EFFICIENT MARKET HYPOTHESIS: FORMS OF

EFFICIENT MARKET HYPOTHESES AND FORMS OF

ANALYSIS.

FINANCIAL AND PROFIT ANALYSIS: BALANCE SHEET,

FUND FLOW STATEMENT, CASH FLOW STATEMENT AND
RATIO ANALYSIS.

THE FUNCTION AND MANAGEMENT OF WORKING

CAPITAL

COURSE TITLE: PORTFOLIO THEORY

COURSE CODE: FIN 810
BY:
QUADRI YUSUF OLAMILEKAN
16/27/MFI 010

BEING ASSIGNMENT SUBMITTED TO THE DEPARTMENT OF

ACCOUNTING AND FINANCE, COLLEGE OF HUMANITIES,
MANAGEMENT AND SOCIAL SCIENCES, KWARA STATE
UNIVERSITY, MALETE, KWARA STATE.

LECTURER: DR. I.B. ABDULLAHI

APRIL, 2017
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ASSIGNMENT ONE:
Efficient market hypothesis: forms of efficient market hypotheses and forms of analysis.
Introduction:
Investors in securities such as shares and convertible bonds want to be confident that
the price they pay for their securities is a fair price. In order for market prices to be fair, it is
important that the stock market should be able to provide the relevant available information
about companies and investors should have immediate access to this information and act on it
when making decisions about buying and selling shares. The efficient markets hypothesis
provides a rational explanation of how share prices change in organized stock markets. The
hypothesis is based on the assumption that share prices change in a logical and consistent
way, in response to new information that becomes available to investors. The speed with
which share prices change depends on how quickly new information reaches investors, and
this varies with the efficiency of the market.
Companies raise long term funds in the forms of equity and debt from the capital
markets. Therefore, finance managers should know the ways in which securities are traded
and priced in the capital markets as well as the procedures to be followed in issuing
securities. Securities will be fairly priced in the capital markets if they are efficient (Pandey,
2008)
The efficiency of capital market can be viewed from the roles the capital markets are
expected to perform in the economy which can be classified into three: allocation efficiency
i.e. capital market is expected to optimally allocate scarce savings to productive investments
in a way that benefits everyone. Another is operational efficiency which means that financial
intermediaries who provide the service of channeling funds from savers to investors do so at
the minimum cost that provides them a fair return for their services. Lastly is pricing
efficiency which implies that for a market to be pricing efficient, the information processing
about the price determined by demand and supply is available. The prices of capital assets
anytime are based on the correct evaluation of all information available (Olowe, 2008).
Concept of capital market efficiency
According to Pandey, (2008), capital market efficiency can be defined as the ability if
securities to reflect and incorporate all relevant information, almost instantaneously in their
prices. The security prices move randomly and unpredictably. This randomness of security
prices (and returns) may be interpreted to imply that investors in the capital markets take a
quick cognizance of all information relating to security prices, and that the security prices
quickly adjust to such information. Thus, the efficiency of security prices depends on the
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speed of price adjustment to any available information. The more the speed of adjustment, the
more efficient will be the security prices.
Assumptions underlying efficiency
Olowe (2008) highlighted the following assumptions that are sufficient for an
efficient market:
a. No transaction cost of trading in securities
b. Information is freely available to all participants
c. All investors have homogenous expectations especially as to the implications of
current information for the current price and distribution of future prices of each
security
d. All investors have same time horizons
Forms of market efficiency
The efficient market hypothesis (EMH) is a theory of market efficiency, based on
research into share price behaviour in stock markets. According to this theory there are three
possible levels or ‘forms’ of market efficiency (ICAN, 2014):
a. Weak form efficiency
b. Semi-strong form efficiency, and
c. Strong form efficiency.
Each financial market can be categorized as being weak form, semi-strong form or
strong form efficient. In equities markets, the way in which share prices move in response to
available information varies according to the efficiency of the market.
Weak form efficiency
The efficient markets hypothesis states that when a market has weak form efficiency,
share prices respond to the publication of historical information, such as the previous year’s
financial statements. When the market displays a weak form, it also means that the current
share price embodies all the historical information that is known about the company and its
shares, including information about share price movements in the past. Until the next
publication of more historical information about the company, there is no other information
about the company that will affect the share price in any obvious way. The weak form
suggests that the current price reflects all past prices and that past prices and upward or
downward trends in the share price cannot be used to predict whether the price will go up or
down in the future. Share prices do rise and fall, with supply and demand in the market, but
the next price movement is equally likely to be up as down.

