WORKING CAPITAL MANAGEMENT: CONCEPT, IMPORTANCE AND OBJECTS
WORKING CAPITAL MANAGEMENT: CONCEPT, IMPORTANCE AND OBJECTS
·
INTRODUCTION
The present research seeks to study in depth
the Working Capital Management of selected paper companies in India
A number of companies for the past few years
have been finding it difficult to solve the increasing problems of adopting
seriously the management of working capital. Business concerns intent on
developing their business have to use to the utmost, their available resources
for the improvement and development of the business there by enabling them to
increase their profits. Working Capital and change in working capital,
especially in inventories, which is one of the components of working capital form
a very important part of the total gross-capital formation in the paper
companies. Efficient and the optimal utilization of fixed assets is very
closely related to the proper management of working capital. The present
research attempts to recognize initially the importance of working capital as a
part of the total capital. It further
goals to recognize the factors influencing the working capital, its volume, and
in the process try to suggest remedial measures which might help in optimizing
the use of working capital. It also
considers as to how precisely “financing working capital” and further more what
should be mix of different components of working capital.
Some important questions to which the research attempts to seek answer as
follows:-
·
Whether paper companies have planted their
working capital requirement properly.
·
Have the paper companies utilized the
investment in current assets?
·
Have the paper companies controlled and
utilized cash resources effectively and profitably?
·
Whether paper companies resort to high build
up of inventory.
·
How far have the paper companies been
successful in collecting their `different
administration of its various components: like as inventory, account
receivable, cash, and accounts payables.
Working Capital is the life blood of every
business concern. Business firm cannot make progress without adequate working
capital. Inadequate working capital means shortage of inputs, whereas excess of
it leads to extra cost. So the quantum of working capital in every business
firm should be neither more nor less than what is actually required. The
management has to see that funds invested as working capital in their
organization earn return at least as much as they would have earned return if
it invested anywhere else. At the time of increasing capital costs and scare
funds, the area of working capital management assumes added importance as it
deeply influences a firm's liquidity and profitability. A notable feature of
utilization of funds is that they are of recurring nature. Therefore, efficient
working capital management requires a proper balance between generation and
utilization of these funds without which either shortage of funds will cause
obstruction in the smoother functioning of the organization or excess funds
will prevent the firm from conducting its business efficiently. So the main
objective of working capital management is to arrange the needed funds on the
right time from the right source and for the right period, so that a tradeoff
between liquidity and profitability may be achieved.
A firm may exist without making profits but
cannot survive without liquidity. The function of working capital management
organization is similar that of heart in a human body. Also it is an important
function of financial management. The financial manager must determine the
satisfactory level of working capital funds and also the optimum mix of current
assets and current liabilities. He must ensure that the appropriate sources of
funds are used to finance working capital and should also see that short term
obligation of the business are met well in time.
·
DEFINITIONS OF WORKING CAPITAL
Definitions of Working Capital, as per various management
experts are as under:
“Working Capital is the excess of C.A.
- H.G, Guthmann “Working Capital is descriptive of that capital which is not fixed. But the
more common use of the Working Capital is to consider it as the difference
between the book value of the C.A. and current liabilities.”
- Hoglend. J. Bierman, and A. K. Mc Adams,.
“Working Capital represents the excess of C.A.
- J.L. Brown and L.R. Housard.
“Working Capital to a firm’s investment in
short term assets cash short term securities, accounts, receivables and
inventories.”
-Weston the Brigham
“Working Capital represents only the current capital
assets.”
- Meal Baker Malott and Field.
“Working Capital means a sum of C.A”
“A Working Capital deficit exits if current
liabilities exceed C.A.”
-Prof. C.W. Gerstoberg.55
“Working Capital equals the aggregate value
of C.A.
- Lincoln
“Gross Working Capital may be used to refer
to total C.A. and net
working capital refers to the surplus of C.A.
