Working Capital

Management

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 WORKING CAPITAL
 Current assets – Current liabilities
 It measures how much in liquid assets a
company has available to build its business.
 A short term loan which provides money to
buy earning assets.
 Allows to avail of unexpected opportunities.
 Positive working capital is required to ensure
that a firm is able to continue its operations
and that it has sufficient funds 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.

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 WORKING CAPITAL

 An increase in working capital indicates that

the business has either increased current
assets (that is received cash, or other current
assets) or has decreased current liabilities, for
example has paid off some short-term
creditors.

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 Working Capital Management

 Decisions relating to working capital and short term

financing are referred to as working capital
management. Short term financial management
concerned with decisions regarding to CA and CL.
 Management of Working capital refers to management
of CA as well as CL.
 If current assets are less than current liabilities, an
entity has a working capital deficiency, also called a
working capital deficit.
 These involve managing the relationship between a
firm's short-term assets and its short-term liabilities.

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 Working Capital Management

 The goal of working capital management is to ensure

that the firm is able to continue its operations and that
it has sufficient cash flow to satisfy both maturing
short-term debt and upcoming operational expenses.
 Businesses face ever increasing pressure on costs and
financing requirements as a result of intensified
competition on globalised markets. When trying to
attain greater efficiency, it is important not to focus
exclusively on income and expense items, but to also
take into account the capital structure, whose
improvement can free up valuable financial resources

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 WORKING CAPITAL MANAGEMENT

 Active working capital management is

an extremely effective way to increase
enterprise value. Optimising working
capital results in a rapid release of
liquid resources and contributes to an
improvement in free cash flow and to a
permanent reduction in inventory and
capital costs, thereby increasing
liquidity for strategic investment and
debt reduction. Process optimisation
then helps increase profitability.

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 WORKING CAPITAL MANAGEMENT

 The fundamental principles of

working capital management are
reducing the capital employed and
improving efficiency in the areas
of receivables, inventories, and
payables.

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 Why working Capital is important?

 Investment in CA represents a
substantial portion of total
investment.
 Investment in CA and level of CL
have to be geared quickly to
changes in sales.

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 Concepts of Working Capital

 Gross Working Capital

 Net working Capital

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 Gross Working Capital

 Total Current assets

 Where Current assets are the
assets that can be converted into
cash within an accounting year &
include cash , debtors etc.
 Referred as “Economics Concept”
since assets are employed to
derive a rate of return.

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 Net Working Capital

 CA – CL
 Referred as ‘point of view of an
Accountant’.
 It indicates liquidity position of a
firm & suggests the extent to
which working capital needs may
be financed by permanent sources
of funds.

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 CONSTITUENTS OF WORKING
CAPITAL
 CURRENT ASSETS
 Inventory
 Sundry Debtors
 Cash and Bank Balances
 Loans and advances
 CURRENT LIABILITIES
 Sundry creditors
 Short term loans
 Provisions

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 Characteristics of Current Assets

 Short Life Span

I.e. cash balances may be held idle for
a week or two , thus a/c may have a
life span of 30-60 days etc.
 Swift Transformation into other Asset
forms
[Link] CA is swiftly transformed into
other asset forms like cash is used for
acquiring raw materials , raw materials
are transformed into finished goods
and these sold on credit are
convertible into A/R & finlly into cash.
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 Matching Principle
 If a firm finances a long term asset(like
machinery) with a S-T Debt then it will
have to be periodically finance the
asset which will be risky as well as
inconvenient.
 i.e. maturity of sources of financing
should be properly matched with
maturity of assets being financed.
 Thus Fixed Assets & permanent CA
should be supported with L-T sources
of finance & fluctuating CA by S-T
sources.
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 MATCHING PRINCIPLE

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 Need for Working Capital
 As profits earned depend upon
magnitude of sales and they donot
convert into cash instantly, thus there
is a need for working capital in the
form of CA so as to deal with the
problem arising from lack of immediate
realisation of cash against goods sold.
 This is referred to as “Operating or
Cash Cycle” .
 It is defined as “The continuing flow
from cash to suppliers, to inventory , to
accounts receivable & back into cash “.
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 Need for Working Capital
 Thus needs for working capital arises
from cash or operating cycle of a firm.
 Which refers to length of time required
to complete the sequence of events.
 Thus operating cycle creates the need
for working capital & its length in
terms of time span required to
complete the cycle is the major
determinant of the firm’s working
capital needs.

