Project Report on:

Working Capital Management

Submitted By:

NAME: Aklesh s. Morya

SEAT NO: __________

TYB.Com (FINANCIAL MARKETS)

Semester Vth

Submitted To:

University Of Mumbai

Project Guide:

1

MR. Sandeep Singh

Academic Year

2013-2014

CERTIFICATE This is to certify that the

project entitled Working Capital Management

is successfully done by Aklesh s.Morya during

the Third Year, Fifth Semester of B.com

[Financial Markets] under the University Of

Mumbai through the Thakur College of Science

& Commerce, Kandivali , Mumbai – 400101.

_______________ _______________

______________

Co-ordinator Project Guide

Principal

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Date: _________

Place: ____________

____________________________

External Examiner

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DECLARATION

I Aklesh s.Morya from Thakur

College of Science & Commerce, student of

T.Y.B.Com (Financial Markets), semester V,

Examination Seat no:-_________, here by

submit my project report on Working Capital

Management

I also declare that this

project which is the partial fulfillment of

the requirement for the degree of T.Y.B.Com

(Financial Markets) of the Mumbai University

is the result of my own efforts with the help

of experts.

Date: __________

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ACKNOWLEDGEMENTIt gives me immense pleasure in presenting the

project on Working Capital Management.Firstly, I take the opportunity in thanking

almightily and my parents without whose continuous

blessings, I would not have been able to complete

this project.

I would like to thank my project guide Prof.Sandeep

Singh for his great help, valuable opinions, advice

and suggestions in fulfillment of this project &

always encouraging and given me new hope to do this

project.

I am also grateful to my father for supporting me

for providing me material and knowledge to make this

project a success. I convey my deep appreciation to

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them for sparing their valuable time and efforts, so

as to make me capable of presenting this project.

I am thankful to our college for all the possible

assistance and support, by making available the

required books and the internet room which have

proved useful to me in successfully completing my

project.

I hope that I have succeeded in presenting this

project to the best of my abilities.

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EXECUTIVE SUMMARY

A company can be endowed with assets and profitability but short of liquidity if its assets cannot readily be converted into cash.Positive working capital is required to ensure that a firm is able to continue its operations and that it has sufficient funds to satisfy both maturing short-term debt and upcoming operationalexpenses. The management of working capital involves managing inventories, accounts receivable and payable, and cash.

Working capital (abbreviated WC) is a financial metric which represents operating liquidity available to a business, organization or other entity, including governmental entity. Along with fixed assets such as plant and equipment, working capital is considered a part of operating capital. Net working capital is calculated as current assets minus current liabilities. It is a derivation of working capital, that is commonly used in valuation techniques such as DCFs(Discounted cash flows). If current assets are less than current liabilities,an entity has a working capital deficiency, also called a workingcapital deficit.

My study gives an overview of Working Capital- definition, types,

benefits, risks, limitations. The main purpose of doing this

project was to know about Working Capital and its functioning.

This helps to know in details about Working Capital right from

its inception stage, calculations. This project will ultimately

help in understanding the benefits of Working capital to

Creditors, and the investors.

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SR.NO INDEX PAGE

NO.1 An Overview

1.1

1.2

1.3

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2 The Objectives and Structure of Working Capital

Management

2.1

2.2

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3 The Working Capital Cycle and Operating

Efficiency23

4 The Accounting Concept of Working Capital: A

Critique

4.1

4.2

31

5 TRADING OF DERIVATIVES CONTRACTS

5.1 Futures and Options Trading System

5.2 The Trader Workstation

5.3 Futures and Options Market

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Instruments

5.4 Criteria for Stocks and Index

Eligibility for Trading 6 CLEARING AND SETTLEMENT

6.1 Clearing Entities

6.2 Clearing Mechanism

6.3 Settlement Procedure

6.4 Risk

6.5 Margining System

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7 The Strategic Impact of Alternative CreditPolicies on Working Capital and Company Profitability7.1

7.2

7.3

7.4

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8 Questionnarie 51

9 CONCLUSION 5610 BIBLIOGRAPHY 65

1 An Overview Working capital (abbreviated WC) is a financial metric which represents operating liquidity available to a business, organization or other entity, including governmental entity. Along with fixed assets such as plant and equipment, working capital is considered a part of operating capital. Net working capital is calculated as current assets minus current liabilities.It is a derivation of working capital, that is commonly used in valuation techniques such as DCF (Discounted cash flows). If current assets are less than current liabilities, an entity has a working capital deficiency, also called a working capital deficit.

