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Components of Working Capital Management for Financial Management and Policy Mcom Sem 2 Delhi University

Components of Working Capital Management for Financial Management and Policy Mcom Sem 2 Delhi University

Components of Working Capital Management for Financial Management and Policy Mcom Sem 2 Delhi University

Components of Working Capital Management for Financial Management and Policy MCOM Sem 2 Delhi University : Working capital management is an addition of fixed capital investment. Working capital management is an important element of every organization, as it helps in continuing the business processes. Decisions related to working capital are known as working capital decisions. The essential elements of working capital are cash, accounts receivable and inventory. Each element of working capital involves some kind of risk in it. Hence, it is clear that each every decision related to finance involves risk-return trade-off. So, it is the responsibility of finance managers to consider both risk and return, while making these decisions.

Working capital management refers to a company’s managerial accounting strategy designed to monitor and utilize the two components of working capital, current assets and current liabilities, to ensure the most financially efficient operation of the company.

Components of Working Capital Management for Financial Management and Policy Mcom Sem 2 Delhi University

FACTORS AFFECTING WORKING CAPITAL

1. Nature of business

2. Production policy

3. Credit policy

4. Inventory policy

5. Abnormal factor

6. Market conditions

7. Conditions of supply

8. Business cycle

9. Taxation policy

10. dividend policy

11. Operating efficiency

12. Price level changes

13. Depreciation policy

14. Availability of raw material

Components of Working Capital Management for Financial Management and Policy Mcom Sem 2 Delhi University

WORKING CAPITAL CYCLE

Working capital cycle:- The determination of WC helps in forecast, control& management of WC. The duration of WC may vary depending upon the nature of business. The duration of operating cycle (WC cycle) for the purpose of estimating WC is equal to the sum of duration of each of above events less the credit period allowed by the supplier For ex.- A co. holds raw material on an average for 60 days, it gets credit firm supplier for 15 days, production process needs 15 days, finished products are held 30 days & 30 days is the total WC cycle. So, 60+15+30+30-15=120 days.

Components of Working Capital Management for Financial Management and Policy Mcom Sem 2 Delhi University

VARIOUS COMPONENTS OF OPERATING CYCLE

It may be calculated as follows:

A) Raw material shortage period = Average stock of raw material Average cost of raw material consumed per day

B) WIP holding period = Average WIP inventory Average cost of production per day

C) Finished goods storage period = Estimated production (in units) * direct lab permit 12 months / 360 days OR Average stock of finished goods Average cost of goods sold per day

D) Debtors collection period = Average goods debtors Average credit sale per day

E) Credit period available to suppliers = Average rate credit Average credit purchase per day

Operating Cycle = R+W+F+D-C

Components of Working Capital Management for Financial Management and Policy Mcom Sem 2 Delhi University

NEED FOR AND COMPONENTS OF WORKING CAPITAL

For smooth running an enterprise, adequate amount of working capital is very essential. Efficiency in this area can help, to utilize fixed assets gainfully, to assure the firm’s long- term success and to achieve the overall goal of maximization of the shareholders, fund. Shortage or bad management of cash may result in loss of cash discount and loss of reputation due to non-payment of obligation on due dates. Insufficient inventories may be the main cause of production held up and it may compel the enterprises to purchase raw materials at unfavourable rates. Like-wise facility of credit sale is also very essential for sales promotions. It is rightly observed that “many a times business failure takes place due to lack of working capital.”

Adequate working capital provides a cushion for bad days, as a concern can pass its period of depression without much difficulty. O’ Donnel correctly explained the significance of adequate working capital and mentioned that “to avoid interruption in the production schedule and maintain sales, a concern requires funds to finance inventories and receivables.” The adequacy of cash and current assets together with their efficient handling virtually determines the survival or demise of a concern. An enterprise should maintain adequate working capital for its smooth functioning. Both, excessive working capital and inadequate working capital will impair the profitability and general health of a concern. Therefore working capital is needed till a firm gets cash on sale of finished products.

Components of Working Capital Management for Financial Management and Policy Mcom Sem 2 Delhi University

It depends on two factors:

a. Manufacturing cycle i.e. time required for converting the raw material into finished product; and

b. Credit policy i.e. credit period given to Customers and credit period allowed by creditors.

Thus, the sum total of these times is called an “Operating cycle” and it consists of the following six steps:

i. Conversion of cash into raw materials.

ii. Conversion of raw materials into work-in-process.

iii. Conversion of work-in-process into finished products.

iv. Time for sale of finished goods—cash sales and credit sales.

v. Time for realization from debtors and Bills receivables into cash.

vi. Credit period allowed by creditors for credit purchase of raw materials, inventory and creditors for wages and overheads.

