Working capital policy pdf

Gross concept deals with the problems of managing various components of current assets separately in day to day operations, while net working capital deals with the operation of current assets which is constant in short run analysis and decision making, but manageable in long term operations.

It has been realized that inadequate working capital is the major reason for business failure. Management of working capital assumes considerable importance of the firm. It aims at protecting the purchasing power of assets and maximizing the return on investment. Charan Singh University, Meerut, p. Weston and Eugene F Brigham, Essential of managerial finance, Rinehart and Winston Inc. Just as circulation of blood is essential in the human body for maintaining life, working capital is also essential to maintain the smooth running of the business.

No business can run successfully without an appropriate amount of working capital. This enables the firm in making payment to its short term creditors in time. This increases the credit standing of the firm and hence, it becomes simple for a firm to obtain the loan from banks and other financial institution on favourable terms. During such period, company more depends on its working capital strength. Lastly, every business concern should have adequate amount of working capital to run its business operation smoothly.

It should neither have excess nor have shortage working capital. Both are not favourable for any business concern. The management of any concern should maintain the appropriate level of working capital on a regular and continuous basis.

Level of appropriate working capital could be achieved with the financial analysis and statistical approaches. Working capital funds are regarded as the life blood of the firm. Thus, each firm must contemplate how to balance the amount of working capital it holds, against the risk of failure.

The working capital management includes and refers to the procedures and policies required to manage the working capital. Inadequate working capital may lead the firm to insolvency and excessive working capital implies idle funds which earn more profits for the business. A study of working capital management is very important for sales expansion, rising price level, dividend declaration, increase in salaries and wages, plants expansion, new product line etc. Failure of any enterprise is doubtlessly due to poor management and lacking of management skill.

Working capital management policies of a firm have a great effect on its profitability, liquidity and structure heath of the organization. A careful maintenance of the proper assets and funds-acquired mixes is subjected to close scrutiny, it must be noted that there exists a close correlation between sales fluctuations and invested amounts in current assets. First, short term, or current, liabilities represent the portion of the funds which have been planned for and raised. Since management should be concerned with proper financial structure, these and other funds must be raised judiciously.

The working capital investment and financing decision independent of one another in order to examine the profitability-risk trade offs associated 16 Bhalla. K , Op. Although short term debt is less expensive than long term, short term funds may only be renewable at much higher interest rates. Conversely, long term funds involve a rather lengthy commitment at fixed, or locked-in, rates of interest.

It should also be contemplated that heavy reliance on low cost, current funds may jeopardize the solvency of the business. Another policy, working capital investment policy, elects to prescribe levels for current assets.

Excessive current assets are usually not advisable, because the yield from short term assets is usually low, while return from long term and fixed assets are usually high.

So management may also be considered as aggressive or conservative according to investment in current verses long term assets. The main elements of current assets are inventories, receivables, cash and bank balance and other resources like short term investments. Current liabilities include trade creditors, bank overdrafts, outstanding expenses and proposed dividends, tax payable income received in advance and others.

The management should try to have maximum utilisation of its components at the minimum possible cost as much as it is possible. This is highly dependent on the structure of working capital21 and hence the study of the structure of working capital is useful. In other words, the effective utilisation of working capital and its needs for a firm should increase less than in proportion to the increase in the output volume.

Structure of current assets and current liabilities is analyzed in order to plan working capital management. The different elements or components of current assets and current liabilities constitute the structure of working capital which can be exhibited in a table as follows: 19 Bhalla.

Narasimhan and R. Creditors are spontaneous or transactionary sources of finance for the company. One of the important decisions in working capital management is to decide which source of working capital to be used for financing current assets. The management has to think of the sources of fund which can be availed to make investment in current assets. Working capital needs could be broken down into permanent and temporary components over time that helps in terms of financing choice.

The permanent component is predictable insofar as it is linked up to expected change in sales or cost of goods sales over time. So, the two components of working capital need to be financed accordingly for which the different sources of funds can be grouped as follows 3.

So many companies find it simple to transfer it to an external agency whereby the external agency is supposed to maintain records and accounts and put in efforts for collection. This process is called factoring. It is a conventional source of short term funding. Factoring facility 22 Dr. Rustagi , Op. The factor financial institution that purchases the accounts receivable for cash, put in efforts to collect all the billings, and charges a fee for rendering this service.

Factoring agreements could be bifurcated under two ways- A If the risk of bad debts is transferred to factor agencies, then it is known as non-recourse factoring agreement and other are known as recourse factoring agreement.

B If any advance payment is received by company from the factor, it is known as advance factoring agreement; if no money is receivable currently then it is maturity factoring agreement. Presently it has five branches at Delhi, Baroda, Mumbai, Pune and Coimbatore, but the company has not been able to make much headway towards the objectives for which it was set up.

