WORKING CAPITAL MANAGEMENT | CAP CLASSES

Hi Friends!!!

Student to Software employee.

Street hawker to stock market strategist.

One thing is common.

Dreaming of doing a business and making hell lot of money.

Ask the basic question “what is required to start a business”?

Well, there are many things. Like commonsense to begin with and the list continues to creativity, innovation, situational awareness, idea, concept, plan, resources, skills, risk appetite and etc etc etc.,

Whatever the answer is undisputedly the most vital and key ingredient is CAPITAL.

Whether you want to start a cool bar to a tea shop to manufacturing to servicing whatever the business is, whatever the nature of industry you want to operate in and whatever the product / service is, one thing is common. It needs money.

Money makes money and to make money, money is required.

CAPITAL can be defined as “wealth in the form of money or other assets owned by a person or organization or available for a purpose such as starting a company or investing.”

In layman’s language it is the money required.

There are so many types of capital. But in our context, we need to discuss two types of capital in specific. They are

1)      Fixed capital:

This is the part of money required to purchase fixed assets which are used in production.

Examples include Plant and Machinery, Land and buildings, Motor Vehicles, factory shed, etc. These are used again and again. (Durable use)

2)      Working capital:

Working capital or variable capital is referred to the single use produced goods like raw materials. They are used directly and only once in production. They get converted into finished goods. Money spend on them is fully recovered when goods made out of them are sold in the market. (Single use)

Since you are a student, you can connect with an example of college easily. Imagine, you want to start a college (which you guys feel is a machine of making profits and dunno the risk involved in it); list down what are the things you need to have and money required to procure / manage those things.

The list includes

a)    College Building

b)    Class room furniture (white boards, dual desk benches, chairs, projector, audio visual devices, podium, dais, Air conditioners etc)

c)    Office Furniture (Computers, Systems & network, Office tables, Executive chairs, visitor chairs, fans, lights, shelves, storage systems etc)

d)    Interiors, Partitions, fixtures, moulds etc.

All the above items are either to be purchased or to be taken on lease. This is long term investment decision making. The money involved for procuring the above assets is called fixed capital.

If you think intricate, money required doesn’t end with the above list. Imagine, you have started the college, the next question is, Will you have enough money to pay rents, salaries, electricity bill, water bill, telephone bill, internet bill, payment to vendors for supply of goods and services??? Will your business be able to generate enough money in the first month itself? What about the timing gap between getting revenue collected in the form of fee collections and the payments to be made? How can that be managed? You agreed with a student to collect fee in installments. Next installment is due after 3 months. Will your landlord wait for 3 months to collect his rent? Will a professor wait 3 months to get his honorarium / remuneration? How to bridge the gap?

Money required to pay the above expenses is “Working Capital”.

Working capital is the fund / money required to meet day to day operating expenses and to pay short term trade creditors which is usually calculated as the current assets minus the current liabilities.

Ø  Working capital is also known as operating capital.

Ø  Decisions relating to Working capital and Short-term Financing are referred to as Working Capital Management.

Ø  Involves managing the relationship between a Firm’s Short-term Assets and Short-term Liabilities.

Ø  Objective is to ensure that the firm is able to continue its operations and that it has sufficient cash flow.

Ø  Current Assets are those, which can be converted into cash within a short duration, i.e. generally less than one year.

Ø  Hence Current Assets = Sum of Inventories, Debtors, Cash and Bank Balances, Prepaid Expenses, Loans and Advances, Marketable Investments.

Ø  Current Liabilities are those, which fall due for payment or settlement within a short duration, i. e. generally less than one year.

Ø  Hence Current Liabilities= Sum of Creditors, Outstanding Expenses, Short Term Loans, Bank Overdraft etc.

CONCEPTS OF WORKING CAPITAL

There are two concepts of working capital, namely, Gross Concept and Net Concept.

a) Gross Working Capital:

Ø  It refers to the firm’s investment in current assets.

