Business and Management Review Vol. 1(4) pp. 73 – 78, June, 2011
Available online at http://wwww.businessjournalz.org/bmr
ISSN: 2047 - 0398
FINANCIAL ANALYSIS THE WORKING CAPITAL
Dr. Ahmed Arbab
Department of Business Administration, Delmon University, P.O. Box 2469
Exhibition Avenue Manama, Kingdom of Bahrain
E-mail: ahmed_arbab@delmon.bh
Dr. Bashar Matarneh
Department of Business Administration, Delmon University, P.O. Box 2469
Exhibition Avenue Manama, Kingdom of Bahrain
E-mail: b_mata10@hotmail.com
ABSTRACT
The registration technique is a very useful statistical technique of working capital forecasting. In the sphere of
working capital management, it helps in making projection after establishing the average relationship in the
past years between sales and working capital (current assets) and its various components. The Analysis can be
carried out through the graphic portrayals (scatter diagrams) or through mathematical formula. This method
with the range of technique suitable for simple as well as complex situations is an undisputed refinement; it's a
traditional approach of forecasting and determining working capital requirements and is particularly suitable
for long-term forecasting.
Keywords: working capital, current liabilities, Organization, of Operations, Business Cycle, Efficiency,
Owners Equity
INTRODUCTION
Meaning and Definition: In a general sense working capital means that part of total capital which is available
and used for carrying out the routine regular business operations. Thus the capital required purchasing the raw
material and to pay wages etc. is called working capital. But in view of financial analysis the working capital
has some different meaning. In their view it is the excess of current assets over current liabilities. Current assets
are defined by the American Institute of certified Public accounts as "Cash and other assets or resources
commonly identified as those which are realized in Cash or sold or consumed during the normal operating cycle
of business." Current liabilities are defined as “obligations whose liquidation is reasonably expected to require
the use of existing resources properly classifiable as current assets or the certain of current liabilities.”
Thus the current assets are those assets, which can be converted into cash within a brief period of time, say not
more than one year. Without any decrease in their values or without effecting business operations. Current
liabilities mean such liabilities which are to be paid with in a course of accounting year from the business
income. Current assets generally include cash in hand, cash at bank. Bills –receivables debtors less provisions,
work in progress, investments, which are realizable within a short period of time whereas current liabilities,
include trade creditors, bank loan, bills payables and other short -term liabilities. Thus, the working capital is
measured by subtracting the current liabilities from current assets. If the current assets are less than current
liabilities then there will be no working capital at all, in fact there will be a deficit of working capital.
FACTORS DETERMINING THE WORKING CAPITAL:
There are so many factors, which determine the capital. The following factors may act as guidelines for textile
industry in India & Jordan
.
i) Nature of Concern:
Public utility and heavy Industries such as textile industries require lesser working capital as compare to that of
manufacturing industries because such industries require huge investments in fixed assets rather than in current
assets.
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Business and Management Review Vol. 1(4) pp. 73 – 78, June, 2011
Available online at http://wwww.businessjournalz.org/bmr
ISSN: 2047 - 0398
ii) Gestation Period:
Certain industries have long gestation period with the result that a considerable number of years must elapse
before production. Operations can be carried on profitably, during this period. Either there is no income or
income is insufficient. Thus the need for working capital for gestation period will be greater.
iii) Time-lag-between Production and Sales:
If smaller is the time lag between production and sales, the working capital requirements will be less and viceversa. The reason is that there shall be smooth, prompt, regular and timely flow and funds into the business
calling for smaller amount of working capital.
iv) Credit Policy of the Organization:
The credit, which the organization expects to allow and receive, will have to be considered. If the period of
credit allowed to customers is larger than the period of the realization, a larger amount of working capital will
needed. The total amount of credit received and allowed, besides the period of credit, will also be considered
received. The cash requirements will be as certained by deducting the total amount of credit received.
INVENTORIES:
Usually inventory is the only item of highest value of all the components of current assets in textile industry. It
is obvious that serious attention should be given to this area. Inventories represent the second largest assets
category for manufacturing companies, next only to plant and equipment. Since huge investment is involved in
inventories or the cost of materials forms major portion of the cost of production, it is absolutely imperative
investment to manage inventories efficiently in order to avoid unnecessary investment in them. A firm
neglecting the management of inventories will be jeopardizing its long run profitably and may fail ultimately. So
if the firm fails in managing its inventories on proper lines its long run profitably is affected and may fail
ultimately because the high inventories are considered or regarded as graveyards of business
The manufacturing firms generally have three kinds of inventories:
1) Raw materials
2) Work-in-process
3) Finished goods
Raw Material: Raw material inventory gives the firm flexibility in its purchasing, without which the "firm
exists on a hand-to-mouth basis; buying raw materials strictly in keeping with its production suffers. Sometimes
the raw materials are also purchased in bulk-to take advantages of quantity discount.