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 Operating or Cash Cycle

1. Conversion of cash into

inventory
2. Conversion of inventory into
Receivables
3. Conversion of Receivables into
Cash

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 OPERATING CYCLE

Phase 3
Receivables
 
 
Phase 2
 
  Cash
Inventory
Phase 1

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 TYPES OF WORKING CAPITAL

 PERMANENT WORKING CAPITAL

 VARIABLE WORKING CAPITAL

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 PERMANENT WORKING CAPITAL

 THERE IS ALWAYS A MINIMUM LEVEL

OF CA WHICH IS CONTINOUSLY
REQUIRED BY A FIRM TO CARRY ON
ITS BUSINESS OPERATIONS.
 THUS , THE MINIMUM LEVEL OF
INVESTMENT IN CURRENT ASSETS
THAT IS REQUIRED TO CONTINUE
THE BUSINESS WITHOUT
INTERRUPTION IS REFERRED AS
PERMANENT WORKING CAPITAL.

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 VARIABLE WORKING CAPITAL

 THIS IS THE AMOUNT OF INVESTMENT

REQUIRED TO TAKE CARE OF
FLUCTUATIONS IN BUSINESS ACTIVITY OR
NEEDED TO MEET FLUCTUATIONS IN
DEMAND CONSEQUENT UPON CHANGES IN
PRODUCTION & SALES AS A RESULT OF
SEASONAL CHANGES.

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 DISTINCTION
 PERMANENT IS STABLE OVER TIME
WHEREAS VARIABLE IS FLUCTUATING
ACCORDING TO SEASONAL DEMANDS.
 INVESTMENT IN PERMANENT PORTION CAN
BE PREDICTED WITH SOME PROFITABILITY
WHEREAS INVESTMENT IN VARIABLE
CANNOT BE PREDICTED EASILY.
 WHILE PERMANENT IS MINIMUM
INVESTMENT IN VARIOUS CA , VARIABLE IS
EXPECTED TO TAKE CARE FOR PEAK IN
BUSINESS ACTIVITY.

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 DISTINCTION
 WHILE PERMANENT COMPONENT
REFLECTS THE NEED FOR A CERTAIN
IRREDUCIBLE LEVEL OF CURRENT ASSETS
ON A CONTINOUS AND UNINTERRUPTED
BASIS , THE TEMPORARY PORTION IS
NEEDED TO MEET SEASONAL & OTHER
TEMPORARY REQUIREMENTS.
 ALSO PERMANENT CAPITAL
REQUIREMENTS SHOULD BE FINANCED
FROM L-T SOURCES , S-TFUNDS SHOULD
BE USED TO FINANCE TEMPORARY
WORKING CAPITAL NEEDS OF A FIRM,

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 OPERATING
ENVIRONMENT OF
WORKING CAPITAL
CHAPTER 2

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 Monetary and Credit Policies
 Monetary policy is the process by which the
govt.,central bank, or monetary authority of a country
controls (i) the supply of money, (ii) availability of
money, and (iii) cost of money or rate of interest, in
order to attain a set of objectives oriented towards the
growth and stability of the economy.
 Monetary policy is the process by which the
government, central bank, or monetary authority of a
country controls (i) the supply of money, (ii) availability
of money, and (iii) cost of money or rate of interest, in
order to attain a set of objectives oriented towards the
growth and stability of the [Link] theory
provides insight into how to craft optimal monetary
policy.
 Monetary policy involves variations in money supply ,
interest rates , lending by commercial banks etc.

