WORKING CAPITAL MANAGEMENT IN STEEL INDUSTRY

INTRODUCTION

Indian steel industry plays a significant role in the country’s economic growth. The major

contribution directs the attention that steel is having a stronghold in the traditional sectors, such

as infrastructure & constructions, automobile, transportation, industrial applications etc. The

liberalization of industrial policy and other initiatives taken by the Government have given a

definite impetus for entry, participation and growth of the private sector in the steel industry.

While the existing units are being modernized/ expanded, a large number of new steel plants

have also come up in different parts of the country based on modern, cost effective, state of-the-

art technologies. In the last few years, the rapid and stable growth of the demand side has also

prompted domestic entrepreneurs to set. At present, crude steel making capacity is 84 mt and

India, the 4th largest producer1 of crude steel in the world, has to its credit, the capability to

produce a variety of grades and that too, of international quality standards up fresh green field

projects in different states of the country. Management of working capital is an important

component of corporate financial management because it directly affects the profitability of the

firms. Net working capital trend is one of the devices for measuring liquidity. Net working

capital trend analysis is highly relevant as it presents the composite reflection of the trend

analysis of current assets and current liabilities. The direction of change in working capital

position over the period of time is an indication of the effectiveness or ineffectiveness of the

working capital management. The study has been done on the basis of published annual reports

of operating five steel companies in India for a period of six years starting from 2006 and ending

on 2011. Company may have an optimal level of working capital that maximizes their value.

Large inventory and generous trade credit policy may lead to high sales. The larger inventory

also reduces the risk of a stock-out. Trade credit may stimulate sales because it allows a firm to

access product quality before paying. Another component of working capital is accounts

payables delaying payment of accounts payable to suppliers allows firms to access the liquidity.

A popular measure of working capital management is the net operating cycle, that is, the time

span between the expenditure for the purchases of raw materials and the collection of sales of

finished goods. Longer the time lag, the larger the investment in working capital. A long net

operating cycle might increase profitability because it leads to higher sales. However, corporate

profitability might decrease with the net operating cycle, if the costs of higher investment in

working capital rise faster than the benefits of holding more inventories and/or granting more

trade credit to customers. The present work aims to examine the working capital management of

steel companies in India

Current assets minus current liabilities. Working capital measures how much in liquid

assets a company has available to build its business. The number can be positive or negative,

depending on how much debt the company is carrying. In general, companies that have a lot of

working capital will be more successful since they can expand and improve their operations.

Companies with negative working capital may lack the funds necessary for growth. also

called net current assets or current capital.

Corporate finance is the area of finance dealing with monetary decisions that business

enterprises make and the tools and analysis used to make these decisions. The primary goal of

corporate finance is to maximize shareholder value. Although it is in principle different from

managerial finance which studies the financial decisions of all firms, rather than corporations

alone, the main concepts in the study of corporate finance are applicable to the financial

problems of all kinds of firms.

The discipline can be divided into long-term and short-term decisions and techniques. Capital

investment decisions are long-term choices about which projects receive investment, whether to

finance that investment with equity or debt, and when or whether to pay dividends to

shareholders. On the other hand, short term decisions deal with the short-term balance of current

assets and current liabilities; the focus here is on managing cash, inventories, and short-term

borrowing and lending (such as the terms on credit extended to customers).

The terms corporate finance and corporate financier are also associated with investment

banking. The typical role of an investment bank is to evaluate the company's financial needs and

raise the appropriate type of capital that best fits those needs. Thus, the terms “corporate finance”

and “corporate financier” may be associated with transactions in which capital is raised in order

to create, develop, grow or acquire businesses

Capital investment decisions are long-term corporate finance decisions relating to fixed assets

and capital structure. Decisions are based on several inter-related criteria. (1) Corporate

management seeks to maximize the value of the firm by investing in projects which yield a

positive net present value when valued using an appropriate discount rate in consideration of

risk. (2) These projects must also be financed appropriately. (3) If no such opportunities exist,

maximizing shareholder value dictates that management must return excess cash to shareholders

(i.e., distribution via dividends). Capital investment decisions thus comprise an investment

decision, a financing decision, and a dividend decision

Management must allocate limited resources between competing opportunities (projects) in a

process known as capital budgeting. Making this investment, or capital allocation, decision

requires estimating the value of each opportunity or project, which is a function of the size,

timing and predictability of future cash flows.

n general,[4] each project's value will be estimated using a discounted cash flow (DCF) valuation,

and the opportunity with the highest value, as measured by the resultant net present value (NPV)

will be selected (applied to Corporate Finance by Joel Dean in 1951; see also Fisher separation

theorem, John Burr Williams#Theory). This requires estimating the size and timing of all of the

incremental cash flows resulting from the project. Such future cash flows are then discounted to

determine their present value (see Time value of money). These present values are then summed,

and this sum net of the initial investment outlay is the NPV. See Financial modeling.

The NPV is greatly affected by the discount rate. Thus, identifying the proper discount rate –

often termed, the project "hurdle rate" – is critical to making an appropriate decision. The hurdle

rate is the minimum acceptable return on an investment—i.e. the project appropriate discount

rate. The hurdle rate should reflect the riskiness of the investment, typically measured by

volatility of cash flows, and must take into account the project-relevant financing mix. [6]

Managers use models such as the CAPM or the APT to estimate a discount rate appropriate for a

particular project, and use the weighted average cost of capital (WACC) to reflect the financing

mix selected. (A common error in choosing a discount rate for a project is to apply a WACC that

applies to the entire firm. Such an approach may not be appropriate where the risk of a particular

project differs markedly from that of the firm's existing portfolio of assets.)

In conjunction with NPV, there are several other measures used as (secondary) selection criteria

in corporate finance. These are visible from the DCF and include discounted payback period,

IRR, Modified IRR, equivalent annuity, capital efficiency, and ROI. Alternatives (complements)

to NPV include Residual Income Valuation, MVA / EVA (Joel Stern, Stern Stewart & Co) and

APV (Stewart Myers). See list of valuation topics.

n many cases, for example R&D projects, a project may open (or close) various paths of action

to the company, but this reality will not (typically) be captured in a strict NPV approach.[7] Some

analysts account for this uncertainty by adjusting the discount rate (e.g. by increasing the cost of

capital) or the cash flows (using certainty equivalents, or applying (subjective) "haircuts" to the

forecast numbers). Even when employed, however, these latter methods do not normally

properly account for changes in risk over the project's lifecycle and hence fail to appropriately

adapt the risk adjustment. Management will therefore (sometimes) employ tools which place an

explicit value on these options. So, whereas in a DCF valuation the most likely or average or

scenario specific cash flows are discounted, here the “flexible and staged nature” of the

investment is modelled, and hence "all" potential payoffs are considered. See further under Real

options valuation. The difference between the two valuations is the "value of flexibility" inherent

in the project.

The two most common tools are Decision Tree Analysis (DTA) and Real options valuation

(ROV); they may often be used interchangeably:

DTA values flexibility by incorporating possible events (or states) and consequent

management decisions. (For example, a company would build a factory given that

demand for its product exceeded a certain level during the pilot-phase, and outsource

production otherwise. In turn, given further demand, it would similarly expand the

factory, and maintain it otherwise. In a DCF model, by contrast, there is no "branching" –

each scenario must be modelled separately.) In the decision tree, each management

decision in response to an "event" generates a "branch" or "path" which the company

could follow; the probabilities of each event are determined or specified by management.

Once the tree is constructed: (1) "all" possible events and their resultant paths are visible

to management; (2) given this “knowledge” of the events that could follow, and assuming

rational decision making, management chooses the branches (i.e. actions) corresponding

to the highest value path probability weighted; (3) this path is then taken as representative

of project value. See Decision theory#Choice under uncertainty.

ROV is usually used when the value of a project is contingent on the value of some other

asset or underlying variable. (For example, the viability of a mining project is contingent

on the price of gold; if the price is too low, management will abandon the mining rights,

if sufficiently high, management will develop the ore body. Again, a DCF valuation

would capture only one of these outcomes.) Here: (1) using financial option theory as a

framework, the decision to be taken is identified as corresponding to either a call option

or a put option; (2) an appropriate valuation technique is then employed – usually a

variant on the Binomial options model or a bespoke simulation model, while Black

Scholes type formulae are used less often; see Contingent claim valuation. (3) The "true"

value of the project is then the NPV of the "most likely" scenario plus the option value.

(Real options in corporate finance were first discussed by Stewart Myers in 1977;

viewing corporate strategy as a series of options was originally per Timothy Luehrman,

in the late 1990s.) See also Option pricing approaches under Business valuation.

