Amity School of Business

Amity School of Business

BBA, Semester 3 FINANCIAL MANAGEMENT 1

Outline of Module Amity School of Business

Working Capital: Meaning & Concept. Characteristics of current assets. Components of Working Capital. Factors Affecting Working Capital Requirement. Operating cycle analysis.

Working Capital: Meaning

Amity School of Business

A measure of both a company's efficiency and its shortterm financial health. The working capital ratio is calculated as follows: Working Capital= Current Assets Current Liabilities Positive working capital means that the company is able to pay off its short-term liabilities. Negative working capital means that a company currently is unable to meet its short-term liabilities with its current assets (cash, accounts receivable and inventory).

Working Capital Concepts

Amity School of Business

Gross working capital is the total investment made in current assets. Net working capital is the difference between current assets and current liabilities. Net Working capital = Current assets Current Liabilities.

Working Capital management: The administration of the firms current assets and the financing needed to support current assets.

The key difference between the long term financing and working capital is the timings of the cash.
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Characteristics of Current Assets

Amity School of Business

Short life span. Swift transformation. Decisions are repetitive & frequent. Difference between profit & present value is insignificant. Constituents of Working Capital Current Assets Current Liabilities Inventories Sundry Creditors. o Raw material. o Work in progress. o Finished Goods. Trade debtors. Trade Advances. Loans & Advances. Borrowings (short Term) Cash & Bank Balances. - Commercial Banks. -Others. Provisions.
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Current Assets Cycle

Amity School of Business

Finished Goods Bills Receivables Wages & Factory Overheads

Work-inProgress

Raw Materials

Cash

Suppliers
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Proportion of Current Assets & Total Assets Amity School of Business

Current Assets(%) Fixed Assets (%) Industries

10-20

80-90

Hotels, Restaurants.

20-30
30-40 40-50 50-60

70-80
60-70 50-60 40-50

Electricity Generation &distribution.

Aluminium, Shipping. Iron & steel, Basic industrial Chemicals. Tea plantation. Cotton Textiles, Sugar. Edible oils, Tobacco. Trading, Construction.

60-70
70-80 80-90

30-40
20-30 10-20

Factors influencing Working Capital Requirements

Amity School of Business

Nature of Business Service Firm- Electricity or Transport corporation. Manufacturing Concern- Machine tools unit. Seasonality of operations Highly fluctuating working capital requirements. Conditions of supply Prompt supply- less working capital. Unpredictable supply- more working capital.

Amity School of Business

Production policy Seasonal fluctuations- sharp variations in working capital. Market conditions High degree of competition & Strong market- more inventory- high working capital. Weak competition & strong market smaller inventory less working capital.

Growth & Expansion Advance planning of working capital is required.

Amity School of Business

Credit policy Credit policy of supplier of raw material. Credit policy extended to customers. The firm must take care of credit policy of the market.

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Significance of Working Capital Amity School of Business 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. Requires continuous, day-to-day managerial supervision. Working capital management affects the companys risk, return, and share price. Investment in current assets and the level of current liabilities have to be geared quickly changes in sales.
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Impact on Liquidity Amity School of Business

Optimal Amount (Level) of Current Assets

ASSET LEVEL (Rs.)

Liquidity Analysis Policy Liquidity A High B Average C Low Greater current asset levels generate more liquidity; all other factors held constant.

Policy A Policy B Policy C

Current Assets

25,000 OUTPUT (units)

50,000
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CARRYING COSTS AND SHORTAGE COSTS

Amity School of Business

Carrying Cost and Shortage Costs

Total Costs

Carrying Costs Shortage Costs

CA*

Level of Current Assets (CA)

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Amity School of Business

Classification of working Capital

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Permanent Working Capital

Amity School of Business

The amount of current assets required to meet a firms long-term minimum needs.

RUPEE AMOUNT

Permanent current assets

TIME
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Temporary Working Capital

Amity School of Business

The amount of current assets that varies with seasonal requirements.

RUPEE AMOUNT

Temporary current assets

Permanent current assets

TIME
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Balance Sheet
Current Liabilities

Amity School of Business

Current Assets

Fixed Asset
Long-Term Debt Preferred Stock Common Stock
Suppose we use long-term financing to finance some of our current assets. This strategy would be less risky, but more expensive!
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Balance Sheet
Amity School of Business

Current Liabilities

Current Assets Fixed Assets

Long-Term Debt Preferred Stock Common Stock

Suppose we use current liabilities to finance some of our fixed assets. This strategy would be less expensive, but more risky!
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The Hedging Principal

Amity School of Business

Permanent Assets (those held > 1 year) should be financed with permanent and spontaneous sources of financing. Temporary Assets (those held < 1 year) should be financed with temporary sources of financing.