Ø  Current assets refers to the assets which are held for their conversion into cash within an operating cycle i.e., time duration between the conversion of cash into inventory items (raw-materials in case of a manufacturing firm and finished goods in case of a trading firm) and receivables and their conversion into cash.

b) Net Working Capital

Net Working Capital is a Qualified Concept, which indicates

a)      Liquidity position of the firm as it represents safety margin available to short term creditors so as to discharge their obligations within an operating cycle.

b)      That part of the current assets which should be financed with long term funds such as equity share capital, preference share capital, debentures, long term borrowings.

Gross Working Capital = Sum of Current Assets

Net Working Capital = Current Assets – Current Liabilities

FACTORS DETERMINING THE WORKING CAPITAL

SOURCE OF FINANCING WORKING CAPITAL

Current Liabilities are source of funds in the sense that these finance Current Assets. For example, a company buys stocks of raw materials for cash. It implies that company is financing raw material stock from its internal sources. Suppose the company gets a two months credit for the same purchase. It implies the stock is financed by creditors.

      APPROACHES TO ESTIMATION OF WORKING CAPITAL REQUIREMENTS:

Working Capital Requirements can be forecast in two ways:

ü  By reference to the Operating Cycle

ü  By estimation of each component of current assets and current liabilities

The second method is more popularly used in practice.

The two approaches in the estimation of working capital requirements are:

1)      Total Approach:–All expenses and profit margin are included.

2)      Cash Cost Approach:-Only Cash expenses (excluding depreciation) are included.

      OPERATING CYCLE

1. Operating cycle is also known as working capital cycle or cash cycle.
2. It indicates the length of time between a company paying cash for raw materials, converting raw materials into work in progress and finished goods, selling stock of finished goods and receiving cash from debtors.
3. Operating cycle can be determined by adding number of days of each stage in operating cycle.
4. It is expressed in terms of number of days or months.

Operating Cycle in a Manufacturing Firm:

Ø  to convert cash into inventory of raw materials

Ø  to convert inventory of raw materials into work-in-progress;

Ø  to convert inventory of work-in-progress into finished goods;

Ø  to convert inventory of finished goods into receivables;

Ø  to convert receivables into cash

WC = R + W + F + D - C

R  = Raw material storage period

W = Work in progress holding period

F = Finished goods storage period

D = Debtors collection period

C = Credit period allowed by Creditors

2	No of operating cycles in a year	365    Operating cycle
3	Working Capital required	Annual Cash operating expenses No of operating cycles in a year OR Annual Cash expenses * Operating cycle                                              365

Increase or decrease of operating cycle

Sl No	Situation	Impact on Operating cycle
1	Collect receivables faster	OC decreases because cash is released from cycle
2	Collect receivables slower	OC increases because cash is blocked in cycle
3	Creditors payment period increased	OC decreases
4	Creditors payment period decreased	OC increases
5	Move inventory faster	OC decreases
6	Move inventory slower	OC increases

Various components of operating cycle can be calculated with the help of following formulas

SL NO	COMPONENT	FORMULA
1	Raw Materials holding period	AVERAGE STOCK OF RM * 360 RM CONSUMED
2	WIP holding period	AVERAGE STOCK OF WIP * 360 WORKS COST
3	Finished goods holding period	AVERAGE STOCK OF FG * 360 COGS
4	Debtors Collection period	AVERAGE DEBTORS * 360 CREDIT SALES
5	Creditors payment period	AVERAGE CREDITORS * 360 CREDIT PURCHASES

Working Capital can also be calculated with the help of current assets and current liabilities as shown below.

NOTES:

Sl No	Particulars	Determinants	Formula
1	Raw materials	RM Consumption & RM HP	Annual Consumption of RM * RMHP 365
2	WIP	Works Cost & WIP HP	100% (RM) + 50% (W+OH) * WIPHP 365
3	Finished Goods	Total Cost & FG HP	Total Cost * FGHP 365
4	Debtors	Credit Sales & ACP	Credit Sales * ACP 365
5	Creditors	Credit Purchases & CPP	Credit Purchases * CPP 365