Given the uncertainty inherent in project forecasting and valuation,[12][14] analysts will

wish to assess the sensitivity of project NPV to the various inputs (i.e. assumptions) to the

DCF model. In a typical sensitivity analysis the analyst will vary one key factor while

holding all other inputs constant, ceteris paribus. The sensitivity of NPV to a change in

that factor is then observed, and is calculated as a "slope": ΔNPV / Δfactor. For example,

the analyst will determine NPV at various growth rates in annual revenue as specified

(usually at set increments, e.g. -10%, -5%, 0%, 5%....), and then determine the sensitivity

using this formula. Often, several variables may be of interest, and their various

combinations produce a "value-surface",[15] (or even a "value-space",) where NPV is then

a function of several variables. See also Stress testing.

Using a related technique, analysts also run scenario based forecasts of NPV. Here, a

scenario comprises a particular outcome for economy-wide, "global" factors (demand for

the product, exchange rates, commodity prices, etc...) as well as for company-specific

factors (unit costs, etc...). As an example, the analyst may specify various revenue growth

scenarios (e.g. 0% for "Worst Case", 10% for "Likely Case" and 20% for "Best Case"),

where all key inputs are adjusted so as to be consistent with the growth assumptions, and

calculate the NPV for each. Note that for scenario based analysis, the various

combinations of inputs must be internally consistent (see discussion at Financial

modeling), whereas for the sensitivity approach these need not be so. An application of

this methodology is to determine an "unbiased" NPV, where management determines a

(subjective) probability for each scenario – the NPV for the project is then the

probability-weighted average of the various scenarios. See First Chicago Method.

A further advancement which "overcomes the limitations of sensitivity and scenario

analyses by examining the effects of all possible combinations of variables and their

realizations." [16] is to construct stochastic[17] or probabilistic financial models – as

opposed to the traditional static and deterministic models as above.[14] For this purpose,

the most common method is to use Monte Carlo simulation to analyze the project’s NPV.

This method was introduced to finance by David B. Hertz in 1964, although has only

recently become widespread. (Risk-analysis add-ins, such as @Risk or Crystal Ball,

allow analysts to run simulations in spreadsheet based DCF models, whereas before

these, some knowledge of programming was required.). Here, the cash flow components

that are (heavily) impacted by uncertainty are simulated, mathematically reflecting their

"random characteristics". In contrast to the scenario approach above, the simulation

produces several thousand random but possible outcomes, or trials, "covering all

conceivable real world contingencies in proportion to their likelihood;" [18] see Monte

Carlo Simulation versus “What If” Scenarios. The output is then a histogram of project

NPV, and the average NPV of the potential investment – as well as its volatility and other

sensitivities – is then observed. This histogram provides information not visible from the

static DCF: for example, it allows for an estimate of the probability that a project has a

net present value greater than zero (or any other value).

Continuing the above example; instead of assigning three discrete values to revenue

growth, and to the other relevant variables, the analyst would assign an appropriate

probability distribution to each variable (commonly triangular or beta), and, where

possible, specify the observed or supposed correlation between the variables. These

distributions would then be "sampled" repeatedly – incorporating this correlation – so as

to generate several thousand random but possible scenarios, with corresponding

valuations, which are then used to generate the NPV histogram. The resultant statistics

(average NPV and standard deviation of NPV) will be a more accurate mirror of the

project's "randomness" than the variance observed under the scenario based approach.

These are often used as estimates of the underlying "spot price" and volatility for the real

option valuation as above; see Real options valuation: Valuation inputs. A more robust

Monte Carlo model would include the possible occurrence of risk events (e.g., a credit

crunch) that drive variations in one or more of the DCF model inputs.

Working capital (abbreviated WC) is a financial metric which represents operating

liquidityavailable to a business, organization or other entity, including governmental entity.

Along with fixed assets such as plant and equipment, working capital is considered a part of

operating capital. Net working capital is calculated as current assets minus current liabilities. It is

a derivation of working capital, that is commonly used in valuation techniques such as DCFs

(Discounted cash flows). If current assets are less than current liabilities, an entity has aworking

capital deficiency, also called a working capital deficit.

A company can be endowed with assets and profitability but short of liquidity if its assets cannot

readily be converted into cash. 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 debtand

upcoming operational expenses. The management of working capital involves managing

inventories, accounts receivable and payable, and cash.

OBJECTIVE

To study the structure of the working capital of selected steel companies.

2. To study the management of working capital components by steel companies

3. To know the comparative position of steel companies in working capital management.

Every business needs some amount of working capital. It is needed for following purposes-

• For the purchase of raw materials, components and spares.

• To pay wages and salaries.

• To incur day to day expenses and overhead costs such as fuel, power, and office expenses etc.

• To provide credit facilities to customers etc.

Factors that determine working capital:

The working capital requirement of a concern depend upon a large number of factors such as 

? Size of business

? Nature of character of business.

? Seasonal variations working capital cycle

? Operating efficiency

? Profit level.

? Other factors.

Achieving the goals of corporate finance requires that any corporate investment be financed

appropriately. The sources of financing are, generically, capital self-generated by the firm and

capital from external funders, obtained by issuing new debt and equity (and hybrid- or

convertible securities). As above, since both hurdle rate and cash flows (and hence the riskiness

of the firm) will be affected, the financing mix will impact the valuation of the firm (as well as

the other long-term financial management decisions). There are two interrelated considerations

here:

Management must identify the "optimal mix" of financing—the capital structure that

results in maximum firm value. (See Balance sheet, WACC, Fisher separation theorem;

but, see also the Modigliani-Miller theorem.) Financing a project through debt results in a

liability or obligation that must be serviced, thus entailing cash flow implications

independent of the project's degree of success. Equity financing is less risky with respect

to cash flow commitments, but results in a dilution of share ownership, control and

earnings. The cost of equity (see CAPM and APT) is also typically higher than the cost of

debt - which is, additionally, a deductible expense - and so equity financing may result in

an increased hurdle rate which may offset any reduction in cash flow risk.

Management must attempt to match the long-term financing mix to the assets being

financed as closely as possible, in terms of both timing and cash flows. Managing any

potential asset liability mismatch or duration gap entails matching the assets and

liabilities respectively according to maturity pattern ("Cashflow matching") or duration

("immunization"); managing this relationship in the short-term is a major function of

working capital management, as discussed below. Other techniques, such as

securitization, or hedging using interest rate- or credit derivatives, are also common. See

Asset liability management; Treasury management; Credit risk; Interest rate risk.

Much of the theory here, falls under the umbrella of the Trade-Off Theory in which firms are

assumed to trade-off the tax benefits of debt with the bankruptcy costs of debt when making their

decisions. However economists have developed a set of alternative theories about financing

decisions. One of the main alternative theories of how firms make their financing decisions is the

Pecking Order Theory (Stewart Myers), which suggests that firms avoid external financing while

they have internal financing available and avoid new equity financing while they can engage in

new debt financing at reasonably low interest rates. Also, Capital structure substitution theory

hypothesizes that management manipulates the capital structure such that earnings per share

(EPS) are maximized. An emerging area in finance theory is right-financing whereby investment

banks and corporations can enhance investment return and company value over time by

determining the right investment objectives, policy framework, institutional structure, source of

financing (debt or equity) and expenditure framework within a given economy and under given

market conditions. One of the more recent innovations in this are from a theoretical point of view

is the Market timing hypothesis. This hypothesis, inspired in the behavioral finance literature,

states that firms look for the cheaper type of financing regardless of their current levels of

internal resources, debt and equity.

Whether to issue dividends, and what amount, is calculated mainly on the basis of the company's

unappropriated profit and its earning prospects for the coming year. The amount is also often

calculated based on expected free cash flows i.e. cash remaining after all business expenses, and

capital investment needs have been met.

If there are no NPV positive opportunities, i.e. projects where returns exceed the hurdle rate, then

– finance theory suggests – management must return excess cash to shareholders as dividends.

This is the general case, however there are exceptions. For example, shareholders of a "growth

stock", expect that the company will, almost by definition, retain earnings so as to fund growth

internally. In other cases, even though an opportunity is currently NPV negative, management

may consider “investment flexibility” / potential payoffs and decide to retain cash flows; see

above and Real options.

Management must also decide on the form of the dividend distribution, generally as cash

dividends or via a share buyback. Various factors may be taken into consideration: where

shareholders must pay tax on dividends, firms may elect to retain earnings or to perform a stock

buyback, in both cases increasing the value of shares outstanding. Alternatively, some companies

will pay "dividends" from stock rather than in cash; see Corporate action. Today, it is generally

accepted that dividend policy is value neutral – i.e. the value of the firm would be the same,

whether it issued cash dividends or repurchased its stock (see Modigliani-Miller theorem).

