Working Capital Management

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3 Publishing-in-support-of, EDUCREATION PUBLISHING RZ 94, Sector - 6, Dwarka, New Delhi Shubham Vihar, Mangla, Bilaspur, Chhattisgarh Website: Copyright, Author All rights reserved. No part of this book may be reproduced, stored in a retrieval system, or transmitted, in any form by any means, electronic, mechanical, magnetic, optical, chemical, manual, photocopying, recording or otherwise, without the prior written consent of its writer. ISBN: Price: ` The opinions/ contents expressed in this book are solely of the author and do not represent the opinions/ standings/ thoughts of Educreation. Printed in India ii

4 Working Capital Management Manika Garg EDUCREATION PUBLISHING (Since 2011) iii

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6 About The Author The Author Manika Garg is presently working as a professor in Yamuna Nagar. She has certified as Retail Trainer/Faculty from Retailers Association s Skill Council of India. She has completed her B.com and MBA from Kurukshetra University. She is one of the University Topper and has published many research papers in National and International journals. She has written a book entitled Portfolio Management and also Participated & won Prizes in different competitions like essay writing competition, Quiz and SKIT etc. Her major area of interest is Working Capital Management, Financial Derivatives, Retailing and Managerial Economics. v

7 About The Book Working Capital Management is the process of planning and controlling the level and mix of the current assets of the firm as well as financing these assets. Thus, Working Capital Management is an essential part of the economic and non economic activities which leads to decide the efficient procurement and utilization of finance with profitable manner. This book reflects the theoretical and practical forces that have brought about dramatic changes in the management of short-term funds. In the olden days the subject Working Capital Management was a part of accountancy with the traditional approaches. Now a days, It has been enlarged with innovative and multi dimensional functions in the field of business with the effect of industrialization. Working Capital Management has become a vital part of the business concern and they are concentrating more in the field of Financial Management. Working Capital Management also developed as corporate finance, business finance, financial economics, financial mathematics and financial engineering. Understanding the basic concept about the Working Capital management becomes an essential part for the students of economics, commerce and management. This book provides detailed information about the working capital and finance related area with simple language and the concepts are explained with easy examples. This book is also prepared based on the B.Com, B.B.A., B.B.M., M.Com, and M.B.A. syllabus of various universities for the benefits of the students. - Manika Garg vi

8 Acknowledgement Success of efforts depends upon solely on the blessings of Almighty and our elders who groomed us time to time. Just as the birds decorate the sky without ever asking for gratitude, Just as the sky decorates their wings without ever receiving acknowledgement, You all decorate my life without ever requiring so much as a nod of appreciation. For that, THANK YOU I, Manika Garg, express my deep sense of gratitude to my father Sh. Ravinder Garg and my Mother Smt. Sunita Garg without their support,trust and motivation, I could not work. My Gratitude would not be completed,if I do not thank my Sister Ms. Shilpi who always inspired me to write and work. I cannot end my expressions if I do not mention the name of my sweet brother Shivam who worked with me day and night. A special thanks to Akash Gupta who really helped and supported me a lot. I also take the opportunity to thank all My Teachers, Colleague and Students, who always gave their precious suggestion, to provide the valuable input for assignment. vii

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10 Preface Financial managers devotes a considerable amount of attention to the management of working capital. Net working capital (current assets less current liabilities) provides an accurate assessment of the liquidity position of the firm. An examination of the components of working capital is helpful because of the preoccupation of management with the proper combination of assets and acquired funds. The text is based on the course being taught by the faculty of Management Studies. Keeping in view the requirements of the students of MBA/ COMMERCE/ BBA/ BUSINESS ECONOMICS at various universities/ Institutes, Chartered Accountants, Company Secretaries and other professional courses. This edition consists of ten chapters like Introduction to working capital management, cash management, receivable management, inventory management, working capital programming etc. since this book is synthesis, I am indebted to all writers who have contributed to the area of working capital management. I hope that I have interpreted their view correctly. I have benefitted greatly from feedback from students and colleagues. I would like to thanks to the members of EDUCREATION PUBLISHING for their support and guidance. ix