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 Credit Policy
 Credit gives the customer the opportunity to buy goods
and services, and pay for them at a later date.
 Clear, written guidelines that set
(1) the terms and conditions for supplying goods on
credit ,
(2) customer qualification criteria
(3) procedure for making collections , and
(4) steps to be taken in case of customer delinquency .
Also called collection policy.
 Where delinquency means Failure to repay an
obligation when due or as agreed. Thus in consumer
installment loans, missing two successive payments
will normally make the account delinquent

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 Advantages of credit trade

 Usually results in more customers than cash

trade.
 Can charge more for goods to cover the risk of
bad debt.
 Gain goodwill and loyalty of customers.
 People can buy goods and pay for them at a
later date.
 Farmers can buy seeds and implements, and
pay for them only after the harvest.
 Stimulates agricultural and industrial
production and commerce.
 Can be used as a promotional tool.
 Increase the sales.

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 Disadvantages of credit trade

 Risk of bad debt.

 High administration expenses.
 People can buy more than they
can afford.
 More working capital needed.
 Risk of Bankruptcy.

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 Instruments of Monetary Policy in
India
 Money Supply
 Bank Rate
 Reserve Ratios
 Interest Rates
 Selective Credit Controls
 Flow of Credit

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 Money Supply
 This is the sum total of money public funds
and can be used for settling transactions to
buy and sell things and make other payments
constitutes the money supply of a nation.
 Money supply = Notes and coins with public +
Demand deposits with Commercial papers

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 Bank Rate
 Standard rate at which bank is prepared to buy or
rediscount bills of exchange or other commercial
papers eligible for purchase under Reserve bank of
India Act,1934.
 The rate of interest charged by central bank on their
loans to commercial banks is called bank
rate(Discount rate).
 An increase in bank rate makes it more expensive for
commercial banks to borrow . This exerts pressure to
bring about the rise in interest rates (lending rates)
charged by commercial banks on their lending to
public. This leads to a general tightening in economy.
 Whereas decrease in bank rate has the opposite effect
and leads to general easing of credit in the economy.

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 RESERVE REQUIREMENTS
 The reserve requirement (or required reserve
ratio) is a bank regulation that sets the minimum
reserves each bank must hold to customer deposits
and notes. These reserves are designed to satisfy
withdrawal demands, and would normally be in the
form of fiat currency stored in a bank vault(vault
cash), or with a central bank.
 The reserve ratio is sometimes used as a tool in the
monetary policy, influencing the country's
economy, borrowing, and interest rates .Western
central banks rarely alter the reserve requirements
because it would cause immediate liquidity
problems for banks with low excess reserves; they
prefer to use open market operations to implement
their monetary policy

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 RESERVE REQUIREMENTS

 Thus central bank makes it

legally obligatory for commercial
banks to keep a certain
minimum percentage of deposits
in reserve.
 These are of 2 types:-
1. Cash reserves
2. Liquidity reserves

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 CRR

 CASH RESERVE RATIO

 THIS IS DEFINED AS A cash
reserve ratio (or CRR) is the
percentage of bank reserves to
deposits and notes. The cash
reserve ratio is also known as the
cash asset ratio or liquidity ratio.

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 STATUTORY LIQUIDITY RATIO
 Statutory Liquidity Ratio (SLR) is a
term used in the regulation of banking
in India. It is the amount which a
bank has to maintain in the form:
 Cash
 Gold valued at a price not exceeding
the current market price,
 Unencumbered approved securities (G
Secs or Gilts come under this) valued
at a price as specified by the RBI from
time to time.

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 STATUTORY LIQUIDITY RATIO
 The quantum is specified as some percentage of the total
demand and time liabilities ( i.e. the liabilities of the bank
which are payable on demand anytime, and those liabilities
which are accruing in one months time due to maturity) of a
bank. This percentage is fixed by the Reserve Bank of India.
The maximum and minimum limits for the SLR are 40% and
25% respectively.
 Following the amendment of the Banking regulation
Act(1949) in January 2007, the floor rate of 25% for SLR was
removed. Presently the SLR is 24% with effect from 8
November, 2008.
 The objectives of SLR are:
 To restrict the expansion of bank credit.
 To augment the investment of the banks in Government
securities.
 To ensure solvency of banks. A reduction of SLR rates looks
eminent to support the credit growth in India.