Decisions relating to working capital and short term financing are referred to as working capital

management. These involve managing the relationship between a firm's short-term assets and its

short-term liabilities. In general this is as follows: As above, the goal of Corporate Finance is the

maximization of firm value. In the context of long term, capital investment decisions, firm value

is enhanced through appropriately selecting and funding NPV positive investments. These

investments, in turn, have implications in terms of cash flow and cost of capital. The goal of

Working Capital (i.e. short term) management is therefore to ensure that the firm is able to

operate, and that it has sufficient cash flow to service long term debt, and to satisfy both

maturing short-term debt and upcoming operational expenses. In so doing, firm value is

enhanced when, and if, the return on capital exceeds the cost of capital; See Economic value

added (EVA). Managing short term finance and long term finance is one task of a modern CFO.

Decision criteria

Working capital is the amount of capital which is readily available to an organization. That is,

working capital is the difference between resources in cash or readily convertible into cash

(Current Assets), and cash requirements (Current Liabilities). As a result, the decisions relating

to working capital are always current, i.e. short term, decisions. In addition to time horizon,

working capital decisions differ from capital investment decisions in terms of discounting and

profitability considerations; they are also "reversible" to some extent. (Considerations as to Risk

appetite and return targets remain identical, although some constraints – such as those imposed

by loan covenants – may be more relevant here).

Working capital management decisions are therefore not taken on the same basis as long term

decisions, and working capital management applies different criteria in decision making: the

main considerations are (1) cash flow / liquidity and (2) profitability / return on capital (of which

cash flow is probably the most important).

The most widely used measure of cash flow is the net operating cycle, or cash conversion

cycle. This represents the time difference between cash payment for raw materials and

cash collection for sales. The cash conversion cycle indicates the firm's ability to convert

its resources into cash. Because this number effectively corresponds to the time that the

firm's cash is tied up in operations and unavailable for other activities, management

generally aims at a low net count. (Another measure is gross operating cycle which is the

same as net operating cycle except that it does not take into account the creditors deferral

period.)

In this context, the most useful measure of profitability is Return on capital (ROC). The

result is shown as a percentage, determined by dividing relevant income for the 12

months by capital employed; Return on equity (ROE) shows this result for the firm's

shareholders. As above, firm value is enhanced when, and if, the return on capital,

exceeds the cost of capital. ROC measures are therefore useful as a management tool, in

that they link short-term policy with long-term decision making.

Management of working capital

Guided by the above criteria, management will use a combination of policies and techniques for

the management of working capital.[24] These policies aim at managing the current assets

(generally cash and cash equivalents, inventories and debtors) and the short term financing, such

that cash flows and returns are acceptable.

Cash management. Identify the cash balance which allows for the business to meet day

to day expenses, but reduces cash holding costs.

Inventory management. Identify the level of inventory which allows for uninterrupted

production but reduces the investment in raw materials – and minimizes reordering costs

– and hence increases cash flow. Note that "inventory" is usually the realm of operations

management: given the potential impact on cash flow, and on the balance sheet in

general, finance typically "gets involved in an oversight or policing way". [25]:714 See

Supply chain management; Just In Time (JIT); Economic order quantity (EOQ);

Dynamic lot size model; Economic production quantity (EPQ); Economic Lot Scheduling

Problem; Inventory control problem; Safety stock.

Debtors management. There are two inter-related roles here: Identify the appropriate

credit policy, i.e. credit terms which will attract customers, such that any impact on cash

flows and the cash conversion cycle will be offset by increased revenue and hence Return

on Capital (or vice versa); see Discounts and allowances. Implement appropriate Credit

scoring policies and techniques such that the risk of default on any new business is

acceptable given these criteria.

Short term financing. Identify the appropriate source of financing, given the cash

conversion cycle: the inventory is ideally financed by credit granted by the supplier;

however, it may be necessary to utilize a bank loan (or overdraft), or to "convert debtors

to cash" through "factoring".

Relationship with other areas in finance

Investment banking

Use of the term “corporate finance” varies considerably across the world. In the United States it

is used, as above, to describe activities, decisions and techniques that deal with many aspects of a

company’s finances and capital. In the United Kingdom and Commonwealth countries, the terms

“corporate finance” and “corporate financier” tend to be associated with investment banking –

i.e. with transactions in which capital is raised for the corporation.[26] These may include

Raising seed, start-up, development or expansion capital

Mergers, demergers, acquisitions or the sale of private companies

Mergers, demergers and takeovers of public companies, including public-to-private deals

Management buy-out, buy-in or similar of companies, divisions or subsidiaries –

typically backed by private equity

Equity issues by companies, including the flotation of companies on a recognised stock

exchange in order to raise capital for development and/or to restructure ownership

Raising capital via the issue of other forms of equity, debt and related securities for the

refinancing and restructuring of businesses

Financing joint ventures, project finance, infrastructure finance, public-private

partnerships and privatisations

Secondary equity issues, whether by means of private placing or further issues on a stock

market, especially where linked to one of the transactions listed above.

Raising debt and restructuring debt, especially when linked to the types of transactions

listed above

Financial risk management

Main article: Financial risk management

See also: Credit risk; Default (finance); Financial risk; Interest rate risk; Liquidity risk;

Operational risk; Settlement risk; Value at Risk; Volatility risk.

Risk management is the process of measuring risk and then developing and implementing

strategies to manage ("hedge") that risk. Financial risk management, typically, is focused on the

impact on corporate value due to adverse changes in commodity prices, interest rates, foreign

exchange rates and stock prices (market risk). It will also play an important role in short term

cash- and treasury management; see above. It is common for large corporations to have risk

management teams; often these overlap with the internal audit function. While it is impractical

for small firms to have a formal risk management function, many still apply risk management

informally. See also Enterprise risk management.

The discipline typically focuses on risks that can be hedged using traded financial instruments,

typically derivatives; see Cash flow hedge, Foreign exchange hedge, Financial engineering.

Because company specific, "over the counter" (OTC) contracts tend to be costly to create and

monitor, derivatives that trade on well-established financial markets or exchanges are often

preferred. These standard derivative instruments include options, futures contracts, forward

contracts, and swaps; the "second generation" exotic derivatives usually trade OTC. Note that

hedging-related transactions will attract their own accounting treatment: see Hedge accounting,

Mark-to-market accounting, FASB 133, IAS 39.

This area is related to corporate finance in two ways. Firstly, firm exposure to business and

market risk is a direct result of previous Investment and Financing decisions. Secondly, both

disciplines share the goal of enhancing, or preserving, firm value. There is a fundamental debate

[28] relating to "Risk Management" and shareholder value. Per the Modigliani and Miller

framework, hedging is irrelevant since diversified shareholders are assumed to not care about

firm-specific risks, whereas, on the other hand hedging is seen to create value in that it reduces

the probability of financial distress. A further question, is the shareholder's desire to optimize

risk versus taking exposure to pure risk (a risk event that only has a negative side, such as loss of

life or limb). The debate links the value of risk management in a market to the cost of bankruptcy

in that market. See Fisher separation theorem.

Personal and public finance

Corporate finance utilizes tools from almost all areas of finance. Some of the tools developed by

and for corporations have broad application to entities other than corporations, for example, to

partnerships, sole proprietorships, not-for-profit organizations, governments, mutual funds, and

personal wealth management. But in other cases their application is very limited outside of the

corporate finance arena. Because corporations deal in quantities of money much greater than

individuals, the analysis has developed into a discipline of its own. It can be differentiated from

personal finance and public finance.

Alternate Approaches

A standard assumption in Corporate finance is that shareholders are the residual claimants and

that the primary goal of executives should be to maximize shareholder value. Recently, however,

legal scholars (e.g. Lynn Stout [29]) have questioned this assumption, implying that the assumed

goal of maximizing shareholder value is inappropriate for a public corporation. This criticism in

turn brings into question the advice of corporate finance, particularly related to stock buybacks

made purportedly to "return value to shareholders," which is predicated on a legally erroneous

assumption.

Calculation

Current assets and current liabilities include three accounts which are of special importance.

These accounts represent the areas of the business where managers have the most direct impact:

accounts receivable  (current asset)

inventory  (current assets), and

accounts payable  (current liability)

The current portion of debt (payable within 12 months) is critical, because it represents a short-

term claim to current assets and is often secured by long term assets. Common types of short-

term debt are bank loans and lines of credit.

An increase in working capital indicates that the business has either increased current assets(that

is has increased its receivables, or other current assets) or has decreased current liabilities,for

example has paid off some short-term creditors.

Implications on M&A: The common commercial definition of working capital for the purpose

of a working capital adjustment in an M&A transaction (i.e. for a working capital adjustment

mechanism in a sale and purchase agreement) is equal to:

Current Assets – Current Liabilities excluding deferred tax assets/liabilities, excess cash, surplus

assets and/or deposit balances.

Cash balance items often attract a one-for-one purchase price adjustment.

Working capital management

Decisions relating to working capital and short term financing are referred to as working capital

management. These involve managing the relationship between a firm's short-term assets and

its short-term liabilities. The goal of working capital management is to ensure that the firm is

able to continue itsoperations and that it has sufficient cash flow to satisfy both maturing short-

term debt and upcoming operational expenses.

