Working capital management

Short-term Debt 1.8 Theories and Approaches to Working Capital 1.8.1 The Hedging or Matching Approach 1.8.2 The Conservative Approach 1.8.3 The Aggressive Approach 1.9 The Statement of C

Working Capital Management

School of Distance Education Bharathiar University, Coimbatore - 641 046

MBA Second Year (Financial Management)

Paper No 2.4

Author: B Muralikrishna Copyright © 2008, Bharathiar University

All Rights Reserved

Produced and Printed

by EXCEL BOOKS PRIVATE LIMITED A-45, Naraina, Phase-I, New Delhi-110028

for

SCHOOL OF DISTANCE EDUCATION

Bharathiar University

Coimbatore-641046

Page No UNIT I

Lesson 1 Working Capital Management: An Introduction 7

Lesson 2 Cash Flows Forecasting and Budgeting 39

UNIT II Lesson 3 Financing of Working Capital-I 61

Lesson 4 Financing of Working Capital-II 71

Lesson 5 Managing Corporate Liquidity and Financial Flexibility 86

UNIT III

UNIT IV Lesson 9 Instruments of the International Money Market 165

UNIT V Lesson 11 Working Capital Control and Banking Policy 183

Lesson 12 Appraisal and Assessment of the Working Capital 198

WORKING CAPITAL MANAGEMENT

SYLLABUS UNIT I

Working Capital Management - Theories and approaches - Ratio Analysis - FundFlow and Cash Flow Analysis - Cash flow forecasting and Budgeting

5 Working Capital Management:

An Introduction

UNIT I

7 Working Capital Management:

1.2 Concept of Working Capital

1.2.1 Balance Sheet Concept

1.2.2 Operating Cycle Concept

1.3 Importance of Working Capital

1.4 Factors Influencing Working Capital Requirement

1.5 Levels of Working Capital Investment

1.6 Profitability vs Risk trade-off

1.7 Optimal Level of Working Capital Investment

1.7.1 Proportions of Short-term Financing

1.7.2 Cost of Short-term vs Long-term Debt

1.7.3 Risk of Long-term vs Short-term Debt

1.8 Theories and Approaches to Working Capital

1.8.1 The Hedging or Matching Approach

1.8.2 The Conservative Approach

1.8.3 The Aggressive Approach

1.9 The Statement of Changes in Financial Position

1.9.1 Basic Approach

1.9.2 Working Capital Approach

1.10 Analysis of Funds Flow Statement

1.10.1 Meaning and Definition of Funds Flow Statement

1.10.2 Funds Flow Statement, Income Statement and Balance-Sheet

1.10.3 Uses, Significance and Importance of Funds Flow Statement

1.10.4 Limitations of Funds Flow Statement

1.10.5 Procedure for Preparing a Funds Flow Statement

1.10.6 Statement of Sources and Application of Funds

1.11 Application or Uses of Funds

1.12 Cash Flow Statement

1.12.1 Cash Flow from Operations

1.12.2 Cash Disbursements for Expenses

8

Working Capital Management 1.0 AIMS AND OBJECTIVES

After studying this lesson, you should be able to understand:

z The concept of working capital

z Types of the working capital

z The levels of working capital

z The factors responsible for requirement of working capital

1.1 INTRODUCTION

Working capital typically means the firm’s holdings of current, or short-term, assets such as cash, receivables, inventory, and marketable securities Much academic literature is directed towards gross working capital, i.e., total current or circulating assets In a retail establishment, cash is initially employed to purchase inventory which is in turn sold on credit and results in accounts receivables Once the receivables are collected, they become cash-part of which is reinvested in additional inventory and part (i.e., the amount above cost) going to profit or cash

Corporate executives devote a considerable amount of attention to the management of working capital Net working capital (current assets minus current liabilities) provides

an accurate assessment of the liquidity position of firm with the liquidity-profitability dilemma solidly authenticated in the financial scheme of obligations which mature within a twelve-month period Management must always ensure the solvency and viability of the firm

An examination of the components of components of working capital is helpful at this point because of the preoccupation of management with the proper combination of assets and acquired funds First, short-term, or current, liabilities constitute the portion

of funds witch have been planned for and raised Since management must be concerned with proper financial structure, these and other funds must be raised judiciously Short-term or current assets constitute a part of the asset-investment decision and require diligent review by the firm’s executives

Although careful maintenance of the proper asset and funds-acquired mixes is subjected to close scrutiny, it must be noted that there exists a close correlation between sales fluctuations and invested amounts in current assets For example, assume a hypothetical increase and in the firm’s sales This increase will necessitate more inventory, more credit sales and resulting accounts receivable, and perhaps more cash Although current liabilities must be financed -frequently from short-term funds, the larger the percentage of funds obtained from short-term funds, the more aggressive (and risky) is firm’s working capital policy and vice-versa Although short-term debt

is less expensive than long-term, short-term funds may only be renewable at much higher rats of interest Conversely, long-term funds involve a rather lengthy commitment at fixed rates of interest It should also be realized that heavy reliance on low-cost, current funds may jeopardize the solvency of the firm The risk/return trade-off is very much in evidence in the firm’s working capital-management approach As

a further illustration of the trade-off, management usually elects to prescribe levels for current assets, despite the fact that sales dictate some fluctuation in short-term are generally not considered to be the earning assets of the firm The yield from short-term assets is usually low, while returns from long-term, more permanent assets are usually quite high So management may also be considered as an aggressive or conservative according to its investments in current versus long-term assets

