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For addition shareholder's wealth a firm has to analyze the ensue of fixed assets and current assets on its return and risk. Working Capital management is linked with the management of current assets. The management of current assets is dissimilar from fixed assets on the basis of the following points:
1. Current assets are for short duration while fixed assets are for more than one Year.
>2. The large holdings of current assets, especially cash, strengthens Liquidity position but also reduces ample profitability, and to allege an optimum level of liquidity and profitability, risk return trade off is complex retention Current assets.
3. Only Current Assets can be adjusted with sales ranging in the short run. Thus, the firm has greater degree of flexibility in managing current Assets. The management of Current Assets helps affirm in building a good market reputation with regard to its enterprise and economic condition.
Now first let us discuss the paradigms of Working Capital Management.
Concept Of Working Capital:
The opinion of Working Capital includes Current Assets and Current Liabilities both. There are two concepts of Working Capital they are Gross and Net Working Capital.
1. Gross Working Capital: Gross Working Capital refers to the firm's venture in Current Assets. Current Assets are the assets, which can be converted into cash within an accounting year or operating cycle. It includes cash, short-term securities, debtors (account receivables or book debts), bills receivables and stock (inventory).
2. Net Working Capital: Net Working Capital refers to the unlikeness between Current Assets and Current Liabilities are those claims of outsiders, which are predicted to mature for cost within an accounting year. It includes creditors or accounts payables, bills payables and excellent expenses. Net Working Copulate can be sure or negative. A sure Net Working Capital will arise when Courtney Assets exceed Current Liabilities and vice versa.
Concept of Gross Working Capital
The opinion of Gross Working Capital focuses attentiveness on two aspects of Current Assets' management. They are:
a) Way of optimizing venture in Current Assets.
b) Way of financing current assets.
a. Optimizing venture in Current Assets: venture in Current Assets should be just enough i.e., neither in excess nor deficit because excess venture increases liquidity but reduces profitability as idle venture earns nothing and inadequate whole of working capital can threaten the solvency of the firm because of its inability to meet its obligation. It is taken into notice that the Working Capital needs of the firm may be ranging with changing enterprise activities which may cause excess or shortage of Working Capital oftentimes and prompt management can operate the imbalances.
b. Way of financing Current Assets: This aspect points to the need of arranging funds to finance Country Assets. It says whenever a need for working Capital arises; financing arrangement should be made quickly. The financial manager should have the knowledge of sources of the working Capital funds as wheel as venture avenues where idle funds can be temporarily invested.
Concept of Net Working Capital
This is a qualitative concept. It indicates the liquidity position of and suggests the extent to which working Capital needs may be financed by permanent sources of funds. Current Assets should be optimally more than Courtney Liabilities. It also covers the point of right combination of long term and short-term funds for financing court Assents. For every firm a particular whole of net Working Capital in permanent. Therefore it can be financed with long-term funds.
Thus both concepts, Gross and Net Working Capital, are equally leading for the effective management of Working Capital. There are no definite rules to resolve a firm's Gross and Net Working Capital but it depends on the enterprise performance of the firm.
Working capital management is implicated with the problems that arise while managing the current assets the current liabilities and the interrelationship that exits between them. Thus, the Wc management refers to all aspects of a management of both current assets the current liabilities.
Every enterprise concern should not have neither redundant nor cause excess Wc nor into should be short of W.C. Both health are harmful and unprofitable for any business. But out of these two the shortage of Wc is more perilous for the well being of the firms.
Impact/Harm of Redundant Or inordinate Working Capital
* inordinate Wc means idle funds, which earn no profits for the business, cannot earn proper rate of return on its investment.
* When there is a redundant Wc, it may lead to unnecessary purchasing and accumulation of inventories causing more chances if theft, waste and losses.
* inordinate Wc implies inordinate debtors and defective reputation policy, which may cause higher incidences of bad debts.
* It may ensue into ample inefficiency in the organizations.
* When there is inordinate Wc relation with banks and other financial institutions may not be maintained.
* The redundant Wc gives rise to speculative transaction.
* Due to low rate of return on investments the value of shares may also fall.
* In case of redundant Wc there is all the time a chance of financing long terms assets from short terms funds, which is very harmful in long run for any organization.
Dangers of Short or Inadequate Working CapitalØ A concern, which had enough Wc, cannot pay its short-term liabilities in time. Thus it will lose its reputation and should be not be able to get good reputation facilities.
* It cannot by its requirements in bulk and cannot avail of discounts. It stagnates growth.
* It becomes difficult for the firms to exploit convenient market conditions and undertake profitable projects due to non-availability of Wc funds.
* The firm cannot pay day-to-day expenses of its operations and its reputation inefficiencies, increases cost and reduces the profits of the business.
* It becomes impossible to use efficiently the fixed assets due to non-availability of liquid funds thus the firms profitability would deteriorate.