During the first eight year of its existence, it was able to develop a portfolio of only about clients out of which only 40 percent were from small scale sector.

Primary reasons behind the slow growth of factoring services in India could be attributed to the absence of systematic credit information in SSI sector and general risk aversion of the bankers who man the factoring arms. One must understand that factoring is different from banking both in respect of the attitude towards risk and scope of financial services. These are provided against inventory, accounts receivable and equipments. The income received in advance will then be debited to the income account and the income account will be credited to the income received in advance account such as rent.

Commercial paper is a money-market security issued by large financial institutions or corporations to get funds to meet short term debt obligations e. Since it is not guaranteed by collateral, only firms with excellent credit ratings given by a recognized rating agency will be enabling to sell their commercial paper at a fair price. The overdraft will be limited. A bank overdraft is also a source of short term finance or type of loan as the fund is technically and systematically borrowed.

Publishing Corporation, New Delhi, p. The letter of credit is generally a guarantee to the seller that issuer of letter of credit will pay the stated amount of invoices if the buyer fails to pay the amount. Naturally, the importer naturally wants to minimize risk by demanding the exporter to document that the goods have been delivered or shipped.

Share capital consists of the nominal values of all shares allotted i. Share capital can simply be defined as the part of capital cash or an equivalent item of capital value that company receives from shareholders or investors for its shares.

A debenture is a written document or certificate that either creates a debt or recognizes it and it is a debt without collateral security. In corporate finance, the term is applied for a medium to long-term debt instrument used by large companies to raise funds.

Debentures can freely be transferred by the debenture holder. In a loan, the borrower at initial stage receives or borrows a sum of money from the lender, and is obligated to pay back or repay the same amount of money to the lender at a later time.

In a typical manner, the money is paid back in regular uniform installments, or partial repayments; in an annuity, each installment is the same amount. Acting as a provider of loans is one of the major tasks for financial institutions like banks. A secured loan is a loan in which the borrower pledges some asset e. As much as the firm stretches or postpones the payments, the funds are available to it for some more time period and that too generally at no cost.

Credit limits from supplier and other outstanding expenses are called spontaneous sources of working capital finance. An aggressive policy may be said to be followed by the business concern when it uses more short term sources of financing as a major part of its permanent current assets. Some externally aggressive firms may even finance a part of their fixed assets with short term funds. The relatively greater use of short term funds makes the firm greater risky.

Figure 3. It implies the financing of short term needs with short term sources and financing long term requirement with long term sources.

Thus, a ten year loan may be raised to finance 25 Schall L. If the accurate matching is possible, the strategy operates without any net working capital since all short term requirements are financed with short term funds.

In this, a firm depends on the long term sources of funds for financing its requirements. The firm relies more on long term funds for financing its needs and short term funds are only to emergency situation. In this strategy, the management finances its permanent current assets and a major part of temporary current assets with long term sources of funds.

A firm can choose from short term or long term sources of finance. Short term financing is less expensive than long term financing but at the same time, short term financing involves greater risk than long term financing. Depending on the mix of short term and long term financing, the approach followed by a company may be referred as aggressive approach, conservative approach and matching approach. For effective management of assets and higher return on investment, there must be optimum investment in both fixed 26 Mohan Rao P.

According to conservative approach, a firm does not take risk of maintaining a low level of current assets.

Since, it holds more current assets that may adversely affect the profitability. Less investment in current assets may be done to increase the return on investment but it is likely to expose to more risk of solvency or liquidity. Moderate investment in current assets is made to support liquidity as well as profitability. The ratio of current assets to total assets can be applied in order to analyse the investment policy pursued by the firm for financing the current assets.

Table 3. Every factor is important because all such factors are of different importance and influence of individual factor fluctuates for a firm over period of time. There are some important factors that determine the working capital requirements, these are as follows: v Basic nature of the business: The working capital requirements of a concern basically rely upon the nature of the business. Trading and financial firms need good quantum of working capital because they require more investment in current assets as compared to fixed assets.

Trading concerns have to carry large stock, more receivables and liquid cash. Manufacturing concerns also require huge amount of working capital for the purchase of raw materials, maintaining the stock of inventories, financing the receivables and meeting operating expenses. The Manufacturing concerns lie between public utility concerns and trading and financial firms. In case of boom conditions, inflationary pressure exists and business operations expand. As a result, the overall requirement for cash, inventories etc.

In case of recession phase, there is usually dullness in business operations and there would be opposite impact on the level of working capital requirement. There will be a fall in inventories and receivables. The working capital requirements would be different between two firms doing same types of business. A firm with larger scale of operations or routine business will require more working capital than a firm with smaller scale of operations.

High accumulation of inventories increases the inventory carrying costs and risks. The production may be reduced during the off season to ignore overstocking and increased during the peak season.

