Nature, Types, Objectives and Significance of Working Capital Example o Kissan sauce company uses Rs.

10,000 to build up its inventory of tomatoes, onions, garlic, spices, etc. o A week later, the company assembles the ingredients into sauce and ships it out. o A week after that, the checks arrive from customers. o That Rs.10000, which has been tied up for two weeks, is the company's working capital. o The quicker the company sells the Kissan sauce, the sooner the company can go out and buy new ingredients, which will be made into more sauce sold at a profit. The better a company manages its working capital, the less the company needs to borrow. Even companies with cash surpluses need to manage working capital to ensure that those surpluses are invested in ways that will generate suitable returns for investors. Significance 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. Working capital management affects the companys risk, return, and share price. Requires continuous, day-to-day managerial supervision. Experience from Indian Corporate Sector Today, Cement Companies carry a feedstock ranging from 5-6 days; it was earlier around 1530 days. As a result of this, top cement companies such as ACC, Gujarat Ambuja, UltraTech Cement and Madras Cement have negative working capital. The same companies have given high returns to their shareholders in terms of dividends, bonuses as well as capital gains. What is Working Capital? Working Capital refers to the cash a business requires for day-to-day operations, or, more

specifically, for financing the conversion of raw materials into finished goods, which the company sells for payment. Among the most important items of working capital are levels of inventory, accounts receivable, and accounts payable. Concept of Working Capital There are two possible interpretations of working capital concept: Balance Sheet Concept Operating Cycle Concept Balance sheet concept: There are two interpretations of working capital under the balance sheet concept. Excess of current assets over current liabilities Gross Or Total Current Assets. Balance Sheet Concept Excess of current assets over current liabilities are called the Net Working Capital Or Net Current Assets. Net Working Capital= Current Assets Current Liabilities [It may be +ve/-ve] Working capital is really what a part of long term finance is locked in and used for supporting current activities. Balance Sheet Current Assets Current Liabilities Fixed Assets Long-Term Debt Preferred Stock Common Stock Positive Working Capital Objective of Working Capital Management To run the firm efficiently with as little money as possible tied up in Working Capital Involves trade-offs between easier operation and the cost of carrying short-term assets Benefit of low working capital Able to funnel money into accounts that generate a higher payoff Cost of low working capital Risky Objective of Working Capital Management

Accounts Receivable High Levels (favorable credit terms) Benefit: Happy customers High sales Cost: Expensive High collection costs Increases financing costs Payables and Accruals High Levels Benefit: Reduces need for external source Cost: Unhappy suppliers

Accounts Receivable High Levels (favorable credit terms) Benefit: Happy customers High sales Cost: Expensive High collection costs Increases financing costs Payables and Accruals High Levels Benefit: Reduces need for external source Cost: Unhappy suppliers

Operating Cycle Concept A companys operating cycle typically consists of three primary activities:

Purchasing resources, Producing the product and Low Distributing Levels (unfavorable (selling) terms) the product. Cost: These activities create funds flows that are both Dissatisfied customers unsynchronized and uncertain. Lower Sales Unsynchronized because cash disbursements (for Benefit: example, payments for resource purchases) usually take Less expensive place before cash receipts (for example collection of receivables). They are uncertain because future sales and costs, which generate the respective receipts and disbursements, cannot be forecasted with complete accuracy. Low Levels Techniques/Methods to cut down Operating Cycle Benefit: Outsourcing of various processes ( e.g. finance--using a spontaneous financing Happy suppliers/employees production, distribution, collection, etc.) Cost: Setting up vendor managed spontaneous financing sourc Not using a inventories Reducing the collection float by using banks with accelerated clearing capabilities Bringing about technological upgradation to achieve reductions in the conversion period for in-house operations Low Levels (unfavorable terms) Classifications of Working Capital On the basis of Components Cost: Cash, Dissatisfied customers Marketable Securities, Lower Sales Receivables, and Inventory Benefit: On the basis of Time Less expensive PermanentTemporary Working Capital- Introduction Meaning WC refers to the investment made by firms in current assets. It is the measure of firms liquidity position. Low Levels Accountants perspective: WC= CA-CL Finance manager angle: WC is total investment made in Benefit: current assets. finance--using a spontaneous financing Happy suppliers/employees Production managers view: WC is the total funds Cost: needed to carry out day-to-day operations. Not using a spontaneous financing sourc An increasing NWC indicates an improving liquidity position as it reflects an increasing usage of long-term funds to partly finance short-term assets. Operation Cycle Formulae

