WORKING CAPITAL MANAGEMENT

CHAPTER 1
INTRODUCTION

1.1 INTRODUCTION TO THE STUDY

Finance is an important function of any business, as money is required to meet the various
activities of it. It has given birth to “Financial Management” as a separate subject. The subject is of recent
origin. It draws heavily on “Economics” for its theoretical concepts. In the early half of the 20 th century
the job of financial management was largely confined to the acquisition of funds. But as business firms
continued to expand their markets and became larger and more diversified, greater control of financial
operation became highly essential. Thus the scope of financial management is very wide and it is not
merely restricted to raising of capital. It also covers other aspects of financing such as assessing the needs
of capital, raising sufficient amount of funds, cost of financing, budgeting, maintaining liquidity, lending
and borrowing policies, dividend policy, and so on.

Financial management occupies a significant place because it has an impact on all the activities of
a firm. Its primary responsibility is to discharge the finance function successfully. Thus financial
management is an appendage of the finance function. No one can think of any business activity in
isolation from its financial implications. The management may accept or reject a business proposition on
the basis of its financial viabilities. In other words, the live executives who are directly involved in the
decision making process should give supreme importance for financial considerations.

In the perfect world, there would be no necessity for current assets and current liabilities because
there would be no uncertainty, no transaction costs, information search costs, scheduling costs, or
production and technology constraints. The unit cost production would not vary with the quantity
produced. Borrowing and lending rate shall be same. Capital, labor and products markets shall be
perfectly competitive and would reflect on all available information. Thus in such an environment, there
would be no advantage for investing in short term assets.

Working capital is the lifeblood of business and the controlling nerve of a firm. No business can be
successfully run without adequate amount of working capital. In ordinary parlance working capital is
taken to be ‘the fund available for meeting day to day requirements of an enterprise’. Working capital
management is concerned with two factors viz, the level of current assets to be held and the type of assets

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and the method by which these assets are financed. Working capital is known as circulation capital or
revolvingcapital. Since investment in current assets represents a substantial portion of total investment,
the study of working capital management becomes important.

1.2 WORKING CAPITAL FINANCIAL POLICY

After having established the optimum level of current assets, (as per the current assets policy),
the company must determine and decide about the source of financing the current assets. This
would in essence mean to arrive at a crucial decision as to what should be the optimal mix of
long term and short term source of funds, to finance the company’s working capital
requirements.
As a matter of principle, all the fixed assets of a company be financed invariably and
exclusively from the long term source, i.e. out of the term loans (deferred liabilities) and equity.
Because financing of some items of fixed assets out of short term loan (or working capital loan)
is considered to be diversion of funds, which is viewed, by the commercial banks, with great
disfavor and distrust.

1.3 WORKING CAPITAL MANAGEMENT

Working capital may be regarded as the lifeblood of business. It inefficient management

can lead not only to loss of profit but also to the downfall of business. Every business needs
funds for two purposes. Long term funds are required to create production facilities through
purchase of fixed assets, such as plant, machinery, land, building etc, funds are also needed for
short term purpose for the purchase of raw materials, payment of wages and other day to day
expense etc. These funds are also known as working capital. Working capital is also revolving or
circulating capital or short-term capital.

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1.4 THEOROTICALFRAMEWORKOF WORKING CAPITAL

MANAGEMENT

There are two concepts of working capital.

1. Gross Concept.
Concepts of
2. Net Concept.
working capital

Gross Net

Concept Concept

Gross working capital refers to the firm’s investment in current assets. Current asset which can be
converted into cash within an accounting year includes cash, marketable securities, debtors, bills
receivable and inventory.

Net working capital refers to the difference between current assets and current liabilities. Current
liabilities are those claims of outsiders, which are expected to mature for payment within an accounting
year and include creditors, bills payable and outstanding expenses. Net working capital can be positive or
negative. A positive net working capital will arise when current assets exceed current liabilities. A
negative net working capital occurs when current liabilities are in excess of current assets.