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1.2 Objectives of the Text The text assumes that We have prior knowledgeof Financial Accounting and an ability to interpret corporatefinancial statements using ratio analysis. So, at the outset, you should be familiar withthe following glossary of terms:

Working capital: a company’s surplus of current assets over current liabilities, which measures the extent to which it can finance any increase in turnover from other fund sources.

Current assets: items held by a company with theobjective of converting them into cash within the near future. The mostimportant items are debtors or account receivable balances (money due fromcustomers), inventory (stocks of raw materials, work in progress and finishedgoods) and cash or near cash (such as short term loans and tax reservecertificates). Current liabilities: short term sources of finance,which are liable to fluctuation, such as trade creditors (accounts payable) fromsuppliers, bank overdrafts and tax payable.

On completion of this text we should be able to: - Distinguish between the internal working capital management function and an external interpretation of a firm’s working capital position revealed by its published accounts, - Calculate the working capital operatingcycle and financing cycle from published accounting data andanalyse the inter-relationships between the two, - Define the dynamics of a company’s credit-related funds system, - Explain how the terms of sale, which

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comprise the credit period, cash discount and discount period, affect thedemand for a firm’s goods and services, - Understand the impact of alternativecredit policies on the revenues and costs which are associated with acapital budgeting decision,

1.2 Working CapitalThe remainder of our study is divided into three sections.

Part Two begins by explaining the relationshipbetween working capital management and financialstrategy. You are reminded that the normativeobjective of financial management is themaximisation of the expected net present value(NPV) of all a company’s investment projects.Because working capital is an integral part ofproject appraisal, we shall define it within thiscontext.

We then reveal why the traditional accountingconcept of working capital is of limited use tothe financial manager. The long-standing rulethat a firm should strive to maintain a 2:1ratio of current assets to current liabilities is questioned. Usingillustrative examples and Activities you will beable to confirm that:

- Efficient working capital management should be guided by cash profitability, which may conflict with accounting definitions of solvency and liquidity developed by external users of published financial statements,

- An optimal working capital structure may depart from accounting conventions by reflecting abalance of credit-related cash flows, which

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are unique to a particularcompany

Part Three initially considers how the terms ofsale offered by a company to its customers is aform of price competition, which can influencethe demand for its goods and services. We shallbegin by using the time value of money conceptwithin a framework of “effective prices” toexplain how the availability of credit periodsand cash discounts for prompt payment providecustomers with reductions in their cash price.

Items bought on credit will be shown to createa utility in excess of their eventual purchaseprice measured by the debtors’ opportunity toutilise this amount during the credit period, ordiscount period. By conferring enhancedpurchasing power upon its customers, a company’sterms of sale will be seen to have true“marketing” significance. They represent anaspect of financial strategy, whereby thecreditor firm can translate potential demandinto actual demand and increase futureprofitability. Your Activities will confirm this.

For the provider of goods and services (thecreditor firm) we then explain why theavailability of trade credit is not withoutcost:

- Invoiced payments for accountsreceivable, which are deferred ordiscounted, represent a claim to cash thathas a value inversely related to the timeperiod in which it is received, - Credit policies are a key determinant ofthe structure, amount and duration of a firm’stotal

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working capital commitment tied to its price-demand function,

- Alternative credit policies, therefore, produce different levels of profit.

So, when a firm decides to sell on credit, orrevise credit policy variables, it shouldensure that the incremental benefits from anyadditional investment exceed the marginal costs.