Components of Working Capital Management for Financial Management and Policy Mcom Sem 2 Delhi University

DETERMINANTS OF WORKING CAPITAL :

The factors influencing the working capital decisions of a firm may be classified as two groups, such as internal factors and external factors. The internal factors includes, nature of business size of business, firm’s product policy, credit policy, dividend policy, and access to money and capital markets, growth and expansion of business etc. The external factors include business fluctuations, changes in the technology, infrastructural facilities, import policy and the taxation policy etc.

These factors are discussed in brief in the following lines.

Components of Working Capital Management for Financial Management and Policy Mcom Sem 2 Delhi University

I. Internal Factors

1. Nature and size of the business

The working capital requirements of a firm are basically influenced by the nature and size of the business. Size may be measured in terms of the scale of operations. A firm with larger scale of operations will need more working capital than a small firm. Similarly, the nature of the business – influence the working capital decisions. Trading and financial firms have less investment in fixed assets. But require a large sum of money to be invested in working capital. Retail stores, business units require larger amount of working capital, where as, public utilities need less working capital and more funds to invest in fixed assets.

2. Firm’s production policy

The firm’s production policy (manufacturing cycle) is an important factor to decide the working capital requirement of a firm. The production cycle starts with the purchase and use of raw material and completes with the production of finished goods. On the other hand production policy is uniform production policy or seasonal production policy etc., also influences the working capital decisions. Larger the manufacturing cycle and uniform production policy – larger will be the requirement of working capital. The working capital requirement will be higher with varying production schedules in accordance with the changing demand.

3. Firm’s credit policy

The credit policy of a firm influences credit policy of working capital. A firm following liberal credit policy to all customers requires funds. On the other hand, the firm adopting strict credit policy and grant credit facilities to few potential customers will require less amount of working capital.

4. Availability of credit

The working capital requirements of a firm are also affected by credit terms granted by its suppliers – i.e. creditors. A firm will need less working capital if liberal credit terms are available to it. Similarly, the availability of credit from banks also influences the working capital needs of the firm. A firm, which can get bank credit easily on favorable conditions, will be operated with less working capital than a firm without such a facility.

5. Growth and expansion of business

Working capital requirement of a business firm tend to increase in correspondence with growth in sales volume and fixed assets. A growing firm may need funds to invest in fixed assets in order to sustain its growing production and sales. This will, in turn, increase investment in current assets to support increased scale of operations. Thus, a growing firm needs additional funds continuously.

6. Profit margin and dividend policy

The magnitude of working capital in a firm is dependent upon its profit margin and dividend policy. A high net profit margin contributes towards the working capital pool. To the extent the net profit has been earned in cash, it becomes a source of working capital. This depends upon the dividend policy of the firm. Distribution of high proportion of profits in the form of cash dividends results in a drain on cash resources and thus reduces company’s working capital to that extent. The working capital position of the firm is strengthened if the management follows conservative dividend policy and vice versa.

7. Operating efficiency of the firm

Operating efficiency means the optimum utilisation of a firm’s resources at minimum cost. If a firm successfully controls operating cost, it will be able to improve net profit margin which, will, in turn, release greater funds for working capital purposes.

8. Co-ordinating activities in firm

The working capital requirements of a firm are depend upon the co-ordination between production and distribution activities. The greater and effective the co-ordinations, the pressure on the working capital will be minimized. In the absence of co-ordination, demand for working capital is reduced.

Components of Working Capital Management for Financial Management and Policy Mcom Sem 2 Delhi University

II. External Factors

1. Business fluctuations

Most firms experience fluctuations in demand for their products and services. These business variations affect the working capital requirements. When there is an upward swing in the economy, sales will increase, correspondingly, the firm’s investment in inventories and book debts will also increase. Under boom, additional investment in fixed assets may be made by some firms to increase their productive capacity. This act of the firm will require additional funds. On the other hand when, there is a decline in economy, sales will come down and consequently the conditions, the firm try to reduce their short-term borrowings. Similarly the seasonal fluctuations may also affect the requirement of working capital of a firm.

2. Changes in the technology

The technological changes and developments in the area of production can have immediate effects on the need for working capital. If the firm wish to install a new machine in the place of old system, the new system can utilise less expensive raw materials, the inventory needs may be reduced there by working capital needs.

3. Import policy

Import policy of the Government may also effect the levels of working capital of a firm since they have to arrange funds for importing goods at specified times.

4. Infrastructural facilities

The firms may require additional funds to maintain the levels of inventory and other current assets, when there is a good infrastructural facility in the company like transportation and communications.

5. Taxation policy

The tax policies of the Government will influence the working capital decisions. If the Government follows regressive taxation policy, i.e. imposing heavy tax burdens on business firms, they are left with very little profits for distribution and retention purpose. Consequently the firm has to borrow additional funds to meet their increased working capital needs. When there is a liberalized tax policy, the pressure on working capital requirement is minimized. Thus the working capital requirements of a firm are influenced by the internal and external factors.

Components of Working Capital Management for Financial Management and Policy Mcom Sem 2 Delhi University

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