An Overview Overview of Working Capital Management 2 After Plant & Machinery has been installed and the manufacturing facility is put in place, the firm would require investment in Short-term assets. Firms would be required to maintain stocks of raw material/finished goods leading to Inventories and /or sell finished products on credit leading to Receivables (or Debtors). Investments in such short-term assets is called Working Capital. Working Capital Management: An Overview 2 Overview of Working Capital Management 3 Those assets that are either in the form of cash or are expected to be converted into cash in the short term (usually defined as less than one year). Cash: most liquid asset Short Term Investments (Marketable securities) such as Government bonds, generally can be converted into cash quickly, at low cost and with minimum loss of value Inventory of Raw Materials, work-in-progress or Finished goods Receivables (Debtors): When a firm sells goods on credit, it creates receivables. On realization , they are converted into cash Current Assets Overview of Working Capital Management 4 Those liabilities that are expected to be paid within a year. Non-interest bearing Current Liabilities Payables ( Creditors): when a firm buys goods on credit, it creates accounts payables Accrued expenses: Firms accrue wages & salaries to their employees or taxes to government Provisions for Dividends/Taxes etc. Interest bearing Current Liabilities Current portion of long-term debt (Interest & Principal) Short-term debt Current Liabilities 3 Overview of Working Capital Management 5 Current Liabilities Overview of Working Capital Management 6 4 Overview of Working Capital Management 7 Gross Working Capital is the aggregate investment in Current Assets. Trade-off between excessive and inadequate Current Assets; Financing of Current Assets. Net Working Capital is the difference between the Current Assets and Current Liabilities of a firm. Indicates the liquidity position of a firm and indicates the extent to which working capital requirements may be financed by long-term sources. Current Assets should be sufficiently in excess of the current liabilities and form a buffer for maturing obligations within a operating cycle. Negative NWC (CL > CA) indicates negative liquidity, may prove harmful to the firm. Excessive liquidity (high +ve NWC) is also not good. Gross & Net Working Capital Raw Material Work-in- Progress Finished Goods Debtors Cash Overview of Working Capital Management 8 Purchase Convert Sale of Goods Realise Operating Cycle Why do we need Working Capital? Convert Current Assets are required as Sales do not convert into cash instantaneously. Operating Cycle time duration required to convert cash into R/M, then into finished goods and finally into cash. 5 Overview of Working Capital Management 9 Operating Cycle Purchase of Raw Material on Credit Collection of Receivables Payment for Credit Purchases Credit Sales Gross Operating Cycle Inventory Conversion Period Receivables Conversion Period Payable Deferral Period Net Operating Cycle D A C B Overview of Working Capital Management 10 Operating Cycle Gross Operating Cycle Inventory Conversion Period Receivables Conversion Period = + Inventory Conversion Period Raw Material Conversion Period WIP Conversion Period Finished Goods Conversion Period = + + Net Operating Cycle (Cash Conversion Cycle) Gross Operating Cycle Payable Deferral Period = - 6 Overview of Working Capital Management 11 Operating Cycle Raw Material Conversion Period = Average time taken to convert Raw Material into Work-in- Progress RMCP depends upon: Average Raw Material Inventory , and Raw Material consumed per day = Average Raw Material Inventory (Op.RM + Cl. RM)/2 RMCP= Raw Material consumed per day Raw Material consumed /360 Rs. 200/- RMCP= = 10 days Rs. 20/- per day Overview of Working Capital Management 12 Operating Cycle (Op.WIP + Cl. WIP)/2 WIPCP = Cost of Production /360 (Op.FG + Cl. FG)/2 FGCP = Cost of Goods Sold /360 (Op.Rec. + Cl. Rec)/2 RCP = Credit Sales /360 (Op.Payables + Cl. Payables)/2 PDP = Credit Purchases /360 7 Overview of Working Capital Management 13 Working Capital Cycle estimation 1 Raw Material Purchased 5,000 2 Opening Inventory of R/M 500 3 Closing Inventory of R/M 900 4 Raw Material Consumed (1+2-3) 4,600 5 Direct Labour 450 6 Depreciation 100 7 Other Manufacturing Expenses 600 8 Total Cost (4+5+6+7) 5,750 9 Opening Inventory of WIP 185 10 Closing Inventory of WIP 325 11 Cost of Production (8+9-10) 5,610 12 Opening Inventory of FG 320 13 Closing Inventory of FG 525 14 Cost of Goods Sold (11+12-13) 5,405 15 Selling, Administrative & General Expenses 300 16 Cost of Sales (14+15) 5,705 17 Credit Sales 6,100 18 Receivables (Average) 750 19 Payables (Average) 450 Overview of Working Capital Management 14 Working Capital Cycle estimation A Raw Material Conversion Period (RWCP) 1 Raw Material Consumption 4,600 2 Raw Material Consumed per day 12.78 3 Average Inventory of RM 700 4 RMCP (Days) A3/A2 55 B WIP Conversion Period (WIPCP) 1 Cost of Production 5,610 2 COP per day 15.58 3 Average Inventory of WIP 255 4 WIPCP (Days) B3/B2 16 C FG Conversion Period (FGCP) 1 Cost of Goods Sold 5,405 2 COGS per day 15.01 3 Average Inventory of FGs 423 4 FGCP (Days) C3/C2 28 D Receivables Conversion Period (RCP) 1 Credit Sales 6,100 2 Credit Sales per day 16.94 3 Average Receivables 750 4 RCP (Days) D3/D2 44 E Payables Deferral Period (PDP) 1 Credit Purchases 5,000 2 Credit Purchases per day 13.89 3 Average Payables 450 4 PDP (Days) E3/E2 32 8 Overview of Working Capital Management 15 Working Capital Cycle estimation Working Capital Cycle 1 Inventory Conversion Period: - RMCP 55 - WIPCP 16 - FGCP 28 2 Receivables Conversion Period 44 3 Gross Working Capital Cycle 144 4 Less: Payables Deferral Period 32 5 Net Working Capital Cycle 111 Overview of Working Capital Management 16 Excess Working