9 Working Capital Management:

An Introduction

1.2 CONCEPT OF WORKING CAPITAL

There are two possible interpretations of working capital concept:

1 Balance Sheet Concept

2 Operating Cycle Concept

It goes without saying that the pattern of management will be very largely influenced

by the approach taken in defining it Therefore the two concepts are discussed

separately in a nutshell

1.2.1 Balance Sheet Concept

There are two interpretations of working capital under the balance sheet concept It is

represented by the excess of current assets over current liabilities and is the amount

normally available to finance current operations But, some-times working capital is

also used as a synonym for gross or total current assets In that case, the excess of

current assets over current liabilities is called the net working capital or net current

assets Economists like Mead, Malott, Baket and Field support the latter view of

working capital They feel that current assets should be considered as working capital

as the whole of it helps to earn profits; and the management is more concerned with

the total current assets as they constitute the total funds available for operational

purposes On the other hand, economists like Lincoln and Salvers uphold the former

view They argue that (a) in the long run what matters is the surplus of current asserts

over current liabilities (b) it is this concept which helps creditors and investors to

judge the financial soundness of the enterprise; (c) what can always be relied upon to

meet the contingencies, is the excess of current assets over the current liabilities since

this amount is not to be returned; and (d) this definition helps to find out the correct

financial position of companies having the same amount of current assets Institute of

Chartered Accountants of India, while suggesting a vertical form of balance sheet,

also endorsed the former view of working capital when it described net current assets

as the difference between current assets and current liabilities

The conventional definition of working capital in terms of the difference between the

current assets and the current liabilities is somewhat confusing Working capital is

really what a part of long-term finance is locked in and used for supporting current

activities Consequently, the larger the amount of working capital so derived, greater

the proportion of long –term capital sources siphoned off to short-term activities It is

about tight working capital situation, the logic of the above definition would perhaps

indicate diversion to bring in cash, under the conventional method, working capital

would evidently remain unchanged Liquidation of debtors and inventory into cash

would also keep the level of working capital unchanged A relatively large amount of

working capital according to this definition may produce a false sense of security at a

time when cash resources may be negligible, or when these may be provided

increasingly by long-term fund sources in the absence of adequate profits Again,

under the conventional method cash enters into the computation of working capital

But it may have been more appropriate to exclude cash from such calculations

because one compares cash requirements with current assets less current liabilities

The implication of this in conventional working capital computations is that during

the financial period current assets get converted into cash which, after paying off the

current liabilities, can be used to meet other operational expenses The paradox,

however, is that such current assets as are relied upon to yield cash must themselves to

be supported by long-term funds until are converted into cash

At least, three points seem to emerge from the above First, the balance sheet

definition of working capital is perhaps not so meaningful, except as an indication of

the firm’s current solvency in repaying its creditors Secondly, when firms speak of

shortage of working capital, they in fact possible imply scarcity of cash resources

10

Working Capital Management Thirdly, in fund flow analysis an increase in working capital, as conventionally

defined, represents employment or application of funds

1.2.2 Operating Cycle Concept

A company’s operating cycle typically consists of thee primary activities; purchasing resources, producing the product, and distributing (selling) the product These activities create funds flows that are both unsynchronized because cash disbursements (for example, payments for resource purchases) usually take place before cash receipts (foe example, collection of receivables) They are uncertain because future sales and costs, which generate the respective receipts and disbursements, cannot be forecasted with complete accuracy If the firm is to maintain a cash balance to pay the bills as they come due In addition, the company must invest in inventories to fill customer orders promptly And, finally, the company invests in accounts receivable to extend credit to its customers

Figure 1.1 illustrates the operating cycle of a typical firm The operating cycle is equal

to the length of the inventory and receivables conversion periods:

Operating cycle = inventory conversion period + Receivables conversion period The inventory conversion period is the length of time required to produce and sell the product ET is defined as follows:

Inventory conversion period = Average inventory

Cost of sales / 365The payables deferral period is the length of time the firm is able to defer payment on its various resource purchases (for example, materials, wages, and taxes)

Payables deferral period

= Accountspayble slaries, benefits, and Payroll taxes payble(Cost of sales sellin, general and Ad min istrative exp ense) / 365

+

Finally, the cash conversion cycle represents the net time interval between the collection of cash receipts from product sales and the cash payments for the company’s various resource purchases It is calculated as follows:

Cash conversion cycle = operating cycle – payable deferral period

Cash conversion cycle

Inventory conversion period

Receivables conversion period

Payables Defer period

Operating cycle

Figure 1.1: Operating cycle of typical company cash

The cash conversion cycle shows the time interval over which additional no spontaneous sources of working capital financing must be obtained to carry out the firm’s activities An increase in the length of the operating cycle, without a corresponding increase in the payables deferral period, lengthens the cash conversion cycle and creates further working capital financing needs for the company

11 Working Capital Management:

An Introduction

1.3 IMPORTANCE OF WORKING CAPITAL

Working capital is the life blood and nerve centre of a business Just as circulation of

blood is essential in the human body for marinating life, working capital is very

essential to maintain the smooth running of a business No business can run

successfully without an adequate amount of working capital The main advantages of

maintaining adequate amount of working capital are as follows:

1 Solvency of the business: Adequate working capital helps in maintaining

solvency of the business by providing uninterrupted flow of production

2 Good will: Sufficient working capital enables a business concern to make prompt

payments and hence helps in creating and maintaining goodwill

3 Easy Loans: A concern having adequate working capital, high solvency and good

credit standing can arrange loans from banks and other on easy and favourable

terms

4 Cash Discounts: Adequate working capital also enables a concern to avail cash

discounts on the purchases and hence it reduces costs

5 Regular supply of raw materials: Sufficient working capital ensures regular

supply of raw materials and continuous production

6 Regular payment of salaries, wages and other day-to-day commitments: A

company which has ample working capital can make regular payment of salaries,

wages and other day-to-day commitments which raises the morale of its

employees, increases their efficiency, reduces wastages and costs and enhances

production and profits

7 Exploitation of favourable market condition: Only concern with adequate

working capital can exploit favourable market conditions such as purchasing its

requirements in bulk when the prices are lower and by holding its inventories for

higher prices

8 Ability to face crisis: Adequate working capital enables a concern to face business

crisis in emergencies such as depression because during such periods, generally,

there is much pressure on working capital

9 Quick and regular return on investments: Every investor wants a quick and

regular return on his investments Sufficiency of working capital enables a

concern to pay quick and regular dividends to its investors as there may not be

much pressure to plough back profits This gains the confidence of its investors

and creates a favourable market to raise additional funds in the future

10 High Morale: Adequacy of working capital creates an environment of security,

confidence, and high morale and creates overall efficiency in a business

Check Your Progress 1

1 Describe the balance sheet concept

1 Nature or Character of Business: The working capital requirement of a firm

basically depends upon the nature of this business Public utility undertakings like electricity water supply and railways need very limited working capital because they offer cash sales only and supply services, not products and as such no funds are tied up in inventories and receivables Generally speaking it may be said that public utility undertakings require small amount of working capital, trading and financial firms require relatively very large amount, whereas manufacturing undertakings require sizable working capital between these two extremes

2 Size of Business/Scale of Operations: The working capital requirement of a

concern is directly influenced by the size of its business which may be measured

in terms of scale of operations

3 Production Policy: In certain industries the demand is subject to wide fluctuations

due to seasonal variations The requirements of working capital in such cases depend upon the production policy

4 Manufacturing process/Length of production cycle: In manufacturing business

the requirement of working capital increases in direct proportion of length of manufacturing process Longer the process period of manufacture, larger is the amount of working capital required

5 Seasonal Variation: In certain industries raw material is not available through out

the year They have to buy raw materials in bulk during the season to ensure and uninterrupted flow and process them during the entire year

6 Rate of stock turnover: There is a high degree of inverse co-relationship between

the quantum of working capital; and the velocity or speed with which the sales are affected A firm having a high rate of stock turnover will need lower amount of working capital as compared to affirm, having a low rate of turnover

7 Credit policy: The credit policy of a concern in it s dealing with debtors and

creditors influence considerably the requirement of working capital A concern that purchases its requirement on credit and sell its products/ services on cash require lesser amount of working capital

8 Business Cycle: Business cycle refers to alternate expansion and contraction in

general business activity In a period of boom i.e., when the business is prosperous, there is a need of larger amount of working capital due to increase in sales, rise in prices, optimistic expansion of business contracts sales decline, difficulties are faced in collection from debtors and firms may have a large amount of working capital lying idle

9 Rate of growth of business: The working capital requirement of a concern

increase with the growth and expansion of its business activities Although it is difficulties to determine the relationship between the growth in the volume of business and the growth in the working capital of a business, yet it may be concluded that of normal rate of expansion in the volume of business, we may have retained profits to provide for more working capital but in fast growth in concern, we shall require larger amount of working capital

13 Working Capital Management:

An Introduction

10 Price Level Changes: Changes in the price level also effect the working capital

requirement Generally the rising prices will require the firm to maintain larger

amount of working capital as more funds will be required to maintain the same

current assets

1.5 LEVELS OF WORKING CAPITAL INVESTMENT

In a “perfect” world, there would be no necessity for working capital assets and

liabilities In such a world, there would be no uncertainty, no transaction costs,

information search costs, scheduling costs, or production and technology constraints

The unit cost of producing goods would not vary with the amount produced Firms

would borrow and lend at the same interest rate Capital, labor, and product markets

would reflect all available information and would be perfectly competitive In such a

world, it can be shown that there would be no advantage for invest or finance in the

short-term

But the world in which real firms function is not perfect It is characterized by the

firm’s considerable uncertainty regarding the demand, market price, quality, and

availability of its own products and those of suppliers There are transaction costs for

purchasing or selling goods or securities Information is faced with limits on the

production capacity and technology that it can employ There are spreads between the

borrowing and lending rates for investments and financings of equal risk Information

is not equally distributed and may not be fully reflected in the prices in product and

labor markets, and these markets may not be perfectly competitive

These real-world circumstances introduce problems with which the firm must deal

While the firm has many strategies available to address these circumstances, strategies

that utilize investment or financing with working capital accounts often offer a

substantial advantage over other techniques For example, assume that the firm is

faced with uncertainty regarding the level of its future cash flows and will incur

substantial costs if it has insufficient cash to meet expenses Several strategies may be

formulated to address this uncertainty and the costs that it may engender Among

these strategies are some that involve working capital investment or financing such as

holding additional cash balances beyond expected needs, holding a reserve of

short-term borrowing capacity One of these strategies (or a combination of them)

may well be the least costly approach to the problem Similarly, the existence of fixed

set-up costs in the production of goods may be addressed in several ways, but one

possible alternative is hold inventory

By these examples, we see that strategies using working capital accounts are some of

the possible ways firms can respond to many of the problems engendered by the

imperfect and constrained world in which they deal One of the major features of this

world is uncertainty (risk), and it is this feature that gives rise to many of the strategies

involving working capital accounts Moreover, a firm’s net working capital position

not only is important from an internal standpoint; it also is widely used as one

measure of the firm’s risk, Risk, as used in this context, deals with the probability that

a firm will encounter financial difficulties, such as the inability to pay bills on time

