UNIT 8 :
WORKING CAPITAL MANAGEMENT
Meaning of Working Capital:
Working capital is that part of the total capital of an enterprise which is required to be invested in the short term or current assets. This capital is needed in an enterprise to meet its day to day expenses. Working capital shows the strength of a business in a short period of time. If a company has some amount of working capital, it means that the company has certain amount of liquid assets out of which it can meet its day to day expenses.
Working capital is also known as short term capital or operating capital or circulating capital.
Concept of Working Capital:
There are two concepts of working capital working capital. They are as follows:
1. Gross Working Capital
2. Net Working Capital
1. Gross Working Capital
Gross working capital is the total current assets of an enterprise. In this concept, we do not deduct current liabilities from current assets, but we use current liabilities as a source of fund. When we buy goods on credit, it means we save
our cash to the extent of the value of goods purchased on credit and we can use this as working capital for paying other expenses. The mathematical formula for calculating the gross working capital is as follows:
Gross Working Capital = Total Current Assets
Current assets are those assets which can be converted into cash within one accounting year. For example, cash, bank, debtors, bill receivables, closing stock, prepaid expenses, accrued incomes, marketable securities etc.
2. Net Working Capital
Net working capital is difference between the total current assets and total current liabilities of an enterprise. The excess of current assets over current liabilities is also called net current assets. In this concept, a business enterprise
has to maintain the minimum level of working capital for smooth operation of the business activities. This concept of working capital is used for the preparation of balance sheet. In the vertical form of balance sheet, we show excess of current assets over current liabilities. The mathematical formula for calculating the net working capital is as follows:
Net Working Capital = Current Assets - Current Liabilities
Current Liabilities are those liabilities which can be paid within one accounting year. For example, creditors, outstanding expenses, bank overdraft, bills payable, short term loans, income tax payable, incomes received in advance, dividend payable etc.
Importance of / Need for Working Capital
A business enterprise needs working capital for various reasons. When creditors demand their money from a company, its high working capital saves the company from this situation. Selling of current assets is easy in small period of
time but a company can not sell their fixed assets within small period of time. So, if a company has sufficient working capital, it can easily pay off its creditors and create his reputation in market. But if a company has zero working capital, then it can not pay its creditors in time. In this situation, the company may either become bankrupt or take a loan at higher rate of interest. In both the conditions, it is very dangerous. Therefore, the company’s finance manager tries to keep some amount of working capital for creating goodwill in market.
Positive working capital enables the company to pay its day to day expenses like payment of wages, salaries, raw materials or goods and other operating expenses. Adequate working capital not only enables the company to pay its matured liabilities but also to pay its outstanding liabilities without any delay.
Determinants of Working Capital Requirements/Factors Influencing Working Capital Requirements
The following are the various factors that determine the working capital requirements of a company:
1. Size of Business
The amount of working capital required in a business firm is largely affected by its size or scale of business operations. The business of a form may be small or large. In small business, the company needs smaller amount of working
capital, but in large business, it requires larger amount of working capital.
2. Nature of Business
The amount of working capital required in a business firm is largely affected by the nature of its business. Manufacturing concerns require larger amount of working capital, whereas trading concerns require smaller amount of working capital.
3. Nature of Demand
Nature of demand also absolutely affects the working capital need. Some product can be easily sold by businessman, in that business; you need small amount of working capital because your earned money from sale can easy fulfill the shortage of working capital. But, if demand is very less, it is required that you have to invest large amount of working capital because your all fixed expenses must be paid by you.
4. Production Policy
Production policy is also main determinant of working capital requirement. Different company may different production policy. Some companies stop or decrease the production level in off seasons, in that time, company may also reduce the number of employees or decrease the purchasing of new raw material, so, it will certainly decrease the amount of working capital but on the side, some company may continue their productions in off season, in that case, they need definitely large amount of working capital.
5. Credit Policy
Credit policy is relating to purchasing and selling of goods on credit basis. If company purchases all goods on credit and sells on cash basis or advance basis, then it is certainly company need very low amount of working capital. But
if in company, goods are purchased on cash basis, and sold on credit basis, it means, our earned money will receive after sometime and we require large amount of working capital for continuing our business.
6. Dividend Policy
Dividend policy also effect working capital requirement. Company can distribute major part of net profit. But, if there is no reserve, we have to invest large amount in working capital because, lacking of reserve will affect on adversely on fulfill our liabilities. In that case, we have to yield working capital by taking short term loan for paying uncertain liability.
7. Working Capital Cycle
Working capital cycle shows all steps which starts from cash purchasing of raw material and then this converted into finished product, after this it is converted into sale, if it is credit sale, debtors will also the part of working capital cycle and when we gets money from our debtors, it is the final part of working capital cycle.
