sapna working capiptal

8/6/2019 Sapna Working Capiptal

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WORKING CAPITAL MANAGEMENT

INTRODUCTION-

Working Capital is the key difference between the long term financial management and short

term financial management in terms of the timing of cash. Long term finance involves the

cash flow over the extended period of time i.e. 5 to 15 years, while short term financial

decisions involve cash flow within a year or within operating cycle. Working capital

management is a short term financial management. Working capital management is

concerned with the problems that arise in attempting to manage the current assets, the current

liabilities & the inter relationship that exists between them. The current assets refer to those

assets which can be easily converted into cash in ordinary course of business, without

disrupting the operations of the firm.

WHAT IS WORKING CAPITAL?

Working capital refers to the investment by the company in short terms assets such as cash,

marketable securities. Net current assets or net working capital refers to the current assets less

current liabilities. Symbolically, it means,

Net Current Assets = Current Assets -Current Liabilities

DEFINITIONS OF WORKING CAPITAL-The following are the most important definitions of Working capital: -

1) Working capital is the difference between the inflow and outflow of funds.In otherwords it is the net cash inflow.

2) Working capital represents the total of all current assets. In other words it is theGross working capital, it is also known as Circulating capital or Current capital for

current assets are rotating in their nature.

3) Working capital is defined as the excess of current assets over current liabilitiesand provisions. In other words it is the Net Current Assets or Net Working Capital.


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Composition of working capital-

Major Current Assets-1)

Cash2) Accounts Receivables

3) Inventory4) Marketable SecuritiesMajor Current Liabilities-1) Bank Overdraft2) Outstanding Expenses3) Accounts Payable4) Bills Payable

What Does Current Assets Mean?

1. A balance sheet account that represents the value of all assets that are reasonably expected

to be converted into cash within one year in the normal course of business. Current assets

include cash, accounts receivable, inventory, marketable securities, prepaid expenses and

other liquid assets that can be readily converted to cash.

2. In personal finance, current assets are all assets that a person can readily convert to cash to

pay outstanding debts and cover liabilities without having to sell fixed assets. In the UnitedKingdom, current assets are also known as "current account

Current Assets

1.Current assets are important to businesses because they are the assets that are used to fund

day-to-day operations and pay ongoing expenses. Depending on the nature of the business,

current assets can range from barrels of crude oil, to baked goods, to foreign currency.

2. In personal finance, current assets include cash on hand and in the bank, and marketable

securities that are not tied up in long-term investments. In other words, current assets are

anything of value that is highly liquid.


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What Does Current Liabilities Mean?

A company's debts or obligations that are due within one year. Current liabilities appear on

the company's balance sheet and include short term debt, accounts payable, accrued liabilities

and other debts.

Current Liabilities

Essentially, these are bills that are due to creditors and suppliers within a short period of time.

Normally, companies withdraw or cash current assets in order to pay their current liabilities.

Analysts and creditors will often use the current ratio, (which divides current assets by

liabilities), or the quick ratio, (which divides current assets minus inventories by current

liabilities), to determine whether a company has the ability to pay off its current liabilities.

The Goal of Capital Management is to manage the firm s current assets &liabilities, so that

the satisfactory level of working capital is maintained. If the firm cannot maintain the

satisfactory level of working capital, it is likely to become insolvent &may be forced into

bankruptcy. To maintain the margin of safety current asset should belarge enough to cover its

current assets. Main theme of the theory of working capital management is interaction

between the current assets & current liabilities.

IMPORTANCE OF WORKING CAPITAL

Working capital may be regarded as the lifeblood of the business. Without insufficient

working capital, any business organization cannot run smoothly or successfully. In the

business the Working capital is comparable to the blood of the human body. Therefore the

study of working capital is of major importance to the internal and external analysis because

of its close relationship with the current day to day operations of a business. The inadequacy

or mismanagement of working capital is the leading cause of business failures. To meet the

current requirements of a business enterprise such as the purchases of services, raw materials

etc. working capital is essential. It is also pointed out that working capital is nothing but one

segment of the capital structure of a business. In short, the cash and credit in the business, is

comparable to the blood in the human body like finance s life and strength i.e. profit of

solvency to the business enterprise. Financial management is called upon to maintain always

the right cash balance so that flow of fund is maintained at a desirable speed not allowingslow down. Thus enterprise can have a balance between liquidity and profitability. Therefore

the management of working capital is essential in each and every activity.


