Liquidity Decision

Unit – V

Liquidity Decision: Meaning - Classification and Significance of Working Capital – Components of Working Capital – Factors determining the Working Capital – Estimating Working Capital requirement – Cash Management Models – Cash Budgeting – Accounts Receivables –Credit Policies – Inventory Management.

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According to Accounting

• In accounting terms working capital is defined as the difference between current assets and current liabilities. If we break down the components of working capital we will find working capital as follows:

Working Capital = Current Assets – Current Liabilities

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Capital required for a business can be classified under two categories:

1. Fixed Capital-Long term funds
2. Working Capital-Short Term Funds

Definition: Shubin: “Working capital is the amount of funds necessary to cover the cost of operating the enterprise.”

Genestenberg: “ Circulating capital means current assets of a company that are changed in the ordinary course of business from one form to another, as for example, from cash to inventories, inventories to receivables, receivables into cash.”

• Working Capital Management is the process which is designed to ensure that an organization operates efficiently by monitoring & utilizing its current assets and current liabilities to the best effect. The primary objective is to enable a company to maintain sufficient cash flows in order to meet its day-to-day operating expenses and its short-term obligations.

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• The concept of working capital can also be explained through two angles.

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There are two concepts of working capital:

1. Gross working Capital
2. Net working Capital

Gross working Capital: It is the capital that is invested in the current assets of the company. Current assets are those assets which in the ordinary course of business can be converted into cash within a short period of normally one accounting year.

Examples of Current Assets:

1. Cash in hand and bank balances
2. Bills receivables
3. Sundry Debtors(less provision for bad debts)
4. Short term loans and advances
5. Inventories of stocks as:
1. Raw materials
2. work in Progress
3. Stores and spares
4. Finished goods
6. Temporary investments of surplus funds
7. Prepaid Expenses
8. Accrued Incomes

In a narrow sense the term net working capital refers to the excess of current assets over current liabilities:

Net working Capital= Current assets – Current Liabilities

Examples of Current liabilities:

1. Bills Payable
2. Sundry creditors or Accounts payable
3. Accrued or outstanding expenses
4. Short term loans, advances and deposits
5. Dividends payable
6. Bank overdraft
7. Provision for taxation if it does not amount to appropriation of profits.

1. For the purchase of raw materials, components and spares.
2. To pay wages and salaries.
3. To incur day to day expenses and overhead costs such as fuel power and office expenses etc.
4. To meet the selling costs such as packing, advertising etc.
5. To provide credit facilities to customers.
6. To maintain the inventories of raw material, work in progress, stores and spares, and finished stock.

Working capital on the basis of time

1. On the basis of time

On the basis of time, working capital may be classified as:

1. Permanent or fixed working capital (Regular (Minimum level of current assets, Circulation of current assets from cash to inventories) and Reserve-For future contingencies)
2. Temporary or variable working capital: it is the amount of working capital which is required to meet the seasonal demands and some special exigencies.

Amount of Working capital

Amount of Working

capital

Time

Time

Temporary or Variable WC

Temporary or

Variable WC

Permanent or Fixed WC

Permanent or Fixed WC

Factors affecting working capital

1. Length of Operating Cycle:

The amount of working capital directly depends upon the length of the operating cycle. The operating cycle refers to the time period involved in production. It starts right from the acquisition of raw materials and ends till payment is received after the sale.

The working capital is very important for the smooth flow of the operating cycle. If the operating cycle is long then more working capital is required whereas for companies having a short operating cycle, the working capital requirement is less.

2. Nature of Business:

The type of business, firm is involved in, is the next consideration while deciding the working capital. In case of trading concern or retail shop the requirement of working capital is less because length of operating cycle is small.

The wholesalers as compared to retail shop require more working capital as they have to maintain large stock and generally sell goods on credit which increases the length of operating cycle. The manufacturing company requires huge amount of working capital because they have to convert raw material into finished goods, sell on credit, maintain the inventory of raw material as well as finished goods.

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3. Scale of Operation:

The firms operating at large scale need to maintain more inventory, debtors, etc. So they generally require large working capital whereas firms operating at small scale require less working capital.

4. Business Cycle Fluctuation:

During boom period the market is flourishing so more demand, more production, more stock, and more debtors which mean more amount of working capital is required. Whereas during depression period low demand less inventories to be maintained, less debtors, so less working capital will be required.