All other things being equal, the more net working capital a firm has, the more likely

that it will be able to meet current financial obligations Because vet working capital is

one debt financing Many loan agreements with commercial banks and other lending

institutions contain provision requiring the firm on maintain a minimum net working

capital position Likewise, bond indentures also often contain such provisions The

overall policy considers both the level of working capital investment and its financing

In practice, the firm has to determine the joint impact of these two decisions upon its

profitability and risk However, to permit a better understanding of working capital

policy, the working capital financing decision is discussed in the following section In

the final section of the chapter, the two decisions are considered together

14

Working Capital Management The size and nature of a firm’s investment in current assets is a function of a number

of different factors, including the following:

1 The type of products manufactured

2 The length of the operating cycle

3 The sales level (because higher sales require more investment in inventories and receivables)

4 Inventory policies (for example, the amount of safety stocks maintained; that is, inventories needed to meet higher than expected demand or unanticipated delays

in obtaining new inventories)

Check Your Progress 2

1 Define production policy

1.6 PROFITABILITY VS RISK TRADE-OFF

Before deciding on an appropriate level of working capital investment, a firm’s management has to evaluate the tradeoff between expected profitability and the risk that it may be unable to meet its financial obligations Profitability is measured by the rate of (operating) return on total assets; that is, EBIT/ total assets The risk that the firm will encounter financial difficulties is related to the firm’s net working capital poison

Policies C represent a conservative approach to working capital management Under this policy the company holds a relatively large proportion of its total assets in the form of current assets Because the rate of return on current assets normally is assumed to be less than the rate of return on fixed assets, this policy results in a lower expected profitability as measured by the rate of return on the company’s total assets Assuming that current liabilities remain constant, this type of policy also increases the company’s net working capital position, resulting in a lower risk that the firm will encounter difficulties

In contrast to policy C policy A represent an aggressive approach Under this policy the company holds a relatively small proportion of its total assets in the form of lower yielding current assets and thus has relatively less net working capital As a result, this policy yields a higher expected profitability and a higher risk that the company will encounter financial difficulties

15 Working Capital Management:

An Introduction

Finally, policy B represents a moderate approach, because expected profitability and

risk levels fall between those of policy C and policy A

Using net working capital as a measure of risk, the aggressive policy is most risky,

and the conservative policy is the least risky The current ratio is another measure of

working capital policies

A firm’s ability to meet financial obligations is as they come due The aggressive

policy would yield the lowest current ratio, and the conservative would yield the

highest current ratio

1.7 OPTIMAL LEVEL OF

WORKING CAPITAL INVESTMENT

The optimal level of working capital investment is the level expected to maximize

shareholder wealth It is a function of several factors, including the variability of sales

and cash flows and the degree of operating and financial leverage employed by the

firm therefore no single working capital investment policy is necessarily optimal for

all firms

1.7.1 Proportions of Short-term Financing

Not only dose a firm have to be concerned about the level of current assets; it also has

to determine the proportions of short-and long-term debt to use in financing use in

these assets The decision also involves tradeoffs between profitability and risk

Sources of debt financing are classified according to their maturities Specifically,

they can be categorized as being either short-term or long-term, with short-term

sources having maturities of 1 year or less and long-term sources having maturities of

greater than 1 year

1.7.2 Cost of Short-term vs Long-term Debt

Historically long-term interest rates normally exceeds short-term rate because of the

reduce flexibility of long–term borrowing relative to short-term borrowing Infect, the

effective cost of long-term debt, even went short-term interest rates are equal to or

greater then long-term rates With long-term debt, a firm incurs the interest expense

even during times went it has no immediate need for the funds, such as during

seasonal or cyclical downturns With short –term debt, in contrast, the firm can avoid

the interest costs on unneeded funds by playing of (or not renewing) the debt

therefore, the cost of long-term debt generally is higher then the cost of short-term

debt

1.7.3 Risk of Long-term vs Short-term Debt

Borrowing companies have different attitudes toward the relative risk of long-term

versus short-term debt then lenders Whereas lenders normally fee that risk increases

with maturity, borrowing feel that there is more risk associated with short-term debt

The reasons for this are two-fold

First, there is always the chance that a firm will not be able to refund its short-term

debt When a firm’s debt matures, it either pays off the debt as part of a debt reduction

program or arranges new financing At the time of maturity, however, the form could

faced with financial problems resulting from such events as strikes, natural disasters,

or recessions that cause sales and cash inflows to decline Under these circumstances

the form may find it very difficult or even impossible to obtain the needed funds This

could lead to operating and financial difficulties The more frequently affirm must

refinance debt, the greater is the risk of its not being able to obtain the necessary

financing

16

Working Capital Management Second, short-term interest rates tend to fluctuate more over time than long-term

interest rates As a result, a firm’s interest expenses and expected earnings after interest and taxes are subject to more variation (risk) over time with short-term debt than with long-term debt

