Monday, January 25, 2010

ADVANCED FINANCIAL MANAGEMENT

Module -1

ADVANCED FINANCIAL MANAGEMENT



Management

Topics to be covered…….

Concept of working capital

Types of working capital

Need for working capital

Management of working capital

Determination of level of current assets

Working capital financing

Working capital leverage

Sources for financing working capital

Bank finance for working capital

Computation of working capital

What is Working Capital?

Working Capital: Funds (current assets) required by a firm to finance day-to-day operations

Working capital is that part of the firm total capital which is required for financing short term assets or current assets such as cash, debtors, inventories, marketable securities. It is also known as circulating capital.

Objectives of Working Capital

To ensure optimum investment in current assets

To strike a balance between the twin objectives of liquidity and profitability in the use of funds

To ensure adequate flow of funds for current operations

To speed up the flow of funds or to minimize the stagnation of funds.

Need for Working Capital

The basic objective of financial management is to maximize share holders’ wealth.

This is possible only when the company earns sufficient profit.

The amount of such profit largely depends upon the magnitude of sales. However, sales do not convert into cash instantaneously.

There is always a time gap between the sale of goods and receipt of cash.

Therefore, additional capital is required to have uninterrupted business operations, the amount will be locked up in the currents assets like account receivable, stock etc.

This, actually happens due to the ‘Cash cycle’ or ‘Operating cycle’

By the time the cash is converted back to cash (Cash to stock to sales to account receivable to cash). The firm needs extra funds and hence the need for working capital.

If this is not provided, the business operations will be affected to a greater extent and hence this part of finance has to managed well.

Need to Maintain Balanced WC

Problems with Excess WC:

i. Unnecessary accumulation of inventory

ii. Defective credit policy

iii. Stock collection period

iv. Increases management’s inefficiency

Problems with inadequate WC:

    1. Stagnates growth
    2. Difficult to implement operating plans
    3. Difficult to meet day-to-day commitments
    4. Inefficient utilisation of fixed assets
    5. Unable to avail attractive cash and trade discounts
    6. Loss of reputation

Working Capital Management

Working capital management refers to the administration of all aspects of current assets namely, cash, debtors, inventories, and marketable securities and current liabilities.

This basically determines the levels and composition of current assets to ensure that right sources are tapped to finance current assets and current liabilities are paid in time.

Concept of Working Capital

Working capital is the amount of funds necessary to cover the cost of operating the enterprises.

There are two concepts of working capital (i) Gross working capital (ii) Net working capital.

1.Gross Working Capital

It is the sum of all current assets appear in balance sheet

According to this concept, working capital refers to the sum total of all current assets of the enterprise employed in the business process.

Gross working capital is a broader concept which includes all the current assets of the enterprises.

2.Net Working Capital

This concepts represents excess of current assets over current liabilities. It can be positive or negative. It is also that proportion of a firm’s current assets which is financed by long term funds.

Kinds of Working Capital

Types of Working Capital

Permanent working capital

Temporary or Variable working capital

Other types of Working capital

Gross working capital

Net working capital

Negative working capital

Balance sheet working capital

Cash working capital

1. Permanent working capital

Permanent working capital represents current assets required on a continuous basis over the entire year.

A manufacturing enterprises has to carry irreducible minimum amount of inventories necessary to ensure uninterrupted production and sales.

Likewise, some amount of funds remain tied in receivables when the firm sells goods on credit terms.

Some amount of cash has also to be held by the firm so as to exploit business opportunities, meet operational requirements and to provide insurance against business fluctuations.

Thus, minimum amount of current assets which the firm has to hold for all time to come to carry an operation at any time is termed as permanent or regular working capital.

Distinction between Permanent and Temporary WC (For non-growing firm)

2. Temporary or Variable Working Capital

It represents the additional assets which are required at different times during the operating year-additional inventory, extra cash, etc.

Seasonal working capital is the additional amount of current assets-particularly cash, receivables and inventory which is required during the more active business seasons of the year.

