working capital
TRANSCRIPT
Funds required for short term purposes or day to day expenses
are working capital. WC refers to part of firm’s capital reqd. for financing short
term or current assets also known as revolving or short term capital or circulating capital
Working Capital may be classified in two ways:- On the basis of concept - gross working capital - net working capital On the basis of time - permanent or fixed WC a) regular WC b) reserve WC - temporary or variable WC a) seasonal WC b) special WC
It refers to the firm’s investment in current assets. Current assets are the assets, which can be converted into cash within an accounting year or within an operating cycle. You can include here cash, short-term securities, debtors (accounts receivable & book debts), bills receivable and stock. enables enterprise to provide correct amount of WC at the
right time. every management is interested in total current assets
with which it has to operate than the sources. gross concepts takes into considerations that every
increase in the funds would increase the working capital. gross concepts of WC is more useful in determining rate of
return on investments in WC.
The net working capital refers to the difference between current assets and current liabilities. Current liabilities are those claims of outsider, which are expected to mature for payment within an accounting year & include creditors, bills payable & the outstanding expenses. In other words you can say that this is the excess of current assets over current liabilities.
It is a qualitative concept which indicates firm’s ability to meet its operating expenses and short term liabilities.
It indicates the margin of protection available to the short term creditors.
Indicator of financial soundness of an enterprise. Net WC is referred to as working capital.
Inventories: Inventories represent raw materials and components, work-in-progress and finished goods.
Trade Debtors: Trade Debtors comprise credit sales to customers. Prepaid Expenses: These are those expenses, which have been
paid for goods and services whose benefits have yet to be received.
Loan and Advances: They represent loans and advances given by
the firm to other firms for a short period of time.
Investment: These assets comprise short-term surplus funds invested in government securities, shares and short-terms bonds.
Cash and Bank Balance: These assets represent cash in hand and
at bank, which are used for meeting operational requirements. One thing you can see here is that this current asset is purely liquid but non-productive.
Sundry Creditors: These liabilities stem out of purchase of raw materials on credit terms usually for a period of one to two months.
Bank Overdrafts: These include withdrawals in excess of
credit balance standing in the firm’s current accounts with banks
Short-term Loans: Short-terms borrowings by the firm
from banks and others form part of current liabilities as short-term loans.
Provisions: These include provisions for taxation, proposed dividends and contingencies.
The operating cycle of the company consists of time period between procurement of the inventory and the collection of the cash from the receivables. The operating cycle is the length of time between the company’s outlay on raw materials, wages, and other expenses and inflow of cash from sale of goods. Operating cycle is an important concept in the management of cash and management of working capital. The operating cycles reveals the time that elapses between outlay of cash and inflow of cash.
Raw material Holding Period = Average Raw material stock _
Average consumption of Raw material/365
Work-in-Process period = Average Work-in-Process
_ Average cost of goods/365 Receivable collection period = Average Receivables
_ Average sales/365
Creditors payment period = Average Work-in-Process
_ Average cost of goods/365 Finished Goods Holding period = Average finished goods stock
_ Average cost of goods sold/365
Permanent working capital or fixed working capital: refer to the minimum amount of investment in current assets required throughout the year for carrying out the business. In other words , it is the amount of working capital which remains in the business permanently in one form or other.
The magnitude of working capital required will not be
constant, but will fluctuate. At any time, there is always a minimum level of current assets which is constantly and continuously required by a business unit to carry on its operations. This minimum amount of current assets, which is required on a continuous and uninterrupted basis is referred to as fixed or permanent working capital.
The amount of current assets required to meet a firm’s long term minimum needs.
TIMETIME
Investment in assets
Investment in assets
FIXED ASSETS
PERMANENT CA
Permanent working capital should be financed (along with other fixed assets) out of long term funds of the unit. However in practice, a portion of these requirements also is met through short term borrowings from banks and suppliers credit.
The amount of current assets required to meet a firm’s long-term minimum needs are called Permanent Current Assets.
For e.g.:- In a manufacturing unit, basic raw materials required for production has to be available at all times and this has to be financed without any disturbance.
Variable working capital or fluctuating working capital: refer to
the amount of working capital which goes on fluctuating or changing from time to time with the change in the volume of business activities.
Any amount over and above the permanent level of working capital is variable, temporary or fluctuating working capital.
This type of working capital is generally financed from short term sources of finance such as bank credit because this amount is not permanently required and is usually paid back during off season or after the contingency.
.
As the name implies, the level of fluctuating working capital keeps on fluctuating depending on the needs of the unit unlike the permanent working capital which remains constant over a period of time.
Current assets that fluctuate due to seasonal or cyclical demand are called variable current assets
FLUCTUATING CA
PERMANENT CA
FIXED CA
TIMETIME
INVESTMENT IN ALL TYPES OF ASSETS
INVESTMENT IN ALL TYPES OF ASSETS
PERMANENT WC
1. Stable over time.2. Investment can be
predicted easily.3. Minimum investment in
various CA4. Need for certain amount
of irreducible level of CA on a continuous & uninterrupted basis.
VARIABLE WC
1. Fluctuating according to seasonal demand.
2. Investment cannot be predicted easily.
3. Expected to take care for peak in business activity.
4. Need to meet seasonal &other seasonal requirement.
PERMANENT WC
Requirements financed from long term funds.
VARIABLE WC
Requirements financed from short term funds.
