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Unit 6 - Notes

FIN212

Unit 6: Working Capital Management

1. Introduction to Working Capital

Working capital is the lifeblood of a business organization. It represents the funds available to meet day-to-day operating expenses and is distinct from fixed capital, which is used to purchase long-term assets.

Concepts of Working Capital

There are two primary concepts of working capital:

  1. Gross Working Capital:

    • Refers to the firm's investment in Current Assets (assets that can be converted into cash within an accounting year).
    • Includes cash, marketable securities, accounts receivable, and inventory.
    • Significance: It focuses on the optimization of investment in current assets.

  2. Net Working Capital (NWC):

    • Defined as Current Assets minus Current Liabilities.
    • Formula:
    • Significance: It indicates the liquidity position of the firm and the extent to which working capital is financed by permanent sources of funds.
      • Positive NWC: Current assets > Current liabilities (Solvent).
      • Negative NWC: Current assets < Current liabilities (Potential liquidity crisis).

Classification of Working Capital (Time-Based)

  1. Permanent (Fixed) Working Capital: The minimum level of current assets required continuously to operate the business (e.g., minimum stock of raw materials).
  2. Temporary (Variable) Working Capital: The additional capital required to meet seasonal demands or special exigencies (e.g., extra inventory for the holiday season).

2. Working Capital Determinants

The amount of working capital a firm needs is not static; it depends on various internal and external factors:

  • Nature of Business:
    • Manufacturing/Trading firms typically require high working capital for inventory and receivables.
    • Service/Utility firms (like railways or electricity) typically require low working capital as they have cash sales and no inventory.
  • Size of Business: Larger operations generally require higher absolute levels of working capital, though the ratio to sales might decrease due to economies of scale.
  • Production Cycle: The time gap between raw material purchase and finished goods production. A longer production cycle ties up funds longer, increasing working capital needs.
  • Business Cycle:
    • Boom: Higher sales, higher production Higher working capital.
    • Recession: Sales drop, inventory piles up (unintentionally), but generally requirements decrease over time.
  • Seasonality: Industries with seasonal peaks (e.g., woolen garments) require high working capital during the peak season to hold inventory and manage receivables.
  • Credit Policy:
    • Credit Allowed: Liberal credit terms to customers increase receivables, thereby increasing working capital needs.
    • Credit Availed: If suppliers grant liberal credit terms to the firm, the need for working capital decreases.
  • Growth and Expansion: Growing firms require more funds to support increased scale of operations.
  • Availability of Raw Materials: If raw materials are scarce, firms may buy in bulk when available, increasing inventory holding costs and working capital.

3. The Operating Cycle

The operating cycle represents the time duration required to convert sales after the conversion of resources into inventories, into cash. It tracks the flow of funds through the business.

Phases of the Operating Cycle

  1. Raw Material Conversion Period: Time taken to convert raw material into Work-in-Progress (WIP).
  2. Work-in-Progress Conversion Period: Time taken to convert WIP into Finished Goods.
  3. Finished Goods Conversion Period: Time goods remain in the warehouse before being sold.
  4. Receivables Conversion Period: Time taken to collect cash from debtors.

The Cash Cycle

The Operating Cycle tracks the asset side. The Cash Cycle accounts for the credit provided by suppliers.

Formula:

  • Goal: A shorter operating cycle is generally preferred as it indicates higher liquidity and less reliance on external financing.

4. Liquidity and Profitability Trade-off

Working capital management is essentially a trade-off between liquidity (solvency) and profitability.

The Conflict

  • Liquidity: The ability to meet short-term obligations. High liquidity implies holding large cash balances and high inventory levels. This ensures safety but results in idle funds that earn no return.
  • Profitability: The ability to earn returns. To maximize profit, a firm should minimize idle assets. However, aggressive reduction of current assets increases the risk of stock-outs or inability to pay creditors.

The Trade-off Matrix

  1. Conservative Approach (High Liquidity, Low Profitability):
    • High investment in current assets.
    • Financed by long-term funds.
    • Risk: Low. Return: Low.
  2. Aggressive Approach (Low Liquidity, High Profitability):
    • Low investment in current assets.
    • Relies heavily on short-term financing.
    • Risk: High. Return: High.
  3. Matching (Hedging) Approach:
    • Matches the maturity of assets with the maturity of financing (Temporary assets financed by short-term debt; Permanent assets by long-term debt).

Conclusion: Financial managers must determine the Optimal Working Capital Level, where the balance between risk (liquidity) and return (profitability) is maximized.

5. Inventory Management

Introduction

Inventory constitutes a significant portion of current assets. It includes Raw Materials, Work-in-Progress (WIP), Finished Goods, and Stores/Spares.