It is temporarily invested in current assets and possesses the following characteristics:

It is not always gainfully employed, though it may change from one asset to another, as permanent working capital does;

It is particularly suited to business of a seasonal of cyclical nature.

3. Gross Working Capital:

It is the amount of funds invested in the various components of current assets.

4.NetWorkingCapital:
It is the difference between current asset and current liabilities. The concept net working capital enables a firm to determine the exact amount available at its disposal for operational requirements.

5.NegativeWorkingCapital:
When current Liabilities exceed current assets negative working capital emerges. Such a situation occurs when a firm is nearing a crisis of some magnitude.

6.BalanceSheetWorkingCapital:
The balance sheet working capital is one which is calculated from the items appearing in the balance sheet. Gross working capital and Net Working Capital are examples of the balance sheet working capital.

7.CashWorkingCapital:
Cash working capital is one which is calculated from the items appearing in the Profit and Loss account. It shows the real flow of money or value at a particular time and is considered to be the most realistic approach in working capital management.

Methods of estimating working capital requirements.

There are two methods usually followed in determining working capital requirements:

Conventional or Cash Cycle Method

Operating Cycle Method

Conventional or Cash Cycle Method

According to the conventional method, cash inflows and outflows are matched with each other.

Greater emphasis is laid on liquidity and greater importance is attached to current ratio, liquidity ratio etc. which pertain to the liquidity of business.

What is Cash Cycle?

It is the net time interval between cash collections from sale of the product and cash payment for resources acquired by the firm.

It also represents the time interval over which additional funds called working capital, should be obtained in order to carry out the firm’s operations.

Meaning of Operating Cycle Or Working Capital Cycle

The term operating cycle refers to the time duration required to complete the following cycle of events in case of a manufacturing firm is called operating cycle.

Conversion of cash in to raw materials,

Conversion of raw materials into work-in-process,

Conversion of work in process into finished goods,

Conversion of finished goods into debtors and bills receivables through sales.

Conversion of debtors and bills receivable into cash.

This cycle will be repeated again and again. The operating cycle of a manufacturing business can be shown as given in the following chart.

Operating Cycle

The time that elapses in conversion of raw materials into cash

Cash Conversion Cycle

Cash cycle = Operating Cycle - Time take to pay Suppliers

Principles of Working Capital

In managing working capital the finance manager must bear in mind certain fundamental principals which serve as useful guidelines.

Principle of Optimization

Principle of Suitability

Principle of Cost of Capital

Principle of Investment in working capital

1. Principle of Optimization

According to this principle, the finance manager must aim at selecting the level of working capital that optimizes the firm’s rate of return.

This level is defined as that point at which the incremental cost associated with a decline in working capital investment is equal to the incremental gain associated it.

Optimization principle is based on the principle that a definite relation exists between degree of risk that a firm assumes and the rate of return.

The more risk that a firm assumes the greater is the opportunity for gain or loss.

2. Principle of Suitability

Principle of suitability should be followed while financing different components of working capital.

This stipulates that each asset should be offset with a financing instrument of the same approximate maturity.

Thus, temporary or seasonal working capital would be financed by short-term borrowings and permanent working capital with long-term sources.

3. Principle of Cost of Capital

This principle emphasizes the different sources of finance, for each source has a different cost of capital.

It should be remembered that the cost of capital moves inversely with risk.

Thus additional risk capital results in the decline in cost of capital.

4. Principle of Investment in WC.

This principle was evolved by professor Walker.

According to this principle, capital should be invested in each component of working capital as long as the equity position of the enterprise increases.

This will strengthen, the financial position of the enterprise and reduce the risk involved in it.

Management of Working Capital

The basic objective of working capital management is to manage the firm’s current assets and current liabilities in such a way that a satisfactory level of working capital is maintained i.e., it is neither inadequate nor excessive.

In order to achieve this objective the finance manager has to perform basically following two functions:

Determinants of Working Capital requirements

In order to determine the amount of working capital needed by the firm, a number of factors have to be considered by Finance Manager.