- Prof. S.C. Kuchhal
·
CONCEPT OF WORKING CAPITAL MANAGEMENT
There are two concepts of working capital viz
.quantitative and qualitative. Some people also define the two
concepts as gross concept and net concept.
According to quantitative concept, the amount
of working capital refers to ‘total of current assets’. What we call current
assets? Smith called, ‘circulating capital’. Current assets are considered to
be gross working capital in this concept.
The qualitative concept gives an idea
regarding source of financing capital. According to qualitative concept the
amount of working capital refers to “excess of current assets over current
liabilities.” L.J. Guthmann defined working capital as “the portion of a firm’s
current assets which are financed from long–term funds.”
The excess of current assets over current
liabilities is termed as ‘Net working capital’. In this concept “Net working
capital” represents the amount of current assets which would remain if all
current liabilities were paid. Both the concepts of working capital have their
own points of importance. “If the objectives is to measure the size and extent
to which current assets are being used, ‘Gross concept’ is useful; whereas in
evaluating the liquidity position of an undertaking ‘Net concept’ becomes
pertinent and preferable.It is necessary to understand the meaning of current
assets and current liabilities for learning the meaning of working capital,
which is explained below.
Current assets – It is rightly observed that “Current assets have
a short life span. These type of assets are engaged in current operation of a
business and normally used for short– term operations of the firm during an
accounting period i.e. within twelve months. The two important characteristics
of such assets are, (i) short life span, and (ii) swift transformation into
other form of assets. Cash balance may be held idle for a week or two; account
receivable may have a life span of 30 to 60 days, and inventories may be held
for 30 to 100 days.”Fitzgerald defined current assets as, “cash and other
assets which are expected to be converted in to cash in the ordinary course of
business within one year or within such longer period as constitutes the normal
operating cycle of a business.”
Current liabilities – The firm creates a Current Liability towards creditors (sellers) from whom
it has purchased raw materials on credit. This liability is also known as
accounts payable and shown in the balance sheet till the payment has been made
to the creditors. The claims or obligations which are normally expected to
mature for payment within an accounting cycle are known as current liabilities.
These can be defined as “those liabilities where liquidation is reasonably
expected to require the use of existing
resources properly classifiable as current assets, or the creation of other
current assets, or the creation of other current liabilities.”
·
CIRCULATION SYSTEM OF WORKING CAPITAL
Working capital is also known as ‘circulating
capital or current capital’ Kulkarni has remarked that, “The use of the term
circulating capital instead of working capital indicates that its flow is
circular in nature”.
Figure – 1.1 Circulation System of Working Capital
The funds in a business are obtained from the
issue of share, the issue of debentures, and other long-term arrangement and
from operations of business. A huge part of generated funds is used to acquire
fixed assets, viz, plant and machinery, land building and some other fixed
assets, while the remaining part of the generated funds is used for day to day
operations of the business e.g. to pay wages and overheads expenses for the raw
materials processed. This makes possible the stocking of finished goods by
whose sales either accounts receivables are created or cash is received. In
this process profits are generated. A part of the profit is used to pay tax,
interest and dividends, while the remaining part is ploughed back in the
business. The circulation system of working capital may be depicted as shown in
figure 1.1 as Above page page. The cycle goes constantly throughout the life of business.
·
TYPES OF WORKING CAPITAL
Following diagram clear the classification of
working capital Accoding to the needs of business, the working capital may be
classified into following two basis:
·
On the basis of periodicity
·
On the basis of concept
Figure -1.2 Types of Working Capital
·
On the basis of periodicity:
The requirements of working capital are
continuous. More working capital is required in a particular season or the peck
period of business activity. On the basis of periodicity working capital can be
divided under two categories as under:
·
Permanent working capital
·
Variable working capital
This type of working capital is known as Fixed
Working Capital. Permanent working capital means the part of working
capital which is permanently locked up in the current assets to carry out the
business smoothly. The minimum amount of current assets which is required to
conduct the business smoothly during the year is called permanent working
capital. For example, investments required to maintain the minimum stock of raw
materials or to cash balance. The amount of permanent working capital depends
upon the size and growth of company. Fixed working capital can further be
divided into two categories as under:
·
Regular Working capital:
Minimum amount of working capital required to
keep the primary circulation. Some amount of cash is necessary for the payment
of wages, salaries etc.