Part Four challenges the extent to whichcompanies adhere to standard industry terms basedon empirical evidence. Given our critique ofconventional working capital analysis comparedto a time-honoured theoretical framework foranalysing effective prices associated withdifferent credit terms.

- Typical cash discounts confer unnecessary benefits on cash customers, - Non-discounting customers often remit payment beyond the permitted credit period, - Standard industry terms produce a sub-optimal investment in working capital, which do not makean efficient contribution to profit.

1.3 Working capital ManagementEvery running business needs working capital. Even abusiness which is fully equipped with all types offixed assets required is bound to collapse without(i) adequate supply of raw materials for processing;(ii) cash to pay for wages, power and other costs; (iii) creating a stock of finished goods to feed

the market demand regularly; and,

(iv) the ability to grant credit to its customers.All these require working capital. Workingcapital is thus like the lifeblood of abusiness. The business will not be able to carryon day-to-day activities without theavailability of adequate working capital. The

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diagram shown on the next page clarifies it:

Working capital cycle involvesconversions and rotation of various constituents/componentsof the working capital. Initially ‘cash’ is converted into rawmaterials.

Subsequently, with the usage of fixed assets resultingin value additions, the raw materials get converted into work in process and then into finished goods. When sold on credit, the finished goods assume the form of debtors who give the business cash on due date. Thus ‘cash’ assumes itsoriginal form again at the end of one such working capital cycle but in the course it passes through various other forms of current assets too. This is how various components of current assets keep on changing their forms due to value addition. they rotate and business operations continue. Thus, the working capital cycleinvolves rotation of various constituents of the working capital.

The working capital has the following components,which are in several forms of current assets:

Stock of Cash Stock of Raw Material Stock of Finished Goods Value of Debtors Miscellaneous current assets like short term investment loans & advances.

The working capital needs of a business are influenced by numerous factors. The important ones are discussed in brief as given below:

1. Nature of Enterprise

The nature and the working capital14

requirements of an enterprise are interlinked. While a manufacturing industryhas a long cycle of operation of the working capital, the same would beshort in an enterprise involved in providing services. The amount requiredalso varies as per the nature; an enterprise involved in pro-duction wouldrequire more working capital than a service sector enterprise.

2.. Manufacturing/Production Policy

Each enterprise in the manufacturing sectorhas its own production policy, some follow the policy of uniform productioneven if the demand varies from time to time, and others may follow theprinciple of 'demand-based produc-tion' in which production is basedon the demand during that particular phase of time. Accordingly,the working capital requirements vary for both of them.

3. Operations

The requirement of working capitalfluctuates for seasonal business. The work-ing capital needs of such businessesmay increase considerably during the busy season and decrease during theslack season. Ice creams and cold drinks have a great demand during summers,while in winters the sales are negligible.

4. Market Condition

If there is high competition in the chosenproduct category, then one shall need to offer sops like credit, immediatedelivery of goods etc. for which the working capital requirement will be high.Otherwise, if there is no competi- tion or less competition in the market thenthe working capital requirements will be low.

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5. Availability of Raw Material If raw material is readily available then one need not maintain a large stock of the same, thereby reducing the working capital investment in raw material stock. On the other hand, if raw material is not readily available then a large inventory/stock needs to be maintained,thereby calling for substantial investment in the same.

6. Growth and Expansion

Growth and expansion in the volume of businessresults in enhancement of the working capital requirement. As businessgrows and expands, it needs a larger amount of working capital.Normally, the need for increased working capital funds precedes growth inbusiness activities.

7. Price Level Changes

Generally, rising price level requires a higherinvestment in the working capital. With increasing prices, the samelevel of current assets needs enhanced investment.

8. Manufacturing Cycle

The manufacturing cycle starts with thepurchase of raw material and is completed with the production of finishedgoods. If the manufacturing cycle involves a longer period, the needfor working capital would be more.

CONSEQUENCES OF UNDER ASSESSMENT OFWORKING CAPITAL

Growth may be stunted. It may become difficult for the enterprise to undertake profitable projects due to non-availability of working capital.