5. Seasonal Factors:

The working capital requirement is constant for the companies which are selling goods throughout the season whereas the companies which are selling seasonal goods require huge amount during season as more demand, more stock has to be maintained and fast supply is needed whereas during off season or slack season demand is very low so less working capital is needed.

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6. Technology and Production Cycle:

If a company is using labour intensive technique of production then more working capital is required because company needs to maintain enough cash flow for making payments to labour whereas if company is using machine-intensive technique of production then less working capital is required because investment in machinery is fixed capital requirement and there will be less operative expenses.

In case of production cycle, if production cycle is long then more working capital will be required because it will take long time for converting raw material into finished goods whereas when production cycle is small lesser funds are tied up in inventory and raw materials so less working capital is required.

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7. Credit Allowed:

Credit policy refers to average period for collection of sale proceeds. It depends on number of factors such as creditworthiness of clients, industry norms etc. If company is following liberal credit policy then it will require more working capital whereas if company is following strict or short term credit policy, then it can manage with less working capital also.

8. Credit Avail:

Another factor related to credit policy is how much and for how long period company is getting credit from its suppliers. If suppliers of raw materials are giving long term credit then company can manage with less amount of working capital whereas if suppliers are giving only short period credit then company will require more working capital to make payments to creditors.

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9. Operating Efficiency:

The firm having high degree of operating efficiency requires less amount of working capital as compared to firm having low degree of efficiency which requires more working capital.

Firms with high degree of efficiency have low wastage and can manage with low level of inventory also and during operating cycle also these firms bear less expense so they can manage with less working capital also.

10. Availability of Raw Materials:

If raw materials are easily available and there is ready supply of raw materials and inputs then firms can manage with less amount of working capital also as they need not maintain any stock of raw materials or they can manage with very less stock.

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Whereas if the supply of raw materials is not smooth then firms need to maintain large inventory to carry on operating cycle smoothly. So they require more working capital.

11. Level of Competition:

If the market is competitive then company will have to adopt liberal credit policy and to supply goods on time. Higher inventories have to be maintained so more working capital is required. A business with less competition or with monopoly position will require less working capital as it can dictate terms according to its own requirements.

12. Inflation:

If there is increase or rise in price then the price of raw materials and cost of labour will rise, it will result in an increase in working capital requirement.

But if company is able to increase the price of its own goods as well, then there will be less problem of working capital. The effect of rise in price on working capital will be different for different businessmen.

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13. Growth Prospects:

Firms planning to expand their activities will require more amount of working capital as for expansion they need to increase scale of production which means more raw materials, more inputs etc. so more working capital also.

14. Taxes: Taxes are often paid in advance. This also blocks a part of working capital. Depending on the tax environment of the industry, working capital needs are also affected.

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15. Dividend Policy: Dividend policy determines the level of retained profits with the business and retained profits are also used for working capital. This is how; dividend policy affects the need for working capital.

16. Price Levels: The price levels of inventory and other expenses such as labour rates etc. increase the working capital requirement. If the company also is able to increase the price of their finished goods, it reduces this impact.

The working capital requirement of a concern depend upon a large number of factors i.e.:

1. Nature or character of business(Utility,trading, manufacturing)
2. Size of business/Scale of Operations(Small, medium large)
3. Production Policy (high in Peak season and less in slack season-Ex-winter garment)
4. Manufacturing process/Length of production cycle 5.Seasonal variations

6.Working capital cycle

CASH

RAW MATERIALS

WORK IN

PROGRESS

FINISHED GOODS

SALES

DEBTORS

7.Credit policy(Debtors and creditors) 8.Business cycles (Boom & Depressions) 9.Rate of growth of business

10.Earning capacity and dividend policy 11.Price level changes

12.Other factors(operating efficiency, management ability, irregularities of supply, import policy, asset structure, importance of labour, banking facilities etc.)

As the working capital requirements of a concern can be classified as:

1. Permanent or fixed working capital requirements
2. Temporary or variable working capital requirements.

▣ The fixed proportion of working capital should be generally financed from the fixed capital sources while the temporary or variable working capital requirements of a concern may be met from the short term sources of capital.

Long term/Permanent or Fixed:

• 1.Shares 2.Debentures 3.Public Deposits
• Ploughing back of Profits
• Loans from Financial Institutions
• Retained Earnings
• Funds raised through
• GDR/NRI

• 1.Commercial Banks 2.Indigenous Bankers 3.Trade Credits 4.Instalment Credit 5.Advances

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• 6.Account Receivable (Credit)

Short term/Temporary or variable

Estimation of working capital :

The following are the steps to be considered while estimating or planning working capital. 

