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    WORKING CAPITALMANAGEMENT:PATTERN OF FINANCING

    ANASSIGNMENT

    ON

    SUBMITTED BY:AKANKSHA RAJROLL NO : 06REG.NO: 08UD1105M.B.A (7 SEMESTER )

    SUBMITTED TO :MS. MAMTA BHARADWAJ( LECTURER )

    INSTITUTE OF MANAGEMENT STUDIES

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    INTRODUCTIONActive working capital management is an extremely effectiveway to increase enterprise value.Optimizing working capital results in a rapid release of liquidresources and contributes to an improvement in free cashflow and to a permanent reduction in inventory and capitalcosts, thereby increasing liquidity for strategic investment anddebt reduction.

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    3

    Sources OfFinance

    SecurityFinancing

    InternalFinancing

    Loan Financing

    EquityShares

    PreferenceShares

    Debentures

    RetainedEarnings

    DepreciationFund

    Short-Term

    Long-Term

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    Introduction: Any business firm requires two types of assets- :

    LONG TERM

    ASSETS

    SHORT TERM

    ASSETS

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    Contd. As studied earlier (basics of finance) threeimportant decisions:Investment decisionFinancing decisionDividend decision

    Now, all this may happen in any business if itcan run smoothly.The question is what is essential to run abusiness or to make fixed assts operative. Theanswer is Working Capital.

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    CONCEPT OF WORKINGCAPITAL

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    Current assets Current liabilities It measures how much in liquid assets a company hasavailable to build its business. A short term loan which provides money to buy earningassets. Allows to avail of unexpected opportunities. Positive working capital is required to ensure that a firmis able to continue its operations and that it has sufficient fundsto satisfy both maturing short-term debt and upcomingoperational expenses.

    WORKING CAPITAL :

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    DEFINATION : Working capital is the amount of funds used forfinancing the day to day affair of the business. It isthat part of total capital which is used for carrying outthe routine business activities.

    The management of working capital Thus involves:a) Managing inventories,b) Accounts receivable and payable and cash.

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    Types of WC

    On the basis of

    concept

    On the basis of

    Periodicity

    Gross WC Net WCFixed or

    Permanent WCVariable WC

    Positive WC

    Negative WC

    Regular WC

    Reserve Margin

    Or Cushion WC

    Seasonal WC

    Special WC

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    On the basis of concept :Classified in to two forms :

    Balance sheet concept

    Operating cycle concept

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    Balance sheet concept ofWC Classified in to 2. They are:

    a) Gross WC andb) Net WC

    Gross WC: Gross W C refers to the firmstotal investment incurrent assets. Net WC: Net W C refers to the difference between current

    assets and current liabilities.When CA is more than CL it is positiveWC and when CL ismore than CA .

    it is negative Working Capital

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    Gross WC It focuses attention on 2 aspects viz,

    a) Optimum investment in current assets andb) Financing of current assets

    Where asNet WC

    It indicates the liquidity position of the firm and It suggests the extent to which WC needs may be financed by

    permanent source of funds.

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    Operating cycle conceptof WC(Circular Flow Concept)Cash

    Raw

    Material

    Work in progress

    Finished goods

    Sales

    Debtors

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    Operating cycle concept classified in to 2:1. Gross operating cycle2. Net operating cycle Gross operating cycle = Raw material conversion

    period + Work in progress conversion period +Finished goods conversion period + receivableconversion period Net operating cycle=Gross operating cycle Payable deferral period

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    On the basis of periodicity : These are Classified in to 2 forms.

    They are:Fixed or Permanent WCVariable WC

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    Fixed or Permanent WC :Minimum amount of WC required to meet the day today activities. It is that part of WC which is locked up in currentassets to carry out business activities smoothly. It is also called core current assetsQuantity of fixed WC increases proportionately tothe expansion of the business

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    Diagrammatic representation

    of Fixed WC

    Fixed WC

    X0

    Y

    Time

    Amount

    of

    WC

    Fixed WC

    X0

    Y

    Time

    Amountof

    WC

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    Classification of fixed WCa) Regular WC -It is the minimum amount of WC needed to keep upthe circulation of capital from cash to inventory toreceivables and again to cash. (WC to be maintainedin normal conditions)b) Reserve margin or Cushion WC-It is the excess over the regular WC kept to meetuncertainties. (WC maintained to meet contingencieslike price rise, strikes, etc)

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    Variable WC

    WC required to meet seasonal demand orspecial needs is called variable or temporary

    WC. It is over and above fixed WC

    It is subdivided in to

    a) Seasonal WC &

    b) Special WC

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    Diagrammatic representation

    of Variable WC

    Fixed WC

    X0

    Y

    Time

    Amount

    of

    WC

    Fixed WC

    X0

    Y

    Time

    Amount

    of

    WC

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    Seasonal WC: The WC required to meet theseasonal demand of the productarises fromfestivals, economic conditions etc.

