Chapter 16 - Working Capital Management

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LEARNING OBJECTIVES Understand the meaning, definition, concepts and kinds of working capital List out the components of working capital Narrate the aspects of working capital Understand the objectives of working capital management Know the importance of working capital management Explain the operate cycle and cash cycle Know the need for maintaining adequate working capital, and list out the dangers of excessive and inadequate working capital Explain the factors that should be considered while estimation of working capital Determining working capital required Know the sources of financing current assets Understand the approaches available to the fair for finance mix of working capital

Concepts of Working Capital :

Concepts of Working Capital Gross working capital (GWC) GWC refers to the firm’s total investment in current assets. Current assets are the assets which can be converted into cash within an accounting year (or operating cycle) and include cash, short-term securities, debtors, (accounts receivable or book debts) bills receivable and stock (inventory).

Concepts of Working Capital:

Concepts of Working Capital Net working capital (NWC). NWC refers to the difference between current assets and current liabilities. Current liabilities (CL) are those claims of outsiders which are expected to mature for payment within an accounting year and include creditors (accounts payable), bills payable, and outstanding expenses. NWC can be positive or negative. Positive NWC = CA > CL Negative NWC = CA < CL

Concepts of Working Capital:

Concepts of Working Capital GWC focuses on Optimisation of investment in current Financing of current assets NWC focuses on Liquidity position of the firm Judicious mix of short-term and long-tern financing

Operating Cycle:

Operating Cycle Operating cycle is the time duration required to convert sales, after the conversion of resources into inventories, into cash. The operating cycle of a manufacturing company involves three phases: Acquisition of resources such as raw material, labour, power and fuel etc. Manufacture of the product which includes conversion of raw material into work-in-progress into finished goods. Sale of the product either for cash or on credit. Credit sales create account receivable for collection.

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The length of the operating cycle of a manufacturing firm is the sum of: inventory conversion period (ICP). Debtors ( receivable ) conversion period (DCP).

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Inventory conversion period is the total time needed for producing and selling the product. Typically, it includes: raw material conversion period (RMCP) work-in-process conversion period (WIPCP) finished goods conversion period (FGCP)

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The debtors conversion period is the time required to collect the outstanding amount from the customers.

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Creditors or payables deferral period (CDP) is the length of time the firm is able to defer payments on various resource purchases.

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Gross operating cycle (GOC) The total of inventory conversion period and debtors conversion period is referred to as gross operating cycle (GOC). Net operating cycle (NOC) NOC is t he difference between GOC and CDP. Cash conversion cycle (CCC) CCC is the difference between NOP and non-cash items like depreciation.

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Permanent or fixed working capital A minimum level of current assets , which is continuously required by a firm to carry on its business operations , is referred to as permanent or fixed working capital . Fluctuating or variable working capital The extra working capital needed to support the changing production and sales activities of the firm is referred to as fluctuating or variable working capital .

Determinants of Working Capital:

Determinants of Working Capital Nature of business Market and demand Technology and manufacturing policy Credit policy Supplies’ credit Operating efficiency Inflation

Issues in Working Capital Management:

Issues in Working Capital Management Levels of current assets Current assets to fixed assets Liquidity Vs. profitability Cost trade-off

Estimating Working capital:

Estimating Working capital Current assets holding period To estimate working capital requirements on the basis of average holding period of current assets and relating them to costs based on the company’s experience in the previous years. This method is essentially based on the operating cycle concept. Ratio of sales To estimate working capital requirements as a ratio of sales on the assumption that current assets change with sales. Ratio of fixed investment To estimate working capital requirements as a percentage of fixed investment.

Working Capital Finance Policies:

Working Capital Finance Policies Long-term Short-term Spontaneous Short-term Vs. Long-term financing Cost Flexibility Risk

Working Capital Finance Policies:

Working Capital Finance Policies Matching Conservative Aggressive

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Receivables Management and Factoring


Topics Nature and Goals of Credit Policy Optimum Credit Policy Credit Policy Variables Credit Evaluation of Individual Accounts Monitoring Receivable Summary of Key Concepts

Nature of Credit Policy:

Nature of Credit Policy Investment in receivable volume of credit sales collection period Credit policy credit standards credit terms collection efforts

Goals of Credit Policy:

Goals of Credit Policy Marketing tool Maximisation of sales Vs. incremental profit production and selling costs administration costs bad-debt losses

Optimum Credit Policy:

Optimum Credit Policy Estimation of incremental profit Estimation of incremental investment in receivable Estimation of incremental rate of return (IRR) Comparison of incre-mental rate of return with required rate of return (RRR) Optimum credit policy: IRR = RRR

Credit Policy Variables:

Credit Policy Variables Credit standards Credit analysis collection period default rate character capacity condition capital collateral

Credit Policy Variables:

Credit Policy Variables customer categories good accounts bad accounts marginal accounts numerical credit scoring ad hoc approach simple discriminant approach multiple discriminant approach

Credit Policy Variables:

Credit Policy Variables Credit terms credit period cash discount Collection policy and procedures regularity of collections clarity of collection procedures responsibility for collection and follow-up case-by-case approach cash discount for prompt payment

Credit Evaluation of Customers:

Credit Evaluation of Customers Credit information financial statements bank references trade references Credit investigation and analysis analysis of credit file financial analysis analysis of business and management Credit limit Collection efforts

Monitoring Receivable:

Monitoring Receivable Collection period Aging schedule Collection experience matrix

Nature of Inventory:

Nature of Inventory Stocks of manufactured products and the material that make up the product. Components: raw materials work-in-process finished goods stores and spares (supplies)

Need for Inventories:

Need for Inventories Transaction motive Precautionary motive Speculative motive

Objectives of Inventory Management:

Objectives of Inventory Management Ensure a continuous supply of raw materials to facilitate uninterrupted production Maintain sufficient stock of raw materials in periods of short supply and anticipate price changes Maintain sufficient finished goods inventory for smooth sales operations and efficient customer service Minimise the inventory costs Control inventory investment by maintaining optimum inventory

Inventory Management Techniques:

Inventory Management Techniques Economic order quantity (EOQ) ordering costs : requisitioning, order placing, transportation, receiving, inspecting and storing, administration carrying costs : warehousing, handling, clerical and staff, insurance, depreciation and obsolescence ordering and carrying costs trade-off:

Inventory Management Techniques:

Inventory Management Techniques Reorder point under certainty lead time average usage Reorder point = Lead time x average usage Reorder point under uncertainty safety stock Reorder point = (Lead time x average usage) + safety stock

Inventory Investment Analysis:

Inventory Investment Analysis Estimation of incremental operating profit Estimation of incremental investment in inventory Estimation of the incremental rate of return (IRR) Comparison of the incremental rate of return with the required rate of return (RRR) Optimum inventory: IRR = RRR

Selective Inventory Control:

Selective Inventory Control ABC analysis classify inventory into three categories according to value control by importance and exception: maximum attention to “A” items

Inventory Management Process:

Inventory Management Process Explicitly state the inventory policy Create an inventory monitoring cell Management group for controlling purchases Periodic meetings between purchase, materials planning and production executives Monthly reviews of total inventory at plant/corporate level Dovetail inventory control to the total budgeting system Identify critical inventory items for closer scrutiny

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