·
Reserve Margin Working capital:
Additional working capital may also be
required for contingencies that may arise any time. The reserve working capital
is the excess of capital over the needs of the regular working capital is kept
aside as reserve for contingencies, such as strike, business depression etc.
·
Variable or Temporary Working Capital:
The term variable working capital refers that
the level of working capital is temporary and fluctuating. Variable working
capital may change from one assets to another and changes with the increase or
decrease in the volume of business.
The variable working capital may also be
subdivided into following two sub-groups.
·
Seasonal Variable Working capital:
Seasonal working capital is the additional
amount which is required during the active business seasons of the year. Raw
materials like raw-cotton or jute or sugarcane are purchased in particular
season. The industry has to borrow funds for short period.
It is particularly suited to a business of a
seasonal nature. In short, seasonal working capital is required to meet the
seasonal liquidity of the business.
·
Special variable working capital:
Additional working capital may also be needed
to provide additional current assets to meet the unexpected events or special
operations such as extensive marketing campaigns or carrying of special job etc.
Difference Between Permanent and Variable Working
Capital:
The distinction between permenent or fixed working
capital and variable working capital or temporary working capital is of great
importance in operating cycle and raising the funds. However, there is always a
minimum level of current assets which is contiuously required by the firm to
carry on its business operations. This minimum level of current assets is
refered to as permenent or fixed working capital and is permanent in the same
way as the firm’s fixed asset.
Permanent and Temporary Working Capital
Depending on the chang in production and sales, the need
of working capital, over and above the permenent working capital, will
fluctuate.
For example, extra inventory of finished good will have
to be maintained to support the peak periods of sale and investment in
receivables may also increse during the period. Both the kinds of working
capital-permenent and temporary –are necessary to facilitate production and
sale through the operating cycle, but temporary working capital is created
by the firm to meet liquidity requriments that will last only
temporarily. In above figuire shows the diference between permentt and
temporary working capital.
It is sh-own in below figure that permenant working
capital is stable over time, while temporary working capital is
fluctuating-some times incrasing and sometimes decrasing. However, the
permanent working capital line need not be horizonltal if the firm’s requriment
for permenent capital is incrasing or decreasing over period. For a growing
firm, the difference between permanent and temporary working capital can be
depicted
2) On the basis of concept:
on the basis of concept working capital is divided into
two categoties as under:
(A) Gross Working Capital:
Gross working capital refers to total
investment in current assets. The current assets employed in business give the
idia about the utilization of working capital and idia about the economic
postion of the company. Thus, gross working capital the amount of funds
invested in different current assets. Gross working capital concepts is popular
and acceptable concept in the field of finance.
(B) Net Working Capital:
Net working capital means current assets
minus current liabilities. The difference between current assets and current
liabilites is called the net working capital. If the net working capital is
positive business is able to meet its current liabilites. Net working capital
concept provides the mesasurement for determining the creditworthiness of
compny.
·
FACTORS DETERMINING OF WORKING CAPITAL
Papers, with their fixed investment, appear to have the
lowest requirement for current assets. This does not mean that the problem of
working capital may be minimized in this field of enterprise, since ready funds
are still essential to cover disbursement for wages, interest on funds debt,
purchase of materials and supplies, etc. indeed, under such conditions the
working capital position may become even more strategic in character because of
its relation to, and control of the large amount of fixed assets. Thus, one of
the outstanding problems of paper management in recent years has been the
maintenance of current position sufficiently strong to permit vigorous
operations. Public utilities, like the paper, have a fixed investment which
causes the current assets to constitute only a relatively small percentage of
the total assets. There is a difference between operating and holding
companies, but even then the funds required to cover current transactions are
minor as compared with those necessary to finance the long term structure.