1. Gross Operating Cycle (GOC)= Inventory conversion period (ICP)+ Debtors conversion period (DCP) 2. Net Operating Cycle (NOC)= GOC- Payables Deferral period (PDP) 3. ICP= Raw material conversion period (RMCP) + WIP conversion period (WCP) + Finished Goods conversion period (FGCP) 4. RMCP= (Avg. RM held/ Total RM consumption ) x365 5. WCP= (Avg. WIP/ Total Cost of Production)x365 6. FGCP = (Avg. FG/ Total cost of Goods sold)x365 7. DCP= (Avg. Debtors/ Total credit sales)x365 8. PDP = (Avg. creditors/ Total credit purchase) x365 Numericals of calculating Operating Cycle Techniques/Methods to cut down Operating Cycle Outsourcing of various processes ( e.g. production, distribution, collection, etc.) Setting up vendor managed inventories Reducing the collection float by using banks with accelerated clearing capabilities Bringing about technological upgradation to achieve reductions in the conversion period for in-house operations Factors determining Working Capital Requirement Nature (Type) of business Size of business/ Scale of Operations Technology and Production policy Length of operating cycle Uncertainty in operating cycle Rapidity of turnover Seasonality business Supply conditions Market conditions Business Cycle Contd Price level changes Operating efficiency Credit Policy Availability of credit Variable production competencies Financing Working Capital Requirements Financing Net Working Capital Since working capital is of a short-term nature, it should be financed with short-term sources

This is known as the maturitymatching principle Permanent working capital can be financed either long or short term Temporary working capital needs should be supported with short-term funds Short-Term vs. Long-Term Financing Long-term financing Safe but expensive Safe because you can raise lots of capital Expensive because long-term rates are generally higher than short-term rates Short-term financing Cheap but risky Cheap because short-term rates are generally lower than longterm rates Risky because you are continually entering marketplace to borrow borrower will face changing conditions Alternative Policies The mix of short- or long-term working capital financing is a matter of policy Use of longer term funds for working capital requirements reflects conservatism Working Capital Financing Policies Working Capital Issues Assumptions 50,000 maximum units of production Continuous production Three different policies for current asset levels are possible Optimal Amount (Level) of Current Assets Impact on Liquidity Liquidity Analysis Policy Liquidity A High B Average C Low

Greater current asset levels generate more liquidity; all other factors held constant. Optimal Amount (Level) of Current Assets Impact on Expected Profitability Profitability Analysis Policy Profitability A Low B Average C High As current asset levels decline, total assets will decline and the ROI will rise. Optimal Amount (Level) of Current Assets Impact on Risk Decreasing cash reduces the firms ability to meet its financial obligations. More risk! Stricter credit policies reduce receivables and possibly lose sales and customers. More risk! Lower inventory levels increase stockouts and lost sales. More risk! Optimal Amount (Level) of Current Assets Impact on Risk Risk Analysis Policy Risk A Low B Average C High Risk increases as the level of current assets are reduced. Optimal Amount (Level) of Current Assets Summary of the Optimal Amount of Current Assets Policy Liquidity Profitability Risk A High Low Low B Average Average Average C Low High High * Profitability varies inversely with liquidity. **Profitability moves together with risk. (risk and return go hand in hand!) Sources of Short-term Financing Spontaneous financing Accounts payable and accruals Unsecured bank loans

Commercial paper Secured loans Spontaneous Financing Accruals Money you owe employees (for example) for work they have performed but not yet been paid Tend to be very short-term Accounts payable (AKA trade credit) Money you owe suppliers for goods you bought on credit Credit Terms: Terms of trade specify when you are to repay the debt Example of terms of trade: 2/10, net/30 You must pay the entire amount by 30 days If you pay within 10 days, you will receive a 2% discount Concept of Float & Accelerating Cash Receipts FLOAT Definition of bank float The time lost between a payor making a payment and a beneficiary receiving value Cost of Float principle amount due x no of days x cost of funds 360 or 365 Components of Float Mail Float delay between when cheque is sent to a payee and is received by payee Processing Float time between receipt of payment by a payee and the deposit of the payment in the payees account Clearing Float time between depositing a cheque and having available spendable funds Accelerating Cash Receipts Lock-box systems

Post office box(es) located near customers in order to shorten mail and processing float Local bank empties the box, deposits payments into firms account, and reports payments to firm May involve significant fees More cost-effective if small number of larger deposits Accelerating Cash Receipts Concentration Banking Customers send cheques sent to firms local collection centres, where they are deposited Local deposits are transferred electronically into one central concentration account Reduces mail float Funds available for paying loans or investing in marketable securities Electronic Funds Transfer Electronic funds transfer mechanisms are reducing the importance of float management techniques for many companies Electronic Funds Transfer Wire Transfers Transferring money electronically Preauthorized Cheques Customer gives payee signed chequelike documents in advance When payee ships product, it deposits preauthorized cheque in its bank account Eliminates mail float Payee must trust payer Managing Cash Outflow Zero balance accounts (ZBAs) Decentralization of cash payments can lead to large number of cash balances around the country Divisions write cheques on ZBAs funded from central account only when cheques are cleared Solves problem of idle cash in decentralized bank accounts

