the buyer should have acceptable and dependable creditworthiness and reputation in the market. Trade credit is generally extended in the form of open account or bills of exchange. Open account is the form of trade credit, where supplier sends goods to the buyer and the payment to be received in future as per terms of the sales invoice. Getting trade credit may be easy to the well-established, but for a new or a firm with financial problems, will generally face problems in getting trade credit. Generally, suppliers look for earnings record, liquidity position and payment record while extending credit.

Advantages of Trade Credit:

1.      Easy availability when compared to other sources of finance

2.      Flexibility is another benefit, as the credit increases with the growth of the firm’s sales.

3.      Informality as stated in the above that it is an automatic finance.

 

Accrued expenses are those expenses which the company owes to the other, but not yet due and not yet paid the amount. Accruals represent a liability that a firm has to pay for the services or goods, it has received. It is spontaneous and interest-free source of financing. Salaries and wages, interest and taxes are the major constituents of accruals. The amount of accrual varies with the level of activities of a firm. When the level of activity expands, accruals increase and automatically they act a source of finance. Accruals are treated as “cost free” source or finance, since it does not involve any payment of interest.

 

Deferred income is income received in advance by the firm for supply of goods or services in future period. This income increases the firm’s liquidity and constitutes an important source of short-term finance. These payments are not showed as revenue till the supply of goods or services, but showed in the balance sheet as income received in advance.

 

Commercial paper represents a short-term unsecured promissory note issued by firms that have a fairly high credit (standing) rating. It was first introduced in the USA and it is an important money market instrument. CP is a source of short-term finance to only large firms with sound financial position.

 

Public deposits or term deposits are in the nature of unsecured deposits, are solicited by the firms (both large and small) from general public primarily for the purpose of financing their working capital requirements.

 

Inter-Corporate Deposits (ICDs): A deposit made by one firm with another firm is known as Inter-Corporate Deposit (ICD). Generally, these deposits are made for a period up to six months.

Such deposits may be of three types:

 

(a) Call Deposits:

 

These deposits are those expected to be payable on call/on just one day notice. But, in actual practice, the lender has to wait for at least 2 or 3 days to get back the amount. Inter-corporate deposits generally have 12 per cent interest per annum.

 

(b) Three Months Deposits:

 

These deposits are more popular among companies for investing the surplus funds. The borrower takes this type of deposits for meeting short-term cash inadequacy. The interest rate on these types of deposits is around 14 per cent per annum.

 

(c) Six months Deposits:

 

Inter-corporate deposits are made for a maximum period of six months. These types of deposits are usually given to ‘A’ category borrowers only and they carry an interest rate of around 16 per cent per annum.

 

 

Commercial banks are the major source of working capital finance to industries and commerce. Granting loan to business is one of their primary functions. Getting bank loan is not an easy task since the lending bank may ask a number of questions about the prospective borrower’s financial position and its plans for the future.

 

At the same time the bank will want to monitor borrower’s business progress. But there is a good side to this, that is borrower’s share price tends to rise, because investor knows that convincing banks is very difficult.

 

 

Factoring is one of the sources of working capital. Banks have been given more freedom of borrowing and lending both internally and externally and facilitated the free functioning in lending and investment operations. From 1994, banks are allowed to enter directly leasing, hire purchasing and factoring services, instead through their subsidiaries. In other words, banks are free to enter or exit in any field depending on their profitability, but subject to some RBI guidelines.

 

Banks provide working capital finance through financing receivables, which is known as “factoring”. A “Factor” is a financial institution, which renders services relating to the management and financing of sundry debtors that arises from credit sales.

 

 

Installment credit is another source of short-term financing, in which the borrowed amount is paid in equal installments with interest. It is also called as installment plan or hire-purchase plan. Installment credit is granted to the organization by the suppliers on the assurance that the repayment would be done in fixed installment at regular intervals of time. It is mostly used to acquire long-term assets used in production processes.

 

 

 

 

 

 Unit 5

Cash management

 

The term cash includes coins, currency and cheques held by the firm and balances in its bank accounts. Sometimes near-cash items such as marketable securities or bank time-deposits are also included in cash. The basic characteristics of near cash assts is that they can readily be converted into cash. Generally, when a firm has excess cash, it invests it in marketable securities. This kind of investment

contributes some profits to the firm.” Cash is both the beginning and the end of the working capital cycle, i.e., cash, inventories, receivables and cash. While the management of all firms should strive hard to secure larger cash at the end of the working capital cycle than what had been invested in to it at its beginning, they must also make it a best possible minimum. This is required to optimally utilise the cash and to avoid the situation of idle cash balances. Its effective management is the key determinant of sufficient working capital management.