Industrial companies, generally, require a large amount
of working capital although it various from business to business of lack of
uniformity characterizing each field of enterprise. However, the underlying
determinants of the amounts of fixed capital are required for operation;
working assets may be expected to occupy
a smaller niche in the assets structure. For similar reasons, a rapid
turnover of capital will inevitably mean a large proportion of current assets. In the
case of industries with fixed
investment, one of the primary uses of working capital is its conversion into
operating plant structure. In turn, it is expected that the income resized form
operations will normally replace such defections. This means that the flow of a
portion of working capital is circulating through fixed investment that its
recovery is dependent upon the income realized. Where the current assets are relatively more
important, a rapid sales turnover is usually found.
Often, as a case of retail concerns, the specific working assets constitute the
object of sale and recovery is direct and immediate. In manufacturing enterprises, a large share of working capital
management is more likely to become charged in form by conversion into finished
products, but even here, the potentiality of recovery is not delayed as long as
in the case of public utilities and paper companies. The need for working
capital varies with changes in the volume of business. A considerable
proportion of current assets is needed permanently as fixed assets. More than
one production cycle may be in process at one and the same time, for business
operations on a continuing basis. Materials are purchase and work is in
progress. Finished inventory is sold. At the same time new receivables
accumulate and old ones are converted into cash. Cash is utilized in the
production process.
The following factor determine the amount of working
capital
·
Nature of
Companies:
The composition of an asset is a function of
the size of a business and the companies to which it belongs. Small companies
have smaller proportions of cash, receivables and inventory than large
corporation. This difference becomes more marked in large corporations. A
public utility, for example, mostly employs fixed assets in its operations,
while a merchandising department depends generally on inventory and receivable.
Needs for working capital are thus determined by the nature of an enterprise.
·
Demand of Creditors:
Creditors are interested in the security of
loans. They want their obligations to be sufficiently covered. They want the
amount of security in assets which are greater than the liability.
·
Cash Requirements:
Cash is one of the current assets which are
essential for the successful operations of the production cycle. Cash should
not adequate and properly utilized. It would be wasteful to hold excessive
cash. A minimum level of cash is always required to keep the operations going.
Adequate cash is also required to maintain good credit relation. Richards Osbom
has pointed out that cash has a universal liquidity and acceptability. Unlike
illiquid assets, its value is clear- cut and defines.
·
Nature and Size of Business:
The working capital requirements of a firm are basically
influenced by the nature of its business. Trading and financial firms have a
very less investment in fixed assets, but require a large sum of money to be
invested in working capital. Retail stores, for example, must carry large
stocks of a variety of goods to satisfy the varied and continues demand of
their customers. Some manufacturing business, such as tobacco manufacturing and
construction firms also have to invest substantially in working capital and a
nominal amount in the fixed assets. In contrast, public utilities have a very
limited need for working capital and have to invest abundantly in fixed assets.
Their working capital requirements and nominal because they have cash sales
only and supply services, not product. Thus, no funds will be tied up in
debtors and inventories. The working capital needs of most of the manufacturing
concerns fall between the two extreme requirements of trading firms and public
utilities. Such concerns have to make adequate investment in current assets
depending upon the total assets structure and other variables. The size of
business also has an important impact on its working capital needs. Size may me
measured in terms of the scale of operation. A firm with larger scale of
operation will need more working capital than a small firm.
·
Time:
The level of working capital depends upon the time
required to manufacturing goods. If the time is longer, the size of working
capital is great. Moreover, the amount of working capital depends upon
inventory turnover and the unit cost of the goods that are sold. The greater
this cost, the bigger is the amount of working capital.
·
Volume of
Sales:
This is the most important factor affecting the size and
components of working capital. A firm maintains current assets because they are
needed to support the operational activities which result in sales. They volume
of sales and the size of the working capital are directly related to each
other. As the volume of sales increase
in the investment of working capital-in the cost of operations, in inventories
and receivables.