These factors are as explained below:

Issues in Working Capital

Levels of current assets

Current assets to fixed assets

Liquidity Vs. profitability

Cost trade-off

HOW IS IT ESTIMATED ?

Current assets holding period

To estimate working capital requirements on the basis of average holding period of current assets and relating them to costs based on the company’s experience in the previous years. This method is essentially based on the operating cycle concept.

Ratio of sales

To estimate working capital requirements as a ratio of sales on the assumption that current assets change with sales.

Ratio of fixed investment

To estimate working capital requirements as a percentage of fixed investment.

Determination of relevant levels of current assets

Working Capital Management (WCM) refers to the admin of all components of working capital-cash, marketable securities, debtors (receivable) and stock (inventories) and creditors (payables).

The importance of working capital management is the determination of relevant levels of current assets and their efficient use as well as the choice of the finance mix.

The financial manager must determine levels and composition of current assets. He must see that right sources are tapped to finance current assets, and the current liabilities are paid in time.

There are many aspects of working capital management which make it an important function of the financial manager.

Time: WCM requires much of the financial manager’s time.

Investment: Working capital represents a large portion of the total investment in assets.

Critically: WCM has great significance for all firms but it is very critical is directly related to the firm’s growth.

There is a direct relationship between a firm’s growth and its working capital needs.

As sales grow, the firm needs to invest more in inventories and debtors. These needs become very frequent and fast when sales grow continuously.

The financial manager should be aware of such needs and finance them quickly.

Continuous growth in sales may also require additional investments in fixed assets.

To decide the levels and financing of current assets, the risk return implications must be evaluated.

Working Capital Financing

Commercial Banks play the most significant role in providing working capital finance, particularly in the Indian context.

The balancing need has to be managed either by long term borrowings or by issuing equity or by earning sufficient profits and retained the same for coping with the additional working capital requirements.

The first choice before a finance manager, when a part of additional working capital is not provided by Banks, is take the long-term sources of finance.

Policies of Working Capital

A firm can adopt different financing policies vis-à-vis current assets. Three types of financing may be distinguished.

1. Short-term financing

2. Long-term financing

3. Spontaneous financing

1. Long Term Financing: The sources of long-term financing include ordinary share capital, preference share capital, debentures, long-term borrowings from financial institutions and reserves and surplus (retained earnings).

2. Short Term Financing: The short term financing obtained for a period less than one year. It is arranged in advance from banks and other suppliers of short term finance in the money market. Short-term finances include working capital funds from banks, public deposits, commercial paper, factoring of receivable etc.

3. Spontaneous Financing: It refers to the automatic sources of short-term funds arising in the normal course of the business. Trade credit (suppliers) and outstanding expenses are example of spontaneous financing. There is not explicit cost of spontaneous financing. A firm is expected to utilize these sources of finances to the fullest extent.

The real choice of financing current assets, once the spontaneous sources of financing have been fully utilized, is between the long-term and short-term sources of finance

What should be the mix of short-and long-term sources in financing current assets?

Depending on the mix of short and long term financing the approach followed by company may be referred to as:

* Matching approach

* Conservative approach

* Aggressive approach

Approaches for Financing Current Assets

Matching Approach

Matching or Hedging Approach: Here funds raised for a period which is matching with the life of an asset

Conservative approach

Conservative Approach: Use of long-term funds for financing short-term funds to finance a part of temporary current assets

Aggressive approach

Aggressive Approach: A firm is aggressive in financing working capital when it uses short-term funds to finance a part of permanent current assets

Working Capital Leverage

Working capital leverage (WCL) measures the sensitivity of return on investment (ROI) to the changes in the level of current assets.

Working capital leverage may be defined as the percentage change in ROI with the given percentage change in current assets. Symbolically:

WAC = % Change in ROI / % change in CA

Sources of Working Capital

Trade Credit

Trade credit is an arrangement made by the firm with their suppliers, wherein the suppliers agree to supply the goods to the firm on credit basis with an agreement, to pay the amount in a future date.