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12 Content List S.no Chapter Page 1. Working Capital Management 01 2 Management of Cash-I 36 3 Management of Cash-II 66 4 Receivables Management 91 5 Inventory Management Sources Of Financing Time Value of Money Programming of working capital Management Cash Flow Forecasting & Budgeting Managing Corporate Liquidity Reference 271 xi

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14 Working Capital Management Chapter 1 Working Capital Management Introduction to Working Capital Meaning of Working Capital Definitions of Working Capital Concepts of Working Capital Constituents of Working Capital Kinds of Working Capital Determinants of Working Capital Principles of Working Capital Finance Adequacy of Working Capital Dangers of Inadequate Working Capital Analysis of Working Capital Measurement of Working Capital Determining the Finance Mix Hedging or matching approach Conservative approach Aggressive approach / show divide sign. 1

15 MANIKA GARG INTR ODUCTION Working Capital is considered as the lifeblood and nerve centre of any business (Khan and Jain) in the present day modern industrial world the term Working Capital refers to the short term funds required for financing the entire duration of the operating cycle of a business known as Accounting Year. Thus, it is the process of planning and controlling the level and mix of the current assets of the firm as well as financing these assets. Working Capital Management requires financial managers to decide what qualities of cash, other liquid assets, account receivables and inventories the firm will hold at any point in time. Financing choices include the mix of current assets as well as longterm liabilities. Organization requires financing for two purposes: i) For their establishment and ii) to carry out their day-to-day operations. So, Working capital is that part of a business capital that is required for the financing of current or short-term assets. The structure of working capital is involved with the issues that come up while managing current assets, current liabilities and the inter-relationships which exist between them. Working capital is an important tool for growth and profitability for corporations. If the levels of working capital are not enough, it could lead to shortages and problems with the day-to-day operations. Working capital is also called net working capital and is defined as current assets less current liabilities (Hillier). Net working capital = Current assets current liabilities Both components of the working capital formula above can be found on the balance sheet. Current assets can be found on the / show divide sign. 2

16 Working Capital Management assets side of the balance sheet and are those assets that generate cash within one year. Current assets are normally divided into cash and cash equivalents, short-term investments, trade and other receivables, prepaid expenses, inventories and work-in-progress. Current liabilities can be found on the liability side of the balance sheet and are obligations which have to be met within one year. Current liabilities are divided in trade payables, short-term debt and accrued liabilities. Figure 1.1 A Typical working capital cycle To illustrate the working capital of a firm, the working capital cycle will now be discussed and can be seen in figure 1.1. The / show divide sign. 3

17 MANIKA GARG cycle begins with the purchase of raw materials which can be found in the inventory. Later on, these raw materials are transformed into finished goods. These goods are stocked in the inventory until they are sold to the customer. The sale can be purchased by cash or by trade credit. This trade credit provides a delay until the cash is received. With every step of the cycle there are associated costs, which are direct costs and opportunity costs. The direct costs are the cost of capital invested in each part of the cycle, for example interest on the debt finance to sustain trade creditors. The opportunity costs are represented by the possible returns forgone by investing in working capital, instead of some alternative investment opportunity. The above discussed working capital and the cycle it forms is managed by what is called Working Capital Management (WCM). MEANING OF WORKING CAPITAL Working Capital refers to that part of the firm s capital, which is required for financing short-term business requirements or Current Assets (CAs) such as Cash, marketable securities, debtors and inventories. Funds so invested in Current Assets keep revolving fast and are being constantly converted into Cash and this Cash turns out again in exchange for other Current Assets. Working Capital Management is part of the financial management of a firm, other parts are e.g. capital budgeting and capital structuring. The first two are mainly focused on the managing of long-term investments and returns. While working capital management focuses mainly on the short-term financing and short-term investment decisions of firms. Working Capital Management is vital for a firm, especially for manufacturing, trading and distribution firms, because in these firms Working Capital Management directly affect the profitability and liquidity. This is because for these firms it accounts for over half of their total assets. It is possible that inefficient Working Capital Management can lead to bankruptcy, even if the profitability of a firm is constantly positive. / show divide sign. 4