·
Terms of Purchases and Sales:
If the credit terms of purchases are more favorable and
those of sales liberal, less cash will be invested in inventory. With more
favorable credit terms, working capital requirements can be reduced. A firm
gets more time for payment to creditors or suppliers. A firm which enjoys
greater credit with banks needs less working capital.
·
Inventory
Turnover:
If the inventory turnover is high, the working capital
requirements will be low. With better inventory control, a firm is able to
reduce its working capital requirements. While attempting this, it should
determine the minimum level of stock which it will have to maintain throughout
the period of its operations.
·
Receivable
Turnover:
It is necessary to have an effective control of
receivables. A prompt collection of receivables and good facilities for setting
payable results into low working capital requirements.
·
Business Cycle:
Business expands during periods of prosperity and
declines during the period of depression. Consequently, more working capital
required during periods of prosperity and less during the periods of
depression. During marked upswings of activity, there is usually a need for
larger amounts of capital to cover the leg between collection and increased
sales and to finance purchases of additional materials to support growing
business activity. Moreover, during the recovery and prosperity phase of the
business cycle, prices of raw materials and wages tend to rise and require
additional funds to carry even the same physical volume of business. In the
downswing of the cycle, there may be a brief period when collection
difficulties and declining sales together cause embarrassment by the resulting
failure to replenish cash. Later, as the depression runs its course, the
concern may find that it has a larger amount of working capital on hand than
current business volume may justify.
·
Value of Current Assets:
Decreases in the real value of current assets as compared
to their book value reduced the size of the working capital. If the real value
of current assets increases, there is an increase in working capital.
·
Variations in Sales:
A seasonal business requires the maximum amount of
working capital for a relatively short period of time.
·
Production
Cycle:
The time taken to convert raw materials into finished
products is referred to as the production cycle or operating cycle. The longer
the production cycle, the greater is the requirements of the working capital.
An utmost care should be taken to shorten the period of the production cycle in
order to minimize working capital requirements.
·
Credit Control:
Credit control includes such factors as the volume of
credit sales, the terms of credit sales, the collection policy, etc. with a
sound credit control policy, it is possible for a firm to improve in cash
inflow.
·
Liquidity and Profitability:
If a firm desires to take a greater risk for bigger gains
or losses, it reduces the size of its working capital in relation to its sales.
If it is interested in improving its liquidity, it increase the level of its
working capital. However, this policy is likely to result in a reduction of the
sales volume, and therefore, of profitability. A firm, therefore, should choose
between liquidity and profitability and decide about its working capital
requirements accordingly.
·
Inflation:
As a result of inflation, size of the working capital is
increased in order to make it easier for a firm to achieve a better cash
inflow. To some extent, this factor may be compensated by the rise in selling
price during inflation.
·
Seasonal Fluctuations:
Seasonal fluctuations in sales affect the level of
variable working capital. Often, the demand for products may be of a seasonal
nature. Yet inventories have got to be purchased during certain seasons only.
The size of the working capital in one period may, therefore, be bigger than
that in another.
·
Profit Planning and Control:
The level of working capital is decided by the management
in accordance with its policy of profit planning and control. Adequate profit
assists in the generation of cash. It makes it possible for the management to
plough back a part of its earnings in the business and substantially build up
internal financial resources. A firm has to plan for taxation payments, which
are an important part of working capital management. Often the dividend policy
of a corporation may depend upon the amount of cash available to it.
·
Repayment
Ability:
A firm’s repayment ability determines level of its
working capital. The usual practices of a firm are to prepare cash flow
projections according to its plans of repayment and to fix working capital
levels accordingly.
·
Cash Reserves:
It would be necessary for a firm to maintain some cash
reserve to enable it to meet contingent disbursements. This would provide a
buffer against abrupt shortages in cash flows.
·
Operational and Financial Efficiency:
Working capital turnover is improved with a better
operational and financial efficiency of a firm. With a greater working capital
turnover, it may be able to reduce its working capital requirements.