If we receive fastly from our debtors, we need small amount working capital. Otherwise, for purchasing new raw material, we need more amount of working capital.
8. Manufacturing Cycle
Manufacturing cycle means the process of converting raw material into finished product. Long manufacturing cycle will create the situation in which we require large amount of working capital. Suppose, we have to construct the building, for constructing colony of buildings, it may consume the time more than 5 years, so according to this we need working capital.
9. Business Cycle
There are two main part of business cycle, one is boom and other is recession. In boom, we need high money or working capital for development of business but in recession, we need only low amount of working capital.
10. Price Level Changes
If there is increasing trend of products prices, we need to store high amount of working capital, because next time, it is precisely that we have to pay more for purchasing raw material or other service expenses. Inflation and deflation are
two major factors which decide the next level of working capital in business.
11. Effect of External Business Environmental Factors
There are many external business environmental factors which affect the need of working capital like fiscal policy, monetary policy and bank policies and facilities.
Over-Trading and Under-Trading
Over-trading and under-trading are the facets of over P-capitalization and under capitalization.
Over-trading
Over-trading means a situation w here a company does more business than what its finances allow . The result of over-trading is disastrous as it gives rise to increase in size, diminishing margin of safety and feeling a sense of stress and
strain. Thus it is advisable for every company to carry on its business in terms of the financial resources that it has and not to do more business or trading than its finances permit. Over- trading is an aspect of under-capitalization.
A company which is under-capitalized will try to do too much with the limited amount of capital which it has. For example it may not maintain proper stock of stock. Also it may not extend much credit to customers and may insist only on cash basis sales. It may also not pay the creditors on time. One can detect cases of over-trading by computing the current ratio and the various turnover ratios. The current ratio is likely to be very low and turn-over ratios are likely to be very higher than normally in the industry concerned.
Over-trading can be defined as “Transacting more business than the firm's working capital can normally sustain, thus placing serious strain on its cash flow and risking collapse or insolvency.”
Over-trading is a term in financial statement analysis. Over-trading often occurs when companies expand its ow n operations too quickly (aggressively). Over-traded companies enter a negative cycle, where increase in interest
expenses negatively impact net profit leads to lesser w working capital leads to increase borrowings leads to more interest expense and the cycles continues. Over-traded companies eventually face liquidity problems and/or running out of working capital.
Under-Trading
Conditions/Symptoms of Over-trading:
· Rapid grow the in business development and sales.
· Lesser net profit.
· The business running a business with limited know ledge.
· Cash flow problem or short of w working capital.
· Bad cash budget or unrealistic.
· Having large amount of unpaid vendors.
· High amount of financial interest expenditure.
· High gearing ratio.
· Keen market competition.
· Overstock or slow movement of inventory
Under-trading is the reverse of over-trading w here the funds of a company are not utilized fully because of insufficient management. This is due to the under employment of assets of the business, leading to the fall of sales and results in
financial crises. This makes the business unable to meet its commitments and ultimately leads to forced liquidation. The symptoms in this case would be a very high current ratio and very low turnover ratio. Under-trading is an aspect of over-capitalization and leads to low profits, low rate of return on investment, decline in the share prices in the market, loss of good will etc.
Capitalization
Capitalization comprises of share capital, debentures, loans, free reserves, etc. Capitalization represents permanent investment in companies excluding long-term loans. Capitalization can be distinguished from capital structure.
Capital structure is a broader term and it deals with qualitative aspect of finance, while capitalization is a narrower term and it deals with the quantitative aspect.
Capitalization is generally of the following two types:
1. Over Capitalization
2. Under Capitalization
Over-capitalization
Meaning of Over-capitalization:
Over-capitalization is a situation in which actual profits of a company are not sufficient enough to pay dividends at a proper rate on shares over a period of time. This situation arises when the company raises more capital than what is actually required. In such a situation, a part of the total capital of the company always remains idle and it results in lower earnings.
Causes of Over-capitalization:
The main causes of over-capitalization are:
1. High promotion cost - When a company goes for high promotional expenditure, i.e., making contracts, canvassing, underwriting commission, drafting of documents, etc. and the actual returns are not adequate in proportion to high expenses, the company is overcapitalized in such cases.
2. Purchase of assets at higher prices - When a company purchases assets at an inflated rate.
The result is that the book value of assets is more than the actual returns. This situation gives rise to over-capitalization of company.
3. A company’s flotation n boom period - At times company has to secure it’s solvency and thereby float in boom periods. That is the time when rate of returns are less as compared to capital employed. This results in actual earnings lowering down and earnings per share declining.
4. Inadequate provision for depreciation - If the finance manager is unable to provide an adequate rate of depreciation, the result is that inadequate funds are available when the assets have to be replaced or when they become obsolete.
New assets have to be purchased at high prices which prove to be expensive.