Objectives

  1. To ensure a continuous supply of materials for uninterrupted production.
  2. To minimize the total cost of inventory (Ordering Costs + Carrying Costs).
  3. To avoid overstocking (capital blockage) and understocking (production stoppage).
  4. To maintain reasonable prices by utilizing economies of scale.

Need for Holding Inventory

  1. Transaction Motive: To facilitate smooth production and sales operations.
  2. Precautionary Motive: To buffer against unpredictable shocks (strikes, transport delays, demand surges).
  3. Speculative Motive: To take advantage of price fluctuations (buying cheap now to use when prices rise).

Techniques of Inventory Management

  1. Economic Order Quantity (EOQ):
    • Calculates the ideal order size that minimizes the sum of Ordering Costs and Holding Costs.
    • Formula: (Where A = Annual demand, O = Ordering cost, C = Carrying cost per unit).
  2. ABC Analysis (Always Better Control):
    • Classifies inventory based on value/usage.
    • A Items: High value, low quantity (Strict control required).
    • B Items: Moderate value, moderate quantity (Moderate control).
    • C Items: Low value, high quantity (Loose control).
  3. Just-In-Time (JIT):
    • A Japanese philosophy where inventory is acquired only when needed for production, reducing holding costs to near zero. Requires highly reliable suppliers.
  4. Re-order Level (ROL):
    • The inventory level at which a new order must be placed.
    • Consideration involves lead time and safety stock.
  5. VED Analysis:
    • Used primarily for spare parts: Vital, Essential, Desirable.

6. Cash Management

Introduction

Cash is the most liquid asset but the least profitable. Cash management involves managing the cash flows (inflows and outflows) and the cash balance within the firm.

Objectives

  1. Meet Payments: To have enough cash to meet obligations as they fall due (solvency).
  2. Minimize Idle Cash: To keep cash balances at a minimum to maximize investment in income-generating assets.

Need for Holding Cash (Keynesian Motives)

  1. Transaction Motive: For day-to-day payments (wages, bills, creditors).
  2. Precautionary Motive: Buffer for unexpected contingencies.
  3. Speculative Motive: To exploit opportunities (e.g., sudden drop in raw material prices).
  4. Compensating Motive: Banks often require clients to keep a minimum balance to offset service costs.

Techniques for Cash Collection (Speeding up Inflows)

The goal is to reduce Float (the time difference between when a customer sends a check and when the funds are usable by the firm).

  1. Concentration Banking:
    • The firm establishes collection centers in various regions closer to customers.
    • Local checks are deposited locally (clearing faster) and then transferred to a central "concentration account."
  2. Lockbox System:
    • A step further than concentration banking. Customers mail payments to a PO Box (Lockbox) managed by the firm's bank.
    • The bank picks up mail several times a day, processes checks immediately, and credits the firm. This eliminates processing float within the company.
  3. Electronic Funds Transfer (EFT):
    • Direct transfer of funds via online banking systems (ACH, Wire Transfers), eliminating mailing and check-clearing time entirely.
  4. Pre-authorized Checks (PAC):
    • The firm draws a check on the customer's account with prior permission (common for recurring payments like insurance premiums).

7. Receivables Management

Introduction

Receivables (Debtors) represent credit sales. Granting credit is a marketing tool to expand sales, but it carries costs (opportunity cost of funds, collection costs, bad debt risk).

Nature of Credit Policy

A firm's credit policy is the set of guidelines determining:

  1. Who gets credit.
  2. How much credit they get.
  3. The payment terms.
  4. The actions taken for late payments.

Credit Policy Variables

Financial managers manipulate these variables to optimize the balance between increased sales and increased costs:

  1. Credit Standards:

    • The criteria a customer must meet to qualify for credit.
    • The 5 C’s of Credit:
      • Character: Customer's willingness to pay.
      • Capacity: Ability to pay (cash flow).
      • Capital: Financial reserves/net worth.
      • Collateral: Assets pledged as security.
      • Conditions: Economic environment affecting the customer.
    • Impact: Strict standards = Lower sales, Lower bad debts. Loose standards = Higher sales, Higher bad debts.

  2. Credit Period:

    • The length of time allowed for payment (e.g., Net 30 days).
    • Extending the period usually stimulates sales but increases the operating cycle and capital costs.

  3. Cash Discount:

    • Incentives for early payment (e.g., "2/10, net 30" means a 2% discount if paid in 10 days, otherwise full amount due in 30).
    • Benefit: Speeds up cash inflow and reduces bad debt risk.
    • Cost: Reduced profit margin per unit.

  4. Collection Policy:

    • The procedures followed to collect past-due accounts (reminders, letters, phone calls, legal action).
    • A rigorous policy reduces bad debts but may damage customer relationships.