Implementation of operating plans may become difficult and conse- quently the profit goals may not be achieved.

Cash crisis may emerge due to paucity of working funds.

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Optimum capacity utilisation of fixed assets may not be achieved due to non-availability of the working capital.

The business may fail to honour its commitment in time, thereby adversely affecting its credibility. This situation may lead to businessclosure.

The business may be compelled to buy raw materials on credit and sell finished goods on cash. In the process it may end up withincreasing cost of purchases and reducing selling prices by offeringdiscounts. Both these situations would affect profitability adversely.

Non-availability of stocks due to non-availability of funds may result in production stoppage.

While underassessment of working capital has disastrous implica- tions on business, overassessment of working capital also has its own dangers.

CONSEQUENCES OF OVER ASSESSMENT OFWORKING CAPITAL Excess of working capital may result in unnecessary accumulation of inventories.

It may lead to offer too liberal credit terms to buyers and very poor recovery system and cash management.

It may make management complacent leading to its inefficiency.

Over-investment in working capital makes capital less productive and may reduce return on investment.

Working capital is very essential for success of abusiness and, therefore, needs efficient management and control. Each ofthe components of the working capital needs proper management tooptimise profit.

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Inventory Management Inventory includes all types of stocks. Foreffective working capital manage-ment, inventory needs to be managedeffectively. The level of inventory should be such that the total costof ordering and holding inventory is the least. Simultaneously,stock out costs should also be minimised. Business, therefore, should fix theminimum safety stock level, re- order level and ordering quantity so that theinventory cost is reduced and its management becomes efficient.

Receivables’ Management Given a choice, every business would preferselling its produce on cash basis. However, due to factors like trade policies,prevailing marketing conditions, etc., businesses are compelled to selltheir goods on credit. In certain circum-stances, a business maydeliberately extend credit as a strategy of increasing sales. Extending creditmeans creating a current asset in the form of ‘Debtors’ or ‘AccountsReceivable’. Investment in this type of current assets needs proper and effectivemanagement as it gives rise to costs such as:

i. Cost of carrying receivable (paymentof interest etc.)

ii. ii. Cost of bad debt losses Thus the objective of any management policy pertaining to accounts receiv- ables would be to ensure that the benefits arising due to the receivables are

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12:48 PM Page 151

more than the cost incurred for receivables and thegap between benefit and cost increases resulting in increased profits. Aneffective control of receiv-ables helps a great deal in properly managing it. Eachbusiness should, there-fore, try to find out average credit extended to itsclient using the below given formula:

Average credit Total amount of receivables=

Extended (in days) Average credit sales per day

Each business should project expected salesand expected investment in receivables based on various factors, whichinfluence the working capital requirement. From this it would be possible tofind out the average credit days using the above given formula. A businessshould continuously try to moni- tor the credit days and see that theaverage credit offered to clients is not crossing the budgeted period. Otherwise,the requirement of investment in the working capital would increase and,as a result, activities may get squeezed. This may lead to cashcrisis.

Cash Management Cash is the most liquid current asset. It is ofvital importance to the daily operations of business. While the proportionof assets held in the form of cash is very small, its efficientmanagement is crucial to the solvency of the business. Therefore, planning cashand controlling its use are very important tasks. Cash budgeting is auseful device for this purpose.

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Cash Budget Cash budget basically incorporates estimatesof future inflows and out- flows of cash over a projected short period oftime which may usually be a year, a half or a quarter year. Effectivecash management is facilitated if the cash budget is further broken downinto month, week or even on daily basis.

There are two components of cash budget (i) cashinflows and (ii) cash out-flows. The main sources for these flows are givenhereunder:

Cash Inflows

(a) Cash sales(b) Cash received from debtors

(c) Cash received from loans, deposits, etc.

(d) Cash receipt of other revenue income (e) Cash received fromsale of investments or assets. Cash Outflows (a) Cash purchases (b) Cash payment to creditors (c) Cash payment for other revenue expenditure d) Cash payment for assets creation (e) Cash payment for withdrawals, taxes (f) Repayment of loans, etc.

