Working Capital

Question 1

Investment decision?

Answer 1

Investment in long term assets:- capital budgeting decision.

Investment in short term assets:- working capital management.

Question 2

Working capital?

Answer 2

It refers to that portion of the firm’s capital which is required to carry out operations of the business on daily basis .
Also called circulating capital as it keeps on changing from one form to another form.

Question 3

Working capital management?

Answer 3

It is concerned with the problems that arise in attempting to manage the current assets , the current liabilities and the interrelationship that exists between them.

Question 4

Scope of financial management?

Answer 4

How large should an organization be and what assets it should invest in .
How will we pay for these assets.
What should we do with the earnings generated by the assets.

Question 5

Working capital management

Answer 5

Here we must see how much we can invest in current assets and what amount of cash do we need to have . So we need to strike a balance between profitability and liquidity.

Question 6

Concepts of working capital?

Answer 6

Gross working capital
It refers to the investment in current assets.
Net working capital
It is the difference between current assets and current liabilities .
It can be positive or negative.

Question 7

Operating cycle?

Answer 7

Operating cycle is the time duration required to convert sales , after the conversion of resources into inventories into cash .
Alternatively operating cycle implies the continuing flow from cash to suppliers to inventory to accounts receivables and back into cash.

Question 8

Phases of operating cycle of a manufacturing firm?

Answer 8

Phase 1: Acquisition of resources : Raw materials ,labour, fuel etc .
Phase 2: manufacture of the product : conversion of raw materials into work in progress then into finished goods .
Phase 3: sale of the product: either for cash or for credit and credit sales create accounts receivable for collection .

Question 9

Gross operating cycle?

Answer 9

It is equal to the length of the inventories and receivables conversion period .
It is calculated in days usually.
Goc=rmcp+wipcp+fgcp+rcp

Question 10

Net operating cycle?

Answer 10

In practice a firm may acquire resources (such as raw materials ) on credit and may temporarily postpone payment of certain expenses .payables which the firm can defer ,are the spontaneous sources of capital .In that case operating cycle period is called net operating cycle period.
Nocp=gocp-payable deferral period .

Question 11

Spontaneous sources of finance?

Answer 11

Spontaneous sources of financing include all those sources that are available upon demand ( eg.trade credit, accounts payable) or that arise naturally as a part of doing business.

Question 12

Formulae for determination of working capital.

Answer 12

RMCP= average stock of raw material÷raw material consumption per day .
WIPCP= Average stock of work in progress ÷total cost of production per day.
FGCP= Average stock of finished goods ÷ total cost of goods sold per day.
RCP=Average accounts receivable ÷net credit sales per day.
Payable deferral period = Average payables ÷ net credit purchases per day

Question 13

Classification of working capital?

Answer 13

On the basis of concept:-
1.Gross working capital.
2.Net working capital.
On the basis of time :-
1. Permanent or fixed  working capital 
   (I)regular working capital .
   (II)reserve working capital. 
2. Temporary or variable working capital 
  (I) seasonal working capital. 
  (II) special working capital.

Question 14

Permanent working capital and its types ?

Answer 14

Permanent working capital meansthe part of working capital which is permanently locked up in the current assets to carry out the business smoothly.

Regular Working Capital
It is the permanent working capital that the company normally requires in the normal course of business for the working capital cycle to flow smoothly.(regular w.cap for w.cap cycle or operating cycle )

Reserve Working Capital:
It is the working capital available over and above the regular working capital. The company keeps it for contingencies that may arise due to unexpected situations.(strikes, rise in price depression etc)

Question 15

Temporary working capital and its types?

Answer 15

it isthe excess amount a business needs over and above its permanent counterpart. It is related to the volume of production in a business. Since sales and production fluctuate throughout a year, working capital requirements may also vary.
In simple terms, it is the difference between net working capital and permanent working capital. The main characteristic which can be made out of the example is “fluctuation”. Therefore, we cannot forecast the temporary working capital.
Seasonal Working Capital
Seasonal working capital is that temporary increase in working capital that is a result of some relevant season for the business. It is applicable to businesses having the impact of seasons, for example, the manufacturer of sweaters for whom the relevant season is the winter. Normally, their working capital requirement would increase in that season due to higher sales in that period and then go down as the collection from debtors is more than sales.

