O slideshow foi denunciado.
Utilizamos seu perfil e dados de atividades no LinkedIn para personalizar e exibir anúncios mais relevantes. Altere suas preferências de anúncios quando desejar.

Financial management 3

Working Capital Management, Approaches, Determinants

  • Entre para ver os comentários

Financial management 3

  1. 1. Unit IV Financial Management • Management of Working Capital: Concepts of working Capital • Approaches to the financing of current Assets • Determining capital (with numerical problems) • Management of different components of working capital. Prepared by:- Dr. Waqar Ahmad Asstt. Professor Allenhouse Business School
  2. 2. WORKING CAPITAL • Working capital management involves the relationship between a firm's short-term assets and its short-term liabilities. • The basic goal of working capital management is to ensure that a firm is able to continue its operations and that it has sufficient ability to satisfy both maturing short-term debt and upcoming operational expenses.
  3. 3. SINGNIFICANCE OF WORKING CAPITAL MANAGEMENT  In a typical manufacturing firm, current assets exceed one-half of total assets.  Excessive levels can result in a substandard Return on Investment (ROI).  Current liabilities are the principal source of external financing for small firms.  Requires continuous, day-to-day managerial supervision.  Working capital management affects the company’s risk, return, and share price.
  4. 4. WORKING CAPITAL CONCEPTS Net Working Capital  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. Current Assets – Current Liabilities
  5. 5. WORKING CAPITAL CONCEPTS Gross Working Capital • 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 • cash, short-term securities, debtors (accounts receivable & book debts), bills receivable and stock. Working capital turnover Working capital turnover= sales/working capital Working Capital Management The administration of the firm’s current assets and the financing needed to support current assets.
  6. 6. CURRENT ASSETS • 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.
  7. 7. CURRENT LIABILITY  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.
  8. 8. WORKING CAPITAL FORMAT CURRENT ASSETS CURRENT LIABILITIES • Cash • Accounts receivable • Notes receivable • Marketable securities • Inventory • Prepaid expenses Total current assets • Accounts payable • Notes payable • Accrued expenses • Taxes payable Total current liabilities
  9. 9. POINTS KEPT IN MIND WHILE PLANNING 1. Excessive investment (Profitability) • It results in unnecessary accumulation of inventories. Thus, chances of inventory mishandling, waste, theft & losses increase. • It is an indication of defective credit policy & slack collection period. • Excessive WC makes management complacent, which degenerates into managerial inefficiency. • Tendencies of accumulating inventories tend to make speculative profits grow.
  10. 10. POINTS KEPT IN MIND WHILE PLANNIN CONT… 2. Inadequate investment (Liquidity)  It stagnates growth.  It become difficult to implement operating plans and achieve the firm’s operating profit target.  Operating inefficiencies creep in when it becomes difficult even to meet day-to-day commitments.  Fixed assets are not efficiently utilized for the lack of working capital funds. Thus, the firm’s profitability would deteriorate.  Paucity of WC funds render the firm unable to avail attractive credit opportunities.  The firm loses its reputation when it is not in a position to honour its short-term obligations.
  11. 11. KINDS OF WORKING CAPITAL 1.Permanent working capital  Permanent working capital is the minimum amount of current assets, which is needed to conduct a business even during the dullest season of the year.  The minimum level of current assets is called permanent or fixed working capital as this part is permanently blocked in current assets. Characteristics of Permanent working capital  It is classified on the basis of the time period  It constantly changes from one asset to another and continues to remain in the business process.  Its size increase with the growth of business operations.
  12. 12. Permanent working capital
  13. 13. Permanent working capital CONT… 2.Temporary working capital  Temporary working capital represents a certain amount of fluctuations in the total current assets during a short period.  Variable working capital is the amount of additional current asset that are required to meet the seasonal needs of a firm, so is also called as the seasonal working capital. Characteristics of Temporary working capital It is not always gainfully employed, though it may change from one asset to another asset, as permanent working capital does.  It is particularly suited to business of a seasonal or cyclical nature.