• Estimation of cash cost of various current assets required by the firm.
• Estimation of spontaneous current liabilities of the firm.
• Compute net working capital by subtracting the estimated current liabilities from current assets. (step 2-step 1) 
• Add some percentage (given in the problem) of networking capital if there is any contingency or safety working capital required, to get the required working capital.

1. Principle of cost minimisation (Minimisation of cost of funding(dividend and interest costs) and holding WC)
2. Principle of risk variation. (lower the amount of Net WC, higher the risk of insolvency- Conservative Policy(Sufficient WC), moderate policy and Aggressive policy(Lowest possible WC)
3. Principle of Profit maximisation
4. Principle of credit-worthiness
5. Tradeoff between liquidity and profitability

As Working capital is the excess of CA over CL, therefore management of working capital refers to the management and control of each components of current assets and current liabilities. Therefore, management of working capital entails three important dimensions:

1. Management of current assets
2. Management of current liabilities
3. Formulation of policies with regard to profitability, risk and liquidity i.e. tradeoff between profitability and liquidity

▣ Working capital is the life-blood and controlling nerve centre of a business.

▣ No business can sustain without adequate amount of working capital. To avoid the shortage of working capital at once, an estimate of working capital requirements should be made in advance so that arrangements can be made to procure adequate working capital.

▣ But estimation of working capital requirements is not an easy task and a large number of factors have to be considered before starting this exercise.

▣ For a manufacturing organisation, the following factors have to be taken into consideration while making an estimate of working capital requirements.

1. The length of time, raw materials are to remain in stores before they are issued for production.
2. The length of the production cycle or work in progress (Time required for conversion of raw material into finished product)
3. The length of sales cycle during which finished goods are to be kept waiting for sales
4. The average period of credit allowed to customers
5. The amount of cash required to pay day to day expenses of the business.
6. The average amount of cash required to make advance payments, if any.
7. The average credit period expected to be allowed by suppliers.
8. Time-lag in the payment of wages and other expenses.

▣ The sum total of point 1 to 6 is the current assets.

▣ The sum total of point 7 & 8 is the current liabilities.

▣ The requirements of working capital or net working capital can be determined by the formula:

WC= CA-CL

▣ It is to be noted that incase of purely trading concerns, points one and two would not arise but all other factors from 3 to 8 are to be taken into consideration.

▣ In order to provide for contingencies, some extra amount generally calculated as a fixed percentage of the working capital may be added as a margin of safety.

1,00,000 units Rs.8 per unit 25%

1. Projected annual sales
2. Selling Price
3. % of net profit on sales

d)

Average credit period allowed to customers: 8 weeks

e) Average credit period allowed by suppliers: 4 weeks

terms of sales

6. Average stock holding in requirement: 12 weeks
7. Allow 10% for contingencies.

Rs.

92,308

1,38,462

2,30,770

46,154

Current Assets:

Debtors (8 weeks): 6,00,000X8 =

52

Stocks (12 weeks): 6,00,000X12 =

52

Less Current Liabilities: Creditors (4 weeks): 6,00,000X4 =

52

Net working Capital

Add 10% for contingencies Working Capital Required

1,84,616

18,462

2,03,078

Working Notes: 1.Sales=1,00,000X8=Rs.8,00,000

Profit = 25% of Rs.8,00,000= Rs.2,00,000 Cost of Sales=8,00,000-2,00,000=Rs.6,00,000

2. As it is a trading concern cost of sales are assumed to be the purchases.
3. Profits have been ignored as funds provided by profits may or may not be used as working capital.

Rs.