Work-In-Process: Work-in-process comprises items, which are at various stages of production period, which is
the time between placing raw materials in production and completing the finished product.
Finished Goods: Finished goods include completely manufactured and inspected goods that are ready for sale.
Inventory management should minimize the investment in inventory and costs of managing that inventory,
while at the same time ensuring a sufficient inventory to meet customer demand. However, holding inventories
entail cost to a firm. The firm has to incur a host of costs to carry inventories, such as capital cost, service cost
and storage cost. Deterioration cost, obsolete cost. Few of these costs are fixed while others are variable.
Besides, the firm has to incur acquisition cost to affect delivery of inventory items to the firm. Such costs
include order costs.
Thus, additional inventory holding is beneficial to the firm but at the same time it entails certain costs.
Therefore, company has to determine optimal level of inventory to be maintained. By using the technique of
economic Ordering Quantity (EOQ), it is possible to determine optimal size of its inventory. It determines the
amount of inventory to be ordered, at a particular time so that the total of ordering and carrying cost is reduced
to a minimum. In addition, the financial manager should maintain records accurately. So as to direct slow selling
items and to know when re-order, considering the lead-time between the placement of the order and receipt of
the goods. In a nutshell, it can be said that the efficiency with which the firm is managed depends upon its
inventory management. The great efficiency, the lower the required investment tied in inventory, and the greater
shall be the improvement in shareholders wealth, of course, other things remaining the same.
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Business and Management Review Vol. 1(4) pp. 73 – 78, June, 2011
Available online at http://wwww.businessjournalz.org/bmr
ISSN: 2047 - 0398
Bills Receivables: The term, Receivable represents credit sales that have not been collected. Bill receivables
represent the extension of credit on an open account by the firm to its customers. Most of the manufacturing
firms find that accounts receivables represents a large portion of their current assets.
A great deal of attention is normally given to the efficient management of, receivables in an enterprise which
involves decisions related to the policy variables such as credit standards, credit period, discounts given for
tightness or laxity. Taken together these policy variables, determine the magnitude of the investment in accounts
receivables and the return thereon. In order to maximize profit arising from credit and collection policies, an
enterprise should evolve out a system in such a manner so as to achieve the best combination of credit standards,
credit period, cash discount policy and level of collection expenditures.
Short -term Investments: It has become a practice to all business units now days, to invest the surplus cash in
securities on which the rate of return is expected in the form of interest/dividend received or capital
appreciation.
Cash and Bank Balances: Cash management is one of the key areas of working capital management. “Apart
from the fact that it is the most liquid current assets, cash is the common denominator to which all current assets
can be converted because the other major liquid assets, that is receivables and inventory also gets eventually
converted into cash.” “Cash imparts life and strength - profit and solvency to the business organization.” The
cash shortage leads a firm into a state of technical insolvency and even to liquidation. However, if the cash
balance is surplus with the firm, it is obvious that the finances are mismanaged. Therefore smooth running,
proper and efficient cash management is very important.
Pre-Paid Expenses: A pre-paid expense is the amount paid in advance to the suppliers for which the goods or
services have not yet been received.
Current-Liabilities: The investment of current assets by using short-term liabilities will also cover working
capital management. The current liabilities are those, which are short-term maturing obligations to be met,
normally within a year, consist of trade creditors, short term borrowings, bank over draft, tax payments due,
dividends payable and outstanding expenses .
Trade Creditors: Trade creditors are one of the major sources of funds to finance inventories. The period and
volume of this type of credit varies from industry to industry and in an industry from firm to firm. The important
advantage of trade credit is that it has generally no cost if discount is not apart of credit terms. But the basic
limitation of trade credit is that originally it is available in the form of goods or services only
Short-term Borrowings: Short-term borrowings include bank credit, public deposit and funds from other
miscellaneous sources such as selling commercial papers and issuing of short-term promissory notes. These
differ from bank overdrafts to the extent that there is fixed time period and rate of interest is also fixed or semifixed at the beginning of the loan. This is one of the major sources of financing the working capital requirements
of a firm.
Bank Overdrafts: Bank overdraft facilities consist of an agreed line of credit on which an enterprise can draw
current account cheque at agreed rate of interest. Technically the overdraft can be repayable at call but in
practice, banks normally fixed longer time period, within which the firm must eliminate the overdraft or reduce
it to a lower level
.
Tax Payment Dues: Taxes due for the payment within a year can be shown as current liability.
Proposed Dividend: The final dividend is not officially declared until the annual general body meeting, and so,
no cash leaves the company in respect of this until possibly six months after the year-end.