  14. 14. TEMPORARY WORKING CAPITAL
  15. 15. DETERMINANTS OF WORKING CAPITAL • Nature of business • Terms of sales and purchases • Manufacturing cycle • Rapidity of turnover • Business cycle • Changes in technology • Seasonal variation • Market conditions • Seasonality of operation • Dividend policy • Working capital cycle
  16. 16. Importance of Working Capital: • It helps measure profitability of an enterprise. In its absence, there would be neither production nor profit. • Without adequate working capital an entity cannot meet its short- term liabilities in time. • A firm having a healthy working capital position can get loans easily from the market due to its high reputation or goodwill. • Sufficient working capital helps maintain an uninterrupted flow of production by supplying raw materials and payment of wages. • Sound working capital helps maintain optimum level of investment in current assets. • It enhances liquidity, solvency, credit worthiness and reputation of enterprise. • It provides necessary funds to meet unforeseen contingencies and thus helps the enterprise run successfully during periods of crisis.
  17. 17. Approaches of Working Capital
  18. 18. Approaches of Working Capital 1.Conservative Approach 2.Aggressive Approach 3.Matching Approach or Hedging Approach
  19. 19. Conservative Approach 1. Conservative approach is a risk-free strategy of working capital financing. 2. A company adopting this strategy maintains a higher level of current assets and therefore higher working capital also. 3. The major part of the working capital is financed by the long-term sources of funds such as equity, debentures, term loans etc. So, the risk associated with short-term financing is abolished to a great extent.
  20. 20. Conservative Approach In the conservative approach, fixed assets, permanent working capital and a part of temporary working capital is financed by long-term financing sources and the remaining part only is financed by short-term financing sources. Financing Strategy in Equation: Long Term Funds will Finance = Fixed Assets + Permanent Working Capital + Part of Temporary Working Capital Short Term Funds will Finance = Remaining Part of Temporary Working Capital
  21. 21. Conservative Approach Diagram
  22. 22. Conservative Approach Diagram The dotted lines horizontal line indicates the point till which the long-term funds will be utilized. The dotted vertical lines indicate the sources of finance and they are tagged as ‘long-term financing’ and ‘short term financing’. We can easily make out that long term funds are financing total fixed assets, total permanent assets and a part of the temporary or seasonal working capital also. Seasonal requirement or temporary working capital has peaks and troughs. The two areas of troughs below the long-term financing line indicate that there are idle long term funds incurring unnecessary interest cost.
  23. 23. Conservative Approach Advantage of Conservative Approach 1. Smooth Operation 2. No Insolvency Risk Disadvantage of Conservative Approach 1. Higher Interest Cost 2. Idle Fund 3. Higher Carrying Cost 4. Inefficient working capital Management
  24. 24. Aggressive Approach The aggressive approach is a high-risk strategy of working capital financing wherein short-term finances are utilized not only to finance the temporary working capital but also a reasonable part of the permanent working capital. In this approach of financing, the levels of inventory, accounts receivables and bank balances are just sufficient with no cushion for uncertainty. There is a reasonable dependence on the trade credit.
  25. 25. Aggressive Approach Fixed assets and a part of permanent working capital are financed by long-term financing sources and the remaining part of permanent working capital and total temporary working capital is only is financed by short- term financing sources. It is explained in the equation below: Financing Strategy in Equation: Long Term Funds will Finance = Fixed Assets + Part of Permanent Working Capital Short Term Funds will Finance = Remaining Part of Permanent Working Capital + Temporary Working Capital
  26. 26. Aggressive Approach Diagram
  27. 27. Aggressive Approach The dotted lines horizontal line indicates the point till which the long-term funds will be utilized. The dotted vertical lines indicate the sources of finance and they are tagged as ‘long-term financing’ and ‘short term financing’. We can easily make out that long term funds are financing total fixed assets and a part of permanent assets. A major part of Seasonal requirement or temporary working capital is financed by short term source of finance. In this approach, the difficult area is the part of permanent working capital which is financed by short-term sources. It can pose problems of liquidity and bankruptcy to the firm.