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Working Capital Financing Policies

Amity School of Business

Moderate Match the maturity of the assets with the maturity of the financing. Aggressive Use short-term financing to finance permanent assets. Conservative Use permanent capital for permanent assets and temporary assets.

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Operating Cycle & Cash Cycle

Amity School of Business

The time that elapses between the purchases of raw material and collection of cash for sales is referred to as operating cycle. Operating Cycle= Inventory period + Accounts Receivables period . The time length between the payment of raw material purchases and collection of cash for sales is referred to as the cash cycle. Cash Cycle= Operating Cycle Accounts Payable Period.
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Operating Cycle

Amity School of Business

The investment in working capital is influenced by following events in the operating cycle of a firm: Purchase of Raw Material. Payments of Raw Material. Manufacture of Goods. Sale of finished Goods. Collection of cash for sales.

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Operating Cycle & Cash Cycle

Amity School of Business

Order Placed

Stock arrives Inventory period

Goods sold

Cash received

Accounts receivable period

Accounts payable period

Firm receives invoice Cash paid for materials Operating cycle Cash cycle
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Operating & Cash Cycle

Amity School of Business

The time lag between the purchase of Raw Materials & the sale of finished goods is the Inventory Period.

Average Inventory InventoryPeriod Annual Costs of Good Sold/365

Customers pay their bills some time after sales. The time period that elapses between the date of sales and the date of collection of receivables is the accounts receivables period (Debtors Period). Average AccountsReceivables AccountsReceivables Period Annual Sale/365

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Operating and Cash Cycle

Amity School of Business

Accounts payable period is the time taken by the firm in paying its suppliers (Creditors).
AccountsPayable Period Average AccountsPayable Annual COGS/365

Operating cycle is the sum of the inventory period & the accounts receivables period. Cash cycle is equal to the operating cycle less the accounts payable period.

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Example:
Profit & Balance Loss A/C Sheet

Amity School of Business

Begn 2008

End 2008

Sales

800

Inventory

96

102
90

Costs of 720 goods Sold

Accounts 86 Receivable Accounts Payable 56

60
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Estimate the working capital requirement

Amity School of Business

Step 1: Estimate the cash cost of various assets required by the firm. Value of the current asset. -Profit element , if included in the value. -Non cash charges like depreciation, if any, included in the value. Step 2: Deduct spontaneous liabilities from the cash cost of the current liabilities.

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Estimate the working capital requirement

Amity School of Business

Current Assets Debtors: Total cash cost Raw material: Material cost Finished goods stock: Cash manufacturing cost Cash balance Current Liabilities Creditors: Material cost Manufacturing expenses outstanding Wages outstanding Working capital = current assets current liabilities + safety margin =Working capital required

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Working Capital Financing Amity School of Business

The finance manager spends great chunk of time in finding the money to finance current assets. Short term sources of finance exclusively support the current assets. The sources are divided into ten sections: Accruals. Trade Credit. Advances by commercial banks. Regulation of Bank finance. Public deposits. Inter corporate deposits. Short term loans. Commercial paper. Factoring. Forfaiting.
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Working Capital Financing

Amity School of Business

Accruals Accruals are what the firm owe to its employees and to the government. Wages & salaries are major accruals. Accruals vary with the activity level of firm. Treated as spontaneous financing. Regarded as Free Financing as no interest is paid. Trade Credit Represents the credit extended by the suppliers of the goods and services. Trade credit is given, provided the firm is considered creditworthy by its suppliers. Spontaneous source of finance.
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Working Capital Financing

Amity School of Business

Trade credit is an important source of finance representing 25% to 50% of short term financing. Obtaining trade credit from the customers monitors: Earnings record over a period of time. Liquidity position of firm. Record of payment. Cultivating the good supplier relationships. Cost of credit.

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Working Capital Financing Amity School of Business

Public deposits
The public deposits refer to the deposits that are attained by the numerous large and small firms from the public. Generally solicited by the firms in order to finance the working capital requirements of the firm. Important conditions: Deposits can not be accepted without the issue of an advertisement containing prescribed particulars. Public deposits should not exceed 25% of paid up capital and free reserves . Interest subject to the ceiling as fixed from time to time, usually 15% per annum with quarterly rests. Annual returns to be filed with the registrar of companies.