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CONCEPT OF WORKING CAPITAL-There are 2 concepts:-

1) Gross Working Capital2) Net Working Capital

1)Gross working capital-It is referred as total current assets. Focuses on, Optimum investment in current assets

Excessive investments impair firm s profitability, as idle investment earns nothing.

Inadequate working capital can threaten solvency of the firm because of its inability to meet

its current obligations. Therefore there should be adequate investment in current assets.

Financing of current assets whenever the need for working capital funds arises, agreement

should be made quickly. If surplus funds are available they should be invested in short term

securities.

2)Net working capital-(NWC) defined by 2 ways,

y Difference between current assets and current liabilitiesy Net working capital is that portion of current assets which is financed with long

term funds.

NET WORKING CAPITAL = CURRENT ASSETS CURRENT LIABILITIES

If the working capital is efficiently managed then liquidity and profitability both will

improve. They are not components of working capital but outcome of working capital.

Working capital is basically related with the question of profitability versus liquidity &

related aspects of risk.


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Implications of Net Working Capital:-

Net working capital is necessary because the cash outflows and inflows do not coincide. In

general the cash outflows resulting from payments of current liability are relatively

predictable. The cash inflows are however difficult to predict. More predictable the cash

inflows are the less NWC will be required. But where the cash inflows are uncertain, it will

be necessary to maintain current assets at level adequate to cover current liabilities that are

there must be NWC.For evaluating NWC position, an important consideration is trade off

between probability and risk. The term profitability is measured by profits after expenses.

The term risk is defined as the profitability that a firm will become technically insolvent so

that it will not be able to meet its obligations when they become due for payment. The risk of

becoming technically insolvent is measured by NWC. If the firm wants to increase

profitability, the risk will definitely increase. If firm wants to reduce the risk, the profitability

will decrease.

OPERATING CYCLEOR CIRCULATING CASH FORMAT:-

Working Capital refers to that part of firms capital which is required for financing short term

or current assets such as cash, marketable securities, debtors and inventories. Funds thus

invested in current assets keep revolving fast and being constantly converted into cash and

these cash flows out again in exchange for other current assets. Hence it is also known as

revolving or circulating capital. The circular flow concept of working capital is based upon

this operating or working capital cycle of a firm. The cycle starts with the purchase of raw

material and other resources and ends with the realization of cash from the sales of finished

goods. It involves purchase of raw material and stores, its conversion into stocks of finished

goods through work in progress with progressive increment of labor and service cost,conversion of finished stocks in to sales, debtors and receivables and ultimately realization of

cash and this cycle continuous again from cash to purchase of raw materials and so on. The

speed/ time of duration required to complete one cycle determines the requirements of

working capital longer the period of cycle, larger is the requirement of working capital.

CLASSIFICATION OR KIND OF WORKING CAPITAL:-Working capital may be classified in two ways:

1) On the basis of concept-

2) On the basis of time-


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On the basis of concept-

Working capital is classified as gross working capital and net working capital. The

classification is important from the point of view of the financial manager.

On the basis of time, working capital may be classified as:

y Permanent or Fixed working capitaly Temporary or Variable working capital.

1. PERMANENT OR FIXED WORKING CAPITALPermanent or fixed working capital is the minimum amount which is required to ensureeffective utilization of fixed facilities and for maintaining the circulation of current assets.

There is always a minimum level of current assets which is continuously required by the

enterprises to carry out its normal business operations.

2. TEMPRORAY OR VARIABLE WORKING CAPITAL:-Temporary or variable working capital is the amount of working capital which is required to

meet the seasonal demands and some special exigencies. Variables working capital can be

further classified as second working capital and special working capital.

The capital required to meet the seasonal needs of the enterprises is called the seasonal

working capital. Temporary working capital differs from permanent working capital in the

sense that is required for short periods and cannot be permanently employed gainfully in the

business.

IMPORATNCE OR ADVANTAGE OF ADEQUATE WORKING

CAPITAL -

Working capital is the life blood and nerve centre of a business. Just a circulation of a blood

is essential in the human body for maintaining life, working capital is very essential to


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maintain the smooth running of a business. No business can run successfully without an

adequate amount of working capital. The main advantages of maintaining adequate amount

of working capital are as follows:

y Solvency of the Businessy Goodwilly Easy Loansy Cash discountsy Regular supply of Raw Materialsy Regular payments of salaries, wages & other day to day commitments.y Exploitation of favourable market conditionsy Ability of crisisy Quick and regular return on investmentsy High morals

THE NEED OR OBJECTS OF WORKING CAPITAL

The need for working capital cannot be emphasized. Every business needs some amount of

working capital. The need of working capital arises due to the time gap between production

and realization of cash from sales. There is an operating cycle

Involved in the sales and realization of cash. There are time gaps in purchase of raw

materials and production, production and sales, And sales, and realization of cash, thus,

working capital is needed for the following purposes

y For the purchase of raw materials , components and spacesy To pay wages and salariesy To incur day to day expenses and overhead costs such as fuel, power andoffice

expenses etc.