In this chapter the main focus of discussion is on current assets management. References to current liabilities
have been made to associate it with the current assets. In this study, the net working capital concept has been
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Business and Management Review Vol. 1(4) pp. 73 – 78, June, 2011
Available online at http://wwww.businessjournalz.org/bmr
ISSN: 2047 - 0398
adopted. It is the excess of current assets over current liabilities, which matters in the long run. The net working
capital concept helps the creditors and investors to judge the liquidity position of an enterprise. It is to be
mentioned here that both the director of commercial audit and government of India have followed the “Net
concept of working capital” for calculation of amount of working capital.
Chart 3.2: Types of Working Capital
Net Working Capital
Gross Working Capital
Permanent Working Capital
Variable Working Capital
Balance sheet Working Capital
Cash Working Capital
Negative Working Capital
Source: P. V. Kulkarni. B. G. Satya Prasad, Financial Management, New Delhi, Himalaya Publishing House,
1999, P. 677
Hedging: Total current assets are financed by a combination of long-term and short-term funds. The long-term
source of finance provides support for a small portion of current assets requirement, which is called as the
working capital margin. Total current assets can be divided into two parts:
1) Permanent current assets
2) Temporary or fluctuating current assets
Permanent current assets are those that persist overtime while temporary current assets are fluctuating with
sales. Long-term borrowings may be equal to or less than or more than permanent working capital. Matching of
long-term borrowings and permanent working capital IS called “HEDGING”. This type of decision is very
important in working capital management. The term hedging is used here to mean matching expected cash
inflow from assets with flows from their respective source of financing. There are three types of hedging
generally observed in textile mills:
1) Perfect hedge
2) Conservative hedge
3) Aggressive hedge
Perfect Hedge (Matching Approach): The perfect hedge consists of financing temporary current assets with
short-term sources of fund while fixed assets and permanent current assets with long-term sources of funds. This
type of hedging is most preferable, but it is observed in identified textile mills, it may not be possible to arrange
the funds in such a perfect manner.
Diagram 1.1
Y
Short Term Financing
Temporary Current Assets
Amount in (Rs./JD)
Long-term Financing
Permanent Current Sale
Fixed Assets
1
2
3
4
5
6
X
Source: Management Accounting & Financial Analysis, BOD, ICAIA, Noida, 2000, P. 104.
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Business and Management Review Vol. 1(4) pp. 73 – 78, June, 2011
Available online at http://wwww.businessjournalz.org/bmr
ISSN: 2047 - 0398
Conservative Hedge: When the textile mills relies more on long-term fund for financing its current assets, the
approach is said to be conservative or cautions, it is of certainly lower risk and imports better solvency, but at
the same time adversely affects the profitability. In the conservative hedge, all the fixed assets, all permanent
current assets and part of temporary current assets are financed with long term sources of funds.
Diagram No. 1.2
Short term financing
Years (times)
Long-term Financing
Amount in (Rs./JD) Y
Temporary Current Assets
1
2
3
4
5
6
X
Source: 1M Pandey, Financial Management, New Delhi, Vikas Publishing House Pvt. Ltd. 2002, P. 829
It is to be noted from the above diagram that the time period marked as x and amount marked as y in the
diagram show surplus cash released on account of very low level of fluctuation current assets. This surplus has
to be invested in short-term investment channels from which it can be converted into cash promptly.
Aggressive Hedge: When a textile mill uses more short-term financial than warranted by matching plan, it is
called aggressive hedge. It makes the mill more risky but profitability is also increased. In the aggressive hedge,
all the temporary current assets and part of the permanent current assets are financed with short-term sources of
funds. The remaining portion is financed with long-term funds. It is observed from below diagram the major
part of permanent
current assets by short-term financing through short-term funds
.
Diagram 1.3
Y
Short Term or
Temporary Financing
Years (time)
Temporary Current Assets
Fixed Assets
1
2
3
4
5
6
Source: I.M Pandey, Financial Management, New Delhi, Vikas Publishing House Pvt.
X
Permanent plus
Spontaneous Financing
Amount in (Rs./JD)
Permanent Current Assets
Ltd. 2002, P. 829
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Business and Management Review Vol. 1(4) pp. 73 – 78, June, 2011
Available online at http://wwww.businessjournalz.org/bmr
ISSN: 2047 - 0398
SUMMARY
Liquidity of the working capital. The requirement of working capital in textile mills differs according to the
capacity of the mills. The arrangement of such working capital is generally made from the banks as a term loan
or cash credit and private borrowing. Some funds are always in the pipeline and are tied up in inventories;
receivable and day-to-day cash payment requirements.
However, the owner also enjoys credit facilities from his suppliers who may give raw materials and other
consumable articles on credit. Similarly, some expenses may not be payable immediately. The workers are also
paid periodically. A certain amount of funds is therefore automatically available to finance the current assets
requirements. The relevant data concerning current assets, loan and advance to employees, current liabilities and
provisions of the sample textile industry is given in the following diagram and tables to facilitate analysis of the
working capital of identified industry.
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Brigham and Johnson, Issues in Managerial Finance, The Dryden Press, I Illinois 1.
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