·
Change in Technology:
Technological developments related to the production
process have a sharp impact on the need for working capital.
·
Firm’s Policies:
These affect the level of permanent and variable working
capital. Changing in credit policy, production policy, etc are bound to affect
the size of working capital.
·
Activities of the Firms:
A firm’s stocking on heavy inventory or selling on easy
credit terms calls for a higher level of working capital for it than for
selling services or making Cash sales.
·
Attitude of Risk:
The greater the amount of working capital, the lower is
the risk of liquidity.
`Whenever there is current strain, it has to be
immediately diagnosed on the basis of the red signals which manifest themselves
in the operations. The restrictions expressed as ratios of the elements of
current assets and current liabilities are frequently referred to as current
position constraints and include the current ratio, the acid test ratio, and
the so-called “compensating balance” ratio. Contracts with fund suppliers
frequently provide for current-position constraints.
If stock not moving fast, and if there is an excess
inventory buildup corrective steps should be taken to sell the stock or bring
down its level.
If the receivable have become sticky, effective recovery
steps should be taken to reduce the debts and to increase the collections. If
the strain is allowed to continue because of involvement in any other business
or industry, the consequences may be disastrous. In such situation, the ability
to meet current demands deteriorates; short term credits are not forthcoming;
production is affected; sales decline; cash flow decline; income may disappear;
and the whole enterprise may get into the red over a period of time. All the
above points are the factors determining working capital management in all the
companies. Some factors are controlled and some factor are not controlled by
the management.
·
OPERATING CYCLE
The duration of time required to complete the sequence of
events right from purchase of raw material / goods for cash to the realization
of sales in cash is called the operating cycle, working capital cycle or cash cycle.
This cycle can be said to be at the heart of the need for
working capital. In the words of O.M. Joy: “The operating cycle refers to the
length of time necessary to complete the following cycle of events.”
The above operating cycle in figure relates to a
manufacturing firm where cash is needs to purchase raw materials and convert
raw materials into work-in-process is converted into finished goods. Finished
goods will be sold for cash or credit and ultimately debtors will be realized.
The non-manufacturing firms, such as whole sellers and
retailers, will not have the manufacturing phase; they will have rather direct
conversion of cash into finished stock, into accounts receivables and then into
cash. The operating cycle of a non manufacturing firm is shown as under.
The non-manufacturing firms, such as whole sellers and
retailers, will not have the
manufacturing phase; they will have rather direct conversion of cash into
finished stock, into accounts receivables and then into cash. The operating
cycle of a non manufacturing firm is shown as
under.
In addition to this, some service and financial concerns
may not have any inventory at all. Suchc firm have the shortes operating cycle
as shown in figure-1.7 as next page.
Operating
Cycle of Service and Financial Firms
A working capital term loan (WCTL) should
process specific characteristic as laid down below:
·
Working capital term loan is a shortage
“long-term surplus” or net working capital(NWC) in a unit that a bank chooses
to fund.
·
It is a long term need of the unit that is
met by the bank though its short term port-folio.
·
Working capital term loan may be either clean
or secured depending upon the margin stipulated or the amount of working
capital term loan in relation to the chargeable current assts.
·
It must be repaid is a prescribed maximum
number of installments.
·
It is not sanctioned as such but segregated
out of existing outstanding, when outstanding exceed the unit’s eligibility.
·
It is a sort of ‘once-in-a-life-time’ loan. It is a post-facto corrective measure, it
should not be repeated normally.
·
It should be repayable form long-term
sources. If the repayment is form short term sources, the permissible bank
finance will fall correspondingly and working capital term loan will rise there
by neutralizing the process of repayment.