1.8 THEORIES AND APPROACHES TO WORKING CAPITAL

There are three basic approaches for determining an appropriate working capital financing mix

Approaches to Financing Mix

The Hedging or Matching Approach

The Conservative Approach

The Aggressive Approach

Figure 1.2: Working Capital Financing Mix

1.8.1 The Hedging or Matching Approach

The term ‘hedging’ usually refers to two off-setting transactions of a simultaneous but opposite nature which counterbalance the effect of each other With reference to financing mix, the term hedging refers to ‘a process of matching maturities of debt with the maturities of financial needs’ According to this approach, the maturity of sources of funds should match the nature of assets to be financed This approach is, therefore, also known as ‘matching approach’ This approach classifies the requirements of total working capital into two categories:

(i) Permanent or fixed working capital which is the minimum amount required to carry out the normal business operations It does not vary over time

(ii) Temporary or seasonal working capital which is required to meet special exigencies It fluctuates over time

The hedging approach suggests that the permanent working capital requirements should be financed with funds from long-term sources while the temporary or seasonal working capital requirements should be financed with short-term funds The following example explains this approach

Table 1.1: Estimated Total Investment in Current Assets of

Company X for the Year 2000

Current Assets

Permanent or Fixed Investments

Temporary or Seasonal Invest

17 Working Capital Management:

An Introduction

According to hedging approach the permanent portion of current assets required

(Rs 45,000) should be financed with long-term sources and temporary or seasonal

requirements in different months (Rs 5,400; Rs 5,000 and so on) should be financed

from short-term sources

1.8.2 Conservative Approach

This approach suggests that the entire estimated investments in current assets should

be financed from long-term sources and the short-term sources should be used only

for emergency requirements According to this approach, the entire estimated

requirements of Rs 52,000 in the month of November (in the above given example)

will be financed from long-term sources The short-term funds will be used only to

meet emergencies The distinct features of this approach are:

(i) Liquidity is severally greater;

(ii) Risk is minimized; and

(iii) The cost of financing is relatively more as interest has to be paid even on

seasonal requirements for the entire period

Trade-off between the Hedging and Conservative Approaches

The hedging approach implies low cost, high profit and high risk while the

conservative approach leads to high cost, low profits and low risk Both the

approaches are the two extremes and neither of them serves the purpose of efficient

working capital management A trade off between the two will then be an acceptable

approach The level of trade off may differ from case to case depending upon the

perception of risk by the persons involved in financial decision-making However, one

way of determining the trade off is by finding the average of maximum and the

minimum requirements of current assets or working capital The average requirements

so calculated may be financed out of long-term funds and the excess over the average

from the short-term funds Thus, in the above given example the average requirements

of Rs 48,500, i.e 45,000+52,000 may be financed from long-term While the excess

capital required during various months from short-term sources

1.8.3 Aggressive Approach

The aggressive approach suggests that the entire estimated requirements of currents

asset should be financed from short-term sources and even apart of fixed assets

investments be financed from short-term sources This approach makes the

finance-mix more risky, less costly and more profitable

Illustration 1

Excel Industries Ltd is considering its current assets policy Fixed assets are

estimated at Rs 40,00,000 and the firm plans to maintain a 50 per cent debt to asset

ratio The interest rate is 14 per cent on all debt Three alternative current asset

policies are under consideration; 40,50 and 60 percent of projected sales

The company expects to earn 50 percent before interest and tax on sales of

Rs 2,00,00,000 The corporate tax rate is 35 percent Calculate the expected return on

equity under alternative

18

Working Capital Management Table 1.2: Alternative Balance Sheets of Excel Industries Ltd

Current Assets Policies

Current Assets 80.00 100.00 120.00 Fixed Assets 40.00 40.00 40.00 Total Assets 120.00 140.00 160.00 Debt (50% of Total Assets) 60.00 70.00 80.00 Equity 60.00 70.00 80.00 Total Liabilities and Equity 120.00 140.00 160.00

Table 1.3: Alternative Income Statements: Effects of

Alternative Current Assets Policies

and Tax (20%) 40.00 40.00 40.00 Interest on Debt (14%) 8.40 9.80 11.20 Earnings Before Tax (EBT) 31.60 30.20 28.80

200.00 200.00

19 Working Capital Management:

An Introduction

Earnings before interest and tax for both the companies are Rs 50 lacs each The

corporate tax rate is 35 percent

(i) What is the return on equity (ROE) for each company if the interest rate on

current liabilities is 10 per cent and 12 per cent on long-term debt?