    Special WC: The WC required for financingspecial operations such as extensivemarketing campaigns, carrying out specialjob orders etc.

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    Flow of Cash through a Business

    Borrowed

    Funds

    Collection of

    Accounts

    Receivable

    Owner's

    Investment

    Borrowed

    Funds

    Sale of

    Fixed Assets

    Collection of

    Accounts

    Receivable

    Payment of

    Expenses

    Payment for

    Inventory

    Payment of

    Dividends

    Cash

    Sales

    Purchase of

    Fixed Assets

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    CONCEPT OF WORKINGCAPITAL MANAGEMENT

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    Theory of Working Capital Management:

    Working capital represents the value of current assetsin the firm. The management of short term assets is soimportant for a firm that it can survive only afterkeeping adequate level of short term assets.

    The working capital plays a role in business firm like alubricants and fuel in automobile. It converts an assetfrom non productive to productive one and vice versa. It applies for all the factors of production. In everybusiness the receipts are uncertain where as thepayments are certain.

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    Contd.. So, to fill this gap a firm needs optimum quantity ofworking capital. The working capital management refers the matchingof current assets and current liabilities to maintain

    long term assets and to pay respectable compensationto the long term funds. It establishes the relationship between current assetsand current liabilities. It Must be noted that it should be adequatelysupplied to increase the wealth of the organization.

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    Contd.Working capital management involves twomain processes.Determining the size of the workingcapitalArranging the sources of working

    capital

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    Determining the size of the workingcapital:

    It is determined on the basis of certain factors, likeNature of IndustrySize of BusinessManufacturing CycleProduction PolicyVolume of SalesTerms of purchase & Sales

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    Contd.Business CycleGrowth and ExpansionSupply of Raw MaterialsPrice Level changesCapital StructureMonetary Policy

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    Arranging the sources of workingcapital:

    It depends mainly upon the availability of funds anddifferent application of this working capital. Currentassets or working capital includes mainly threecomponents Inventories Cash ReceivablesSo, in short we can also say that the working capitalmanagement means to manage all these threecomponents in the firm.

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    Contd. Types of Working Capital: There two broadclassifications of the working capital.Gross Working CapitalNet Working Capital

    There are two more classifications which are also veryimportant. Permanent Working Capital Temporary Working Capital

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    Determining the Financing mix :In working capital finance we will discuss twothings- :

    Sources of Working CapitalApproaches for determining the Financing Mix

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    Sources of Working Capital: On the basis of sources, we can classify it in tothree broad categories-Long Term FinancingShort Term FinancingSpontaneous Financing

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    Short Term Financing: Short term financing is essential to provide capital

    deficit businesses funds for short term period of a year orless. These funds are usually for businesses to run theirday-to day operations including payment of wages toemployees, inventory ordering and supplies . It includes following- Bank overdraft trade credit , credit card short term bank loans

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    Bank over-draft.If the borrower requires temporary finance , the banker may allowhim to overdraw on his account with or without security

    Cash creditCash credit is a financial arrangement through which thecommercial banks allow the borrower to the borrow money up toa certain limit

    Public deposit

    Business firm are raising short-term finance from their member ,directors and the general public. Bills discounting

    The commercial banks advance to the borrower by discountinghis bill. Short-term loans

    The bankers makes a lump-sum payment to the borrower or credithis deposit account with the money advanced..

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    Spontaneous Financing:This source of finance is cost free sources. It includes following-Trade CreditorsOutstanding Expenses etc.

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    Approaches for determining theFinancing Mix: There are following three types of approachesto finance the working capital Matching Approach or Hedge Approach Conservative Approach Aggressive Approach

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    Matching Approach or HedgeApproach:

    In this approach of financing the workingcapital the firm tries to finance the permanentworking capital through the long term fundsand temporary working capital through shortterm funds.