Maintains solvency of business. Helps in creating & maintaining goodwill. Helps in arranging loans from banks & others on easy and
favorable terms. Enables a concern to avail cash discount and hence reduce
cost. Ensures regular supply of raw materials. Regular payment of salaries, wages & other day to day commitment. Exploitation of favorable market condition. Enables a concern to face business crisis.
Disadvantages of redundant or excessive WC:- Excessive WC means idle funds which earn no profit for the
business & hence, business cannot earn a proper rate of return on its investments.
When there is redundant WC, it may lead to unnecessary purchasing & accumulation of inventories causing more chance of theft, waste & losses.
Excessive WC implies excessive debtors & defective credit policy which may cause higher incidences of bad-debts.
It may result in overall inefficiency in org. When there is excessive WC, relationships with banks &other
financial institutions may not be maintained due to low rate of returns on investments, the value of share may also fall.
Nature of business: The working capital requirements of an enterprise are basically
related to the conduct of the business. Public utility undertakings like Electricity, Water supply, Railways, etc. need very limited working capital because they offer cash sales only and supply services, not products and as such no funds are ties up in inventories and receivables. But at the same time have to invest fewer amounts in fixed assets. The manufacturing concerns on the other hand require sizable working capital along with fixed investments, as they have to build up the inventories.
Terms of sales and purchases: Credit sales granted by the concerns too its customers as well
as credit terms granted by the suppliers also affect the working capital. If the credit terms of the purchases are more
Manufacturing cycle: The length of manufacturing cycle influences the quantum
of working capital needed. Manufacturing process always involves a time lag between the time when raw materials are fed into the production line and finished goods are finally turned out by it. The length of the period of manufacture in turn depends o the nature of product as well as production technology used by a concern. Shorter the manufacturing cycle; lesser the working capital required.
Business cycle: Cyclical changes in the economy also influence quantum
of working capital. In a period of boom i.e., when the business ism prosperous, there is s need of larger amount of working capital due to increases in sales, rise in price etc and vice-a-versa during period of depression
Production policies Production policies of the organizations effects
working capital requirements very highly. Seasonal industries, which produces only in specific season requires more working capital. Some industries which produces round the year but sale mainly done in some special seasons are also need to keep more working capital.
Length of operating cycle Operating cycle of the firm also influence the
working capital. Longer the orating cycle, the higher will be the working capital requirement of the organization.
Current asset policies The quantum of working capital of a company is
significantly determined by its current assets policies. A company with conservative assets policy may operate with relatively high level of working capital than its sales volume. A company pursuing an aggressive amount assets policy operates with a relatively lower level of working capital.
Fluctuations of supply and seasonal variations
Some companies need to keep large amount of working capital due to their irregular sales and intermittent supply. Similarly companies using bulky materials also maintain large reserves’ of raw material inventories. This increases the need of working capital. Some companies manufacture and sell goods only during certain seasons. Working capital requirements of such industries will be higher during certain season of such industries period.
WC = CA-CL Need to follow the following four step procedure: Estimation of cash cost of the various CA required by the
firm. Estimation of spontaneous CL of the firms. Compute net working capital by subtracting the estimate CL
(step 2) from CA(step 1) Add some percentage of net working capital if there is any
contingency or safety working capital required, to get the required WC
Once the estimation or determination of the current assets is over then the next step in working capital management is financing of current assets.
There are three financing policies Short term financing Long term financing Spontaneous financing
Generally current assets should be financed by only short term financial sources. short term finance is obtained for a period of less than one year.
The sources of short term finance are Loans from banks Public deposits Commercial papers Factoring of receivables Bills discounting Retention of profits etc.
Net current assets or permanent current assets or working capital are supposed to be financed by long term sources of finance.
Long term finance is raised for a period of more than five years.
Long term finance sources include, ordinary share capital, preference share capital, debentures, long term loans from banks and surpluses(include retained earnings)
It refers to the automatic sources of short term funds arising in the normal course of a business. The source include trade credit(suppliers) and outstanding expenses.
Spontaneous sources of finance is available at no cost.
Sources of additional working capital include the following
Existing cash reserves Profits (when you secure it as cash) Payables (credit from suppliers) New equity or loans from shareholder Bank overdrafts line of credit Long term loans
The firm can adopt a financial plan which matches the expected life of assets with the expected life of the source of funds raised to finance assets. When the firms follow the matching approach (known as hedging approach), long term financing will be used to finance the fixed assets and permanent current assets and short term financing to finance temporary or variable current assets.
When the firm uses long term sources to finance fixed assets and permanent current assets, and short term financing to finance temporary current assets.
Under this approach a firm finances its permanent assets and also a part of temporary current assets with long term financing. It relies heavily on long term financing and is less risky so far as solvency is concerned, however, the funds may be invested in such instruments, which fetch small returns to build up liquidity. This adversely affects profitability.
The financing policy of the firm is said to be conservative when it depends more on long term funds for financing needs. Under a conservative plan, the firm finances its permanent assets and also a part of temporary current assets with long term financing.
A firm may be aggressive in financing its assets. An aggressive policy is said to be followed by the firm when its uses more short term financing than warranted by the matching plan. Under an aggressive policy, the firm finances a part of its permanent current assets with short term financing.
The firm uses more short term financing than what is justified, in this approach. The firm finances a part of its permanent current assets with short term financing. This is more risky but may add to the return on assets.