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 A weak form of stock market efficiency is consistent with the random walk theory.
This theory states that share prices move up and down randomly over time, in response to the
arrival of favourable or unfavourable information on the market. Random walk theory is
opposed to the view that future share price movements can be predicted from patterns of
share price movements in the past, since patterns repeat themselves, and historical trends can
be used to predict future trends. Some stock market analysts believe that they can predict
future movements in share prices from recognisable patterns of share price movement. These
analysts are sometimes called chartists, because recognisable patterns of share price
movements can be illustrated by graphs or charts of share prices over a period of time.
Chartism does not have a rational justification.
Semi-strong form efficiency
When a market has semi-strong form efficiency, current share prices reflect all
publicly-available information about the company and its prospects, in addition to historical
information. For example, share prices might respond to a new announcement by a company
about its trading prospects for the remainder of the year. Similarly, the share price might also
respond to an announcement that the company is seeking to make a new acquisition, or a
major new investment. If a market displays semi-strong form efficiency, share prices should
move when new information becomes available to the public, but not before. For example, if
a company is planning a major acquisition, the share price should not be affected by
unconfirmed rumours in the market. However, the share price will react to the official
announcement of a takeover bid by a company.
It also means that individuals who have access to information that has not yet been
made public (‘inside information’) will be able to buy or sell the shares in advance of the
information becoming public, and make a large personal profit. This is because the inside
information will indicate whether the share price is likely to go up or down, and the
individual can buy or sell accordingly. Using inside information to make a personal profit
from trading in shares is called insider dealing, which is illegal in countries with well-
established stock markets.
Strong form efficiency
When a market has strong form efficiency, current share prices reflect all relevant
information about the company as soon as it comes into existence, even if it has not been
made publicly-available. In other words, the share price reflects all inside information as well
as publicly-available information. The market is so efficient that all information is
immediately transmitted throughout the market instantly, and all investors have access to this
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same information. If the stock market has strong form efficiency, it is impossible for
individuals to profit from insider trading, because there is no inside knowledge that the
market has not already found out about.
In practice, research suggests that most markets have weak form efficiency, but some
well-developed markets such as the New York Stock Exchange and London Stock Exchange
are semi-strong form efficient.
Illustration 1:
A company decides to undertake a major capital investment. The investment will be a
five-year project, and over the course of the five years, the company’s directors believe that
the net profits will add ₦125 million to the value of the company’s shares. The company
made the decision to invest on 1st October Year 1, and the first year of profits from the
investment will be Year 2. It announces the investment and the expected benefits to the stock
market on 1st December. It is assumed that the stock market investors believe the company
estimate that the project will add ₦125 million to share values.
Solution:
Strong form efficiency
If the stock market has strong form efficiency, the company’s share price should go
up on 1st October, as soon as the decision to invest is made. The total increase in share value
should be ₦125 million.

Semi-strong form efficiency

If the stock market has semi-strong form efficiency, the share price should go up on
1st December, when the investment and its expected benefits are announced to the market
and so become public information. (Between 1st October and 1 st December, the information
is ‘inside information’).

Weak form efficiency

If the stock market displays weak form efficiency, the share price will not be affected
by the announcement on 1st December Year 1. The share price will eventually respond, after
each of the next five years, when the actual historical profits of the company, including the
profits from the new investment, are announced.

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Implications of strong capital market efficiency
There are several theoretical implications of market efficiency. If a capital market has strong
efficiency:
a. Share prices will be fair at all times and reflect all information about a company. This
means that there is no ‘good time’ or ‘bad time’ to try issuing new shares or bonds.
b. Companies will gain no benefit from trying to manipulate their financial results and
present their performance and financial position in a favourable light. In a market with
strong-form efficiency, investors will see through the pretence and will understand the
true financial position of the company.
c. For investors there will never be any ‘bargains’ in the stock market, where share
prices are under-valued. Similarly there will be no over-priced shares that clever
investors will sell before a share price fall.
d. If the capital market has strong form efficiency, if a company invests in any new
capital project with a positive net present value, the share price should respond by
going up to reflect the increase in the value of the company represented by the project
NPV.

Factors that may have an impact on the market value of shares

In practice, research suggests that most markets have either weak form or semi-strong
form efficiency. Factors which may impact on the efficiency of the market include:
a. The marketability and liquidity of shares: The greater the volume of shares traded
the more opportunity there is to reflect new information in the share price.
b. Availability of information: Not all information can be available to all investors at
the same time. Shares which are traded more by professional dealers are more likely
to reflect full information as they can afford to pay for better monitoring systems and
may have better access to early information.
c. Pricing anomalies: Share prices may be affected by investor behaviour at the end of
the tax year.

