Working Capital Management

By CA Shubha Ganesh Moneyshiksha www.shubhaganesh.com

www.moneyshiksha.co.in

shubha.ganesh@gmail.com

Learning Objectives

Importance of working capital in a small business

Differentiate between long term and

short term assets

Components of working capital

Working capital cycle of a small business

Managing the big three

Identify working capital stress signals

Theoretically

Working Capital is stated in two ways:

Gross Working capital - Sum of all current assets

Net Working capital - Current assets less current liabilities

Practically

Apart from one time buying land, machinery, furniture and other fixed assets for manufacturing your firm’s products, you will need short –term assets and short –run resources to run the firm

This is called working capital

Need for Working capital

Working capital is required to ensure that a firm has sufficient funds to pay maturing short-term debt, upcoming operational expenses and for regular operations.

Current Assets

Those assets which in ordinary course of business will be converted to cash within one year without losing value or without disrupting the operations of the firm

The differentiator

Time dimension

Short term asset lose their identity very quickly say within a year/operating cycle

Time factor not crucial for decision making

Current Assets Inventories

Raw material

Work in progress

Finished goods

Sundry debtors

Loans and advances

Cash and bank balances

Other current assets

Current Liabilities

Current liabilities are those liabilities which are intended at their inception, to be paid within one year out of current assets or profits of the firm

Sundry creditors

Borrowings (short term)

Commercial banks

Others

Provisions

Managing working capital

This involves decisions regarding:

Stock levels

Debtor levels

Cash levels

Creditors

Working capital management

Decisions regarding working capital should be taken very carefully as they affect either:-

Profitability of the firm

Liquidity of the firm

Increases or decreases the relative risk of the firm

Why manage them?

Working capital management should therefore aim at striking a balance such that there is an optimum amount of short term assets so that there is sufficient liquidity to pay the liabilities at minimum cost

Liquidity a primary concern

A company can be endowed with assets and profitability but is short of liquidity if its assets

cannot readily be converted into cash

The key issue in working capital management is to avoid running out of cash

Learning to balance

If the size of current assets are large the comfort zone increases and liquidity increases but profits will go down as funds are kept idle. They have a cost too

If the size of current assets is too small profits will improve but liquidity will decline and you are exposed to technical insolvency

Working Capital

Cash flow in a business is:

uncertain

asynchronous

Buffers

There is a need for buffers

To manage the mismatch

Decouple sourcing and production

Makes activity smooth, efficient

Types of capital

Permanent

Temporary

Working capital mix

Hedging

Conservative

Mix of both

• Choice will be based on trade off of risk vs. cost

Sources of working capital

Bank credit

Trade credit

Factoring

Commercial paper

Cost of these funds

Determinants of working capital requirements

Nature of business

Time taken for production

Availability of raw materials

Production policy

Credit policy

Operating efficiency

Approximate working capital required can be pre-determined

Determination of working capital required

Caselet -1

Working capital cycle

The daily flow of resources through a firm's short term assets and liabilities

Operating cycle

The continuing flow from cash to suppliers to inventory, to accounts receivable and back to cash is called the operating cycle

Timeline

OG1 RG15 PI40 SG218 DG221 SI230 CP280

Cash flow chart

Cash

Accts. Payable

Cash Purchases

Inventory

Cash Sales

Accounts Receivable

L

L

Cash flow

There is a continuous flow of cash in a business

Cash inflows and outflows do not match

Cash flows in and out of business from sale of goods to purchase of inventory

They happen in stages

If all stages were completed instantaneously there would be no need for working capital

Cash flow cycle

The time lag between paying the suppliers and receiving payment from customers

The time lag between each of these is called cash cycle Conversion of cash to inventory

Conversion of inventory to receivables

Conversion of receivables to cash

Cash conversion cycle

Exercise

Garfield cat foods Ltd. On an average collects debtors after 45 days, holds inventory for 75 days and pays creditors in 30 days. It’s total spend Rs. 120 lakhs annually at constant rate. It can earn 10% if it invests this money.

Find-cash cycle, cash turnover, minimum cash balance and savings if inventory holding period is 45 days

Answer

Cash cycle-45+75-30=90 days, 3 months

Cash turnover-12mths/3mths=4

Minimum working capital-120/4=Rs.30 lakhs

New cash cycle-45+45-30=60 days, 2 months

12/2=6

120/6=Rs. 20 lakh

Savings=10lakhs*10%=Rs.1 lakh

Thank you