After reading this essay you will learn about:- 1. Introduction to Working Capital 2. Operating Cycle Concept of Working Capital Computation 3. Working Capital Financing Approaches 4. Sources of Working Capital Finance 5. Management of Liquid Assets.
Essay # 1. Introduction to Working Capital:
Components of current assets are (i) Inventories, (it) Debtors and (m) Cash and Bank Balance. Components of current liabilities are trade and expense creditors.
Although cash budget gives accurate estimate of working capital requirement, asset based operating cycle concept is used to make a rough estimate. Since this approach is easier to follow, cash budget approach is not generally used for assessing working capital requirement.
Investment decision is not complete unless the working capital required for running the project is ascertained and a policy for financing is adopted. However, we have to keep in mind, working capital requirement is not static in nature — it varies with production. In lean season when demand is less, production is less, there is lower requirement for working capital whereas in the busy season when demand is high, production expands, and there will be higher need for working capital. So working capital requirement of business changes from period to period.
What are components of working capital? Various components are:
i. Inventory of raw materials
ii. Inventory of work in progress
iii. Inventory of finished goods
v. Cash balance
In manufacturing company, raw material is purchased and stored for production. For smooth running of the production it is necessary that adequate raw materials are in the stock such that because of delay in delivery by the supplier does not hamper the production process.
Now in the continuous production process, a portion of the raw material along with a portion of conversion cost always remains in the system. So necessary investment is blocked. Conversion cost means labour, factory overhead and direct production expenses. Once the production is complete, goods are not immediately sold.
Always an inventory of finished goods is maintained such that no order is refused for want of finished stock. Goods should always remain in a ready state for supply. To make this possible, money is blocked in inventory of finished goods. Once the goods are sold on credit, still you have to wait for cash collection. So when goods are sold on credit, the money is blocked in debtors. Once cash is collected, the production cycle is complete.
The cash conversion cycle focuses on the time between payments made for materials and labour and payments received from sales:
In trading business, all that is required is finance for stock in trade and credit sales. For example, if a trader wants that always there should be goods worth of Rs.60,00,000 in stock and maximum amount of credit to customers at any point in time is Rs.20,00,000, then he needs Rs.80,00,000 working capital.
Often working capital requirement is computed applying operating cycle concept.
Essay # 2. Operating Cycle Concept of Working Capital Computation:
Cost items like raw material, labour and direct expenses and variable overhead can be determined on per unit basis and items of fixed overheads are ascertained in total which can be divided by estimated annual production to determine cost per unit.
Let us take an example of cost sheet:
To determine working capital, we need to know the working capital policies of the company, i.e., what is inventory holding period, production period, collection period and payment period.
In addition, cash should be kept in hand to the extent of 5% of inventory and debtor to meet contingency cash need.
Now applying the cost data given in the cost sheet to the working policies, working capital requirement is determined.
Let us now learn the valuation criteria:
We are now in a position to compute working capital requirement:
Now let us solve a problem relating to computation of working capital requirement using operating cycle concept.
ABC Ltd. produces 120000 units in year.
It has estimated the following costs:
The company follows a policy of holding 1 month’s raw material inventory and finished goods inventory, its production cycle is of 0.5 months, collection period is 2 months on an average and payment period is of 0.5 months. The company intends to maintain 5% cash balance of the amount necessary to finance stock and debtors.
Prepare a statement showing working capital requirement of the company.
Per unit factory overhead = Rs. 900000/120000 = Rs. 7.50
Per unit administrative overhead = Rs. 12,00,000/120000 = Rs. 12.00
Per unit selling and distribution overhead = 18,00,000/120000 = RS. 15.00 per unit
Statement showing working Capital requirement of ABC Ltd.
Given below are the extracts of cost sheet of Anup Engineering which manufactures fabrication items:
The company manufactures 30000 units of fabricated items. Selling Price per unit is Rs.1000 pu. The company follows a policy of maintaining 1 month’s raw material requirement in stores. An item takes on an average 10 days of fabrication time.
Finished goods are sold instantly, no significant stock of finished goods is there at any point of time. Customers pay on an average in the months’ time but the company make cash purchases. It has a policy to keep always Rs.4 lacs bank balance to meet contingencies. Factory overhead included depreciation Rs.3 lacs and administrative overhead includes depreciation amounting to Rs.2 lacs.