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 INTEREST RATES
 This is generally done by stipulating min.
rates of interest for extending credit against
commodities covetred under selective credit
control.
 Also, concessive or ceiling rates of interest are
made applicable to advances for certain
purposes ao to certain sectors to reduce the
interest burden and thus facilitate their
development.
 Further obj. behind fixing rates on deposits
are to avoid unhealthy competition amongst
the banks for deposits and keep the level of
deposit rates in alignment with lending rates
of banks for deposits.
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 Selective Credit Controls

 These are Qualitative instruments

which are aimed at affecting
changes in the availability of
credit with respect to particular
sectors of the economy.
 Thus selective controls are called
selective because they are aimed
at movement of credit towards
selective sectors of the economy.

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 Selective Credit Controls
 The general instruments such as
Reserve ratios, Bank rate and open
market operations.
 They are called so because they
influence the nation’s money supply
and general availability of credit.
 Quantitative instruments are called
quantitative because they affect the
total volume(quantity) of money supply
and credit in the country.

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 Selective Credit Controls
 The most widely used qualitative
techniques are selective control and
moral suasion.
 While the general credit controls
operate on the cost and total volume of
credit , selective credit controls relate
to tools available with the monetary
authority for regulating the
distrubution or direction of bank
resources to particular sectors of
economyin accordance with broad
national priorities considered necessary
for achieving the set.

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 MORAL SUASION

 IT IMPLIES THE CENTRAL BANK

EXERTING PRESSURE ON
BANKS BY USING ORAL AND
WRITTEN APPEALS TO EXPAND
OR RESTRICT CREDIT IN LINE
WITH ITS CREDIT POLICY.

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 DETERMINATION OF
WORKING CAPITAL NEEDS

CHAPTER 3

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 Different approaches in
determination of working
capital
 Industry norm approach
 Economic modeling approach
 Strategic choice approach

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 INDUSTRY NORM APPROACH
 THIS APPROACH IS BASED ON
THE PREMISE THAT EVERY
COMPANY IS GUIDED BY THE
INDUSTRY PRACTICE.
 LIKE IF MAJORITY OF FIRMS
HAVE BEEN GRANTING 3
MONTHS CREDIT TO A
CUSTOMER THEN OTHERS WILL
HAVE TO ALSO FOLLOW THE
MAJORITY DUE TO FEAR OF
LOSING CUSTOMERS.

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 ECONOMIC MODELLING
APPROACH
 TO ESTIMATE OPTIMUM
INVENTORY IS DECIDED WITH
THE HELP OF EOQ MODEL.

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 STRATEGIC CHOICE APPROACH
 THIS APPROACH RECOGNISES
THE VARIATIONS IN BUSINESS
PRACTICE AND ADVOCATES USE
OF STRATEGYIN TAKING
WORKING CAPITAL DECISIONS.
 THE PURPOSE BEHIND THIS
APPROACH IS TO PREPARE THE
UNIT TO FACE CHALLENGES OF
COMPETITION & TAKE A
STRATEGIC POSITION IN THE
MARKET PLACE.

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 STRATEGIC CHOICE APPROACH

 THE EMPHASIS IS ON
STRATEGIC BEHAVIOUR OF
BUSINESS [Link] THE FIRM
IS INDEPENDENT IN CHOOSING
ITS OWN COURSE OF ACTION
WHICH IS NOT GUIDED BY THE
RULES OF INDUSTRY,

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 Determinants of working capital

 General nature of business

 Production cycle
 Business cycle
 Credit policy
 Production policy
 Growth and expansion
 Profit level
 Operating efficiency

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