Conclusion
In finance literature, capital market efficiency is a market where security prices
quickly and fully reflected all available information. In an efficient market, the same rate of
return for a given level of risk should be realized by all investors (Olowe, 2008). Capital
market efficiency was categorized into three: weak form efficiency, semi-strong strong
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efficiency and strong form efficiency. Weak form efficiency is concerned with the adjustment
of security prices to historical price or return information. If the market is weak form
efficient, no investor can earn any excess or abnormal return based on historical price or
return information. Semi-strong form efficiency is concerned with whether security prices
fully reflect all publicly available information. Finally, strong form efficiency is concerned
with whether security prices fully reflect all information whether available to the public or
not.

6
ASSIGNMENT 2
FINANCIAL AND PROFIT ANALYSIS: Balance Sheet, Fund Flow Statement, Cash Flow
Statement and Ratio Analysis.

Introduction
The basis for financial planning, analysis and decision making is the financial
information. Financial information is needed to predict, compare and evaluate the firm’s
earning ability. It is also required to aid in economic decision making; investment and
financing decision making. The financial information of an enterprise is contained in the
financial statement or accounting reports. Three basic financial statements of great
significance to owners, management and investors are balance sheet, profit and loss account
and cash flow statement (Pandey, 2008).
The financial statements are the final output of the accounting process of any
organization. The typical set of financial statements prepared by publicly held companies
contains useful information as regards the success of operation of the firm, the financial
position of the firm, the policies and strategies of management, and insight into its future
performance. The financial statements will assist a financial analyst in determining whether
(Olowe, 2008):
a. Returns generated by an investment is adequate to be attractive
b. Selling off an existing investment
c. Interest and principal repayments in loans are paid regularly
d. There is opportunity for employment in the firm
e. The company is coping with competition within its industry
f. The firm offers a good prospect.

Concept and Components of Financial statement

The financial statement is an organized collection of data according to logical and
consistent accounting procedures. Its purpose is to convey an understanding of financial
aspects of a business firm. It may show a position at a moment of time as in the case of a
balance-sheet or may reveal a service of activities over a given period of time, as in the case
of an income statement. Financial statements are the summary of the accounting process,
which provides useful information to both internal and external parties. Financial statements
can also be described as statement that provides a summary of the accounting of a business

7
enterprise, the balance-sheet reflecting the assets, liabilities and capital as on a certain data
and the income statement showing the results of operations during a certain period.
A typical financial statement therefore comprises:
a. Balance sheet
b. profit and loss account or income statement
c. statement of cash flow

Balance Sheet
Balance sheet is the most significant financial statement. It indicates the financial
condition or the state of affairs of a business at a particular moment of time. More
specifically, balance sheet contains information about resources and obligations of a business
entity and about its owner’s interests in the business at a particular point in time. Thus the
balance sheet of a firm prepared on 31 st December reveals the firms’ financial position on this
specific date. In the accounting language, balance sheet communicates information about
assets, liabilities and owner’s equity for a business firm as on a specific date. It provides a
snapshot of the financial position of the firm at the close of the firm’s accounting period
(Pandey, 2008).

Profit and Loss Account or Income Statement

Profit and Loss account presents the summary of revenues, expenses and net income
(net loss) of a firm. The earning capacity and potential of a firm are reflected by its profit and
loss account. The profit and loss account is a score-board of the firm’s performance during a
period of time. The generally accepted convention is to show one year’s events in the profit
and loss account. Income statement serves as a measure of the firm’s profitability. Revenues
are amounts that the company pays to the firm for providing them goods and services to the
customers. The cost of the economic resources used to earn revenues during a period of time
is called expenses. Thus, to determine the net profit, the accounting system matches expenses
incurred during the accounting period against revenues earned during this period. This
matching of expenses with revenue is called matching concept.

Statement of cash flow

A statement of changes in financial position on cash basis, commonly known as the
cash flow state, summarizes the causes of changes in cash position between dates of the two
balance sheets. It indicates the sources and uses of cash. The cash flow statement is similar to
8
the fund flow statement except that it focuses attention on cash (immediate or near cash
liquidity) instead of working capital or funds (potential or medium term liquidity). Thus, this
statement analyses changes in non-current accounts as well as current accounts (other than
cash) to determine the flow of cash.
Sources and uses of cash are critically analyzed in the statement of cash flow. The
sources of cash include: profitable operations of the firm, decrease in assets (except cash),
increase in liabilities (including debentures or bond) and sales proceeds from an ordinary or
preference shares. The uses of cash include the loss from operations, increase in assets
(except cash), decrease in liabilities (including redemption of debentures or bond),
redemption of redeemable preference shares and cash dividend.