* The rate of return on investments also falls with the shortage of Wc.
* Operating inefficiency creeps in and it becomes difficult to implement operating plans and perform the firms behalf targets.
Need for Working CapitalFor earning behalf and continue output activity, the firm has to spend enough funds in Current Assets in generating sales. Current Assets are needed because sometimes sales do not change into cash instantaneously and it includes an operating cycle.
Operating Cycle: Operating cycle is the time duration required to change sales, after the conversion of resources into inventories, into cash. venture in current assets such as inventories and debtors is realized while the firm's operating cycle, which is ordinarily less than a year.
The operating cycle of a manufacturing enterprise involves three phases: -
1. Acquisition of resources such as raw material, labor, power and fuel etc.
2. Institute of the stock which includes conversion into work-in-progress into complete goods.
3. Sale of the stock whether for cash or on credit.
These phases affect cash flows because sometimes sale is done on reputation and it takes sometimes to realize.
Length or duration of the Operating Cycle: The distance of the operating cycle of a manufacturing firm in the sum of the following:
1.Inventory Conversion period
2. Debtors Conversion periods.
The total of Debtors Conversion duration and catalogue Conversion duration is referred to as Gross Operating Cycle.
1. catalogue Conversions Period: The catalogue Conversion duration is the total time needed for Producing and selling the product. It includes:
a. Raw Material Conversion Period.
b. Work-in-progress Conversion Period.
c. complete Goods Conversion Period.
2. Debtors Conversion Period: It is the time required to regain the excellent whole from the customers.
Net Operating Cycle: Generally, a firm may resources (raw materials) on reputation and temporarily postpones cost of sure expenses. Payables, which the firm can defer, are spontaneous sources of capital to finance venture in Courtney Assets.
The distance of the time in which the firm is able to defer payments on various reserved supply purchases is Payables Deferral period. The deference between Gross Operating Cycle and payables Deferral duration is called Net Operating Cycle. If depreciation is excluded from Net Operating Cycle, the computation repercussion represents Cash Conversion Cycle. It is net time interval between cash outflow.
Operating Cycle also report the time interval over which additional funds, called Working Capital, should be obtained in order to carry out the firm's operations. The firm has to negotiate Working Capital from sources such as banks. The negotiated sources of Working Capital financing are called non-spontaneous sources. If net Operating Cycle of a firm increases it means additional need for negotiated Working Capital.
Calculation of Operating Cycle: The calculation of operating cycle helps to know the exact duration of Wc turnover i.e. How long it takes to change cash again into cash? through this calculation one can ascertain the Wc period.
Formula: -Raw Material retention duration = Avg. Stocks of Raw Material
Avg. Cost of consumption per day
Work in develop Conversion duration = Avg. Work in progress
Avg. Cost of output per day
Finished goods retention duration = Avg. Stock of complete goods
Avg. Cost of goods sold per day
Receivables & Debtors collections duration = Avg. Book debts.
Avg. reputation sales per day
Credit duration allowed by creditors = Avg. Creditors
Avg. reputation purchase
Duration Of Operating Cycle
Goc = Rm + Wip + Fg + D + R
Noc = Goc-C
Where Gov = Gross operating cycle.
Noc = Net operating cycle
Rm = Raw material conversion period.
C = reputation duration available
Wip = Wip conversion period
Fg = Fg retention period
D & R = Detors and receivables variety period.
Note:
360 working days in a year are taken to presuppose per day average.
Avg. Means chance + windup /2
Depreciation is excluded while calculating cost of output & sales as it is a non-fund charge and does not want working capital.
Permanent and variable Working Capital
There is all the time a minimum level of current Assets, which is continuously required by the firm to carry on its enterprise operations. The minimum level of Current Assets is referred to as permanent of fixed Working Capital. It is permanent in the same way as the firm's fixed assets are. The extra Working Capital, needed to support the changing output and sales activities is called ranging or variable or temporary Working Capital.
Both Kinds of Working Capital, permanent and temporary, are primary to facilitate output and sale through the operating Cycle.
Estimating Working Capital Needs: Working Capital needs can be estimated by three dissimilar methods, which have been successfully applied in practice. They are follows:
1. Current Assets retention Period: To estimation Working Capital requirements on the basis of average retention duration of Current Assets and relating them to costs based on the company's taste in the previous years. This recipe is based on the operating cycle concept.
2. Ratio of Sales: To estimation Working Capital requirements as a ratio of sales on assumption that Current Assets change with sales.
3. Ratio of fixed Investment: To estimation Working Capital requirements as a division of fixed investment.
The most standard recipe of calculating the Working Capital needs of firm is the opinion of operating cycle. There are some limitations with all the three approaches therefore some factors govern the choice of recipe of Working Capital.
Factors considered are seasonal variations in operations, accuracy sales forecasts, venture cost and variability in sales price would commonly be considered. The output cycle and reputation and variety policy of the firm would have an impact on Working Capital requirements.