18 Working Capital Management According to Shubin,`Working Capital is the amount of funds necessary to cover the cost of operating the enterprise. It is that part of firm capital which is invested in current assets. It is also known as circulating capital because of its continuous conversion process. Working capital may be defined in two ways, either as the total of current assets or as the variation flanked by the total of current assets and total of current liabilities. Like mainly other financial conditions the concept of working capital is used in dissimilar connotation through dissimilar writers. DEFINITIONS ON WORKING CAPITAL MANAGEMENT Working capital refers to the circulating capital required to meet the day to day operations of a business firm. Working capital may be defined by various authors as follows: 1. According to qualitative concept the amount of working capital refers to excess of current assets over current liabilities. 2. L.J. Guthmann defined working capital as the portion of a firm s current assets which are financed from long term funds. 3. Arnold defines working capital as, the difference between current assets and current liabilities 4. According to Weston & Brigham - Working capital refers to a firm s investment in short term assets, such as cash amounts receivables, inventories etc. 5. Working capital means current assets. Mead, Baker and Malott. 6. The sum of the current assets is the working capital of the business J.S.Mill 7. Working capital is defined as the excess of current assets over current liabilities and provisions. But as per accounting / show divide sign. 5

19 MANIKA GARG terminology, it is difference between the inflow and outflow of funds. 8. In the Annual Survey of Industries (1961), working capital is defined to include Stocks of materials, fuels, semi-finished goods including work-in-progress and finished goods and byproducts; cash in hand and bank and the algebraic sum of sundry creditors as represented by (a) outstanding factory payments e.g. rent, wages, interest and dividend; (b) purchase of goods and services; (c) Short-term loans and advances and sundry debtors comprising amounts due to the factory on account of sale of goods and services and advances towards tax payments. 9. The term working capital is often referred to circulating capital which is frequently used to denote those assets which are changed with relative speed from one form to another i.e., starting from cash, changing to raw materials, converting into work-in-progress and finished products, sale of finished products and ending with realization of cash from debtors. 10. Working capital has been described as the life blood of any business which is apt, because it constitutes a cyclically flowing stream through the business. Therefore, there appeared the following two concepts of working capital. / show divide sign. 6

Working Capital Management CONCEPTS OF WORKING CAPITAL Gross concept of working capital Net concept of working capital Gross Concept The term Gross Working Capital refers to working Capital which

20 Working Capital Management CONCEPTS OF WORKING CAPITAL Gross concept of working capital Net concept of working capital Gross Concept The term Gross Working Capital refers to working Capital which means the total of current assets. No special distinction is made flanked by the conditions total current assets and working capital through authors like Mehta, Archer, Bogen, Mead, and Baker. Just as to them working capital is nothing but the total of current assets for the following causes: Profits are earned with the help of the assets which are partly fixed and partly current. The management is more concerned with the total current assets as they constitute the total funds accessible for operating purposes than with the sources from which the funds came, and that the net concept of working capital had relevance when the shape of organization was single entrepreneurship or partnership. / show divide sign. 7