Moreover, both physical and financial follow up can be
used to complement each other, if the concept of the ‘margin’ is refined and
integrated into the maximum permissible bank finance (MPBF)
MPBF = NWC + OSCL – NCCA/CCA Margin
Where NWC is net working capital, OSCL means other
current liabilities less creditors for purchases. NCCA are non-chargeable
current assets on which no drawls are permitted. CCA means chargeable current
assets on which margin are proposed to be stipulated. The application of margin
would be coupled with the deduction of the value of creditors for purchases
from the advance value to arrive at the drawing power. Once a margin is
stipulated, it can be utilized as the operating thumb rule for monitoring the
borrower’s stake in the stocks charged to the bank as well as a rough and ready
method for keeping the drawings power within the MPBF limits.
·
ADEQUACY OF WORKING CAPITAL
N.K. Kulshrestha has observed that, “the need for
maintaining an adequate working capital can hardly be questioned. Just a
circulation of blood is very necessary in the human body to maintain life,
smooth flow of funds is very necessary to maintain the heath of the firm”.
Adequate working capital becomes necessary because of the following reasons:
·
It protects a business form the adverse
effects of shrinkage in the values of current
assets.
·
It is possible to pay all the current
obligations promptly and to take advantages of cash discounts.
·
It ensures to a greater extent the
maintenance of a company’s credit standing and provides for such emergencies as
strikes, floods, fibers, etc.
·
It permits the carrying of inventories at a
level that would enable a business to serve satisfactory the needs of its customers.
·
It enables a company to extend favorable
credit terms to customer.
·
It enable a company to operate its business
more efficiently because there is no delay in obtaining materials, etc.,
because of credit difficulties.
·
It enables a business to withstand periods of depression smoothly.
·
There may be operating losses or decreased
retained earnings.
·
There may be excessive non-operating or
extraordinary losses.
·
The management may fail to obtain funds from
other sources for the purposes of expansion.
·
There may be an unwise divided policy.
·
Current funds may be invested in non-current assets.
·
The management may fail to accumulate funds
necessary for meeting debentures on maturity.
·
There may be increasing price necessitating
bigger investments in inventories and fixed
assets.
·
EXCESS OF INADEQUACY OF WORKING CAPITAL
The firm should maintain a sound working capital
position. It should have adequate working capital to run its business
operations. Both excessive as well as inadequate working capital positions are
dangerous form the firm’s point of view. Excessive working capital means idle
funds which earn no profit for the firm. Paucity of working capital not only
impairs firm’s profitability but also results in production interruption and
inefficiencies.
When the company is inadequate, a company faces the
following problem:
·
It is not possible for it to utilize
production facilities fully for want of working capital.
·
A company may not be able to take advantages
of cash discount facilities.
·
The credit-worthiness of the company is
likely to be jeopardized because of lack of
liquidity.
·
A company may not be able to take advantages
of profitability business opportunities.
·
The modernization of equipment and even
routine repairs and maintenance facilities may be difficult to administer.
·
A company will not be able to pay its
dividends because of the non- availability of
funds.
·
A company cannot afford to increase its cash
sales and may have to restrict its activities to credit sales only.
·
A company may have to borrow funds at
exorbitant rates of interest.
·
Its low liquidity may lead to low
profitability in the same way as low profitability results in low liquidity.
·
Low liquidity would positively thirteen the
solvency of the business. A company is considered illiquid when it is not able
to pay its debts on maturity. It must be wound up under section 433 of the
companies Act, 1956, upon its inability to pay its debts.
An enlightened management should therefore, maintain an
adequate amount of working capital on a continuous basis. Sound financial and
statistical techniques by judgments should be used to predict the quantum of
working capital.
·
Commercial Bank (Bank Credit):
The major part of working capital is provided by commercial bank to their
customer. Commercial banks play an important role in providing capital to its
customers. Commercial banks are an important source of working capital in India India
Banks provided working capital in the form of cash
credit, overdraft, discounting bills of exchanges etc. banks take into account
the several factors of the borrowing concern before fixing credit limit. Bank
credit to commercial sector was Rs. 21, 23,363 crores at the end of March 200723.
There were 36,927 officers of nationalized banks at the end of March 2007.