Prepare a Working Capital Requirement Plan.
Note: Total cost of 30000 units is Rs.21,00,000.
Essay # 3. Working Capital Financing Approaches:
Traditional method of financing working capital requirement of a company is working capital financing from a bank. For this purpose, bank first decides the amount of working capital requirement and asks the company to bring margin money out of its long term sources preferably from equity. Balance is financed by bank.
While making working capital financing, bank extends pure working capital loan which will bear interest from the day the loan is sanctioned. It also offers cash credit for which the company has to pay a commitment fees at a low rate and it has to interest only on withdrawal of the money. Since cash credit carries only low commitment fee, it is risky for the bank to sanction high amount of cash credit to different parties and wait for withdrawal, the proportion of cash credit in working capital loan is only 20%, balance 80% should be taken by way of pure working capital loan.
A bank always demands working capital margin from the borrower. A traditional practice is to go through current ratio test while making working capital financing. The current ratio of the company including working capital loan should be around 1.33.
Ask the borrower to give 25% margin on net working capital or 25% margin on gross working capital.
Study the problem given in Box 17.1.
In case the borrower brings 25% margin on net working capital requirement of Rs.90 lakhs, his contribution is Rs.22.5 lakhs. So the bank gives working capital loan of Rs.67.5 lakhs.
By this his current ratio will be as shown below:
Under this approach, the company cannot achieve 1.33 current ratio.
Alternatively, if the company brings 25% margin on gross working capital, i.e., Rs. 25 lakhs and the balance Rs. 65 lakhs is financed through working capital loan, then the current ratio would be as given below:
Thus we have observed that a 25% margin on gross working capital is required to achieve 1.33 current ratio standard.
Volatility of Working Capital Requirement and Financing Approaches:
Working capital requirement always changes with expansion and recession in business. In times of demand, there is more production and higher utilization of working capital. On the other hand, in times of recession, there is lower demand and lower utilization of working capital.
Let us understand volatility of working capital requirement by way of a simple example.
Study data given in Table 17.1. Working capital requirement changes month by month. In this case we are presenting three approaches which may be equated to the classic approaches of (a) conservative, (b) middle the way and (c) aggressive.
Keep very high long term financing for working capital. Only fluctuating portion should be financed through short term borrowing.
See Figure 17.1 Series 1 shows actual working capital requirement and series 2 shows requirement at 75th percentile. The company may like to treat the working capital requirement at 75th percentile as core and balance (in case of high demand) will be financed from short term sources. As you can observe from the Figure 17.1, by this the company covers a portion of the working capital requirement in the uptrend.
Series 1: Actual working capital requirement,
Series 2: Working Capital at 75th percentile.
Observe working capital requirement shown in Figure 17.1. When the working capital level increases beyond the core limit set at 75th percentile, the company needs to arrange short term funds for financing additional working capital requirements. On the other hand, when funds requirement is below the core capital limit, the finance department arranges for short term investments.
Keep very low long term financing for working capital. A major portion should be financed through short term borrowing. For this we may decide that 25th percentile of the working capital requirement should be financed from long term sources. See Data in Table 17.2 and Figure 17.2.
Series 1: Actual working capital requirement,
Series 2: Working Capital at 25th percentile.
Observe Figure 17.2. In aggressive working capital policy, shortage of working capital is more frequent than the surplus.
What do you learn from Figure 17.2? In case of aggressive policy, a company only covers the lowest point of the working capital requirement between two uptrends. So it has to depend upon short term financing during uptrends. In case short term financing is not available, its business may be affected.
Middle the way approach:
Under this approach, a balancing is done between the aggressive and conservative approach. Under aggressive approach only 25 percentile of the working capital requirement is covered through long term sources while in the conservative approach, 75th percentile requirement has been covered. Thus the ‘middle the way’ approach should be to cover median requirement from long term sources. See data given in Table 17.2 and Figure 17.3.
Series 1: Actual working capital requirement,
Series 2: Working Capital at median level.
Essay # 4. Sources of Working Capital Finance:
Major sources of working capital finance are:
(a) Working capital loan from banks that comprises of:
(i) Loan component and
(ii) Cash credit.