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2 The Objectives and Structure of Working

Capital Management Working capital is conventionally defined as a firm’scurrent assets minus current liabilities on the datethat a Balance Sheet is drawn up.

Respectively, current assets and current liabilities are assumed to represent those assets that are soon to be converted into cash and those liabilities that are soon to be repaid within the next financial period (usually a year). From an internal financial management stance, however, these definitions are too simplistic.

Working capital represents a firm’s net investment in current assets required to support its day to day activities. Working capital arises because of thedisparities between the cash inflows and cashoutflows created by the supply and demand forthe physical inputs and outputs of the firm.

2.2 The Objectives of Working Capital Management The internal management of working capital canbe distinguished from the capital budgeting decision that itunderpins by:

a) The Production Cycle Unlike fixed asset investment, the workingcapital planning horizon, which definesthe cyclical conversion of raw materialinventory to the eventual receipt ofcash from its sale, can be measured inmonths rather than years. Workingcapital can also be increased by smallerphysical and monetary units. Suchdivisibility has the advantage thataverage investment in current assets canbe minimised, thereby reducing its

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associated costs and risk.

b) The Financing Cycle Because the finance supporting workingcapital input (its conversion to outputand the receipt of cash) can also bemeasured in months, management’s fundingof inventory, debtors and precautionarycash balances is equally flexible. Unlikefixed asset formation, where financialprudence dictates the use of long-termsources of finance wherever possible,working capital cycles may be supported bythe long and short ends of the capitalmarket. Finance can also be acquiredpiecemeal. Consequently, greater scopeexists for the minimisation of capitalcosts associated with current assetinvestments.

Despite these differences arising from thetime horizons of capital budgeting and workingcapital management, it is important to realisethat the two functions should never conflict.Remember that the unifying objective offinancial management is the maximisation ofshareholders wealth, evidenced by an increase ina corporate share price. This follows logicallyfrom a combination of:

- Investment decisions, which identify andselect investment opportunities that maximise anticipatednet cash inflows in NPV terms, - Finance decisions, which earmark potentialfunds sources required to sustain investments,evaluate the return expected by each and select the optimum mix whichminimises their overall capital cost.

2.3 The Structure of Working CapitalUltimately, the purpose of working capital management

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is to ensure that the operational cash transactionsto support the demand for a firm’s products andservices actually take place. These define a firm’sworking capital structure at any point in time, whichis summarised in Figure 2.2 below. We shall refer toaspects of this diagram several times throughout thetext, but for the moment, it is important to notethe three square boxes and two dotted arrows.

- The cash balance at the centre of thediagram represents the total amount available on any particular day. - This will be depleted by purchases ofinventory, plus employee remuneration and overheads, which arerequired to support production. - Any cash surplus can be retained forreinvestment, placed on deposit or withdrawn from the business.

3 The Working Capital Cycle and

Operating Efficiency

3.1 IntroductionThe previous Chapter’s Activities suggest thata conventional interpretation of workingcapital data contained published financialstatements may not only mislead external users ofaccounts but also contrast sharply with the

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overall wealth maximising objective of financialmanagement, namely:

To maximise the demand for a firm’s productsand services through optimum, profitableinvestments, financed at minimum cost.

To prove the case conclusively, we shall nowconfirm why the accounting concept of workingcapital (which defines an excess of currentassets over current liabilities as an indicationof financial strength) and its interpretation(often benchmarked by a 2:1 current asset ratio)is invariably suboptimal and way of target. Aswe shall discover:

The normative objective of efficient working capital management should be to minimise current assets and maximise current liabilities, subject to theconstraint of maintaining a sound liquidityposition, which also maximises opportunitiesfor fixed asset investment.

3.2 The Working Capital CycleWhen evaluating overall corporate performance it isnot sufficient to calculate the working capital andliquidity ratios from the Balance Sheet andcorresponding sales to net working capital ratiosand cash velocity using turnover data. As weobserved from Figure 3.1 in Chapter Three, it isalso necessary to analyses the turnover ratios forother working capital constituents (notably therelationship between inventory, debtors andcreditors).