Capital: Accumulation of Inventory Issues with Credit Policy & Slack collection efforts Idle cash Complacent management Inadequate Working Capital: Hampered Sales & hence loss of profit Operating difficulties due to inability to meet day-to-day expenses Inefficient utilization of Fixed assets Loss of reputation Excessive vs. Inadequate Working Capital 9 Overview of Working Capital Management 17 As Operating Cycle is a continuous process, hence Current Assets are required continuously but the quantum of Current Assets required may not remain constant throughout and may vary over time. Some part of the Working Capital is required continuously, which is called FIXED Working Capitalrepresents the MINIMUM level of Current Assets. Depending upon changes in production & sales, the need for Working Capital over and above the Fixed Working Capital may fluctuate. Additional working capital required to support the changing production & sales level is called VARIABLE or TEMPORARY Woking Capital. Fixed & Variable Working Capital Overview of Working Capital Management 18 Fixed & Variable Working Capital (Contd.) Time A m o u n t
o f
W o r k i n g
C a p i t a l
Variable Working Capital Fixed Working Capital A m o u n t
o f
W o r k i n g
C a p i t a l
Time Fixed Working Capital Variable Working Capital 10 Overview of Working Capital Management 19 Short term vs. Long term funds Short-term funds are less costly and more flexible but at the same time more Risky. Hence, a Risk-Return trade-off has to be achieved while deciding the financing mix. Overview of Working Capital Management 20 Approaches to Working Capital Financing Based on the mix of Short Term(Spontaneous Sources/Current Liabilities) and Long term sources of financing working Capital, and the Fixed & Variable Current Assets, there are three approaches to Working Capital Financing. Matching Approach Conservative Approach Aggressive Approach 11 Overview of Working Capital Management 21 Matching Approach Expected life of an asset should match the tenure of the financing source. Fixed Current Assets should be financed by long-term sources while the Variable Current Assets should be financed by short-term sources. Variable Working Capital Fixed Working Capital A m o u n t
o f
W o r k i n g
C a p i t a l
Time Long Term Sources Short Term Sources Overview of Working Capital Management 22 Under this approach, more reliance is on long-term sources Long term sources are used to finance Fixed Assets + Fixed Current Assets + Part of the Variable Current Assets. Lower level of risk of shortage of funds. Conservative Approach Long Term Sources Variable Current Assets Fixed Assets A m o u n t
o f
W o r k i n g
C a p i t a l
Time Short Term Sources 12 Overview of Working Capital Management 23 Aggressive Approach Under this approach, more reliance is on Short-term sources of funds to finance assets. Part of Fixed Current Assets + Temporary Current Assets are financed by short-term sources. Variable Current Assets Fixed Assets A m o u n t
o f
W o r k i n g
C a p i t a l
Time Short Term Sources Long Term Sources Overview of Working Capital Management 24 Impact of Short term vs. Long term Financing Conservative Moderate Aggressive Fixed Assets 60.00 60.00 60.00 Current Assets 40.00 40.00 40.00 Equity 40.00 40.00 40.00 Long Term Debt 48.00 30.00 0.00 Short Term Debt 12.00 30.00 60.00 EBIT 20.00 20.00 20.00 Interest - LT Debt @ 15% 7.20 4.50 0.00 Interest - ST Debt @ 10% 1.20 3.00 6.00 EBT 11.60 12.50 14.00 Taxes @ 35% 4.06 4.38 4.90 PAT 7.54 8.13 9.10 PAT/Equity 18.9% 20.3% 22.8% STF/TF 12% 30% 60% Higher returns, but Higher risk as well 13 Overview of Working Capital Management 25 Determinants of Working Capital Large number of factors influence the working capital requirements. Each factor has different importance which varies over time as well. 1. Nature & Size of Business: As compared with Total assets, Trading companies require large investment in working capital (than investment in Fixed Assets), while Utility companies such as Power Generation Company, require low levels of working capital and huge investments in Fixed Assets. Size (Scale of operations) - Large company would require more working capital. 2. Manufacturing Cycle: Longer the Manufacturing cycle, larger will be requirement of working capital. 3. Sales Growth: As sales grow, more working capital would be required, though a definite relationship is difficult to determine. Overview of Working Capital Management 26 4. Demand Conditions: For seasonal products, as demand varies, so does the working capital varies. During Boom periods, as demand picks up, not only the variable, but the fixed working capital requirements also goes up. 5. Production Policy: Constant Production Policy would lead to accumulation of inventory in off-season. Cost of maintaining inventory Risks- damage; no- off take. To minimize - firm may choose to vary its production schedules. 6. Price Level Changes: Increase in prices, calls for higher investment in working capital. Though, the impact of increase in general prices may be different on different companies. Determinants of Working Capital 14 Overview of Working Capital Management 27 7. Operating Efficiency: A firm should make optimum utilisation of its resources at minimum costs. Efficient utilisations of various factors of production, helps in reducing the overall quantumof working capital. 8. Credit Policy: Liberal Credit Policy means high debtors, high collection period, and high bad debts - hence more working capital would be required. Therefore, company should follow a rational credit policy evaluate the credit worthiness of customers and review them. 9. Availability of Credit fromSuppliers: If a firm gets liberal credit from its suppliers, the requirements of working capital would be less. Suppliers credit finances the firms inventory and reduces the WC finance. Determinants of Working Capital