Decision criteria

By definition, working capital management entails short term decisions - generally, relating to

the next one year period - which are "reversible". These decisions are therefore not taken on the

same basis as Capital Investment Decisions (NPV or related, as above) rather they will be based

on cash flows and / or profitability.

One measure of cash flow is provided by the cash conversion cycle - the net number of days

from the outlay of cash for raw material to receiving payment from the customer. As a

management tool, this metric makes explicit the inter-relatedness of decisions relating to

inventories, accounts receivable and payable, and cash. Because this number effectively

corresponds to the time that the firm's cash is tied up in operations and unavailable for other

activities, management generally aims at a low net count.

In this context, the most useful measure of profitability is Return on capital (ROC). The

result is shown as a percentage, determined by dividing relevant income for the 12 months

by capital employed; Return on equity (ROE) shows this result for the firm's shareholders.

Firm value is enhanced when, and if, the return on capital, which results from working

capital management, exceeds the cost of capital, which results from capital investment

decisions as above. ROC measures are therefore useful as a management tool, in that they

link short-term policy with long-term decision making. See Economic value added (EVA).

Credit policy  of the firm: Another factor affecting working capital management is credit

policy of the firm. It includes buying of raw material and selling of finished goods either in

cash or on credit. This affects the cash conversion cycle.

Management of working capital

Guided by the above criteria, management will use a combination of policies and techniques for

the management of working capital. These policies aim at managing the current

assets (generally cash andcash equivalents, inventories and debtors) and the short term financing,

such that cash flows and returns are acceptable.

Cash management . Identify the cash balance which allows for the business to meet day to

day expenses, but reduces cash holding costs.

Inventory management. Identify the level of inventory which allows for uninterrupted

production but reduces the investment in raw materials - and minimizes reordering costs -

and hence increases cash flow. Besides this, the lead times in production should be lowered

to reduce Work in Progress (WIP) and similarly, the Finished Goodsshould be kept on as low

level as possible to avoid over production - see Supply chain management; Just In

Time (JIT); Economic order quantity (EOQ); Economic quantity

Debtors management. Identify the appropriate credit policy, i.e. credit terms which will

attract customers, such that any impact on cash flows and the cash conversion cycle will be

offset by increased revenue and hence Return on Capital (or vice versa); see Discounts and

allowances.

Short term financing. Identify the appropriate source of financing, given the cash

conversion cycle: the inventory is ideally financed by credit granted by the supplier;

however, it may be necessary to utilize a bank loan (or overdraft), or to "convert debtors to

cash" through "factoring".

Accounts receivable

Accounts receivable also known as Debtors, is money owed to a business by its clients

(customers) and shown on its Balance Sheet as an asset It is one of a series of accounting

transactions dealing with the billing of a customer for goods and services that the customer has

ordered.

Overview

Accounts receivable represents money owed by entities to the firm on the sale of products or

services on credit. In most business entities, accounts receivable is typically executed by

generating an invoice and either mailing or electronically delivering it to the customer, who, in

turn, must pay it within an established timeframe, called credit terms or payment terms.

The accounts receivable departments use the sales ledger, this is because a sales ledger normally

records [2]:

- The sales a business has made.

- The amount of money received for goods or services.

- The amount of money owed at the end of each month varies (debtors).

The accounts receivable team is in charge of receiving funds on behalf of a company and

applying it towards their current pending balances.

Collections and cashiering teams are part of the accounts receivable department. While the

collection's department seeks the debtor, the cashiering team applies the monies received.

Payment terms

An example of a common payment term is Net 30, which means that payment is due at the end

of 30 days from the date of invoice. Thedebtor is free to pay before the due date; businesses

entities can offer a discount for early payment. Other common payment terms includeNet 45, Net

60 and 30 days end of month.

Booking a receivable is accomplished by a simple accounting transaction; however, the process

of maintaining and collecting payments on the accounts receivable subsidiary account balances

can be a full-time proposition. Depending on the industry in practice, accounts receivable

payments can be received up to 10 – 15 days after the due date has been reached. These types of

payment practices are sometimes developed by industry standards, corporate policy, or because

of the financial condition of the client.

Since not all customer debts will be collected, businesses typically estimate the amount of and

then record an allowance for doubtful accounts [3]  which appears on the balance sheet as a contra

account that offsets total accounts receivable. When accounts receivable are not paid, some

companies turn them over to third party collection agencies or collection attorneys who will

attempt to recover the debt via negotiating payment plans, settlement offers or pursuing other

legal action.

Outstanding advances are part of accounts receivable if a company gets an order from its

customers with payment terms agreed upon in advance. Since billing is done to claim the

advances several times, this area of collectible is not reflected in accounts receivables. Ideally,

since advance payment occurs within a mutually agreed-upon term, it is the responsibility of the

accounts department to periodically take out the statement showing advance collectible and

should be provided to sales & marketing for collection of advances. The payment of accounts

receivable can be protected either by a letter of credit or by Trade Credit Insurance

Accounts Receivable Age Analysis

The Accounts Receivable Age Analysis Printout, also known as the Debtors Book is divided in

categories for current, 30 days, 60 days, 90 days, 120 days, 150 days and 180 days and over due

that are produced in Modern Accounting Systems. The printout is done in the order of the Chart

of Accounts for the Accounts Receivable and/or Debtors Book. The option to include Zero

Balances outstanding or to specifically leave it out is also possible in the printout features.

Bookkeeping

On a company's balance sheet, accounts receivable is the money owed to that company by

entities outside of the company. The receivables owed by the company's customers are

called trade receivables. Account receivables are classified as current assets assuming that they

are due within one year. To record a journal entry for a sale on account, one must  debit a

receivable and credit a revenue account. When the customer pays off their accounts, one debits

cash and credits the receivable in the journal entry. The ending balance on the trial balancesheet

for accounts receivable is usually a debit.

Business organizations which have become too large to perform such tasks by hand (or small

ones that could but prefer not to do them by hand) will generally use accounting software on

a computer to perform this task.

Companies have two methods available to them for measuring the net value of accounts

receivable, which is generally computed by subtracting the balance of an allowance account from

the accounts receivable account.

The first method is the allowance method, which establishes a contra-asset account, allowance

for doubtful accounts, or bad debt provision, that has the effect of reducing the balance for

accounts receivable. The amount of the bad debt provision can be computed in two ways, either

(1) by reviewing each individual debt and deciding whether it is doubtful (a specific provision);

or (2) by providing for a fixed percentage (e.g. 2%) of total debtors (a general provision). The

change in the bad debt provision from year to year is posted to the bad debt expense account in

the income statement.

The second method is the direct write-off method. It is simpler than the allowance method in that

it allows for one simple entry to reduce accounts receivable to its net realizable value. The entry

would consist of debiting a bad debt expense account and crediting the respective accounts

receivable in the sales ledger.

The two methods are not mutually exclusive, and some businesses will have a provision for

doubtful debts, writing off specific debts that they know to be bad (for example, if the debtor has

gone into liquidation.)

Special uses

Companies can use their accounts receivable as collateral when obtaining a loan (asset-based

lending). They may also sell them throughfactoring or on an exchange. Pools or portfolios of

accounts receivable can be sold in capital markets through securitization.

For tax reporting purposes, a general provision for bad debts is not an allowable deduction from

profit[4] - a business can only get relief for specific debtors that have gone bad. However, for

financial reporting purposes, companies may choose to have a general provision against bad

debts consistent with their past experience of customer payments, in order to avoid over-stating

debtors in the balance sheet.

Inventory

Inventory means a list compiled for some formal purpose, such as the details of an estate going

to probate, or the contents of a house let furnished. This remains the prime meaning in British

English.[1] In the USA and Canada the term has developed from a list of goods andmaterials to

the goods and material available in stock by a business; and this has become the primary

meaning of the term in North American English, equivalent to the term "stock" in British

English. In accounting, inventory or stock is considered an asset.

Inventory management

Inventory management is primarily about specifying the shape and percentage of stocked goods.

It is required at different locations within a facility or within many locations of a supply network

to precede the regular and planned course of production and stock of materials.

The scope of inventory management concerns the fine lines between replenishment lead time,

carrying costs of inventory, asset management, inventory forecasting, inventory valuation,

inventory visibility, future inventory price forecasting, physical inventory, available physical

space for inventory, quality management, replenishment, returns and defective goods, and

demand forecasting. Balancing these competing requirements leads to optimal inventory levels,

which is an on-going process as the business needs shift and react to the wider environment.

Inventory management involves a retailer seeking to acquire and maintain a proper merchandise

assortment while ordering, shipping, handling, and related costs are kept in check. It also

involves systems and processes that identify inventory requirements, set targets, provide

replenishment techniques, report actual and projected inventory status and handles all functions

related to the tracking and management of material. This would include the monitoring of

material moved into and out of stockroom locations and the reconciling of the inventory

balances. It also may include ABC analysis, lot tracking, cycle counting support, etc.