Current Assets Financing
A firm can adopt dissimilar financing policies for Current Assets Three types of financing used can be:
1. Long-term financing such as shares, debentures etc.
2. Short-term financing such as group deposits, industrial papers etc.
3. Spontaneous financing refers to the self-operating sources of short-term funds arising in the normal policy of a enterprise such as trade reputation (suppliers) and excellent expenses etc.
The real choice of financing Current Assets is between the long term and short-term sources of finances. The three approaches based on the mix of long and short-term mix are:
1. Matching Approach: When the firm follows matching arrival (also known as hedging approach), long term financing will be used to finance Fixed Assets and permanent Current Assets and short-term financing to finance temporary or variable Current Assets. The justification for the exact matching is that, since the purpose of financing is to pay for assets, the source of financing and the assets should be relinquished simultaneously so that financing becomes less costly and inconvenient. However, exact matching is not possible because of the uncertainty about the predicted lives of assets.
2. Conservative Approach: The financing policy of the firm is said to be a conservative when it depends more on long-term funds for financing needs. Under a conservative plan, the firm finances its permanent assets and also a part of temporary Current Assets with long term financing. In the periods when the firm has no need for temporary Current Assets, the idle long-term funds can be invested in the tradable securities to conserve liquidity. Thus, the firm has less risk of shortage of funds.
3. Aggressive Approach: An aggressive arrival is said to be followed by the firm when it uses more short term financing than warranted by the matching approach. Under an aggressive approach, the firm finances a part of its permanent current assets with short term financing. Some firms even finance a part of their fixed assets with short term financing which makes the firm more risky.
Managing Current Assets: management of Current Assets is done in three parts. They are:
1) management of cash and cash equivalents.
2) management of inventory.
3) management of accounts receivable and factoring.
Thus, the basic goal of Wc management is to administrate the current assets the current liabilities of the firm in such a way that a satisfactory level of Wc is maintained, i.e. It is neither inadequate nor inordinate Wc management policies of a firms have a great ensue on its Profitability, Liquidity and Structural health of the organization.
Wc management is an integral part of ample corporate management. For proper Wc management the financial manager has to perform the following basic functions:-
· Estimating the Wc requirement.
· Determining the optimum level of current assets.
· Financing of Wc needs.
· analysis and operate of Wc.
Wc management decision are three dimensional in nature i.e. These decisions are ordinarily linked to these there sphere or fields.
· Profitability, risk and liquidity.
· combination and level of current assets.
· combination and level of current liabilities.
Principles Of Working Capital
There are four principle of working capital management. They are being depicted as below :
(i) Principle of Risk Variation: - The goal of Wc management is to Institute a convenient trade between profitability and risk. Risk here refers to a firm's quality to honor its promulgation as and when they come to be due for payments. Larger venture in current assets will lead to dependence. Short term borrowings increases liquidity, reduces risk and thereby decreases the chance for gain or loss On the other hand the support situation will growth risk and profitability And sacrifice liquidity thus there is direct association between risk and profitability and inverse association between liquidity and risk.
(ii) Principle of Cost Capital: - The various sources of raising Wc finance have dissimilar cost of capital and the degree of risk involved. commonly higher the cost lower the risk, Lower the risk higher the cost. A sound Wc management should all the time try to perform the equilibrium between these two.
(iii) Principle of Equity Position: - This principle is considered with planning the total venture in current assets. As per this principle the whole of Wc venture in each component should be adequately justified by a firms equity position Every rupee contributed current assets should contribute to the net worth of the firm The level of current assets may be measured with the help of two ratios. They are:
· Current assets as a division of total assets.
· Current assets as a division of total sales.
(iv) Principle of Maturity Payment: - This principle is implicated with planning the source of finance for Wc. As per this principle a firm should make every exertion to recap maturities of its flow of internally generated funds in other words it should plan its cash inflow in such a way that it could literally cover its cash out flows or else it will fail to meet its promulgation in time.
Reference
Anand, M. 2001. "Working Capital doing of corporate India: An empirical survey", management & Accounting Research, Vol. 4(4), pp. 35-65. Bhalla, V. K., 'Working Capital Management', Anmol, New Delhi, 2005. Bhattacharya, Hrishikes, 'Working Capital Management: Strategies and Techniques', Prentice-Hall of India Products, 2004. Burns, R and Walker, J. 1991. "A survey of Working Capital policy Among Small Manufacturing Firms", The Journal of Small enterprise Finance, 1 (1), pp. 61-74 Padachi, Kesseven, 'Trends in working capital managmenet and its impacts on firms performance: An analysis of Mauritius small manufacturing firm', International recap of enterprise investigate Papers, Vol. 2., October 2006, p-45-58. Sadri, Sorab & Tara, Sharukh, N., 'Understanding Working Capital Management', Rai enterprise School, Mumbai, March 25, 2006.
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