One simple framework is given by an equation whichdefines how many times net working capital is“turned over” within the period under observation,relative to the rate at which goods are sold,debtors pay and the firm repays its own creditors,typically calculated from the data contained inpublished annual reports.

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The net operating cycle is an important concept in workingcapital management, which improves upon our previous working capital ratios.

- Stocks and creditors are now related to their appropriate costs and not revenues. As such they are proper turnover ratios. On a par withdebtors, they produce an analysis in physical terms (days) rather than monetaryvalues. - The greater the time lag between the operatingcycle and the financing cycle, the more funds the company presumably needs to supportproduction. - The relative significance of the net operatingcycle’s constituents can therefore suggest where managerial effort should be expended toreduce funds which are tied up in workingcapital. - Conversely, the cycle reveals how profitabilitycan be improved without putting undue strain on liquidity.

4.3 Operating Efficiency Our study of working capital began by regarding an excessof current assets over current liabilities as highly desirable. Convention dictates that it measures the extent to which a company can finance any future increase in turnover. If the balance is zero, it may be a sign of trouble. The firm is assumed to possess no working capital, since the net cash inflows from future operating cycles must be committed to the payment of existing financial obligations. However, it is also important to realise that any “surplus” may be misleading, since it could relate to assets already committed to a firm’s existing operating cycles.

(a) Introduction For the purpose of exposition, I have kept the

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example deliberately simple. The data relates toa trading and not a manufacturing company, whichwe shall consider in Chapter Five. So, there areno raw materials, or work in progress, to complicate our analysis.The absence of any start up capital (ownershipor debt) also enables us to focus on theflexibility of working capital investment.Specifically, how creditor finance or cash surpluses can be diverted to fixed assetformation, without compromising a firms “real”solvency or liquidity positions. Beginning and end of month Balance Sheets forthe first quarter are reproduced in Table 4.2,assuming that the “terms of trade” offered tocustomers and received from suppliers remainconstant throughout the twelve month period andnone of the sequential fixed asset investmentshave been sold. I have left you to calculate theBalance Sheets for the remainder of the year toconfirm the figures that I have also providedfor July 1st twelve months later. Table 4.3 thenprovides a summary of the requisite financialratios derived from Table 4.2 as a basis forinterpretation.

(b) The Balance Sheets

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(c) The Ratios Now we can reformulate Table 4.2 using aselection of financial ratios within a coherentframework as a basis for interpretation.

- Profitability in terms of return on assets (ROCE), net profit margins and asset utilisation, - Working capital, using current asset and liquidity ratios,- The operating cycle (stock turnover),- The financing cycle (creditor turnover).

(ii) Working Capital

The decline in working capital is a corollaryto the build up of creditors and thetransformation of cash into fixed assets. InAugust, working capital is negative and for themost part liquidity is non-existent. By July ofthe following year, both the current andliquidity ratios are still highly unfavourableat 1:3 respectively. But you are neitherinsolvent, nor illiquid, unless you were tocease trading altogether.

(iii) The Net Working Capital Cycle

Given the terms of trade, you are well able tomeet your financial obligations when they firstfall due in October. Moreover, you can stillcontinue to invest £2,500 elsewhere. Reversingconventional logic, it is no accident that therelationship between the operating and financingcycles, first revealed on October 1st is also

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1:3. Inventory is being profitably converted tocash three times quicker than debts are being legitimately paid. All other things being equal,only if credit had been granted to customers,perhaps accompanied by bad debt loss (thereby,increasing the operating cycle) or suppliersdemanded earlier repayment (reducing the financing cycle) wouldyou have experienced a cash shortage, leading topossible insolvency. Yet, ironically, all theBalance Sheet analysis would reveal is anincrease in current assets, a reduction in current liabilities perhapsculminating in a “positive” net working capitalposition!

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