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1.5 KINDS OF WORKING CAPITAL

Current assets are short charges in and long terms, have led to the classification of working
capital in two components.

1. PERMANENT OR FIXED WORKING CAPITAL

Every firm has to maintain minimum quantity of raw materials, semi finished goods and
minimum amount of cash to meet operating expenses. The minimum amount invested in current
assets such as minimum stock, minimum cash balance etc, is called permanent working capital
because amount invested will be locked out the life of the business. Permanent working capital
may also increase in case of the expansion of the business.

2. TEMPORARY OR VARIABLE WORKING CAPITAL

The extra working capital needed to support the changing production and sales activities are called
fluctuating or variable or temporary working capital.

1.6 FACTORS DETERMINING THE QUANTUM OF WORKING

CAPITAL

Determination of working capital requirements is not so easy because it requires careful analysis
of various factors. Some importance factors, which influence working capital, are given below.

1. Nature of Business
Working capital requirement is considerably influenced by the nature of business. Trading,
manufacturing, publicity service requires more, moderate less working capital respectively.

2. Volume of Business
For a small-scale business the working capital requirement is less whereas for large scale
operation the working capital requirement is more.

3. Length of Manufacturing Process

It is the gap between the input of raw materials and output of finished goods. Longer the length of
manufacturing cycle, working capital requirement is more and vice versa.

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4. Operating Cycle

It is the speed at which the cash is converted in to other current assets and current assets in
to cash. Number of operating cycle is more working capital requirement is less and vice versa.

Finishedgo
ods
Work-in-
progress
Accounts
Overheads
Receivable.

Raw materials

Cash Suppliers

5. Condition of supply of raw materials

Regular supply of raw materials reduces the working capital Requirement and irregular supply increases
the working capital requirement.

6.Speed and stock turnover

If the inventory or stock turnover is high the working capital requirement is less and vice versa .

7. Terms of sale and purchase

Credit term granted by the concern to its customers as well as credit terms granted by its suppliers
also affect the working capital. If the credit terms of purchase are more favorable and those of sales are
less liberal, less cash will be invested in the inventory.

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8.Market conditions
If the degree of competition is more, credit terms are to be extended; the requirement of working capital
will be more if the degree competition is less working capital requirement is also less.

9.Dividend policy

Liberal dividend policy requires more working capital and vice versa.

10.Business cycle

Cyclical changes in the economy via depression boom also influence the quantum of working capital. In

the case of depression sales will be less and collection will be delayed. Hence the requirement of working

capital will be more. In the case of boom, sales will be more and more stock should be maintained which

also require more working capital.

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1.7 ADVANTAGES OF ADEQUATE WORKING CAPITAL

1. It helps for continuous supply of raw materials, which leads for uninterrupted
production

2. It helps for prompt payment of wages, salaries and other day-to-day expenses and
it also increase the goodwill of the firm

3. It helps to utilize the favorable market conditions i.e., by purchasing in bulk at

cheaper price

4. It helps for reduction of cost i.e. ,purchase at cheaper rate reduces the cost of
production

5. It helps for maintaining the solvency of business

6. It helps for raising short-term loans especially from banks

7. It also helps for prompt supply of finished goods by which the brand loyal
customers can be maintained

8. It also helps for prompt payment of dividend and makes raising additional capital
easily

9. It increase high morale and provides jobsecurity for employees

1.8 IMPORTANCE OF WORKING CAPITAL MANAGEMENT

The importance of working capital management can be judged from the following facts.
1. There is direct and positive correlation between Sales and working capital needs of the firm. An
increase in the sale of product requires a corresponding increase in current assets. Hence current
assets are to be managed properly and efficiently.
2. Fixed assets can be required on lease but there is no alternative for current assets. Investment in
current assets can in no way be avoided.
3. Working capital needs are generally financed through outside sources. So continuous care is
necessary to utilize them in the best way.