21 MANIKA GARG The concept of Gross working capital (GWC) focuses attention on two aspects of current assets management. i) Optimum investment in current assets,& ii) Financing of current assets The consideration of the level of investment in current assets should avoid two danger points: Excessive and Inadequate investment in current assets. The investment in current assets should be just adequate, not more or less, to the need of the business firm. Net Concept The term Net working capital can be defined as: a) The difference between current assets and current liabilities (Net working capital=current assets-current liabilities) b) According to Gitman, Net working capital can be defined as that portion of a firm s current assets which are financed with long term funds. Net working capital (NWC) can be positive or negative. When current assets are more than current liabilities, a positive net working capital occurs. When current liabilities are more than current assets, a negative working capital occurs. Contrary to the aforesaid point of view, writers like Smith, Guthmann, and Dongall. Howard and Gross believe working capital as the mere variation flanked by current assets and current liabilities. A broader view of working capital would also contain current liabilities such as explanations payable, notes payable and other accruals. In his opinion, Working Capital Management involves the managing of individual current liabilities and the managing of all inter-relationships that link current assets with current liabilities. In common, the gross concept is referred to as the Economics concept, as assets are employed to derive a rate of return. What / show divide sign. 8

Working Capital Management rate of return is generated through dissimilar assets is more significant than the analyzed variation flanked by assets and liabilities.

22 Working Capital Management rate of return is generated through dissimilar assets is more significant than the analyzed variation flanked by assets and liabilities. On the contrary, the net concept is said to be the point of view of an accountant. In this sense, working capital is viewed as a liquidation concept. So, the solvency of the firm is seen from the point of view of this variation usually, lenders and creditors view this as the mainly pertinent approach to the problem of working capital. CONSTITUENTS OF WORKING CAPITAL No matter how, we describe working capital, we should know what constitutes current assets and current liabilities. Current Assets Current Assets are those assets which, in the ordinary course of business, can be converted into Cash within a short period of time, say, one year. The constituents of Current Assets are: - Economists like Mead, Mallot, Baker, and Field support the latter view of working capital. They feel that current assets should be / show divide sign. 9

MANIKA GARG considered as working capital as the whole of it helps to earn profits & the management is more concerned with the total current assets as they constitute the total funds available for

Current Liabilities Current Liabilities are those claims of outsiders that are expected to mature for payment within an accounting year.

23 MANIKA GARG considered as working capital as the whole of it helps to earn profits & the management is more concerned with the total current assets as they constitute the total funds available for operational purposes. On the other hand, economists like Lincoln and Saliers uphold former view. They argue that in the long run what matters is the surplus of current assets over current liabilities. Current Liabilities Current Liabilities are those claims of outsiders that are expected to mature for payment within an accounting year. The firm creates a Current Liability towards creditors (sellers) from whom it has purchased raw materials on credit. This liability is also known as accounts payable and shown in the balance sheet till the payment has been made to the creditors. The claims or obligations which are normally expected to mature for payment within an accounting cycle are known as current liabilities and include the following: Those liabilities where liquidation is reasonably expected to require the use of existing resources properly classifiable as current assets, or the creation of other current assets, or the creation of other current liabilities. / show divide sign. 10

24 Working Capital Management Get Complete Book At Educreation Store / show divide sign. 11

You may reach author at: manikagarg@educreation.in Author, Manika Garg is presently a professor in Yamuna Nagar.

She has completed her B.com and MBA from Kurukshetra University.

She has written a book entitled Portfolio Management and also participated & won prizes in different competitions like essay

25 You may reach author at: Author, Manika Garg is presently a professor in Yamuna Nagar. She has been certified as a Retail Trainer/ Faculty from Retailers Association s Skill Council of India. She has completed her B.com and MBA from Kurukshetra University. She is one of the University Toppers and has published many research papers in National and International journals. She has written a book entitled Portfolio Management and also participated & won prizes in different competitions like essay writing competition, Quiz and SKIT etc. Her major area of interest is Working Capital Management, Financial Derivatives, Retailing and Managerial Economics. EDUCREATION PUBLISHING (Delhi) Also available as an ebook ACADEMIC

INTRODUCTION MEANING OF WORKING CAPITAL

INTRODUCTION MEANING OF WORKING CAPITAL INTRODUCTION Working capital management is also one of the important parts of the financial management. It is concerned with short-term finance of the business concern which is a closely related trade