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A measure of both a company's efficiency and its shortterm financial health. The working capital ratio is calculated as follows: Working Capital= Current Assets Current Liabilities Positive working capital means that the company is able to pay off its short-term liabilities. Negative working capital means that a company currently is unable to meet its short-term liabilities with its current assets (cash, accounts receivable and inventory).
Gross working capital is the total investment made in current assets. Net working capital is the difference between current assets and current liabilities. Net Working capital = Current assets Current Liabilities.
Working Capital management: The administration of the firms current assets and the financing needed to support current assets.
The key difference between the long term financing and working capital is the timings of the cash.
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Short life span. Swift transformation. Decisions are repetitive & frequent. Difference between profit & present value is insignificant. Constituents of Working Capital Current Assets Current Liabilities Inventories Sundry Creditors. o Raw material. o Work in progress. o Finished Goods. Trade debtors. Trade Advances. Loans & Advances. Borrowings (short Term) Cash & Bank Balances. - Commercial Banks. -Others. Provisions.
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Work-inProgress
Raw Materials
Cash
Suppliers
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10-20
80-90
Hotels, Restaurants.
20-30
30-40 40-50 50-60
70-80
60-70 50-60 40-50
60-70
70-80 80-90
30-40
20-30 10-20
Nature of Business Service Firm- Electricity or Transport corporation. Manufacturing Concern- Machine tools unit. Seasonality of operations Highly fluctuating working capital requirements. Conditions of supply Prompt supply- less working capital. Unpredictable supply- more working capital.
Production policy Seasonal fluctuations- sharp variations in working capital. Market conditions High degree of competition & Strong market- more inventory- high working capital. Weak competition & strong market smaller inventory less working capital.
Credit policy Credit policy of supplier of raw material. Credit policy extended to customers. The firm must take care of credit policy of the market.
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Significance of Working Capital Amity School of Business Management In a typical manufacturing firm, current assets exceed one-half of total assets. Excessive levels can result in a substandard Return on Investment (ROI). Current liabilities are the principal source of external financing for small firms. Requires continuous, day-to-day managerial supervision. Working capital management affects the companys risk, return, and share price. Investment in current assets and the level of current liabilities have to be geared quickly changes in sales.
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Liquidity Analysis Policy Liquidity A High B Average C Low Greater current asset levels generate more liquidity; all other factors held constant.
Current Assets
50,000
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Total Costs
CA*
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The amount of current assets required to meet a firms long-term minimum needs.
RUPEE AMOUNT
TIME
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RUPEE AMOUNT
TIME
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Balance Sheet
Current Liabilities
Current Assets
Fixed Asset
Long-Term Debt Preferred Stock Common Stock
Suppose we use long-term financing to finance some of our current assets. This strategy would be less risky, but more expensive!
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Balance Sheet
Amity School of Business
Current Liabilities
Suppose we use current liabilities to finance some of our fixed assets. This strategy would be less expensive, but more risky!
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Permanent Assets (those held > 1 year) should be financed with permanent and spontaneous sources of financing. Temporary Assets (those held < 1 year) should be financed with temporary sources of financing.
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Moderate Match the maturity of the assets with the maturity of the financing. Aggressive Use short-term financing to finance permanent assets. Conservative Use permanent capital for permanent assets and temporary assets.
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The time that elapses between the purchases of raw material and collection of cash for sales is referred to as operating cycle. Operating Cycle= Inventory period + Accounts Receivables period . The time length between the payment of raw material purchases and collection of cash for sales is referred to as the cash cycle. Cash Cycle= Operating Cycle Accounts Payable Period.
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Operating Cycle
The investment in working capital is influenced by following events in the operating cycle of a firm: Purchase of Raw Material. Payments of Raw Material. Manufacture of Goods. Sale of finished Goods. Collection of cash for sales.
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Order Placed
Goods sold
Cash received
The time lag between the purchase of Raw Materials & the sale of finished goods is the Inventory Period.
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Accounts payable period is the time taken by the firm in paying its suppliers (Creditors).
AccountsPayable Period Average AccountsPayable Annual COGS/365
Operating cycle is the sum of the inventory period & the accounts receivables period. Cash cycle is equal to the operating cycle less the accounts payable period.
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Example:
Profit & Balance Loss A/C Sheet
Begn 2008
End 2008
Sales
800
Inventory
96
102
90
60
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Step 1: Estimate the cash cost of various assets required by the firm. Value of the current asset. -Profit element , if included in the value. -Non cash charges like depreciation, if any, included in the value. Step 2: Deduct spontaneous liabilities from the cash cost of the current liabilities.
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Current Assets Debtors: Total cash cost Raw material: Material cost Finished goods stock: Cash manufacturing cost Cash balance Current Liabilities Creditors: Material cost Manufacturing expenses outstanding Wages outstanding Working capital = current assets current liabilities + safety margin =Working capital required
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Accruals Accruals are what the firm owe to its employees and to the government. Wages & salaries are major accruals. Accruals vary with the activity level of firm. Treated as spontaneous financing. Regarded as Free Financing as no interest is paid. Trade Credit Represents the credit extended by the suppliers of the goods and services. Trade credit is given, provided the firm is considered creditworthy by its suppliers. Spontaneous source of finance.
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Trade credit is an important source of finance representing 25% to 50% of short term financing. Obtaining trade credit from the customers monitors: Earnings record over a period of time. Liquidity position of firm. Record of payment. Cultivating the good supplier relationships. Cost of credit.
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Short term loans The insurance companies provide loans to the manufacturing companies with excellent track records. Features: The loan is given for a period of one year and renewed for two consecutive years. After repayment, wait for 6 months for another loans.
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Inter corporate deposits A deposit made by one company with another, normally upto the period of six months is referred to as inter corporate deposits. Types: Call deposits. Three months deposits. Six months deposits.
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Working capital advance by commercial banks represent the important source for financing the current assets. It includes the: Application & processing. Sanction terms of condition. Forms of bank finance. Nature of security. Margin amount.
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RBI has authorized only 4 banks in public sector in India: SBI (through its subsidiary SBI factoring & Commercial services Ltd). Canara Bank ( through its subsidiary Canbank Factoring Ltd). Punjab National Bank. Bank of Allahabad.
Features: The factor selects the accounts of the client that would be handled by it & establishes along with the client the credit limits applicable. The factor assumes the responsibility for collecting the debt of accounts handled by it. The factor advances the money to the client not-yet-collected & not-yet-due debts. The amount advanced is 70%-80% of the face value of debt and carries the interest rate. Factoring may be on a recourse basis or non recourse basis. The interest on advances against debt, the factor charges a commission which may be 1% or 2% of the face value of the debt.
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Forfaiting is the purchase of a series of credit instruments such as drafts drawn under time letters of credit, bills of exchange, promissory notes, or other freely negotiable instruments on a "non recourse basis (non-recourse means that there is no comeback on the exporter if the importer does not pay). The Forfaiter deducts interest (in the form of a discount), at an agreed rate for the full credit period covered by the notes. The debt instruments are drawn by the exporter (seller), accepted by the importer (buyer), and will bear unconditional guarantee. The guarantee will normally be issued by the importer's bank, but some strong corporates can be accepted without a bank guarantee.
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