In the words of P. V. Kulkarni:

“Cash in the business enterprise may be compared to the blood of the human body; blood gives life and strength to the human body, and cash imparts life and strength to the business organisation”.

 

According to J. M. Keyens:

“It is the cash which keeps a business going. Hence every enterprise has hold necessary cash for its existence”.

 

In a business firm, ultimately, a transaction results in either an inflow or an outflow of cash. In an efficiently managed business, static cash balance situation generally does not less. Cash shortage will disrupt the firm’s manufacturing operation, while excessive cash will simply remain idle, without contributing anything towards the firm’s profitability. Therefore, for its smooth running and maximum profitability proper and effective cash management in a business is of paramount importance.

 

MOTIVES FOR HOLDING CASH

J. M. Keynes, a prominent economist, pointed out three primary motives for

holding cash.

 The transaction motives;

 The precautionary motive; and

 The speculative motive.

These motives are explained in the following paragraph:

 

The transaction motives:

The transaction motive requires a firm hold cash to conduct its business in the ordinary course. The firms need cash primarily to make payment for purchases, wages, operating expenses, taxes, dividends etc. A firm needs a pool of cash because its receipts and payments are not perfectly synchronised. A pool of cash is also known as ‘transaction balance’. A cash budget is often used to decide what the transaction

balance should be.

 

The precautionary motive:

The precautionary motive is to hold cash to meet any contingencies in future.

It provides a cushion or buffer to withstand some unexpected emergency. The precautionary amount of cash depends upon the predictability of cash flows. If cash flows can be predicted with accuracy, less cash will be maintained against an emergency. On other hand, unpredicted the cash flows, the larger the need for such balances.

 

 

The speculative Motives:

The financial manager would like to take advantage of unexploited opportunities. Some reserve of money is always essential to enable the firm to take advantage of cash when such opportunities arise. The speculative motives helps to take advantage of: An opportunity to purchase raw materials at a reduced price on payment of immediate cash.

 A chance to speculate on interest rate movements by buying securities when interest rates are expected to decline.

 Delay purchases of raw materials on the anticipation of decline in prices.

 To make purchases at favourable prices

 Any other opportunity.

Of three primary motives of holding cash balance, the two of them are important viz.: the transaction motive and the precautionary motive. Business firm normally do not speculate and need not have speculative balances. The firm must decide the quantum of transitions and precautionary balance to be

held. This depends upon the following factors:

 The expected cash inflows and outflows based on the cash budget and forecasts, encompassing long and short term cash requirements of the firm.

 The degree of deviation between the expected and actual net cash flows.

 The maturity structure of the firms liabilities.

 The firm’s ability to borrow at short notice, in the event of any emergency.

 The philosophy of management regarding liquidity and risk of insolvency.

 The efficient planning and control of cash.

All these factors, analysed together, will determine the appropriate level of the transactions and precautionary balances.

 

 

FUNCTIONS OF CASH MANAGEMENT

In order to resolve the uncertainty about cash flow prediction and lack of synchronization between cash receipts and payments, the firm should devlope some strategies for cash management. Efficient cash managementrequires proper cash planning, an organisation for managing receipts anddisbursement, and an efficient control and review mechanism. The firm should evolve strategies regarding the following four function of cash management:

 

1) Cash planning:-

Cash planning can help anticipate future cash flows and needs of the firm and

reduces the possibility of idle cash balances and cash deficits. Cash planning is a

technique for planning and controlling the use of cash. Cash plans are very crucial in

developing the overall operating plans of the firm. Cash planning may be done on

daily, weekly or monthly basis. The period and frequency of cash planning generally

depends upon the size of the firm and philosophy of management. Cash budget should

be prepared for this proposes. Cash budget is the most significant device to plan for

and control the cash receipts and payments.

In the words of Van Horne:

“A cash budget is a summary statement of the firm’s expected cash inflows

and outflows over a projected time period. It gives information on the timing and

magnitude of expected cash flows and cash balances over the projected period. The

information helps the financial manager to determine the future cash needs of the

firm, plan for financing of these needs, and exercise control over the cash and

liquidity of the firm”.

Cash forecasts are needed to prepare cash budget. Cash forecasting may be

done on a short-term or long-term basis. It is comparatively easy to make short-term

forecasts. Short-terms cash forecasts, routinely prepared by business firms, are helpful

in:

 Estimating cash requirements;

 Planning short-term financing;

 Scheduling payments in connection with capital expenditure projects;

 Planning purchases of materials;

 Developing credit policies; and

 Checking the accuracy of long –term forecasts.

 

Long-term cash forecasts are generally prepared for a period ranging from 2 to

5 years and serve to provide a rough picture of firm’s financing needs and availability

of investable surplus in future. Long-term cash forecasts are helpful in:

 Planning the outlays on capital expenditure projects and

 Planning the rising of long-term funds.