    A company that uses more short-term source offinance and less long-term source of finance will incurless cost but with a corresponding high risk. This hasthe effect of increasing its profitability but with apotential risk of facing liquidity problem should suchshort-term source of finance be withdrawn orrenewed on unfavorable terms.

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    Conservative Approach: According this approach the whole amount ofworking capital should be financed throughthe long term funds. In this approach the firm does not want to takeany risk. It is a costly approach in comparison tomatching approach.

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    Cont.

    This option means that the companys financeis going to be relatively high cost (that issacrificing low cost finance) but low risk; thiswill make the companys profit to be low butdoes not run the risk of being faced withliquidity problem as a result of withdrawal ofits source of finance

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    Aggressive Approach: Between the two extreme approaches to financingworking capital is the moderate (or the matching orbalancing) approach. This approach makes distinction between fluctuatingcurrent assets and permanent current assets with thesuggestion that to finance working capital; short-termsource of finance should be used to finance

    fluctuating current assets, whiles long-term source offinance should be used to finance permanent currentassets..

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    Cont.

    Under this approach the firm uses the shortterm funds to finance some part of permanentworking capital and the whole of part oftemporary working capital. But this approach is more risky for the firm,however this the cheapest approach.

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    How to decide the levels andfinancing of current assets??

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    Planning of working capital Every firm must maintain a sound working capitalotherwise; its business activities may be adverselyaffected. The objective of financial management i.e. tomaximize the wealth of the shareholder cannot beattained if operations the firm are not optimized. Thus, every firm has to maintain adequate workingcapital. It should have neither the excessive workingcapital nor inadequate working capital.

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    Need of working capital To increase operating profit, the firm should increaseits sales. In practical life it has been seen that when firmincreases its sales the profit may increase but it is notnecessary that the cash profit may increase, becausesales include the cash and credit sales. Cash sales increase the cash position whereas creditsales increase the receivables.

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    The collection of cash from receivables require sometimes span. So, to meet out day to day expenses thefirm needs some sort of funds to run uninterruptedbusiness operations, the amount will be locked up inthe current assets. It happens due to operating cycles. The need ofworking capital is based on the length of operatingcycles. The length of operating cycle depends mainlyon the nature of business it self.

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    Operating CycleCash Raw material

    Work in progress Finished

    Goods Sales

    Debtors Bills receivables

    Cash

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    Concept and Computation ofOperating Cycle:

    The operating cycle concept refers to the timelag, which is required to convert the rawmaterial in to finished products and finishedproduct to cash again.

    The Total Operating Cycle Period (TOCP) will beequal to Inventory Conversion Period (ICP) +Receivable Conversion Period (RCP). The firm might get some credit form supplier of rawmaterial, wages earners etc.

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    Cont The period for which the payments to theseparties are delayed or deferred is known as

    Deferred Period (DP). The Net Operating Cycle (NOC) of the firmmay be calculated by deducting Deferred

    Period (DP) from the Total Operating CyclePeriod (TOCP).

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    Problems Associated with Excess andInadequate Working Capital:

    This is very important aspect of working capitalmanagement that excessive as well as inadequateworking capital both are harmful to the organization.Excess working capital creates idle funds, whichcannot earn any return, whereas shortages of workingcapital will hamper the production process and otherbusiness operations. In both the situations firm has tosuffer loss.

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    Demerits of Excessive WorkingCapital

    There may be following problems : It can accumulate unnecessary inventories. Thuschance of mishandling, theft, wastage of inventoriesmay occur. It also indicates poor collection of receivable and veryliberal credit policy regarding sales. The bad debtswill increase it such situation continues for long time. It allows to the management to inefficiently Accumulation of excessive inventories also leads tospeculative profit. This may tend to make dividendpolicy liberal, which may create serious problems infuture. Excessive availability of cash tempts the executive to

    spend more.

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    Demerits of Inadequate WorkingCapital:

    There may be following problems- It becomes difficult for the firms to undertake profitableprojects due to shortage of working capital. The firm may face problems in implementing the operating

    plans and achieve the firms profit target. It also creates problem in meeting out day-to-day or routineexpenses. Fixed assets can be utilized more effectively, thus the overallreturn may go down. Due to inadequate working capital firm may loose some goodcredit opportunities The firm may spoil its fame and reputation if it fails to honourshort-term obligations. As a result, the firm faces tight creditterms. It directly affects the liquidity positions of the business firms.

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