Remote disbursing Using bank in remote location for disbursement chequing account Increases mail float Example-Evaluating Cash Management Services WHY DOES FLOAT OCCUR? Deliberately Inefficiency Logistical situations Compensation mechanism STAGES OF FLOAT Controlling Float We need to look at controlling / influencing float in three areas * Ourselves * Our Customers * Our Banks HOW TO REDUCE/CONTROL FLOAT Your Own Actions Change own systems Educate customers Include costs in prices Negotiate with bank Cash Management Models Baumols Model of Managing Cash ..According to this, the optimum cash balance is that level of cash at which carrying cost and transaction cost are the minimum. Assumptions: 1.The forms uses cash at a constant rate which is already known. 2. The firm is able to forecast its cash needs with certainity. 3.Oppurtunity cost of holding cash is known and is constant. 4.Same transaction cost everytime marketable securities is converted to cash and vice-versa. Optimum Cash Balance (C) C = sqrt (2FT/r) F- total cash required in a year T- cost of transaction in converting marketable securities to cash and vice-versa r- rate of return on marketable securities Q. A firm has estimated that total disbursements during the coming year will be Rs.720 lakhs. The outflows will be incurred steadily over the

period. The firm has been parking its surplus cash in a portfolio of securities, with an average yield of 12% per annum. The cost per transaction (disinvestment or investment) for the firm has been Rs.1000. Calculate the optimal cash balance. Solution: Given F= 720 lakhs, T=Rs.1000, r=0.12 C = sqrt(2FT/r) = sqrt [(2*720*1000)/0.12] =Rs. 10,95,445 No. of transactions during the year = 7,20,00,000/10,95,445 = 65 transactions. Miller-Orr Model The model solves the problem of managing cash under assumption of stochastic/random cash flows by laying down control limits for cash balance. Assumptions: 1. Only two forms of assets exist: cash and marketable securities. 2. Transfer of cash is done without any delay but there is some transfer of cost. 3. Net cash flows are completely stochashtic. -The assumption is that the net cash flows are normally distributed, with a zero value of mean and a standard deviation. - The firms cash balance is allowed to fluctuate between the upper control limit and the lower control limit & No transaction is needed, (as per the model), till the cash balance fluctuate between these two limits. - The lower limit (L) is set by the firm based on its desired safety stock of cash in hand. It depends on cash held by the firm, & the volume of business expected in the period for which the working balance is estimated. - The optimal values of Upper control limit (H) and the return point (R) depends on the fixed transaction cost (b), opportunity cost (K) and the variance of the firms cash flows (s2). - The variance of cash flows can be estimated based on the past cash flow behavior of the firm. Return Point : R= L + cuberoot {(3bs2 )/4K} Upper control limit H= L+ 3 * cuberoot {(3bs2 )/4K}

Q. Projected cash flows of Z Ltd. for the coming weeks are as follows: { Cash flow (CF) in rs. Lakhs.} The firm incurs a fixed cost of Rs.2,000 per transaction every time it invests or disinvests. The average return that the firm earned during the previous year by investing its surplus in marketable securities was 12%.The companys management always keeps a minimum cash balance of Rs.25,000. Based on the above information, find the return point and the upper control limit using Miller-Orr model. Solution: Min. Cash Balance (L)=25,000 Transaction cost (b) = 2,000 Opportunity cost (K) = 0.12/365..per day Variance (s2)= 80,36,32,653 (Rs.80.363 lakhs) Return Point (R )= 25,000 +cuberoot {3*2000*80,36,300)/ [4*(0.12/365)]} = Rs.1,79,200 (approx.) H = 3R + L = 3* (179200) + 25,000 = Rs.5,62,600 Basics of Cash Management Motives of holding Cash Transactions demand: need money to pay bills (employees, suppliers, utility/phone, suppliers, etc.)cash to meet anticipated payment obligations. Precautionary demand: to handle emergencies (unforeseen expenses)e.g. slowdown in bill collection, sudden increase in raw material prices, etc. Speculative demand: to take advantage of unexpected opportunities (purchase of raw materials that are on sale) Compensation motive- The need to maintain minimum cash balance because the financiing institutions (banks) stipulate that. Objectives of Cash Management Cash doesnt earn a return Want to maintain liquidity Take cash discounts Maintain firms credit rating Minimize interest costs

Avoid insolvency Good cash management implies maintaining adequate liquidity with minimum cash in bank Can place portion of cash balance into marketable securities (AKA: near cash or cash equivalents) BANK DEFINITION OF CASH MANAGEMENT The effective planning, monitoring and management of liquid / near liquid resources including: Provision of bank accounts Deposit / withdrawal facilities Provision of information regarding bank accounts and positions Money transfers and collection services Investment facilities Financing facilities Pooling and netting BENEFITS OF GOOD CASH MANAGEMENT Control of financial risk Opportunity for profit Strengthened balance sheet Increased customer, supplier, and shareholder confidence The Operating Cycle and the Cash Conversion Cycle Inventory conversion collection

period plus: period equals: Operating cycle minus: Payables deferral period equals: Cash conversion cycle Shortening cash conversion cycle frees up cash to reinvest in business or to reduce debt and interest Receivable