(ii) Assuming that the rate of interest on current liabilities rises to 15 percent, while it

remains unchanged for ling-term debt, would be its effect on return on equity for

Earnings Before Interest and Tax 50.00 50.00 50.00 50.00

Interest on Current and

Long-term Debt 11.60 12.60 10.40 14.40

Earnings Before Tax (EBT) 38.40 37.40 39.60 35.60

Tax (35%) 13.44 13.09 13.86 12.46

Earnings After Tax (EAT) 24.96 24.31 25.74 23.14

Equity (Eq Share Capital

+ Retained Earnings 100.00 100.00 100.00 100.00

Return on Equity (EAT/Equity) 24.96% 24.31% 25.74% 23.14%

1.9 THE STATEMENT OF CHANGES IN

FINANCIAL POSITION

Historically, financial reporting requirements have included a balance sheet, a profit

or loss statement, and a statement of changes in financial position If only one

financial statement is to be presented for a business, that statement would have to be

the Balance Sheet For the Balance Sheet reports the irreducible minimum of modern

double-entry accounting, namely the resources of a firm and the various liabilities and

other equity interests in those resources All other financial statements report

particular aspects of assets and equities If, however, the most important statement

were to be selected, the choice would probably be the income statement in the

majority of cases Earnings are the real basis of asset and enterprise values, the best

test of managerial effectiveness in the business world, and therefore, a leading

criterion in business decisions Still, as earning power is a rate of return, dependent

well as income statements are necessary even when the emphasis is primarily on

earnings Thus, the accountants report on the results of operations and on the current

Balance Sheet and the income statement However, because of inherent limitations in

the Balance Sheet and income statements, the two basic statements are supplemented

in corporate annual reports by a third statement, the Statement of Changes in Financial

Position And by footnotes which explain and amplify the reported numerical data It

did exist in the past with some minor differences in the forms and under different

titles, such as the Statement of Sources and Uses ( or Applications ) of Funds; Funds

Statements or Funds flow Statement, Statement of Funds provided and Applied and

so on

The purpose of this financial statement is to present an analysis of the changes in the

financial position-the changes in the Balance Sheet of a company from the beginning

20

Working Capital Management of an accounting person to the end of the period The statement of changes in financial

position assist the user in assessing the causes of changes in the Balance Sheet Some

of the types of questions that can be answered by an analysis of the statement are:

1 What were the sources of funds-either cash or working capital that became available to the company during the period? Where funds obtained from net income, borrowing, and investments by owners or sale of assets?

2 Why did cash or working capital decr4ese during the period in which the company earned a profit?

3 How were funds used? Were they used from expansion, payment of debt, payment

of dividends, and so on?

4 How were assets acquisition financed—by long-term borrowings, by short-term debt, from working capital, or investments by owners?

1.9.1 Basic Approach

An analysis of the flow of resources-funds flow-through a business enterprise has long been viewed as a useful technique for analyzing the effectiveness of the enterprise’s financial activities and for assisting in the prediction of its financial success or failure The term funds has a particular meaning in this context However in everyday usage, the term funds usually means cash Therefore, it might appear that a statement of changes in financial position would provide a summary of the firm’s cash receipts and disbursements for the period Using this definition of funds, the statement is essentially an analysis of cash flow

In financial reporting, the term “funds” has usually been defined as working capital, or the excess of current assets over current liabilities According to this concept, the statements report financing and investing activities as a summary of the sources and uses of working capital for the period Thus, the purpose of the statements is to indicate the source of working capital inflow into the firm and the uses which were made of working capital during the period

The working capital concept for “funds” is the more commonly used method for preparing a statement of changes in financial position Since it is more often used, and

is usually easier to apply, we will first discuss this method and then cover the cash

“funds” approach

1.9.2 Working Capital Approach

Working capital is defined as current assets minus current liabilities It is a broader definition of “funds” than just cash, but bear in mind that cash is one component of working capital Since working capital is the difference between current assets and current liabilities, a change in either or both results in a changes in working capital The statement of changes in financial position is prepared to present an analysis of the change in working capital from the beginning to the end of an accounting period The statement of changes in financial position on a working capital basis includes information relating to the changes in working capital based on the various sources and uses of funds The statement of sources and uses of capital gives a picture of management’s handling of circulating capital It is, therefore, a “window” through which the analyst can closely examine on phase of management’s planning and decision-making The statement provides answers to several questions which cannot

be supplied by the conventional statements, such as those listed below that may be raised by management, shareholders, creditors, and others

1 What has caused the change in the working capital position?

2 How much working capital was provided by current operations, and what disposition was made of it?

21 Working Capital Management:

An Introduction

3 What was the amount of capital derived from the sale of capital stock or through

long-term borrowing, and what use was made of these funds?

4 Did company dispose of any of the non-current assets, and if so, what were the

proceeds?

5 What additional plant and equipment or other non-current assets were acquired by

using working capital?

Sources and Uses of Working Capital

The statement of changes in financial position is divided into two major segments:

funds that the firm has obtained during the period (sources of funds), and the outflow

of funds which has occurred (use of funds) The “sources of funds” section

summarizes all transactions of the business that caused a decrease in working capital

during the period

Sources of Funds

Transactions that increase working capital are sources of funds The primary sources

of working capital of a firm include:

Funds generated from operations: The earnings of a business represent on of the

principal “sources of funds” The amount of funds generated from operations is not

the net income shown on the income statement, however, because some of the

expenses, principally depreciation and amortization, do not involve the expenditure of

funds In order to determine working capital provided by operations, it is necessary to

deduct from revenues only those expense which required an expenditure of funds and

therefore caused a decrease in working capital A convenient way of determining

working capital from operations is simply to add back to net income all those

expenses which did not a source of funds in and of itself, but instead is simply a

means of determining the amount of working capital generated by operations

Certain items included in the income statement decrease expenses (there by increasing

income) without increasing working capital For example, the amortization of

premium on bonds payable cause interest expenses to be less than the amount of the

cash paid Therefore, these items should be deducted from net income in computing

the amount of working capital provided by operations

The computation of the working capital fund provided by operations may be

summarized as follows:

Net Income + Items Reducing Net Income Which Do Not Affect Working Capital +

Non-operating Loses – Non-operating Gains – Items Increasing Net Income Which

Do Not Affect Working Capital

Working Capital Provided by Operations

Increase in long-term liabilities: A second source of funds is long-term borrowing

The change in the amount of funds from long-term borrowing can be calculated by

subtracting the balance at the end of the period from the balance at the beginning of

the period If the difference is appositive number (i.e., liabilities have increased), it is

a source of funds; if long-term liabilities have decreased, it is a use of funds

Increase in share capital: If a business has issued share capital during a period, the

amount for which the shares were sold is a source of funds

Sale of non-current assets: The sale of non-current assets will be another source of

funds equal to the net proceeds form the sales (Notice that profit or loss from the sale

of non-current assets is neither a source nor use of funds)

22

Working Capital Management Uses of Funds

Transactions that decrease working capital are classified as uses of funds Typical uses

of working capital include:

Purchase of non-current assets: One of the major use of funds is the purchase of

non-current assets, principally land buildings, machinery investments, and intangible assets The amount of funds used to purchase machinery, building etc cannot be calculated by taking the difference between net value at the beginning and end of the year Non-current asset accounts are affected not only by purchases, but also by the amount of depreciation taken during the year and the sale or disposition of assets dung the year Consequently, it is necessary to have information on all of these three items

Dividends: The declaration of a cash dividend to be paid at a later date is also a use of

funds Working capital is reduced at the time the declaration is made because a current liability, dividends payable, is incurred and recorded at that time The subsequent payments of the cash dividend does not affect working capital because cash, a current asset, and dividends payable, a current liability are reduced by equal amounts

Decrease in long-term liabilities: Funds may be used to pay-off long-term liabilities

The amount of funds used for the purpose can be calculated by subtracting the balance

of the long-term liabilities at the beginning of the period from the balance at the end

of the period A decrease in term liabilities is a use of funds An increase in term liabilities is a source of funds If there are different types of long-term liabilities and the amounts arte significant, it is usual to show each type as a separate item

long-Changes in Working Capital

An increase in a current assets balance causes an increase in working capital This increase in working capital may be reflected in cash and marketable securities or in receivables and inventories which might be slow of collection and low of turnover, respectively The increase may be a result of one or a combination of such transactions as the following:

1 Issuance of debentures in exchange for current liabilities

2 Working capital provided by current operations (income before deducting depreciation, depletion, and amortization charges, i.e revenue less charges against revenue which required the use of working capital)

3 Payment of current dividends

4 Sale of long-term assets

5 Issuance of fresh share capital

A different interpretation would be made of the increase in working capital depending upon the relative importance of the various sources, if the entire increase was a result

of current operations (less reasonable dividends), a more favorable position would obtain than if the source were primarily from the issuance of long-term debt obligations A less factorable impression of the increase would be created if dividend payments exceeded the net income or if a loss were incurred and long-term debt obligations has been issued

In determining changes in working capital we are concerned only with those in determining working capital and the accounts not included in working capital (i.e., non-working capital accounts) at the same time Transactions that involve only working capital accounts or non-working capital may be ignored in determining the changes in working capital For example, if a cash payment is made or creditors, working capital is not affected because cash (and current assets) and creditors (and current liabilities) decrease by equal amounts Likewise, if shares are exchanged for a machine, working capital does not change because on working capital accounts are involved in the exchange

23 Working Capital Management:

An Introduction

Changes in non-current accounts: One the change in working capital has been

calculated, the next step is to examine the changes in the financial position of

non-working capital amount, i.e., non-current assets, non-current liabilities, and

shareholders’ equity The purpose of this examination is to identify those transactions

that may have equity The purpose of this examination is to identify those transactions

that may have affected working capital

The first change encountered in the non-working capital account on the Balance Sheet

is the change in equipment It is important to note that this is a net change; that is, the

result of an increase that is partially offset by a decrease in the equipment account, on

the Balance Sheet, the next change in a non-current accounts is the change in bills

payable The liquidation of long-term liabilities is assumed to be the result of a cash

payment unless otherwise noted, it is reported on the statement of changes in financial

position as an application of working capital Change in debentures indicates that a

company has incurred additional debt during the period Unless otherwise noted, it is

assumed that the company borrowed cash This transaction is presented on the

statement of change in financial position under other sources of working capital

Change in equity capital and paid-up capital along with retained earnings are also

provided under the other sources of working capital Other non-working capital

revenue and expenses items that may appear in given situation are the amortization of

premiums and discounts on long-term investments in bonds and bonds payable

Changes in working capital due to flood damage and dividends declared are also

recorded under other sources of working capital

The first change encountered in the non-working capital account on the Balance Sheet

is the change in equipment It is important to note that this is a net change; that is, the

result of an increase that is partially offset by a decrease in the equipment account, on

the Balance Sheet, the next change in a non-current accounts is the change in bills

payable The liquidation of long-term liabilities is assumed to be the result of a cash

payment unless otherwise noted, it is reported on the statement of changes in financial

position as an application of working capital Change in debentures indicates that a

company has incurred additional debt during the period Unless otherwise noted, it is

assumed that the company borrowed cash This transaction is presented on the

statement of change in financial position under other sources of working capital

Change in equity capital and paid-up capital along with retained earnings are also

provided under the other sources of working capital Other non-working capital

revenue and expenses items that may appear in given situation are the amortization of

premiums and discounts on long-term investments in bonds and bonds payable

Changes in working capital due to flood damage and dividends declared are also

recorded under other sources of working capital

Check Your Progress 3

Define working capital

………

………

1.10 ANALYSIS OF FUNDS FLOW STATEMENT

1.10.1 Meaning and Definition of Funds Flow Statement

Funds Flow Statements is a method by which we study changes in the financial

position of a business enterprise between beginning and ending financial statements

dates It is a statement showing sources and uses of funds for a period of time

24

Working Capital Management Foulke defines these statements as:

“A statement of sources and application of funds is a technical device designed to analyse the changes in the financial condition of a business enterprise between two dates.”

