FINANCIAL MANAGEMENT (PART-6) WORKING CAPITAL MANAGEMENT 1. INTRODUCTION Dear Student Welcome to the lecture series on Financial Management. Today in this lecture we shall cover the topic Working Capital Management. Under Working Capital Management, we shall cover the introductory part 1. Meaning of Working Capital 2. Purpose of Working Capital 3. The various types of Working Capital And 4. Operating Cycle The objective of this lecture is to understand the conceptual framework of working capital management, the meaning of working capital based on concept i.e. balance sheet concept that is Gross working capital and Net working capital. We shall also learn the meaning of working capital based on Time that is permanent working capital and temporary working capital and the how the working capital is used in a stable firm and in a growing firm. We shall also learn the purpose for which the working capital is being used and finally we shall learn the meaning of operating cycle, the length of operating cycle, manner of computation of the operating cycle and the example to illustrate the operating cycle mechanism. 2. MEANING AND PURPOSE OF WORKING CAPITAL Working capital refers to the fund which needs to be invested in the short -term assets or current assets, meaning thereby, those assets which are required in running day to day business such as – 1. 2. 3. 4. Cash Marketable Securities Receivables Inventories It is a form of short term loan which we require to acquire the short term assets. Elaborating it we can say that any balance sheet item that represents the current liquidity position of the firm are being financed by a fund called working capital that is it is the dedicated fund which we require to use in our business. Let us learn the definition of the working capital. Working capital refers to that part of the firm’s capital, which is required for financing short-term or current assets such as cash, marketable securities, receivables and inventories. Thus, funds invested in current assets keep revolving fast and are constantly converted into cash and this cash flow out again in exchange of other current assets. Working capital is also known as revolving or circulating capital. Let us analysis this definition. This definition holds two parts 1. First part says that it is a dedicated fund which we are using for acquiring for the current assets. What are the current assets? Current assets are those assets are those balance sheet items which are represented on the asset side of the balance sheet. They are such assets which are being used for less than one year and they can be converted easily into money. They are also called earning assets because our day to day business activities are running on, on the basis of these assets. They are different from fixed assets because fixed assets are used for a longer period. For example, fixed assets are Plant and Machinery which can be acquired once and can be used for a longer period around 5 to 10 years while stock is a current asset because it is coming to an end as and when a production cycle is ending. This is the basic difference between current assets and fixed asset. Under working capital we are focusing our attention towards these assets which are easily converted into money. 2. It puts its emphasis on the revolving capital meaning thereby that the cash is being used for acquiring current assets i.e., stock. Again when this stock is being sold on credit and the receivables are generated. The time receivables are converted into cash again we are getting cash inflow. These cash flows will again be used in purchasing inventories. So what we are generating in current assets we are putting it back in the other form of current asset. This is called the revolving working capital or circulating working capital. Purpose of the Working Capital: We know that working capital is being used for financing the short- term assets. Very specifically, working capital is required 1. To hold cash for acquiring the raw material. 2. To hold work in progress for the production process meaning thereby the period required for transforming the work in progress into finished product. For that particular period we are in need of fund which is being generated by working capital or financed by working capital. 3. To hold the finished goods up till it is reaching the final consumer for meeting their continuous demand or to meet a sudden demand or seasonal demand we are requiring working capital fund. 4. We require Working capital for the period receivables are being converted into cash. Primarily they are being used in following hierarchy; This is the cycle moving in a working capital management. We know that stock has three elements. Under working capital, we are putting our putting our emphasis on Management of receivable, Management of cash Management of inventories Under management of inventories, we need to look at the aspect of raw material, work in progress and finished goods. We can use different techniques like economic order quantities and other models by which ordering cost and carrying cost can be minimized and be controlled. The procurement can be controlled. We need to do this exercise so that there is uninterrupted flow of inventories in the production process. Working capital is required to ascertain the need of fund for our production process so that production may not get hampered because of the lack of fund. Secondly, we need working capital in a sufficient quantity. If we block the working capital in all short -term asset even then it is harmful to the business as we are not using or circulating the cash as it is being required. So this is the purpose for which working capital is needed in a business organization. How efficiently we can use this working capital is called the management of working capital. 3. TYPES OF WORKING CAPITAL There are broad two categories under which we will learn the concept of working capital. 1. Balance sheet concept 2. Operating Cycle concept. Balance sheet Concept has recognized working capital as a. Gross Working Capital b. Net Working Capital Gross Working Capital means - The total of all current assets or all short-term assets. Current assets here mean cash, marketable securities, inventories and receivables. They are meant for a lesser period. They represent liquid asset. - Gross working capital represents the liquidity position of the organization. That this much of the asset they are holding for Getting readily available as the cash in the business. Net Working Capital It is a broader concept. It works on the principle on solvency. It is more appropriate concept while analyzing the financial position of an organization. The corporate experts are using net working capital as a medium to evaluate the short-term financial position of the organization. What do we mean by Net working capital? Net working capital means excess of current assets over current liabilities. Current assets we all know are cash, marketable securities, receivables and