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1.9 SOURCES OF WORKING CAPITAL

The financial managers are always interested in obtaining the working capital at the right time, at a
reasonable cost and at the best favorable terms. A part of the working capital investment is permanent
investment in fixed asset. The valuable source of working capital available to a firm is:

Source of Working Capital

Long Term Short Term Source

Source

1. Issue of share. 1. Trade credit.

2. Issue of 2. Credit paper.

debentures

3. Retained
earnings 3. Bank credit.
4. Sale of fixed
assets
4. Public
deposits.
5. Security from
employee and
from
customers.
5. Government
assistance
6. Term loans.

6. Customer
credit.

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1.10ASSESSMENT OF WORKING CAPITAL REQUIREMENTS BY

BANKS

The working capital requirements can be assessed by the banks under three different methods
under different circumstances

They are:

A. Projected Balance Sheet Method

B. Cash budget Method
C. Projected yearly Turnover Method
1.
(A).Projected Balance Sheet Method

As the name itself suggests, the modified approach of assessment of the credit requirement [in
lieu of the MPBF (Maximum Permissible Bank Finance) method], is based on the Projected balance
Sheet of the borrowers, the funds flow planned for the current year and the following years, as also on the
examination of the profitability and such other financial parameters . In fact the PBS method is also based
on similar lines, as those of the then prevalent CMA (Credit Monitoring Arrangement) assessment
method, of course, with some differences and modifications, with a view to ensuring that all the genuine
credit requirements of the borrowers are fully met.

(B). Cash budget (CB) Method

As against PBS method, in cash budget (CB) method, the financial requirements are assessed on
the basis of the projected cash flows, (and not on that of the projected value of assets and liabilities, as is
done under the PBS method). In the cases of seasonal industries(like Tea, Sugar, Jute, Rubber, etc), and
for construction activities as also in the cases of hire- purchase and leasing financing, the CB Method
continuous to be in used. However in this method of assessment also, besides cash budget, several other
relevant financial parameters like the borrowers projected profitability, liquidity, gearing, fund flow, etc.,
are analyzed and evaluated, as is done in the case of PBS method.

Incidentally, cash budget analyses is also used for sanction of ad-hoc (i.e., temporarily additional)
working capital limit during a year.

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(C) Projected yearly Turnover Method

Under the projected yearly turnover (PYT) method, the working capital requirement is assessed on
the basis of the value of the projected yearly turnover. Till recently, this method was being used by the
banks for assessment of the working capital finance up to a limit of Rs.1crore, for both

Small scale and other (non-SSI) borrowers. But now, while the banks have the flexibility to adopt their
own criteria for sanction of working capital limit to non-SSI borrowers will have to be sanctioned the
working capital limit up to rs.5 core,(raised from Rs. 2 core earlier)on the basis of minimum 20% of their
projected yearly turn-over(PYT).

[PYT comprises total annual gross sales, i.e. Cash Sales and credit sales taken together plus excise duty].

And, the owners stake (margin) would be 5% of the PYT, total working capital requirement will be 25%
(20%+5%) of the (PYT).

1.11 OBJECTIVES OF THE STUDY

Working capital management is very important in modern business. Analysis and interpretation
of financial statement and working capital is very useful for short-term management of funds.
The following are the main objectives of the study:

PRIMARY OBJECTIVES
To analyze and evaluate liquidity position of the company.

SECONDARY OBJECTIVES

A. To analyze the components of working capital of the company.

B. To assess the impact of working capital on profitability.
C. To determine the amount of working capital of the company for another five years.
D. To understand the solvency position of the company.

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1.12 LIMITATIONS OF THE STUDY

 The study is restricted for a period of two months
 The present study is only for a period of 5 years from 2013-14 to 2015-17
 The annual report for 2015-2017 has not yet been published, so the current status of the
company is not presented in the study.
 Due to inadequate time it is not possible to analyze all aspects relevant to the
study.
 The findings of the study cannot be generalized.
 The analysis is based on annual reports of the company.

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