 

2) Managing the cash flows:

The twin objectives in managing the cash flows are: cash inflows and cash

outflows. The inflows of cash should be accelerated while, as far as possible, the out

flow of the cash should be decelerated.

A firm can conserve cash and reduce its requirements for cash balances, if it

can speed up its cash collections. Cash collections can be accelerated by reducing the

lay or gap between the time a customer pays his bills and the time the cheque is

collected and funds become available for the firms use. Within this time gap, the

delay is caused by the mailing time, e.g., the time taken by cheque in transit and the

processing time, e.g., the time taken by the firm processing cheque for internal

accounting purpose. The amount of cheques sent by customers but not yet collected is

called deposit floats. The greater will be the firm’s deposit float, the longer the time

taken in converting cheques into usable funds. In India, these floats can assume

sizeable proportions, as cheques normally take a longer time to go realised, than in

most countries. An efficient financial manager will attempt to reduce the firm’s

deposits float by speeding up the mailing, processing and collections time. There are

mainly two techniques which can be used to save mailing and processing timesdecentralised collections and lock box system.

In decentralisation collection system affirm sets up collection centres in

various marketing centres of the country instead of a single collection centre. The

customers are instructed to remit their payments to the collection centre of their

region. The collection centre deposits the cheques in the local bank. These cheques

are collected quickly because many of them originate in the very city in which the

bank is located. Surplus money of the local bank can then be transferred to the

company’s main bank. Another technique of speeding up mailing processing and

collection times is ‘Lock Box System’. In this system, the local post office box is

rented by the company in a city and customers of the nearby area are asked to send

their remittances to it. Local bank is authorised to pick up remittances from the box

and deposit them in the account of the company, ultimately to be transferred to the

central bank account of the company.

It may be concluded that the major advantage of accelerating collections is to

reduce the firm’s total financing requirements.

 

3) Determining the optimum cash balance:

One of the primary responsibilities of the financial manager is to maintain a

sound liquidity position of the firm so that dues may be settled in time. The test of

liquidity is really the availability of cash to meet the firm’s obligations when they

become due. Thus, cash balance is maintained for day to day transactions and an

additional amount may be maintained as a buffer or safety stock. The financial

manager should determine the appropriate amount of cash balance.

Such a decision is influenced by a trade off between risk and return. If the firm

maintains a small cash balance, its liquidity position becomes week and suffers from a

paucity of cash to make payments. But at the same time a higher profitability can be

attained by investing runs out of cash it may have sell its marketable securities,

released funds in some profitable opportunities. When the firm runs out of cash it may

have to sell its marketable securities, if available, or borrow.

This involves transaction costs. On the other hand, if the firm maintains cash

balance at a high level, it will have a sound liquidity position but forgo the

opportunities to earn interest. The potential interest lost on holding large cash balance

involves an opportunity cost to the firm. Thus, the firm should maintain an optimum

cash balance, neither a small nor a large cash balance. To find out the optimum cash

balance, the transaction costs and risk of too small a balance should be matched with

the opportunity costs of too large a balance. figure 7.1 – Optimal size of cash

balance Figure 7.1 shows this trade off graphically costs would decline, but the

opportunity costs would increase. At point x the sum of the two costs is minimum.

This is the point of optimum cash balance which a firm should seek to achieve.

 

4) Investing Idle Cash:

The idle cash or precautionary cash should be properly and profitably

invested. The firm should decide about the division of cash balances between

marketable securities and bank deposits. The management of the investment in

marketable securities is an important financial management responsibility because of

the close relationship between cash and marketable securities. Therefore, the

investment in marketable securities should be properly managed. Excess cash should

normally be invested in marketable securities which can be conveniently and properly

managed. Excess cash should normally be invested in marketable securities which can

be covalently and promptly converted into cash. Cash in excess of working capital

cash balance requirements of firm may fluctuate because of the element of seasonality

and business cycles. Secondly, excess cash may be as a buffer to meet unpredictable

financial needs. A firm holds extra cash because cash-flows cannot be predicated with

certainty. Cash balance held to cover the future exigencies is called the precautionary

balance ad usually is invested in marketable securities until needed.

Instead of holding excess cash for the above mentioned purpose, the firm may

meet its precautionary requirements as and when they arise by making short-term

borrowings. The choice between the short-term borrowings and liquid asset holding

will depend upon the firm’s policy regarding the mix of short-term and long-term

financing. The excess amount of cash held by the firm to meet its variable cash

requirements and future contingencies should be temporarily invested in marketable

securities, which can be regarded as near currency of cash.