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y To meet the selling costs as packing, advertising etc.y To provide credit facilities to the customers.

FACTORS DETERMING THE WORKING CAPITAL REQUIRMENT:

The working capital requirements of a concern depend upon a large number of factors

such as nature and size of the business, the characteristics of their operations, the

length of production cycle, the rate of stock turnover and the state of economic

situation .However the following are the important factors generally influencing the

working capital requirements.

NATURE OR CHARACTERSTICS OF A BUSINESS

The nature and the working capital requirement of enterprises are inter linked. Whilea manufacturing industry has a long cycle of operation of the working capital, the

same would be short in an enterprises involve in providing services. The amount

required also varies as per the nature, an enterprises involved in production would

required more working capital then a service sector enterprise.

MANAFACTURE PRODUCTION POLICY:

Each enterprises in the manufacturing sector has its own production policy, some

follow the policy of uniform production even if the demand varies from time to time

and other may follow the principles of demand based production in which productionis based on the demand during the particular phase of time. Accordingly the working

capital requirements vary for both of them.

OPERATIONS:

The requirement of working capital fluctuates for seasonal business. The working

capital needs of such business may increase considerably during the busy season and

decrease during the

MARKET CONDITION:

If there is a high competition in the chosen project category then one shall need to

offer sops like credit, immediate delivery of goods etc for which the working capital

requirement will be high. Otherwise if there is no competition or less competition in

the market then the working capital requirements will be low.


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AVABILITY OF RAW MATERIAL:

If raw material is readily available then one need not maintain a large stock of the

same thereby reducing the working capital investment in the raw material stock .On

other hand if raw material is not readily available then a large inventory stocks need

to be maintained, there by calling for substantial investment in the same.

GROWTH AND EXAPNSION:

Growth and Expansions in the volume of business result in enhancement of the working

capital requirements. As business growth and expands it needs a larger amount of the

working capital. Normally the needs for increased working capital funds processed growth in

business activities.

FACTORS DETERMINING THE WORKING CAPITAL

REQUIREMENTS

1. NATUREOF BUSINESS: The requirements of working is very limited in public utility

undertakings such as electricity, water supply and railways because they offer cash sale only

and supply services not products, and no funds are tied up in inventories and receivables. On

the other hand the trading and financial firms requires less investment in fixed assets but have

to invest large amt. of working capital along with fixed investments.

2. SIZE OF THE BUSINESS : Greater the size of the business, greater is the requirement of

working capital.

3. PRODUCTION POLICY: If the policy is to keep production steady by accumulating

inventories it will require higher working capital.

4. LENTHOF PRDUCTION CYCLE: The longer the manufacturing time the raw material and

other supplies have to be carried for a longer in the process with progressive increment of

labor and service costs before the final product is obtained. So working capital is directly

proportional to the length of the manufacturing process.


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5. SEASONALS VARIATIONS: Generally, during the busy season, a firm requires larger

working capital than in slack season.

6. WORKING CAPITAL CYCLE: The speed with which the working cycle completes one

cycle determines the requirements of working capital. Longer the cycle larger is therequirement of working capital.

7. RATE OF STOCK TURNOVER: There is an inverse co-relationship between the

question of working capital and the velocity or speed with which the sales are affected. A

firm having a high rate of stock turnover will needs lower amt. of working capital as

compared to a firm having a low rate of turnover.

8. CREDIT POLICY: A concern that purchases its requirements on credit and sales its

product / services on cash requires lesser amt. of working capital and vice-versa.

9. BUSINESS CYCLE: In period of boom, when the business is prosperous, there is need

for larger amt. of working capital due to rise in sales, rise in prices, optimistic expansion of

business, etc. On the contrary in time of depression, the business contracts, sales decline,

difficulties are faced in collection from debtor and the firm may have a large amt. of working

capital.

10. RATE OF GROWTH OF BUSINESS: In faster growing concern, we shall require large

amt. of working capital.

11.EARNING CAPACITY AND DIVIDEND POLICY: Some firms have more earning

capacity than other due to quality of their products, monopoly conditions, etc. Such firms

may generate cash profits from operations and contribute to their working capital. The

dividend policy also affects the requirement of working capital. A firm maintaining a steady

high rate of cash dividend irrespective of its profits needs working capital than the firm thatretains larger part of its profits and does not pay so high rate of cash dividend.