Special Working Capital
Special working capital is that rise in the temporary working capital which occurs due to a special event that otherwise normally does not take place. It has no basis to forecast and has rare occurrence normally. For example, in a country there is an Olympic Games, all the businesses will require extra working capital due to a sudden rise in business activity.

Question 16

Objectives of working capital management.

Answer 16

1.Solvency of the business:
Adequate working capital helps in maintaining the solvency of the business by providing uninterrupted flow of production.
2.goodwill:
Sufficient working capital enhances a business concern to make prompt payment and hence helps in creating and Maintaining the goodwill.
3.easy loans:
A concern having adequate working capital ,high solvency and good credit standing can arrange loans from banks and others on easy and favorable terms.
4.cash discounts : adequate working capital also enables a concern to avail cash discounts on the purchases and hence it reduces cost.
5.regular supply of raw materials :
Sufficient working capital ensures regular supply of raw material and continuous production.

Question 17

Factors affecting/determining working capital requirements.

Answer 17

1.nature of business.
2.size of business/ scale of operations.
3. Production policy :determined by seasonal variations (dependent on demand)
4. Manufacturing process / length of production cycle.
5. Seasonal variations :determined by availability of raw materials.
6. Working capital cycle.
7. Business cycle.
8. Rate of business growth.
9. Earning capacity and dividend policy .
10. Inflationary effects.
(Public utilities like railways, electric companies, water supply etc require less amount of working capital whereas trading and manufacturing require large and sizable amount of working capital .

Question 18

Components of working capital?

Answer 18

The working capital cycle is made up of four core components:  Cash & Cash equivalent.  Creditors/accounts payable.  Inventory/stock in hand.  Debtors/accounts receivables.
Cash equivalents:-
Money market accounts—A bank savings vehicle with higher interest rates and stricter minimum balance requirements than a standard savings account

Certificates of deposit—A savings account that you agree to leave untouched until it reaches maturity, usually between three months and one year

Treasury bills (T-bills)—A U.S. Treasury Department-backed note with a maturity term of under one year
Stocks and bonds—Public company shares that are freely traded on the stock exchange

Exchange-traded funds—A mutual fund designed to be more liquid than other funds.
Receivables:-
Open invoices—When you invoice your customers, you give them a period (often 30 days) to pay their debts. This process is known as an AR cycle. Because you expect to collect the funds in the near future, include them in your asset column.

Outstanding credit—To foster future business relationships, you may choose to extend credit to other companies. Until they pay you back, count this as an asset.

Accrued interest—Anytime you charge interest, even if it has not been added to the customer invoice, you can include it as AR.
Payables:-
Supplier or vendor invoices—AP includes payments not yet remitted to suppliers for goods and services received.

Unpaid dividends—Some companies give investors a share of the profits each quarter in the form of dividends.

Upcoming tax payments—Whether your company pays the IRS quarterly or yearly, be sure to include expected tax outlays over the next 12 months.

Operational costs—These expenses will vary from business to business but could consist of supply and material costs, utility payments, and leases on offices or warehouse space.

Debt repayments—Include all principal and interest payments you expect to make toward your mortgages, loans, lines of credit, and other borrowed funds.

Question 19

Process of working capital management .

Answer 19

》Estimating working capital requirement.
》financing the working capital requirement.
》Analysis and control of working capital.

Question 20

Financing of working capital?

Answer 20

Permanent or fixed working capital sources :

1. Shares
2. Debentures
3. Public deposits
4. Retained earnings
5. Loans from financial institutions

Temporary or variable working capital sources:

1. Trade credit
2. Accrued expenses
3. Deferred incomes / advances
4. Bank credit
5. Commercial papers
6. Indigenous bankers
7. Installment credit
8. Accounts receivables credit / factoring .

Question 21

Trade credit ?

Answer 21

It refers to the credit that a customer gets from suppliers of goods in the normal course of business. In practice the buying firms don’t have to pay cash immediately for the purchases . This deferral of payments is a short term financing called trade credit.

Question 22

Working capital loan under bank credit?