  28. 28. Aggressive Approach Advantage of Aggressive Approach 1. Lower Financing Cost, High Profitability 2. Lower Carrying and Handling Cost 3. Highly Efficient Working Capital Management Disadvantage of Aggressive Approach 1. Insolvency Risk 2. Lost Opportunities and Unexpected Shocks
  29. 29. Matching Approach or Hedging Approach Maturity matching or hedging approach is a strategy of working capital financing wherein short term requirements are met with short-term debts and long- term requirements with long-term debts. The underlying principal is that each asset should be compensated with a debt instrument having almost the same maturity.
  30. 30. Matching Approach or Hedging Approach Maturity Matching or Hedging Approach Equation This matching approach of working capital financing can be explained in terms of a simple equation as follows:{ Long Term Funds will Finance = Fixed Assets + Permanent Working Capital Short Term Funds will Finance = Temporary Working Capital
  31. 31. Matching Approach or Hedging Approach
  32. 32. Matching Approach or Hedging Approach In the diagram, we can see three levels, each of fixed assets, permanent working capital and temporary working capital. The red vertical line with white spaces represents the type of financing. The bigger line which stretches till permanent working capital is long-term financing and a smaller line is the temporary working capital. The line from where the temporary working capital starts and the line of a hedging strategy is the same. Any strategy below this line will be an aggressive strategy and a strategy above it will be a conservative strategy.
  33. 33. Matching Approach or Hedging Approach RATIONALE BEHIND MATURITY MATCHING OR HEDGING APPROACH Knowing why to apply maturity matching strategy is very important. It suggests financing permanent assets with long-term financing and temporary with short-term financing. Now let us suppose opposite situations and see. There can two such situations.
  34. 34. Matching Approach or Hedging Approach 1. Permanent Assets Financed with Short Term Financing 2. Temporary Assets Financed with Long Term Financing
  35. 35. Management for different components of working capital 1.Cash Management 2.Inventory Management 3.Debtors Management 4.Creditors Management
  36. 36. 1.Cash Management Business concern needs cash to make payments for acquisition of resources and services for the normal conduct of business. Cash is one of the important and key parts of the current assets. Cash is the money which a business concern can disburse immediately without any restriction. The term cash includes coins, currency, cheques held by the business concern and balance in its bank accounts. Management of cash consists of cash inflow and outflows, Cash flow within the concern and cash balance held by the concern etc.
  37. 37. Motives for Holding Cash 1. Transaction motive It is a motive for holding cash or near cash to meet routine cash requirements to finance transaction in the normal course of business. Cash is needed to make purchases of raw materials, pay expenses, taxes, dividends etc. 2. Precautionary motive It is the motive for holding cash or near cash as a cushion to meet unexpected contingencies. Cash is needed to meet the unexpected situation like, floods strikes etc. 3. Speculative motive It is the motive for holding cash to quickly take advantage of opportunities typically outside the normal course of business. Certain amount of cash is needed to meet an opportunity to purchase raw materials at a reduced price or make purchase at favourable prices. 4. Compensating motive It is a motive for holding cash to compensate banks for providing certain services or loans. Banks provide variety of services to the business concern, such as clearance of cheque, transfer of funds etc.