5,000

8,000

3,12,000

78,000

1. Amount blocked up for stocks: Stocks of finished product Stocks of stores, materials etc.
2. Average credit given; Inland sales-6weeks credit

Export sales-1½ weeks credit

3. Lag in Payments: Wages 1½ weeks

Stocks materials etc. -1½ months Rent Royalties etc .-6months

Clerical staff ½ mo nth manager ½ month

Miscellaneous Expenses 1 ½ Months

2,60,000

48,000

10,000

62,400

4,800

48,000

4. Payment in advance: Rs.

Sundry expenses (paid quaterly in advance) 8,000

5. Undrawn profit on the average

throughout the year 11,000

6. Add 10% to your computed figures as contingencies.

Rs. 5,000

8,000

Current Assets:

1. Stock of finished products
2. Stock of stores materials etc. (iii)Sundry Debtors:

(a) inland (6weeks) 3,12,000X6/52 =

36,000

(b) Export 1 ½ weeks 78,000X3/52 X1/2=2,250

38,250

(iv) Payments in advance 8,000X ¼(Quaterly) 2,000 Total of current Assets 53,250

Less Current Liabilities: Lag in Payment of:

Rs.

(i) wages(1 ½ weeks)2,60,000X3/52X1/2=7,500

(vi) Misc. Exp.1½ months)48,000/12X3/2=6,000 Total of current liabilities

Net Working Capital (CA-CL)

27,300

25,950

Add 10% margin for contingencies10% of 25,950

Average working capital requirement

2,595

28,545

1. The total estimated sales in a year will be Rs.12.00,000
2. His estimated fixed expenses are of Rs.2,000 per month and variable expenses equal to 5% of his turnover.
3. He expects to fix a sales price for each product which will be 25% in excess of his cost of purchases.
4. He expects to turnover his stock four times in a year.
5. The sales and purchases will be evenly spread throught the year. All sales will be for cash but he expects one month’s credit for purchases.

Rs.

12,00,000

2,40,000

9,60,000

2,40,000

Sales

Less Gross profit(12,00,000X25/125) Cost of Goods sold

Gross profit Less Expenses:

Fixed (2,000X12)

Variable (12,00,000X5/100)

=24,000

=60,000

Total expenditure

84,000

Net Profit

1,56,000

Current Assets:

1. Stock
1. Turnover of stock is 4 times
2. Average stock= cost of goods sold/Stock turnover
3. = 9,60,000/4=
2. Cash:
1. To meet fixed expenses 2,000
2. To meet variable expenses

Rs.

2,40,000

5,000

7,000

12,00,000X5/100 X 1/12 =

(Assumed to be for one month)

Debtors(As all sales are for cash only)

NIL

Total of current assets

2,47,000

Less Current Liabilities:

Creditors (1month) 9,60,000 X 1/12=

80,000

Working Capital Required

1,67,000

Methods of Working Capital Estimation�

• The methods are:
• 1. Percentage of Sales Method
• 2. Regression Analysis Method
• 3. Operating Cycle Method.

Percentage of Sales Method:�

• It is a traditional and simple method of determining the level of working capital and its components. In this method, working capital is determined on the basis of past experience. If, over the years, the relationship between sales and working capital is found to be stable, then this relationship may be taken as a base for determining the working capital for the future.

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• This method is simple, easy to understand and useful for projecting relatively short-term changes in working capital. However, this method cannot be recommended for universal application because the assumption of linear relationship between sales and working capital may not hold good in all cases.

• XYZ Ltd. has achieved a turnover of Rs. 85 crores for the accounting year 2007-08. It is anticipated that the turnover of the company will reach Rs. 110 crores for the year 2008-09.
• The financial position of the company as on 31st March, 2009 as follows:

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Estimate the working capital requirement for the year 2008-09.

• Solution:
• Estimation of working capital requirement for 2008-09.

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Regression Analysis Method:�

• It is a useful statistical technique applied for forecasting working capital requirements. It helps in making working capital requirement projections after establishing the average relationship between sales and working capital and its various components in the past years. The method of least squares is used in this regard.

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• The relationship between sales and working capital is given by the equation:
• Y = a + bx
• Where,
• x = Sales (independent variable)
• y = Working capital level (dependent variable)
• a = Intercept of the least square line with vertical axis
• b = Slope of the line

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• Linear regression model is used to judge the relationship of two variables. By using the mode we can estimate level of working capital needed for given amount of sales. The data relating to level of working capital and its corresponding sales during past 5 – 6 years is used in establishment of trend relationship.

• The value of ‘a’ and ‘b’ are obtained by the solution of simultaneous linear equations given below:
• ∑y = na + b∑
• ∑xy = a∑x + b∑x²

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Calculate working capital requirement when forecasted sales for the year 2015 are 300

• After all this exercise, we get the following equation,

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• Working Capital (x) = -15.078 + 0.7185 Sales (b)

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• Now, if the forecasted sales for the year 2015 are 300, the working capital as per this method would be 200.472. (Working Capital = -15.078 + 0.7185 * 300 = 200.472).