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Working Capital Financing Amity School of Business

Advantages: No restrictive covenants. No security is offered. Post tax cost is reasonably fair. Simple procedure.

Disadvantages: Limited quantum of finance can be raised. Short maturity.

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Working Capital Financing Amity School of Business

Commercial paper: Commercial Paper (CP) is an unsecured money market instrument issued in the form of a promissory note. It was introduced in India in 1990. Large firms with considerable financial strength can issue the commercial paper. Features: Maturity period ranges from 90 to 180 days. They are sold at discount from its face value and redeemed at its face value. Directly placed with the investors intending to hold it till maturity.
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Working Capital Financing Amity School of Business

Advantages of commercial paper are: To obtain cash with which to take advantage of cash discounts offered by trade creditors To establish national credit by credit rating agencies: CRISIL, CARE, ICRA, To keep a reserve of borrowing power at local banks To borrow at cheaper rates than is possible at your local banks To establish a broader market for the paper than is possible locally. Disadvantages: Available only to sound and highly rated companies. Amount of loan able funds available is limited to the amount of excess liquidity of various purchasers of CP. Cannot be redeemed until maturity.

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Working Capital Financing

Amity School of Business

Short term loans The insurance companies provide loans to the manufacturing companies with excellent track records. Features: The loan is given for a period of one year and renewed for two consecutive years. After repayment, wait for 6 months for another loans.

Benefits A short-term loan is best for a lower interest rate.

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Working Capital Financing

Amity School of Business

Inter corporate deposits A deposit made by one company with another, normally upto the period of six months is referred to as inter corporate deposits. Types: Call deposits. Three months deposits. Six months deposits.

Characteristics: Lack of regulations. Secrecy. Importance of personal contacts.

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Working Capital Financing Advance by Commercial Banks

Amity School of Business

Working capital advance by commercial banks represent the important source for financing the current assets. It includes the: Application & processing. Sanction terms of condition. Forms of bank finance. Nature of security. Margin amount.

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Working Capital Financing Amity School of Business

Factoring A factor is a financial institution which offers services relating to management and financing of debt arising from the credit sales.

RBI has authorized only 4 banks in public sector in India: SBI (through its subsidiary SBI factoring & Commercial services Ltd). Canara Bank ( through its subsidiary Canbank Factoring Ltd). Punjab National Bank. Bank of Allahabad.

Features: The factor selects the accounts of the client that would be handled by it & establishes along with the client the credit limits applicable. The factor assumes the responsibility for collecting the debt of accounts handled by it. The factor advances the money to the client not-yet-collected & not-yet-due debts. The amount advanced is 70%-80% of the face value of debt and carries the interest rate. Factoring may be on a recourse basis or non recourse basis. The interest on advances against debt, the factor charges a commission which may be 1% or 2% of the face value of the debt.
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Factoring Process Amity School of Business

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Factoring Process Amity School of Business

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Working Capital Financing Forfaiting

Amity School of Business

Forfaiting is the purchase of a series of credit instruments such as drafts drawn under time letters of credit, bills of exchange, promissory notes, or other freely negotiable instruments on a "non recourse basis (non-recourse means that there is no comeback on the exporter if the importer does not pay). The Forfaiter deducts interest (in the form of a discount), at an agreed rate for the full credit period covered by the notes. The debt instruments are drawn by the exporter (seller), accepted by the importer (buyer), and will bear unconditional guarantee. The guarantee will normally be issued by the importer's bank, but some strong corporates can be accepted without a bank guarantee.
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Working Capital Financing Amity School of Business

Forfaiting is used for international trade transactions. Normally, a Forfaiting house would not expect to handle transactions worth less than $100,000. Forfaiting is fixed rate, medium term (one to five years) finance, but Forfaiter have become very flexible about the terms they will accept.

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Working Capital Financing Amity School of Business

What documents are required by the Forfaiter from the exporter? Usually required are: a) Copy of supply contract, or of its payment terms b) Copy of signed commercial invoice c) Copy of shipping documents including certificates of receipt, railway bill, airway will, bill of lading or equivalent documents. d) Letter of assignment and notification to the guarantor e) Letter of guarantee or aval. The aval is the Forfaiters' preferred form of security of payment of a bill or note. For an aval to be acceptable, the avalizing bank must be internationally recognized and credit worthy.
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