Answer 22

Security for acquiring bank finance:-
a) Hypothecation :- loan is sanctioned against the Hypothecation of movable property generally inventories. It is generally given to high rated borrowers not new borrowers. Here the borrower has to transfer the physical possession of the property offered as security to the bank to obtain credit. Here lender can sell the property to recover losses in the event of losses even without its mention in the contract.
Pledge:-A pledged asset is a valuable possession that is transferred to a lender to secure a debt or loan. A pledged asset iscollateralheld by a lender in return for lending funds.Pledged assets can reduce thedown paymentthat is typically required for a loan as well as reduces the interest rate charged. Pledged assets can include cash, stocks, bonds, and other equity or securities.
Mortgage:-A mortgage isan agreement between you and a lender that gives the lender the right to take your property if you fail to repay the money you’ve borrowed plus interest.
Lien:- A lien is the right of a creditor in possession of goods, securities or any other assets belonging to the debtor to retain them until the debt is repaid, provided that there is no contract express or implied, to the contrary.

Question 23

Commercial papers?

Answer 23

Unsecured promissory notes issued by the firm to raise short term funds . It is an important money market instrument in countries like USA

*It was introduced in India by RBI in 1990 on the recommendations of Voghul Committee with a view to enabling highly rated corporate borrowers to diversify their sources of short-term borrowings and to provide an additional instrument to investors. Subsequently, primary dealers and all-India financial institutions were also permitted to issue CP to enable them to meet their short-term funding requirements for their operations.

the tangible net worth of the company, as per the latest audited balance sheet, is not less than ₹4 crore

Question 24

Crisil?

Answer 24

Credit rating information services of India ltd.

Question 25

Icra?

Answer 25

ICRA Limited (formerlyInvestment Information and Credit Rating Agency of India Limited) was set up in 1991 by leading financial/investment institutions, commercial banks and financial services companies as an independent and professional investment Information and Credit Rating Agency.

Question 26

Indigenous bankers?

Answer 26

Indigenous banking system isthe system of banking that involves private firms or individuals who act as banks by providing financial services such as loans and accepting deposits. Indigenous banking system is made up of indigenous bankers who do not fall under the purview of the government. Their primary business is not banking.

Question 27

Account receivables factoring ?

Answer 27

Accounts receivable factoring, also known as factoring, isa financial transaction in which a company sells its accounts receivable.Companies allow to a finance company that specializes in buying receivables at a discount(called a factor).

Question 28

Installment credit?

Answer 28

Installment credit is simplya loan you make fixed payments toward over a set period of time. The loan will have an interest rate, repayment term and fees, which will affect how much you pay per month. Common types of installment loans include mortgages, car loans and personal loans

Question 29

Approaches to working capital financing?

Answer 29

1.Matching approach/hedging approach :-The hedging approach is also known as the matching approach. Under this approach, the funds for acquiring fixed assets and permanent current should be acquired with long term funds and fortemporary working capitalshort term funds should be used.
2. Conservative approach:- here the firm depends more on long term sources of finance . In this approach the firm finances its permanent assets and also a part of its temporary current assets using long term funds . During the time when the firm has no requirement of temporary working capital ,idle long term funds can be invested in tradeable marketable securities to avoid profitability issues.
Aggressive approach:- when the firm uses more short term financing than warranted by the matching plan .under this plan the firm finances a part of it’s fixed current assets through short term sources. This makes the firm more risky. Adoption of this strategy will minimize the investment in net working capital and ultimately it lowers the cost financing working capital needs.
(Risk preferences of management shall decide the approach to be adopted. The risk neutral will adopt the hedging approach, the risk averse will adopt the conservative approach and risk seekers will adopt the aggressive approach.)

Question 30

Factors to be considered while estimating working capital?

Answer 30

1. Total cost incurred on material , wages and overheads .
2. The length of time for which raw materials are to remain in stores before they are issued for production.
3. The length of the production cycle or WIP.
4. The length of sales cycle during which finished goods are to be kept waiting for sales.
5. The average of credit allowed to customers.
6. The amount of cash required to pay for daily operating business expenses.
7. The average amount of cash required to make advance payments ,if any .
8. The average credit period expected to be allowed by suppliers.
9. Time lag in the payment of wages and other expenses.

Question 31

Promissory notes

Answer 31

A promissory note is a debt instrument that contains a written promise by one party (the note’s issuer or maker) to pay another party (the note’s payee) a definite sum of money, either on-demand or at a specified future date.

Question 32

Relaxed ,restricted, and moderate policy

Answer 32

The working capital policy of a company refers to the level of investment in current assets for attaining their targeted sales. It can be of three types: restricted, relaxed, and moderate. The relaxed policy has higher and restricted has lower levels of current assets, whereas moderate places itself between relaxed and restricted. Commonly, these policies are also named aggressive, conservative, and hedging policies.