Fund Flow Statement

The statement of changes in financial position, prepared to determine only the sources
and uses of working capital between dates of two balance sheets is known as the funds flow
statement. Working capital is defined as the difference between current assets and current
liabilities. Working capital determines the liquidity position of the firm. Funds flow statement
is one of the important tools, which is used in many ways. It helps to understand the changes
in the financial position of a business enterprise between the beginning and ending financial
statement dates. It is also called as statement of sources and uses of funds.
As a historical analysis, the statement of changes in working capital reveals to
management the way in which working capital was obtained and used. With this insight,
management can prepare the estimates of the working capital flows. A statement reporting
the changes in the working capital is useful in addition to the financial statement. A projected
statement of changes in working capital is immensely useful in the firm’s long range
planning.

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 Difference between Funds Flow and Cash Flow Statement
Funds Flow Statement Cash Flow Statement
1. Funds flow statement is the report on the 1. Cash flow statement is the report showing
movement of funds or working capital sources and uses of cash.
2. Funds flow statement explains how 2. Cash flow statement explains the inflow
working capital is raised and used during the and out flow of cash during the particular
particular period period.
3. The main objective of fund flow statement 3. The main objective of the cash flow
is to show the how the resources have been statement is to show the causes of changes in
balanced mobilized and used. cash between two balance sheet dates.
4. Funds flow statement indicates the results 4. Cash flow statement indicates the factors
of current financial management. contributing to the reduction of cash balance
in spite of increase in profit and vice-versa.
5. In a funds flow statement increase or 5. In a cash flow statement only cash receipt
decrease in working capital is recorded. and payments are recorded.
6. In funds flow statement there is no 6. Cash flow statement starts with opening
opening and closing balances. cash balance and ends with closing cash
balance.

Techniques of Financial Statement Analysis

Financial statement analysis is interpreted mainly to determine the financial and
operational performance of the business concern. A number of methods or techniques are
used to analyze the financial statement of the business concern. The following are the
common methods or techniques, which are widely used by the business concern:
a. Comparative Statement Analysis
 Comparative Income Statement Analysis
 Comparative Balance Sheet Analysis
b. Trend Analysis
c. Common Size Analysis
d. Fund Flow Statement
e. Cash Flow Statement
f. Ratio Analysis

Comparative Statement Analysis

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 Comparative statement analysis is an analysis of financial statement at different
period of time. This statement helps to understand the comparative position of financial and
operational performance at different period of time. Comparative financial statements again
classified into two major parts such as comparative balance sheet analysis and comparative
profit and loss account analysis.

Comparative Balance Sheet Analysis

Comparative balance sheet analysis concentrates only the balance sheet of the concern
at different period of time. Under this analysis the balance sheets are compared with previous
year’s figures or one-year balance sheet figures are compared with other years. Comparative
balance sheet analysis may be horizontal or vertical basis. This type of analysis helps to
understand the real financial position of the concern as well as how the assets, liabilities and
capitals are placed during a particular period.
Illustration 2
The following are the balance sheets of Tamil Nadu Mercantile Bank Ltd., for the years 2003
and 2004 as on 31st March. Prepare a comparative balance sheet and discuss the operational
performance of the business concern.

Balance Sheet of Tamil Nadu Mercantile Bank Limited as on 31st March

Liabilities 2014 2015 Assets 2014 2015
Capital 2,845 2,845 Cash and Balance
Reserve and Surplus 3,966,009 4,765,406 with CBN 2,706,808 2,237,601
Deposits 40,845,783 44,042,730 Balance with Banks
Borrowings 727,671 284,690 and Money at call 1,136,781 1,607,975
Other Liabilities and 1,674,165 1,799,197 Investments 21,421,060 23,537,098
Provision Advances 19,599,764 21,129,869
Fixed Assets 493,996 536,442
Other Assets 1,858,064 1,835,883
47,216,473 50,894,868 47,216,473 50,894,868

Solution:

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 Comparative Balance Sheet Analysis as at 31st March
Increased/ Increased/
Decreased Decreased
(Amount) (Percentage)
2014 2015
# # # #
Assets
Current Assets
Cash and Balance with CBN 2,706,808 2,237,601 +469,207 +17.33
Balance with Banks & Money at call 1,136,781 1,607,975 –471,194 –41.45
Total Current Assets 3,843,589 3,845,576 1,987 0.052
Fixed Assets
Investments 21,421,060 23,537,098 -2,116,038 - 9.88
Advances 19,599,764 21,139,869 -1,540,105 -7.86
Fixed Assets 493,996 536,442 -42,446 -8.59
Other Assets 1,858,064 1,835,883 +22,181 +1.19
Total Fixed Assets 43,372,884 47,049,292 +3,676,408 8.48
Total Assets 47,216,473 50,894,868 3,678,395 7.79
Current Liabilities
Borrowings 727,671 284,690 +442,981 60.88
Other Liability and
Provisions 1,674,165 1,799,197 –125,032 7.47
Total Current Liability 2,401,836 2,083,887 317,949 13.24
Fixed Liability Capital 2,845 2,845 — —
Reserves surplus 3,966,009 4,765,406 +799,397 20.16
Deposit 40,845,783 44,042,730 +3,196,947 7.83
Total Fixed Liability 44,814,637 48,810,981 +3,996,344 8.92
Total Liability 47,216,473 50,894,868 3,678,395 7.79

Illustration 3
From the following balance sheet of XYZ Company Ltd. you are required to prepare a
schedule of changes in working capital and statement of flow of funds.
Balance Sheet of XYZ Company Ltd., as on 31st March
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Liabilities 2015 2016 Assets 2015 2016
Share Capital 100,000 110,000 Land and Building 60,000 60,000
Profit and Loss a/c 20,000 23,000 Plant and Machinery 35,000 45,000
Loans — 10,000 Stock 20,000 25,000
Creditors 15,000 18,000 Debtors 18,000 28,000
Bills payable 5,000 4,000 Bills receivable 2,000 1,000
Cash 5,000 6,000
140,000 165,000 140,000 165,000
Solution:
Schedule of Changes in Working Capital
Particulars 2015 2015 Increase Decrease
# # # #
Current Assets
Stock 20,000 25,000 5,000 —
Debtors 18,000 28,000 10,000 —
Bills Receivable 2,000 1,000 — 1,000
Cash 5,000 6,000 1,000
A 45,000 60,000
Less Current Liabilities
Creditors 15,000 18,000 3,000
Bills Payable 5,000 4,000 1,000
B 20,000 22,000 17,000 4,000
A-B 25,000 38,000 — 13,000
Increase in W.C. 38,000 38,000 17,000 17,000

Fund Flow Statement

Sources # Application #
Issued Share Capital 10,000 Purchase of Plant and Machinery 10,000
Loan 10,000 Increase in Working Capital 13,000
Funds from Operations 3,000
23,000 23,000

Illustration 4
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From the above illustration3 prepare a Cash Flow Statement.
Solution
Cash Flow Statement
Operating Activities
Balance c/d 5,000
Profit from operating activities 3,000
Dec. in bill receivables 1,000
Increase in creditors 3,000
Increase in current assets (5,000)
Stock (10,000)
Dec. in payables (1,000)
(4,000)
Investing Activities
Purchase of Plants (10,000)

Financing Activities
Issued share capital 10,000
Loan 10,000
Net cash flow 6,000

Ratio Analysis
Ratio analysis is a commonly used tool of financial statement analysis. Ratio is a
mathematical relationship between one number to another number. Ratio is used as an index
for evaluating the financial performance of the business concern. An accounting ratio shows
the mathematical relationship between two figures, which have meaningful relation with each
other. Ratio can be classified into various types. Classification from the point of view of
financial management is as follows:
● Liquidity Ratio
● Activity Ratio
● Solvency Ratio
● Profitability Ratio

Liquidity Ratio
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 It is also called as short-term ratio. This ratio helps to understand the liquidity in a
business which is the potential ability to meet current obligations. This ratio expresses the
relationship between current assets and current assets of the business concern during a
particular period. The following are the major liquidity ratio:

Current Asset
1. Current Ratio= 2 :1
Current Liabilities
Current Asset−Stock
2. Quick Ratio= 1:1
Current Liabilities
Activity Ratio
It is also called as turnover ratio. This ratio measures the efficiency of the current
assets and liabilities in the business concern during a particular period. This ratio is helpful to
understand the performance of the business concern. Some of the activity ratios are given
below:

Cost of Sales
1. Stock Turnover Ratio=
Average Inventory
Credit Sales
2. Debtor Turnover Ratio=
Average Debtors
Credit Purchases
3. Creditor Turnover Ratio=
Average Creditors
Sales
4. Working Capital Turnover Ratio=
Net Working Capital
Solvency Ratio
It is also called as leverage ratio, which measures the long-term obligation of the
business concern. This ratio helps to understand, how the long-term funds are used in the
business concern. Some of the solvency ratios are given below:

Debt
1. Debt−Equity Ratio=
Equity

Shareholders Fund
2. Proprietory Ratio=
Total Assets
EBIT
3. . Interest Coverage Ratio=
¿ Interest Charges

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Profitability Ratio
Profitability ratio helps to measure the profitability position of the business concern.
Some of the major profitability ratios are given below.