Trade credit as a source of short term finance is easy and convenient method of finance and also flexible as the credit increases with growth of the firm.

Accrued Expenses and Deferred Income

Accrued expenses are the expenses which have been incurred but not yet due and hence not yet paid also.

These represents a liability that a firm has to pay for the services already received by it. Wages, Salaries, Interest and taxes are the most important components of accrued expenses.

Deferred incomes are incomes received in advance before supplying goods or services. However, firms having great demand for its products and services, and those having good reputation in the market can demand deferred incomes.

Commercial Papers (CPs)

CP: A short-term unsecured promissory note issued by firm with highly credit rating

Features:

The maturity period of CP ranges from 15 to 365 day (but in India it ranges between 91 to 180 days).

It is sold at a discount from its face value and redeemed at its face value.

Return on CP is the difference between par value and redeemable value.

It may be sold directly to investors or indirectly through dealers.

There is no developed secondary market for CP.

Eligibility to Issue CPs

Latest tangible networth should be not less than Rs.5 crore

Company should be eligible to sanction fund based bank finance

Can be issued CPs for 75% of bank credit

Minimum credit rating should be: P2 from CRISK A-2 from ICRA

Minimum size of each CP Rs.5 lakhs

Issue size should not be less than one crore

Evaluation of CPs

Advantages:

Alternative source of finance during the period of tight bank credit

Cheaper source when compared to bank credit

Disadvantages:

Available only for large and financially sound companies

Can not be redeemed before maturity date

Public Deposits [Regulations]

Public deposits can not be issued more than 25% of share capital and free resources

Can be issued for a period ranging from 6 months to 3 years period

Maximum period is 5 years for NBFCs

Need to set aside 10% of maturity value of public deposit every year by 31st March

Need to disclose relevant, true, fair, vital facts of financial performance

Evaluation of Public Deposits

Advantages:

Simple procedure involved in issuing PDs.

No restrictive covenants are involved.

No security is offered against public deposits

Cheaper source (post tax cost is fairly reasonable)

Disadvantages:

Limited funds can be raised

Funds available only for short-period

Inter-corporate Deposits

Inter-corporate Deposits (ICDs): A deposit make by one firm with another firm is known as inter corporate deposits.

Generally, these deposits are usually made for a period up to six months. Such deposits may be the following three types:

Inter-corporate Deposits

Types:

* Call Deposits

* Three months deposits

* Six months deposits

Features:

* No legal regulations

* Given and taken in secrecy

* Available on personal contacts

Factoring

A factor is a financial institution which offers services relating to management and financing of debts arising out of credit sales.

Factors render services varying from bill discounting to a total take over a administration of credit sales including maintenance of sales ledger, collection of accounts receivable, credit control and protection from bad debts, provision of finance and rendering of advisory services to their clients.

Factoring may be on a recourse basis, where the risk of bad debt is bone by the client, or on a non recourse basis, where the risk of credit is borne by the factor.

Factoring (concise)

Factor: A financial institution which render services relating to the management and financing of debtors.

Factor selects accounts receivables of their client

Factor takes responsibility of collecting accounts receivables selected by it

Forms of Bank Finance

Banks provide different types of tailor made loans that are suitable for specific needs of a firm. The different forms of loans are:

* Loans

* Overdrafts

* Cash credit

* Bills discounting

* Bills purchase

* Letter of credit (L/C)

Security required in Bank Finance

Hypothecation

Pledge

Mortgage

Regulation of Bank Finance

Dehejia Committee (1968)

Tandon Committee (1974)

Chore Committee (1979)

In the deregulated economic environment in India recently, banks have considerably relaxed their criteria of lending. In fact, each bank can develop its own criteria for the working capital finance.

Financing of Long Term WC

Permanent working capital should be financed by long term sources like shares (equity & preference share), debentures, long term public deposits and retained earnings and loan from FIs.

2 comments:

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