12.PRICE LEVEL CHANGES: Changes in the price level also affect the working capital

requirements. Generally rise in prices leads to increase in working capital.


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WORKING CAPITAL ANALYSIS

As we know working capital is the life blood and the centre of a business. Adequate amount

of working capital is very much essential for the smooth running of the business. And the

most important part is the efficient management of working capital in right time. The

liquidity position of the firm is totally effected by the management of working capital. So, astudy of changes in the uses and sources of working capital is necessary to evaluate the

efficiency with which the working capital is employed in a business. This involves the need

of working capital analysis.

The analysis of working capital can be conducted through a number of devices, such as:

1. Ratio analysis.

2. Fund flow analysis.

3. Budgeting.

1. RATIO ANALYSIS

A ratio is a simple arithmetical expression one number to another. The technique of ratio

analysis can be employed for measuring short-term liquidity or working capital position of a

firm. The following ratios can be calculated for these purposes:

1. Current ratio.

2. Quick ratio

3. Absolute liquid ratio

4. Inventory turnover.


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5. Receivables turnover.

6. Payable turnover ratio.

7. Working capital turnover ratio.

8. Working capital leverage

9. Ratio of current liabilities to tangible net worth.

2. FUND FLOW ANALYSIS

Fund flow analysis is a technical device fund designated to the study the source from which

additional funds were derived and the use to which these sources were put. The flow analysis

consists of:

a. Preparing schedule of changes of working capital

b. Statement of sources and application of funds.

It is an effective management tool to study the changes in financial position (working capital)

business enterprise between beginning and ending of the financial dates.

3. WORKING CAPITAL BUDGET

A budget is a financial and / or quantitative expression of business plans and polices to be

pursued in the future period time. Working capital budget as a part of the total budge ting

process of a business is prepared estimating future long term and short term working capital

needs and sources to finance them, and then comparing the budgeted figures with actual

performance for calculating the variances, if any, so that corrective actions may be taken in

future. He objective working capital budget is to ensure availability of funds as and needed,

and to ensure effective utilization of these resources. The successful implementation of

working capital budget involves the preparing of separate budget for each element of working

capital, such as, cash, inventories and receivables etc.


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S


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Days Working Capital

What Does Days Working Capital Mean?

An accounting and finance term used to describe how many days it will take for a company

to convert its working capital into revenue. The faster a company does this, the better.

To calculate days working capital, the following formula can be used:

Average Working capital*365/annual sales revenue

Days working capital can be used in ratio and fundamental analysis.

When utilizing any ratio, it is important to consider how this company has evolved over time

and how it compares to similar companies in the same industry. By comparing this ratio in a

historical and relative basis, you will get a better understanding of how efficient a given

company actually is.

Working Capital Works

Cash is the lifeline of a company. If this lifeline deteriorates, so does the company's ability to

fund operations, reinvest and meet capital requirements and payments. Understanding a

company's cash flow health is essential to making investment decisions. A good way to judge

a company's cash flow prospects is to look at its working capital management (WCM).

Where is Working Capital Analysis Most Critical?

On the one hand, working capital is always significant. This is especially true from the

lender's or creditor's perspective, where the main concern is defensiveness: can the company

meet its short-term obligations, such as paying vendor bills? But from the perspective of

equity valuation and the company's growth prospects, working capital is more critical to

some businesses than to others. At the risk of oversimplifying, we could say that the models

of these businesses are asset or capital intensive rather than service or people intensive.

Examples of service intensive companies include H&RBlock, which provides personal tax

services, and Manpower, which provides employment services. In asset intensive sectors,

firms such as telecom and pharmaceutical companies invest heavily in fixed assets for the

long term, whereas others invest capital primarily to build and/or buy inventory. It is the

latter type of business - the type that is capital intensive with a focus on inventory rather than

fixed assets - that deserves the greatest attention when it comes to working capital analysis.


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These businesses tend to involve retail, consumer goods and technology hardware, especially

if they are low-cost producers or distributors.

Working capital is the difference between current assets and current liabilities:

Data Analysis and Interpretation

Working Capital management Components

1. Receivables Management

2. Inventory Management

3. Cash Management

1) Receivables Management

Receivables or debtors are the one of the most important parts of the current assets

which is created if the company sells the finished goods to the customer but not receive the

cash for the same immediately. Trade credit arises when firm sells its products and

services on credit and dose not receive cash immediately. It is essential marketing tool,

acting as bridge for the movement of goods through production and distribution stages to

customers. Trade credit creates receivables or book debts which the firm is expected to

collect in the near future. The receivables include three characteristics

1) It involve element of risk which should be carefully analysis.