Management of the inventories, with the primary objective of determining/controlling stock

levels within the physical distribution system, functions to balance the need for product

availability against the need for minimizing stock holding and handling costs.

Principle of inventory proportionality

Purpose

Inventory proportionality is the goal of demand-driven inventory management. The primary

optimal outcome is to have the same number of days' (or hours', etc.) worth of inventory on hand

across all products so that the time of runout of all products would be simultaneous. In such a

case, there is no "excess inventory," that is, inventory that would be left over of another product

when the first product runs out. Excess inventory is sub-optimal because the money spent to

obtain it could have been utilized better elsewhere, i.e. to the product that just ran out.

The secondary goal of inventory proportionality is inventory minimization. By integrating

accurate demand forecasting with inventory management, replenishment inventories can be

scheduled to arrive just in time to replenish the product destined to run out first, while at the

same time balancing out the inventory supply of all products to make their inventories more

proportional, and thereby closer to achieving the primary goal. Accurate demand forecasting also

allows the desired inventory proportions to be dynamic by determining expected sales out into

the future; this allows for inventory to be in proportion to expected short-term sales or

consumption rather than to past averages, a much more accurate and optimal outcome.

Integrating demand forecasting into inventory management in this way also allows for the

prediction of the "can fit" point when inventory storage is limited on a per-product basis.

Applications

The technique of inventory proportionality is most appropriate for inventories that remain unseen

by the consumer, as opposed to "keep full" systems where a retail consumer would like to see

full shelves of the product they are buying so as not to think they are buying something old,

unwanted or stale; and differentiated from the "trigger point" systems where product is reordered

when it hits a certain level; inventory proportionality is used effectively by just-in-time

manufacturing processes and retail applications where the product is hidden from view.

One early example of inventory proportionality used in a retail application in the United States

was for motor fuel. Motor fuel (e.g. gasoline) is generally stored in underground storage tanks.

The motorists do not know whether they are buying gasoline off the top or bottom of the tank,

nor need they care. Additionally, these storage tanks have a maximum capacity and cannot be

overfilled. Finally, the product is expensive. Inventory proportionality is used to balance the

inventories of the different grades of motor fuel, each stored in dedicated tanks, in proportion to

the sales of each grade. Excess inventory is not seen or valued by the consumer, so it is simply

cash sunk (literally) into the ground. Inventory proportionality minimizes the amount of excess

inventory carried in underground storage tanks. This application for motor fuel was first

developed and implemented by Petrolsoft Corporation in 1990 for Chevron Products Company.

Most major oil companies use such systems today.

High-level inventory management

It seems that around 1880[4] there was a change in manufacturing practice from companies with

relatively homogeneous lines of products to horizontally integrated companies with

unprecedented diversity in processes and products. Those companies (especially in

metalworking) attempted to achieve success through economies of scope - the gains of jointly

producing two or more products in one facility. The managers now needed information on the

effect of product-mix decisions on overall profits and therefore needed accurate product-cost

information. A variety of attempts to achieve this were unsuccessful due to the huge overhead of

the information processing of the time. However, the burgeoning need for financial reporting

after 1900 created unavoidable pressure for financial accounting of stock and the management

need to cost manage products became overshadowed. In particular, it was the need for audited

accounts that sealed the fate of managerial cost accounting. The dominance of financial reporting

accounting over management accounting remains to this day with few exceptions, and the

financial reporting definitions of 'cost' have distorted effective management 'cost' accounting

since that time. This is particularly true of inventory.

Hence, high-level financial inventory has these two basic formulas, which relate to the

accounting period:

1. Cost of Beginning Inventory at the start of the period + inventory purchases within the

period + cost of production within the period = cost of goods available

2. Cost of goods available − cost of ending inventory at the end of the period = cost of

goods sold

The benefit of these formulae is that the first absorbs all overheads of production and raw

material costs into a value of inventory for reporting. The second formula then creates the new

start point for the next period and gives a figure to be subtracted from the sales price to

determine some form of sales-margin figure.

Manufacturing management is more interested in inventory turnover ratio or average days to sell

inventory since it tells them something about relative inventory levels.

Inventory turnover ratio (also known as inventory turns) = cost of goods sold / Average

Inventory = Cost of Goods Sold / ((Beginning Inventory + Ending Inventory) / 2)

and its inverse

Average Days to Sell Inventory = Number of Days a Year / Inventory Turnover Ratio =

365 days a year / Inventory Turnover Ratio

This ratio estimates how many times the inventory turns over a year. This number tells

how much cash/goods are tied up waiting for the process and is a critical measure of

process reliability and effectiveness. So a factory with two inventory turns has six

months stock on hand, which is generally not a good figure (depending upon the

industry), whereas a factory that moves from six turns to twelve turns has probably

improved effectiveness by 100%. This improvement will have some negative results in

the financial reporting, since the 'value' now stored in the factory as inventory is reduced.

While these accounting measures of inventory are very useful because of their simplicity,

they are also fraught with the danger of their own assumptions. There are, in fact, so

many things that can vary hidden under this appearance of simplicity that a variety of

'adjusting' assumptions may be used. These include:

Specific Identification

Weighted Average Cost

Moving-Average Cost

FIFO and LIFO .

Inventory Turn is a financial accounting tool for evaluating inventory and it is not

necessarily a management tool. Inventory management should be forward looking. The

methodology applied is based on historical cost of goods sold. The ratio may not be able

to reflect the usability of future production demand, as well as customer demand.

Business models, including Just in Time (JIT) Inventory, Vendor Managed Inventory

(VMI) and Customer Managed Inventory (CMI), attempt to minimize on-hand inventory

and increase inventory turns. VMI and CMI have gained considerable attention due to

the success of third-party vendors who offer added expertise and knowledge that

organizations may not possess.

Financial accounting

An organization's inventory can appear a mixed blessing, since it counts as an asset on

thebalance sheet, but it also ties up money that could serve for other purposes and requires

additional expense for its protection. Inventory may also cause significant tax expenses,

depending on particular countries' laws regarding depreciation of inventory, as in Thor Power

Tool Company v. Commissioner.

Inventory appears as a current asset on an organization's balance sheet because the organization

can, in principle, turn it into cash by selling it. Some organizations hold larger inventories than

their operations require in order to inflate their apparent asset value and their perceived

profitability.

In addition to the money tied up by acquiring inventory, inventory also brings associated costs

for warehouse space, for utilities, and forinsurance to cover staff to handle and protect it from

fire and other disasters, obsolescence, shrinkage (theft and errors), and others. Suchholding

costs can mount up: between a third and a half of its acquisition value per year.

Businesses that stock too little inventory cannot take advantage of large orders from customers if

they cannot deliver. The conflicting objectives of cost control and customer service often pit an

organization's financial and operating managers against its sales and marketingdepartments.

Salespeople, in particular, often receive sales-commission payments, so unavailable goods may

reduce their potential personal income. This conflict can be minimised by reducing production

time to being near or less than customers' expected delivery time. This effort, known as "Lean

production" will significantly reduce working capital tied up in inventory and reduce

manufacturing costs (See the Toyota Production System).

Role of inventory accounting

By helping the organization to make better decisions, the accountants can help the public sector

to change in a very positive way that delivers increased value for the taxpayer’s investment. It

can also help to incentivise progress and to ensure that reforms are sustainable and effective in

the long term, by ensuring that success is appropriately recognized in both the formal and

informal reward systems of the organization.

To say that they have a key role to play is an understatement. Finance is connected to most, if not

all, of the key business processes within the organization. It should be steering the stewardship

and accountability systems that ensure that the organization is conducting its business in an

appropriate, ethical manner. It is critical that these foundations are firmly laid. So often they are

the litmus test by which public confidence in the institution is either won or lost.

Finance should also be providing the information, analysis and advice to enable the

organizations’ service managers to operate effectively. This goes beyond the traditional

preoccupation with budgets – how much have we spent so far, how much do we have left to

spend? It is about helping the organization to better understand its own performance. That means

making the connections and understanding the relationships between given inputs – the resources

brought to bear – and the outputs and outcomes that they achieve. It is also about understanding

and actively managing risks within the organization and its activities.

FIFO vs. LIFO accounting

When a merchant buys goods from inventory, the value of the inventory account is reduced by

the cost of goods sold (COGS). This is simple where the CoG has not varied across those held in

stock; but where it has, then an agreed method must be derived to evaluate it.

Forcommodity items that one cannot track individually, accountants must choose a method that

fits the nature of the sale. Two popular methods that normally exist are: FIFO and LIFO

accounting (first in - first out, last in - first out). FIFO regards the first unit that arrived in

inventory as the first one sold. LIFO considers the last unit arriving in inventory as the first one

sold. Which method an accountant selects can have a significant effect on net income and book

value and, in turn, on taxation. Using LIFO accounting for inventory, a company generally

reports lower net income and lower book value, due to the effects of inflation. This generally

results in lower taxation. Due to LIFO's potential to skew inventory value, UK

GAAP and IAS have effectively banned LIFO inventory accounting.