5. Liberal dividend policy - When the directors of a company liberally divide the dividends into the shareholders, the result is inadequate retained profits which are very essential for high earnings of the company. The result is deficiency in company. To fill up the deficiency, fresh capital is raised which proves to be a costlier affair and leaves the company to be over- capitalized.
6. Over-estimation of earnings - When the promoters of the company overestimate the earnings due to inadequate financial planning, the result is that company goes for borrowings which cannot be easily met and capital is not profitably invested. This results in consequent decrease in earnings per share.
Effects of Over-capitalization
On Shareholders -
Over capitalization has the following effect on shareholders:
1. Since the profitability decreases, the rate of earning of shareholders also decreases.
2. The market price of shares goes down because of low profitability.
3. The profitability going down has an effect on the shareholders. Their earnings become uncertain.
4. With the decline in goodwill of the company, share prices decline. As a result shares cannot be marketed in capital market.
On Company -
Over capitalization has the following effect on the company:
1. Because of low profitability, reputation of company is lowered.
2. The company’s shares cannot be easily marketed.
3. With the decline of earnings of company, goodwill of the company declines and the result is fresh borrowings are difficult to be made because of loss of credibility.
4. In order to retain the company’s image, the company indulges in malpractices like manipulation of accounts to show high earnings. The company cuts down its expenditure on maintenance, replacement of assets, adequate depreciation, etc.
On Public -
Over-capitalization has the following adverse effects on the public:
1. In order to cover up their earning capacity, the management indulges in tactics like increase in prices or decrease in quality.
2. Return on capital employed is low. This gives an impression to the public that their financial resources are not utilized properly.
3. Low earnings of the company affects the credibility of the company as the company is not able to pay it’s creditors on time.
4. It also has an effect on working conditions and payment of wages and salaries also lessen.
Remedies for Over-capitalization:
Restructuring of the firm is to be executed to avoid the over-capitalization situation of the company. It involves:
1. Reduction of debt burden/ Reduction of funded debts.
2. Negotiation with term lending institutions for reduction in interest obligation/ Reduction of interest on debentures and loans.
3. Redemption of preference share through a scheme of capital reduction.
4. Reduction of the face value and paid-up value of equity shares.
5. Reduction in the number of equity shares.
6. Ploughing back of profits.
7. Initiating merger with well managed profit making companies interested in
talking over ailing company.
Under-Capitalization
An under-capitalized company is one which earns exceptionally high profits as compared to industry. An under-capitalized company situation arises when the estimated earnings are very low as compared to actual profits. This gives rise to additional funds, additional profits, high goodwill, and high earnings and thus the return on capital shows an increasing trend.
Causes of Under-capitalization
The main causes of under-capitalization are:
· Low promotion costs
· Purchase of assets at deflated rates
· Conservative dividend policy
· Flotation of company in depression stage
· High efficiency of directors
· Adequate provision of depreciation
· Large secret reserves are maintained.
Effects of Under Capitalization
On Shareholders
a. Company’s profitability increases. As a result, rate of earnings go up.
b. Market value of share rises.
c. Financial reputation also increases.
d. Shareholders can expect a high dividend.
On company
1. With greater earnings, reputation becomes strong.
2. Higher rate of earnings attract competition in market.
3. Demand of workers may rise because of high profits.
4. The high profitability situation affects consumer interest as they think that the company is overcharging on products.
On Society
1. With high earnings, high profitability, high market price of shares, there can be unhealthy speculation in stock market.
2. ‘Restlessness in general public is developed as they link high profits with high prices of product.
3. Secret reserves are maintained by the company which can result in paying lower taxes to government.
4. The general public inculcates high expectations of these companies as these companies can import innovations, high technology and thereby best quality of product.
Remedies for Under-capitalization:
The possible corrections for under-capitalisation may be outlined as under:
1. Splitting up of the shares: The effect of this measure will be more apparent than real because the overall rate of earnings in this case will remain the same though the dividend per share will now be a smaller amount. Thus, split up of the company’s shares will reduce the dividend per share.
2. Issue of bonus shares: This will reduce both the dividend per share and earning per share of the company. The most widely used and effective remedy for under capitalisation is the conversion of reserves and accumulated profits into shares. This will affect both dividend per share and the over-all rate of earnings.
3. Increase in par value of shares: The values of assets, under this scheme, may be revised upwards and the existing shareholders may be given new shares carrying higher par (face) value. In this way, the rate of earnings will decline though the amount of dividend per share may not be affected. As a further step, the com pay may offer the shareholders a share split- up and an increase in par-value.
In short, the remedies of under-capitalisation are:
1. Splitting up of shares.
2. Increasing the number of shares. Increase in the par value of shares. Issue of Bonus shares.
3. Fresh issue of shares.
Both over-capitalization and under-capitalization are detrimental to the interests of the society.