2) It is based on economic value. To the buyer, the economic value in goods or services

passes immediately at the time of sale, while seller expects an equivalent value to be

received later on.


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3) It implies futurity. The cash payment for goods or serves received by the buyer

will be made by him in a future period.

Objective of receivable management

The sales of goods on credit basis are an essential part of the modern

competitive economic system. The credit sales are generally made up on

account in the sense that there are formal acknowledgem ents of debt obligation

through a financial instrument. As a marketing tool, they are intended to

promote sales and there by profit. However extension of credit involves risk and

cost, management should weigh the benefit as wel l as cost to determine the goal

of receivable management. Thus the objective of receivable management is to

promote sales and profit until that point is reached where the return on

investment in further funding of receivables is less than the cost of funds raisedto finance that additional credit.

Average collection period

The average collection period measures the quality of debtors since it indicates the speed of

there collection. The shorter the average collection period, the better the quality of the


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debtors since a short collection period implies the prompt payment by debtors. The

average collection period should be compared against the firms credit terms and policy

judges its credit and collection efficiency. The collection period ratio thus helps an analyst

in two respects:

1. In determining the collectability of debtors and thus, the efficiency of collection

efforts.

2. In ascertaining the firm s comparative strength and advantages related to its credit policy

and performance.

The debtors turnover ratio can be transformed in to the number of days of holding of

debtors.

AVERAGE COLLECTION PERIOD (ACP)

Year DTR No. of Months ACP (mth)

FY2007-08 2.65 12 4.5

FY2006-07 2.53 12 4.7

FY2005-06 2.41 12 4.9

Observations

The size of receivables are staidly increasing it indicates that the company was allowing

more credit year to year, but it was not bad signal because as receivables were

supporting to the increase in the sales. Average collection period are reducing to


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present situation, but as compare with the normal collection period allowed to customer

is 90 days, it was clear that the company required to increase our efficiency of collection

of receivables. All the above factors directly or indirectly affects in the debtors

turnover ratio, current ratio and working capital ratio. For effective management of credit,

the firm should lay down clear cut guidelines and procedure for granting credit to

individual customers and collecting individual accounts should involve following steps:

(1) Credit information

(2) Credit investigation

(3) Credit limits

(4) Collection procedure.

2) Inventory Management

The term inventory is used to designate the aggregate of those items of tangible

assets which are

1. Finished goods ( saleable )

2. Work-in-progress ( convertible )

3. Material and supplies ( consumable )

In financial view, inventory defined as the sum of the value of raw material and supplies,

including spares, semi processed material or work in progress and finished goods. Thenature of inventory is largely depending upon the type of operation carried on. For

instance, in the case of a manufacturing concern, the inventory will generally comprise all

three groups mentioned above while in the case of a trading concern, it will simply be by

stock- in- trade or finished goods.

Objective of inventory management

In company there should be an optimum level of investment for any asset, whether it

is plant, cash or inventories. Again inadequate disrupts production and causes losses in

sales. Efficient management of inventory should ultimately result in wealth maximization

of owner s wealth. It implies that while the management should try to pursue financial


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objective of turning inventory as quickly as possible, it should at the same time ensure

sufficient inventories to satisfy production and sales demand. The objectives of inventory

management consist of two counterbalancing parts:

1. To minimize the firms investment in inventory

2. To meet a demand for the product by efficiently organizing the firms productionand sales operation.

This two conflicting objective of inventory management can also be expressed in term of

cost and benefits associated with inventory. That the firm should minimize the

investment in inventory implies that maintaining an inventory cost, such that smaller the

inventory, the better the view point .obviously, the financial manager should aim at a level

of inventory which will reconcile these conflicting elements. Some objective as follow

1. To have stock available as and when they are required.

2. To utilize available storage space but prevents stock levels from exceeding space

available.

3. To maintain adequate accountability of inventories assets.

4. To provide, on item by- item basis, for re-order point and order such quantity as

would ensure that the aggregate result confirm with the constraint and objective of

inventory control. To keep low investment in inventories carrying cost an obsolesce losses

to the minimum.

Inventory components

The manufacturing firm s inventory consist following components

I) Raw material

ii) Work- in-progress

iii) Finished goods

To analyze the level of raw material inventory and work in progress inventory held by the

firm on an average it is necessary to examine the efficiency with which the firm

converts raw material inventory and work in progress into finished goods.