Standard cost accounting

Standard cost accounting uses ratios called efficiencies that compare the labour and materials

actually used to produce a good with those that the same goods would have required under

"standard" conditions. As long as similar actual and standard conditions obtain, few problems

arise. Unfortunately, standard cost accounting methods developed about 100 years ago, when

labor comprised the most important cost in manufactured goods. Standard methods continue to

emphasize labor efficiency even though that resource now constitutes a (very) small part of cost

in most cases.

Standard cost accounting can hurt managers, workers, and firms in several ways. For example, a

policy decision to increase inventory can harm a manufacturing manager's performance

evaluation. Increasing inventory requires increased production, which means that processes must

operate at higher rates. When (not if) something goes wrong, the process takes longer and uses

more than the standard labor time. The manager appears responsible for the excess, even though

s/he has no control over the production requirement or the problem.

In adverse economic times, firms use the same efficiencies to downsize, rightsize, or otherwise

reduce their labor force. Workers laid off under those circumstances have even less control over

excess inventory and cost efficiencies than their managers.

Many financial and cost accountants have agreed for many years on the desirability of replacing

standard cost accounting. They have not, however, found a successor.

Calculating Working Capital

The number one reason most people look at a balance sheet is to find out a company's working

capital (or "current") position. It reveals more about the financial condition of a business than

almost any other calculation. It tells you what would be left if a company raised all of its short

term resources, and used them to pay off its short term liabilities. The more working capital, the

less financial strain a company experiences. By studying a company's position, you can clearly

see if it has the resources necessary to expand internally or if it will have to turn to a bank and

take on debt.

Working Capital is the easiest of all the balance sheet calculations. Here's the formula.

Current Assets - Current Liabilities = Working Capital

One of the main advantages of looking at the working capital position is being able to foresee

any financial difficulties that may arise. Even a business that has billions of dollars in fixed

assets will quickly find itself in bankruptcy court if it can't pay its monthly bills. Under the best

circumstances, poor working capital leads to financial pressure on a company, increased

borrowing, and late payments to creditor - all of which result in a lower credit rating. A lower

credit rating means banks charge a higher interest rate, which can cost a corporation a lot of

money over time.

Negative Working Capital Can Be a Good Thing for High Turn Businesses

Companies that have high inventory turns and do business on a cash basis (such as a grocery

store) need very little working capital. These types of businesses raise money every time they

open their doors, then turn around and plow that money back into inventory to increase sales.

Since cash is generated so quickly, managements can simply stockpile the proceeds from their

daily sales for a short period of time if a financial crisis arises. Since cash can be raised so

quickly, there is no need to have a large amount of working capital available.

A company that makes heavy machinery is a completely different story. Because these types of

businesses are selling expensive items on a long-term payment basis, they can't raise cash as

quickly. Since the inventory on their balance sheet is normally ordered months in advance, it can

rarely be sold fast enough to raise money for short-term financial crises (by the time it is sold, it

may be too late). It's easy to see why companies such as this must keep enough working capital

on hand to get through any unforeseen difficulties.

Working Capital and Cash Flow Analysis

Cash is the most liquid of all assets, so many managers are particularly interested in how much

cash is available to a business at any given time. Because the flow of cash into and out of a

business is mainly a matter of investing (purchasing assets) and disinvesting (disposing of

assets), an analysis of cash flows can help measure management’s performance. This chapter

describes the process of accounting for and analyzing cash flows. Although it doesn’t replace

them, the cash flow statement is a useful adjunct to income statements and balance sheets. Using

tools that are available to you in the form of different functions and links, you’ll see how to use

Excel to convert the information in a balance sheet and income statement to a cash flow

statement. To set the stage, the next section discusses how costs are timed.

Cash vs.Working Capital

So far, we have discussed funds in terms of cash only. A broader and more useful way of looking

at the availability of funds involves the concept of working capital. How does your company

create income? If you manufacture a product, you use funds to purchase inventory, produce

goods with that inventory, convert those goods into accounts receivable by selling them, and

convert accounts receivable into cash when you take

payment. If you are a merchandising firm, the process is basically the same, although you

probably purchase finished goods instead of producing them. Each of the components in this

process is a current asset, such as an asset that you can convert into cash in a relatively short

period (usually, but not always, one year) as a result of your normal business operations.

Inventory and accounts receivable, for example, are not as

liquid as cash, but your business expects to convert both to cash before too long. Current

liabilities, on the other hand, are obligations that you must meet during the same relatively short

time period that defines your current assets. Notes payable, accounts payable, and salaries are

examples of current liabilities.

5

Matching Costs and Revenues

Several other chapters of this book mention the matching principle—the notion that revenue

should

be matched with whatever expenses or assets produce that revenue. This notion leads inevitably

to the accrual method of accounting. If you obtain the annual registration for a truck in January

and use that truck to deliver

products to your customers for 12 months, you have paid for an item in January that helps you

produce

revenue all year long. If you record the entire amount of the expense in January, you overstate

your costs and understate your profitability for that month. You also understate your costs and

overstate your profitability for the remaining 11 months.

Largely for this reason, the accrual method evolved. Using the accrual method, you would accrue

1/12th of the expense of the truck registration during each month of the year. Doing so enables

you to measure your expenses against your revenues more accurately throughout the year.

Similarly, suppose that you sell a product to a customer on a credit basis. You might receive

periodic payments for the product over several months, or you might receive payment in a lump

sum sometime after the sale. Again, if you wait to record that income until you have received full

payment, you will misestimate your profit until the customer finishes paying you. Some very

small businesses—primarily sole proprietorships—use an alternative to accrual, called the cash

method of accounting. They find it more convenient to record expenses and revenues when the

transaction took place. In very small businesses, the additional accuracy of the accrual method

might not be worth the effort. An accrual basis is more complicated than a cash basis and

requires more effort to maintain, but it is often a more accurate method for reporting purposes.

The main distinction between the two methods is that if you distribute the recording of revenues

and expenses over the full time period when you earned and made use of them, you are using the

accrual method. If you record their totals during the time period that you received or made

payment, you are using the cash method.

Suppose that Jean Marble starts a new firm, Marble Designs, in January. At the end of the first

month of operations, she has made $10,000 in sales and paid various operating expenses: her

salary, the office lease, phone costs, office supplies, and a computer. She was able to save 20%

of the cost of office supplies by making a bulk purchase that she estimates will last the entire

year. Recording all of these as expenses during the current period results in net income for the

month of $1,554.

Using the accrual method, Marble Designs records 1/12th of the cost of the office supplies

during January. This is a reasonable decision because they are expected to last a full year. It also

records 1/36th of the cost of the computer as depreciation. The assumption is that the computer’s

useful life is three years and that its eventual salvage or residual value will be zero. The net

income for January is now $5,283, which is 3.4 times the net income recorded under the cash

basis.

The net income of $5,283 is a much more realistic estimate for January than $1,554. Both the

office supplies and the computer will contribute to the creation of revenue for much longer than

one month. In contrast, the benefits of the salary, lease, and phone expenses pertain to that month

only, so it is appropriate to record the entire expense for January. But this analysis says nothing

about how much cash Marble Designs has in the bank. Suppose that the company must pay off a

major loan in the near future. The income statement does not necessarily show whether Marble

Designs will likely be able to make that payment.

Structuring the Balance Sheet

Finally, the Debit and Credit columns of the balance sheet are obtained by formulas similar to

those used for the income statement. This formula returns the debit amounts:

=IF(OR(AccountType=”Assets”,AccountType=”Liabilities”),AdjustedDebits,0)

This formula returns the credit amounts:

=IF(OR(AccountType=”Assets”,AccountType=”Liabilities”),AdjustedCredits,0)

Now Marble is in a position to calculate her working capital. Recall that this is defined as the

difference between current assets and current liabilities. As of January 31, 2007,Marble’s current

assets are as follows:

$2,554.00 (cash)

$8,000.00 (accounts receivable)

$1,833.33 (office supplies, a prepaid expense)

$1,500.00 (ending inventory)

This adds up to $13,887.33. Marble’s current liabilities include only the $2,000 note payable.

Her working capital, therefore, is $11,887.33, or $13,887.33-$2,000.

Using Transactions to Calculate Changes to Working Capital

During January, the sale of products for more than they cost increased working capital:

The gross profit was $9,500. Placing $2,000 worth of materials in inventory also increased

working capital. These are both current assets, totaling $11,500. Acquiring a loan of $2,000, the

note payable that was used to purchase the inventory, decreased working capital. Working

capital was also decreased by the payment of cash for the computer, various operating expenses,

and the use of office supplies. These are all

current liabilities, totaling $8,612.67. The net effect of the increase of $11,500 in working capital

and the decrease of $8,612.67 in working capital is $2,887.33. During the month of January,

Marble Designs increased its working capital by this amount. Note that this is the same figure as

was determined by the analysis in Figure 5.6 ($11,887.33-$9,000).