Gross Profit
1. Gross Profit Ratio= X 100
Sales

Net Profit
2. Net Profit Ratio= X 100
Sales

Operating Profit
3. Operating Profit Ratio= X 100
Sales

Profit After Tax

4. Return on Investment = '
X 100
Shareholder s Fund

Illustration 5
Calculate appropriate ratios from the following balance sheet of KWASU Industries Ltd., as
31st March 2016.
Liabilities # Assets #
Equity Share Capital 10,000 Fixed assets (less dep. of #10,000) 26,000
7% Preference Share Capital 2,000
Reserves and Surplus 8,000 Current Assets:
6% Mortgage Debentures 14,000 Cash 1,000
Current Liabilities: Investments (10%) 3,000
Creditors 1,200 Sundry debtors 4,000
Bills payable 2,000 Stock 6,000
Outstanding expenses 200
Tax Provision 2,600
40,000 40,000

Other information: #
a. Net sales 60,000
b. Cost of goods sold 51,600

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 c. Net income before tax 4,000
d. Net income after tax 2,000

Solution
Short-term solvency ratios
Current Asset 14,000
1. Current Ratio= = =2.33 :1
Current Liabilities 6,000
Current Asset−Stock 8,000
2. Quick Ratio= = =1.33 :1
Current Liabilities 6,000
Long-term solvency ratios

Proprietors fund 20,000

1. Proprietor Ratio= = =0.5 :1
Total Assets 40,000
Debt 20,000
2. Debt−Equity Ratio= = =1:1
Equity 20,000
EBIT 4840
3. Interst Coverage Ratio= = =5.7׿
¿ Interest Charge 840

Activity Ratio

Cost of Sales 51,600

1. Stock Turnover Ratio= = =8.6׿
Average Inventory 6,000
Credit Sales 60,000
2. Debtor Turnover Ratio= = =6׿
Average Debtors 6,000
Credit Purchases 43,200
3. Creditor Turnover Ratio= = =36׿
Average Creditors 1,200
Sales 60,000
4. Working Capital Turnover Ratio= = =7.5׿
Net Working Capital 8,000

Profitability Ratios
Gross Profit 8,400
1. Gross Profit Ratio= X 100= x 100=14 %
Sales 60,000

Net Profit 2,000

2. Net Profit Ratio= X 100= x 100=3.33 %
Sales 60,000

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 Profit After Tax 2,000
3. Returnon Investment = X 100= x 100=10 %
'
Shareholder s Fund 20,000

QUESTION 3: THE FUNCTION AND MANAGEMENT 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 between profitability and liquidity. Efficient working capital
management leads to improve the operating performance of the business concern and it helps

18
to meet the short term liquidity. Hence, study of working capital management is not only an
important part of financial management but also is overall management of the business
concern. Working capital is described as the capital which is not fixed but the more common
uses of the working capital is to consider it as the difference between the book value of
current assets and current liabilities.

Concept of Working Capital

Capital of the concern may be divided into two major headings: fixed and working
capital. Fixed capital means that capital, which is used for long-term investment of the
business concern. For example, purchase of permanent assets. Normally it consists of non-
recurring in nature. Working Capital is another part of the capital which is needed for
meeting day to day requirement of the business concern. For example, payment to creditors,
salary paid to workers, purchase of raw materials etc., normally it consists of recurring in
nature. It can be easily converted into cash. Hence, it is also known as short-term capital.
Working capital can be classified or understood with the help of the following two important
concepts:
a. Gross Working Capital: Gross Working Capital is the general concept which
determines the working capital concept. Thus, the gross working capital is the capital
invested in total current assets of the business concern. Gross Working Capital is
simply called as the total current assets of the concern.
GWC = CA
b. Net Working Capital: Net Working Capital is the specific concept, which considers
both current assets and current liability of the concern. Net Working Capital is the
excess of current assets over the current liability of the concern during a particular
period. If the current assets exceed the current liabilities it is said to be positive
working capital; it is reverse, it is said to be Negative working capital.
NWC = C A – CL
Component of Working Capital
Working capital constitutes various current assets and current liabilities.
Current Assets
 Cash at Bank
 Bills Receivable
 Sundry Debtors
 Short-term Loans Advances
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  Inventories
 Prepaid Expenses
 Accrued Income