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3) Management of Cash

Cash is common purchasing power or medium of exchange. As such, it forms the most

important component of working capital. The term cash with reference to cash management

is used in two senses, in narrow sense it is used broadly to cover cash and generally accepted

equivalent of cash such as cheques, draft and demand deposits in banks. The broader viewof cash also induce hear- cash assets, such as marketable sense as marketable securities

and time deposits in banks. The main characteristics of this deposits that they can be really

sold and convert in to cash in short term. They also provide short term investment outlet for

excess and are also useful for meeting planned outflow of funds. We employ the term cash

management in the broader sense. Irrespective of the form in which it is held, a

distinguishing feature of cash as assets is that it was no earing power. Company have to

always maintain the cash balance to fulfill the dally requirement of expenses. There are four

primary motive for maintain the cash a follow

Motive of holding cash there are four motives for holding cash as follow

1. Transaction motive

2. Precautionary motive

3. Speculative motive

4. Compensating motive

Transaction motive

Cash balance is necessary to meet day-to-day transaction for carrying on with the

operation of firms. Ordinarily, these transactions include payment for material, wages,

expenses, dividends, taxation etc. there is a regular inflow of cash from operating sources,

thus in case of JISL there will be two-way flow of cash- receipts and payments. But since

they do not perfectly synchronize, a minimum cash balance is necessary to uphold the

operations for the firm if cash payments exceed receipts.

a major part of transaction balances is held in cash, a part may be held in the form of

marketable securities whose maturity conforms to the timing of anticipated payments of

certain items, such as taxation, dividend etc.

Precautionary Motive


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Cash flows are somewhat unpredictable, with the degree of predictability varying

among firms and industries. Unexpected cash needs at short notice may also be the result of

following:

1. Uncontrollable circumstances such as strike and natural calamities.

2. Unexpected delay in collection of trade dues.

3. Cancellation of some order for goods due unsatisfactory quality.

4. Increase in cost of raw material, rise in wages, etc.

The higher the predictability of firm s cash flows, the lower will be the necessity of

holding this balance and vice versa. The need for holding the precautionary cash

balance is also influence d by the firm s capacity to have short term borrowed funds and

also to convert short term marketable securities into cash.

Speculative motive

Speculative cash balances may be defined as cash balances that are held to enable the

firm to take advantages of any bargain purchases that might arise.

While the precautionary marketable securities portfolios than on actual cash holdings for

speculative purposes.

Advantages of cash management

Cash does not enter in to the profit and loss account of an enterprise, hence cash is neither

profit nor losses but without cash, profit remains meaningless for an enterprise owner.

1. A sufficient of cash can keep an unsuccessful firm going despite losses

2. An efficient cash management through a relevant and timely cash budget

may enable a firm to obtain optimum working capital and ease the strains of cash

shortage, fascinating temporary investment of cash and providing funds normal growth.

3.Cash management involves balance sheet changes and other cash flow that do not

appear in the profit and loss account such as capital expenditure.


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WORKING CAPITAL RATIO ANALYSIS

Ratio analysis is the powerful tool of financial statements analysis. A ratio is defined as

the indicated quotient of two mathematical expressions and as the relationship between twoor more things .The absolute figures reported in the financial statement do not provide

meaningful understanding of the performance and financial position of the firm. Ratio helps

to summaries large quantities of financial data and to make qualitative judgment of the

firms financial performance

Role of ratio analysis

Ratio analysis helps to appraise the firms in the term of there profitability and efficiency of

performance, either individually or in relation to other firms in same industry. Ratio

analysis is one of the best possible techniques available to management to impart the basic

functions like planning and control. As future is closely related to the immediately past,

ratio calculated on the basis historical financial data may be of good assistance to predict the

future. E.g. On the basis of inventory turnover ratio or debtor s turnover ratio in the past, the level of

inventory and debtors can be easily ascertained for any given amount of sales. Similarly,

the ratio analysis may be able to locate the point out the various areas which need the

management attention in order to improve the situation. E.g. Current ratio which shows

a constant decline trend may be indicate the need for further introduction of long term

finance in order to increase the liquidity position. As the ratio analysis is concerned

with all the aspect of the firms financial analysis liquidity, solvency, activity,

profitability and overall performance, it enables the interested persons to know the

financial and operational characteristics of an organization and take suitable decisions.