Normally, you would not determine changes in working capital by examining each transaction

that occurred in a given period: There are quicker ways. Also, many transactions occur that

affect current assets and current liabilities to the same degree and, therefore, have no net effect

on working capital.

For example, when you collect payment for a product or service, this transaction has no effect on

working capital. Doing so merely increases one current asset (cash) and decreases another

current asset (accounts receivable) by identical amounts. When you write a check for an account

payable, you decrease both a current asset account (cash) and a current liability account

(accounts payable) by equal amounts. There is no net effect on the amount of working capital.

In general, transactions that involve only current asset or current liability accounts do have an

effect on individual working capital accounts, but they do not have a net effect on the amount of

working capital.

Checking the Sources and Uses of Working Capital

Another means of determining changes in working capital is to compare its sources with its uses.

Recall that transactions involving only current asset and current liability accounts have no net

effect on working capital. The same is true of transactions that involve only noncurrent accounts.

For example, when Marble records $54.17 as the month’s depreciation on the computer, she adds

$54.17 to a noncurrent account, with no net effect on working capital.

However, a transaction that involves a current account and a noncurrent account does affect the

amount of working capital. Suppose that Marble invested an additional $1,000 in her business,

recording it in both the capital account (noncurrent) and the cash account (a current asset). This

transaction would increase working capital by $1,000. Therefore, when determining changes to

working capital, it can be convenient to limit the analysis to transactions that affect only current

accounts and noncurrent accounts.

The sources of working capital, in this case, consist solely of net income. What is depreciation

doing there? Recall that depreciation is a noncash expense that, for the purposes of the income

statement, acts as an offset to gross profit in the calculation of net income. But no funds change

hands as a result of recording depreciation. Therefore, when you use net income to calculate your

sources of working capital, it is necessary to add depreciation back—in other words, to reverse

the effect of subtracting it in the calculation of net income.

The cash portion of net income, a noncurrent account, is deposited in the cash account, a current

asset. Therefore, in combination with the act of adding depreciation back, it can be used to

calculate the change in working capital.

Analyzing Cash Flow

For various reasons, you might want to determine how a company uses its cash assets. The

choice to use cash to acquire an asset, to meet a liability, or to retire a debt is a process of

Analyzing Cash Flow investment and disinvestment, and a manager always has choices to make,

some smart and some maladroit. It’s important to keep track of how well a company’s

management is making these choices.

Furthermore, as useful as the accrual method of accounting is in matching revenues with

expenses, it tends to obscure how cash flows through a firm. One of the purposes of cash flow

analysis is to highlight differences between, say, net income and the actual acquisition of cash.

For example, accounts receivable is one component of net income, but it will not show up as

cash until the check clears. A company might have a healthy net income, but if its customers do

not pay it on a timely basis, it might have difficulty meeting its obligations. Cash flow analysis

can illuminate problems, even impending problems such as that one.

Identifying Cash Flows Due to Operating Activities

The next step in analyzing cash flows is to focus on cash generated by and used in operations.

Cash receipts from customers—You can easily determine this amount by combining the value

for sales (net of any discounts that might have been provided to customers) with changes in

accounts receivable. That is, add accounts receivable at the end of the period to the sales figure

and then subtract accounts receivable at the beginning of the period. The logic is that if accounts

receivable has declined during the period, you have collected more in cash than you have

accrued in accounts receivable; if it has increased, you have accrued more in receivables than

you have collected in cash.

■ Cash outlays for purchases—From the standpoint of operating activities, there is one use of

cash for purchases: inventory. Therefore, to summarize cash flow for operating purchases, add to

the cost of goods sold during the period of the ending inventory level, and subtract the beginning

inventory level.

Additionally, you might have purchased inventory with a note or account payable to the

suppliers of your inventory materials. In this case, you add any decrease in these payables

(because you used cash to decrease them) or subtract any increase in these payables (because you

used credit, not cash, to acquire the materials).

■ Cash outlays for expenses—These are available from the operating expenses portion of the

income statement. Combine the total operating expenses with any changes in prepayments and

accrued liabilities, such as employee salaries earned but as yet unpaid, at the end of the period.

In the case of Marble Designs, applying these calculations indicates that sales, increased by a

reduction of $2,500 in accounts receivable, results in cash receipts of $92,500. Cost of goods

sold, increased by the $500 change in inventory level, results in $25,000 in cash purchases. Total

operating expenses also were (a) reduced by $1,036.67 in depreciation, a noncash, long-term

prepayment, and (b) increased by a change in the amount of notes payable, converted to cash and

used to acquire office supplies. Subtracting cash payments for purchases and for expenses from

total receipts results in $12,549.00, the amount of cash provided by operations.

This completes the process of converting information contained in the income statement,

receipts, and outlays represented as accruals into a cash basis, represented as actual cash receipts

and outlays occurring during the period in question.

Combining Cash from Operations with Cash from Nonoperating Transactions

The final step in developing the cash flow analysis is to combine the cash amounts used for

normal operations with the cash transactions that apply to nonoperating activities.

Cash receipts, in this case, consist of cash from operations and cash received from selling the

office space. Cash outlays consist of the purchase of the new computer and the office space. The

difference between the two, $15,229, represents the amount of cash Marble Designs generated

during the 12-month period, and this figure should agree with the difference in the cash account

between January 31, 2007, and January 31, 2008. The difference between the ending balance of

$17,783 and the beginning balance of $2,554 is $15,229, which agrees with the results of the

cash flow analysis. In reality, cash flow analysis is a much more complicated task than the

relatively simple example provided here. It includes many more transactions than were included

in this

example: The effect of taxes must be taken into account, accrued liabilities complicate the

process, and such transactions as the issuance of stock, dividends, and long-term bonds affect the

identification and calculation of cash flows. However, the example illustrates the basic principles

and overall process of converting balance sheets and income statements into information about

how a company creates and uses its cash resources.

Working Capital Cycle

As an introduction to the working capital cycle, here is a quick reminder of the main types of

cash inflow and outflow in a typical business:

Inflows Outflows

Cash sales to customers Purchasing finished goods for re-sale

Receipts from customers who were allowed to

buy on credit (trade debtors)

Purchasing raw materials and other components

needed for the manufacturing of the final product

Interest on bank and other balances Paying salaries and wages and other operating

expenses

Proceeds from sale of fixed assets Purchasing fixed assets

Investment by shareholders Paying the interest on, or repayment of loans

  Paying taxes

Cash flow can be described as a cycle: 

The business uses cash to acquire resources (assets such as stocks)

The resources are put to work and goods and services produced. These are then sold to

customers

Some customers pay in cash (great), but others ask for time to pay. Eventually they pay

and these funds are used to settle any liabilities of the business (e.g. pay suppliers)

And so the cycle repeats

Hopefully, each time through the cash flow cycle, a little more money is put back into the

business than flows out. But not necessarily, and if management don’t carefully monitor cash

flow and take corrective action when necessary, a business may find itself sinking into trouble.

The cash needed to make the cycle above work effectively is known as working capital.

Working capital is the cash needed to pay for the day to day operations of the business.  

In other words, working capital is needed by the business to:

Pay suppliers and other creditors

Pay employees

Pay for stocks

Allow for customers who are allowed to buy now, but pay later (so-called “trade

debtors”)

What is crucially important, therefore, is that a business actively manages working capital. It is

the timing of cash flows which can be vital to the success, or otherwise, of the business. Just

because a business is making a profit does not necessarily mean that there is cash coming into

and out of the business.

There are many advantages to a business that actively manages its cash flow:

It knows where its cash is tied up, spotting potential bottlenecks and acting to reduce their

impact

It can plan ahead with more confidence. Management are in better control of the business

and can make informed decisions for future development and expansion

It can reduce its dependence on the bank and save interest charges

It can identify surpluses which can be invested to earn interest

Case study-Intel : Working Capital

Case Details: Price:

Case Code : FINA010 For delivery in electronic format: Rs. 300;

For delivery through courier (within India): Rs.

300 + Rs. 25 for Shipping & Handling Charges

Themes

Case Length : 08 Pages

Period : 1968 - 2003

Pub. Date : 2005

Teaching Note : Not Available

Organization : Intel

Managing Working Capital

Industry : Semi Conductors

Countries : USA

Intel is the undisputed leader in the microprocessor industry with about a 90% market share.

Since 1968 when it was founded, Intel has launched many ground-breaking products. Many

analysts attribute Intel''s success to its technology, innovation and management. It has also

attempted to become a disciplined company that maximises operational efficiency, one important

dimension of which is working capital management. The case outlines various aspects of

working capital management at Intel.