(b) Export credit:
Banks offer pre-shipment and post-shipment credit against export orders at lower interest rate.
Temporary cash deficit can be financed using overdraft arrangement with banks by which the bank will allow a limit within which cheques issued by the company above the bank balance will be paid by the bank.
(d) Commercial paper:
This is applicable to big companies listed in a stock exchange having net worth of Rs.10 crore and maximum permissible bank credit of Rs.25 crore. A company can issue commercial paper to the extent of 75% of the permissible bank credit. The minimum size of the issue is Rs.25 lakh.
(e) Bill discounting:
Banks and other financial institutions discount trade bills which is a mechanism of financing trade debtors. When a company makes credit sales, the sale proceeds will be collected only after the allowed credit period (say, 3 months). So the sale proceeds will be locked in for a period of 3 months.
This is of course, included in the working capital requirement of a company. A company can discount trade bills which are not included in the working capital requirement or trade debtors can be excluded from the working capital requirement analysis, in case the company wants to discount the trade bills. On discounting trade bills, banks/ financial institutions pay the seller the present value of the sale proceeds. For example, Company A sells goods to Company B amounting to Rs.10000. The sale proceeds is payable after 2 months. If the discount rate is 10%, the bank will pay present value of Rs.10000 payable after 2 months @ 10%, i.e. Rs.10000 1/(1 + 10/100 × 63/365) = Rs.10000 0.9830 = Rs.9830. This is a method of financing trade debtors.
Another method of financial trade debtor is factoring. In fact, factoring includes debtor management as well. There are certain factoring companies in India like SBI Factors, Canbank Factors, etc. A company can factor out its debtors books to a factoring agency which will take care of management of debtors’ book including collection. Of course, the factoring agency will pay the company upfront the outstanding amount deducting discount and fees. There are many types of factoring contract of which two important variants are recourse factoring and non-recourse factoring. In recourse factoring, the factor will claim money if the debtors account turns bad. On the other hand, in non-recourse factoring, the factor bears the bad debt risk as well; for this a factor charges higher fees.
Essay # 5. Management of Liquid Assets:
Cash and cash equivalents are liquid assets. Cash equivalents are bank balances, marketable securities. Managing cash is an important aspect of working capital management. Every company intends to reduce cheque collection period such that sales proceeds can be utilized for re-investment as working capital. If you inspect balance sheet of companies, you will see that every company maintains some cash balance.
Cash doesn’t earn interest, so why to hold it?
It must have some cash to pay current bills.
“Safety stock.” To meet any emergency cash requirement. It may so happen that a debtor fails to pay on time. This should not affect other business operations. The level of cash holding, of course, can be reduced by credit line and revolving credit facilities.
Often the suppliers offer discounts on cash purchase. To take advantage of bargains and to take discounts on purchases, a company needs to maintain cash.
However, since cash is a non-earning asset, the goal of cash management is not to have cash one rupee more than required for smooth running of the business.
Most cash management activities are performed jointly by the company and its bank.
Effective cash management encompasses proper management of cash inflows and cash outflows, which includes:
(i) Synchronization of cash flows,
(ii) Using float,
(iii) Accelerating collections,
(iv) Directing available funds to cover the cash requirements for investment, repayment of loans/debts, buy backs, etc.
(v) Controlling disbursements.
A big company like ACC, Tata Motors or Hero Honda Motors have manufacturing plants in one more locations, sales offices in many cities in India and abroad and so they have banks accounts in virtually every city in which they do business. Their collection points follow sales pattern. Some disbursements are made from local offices but most are made from the headquarters or regional offices. Thus a company may have hundred of bank accounts. There is no reason to believe that each such bank account can be balanced in terms of cash inflows and outflows. Rather cash flows are to be balanced across the business centres.
In the age of internet linked operations, cash management policies are changing quickly and these are linked to creating operational flexibility. For example, Life Insurance Corporation used to receive the outstation cheques by post (for policies written by a branch but the policyholders are now in different locations) and these cheques took 10-15 days collection period. Now its collection centres are linked nationally meaning that all branches can collect cheques of policy written by any of its branches. Thus collection period is reduced to 3 days.