Current Liability
 Bills Payable
 Sundry Creditors
 Outstanding Expenses
 Short-term Loans and Advances
 Dividend Payable
 Bank Overdraft
 Provision for Taxation

Types of Working Capital
Working Capital may be classified into three important types on the basis of time.
a. Permanent Working Capital: It is also known as Fixed Working Capital. It is the
capital; the business concern must maintain certain amount of capital at minimum
level at all times. The level of Permanent Capital depends upon the nature of the
business. Permanent or Fixed Working Capital will not change irrespective of time or
volume of sales.
b. Temporary Working Capital: It is also known as variable working capital. It is the
amount of capital which is required to meet the Seasonal demands and some special
purposes. It can be further classified into Seasonal Working Capital and Special
Working Capital. The capital required to meet the seasonal needs of the business
concern is called as Seasonal Working Capital. The capital required to meet the
special exigencies such as launching of extensive marketing campaigns for
conducting research, etc.
c. Semi Variable Working Capital: Certain amount of Working Capital is in the field
level up to a certain stage and after that it will increase depending upon the change of
sales or time.

Needs of Working Capital

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 Working Capital is an essential part of the business concern. Every business concern
must maintain certain amount of Working Capital for their day-to-day requirements and meet
the short-term obligations. Working Capital is needed for the following purposes.
a. Purchase of raw materials and spares: The basic part of manufacturing process is
raw materials. It should purchase frequently according to the needs of the business
concern. Hence, every business concern maintains certain amount as Working
Capital to purchase raw materials, components, spares, etc.
b. Payment of wages and salary: The next part of Working Capital is payment of
wages and salaries to labour and employees. Periodical payment facilities make
employees perfect in their work. So a business concern maintains adequate the
amount of working capital to make the payment of wages and salaries.
c. Day-to-day expenses: A business concern has to meet various expenditures
regarding the operations at daily basis like fuel, power, office expenses, etc.
d. Provide credit obligations: A business concern responsible to provide credit
facilities to the customer and meet the short-term obligation. So the concern must
provide adequate Working Capital.

Working Capital Position/ Balanced Working Capital Position.

A business concern must maintain a sound Working Capital position to improve the
efficiency of business operation and efficient management of finance. Both excessive and
inadequate Working Capital lead to some problems in the business concern.
a. Causes and effects of excessive working capital.
 Excessive Working Capital leads to unnecessary accumulation of raw materials,
components and spares.
 Excessive Working Capital results in locking up of excess Working Capital.
 It creates bad debts, reduces collection periods, etc.
 It leads to reduce the profits.
b. Causes and effects of inadequate working capital
 Inadequate working capital cannot buy its requirements in bulk order.
 It becomes difficult to implement operating plans and activate the firm’s profit target.
 It becomes impossible to utilize efficiently the fixed assets.
 The rate of return on investments also falls with the shortage of Working Capital.
 It reduces the overall operation of the business.

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Factors Determining Working Capital Requirements
Working Capital requirements depends upon various factors. There are no set of rules
or formula to determine the Working Capital needs of the business concern. The following
are the major factors which are determining the Working Capital requirements.
a. Nature of business: Working Capital of the business concerns largely depend upon
the nature of the business. If the business concerns follow rigid credit policy and sell
goods only for cash, they can maintain lesser amount of Working Capital. A transport
company maintains lesser amount of Working Capital while a construction company
maintains larger amount of Working Capital.
b. Production cycle: Amount of Working Capital depends upon the length of the
production cycle. If the production cycle length is small, they need to maintain lesser
amount of Working Capital. If it is not, they have to maintain large amount of
Working Capital.
c. Business cycle: Business fluctuations lead to cyclical and seasonal changes in the
business condition and it will affect the requirements of the Working Capital. In the
booming conditions, the Working Capital requirement is larger and in the depression
condition, requirement of Working Capital will reduce. Better business results lead to
increase the Working Capital requirements.
d. Production policy: It is also one of the factors which affect the Working Capital
requirement of the business concern. If the company maintains the continues
production policy, there is a need of regular Working Capital. If the production policy
of the company depends upon the situation or conditions, Working Capital
requirement will depend upon the conditions laid down by the company
e. Credit policy: Credit policy of sales and purchase also affect the Working Capital
requirements of the business concern. If the company maintains liberal credit policy
to collect the payments from its customers, they have to maintain more Working
Capital. If the company pays the dues on the last date it will create the cash
maintenance in hand and bank.
f. Growth and expansion: During the growth and expansion of the business concern,
Working Capital requirements are higher, because it needs some additional Working
Capital and incurs some extra expenses at the initial stages.
g. Availability of raw materials: Major parts of the Working Capital requirements are
largely depend on the availability of raw materials. Raw materials are the basic
components of the production process. If the raw material is not readily available, it
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 leads to production stoppage. So, the concern must maintain adequate raw material;
for that purpose, they have to spend some amount of Working Capital.
h. Earning capacity: If the business concern consists of high level of earning capacity,
they can generate more Working Capital, with the help of cash from operation.
Earning capacity is also one of the factors which determine the Working Capital
requirements of the business concern.