In early 2004, Intel was the undisputed leader in the microprocessor industry with about 90%

market share. Since 1968 when it was founded, Intel had launched many groundbreaking

products. 

By 2004, it had 450 products and services ranging from the ubiquitous PC microprocessors like

Pentium, the 64-bit high-end Itanium 2 to mobile computing chipsets such as Centrino. Intel

ended 2002 with revenues of $ 26.7 billion. Many analysts believed Intel's success was as much

about technology as about management. They attributed the success of Intel to its unbroken

leadership chain. As one great leader retired, another took over. While Intel was well known for

innovation, it had also attempted to be a disciplined company that maximized operational

efficiency. Intel realized that as competition intensified, working capital management would

become increasingly important...

Corporate Background

A popular story which went around in Intel was that one weekend afternoon in the spring of

1968, Gordon Moore (Moore) dropped by Robert Noyce's (Noyce) home. The two decided to

launch a new company to pursue large-scale integrated (LSI) memory. That was the moment

when Intel (abbreviation of Integrated Electronics) was born though the company was officially

launched in the month of July that year. Little did they know that their new venture would define

contemporary electronics and change the way the world worked, lived and played...

Business Segments

Intel's major products included microprocessors; chipsets; boards; flash memory; application

processors used in cellular handsets and hand-held computing devices; cellular chipsets;

networking and communications products, such as Ethernet connectivity products, optical

components and network processing components, and embedded control chips (micro

controllers)...

Working Capital

John Mathew, a young MBA had joined Intel in its Corporate Finance Department. His

supervisors asked him to understand and analyze the financials of the company and make

suggestions on improving Intel's working capital management and compare it with that of rival

AMD...

Working capital is an excess of current assets over current liabilities. In other words, The

amount of current assets which is more than current liabilities is known as Working Capital. If

current liabilities are nil then, working capital will equal to current assets. Working capital

shows strength of business in short period of time . If a company have some amount in the form

of working capital , it means Company have liquid assets, with this money company can face

every crises position in market. "

Working Capital = Current Assets - Current Liabilities

Current Assets

Current assets are those assets which can be converted into cash within One year or less then one

year . In current assets, we includes cash, bank, debtors, bill receivables, prepaid expenses,

outstanding incomes .

Current Liabilities

Current Liabilities are those liabilities which can be paid to respective parties within one year or

less than one year at their maturity. In current liabilities, we includes creditors, outstanding bills,

bank overdraft, bills payable and short term loans, outstanding expenses, advance incomes .

Other names of Working Capital

Some Professional accountants know working capital as operating capital, operating

liquidity, positive working capital.

Important things about Working Capital

1. Working Capital can be negative. At that time, We add one word " deficiency" in the back of

working capital . It means if Current Liabilities are more than current assets, it is known as

working capital deficiency or inverse working capital or negative working capital.

2. Working capital can be easily adjusted, if Accounts manager knows different techniques of

managing working capital . He can try to get short term loan or he can increase working capital

by proper management of inventory and outstanding incomes and debtors .

3. Working capital can also change by Changing in Cash Conversion period. Cash conversion

period is a period in which company changes current assets into cash or bank.

4. Working capital can also positive by increasing growth rate of company. If company does not

invest more money and increase profit, the same amount will increase in the cash position of

company and with cash company can increase their working capital position.

Importance of Working Capital

Some time, If creditors demands their money from company, at this time company's high

working capital saves company from this situation . You know that selling of current assets are

easy in small period of time but Company can not sell their fixed assets with in small period of

time. So, If Company have sufficient working capital , Company can easily pay off the creditors

and create his reputation in market . But If a company have zero working capital and then

company can not pay creditors in emergency time and either company becomes bankrupt or

takes loan at higher rate of Interest . In both condition , it is very dangerous and always

Company's Account Manager tries to keep some amount of working capital for creating goodwill

in market .

Positive working capital enables also to pay day to day expenses like wages, salaries, overheads

and other operating expenses. Because sufficient working capital can not only pay maturity

liabilities but also outstanding liabilities without any more delay.

One of advantages of positive working capital that Company can do every risky work without

any tension of self security.

References

1. ^ See Corporate Finance: First Principles, Aswath Damodaran, New York University's

Stern School of Business

2. ^ The framework for this section is based on Notes by Aswath Damodaran at New York

University's Stern School of Business

3. ^ See: Investment Decisions and Capital Budgeting, Prof. Campbell R. Harvey; The

Investment Decision of the Corporation, Prof. Don M. Chance

4. ^ See: Valuation, Prof. Aswath Damodaran; Equity Valuation, Prof. Campbell R. Harvey

5. ^ See for example Campbell R. Harvey's Hypertextual Finance Glossary or

investopedia.com

6. ^ Prof. Aswath Damodaran: Estimating Hurdle Rates

7. ^ See: Real Options Analysis and the Assumptions of the NPV Rule, Tom Arnold &

Richard Shockley

8. ^ Aswath Damodaran: Risk Adjusted Value; Ch 5 in Strategic Risk Taking: A

Framework for Risk Management. Wharton School Publishing, 2007. ISBN 0-13-

199048-9

9. ^ See: §32 "Certainty Equivalent Approach” & §165 "Risk Adjusted Discount Rate" in:

Joel G. Siegel; Jae K. Shim; Stephen Hartman (1 November 1997). Schaum's quick guide

to business formulas: 201 decision-making tools for business, finance, and accounting

students. McGraw-Hill Professional. ISBN 978-0-07-058031-2. Retrieved 12 November

2011.

10. ^ Dan Latimore: Calculating value during uncertainty. IBM Institute for Business Value

11. ^ See: Decision Tree Analysis, mindtools.com; Decision Tree Primer, Prof. Craig W.

Kirkwood Arizona State University; Using Decision Trees In Finance, investopedia.com

12. ^ a b See: "Capital Budgeting Under Risk". Ch.9 in Schaum's outline of theory and

problems of financial management, Jae K. Shim and Joel G. Siegel.

13. ^ See:Identifying real options, Prof. Campbell R. Harvey; Applications of option pricing

theory to equity valuation, Prof. Aswath Damodaran; How Do You Assess The Value of

A Company's "Real Options"?, Prof. Alfred Rappaport Columbia University & Michael

Mauboussin

14. ^ a b See Probabilistic Approaches: Scenario Analysis, Decision Trees and Simulations,

Prof. Aswath Damodaran

Virginia Clark, Margaret Reed, Jens Stephan (2010). Using Monte Carlo simulation for a

capital budgeting project, Management Accounting Quarterly, Fall, 2010

^ a b See: Quantifying Corporate Financial Risk, David Shimko.

^ The Flaw of Averages, Prof. Sam Savage, Stanford University.

^ See: The Financing Decision of the Corporation, Prof. Don M. Chance; Capital Structure,

Prof. Aswath Damodaran

^ Capital Structure: Implications, Prof. John C. Groth, Texas A&M University; A

Generalised Procedure for Locating the Optimal Capital Structure, Ruben D. Cohen, Citigroup

^ See:Optimal Balance of Financial Instruments: Long-Term Management, Market Volatility

& Proposed Changes, Nishant Choudhary, LL.M. 2011 (Business & finance), George

Washington University Law School

^ See Dividend Policy, Prof. Aswath Damodaran

^ See Working Capital Management, Studyfinance.com; Working Capital Management,

treasury.govt.nz

^ See The 20 Principles of Financial Management, Prof. Don M. Chance, Louisiana State

University

^ William Lasher (2010). Practical Financial Management. South-Western College Pub; 6 ed.

ISBN 1-4390-8050-X

^ Beaney, Shaun, "Defining corporate finance in the UK", Corporate Finance Faculty,

ICAEW, April 2005 (revised January 2011)

^ See: Global Association of Risk Professionals (GARP); Professional Risk Managers'

International Association (PRMIA)

CONCLUSION

Assets Fixed assets Fixed assets investments Operations needs Assets linked to operations

Receivables, prepaid suppliers, normal levels of inventory (Reclassify unusual levels of

inventory as investment in fixed assets) Positive Cash Cash, Bank deposits, marketable securities

Reclassify non marketable securities as investments in fixed assets.

- Financing Permanent capital (stable resources) Result from long term financing activities,

either equity or long term loans. Operations resources (cyclical resources) Short term debt linked

to operations (Payables, Taxes Payables,…) We may need to classify as stable resources some

short term debt, namely the part of the long term debt due within a year, or revolving loans. Cash

liabilities Credit lines, short term debt.

Working capital Early approach of the cash flow statement. Not commonly used internationally,

but does indeed provide interesting information. Working capital = Current Assets – Current

Liabilities

Asset valuation rules Historical cost rule applies to long lived assets ( Input value rule) Includes

acquisition costs, all costs to get the equipment in working conditions (including legal fees, non

returnable taxes, demolition costs, transformation costs, eventually even financing costs).