stock. Assuming them to be Rs.100/- and our current liabilities that means trade creditors, outstanding expenses they all shall form part of current liabilities. Assume them to be Rs. 70/- the working capital will come out to be This is the formula by which we can assess the net working capital of the organization. Going ahead it can be represented in another formula which is used for analyzing the ratios. Its formula is Ideally it should be 2:1. That means the current assets should be double the current liabilities. An organization should have at least double the amount of readily convertible assets so that it can pay off its liabilities in a much better manner. These are the two types of working capital calculations based on Balance sheet concept. Next one is Operating Cycle concept Operating cycle means the time period between procurement of supplies and collection of cash through receivables and inventories. We will learn the concept of operating cycle in detail later on. Let see this presentation of working capital. We have classified working capital broadly in two concepts. On the basis of Balance Sheet – i.e. Gross Working and Net working CapitaLand another is based on Time. Let’s learn what the working capitals which are based on time. It can be permanent working capital or it is also known as fixed working capital and other is Temporary working and it is also known as variable working capital. Now permanent working capital also has two sub-categories first one is Regular working capital and other is Reserve Working capital. Similarly temporary/ variable working capital also has two parts 1. Seasonal Working 2. Special Working. Let us learn them one by one. First one we are elaborating is permanent working capital. a. Permanent Working CapitalIt refers to a certain minimum level of current assets which is essential for the firm to carry on its business irrespective of its level of operation. For example, there is a bakery. The bakery requires minimum of 2 bags of flour every time in their stores. For this they need a permanent stock and they will dedicate fund for acquiring this fixed level of inventory. It is suggested that this inventory can be purchased or it should be financed by long term fund because it is a permanent requirement. We can say that permanent working capital is that source of fund which is invested in acquiring a minimum fixed level of inventory irrespective of level of operation. Irrespective of Level of operation means whether 100 units are being produced or 200 units are being produced or nil unit is being produced, this much amount of inventory should be maintained by the management in the organization. b. Variable Working Capital-is that requirement of fund which is Over and above the fixed minimum working capital. It is not that dedicated fund as that of permanent working capital. 4. USE OF WORKING CAPITAL IN STABLE FIRM AND GROWING FIRM In case of stable firm, the permanent working capital is stable over time and takes the shape of a horizontal line while temporary working capital is fluctuating – sometimes increasing and sometimes decreasing. Both these kind of working capitals are shown in this graph. Let us see these colored lines on the graph. This blue line is presenting the permanent working capital to the X axis. This fluctuating line is showing temporary working capital, the arrows are showing how the difference in both the type of working capital is there. In the case of growing firm, the graph has changed. The requirement of permanent working capital is sometime increasing or it is increasing with the increase in the production. Let us see how the mechanism of permanent working capital and temporary working capital is being managed in a growing firm with the help of the graph. The permanent working capital may also keep on increasing over time to support a rising level of activity and hence permanent working capital line may not always be horizontal. Both these kinds of working capitals are shown in the graph. As level of activity is increasing that means earlier we were producing 100 units, now 200 units are being produced afterward 500 units are produced since this is a growing firm a fixed amount of working capital is blocked for the irreducible inventory with the passage of time while temporary working capital has a fluctuating line shown in the graph. 5. OPERATING CYCLE Operating cycle is the time lag between the procurement of supplies and collection of cash from receivables. How this operating cycle is managed? There are certain phases in which this operating cycle works. In the case of trading concern, the length of the operating cycle will beUsing of cash for procurement of trading goods, Then selling them on credit so receivable will be generated And when receivable will be converted into cash again we are getting the liquidity in our hand. This cash will again be used in purchase of trading goods. LENGTH OF OPERATING CYCLE IN A TRADING CONCERN LENGTH OF OPERATING CYCLE IN A MANUFACTURING CONCERN When the concern is manufacturing, the phase in inventory cycle will increase. The inventory will hold three parts So in that case, the cash will be used first to procure raw material then we will be needing cash for procuring work in progress and then this work in progress is transformed into finished goods, then it is being sold on credit so receivables will be there and finally we will get back the cash. So this time lag between conversion of finished goods and work in progress and finished goods and holding of raw material during this period whatever fund we are requiring is called working capital used in an operating cycle. This operating cycle will be computed in number of days. There are specific formulas requiring for computing the days in operating cycle. Now let us learn the components of operating cycle. The components of operating cycle are represented in symbolic manner they are called R W F D C Components of Operating Cycle Adding R, W, F D we are getting Gross operating period. When we subtract C from it, we will get Net operating Cycle. C represents the credit period allowed by supplier. And it shall also include the time lag for the expenses. These outstanding expenses period will also be considered in C. With this we have learnt how the computation of operating cycle will be done. Now there are certain formulas from which R, W, F D and C are computed. Let see them on screen. Now we have to compute no of cycle i.e., how many operating cycles has to be run in a year. Net operating cycle has been computed using the equation. R+W+F+D-C 6. SUMMARY Let us summarize what we have learnt in today’s lecture. We have learned meaning of Working capital, what is gross working capital ,how the net working capital is being computed, what are purpose for which working capital is required, types of working capital based on time i.e., permanent working capital and temporary working capital. We have also learnt the mechanism of computing operating cycle. Thank You Students !