·
OPTIMUM LEVEL OF CURRENT ASSETS
The financial manager should determine the optimum level
of current assets so that the wealth of shareholders be maximized. In fact,
optimum level for each type of current assets should be fixed. The question of
optimum investment in each type of current assets is discussed. Here we simply
discuss the basic concept involved in determining the level of current assets.
Current Assets and Fixed Asset:
A firm needs fixed and current assets to support a particular level of
output. However, to support the same level of output, the firm can have
difference levels of current asset. As the firm’s output and sales increase,
the need for current assets increase in direct proportion to output; current
assets increase at a decreasing rate with output. This relationship is based
upon the notion that it takes a greater proportional investment in current
assets when only a few units of output are produced than it does later on when
the firm can used its current assets more efficiently.
Alternative Current Assets
Polices
The help of the above graph the most
conservative policy is alternative A, where CA/FA ratio is greatest at every
level of output. Alternative C is the most aggressive policy, as CA/FA ratio is
lowest at all levels of output. Alternative B lies between the conservative and
aggressive polices and is an average policy.
Other things assuming constant, a
conservative policy implies greater liquidity and lover risk and poor
liquidity. The current assets policy of the most firms may fall between these
two extreme policies.
The level of current assets can be measured by relating
current asset to fixed assets. Dividing current assets by fixed assets gives
the CA/FA ratio. Assuming a constant level of fixed assets, a higher CA/FA
ratio indicates a conservative current assets policy, and a lover CA/FA ratio
means an aggressive current assets policy.
·
FINANCING CURRENT ASSETS
The firm must find out sources of funds to finance its
current assets. It can adopt difference financing policies. Three types of
financing be distinguished: long term financing, short-term financing and
spontaneous financing. The important sources of long term financing are shares,
debenture, preference share, retained earnings and debt form financial
institutions. Short-term financing refers to those sources of short term credit
that the firm must arrange in advance. These sources included short-term bank
loans, commercial papers and factoring receivable. The firm must find out the
sources of funds to finance its current assets. In the words of O.M. Joy: “in
comparing financing plans we should distinguish between three different kinds
of financing: long-term financing, negotiated short-term financing and
spontaneous short-term financing”. The major source of spontaneous short-term
financing is trade credit and outstanding expenses. Therefore, a firm would
like to finance its current assets with spontaneous source of the fullest
extent. Every firm is expected to utilize spontaneous sources to the fullest
extent. Thus, the real choice of financing current assets is between short-term
and long term sources. The following three important approaches are applied in
practice.
·
Matching Approach:
The firm can adopt a financial plan which involves the
matching of the expected life of assets with the expected life of the source of
funds raised to finance assets. Thus, a ten years loan may be raised to finance
a plant with an expected life of ten years; stock to be sold thirty day may be
financed with a thirty-day bank loan or
so on. Thus, when the firm follows matching approach, long-term
financing will be used to finance fixed assets and permanent current assets.
shows the firm’s investment and financing patterns over
time under a matching plan. As the firm’s fixed assets and permanent current
asset levels increase, the long term-term financing level also increases. When
temporary current assets level increase, short-term negotiated financing
increase, and when the firm has no temporary current assets, it is also has no
short-term negotiated financing.
·
Conservative
Approach:
Conservative finacing plasare those plans that use more
long-term finacing than is needed under a matching approch. The above figure-1.11
illustrates this approch. The firm is financing a protion of its temporary
current assets requriments with long-term finanging. Also, in periods when the
firm has no temporary current assets, the firm has exess finacing available
that will be invested in marketable securities.
These
plans are called conservative because they involve relatively heavy use of
long-term financing.
Figuer-1.11
·
Aggressive
Approach:
A firm may be aggressive in financing its assets. An
aggressive policy is said to befollowed by the firm when it uses more
short-term financing than warranted by the matching plan. Under an aggressive
policy, the firm finances a part of its permenent current assets with short-term
financing.
Some
exxtemely aggressive firms may even finance a part of their fixed assets with
short-term financing. The relatively more use of short-term financing makes the
firm more risky.
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