Approaches of Current Assets/Working Capital Financing. (Mix of short and long term sources of finance). Approaches. Fixed Assets. Permanent CA. Temporary ...
Working Capital Management
CONTENTS • Characteristics of Current Assets • Factors Influencing Working Capital Requirements
• Current Assets Financing Policy • Operating Cycle Analysis • Cash Requirement for Working Capital
Current Assets Cycle
Finished goods
Accounts receivable
Work-inprocess Wages, salaries, factory overheads Raw materials
Cash
Suppliers
Characteristics of Current Assets Current Assets
Current Liabilities
Inventories • Raw Material and Components • Work-in-Process • Finished Goods
Short term Borrowings: • Commercial Banks • Others
Trade Debtors
Sundry Creditors
Loans and Advances
Trade Advances
Cash and Bank Balance
Provisions
• Short life span • Swift transformation into other asset forms
Factors Influencing Working Capital Requirements • Nature of Business •
Seasonality of Operations
•
Production Policy
•
Market Conditions
•
Conditions of Supply
Level of Current Assets Flexible Policy/Conservative Policy Investments in current assets is high
Restrictive Policy Investments in current assets is low
Benefits: Benefits: • Fewer production stoppages • Low investment in current assets • Ensures quick delivery to customers • Stimulates sales due to liberal credit to customers Limitations: • Carrying costs: high investment in current assets
Limitations: • Frequent production stoppages • Delayed deliveries to customers • Loss of sales
Current Assets Financing Policy Long-term Financing (LTF)
Short-term Financing (STF)
Spontaneous Financing (SF)
Equity share capital, Preference share capital
Commercial paper
Trade (suppliers’) credit
Reserves & Surplus (retained earnings)
Public deposits
Outstanding expenses
Debentures
Factoring of receivables
Borrowings from Financial Institutions
Working capital funds from banks
Approaches of Current Assets/Working Capital Financing (Mix of short and long term sources of finance) Approaches
Fixed Assets
Permanent CA
Temporary CA
Conservative
LTF
LTF
LTF + STF
Matching/Hedging
LTF
LTF
STF
Aggressive
LTF
LTF + STF
STF
Financing under Conservative Plan
Financing under Matching Plan
Financing under Aggressive Plan
OPERATING CYCLE AND CASH CYCLE Order placed
Stock arrives
Goods sold Inventory period
Cash received Accounts receivable period
Accounts payable period Firm receives invoice
Cash paid for materials Operating cycle Cash cycle
Average inventory Inventory period = Average COGS / 365 Average accounts receivable Accounts receivable period =
Annual sales / 365 Average accounts payable Average payable period = Average COGS / 365
ILLUSTRATION Financial Information for Horizon Limited Balance Sheet Data Profit and Loss Account Data
Beginning of 20X0
End of 20X0
Sales
800
Inventory
96
102
Cost of goods
720
Accounts receivable
86
90
Accounts payable
56
60
Sold
(96 + 102) / 2 Inventory period =
= 50.1 days 720 / 365
(86 + 90) / 2 Accounts receivable period
=
= 40.2 days 800 / 365 (56 + 60) / 2
Accounts payable period
=
= 29.4 days 720 / 365
Operating cycle
=
50.1 Inventory period
+
Cash cycle
=
90.3 Operating cycle
-
40.2 = 90.3 days Accounts receivable period
29.4 = 60.9 days Accounts payable period
Following financial information is available for Xavier Ltd. for the year ending 2010 P&L A/C Data (in Rs. Million)
Balance Sheet Data (for the year 2010) Beginning
End
Sales
80
Inventory
9
12
Cost of Goods Sold
56
Accounts Receivable
12
16
Accounts Payable
7
10
What is the length of operating cycle and cash cycle. Assume 365 days in a year.
Cash Requirement For Working Capital Step 1 : Estimate the cash cost of various current assets required by the firm. • Inventory o Raw material = Material cost o Finished Goods = Cash Manufacturing Cost
Material Cost + Wages + Manufacturing expenses
• Debtors = Total Cash Cost
Total Manufacturing Expenses (including depreciation)
Step 2 : Deduct the spontaneous current liabilities from the cash cost of current assets Working Capital Required = (Current Assets – Current Liabilities) + Safety Margin
Estimating Cash Requirement for Working Capital A firm sells goods at a profit margin of 25% counting depreciation as a part of the cost of manufacture. Its annual figures are as follows: (in Rs. Million) Sales (2 months credit is given)
240
Materials Cost (Suppliers give 3 months credit)
72
Wages (Wages are paid 1 month in arrears)
48
Manufacturing Expenses o/s at the year end (Cash expenses are paid 1 month in arrears)
4
Administrative and sales expenses (Paid as incurred)
30
Firm keeps 2 months stock of raw materials and 1 month stock of finished goods. It wants to maintain a cash balance of Rs. 5 million. Estimate the requirement of working capital on cash cost basis, assuming a 10% safety margin. Ignore work-in-progress.
Estimating Cash Requirement for Working Capital (in Rs. Million) Sales (2 months credit is given) (-) Gross Profit (25%)
240 60
Total Manufacturing Cost
180
(-) Materials & Wages (72 + 48)
120
Manufacturing Expenses
60
(-) Cash Manufacturing Expenses (4 mln x 12)
48
Depreciation
12
Total cash cost Estimation Total Manufacturing Cost (-) Depreciation Cash Manufacturing Cost (+) Administration and selling Expenses Total Cash Cost
180 12 168 30 198
Estimating Cash Requirement for Working Capital Current Assets (in Rs. million) Debtors = (Total cash cost) x 2/12 = (198 x 2)/12 = 33 Raw material stock = (Material cost) x 2/12 = (72 x 2)/12 = 12 Finished goods = (Cash manufacturing cost) x 1/12 = 168/12 = 14 Cash balance (predetermined) = 5 Current Liabilities (in Rs. million) Sundry creditors = (Material cost) x 3/12 = (72 x 3)/12 = 18 Mfg expenses o/s = 1 month’s cash mfg. expenses = 4 Wages o/s = 1 month’s wages = 48/12 = 4 Net Working Capital (NWC) = Current assets – Current liabilities = 64-26= 38 Million Safety margin (10% of NWC) = 3.8 million Total NWC required = WC + Safety margin = 38 + 3.8 = 41.8 million
Following annual figures (in Rs.) are available for Abacus Ltd. Sales (at 2 months credit)
Manufacturing expenses o/s at year end (Cash expenses are paid 1 month in arrear)
80,000
Total administrative expenses (paid as above)
2,40,000
Sales promotion expenses (paid quarterly in advance)
1,20,000
Company sells its products at a gross profit of 25% counting depreciation as part of cost of production. It keeps 1 month stock each of raw materials and finished goods, and a cash balance of Rs. 1,00,000. Assuming a 20% safety margin, calculate the working capital requirements of the company on cash cost basis. Ignore work in process.