Efficiency ratio

The ratios compounded under this group indicate the efficiency of the

organization to use the various kinds of assets by converting them the form of

sale. This ratio also called as activity ratio or assets management ratio. As the


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assets basically cate gorized as fixed assets and current assets and the

current assets further classified according to individual components of

current assets viz. investment and receivables or debtors or as net current

assets, the important of efficiency ratio as follow:

1. Working capital turnover ratio

2. Inventory turnover ratio

3. Receivable turnover ratio

Liquidity ratio

The ratios compounded under this group indicate the short term position of the organization

and also indicate the efficiency with which the working capital is being used. The most

important ratio under this group is follows

1. Current ratio

2. Quick ratio

1) Efficiency Ratio

WORKING CAPITAL TURNOVER RATIO

Working Capital Turnover Ratio is increasing over the years indicating a higher utilization of

Current Assets. A higher ratio indicates efficient utilization of working capital.

Working capital turnover = Turn Over / Net Working Capital

WORKING CAPITAL TURNOVER RATIO (WCTR)


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Year Sales Working Capital WCTR

FY2007-08 8,87,79,405 3,63,63,315 2.44

FY2006-07 5,55,44,779 1,87,68,861 2.95

FY2005-06 3,97,21,654 1,28,79,871 3.08

Inference:

3.082.95

2.44

0

0.5

1

1.5

2

2.5

3

3.5

FY2005-06 FY2006-07 FY2007-08

WORKING CAPITAL TURNOVER RATIO

WORKING CAPITAL TURNOVER

RATIO


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The Working Capital Turnover Ratio was 3.08 in 2005-2006 and decreased to 2.44.The

decreasing trend was due to slow paying debtors. The working capital turnover ratio suggests

that the working capital is being efficiently utilized.

DEBTORS TURNOVER RATIO

Debtor's turnover ratio throws light on the credit and collection policies of the business and

thus related to liquidity.

Debtors Turnover = Credit Sales/Average Accounts Receivable

DEBTORS TURNOVER RATIO (DTR)

Year Credit Sales Avg. Receivables DTR

FY2007-08 8,87,79,405 3,34,96,243 2.65

FY2006-07 5,55,44,779 2,18,80,936 2.53

FY2005-06 3,97,21,654 1,64,75,692 2.41


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Inferences:

Debtor's turnover ratio throws light on the credit and collection policies of the business and

thus related to liquidity. This table shows that the Debtors turnover ratio is 2.41 in 2005-2006

and in 2006-07 there is a increase in the ratio as 2.53. In the year 2007-08there is a futher

increase in the ratio as 2.65.

The Debtors turnover ratio shows that the firm is not utilizing its resources effectively.

Debtors turnover ratio of 2.65 for 2008 is not satisfactory for a manufacturing company.

The low Debtor's turnover ratio for indicates that the company is having a significant portion

of slow paying Debtors.

AVERAGE COLLECTION PERIOD

The average collection period measures the quality of debtors since it indicates the speed of

their collection. The shorter the average collection period, the better the quality of debtors,

since a short collection period implies the prompt payment by debtors. The average collection

period should be compared against the firm's credit terms and policy to judge its credit and

collection efficiency.

Average Collection Period = No. of working days / Debtors Turnover Ratio

2.41

2.53

2.65

2.25

2.3

2.35

2.4

2.45

2.5

2.55

2.6

2.65

2.7

FY2005-06 FY2006-07 FY2007-08

Debt rs T r ver Rati

Debtors Turnover Ratio


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AVERAGE COLLECTION PERIOD (ACP)

Year DTR No. of Months ACP (mth)

FY2007-08 2.65 12 4.5

FY2006-07 2.53 12 4.7

FY2005-06 2.41 12 4.9

Inferences:

From the above we can understand that, in 2005-2006 the ratio was 4.9 and by the year 2007-2008 it

was 4.5. For a company like AFCIL industries, the average collection period should be between 1.5-2months. The average collection period of 4.5 months for 2008 indicates that the collection policy of

the company is not satisfactory.

CREDITORS TURNOVER RATIO

In the course of business operations, a firm has to make credit purchases and incur short-termliabilities. A supplier of goods i.e. creditor is naturally interested in finding out how much

time the firm is likely to take in repaying its trade creditors. The analysis for creditors

turnover is basically the same as of debtors turnover ratio except that in place of average

daily sales, average daily purchases are taken as the other component of the ratio and in place

of average daily sales

Creditors Turnover = Credit Purchases/Average Accounts Payable


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CREDITORS TURNOVER RATIO (CTR)

Year Credit Purchase Avg .Accounts Payable CTR

FY2007-08 5,31,42,731 2,21,94,822 2.39

FY2006-07 3,95,41,667 1,56,50,348 2.24

FY2005-06 4,00,23,125 1,65,12,346 2.42

Inferences:

Creditors turnover ratio indicates the velocity with which the creditors are turned over in

relation to purchases. Higher the creditors velocity better it is or lower the creditors velocity

, less favorable the results are. This table shows that the Creditors turnover ratio is 2.42 in

2005-2006 and in 2006-07 there is a decrease in the ratio as 2.24 and a further increases in

2007-08 to 2.39.