Computation of Working Capital

Working Capital requirement depends upon number of factors, which are already
discussed in the previous parts. Now the discussion is on how to calculate the Working
Capital needs of the business concern. It may also depend upon various factors but some of
the common methods are used to estimate the Working Capital.
a. Estimation of components of working capital method: Working capital consists of
various current assets and current liabilities. Hence, we have to estimate how much
current assets as inventories required and how much cash required to meet the short
term obligations. Finance Manager first estimates the assets and required Working
Capital for a particular period.
b. Percent of sales method: Based on the past experience between Sales and Working
Capital requirements, a ratio can be determined for estimating the Working Capital
requirement in future. It is the simple and tradition method to estimate the Working
Capital requirements. Under this method, first we have to find out the sales to
Working Capital ratio and based on that we have to estimate Working Capital
requirements. This method also expresses the relationship between the Sales and
Working Capital.
c. Operating cycle: Working Capital requirements depend upon the operating cycle of
the business. The operating cycle begins with the acquisition of raw material and ends
with the collection of receivables.

Operating cycle consists of the following important stages:

a. Raw Material and Storage Stage, (R)
b. Work in Process Stage, (W)
c. Finished Goods Stage, (F)
d. Debtors Collection Stage, (D)
e. Creditors Payment Period Stage. (C)
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 O=R+W+F+D–C

Each component of the operating cycle can be calculated by the following formula:

Average Stock of Raw Material

R=
Average Raw Material Consumption per day
Average Work ∈Process Inventory
W=
AverageCost of Production per day

Average Finished Stock Inventory

F=
Average Cost of Goods Sold per day

Average Trade Debtor

D=
Average Credit Sales per day

Average Trade Creditor

C=
Average Credit Purchase per day

Illustration 6
From the following information extracted from the books of a manufacturing
company, compute the operating cycle in days and the amount of working capital required:
Period Covered 365 days
Average period of credit allowed by suppliers 16 days
Average Total of Debtors Outstanding 480
Raw Material Consumption 4,400
Total Production Cost 10,000
Total Cost of Sales 10,500
Sales for the year 16,000
Value of Average Stock maintained:
Raw Material 320
Work-in-progress 350
Finished Goods 260

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Solution
Computation of Operating Cycle

Average Stock of Raw Material 320

R= = x 365=27 days
Average Raw Material Consumption per day 4,400
Average Work ∈Process Inventory 350
W= = x 365=13 days
AverageCost of Production per day 10,000

Average Finished Stock Inventory 260

F= = x 365=9 days
Average Cost of Goods Sold per day 10,500
Average Trade Debtor 480
D= = x 365=11 days
Average Credit Sales per day 16,000
Calculation of Operating Cycle
O=R+W+F+D–C
Operating Cycle = 27 + 13 + 9 + 11 - 16=44days

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 REFERENCES
Copeland, T.E., and Weston J.F. (1983): Financial Theory and Corporate Policy, 2nd edition,
Carlifonia: Addison-wesley.
Hishleifer, J. (1990): Investment, Interest and Capital, Engllewood Cliffs
ICAN (2014): Strategic Financial Management. Emile Woolf International, Ocean House,
United Kingdom
Olowe, R.A. (2008): Financial Management: Concept Financial System and Business
Finance, Ibadan University Press
Pandey, I.M. (2008): Financial Management. New Delhi: Vikas Publishing
House Company.
Paramasivan, C. and Subramanian T. (2012): Financial Management. New Age
International Publisher

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