In case of cold drink business, the demand will surely be higher during summer season and therefore, more working capital is required to meet with higher production, which compels to have larger inventories and big size of receivables. On the other hand, if the operations are smooth and even throughout the year then the working capital requirement will be constant and will not be influenced by the seasonal factors.

In general, for normal rate of expansion in the volume of business i. But in fast growing firm, larger amount of working capital is required to finance the additional fixed assets and current assets in order to nurture its growing requirement of sales and production. It should be taken into consideration that a fast growing firm needs funds continuously. An inspection of the competitive conditions existing in the market, the firm may have to provide liberal credit terms to the customers which lead to higher receivables.

Even larger inventories may be maintained to fulfill an order as and when received; otherwise the customer may switch over to some other suppliers.

Hence, the working capital tends to be high as a result of higher investment in inventories and receivables. While, a monopolistic firm does not require larger working capital. It may demand the customer to pay in advance or wait for some days after receiving the order. Sometimes supplier takes long time to supply raw materials etc. On the other hand, if a supplier sends the raw materials in a short period after placing an order, then purchasers will not have to maintain a high level of inventory, and hence low working capital is required.

A concern has to deal with two kinds of credit policies at a time. First, the credit policy of the supplier of raw materials, goods etc. In both the cases, however the firm while contemplating its credit policy has to take care of the credit policy prevailing in the market. The credit policy of a firm in its dealing with receivables and payables both affect the requirement of working capital.

A firm that purchases its raw materials on credit and sells its products on cash, requires lesser working capital and vice versa. A firm gets liberal credit from its suppliers need less working capital and vice versa. The time which is taken to convert raw materials into finished goods is known as manufacturing or production cycle. Longer manufacturing cycle will require more working capital.

The shorter the production cycle, the less will be the requirement of working capital. Hence, utmost care should be given to shorten the period of the manufacturing cycle in order to minimize the working capital requirements.

John L. Donnell and Milton S. Working capital control plays very important role its adequacy. Working capital control depends upon the level of operation and the length of operating cycle.

Monitoring the time period of the operating cycle is an important element of working capital control. The duration of the raw material stage depends on regularity of supply, transportation time, price fluctuations and economy of bulk purchase. The duration of the work-in-process depends on the length of manufacturing cycle, consistency in capacities at different stages, and efficient coordination of various inputs.

The duration of the finished goods depends on the pattern of production and sales. If production is fairly uniform throughout the year but sales are highly seasonal, then the duration of finished goods tends to be long. Better control of working capital depends on the control of its components like inventories, receivable and cash which may be discussed as follows: 3.

The inventory should be controlled by applying different techniques of inventory control. Traditional methods, accounting methods ratio analysis , and scientific methods like time series analysis, regression analysis etc. Calculation of these ratios is not enough.

As a control device, these ratios could be compared with the same ratio of the firm over past few years to find if there is an important trend or variation.

Fixation of stock levels depends upon two important factors, one rate of consumption and second lead time. It requires fixing of various types of stock level e. It would be worthwhile if standards of inventories were set by the management by objectives concept. This concept expects the top management to determine and to specify the inventory norms limit after consultation with the materials department. JIT system of inventory developed by Japanese is used in repetitive manufacturing organisation.

It could be regarded as an extension of the original concept of managing the material flow in a production system to reduce the level of inventory. The main objectives of JIT system are that pilling of inventory is undesirable and lead time in arranging and disposing of the inventory must be reduced as far as possible.

The companies having relaxed working capital policies assume the advantage of almost no risk or low risk. This policy guarantees the entrepreneur of the smooth functioning of the operating cycle. We know that earnings are more important than higher earnings. On the other hand, there is a disadvantage of lower return on investment because higher investment in the current assets attracts higher interest cost which in turn reduces profitability. Because of its conservative nature, this policy is also called a conservative working capital policy.

The moderate policy is a balance between the two policies i. It assumes the characteristics of both policies. To strike a balance, moderate policy assumes risk which is lower than restricted and higher than conservative. In the profitability front also, it lies between the two. The biggest benefit of this policy is that it has reasonable assurance of smooth operation of working operating capital cycle with moderate profitability. Working capital policies can be further framed for each component of networking capital i.

Cash policies can be to maintain an appropriate level of cash. When the level is high, it should be invested in liquid investments for the short term and vice versa.

Accounts receivable policy may state payment terms, credit period, credit limit, etc. Inventory policy may speak of minimizing the levels of inventory till the point it poses any risk to the satisfaction of customer demands.

Accounts payable policies include policies of payment terms, quality terms, return policies, etc. Your answer:. Correct answer:. He is passionate about keeping and making things simple and easy. Running this blog since and trying to explain "Financial Management Concepts in Layman's Terms". This will definitely help me to understand working capital and be able to handle it well. Thanks for sharing this. Save my name, email, and website in this browser for the next time I comment.

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