AVERAGE PAYMENT PERIOD

The average payment period ratio represents the average number of days taken by the firm to

pay its creditors. Generally lower the ratio, the better is the liquidity position and higher the

ratio, less liquid is the position of the firm.

Average Payment Period = No. of working days / Creditors Turnover Ratio


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AVERAGE PAYMENT PERIOD (APP)

Year CTR No.of Months APP

FY2007-08 2.39 12 5.02

FY2006-07 2.24 12 5.35

FY2005-06 2.42 12 4.95

Inferences:

The average payment period ratio represents the average number of days taken by the firm to

pay its creditors. Generally lower the ratio, the better is the liquidity position and higher the

ratio, less liquid is the position of the firm. In 2005-06 the average payment period was 4.95

which increased to 5.02 in 2007-08 showing a constant change. The average payment period

of the company is around five months which is satisfactory.

2) Liquidity Ratio

CURRENT RATIO

Current ratio may be defined as the relationship between current assets and current liabilities.

This ratio is also known as working capital ratio, is a measure of general liquidity and is most

widely used to make the analysis of the short-term position or liquidity of a firm. It is

calculated by dividing the total of current assets by total of the current liabilities.

Current Ratio = Current Assets/ Current Liabilities


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CURRENT RATIO

Year Current Asset Current liabilities Current Ratio

2007-2008 6,19,88,011 2,56,24,696 2.419

2006-2007 4,54,09,927 2,66,41,066 1.704

2005-2006 3,83,17,816 2,51,37,807 1.524


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Inferences:

The Current ratio represents a margin of safety for creditors. The higher the ratio, the greater

the margin of safety; the larger the amount of current assets in relation to current liabilities,

the more the firms ability to meet its current obligations. The ratio is1.52 in the year 2005

2006 and 1.70 in the year 2006-2007 and it increased to 2.19 in the year 2007-2008. The

main reason for increase of ratio was increase in the current assets.

Ideal Ratio is 2:1. Current ratio exceeding 1.5 is satisfactory for the business. Since the

current ratio is higher than the normal benchmark, the short-term solvency of the firm is

satisfactory.

QUICK RATIO

Quick Ratio, also known as acid test or Liquid Ratio is more rigorous test of liquidity than the

current ratio. Quick ratio may be defined as the relationship between quick/liquid assets and

current or liquid liabilities. An asset is said to be liquid if it can be converted into cash within

a short period without loss of value. In that sense, cash in hand and cash at bank are most

liquid assets. The other assets, which can be included in the liquid assets and sundry debtors,

marketable securities and short-term or temporary investments. Inventories cannot be termed

to be liquid asset because they cannot be converted into cash immediately without a sufficient

1.52

1.7

2.41

0

0.5

1

1.5

2

2.5

3

FY2005-06 FY2006-07 FY2007-08

Current Ratio

Current Ratio


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loss of value. In the same manner, prepaid expense is also excluded from the list of

quick/liquid assets because they are not expected to be converted into cash

Quick Ratio = Quick Assets/Quick Liabilities

Quick Assets = Current Assets (Inventories + Prepaid expenses)

Quick Liabilities = Current Liabilities (Bank Overdraft Cash Credit)

QUICK RATIO

Year Quick Asset Quick Liabilities Quick Ratio

FY2007-08 3,83,89,273 2,56,24,696 1.49

FY2006-07 3,51,74,452 1,95,17,932 1.8

FY2005-06 3,20,74,620 1,64,31,721 1.95


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Inferences:

As the quick ratio is higher than the normal benchmark of 1:1, the liquidity of the firm is

good. In 2005 2006 the ratio was 1.95,in 2006-2007 it was 1.802 which then reduced to

1.498 in 2007-2008 showing that the ratios are within the acceptable limits. As the Current

ratio and Quick ratio are within the acceptable limits, company's liquidity position and short

term solvency is satisfactory.

1.95

1.8

1.49

0

0.5

1

1.5

2

2.5

FY2005-06 FY2006 -07 FY2007-08

Quick Ratio

Quick Ratio


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