CASH MANAGEMENT

• Business concern needs cash to make payments for the acquisition of resources and services for the normal conduct of business. Cash is one of the important and key parts of the current assets. Cash is the money which a business concern can disburse immediately without any restriction. The term cash includes coins, currency, cheques held by the business concern and balances in its bank accounts. Management of cash consists of cash inflow and outflows, cash flow within the concern and cash balance held by the concern etc.

Motives for Holding Cash �

• 1. Transaction motive

It is a motive for holding cash or near cash to meet routine cash requirements to finance transactions in the normal course of business. Cash is needed to make purchases of raw materials, pay expenses, taxes, dividends etc.

• 2. Precautionary motive

It is the motive for holding cash or near cash as a cushion to meet unexpected contingencies. Cash is needed to meet unexpected situations like, floods strikes etc.

• Speculative motive

It is the motive for holding cash to quickly take advantage of opportunities typically outside the normal course of business. A certain amount of cash is needed to meet an opportunity to purchase raw materials at a reduced price or make purchases at favourable prices.

• 4. Compensating motive

It is a motive for holding cash to compensate banks for providing certain services or loans. Banks provide a variety of services to the business concern, such as clearance of cheques, transfer of funds etc

Cash Management Models

• Cash management models analyse methods which provide a certain framework as to how cash management is conducted in the firm. Cash management models are the development of theoretical concepts into analytical approaches with mathematical applications. There are three cash management models which are very popular in the field of finance

• 1. Baumol model
• The basic objective of the Baumol model is to determine the minimum cost amount of cash conversion and the lost opportunity cost. It is a model that provides for cost-efficient transactional balances and assumes that the demand for cash can be predicated with certainty and determines the optimal conversion size. The total conversion cost per period can be calculated with the help of the following formula:

• A Company expects to have Rs. 37500 cash in hand on 1st April and requires you to prepare an estimate of cash position during the three months. April, May and June the following information is supplied to you:

• Other Information: (i) Period of credit allowed suppliers 2 months.
• (ii) 20% of sales for cash and the period of credit allowed to customers for credit is one month.
• (iii) Delay in payment of all expenses:1 month.
• (iv) Income tax of Rs. 57,500 is due to be paid on June 15th.
• (v) The company is to pay dividends to shareholders and bonuses to workers of Rs. 15,000 and Rs. 22,500 respectively in the month of April.
• (vi) A plant has been ordered to be received and paid in May. It will cost Rs. 1,20,000.

• Receivables are also one of the major parts of the current assets of the business concerns. It arises only due to credit sales to customers, hence, it is also known as Account Receivables or Bills Receivables. Management of account receivable is defined as the process of making decisions resulting to the investment of funds in these assets which will result in maximizing the overall return on the investment of the firm. The objective of receivable management is to promote sales and profit until that point is reached where the return on investment in further funding receivables is less than the cost of funds raised to finance that additional credit.

Credit Policy

• Credit policy is the determination of credit standards and analysis. It may vary from firm to firm or even some times product to product in the same industry. Liberal credit policy leads to increase the sales volume and also increases the size of receivable. Stringent credit policy reduces the size of the receivable.

INVENTORY MANAGEMENT

• Inventories constitute the most significant part of the current assets of the business concern. It is also essential for the smooth running of the business activities. A proper planning of purchasing of raw material, handling, storing and recording is to be considered as a part of inventory management. Inventory management means, management of raw materials and related items. Inventory management considers what to purchase, how to purchase, how much to purchase, from where to purchase, where to store and when to use for production etc.

• Meaning
• The dictionary meaning of the inventory is stock of goods or a list of goods. In accounting
• language, inventory means stock of finished goods. In a manufacturing point of view,
• inventory includes, raw material, work in process, stores, etc.
• Kinds of Inventories
• Inventories can be classified into five major categories.
• A. Raw Material
• It is basic and important part of inventories. These are goods which have not yet
• been committed to production in a manufacturing business concern.

• B. Work in Progress
• These include those materials which have been committed to production process but have not yet been completed.
• C. Consumables
• These are the materials which are needed to smooth running of the manufacturing process.
• D. Finished Goods
• These are the final output of the production process of the business concern. It is ready for consumers.
• E. Spares
• It is also a part of inventories, which includes small spares and parts.

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