  38. 38. Cash Management Techniques Managing cash flow constitutes two important parts: A. Speedy Cash Collections. B. Slowing Disbursements. The techniques aim at, the customer who should be encouraged to pay as quickly as possible and the payment from customer without delay. Speedy Cash Collection business concern applies some of the important techniques as follows: •Prompt Payment by Customers •Early Conversion of Payments into Cash •Concentration Banking •Lock Box System
  39. 39. Slowing Disbursement An effective cash management is not only in the part of speedy collection of its cash and receivables but also it should concentrate to slowing their disbursement of cash to the customers or suppliers. Slowing disbursement of cash is not the meaning of delaying the payment or avoiding the payment. Slowing disbursement of cash is possible with the help of the following methods:. 1. Avoiding the early payment of cash 2. Centralised disbursement system
  40. 40. Cash Management Models Baumol model The basic objective of the Baumol model is to determine the minimum cost amount of cash conversion and the lost opportunity cost. Total conversion cost per period can be calculated with the help of the following formula: t= Tb C Opportunity cost can be calculated with the help of the following formula; i = C 2 Optimal cash conversion can be calculated with the help of the following formula; C = 2bT i where, T = Total transaction cash needs for the period b = Cost per conversion C = Value of marketable securities where, i = interest rate earned, C/2 = Average cash balance, C = Optimal conversion amount b = Cost of conversion into cash per lot or transaction T = Projected cash requirement i = interest rate earned
  41. 41. Management for different components of working capital Orgler’s model Orgler model provides for integration of cash management with production and other aspects of the business concern. Multiple linear programming is used to determine the optimal cash management. Orgler’s model is formulated, based on the set of objectives of the firm and specifying the set of constrains of the firm.
  42. 42. 2. Inventory Management Inventory constitutes a major part of total working capital. Efficient management of inventory results in maximization of earnings of the shareholders. Efficient inventory management consists of managing two conflicting objectives: 1. Minimization of investment in inventory on the one hand 2. Maintenance of the smooth flow of raw materials for production and sales on the other.
  43. 43. Types of Inventory 1. Raw-Materials Inventory 2. Work-in-Process Inventory 3. Finished-Goods Inventory 4. Stock of Cash
  44. 44. Inventory Management Techniques 1. Economic order quantity 2. Fixation of stock levels 3. ABC Analysis 4. Just in Time (JIT)
  45. 45. Inventory Management Techniques 1. Economic order quantity Economic Order Quantity (EOQ) is one of the important techniques of inventory management. EOQ represents that level of inventory which minimizes the total inventory cost. The formula for calculating EOQ is given below: EOQ = √2QA / K Where, Q = Annual requirement or Production, A = Ordering Cost per order, and K = Carrying Cost per unit per Year.
  46. 46. Inventory Management Techniques 2. Fixation of stock levels Efficient inventory management requires an effective stock control system. One of the important aspects of inventory control is stock level. Level of stock has a significant bearing on the profitability. Over-stocking requires large capital investments whereas under-stocking affects flow of the production process. The following are the levels of stock fixed for efficient management of inventory.
  47. 47. Inventory Management Techniques 1. Re-order Level 2. Minimum Stock Level 3. Maximum Stock Level 4. Average Stock Level
  48. 48. Inventory Management Techniques 3. ABC Analysis ABC Analysis is one of the important inventory control techniques. In a big manufacturing concern it is not always possible to pay equal attention to each and every raw material. In such cases raw materials are classified according to their value so that proper control may be exercised on materials having high value. ABC Analysis is an analytical technique that tries to group materials into three categories on the basis of cost involved.
  49. 49. Inventory Management Techniques 3. ABC Analysis The categories are: A – High value materials B – Medium value materials C – Low value materials
  50. 50. Inventory Management Techniques 4. Just in Time (JIT) Just in time (JIT) inventory control system was developed by Taiichi Okno of Japan and was first introduced in Toyata Manufacturing Company of Japan. So it is also known as Toyata Production Method. The basic idea behind this system is that a firm should keep minimum level of inventory on the assumption that suppliers will deliver the raw materials as and when required. This system tries to make inventory carrying cost as zero. Three important elements of JIT are Just in time purchasing, just in time production and just in time supply. Just in time purchasing, just in time production and just in time delivery can be effectively applied through adoption of advanced manufacturing technology.
  51. 51. 4. Accounts Payable Management: Payables or creditors are one of the important components of working capital. Payables provide a spontaneous source of financing of working capital. Payable management is very closely related with the cash management. Effective payable management leads to steady supply of materials to a firm as well as enhances its reputation. It is generally considered as a relatively cheap source of finance as suppliers rarely charge any interest on the amount owed. However, trade creditors will have a cost as a result of loss of enjoying cash discount on cash purchases.
  52. 52. Thank You

×