In the words of Anthony, “The funds flow statement describes the sources from which additional funds were derived and the use to which these sources were put.”

I.C.W.A in Glossary of Management Accounting terms defines Funds Flow Statement

as “a Statement either prospective or retrospective, setting out the sources and applications of the funds of an enterprise The purpose of the statement is to indicate clearly the requirement of funds and how they are proposed to be raised and the efficient utilization and application of the same.”

Thus, funds flow statement is statement which indicates various means by which the funds have been obtained during certain period and the ways to which these funds have been used during that period The term ‘funds’ used here means working capital, i.e., the excess of current assets over current liabilities

Funds flow statement is called by various names such as Sources and Application of Funds; Statement of Changes in Financial Position; Sources and Uses of Funds; Summary of Financial Operations: Where came in and Where gone out Statement; Where got, Where gone Statement; Movement of Working Capital Statement; Movement of Funds Statement; Funds Received and Disbursed Statement; Funds Generated and Expended Statement; Sources of Increase and Application of Decrease; Funds Statement, etc

1.10.2 Funds Flow Statement, Income Statement and Balance Sheet

Funds flow statement is not a substitute of an income statement, i.e., a profit and loss account, and a balance sheet The Profit and Loss Account is a document which indicates the extent of success achieved by a business in earning profits It reports the results of business activities and indicates the reasons for the profitability or lack thereof The Profit and Loss Account does not highlight the changes in the financial position of a business It does not reveal the inflows and outflows of funds in business during a particular period

A balance sheet is statement of financial position or status of business on a given date

It is prepared at the end of accounting period The balance sheet depicts various resources of an undertaking and the deployment of these resources in various assets on

a particular date As it indicates the financial condition on a particular date, it is static

innature; while funds flow statement is a dynamic one Funds statement tells us many financial facts which a balance sheet cannot tell Balance Sheet does not disclose the causes for changes in the assets and liabilities between two different points of time Again, while balance sheet is the end result exercise, it is prepared (Funds Statements)

to show various sources from which the funds came into business and various applications where they have been used

Hence, funds flow statement is not competitive but complementary to financial statements The funds statement provides additional information as regards changes in working capital, derived from financial statements at two points of time It is a tool of management for financial analysis and helps in making decisions

25 Working Capital Management:

An Introduction

Difference Between Funds Flow Statement and Income Statement

1 It highlights the changes in the financial

position of a business and indicates the

various means by which funds were

obtained during a particular period and the

ways to which these funds were employed

1 It does not reveal the inflows and outflows

of funds but depicts the items of expenses and incomes arrive at the figure of profit or loss

2 It is complementary to income statement

Income statement helps the preparation of

Funds Flow Statement

2 Income statement is not prepared from Funds Flow Statement

3 While preparing Funds Statement both

capital and revenue items are considered

3 Only revenue items are considered

4 There is no prescribed format for preparing

a Funds Flow Statement

4 It is prepared in prescribed format

Difference between Funds Flow Statement and Balance Sheet

1 It is statement of changes in financial

position and hence is dynamic in nature

1 It is a statement of financial position on a particular date and hence is static in nature

2 It shows the sources and uses of funds in a

particular period of time

2 It depicts the assets and liabilities at a particular point of time

3 It is a tool of management for financial

analysis and helps in making decisions

3 It is not of much help to management in making decisions

4 Usually, Schedule of Changes in Working

Capital has to be prepared before preparing

Funds Flows Statement

4 No such schedule of Changes in Working Capital is required Rather Profit and Loss Account is prepared

1.10.3 Uses, Significance and Importance of Funds Flow Statement

A funds flow statement is an essential tool for the financial analysis and is of primary

importance to the financial management Now-a-days, it is being widely used by the

financial analysts, credit granting institutions and financial managers The basic

purpose of a funds flow statement is to reveal the changes in the working capital on

the two balance sheet dates It also describes the sources from which additional

working capital has been financed and the uses to which working capital has been

applied Such a statement is particularly useful in assessing the growth of the firm, its

resulting financial needs and in determining the best way of financing these needs By

making use of projected funds flow statements, the management can come to know

the adequacy or inadequacy of working capital even in advance One can plan the

intermediate and long-term financing of the firm, repayment of long-term debts,

expansion of the business,allocation of resources, etc The significance or importance

of funds flow statement can be well followed from its various uses given below:

1 It helps in the analysis of financial operations The financial statements reveal the

net effect of various transactions on the operational and financial position of a

concern The balance sheet gives a static view of the resources of a business and

the uses to which these resources have been put at a certain point of time But it

does not disclose the causes for changes in the assets and liabilities between two

different points of time The funds flow statement explains causes for such

changes and also the effect of these changes on the liquidity position of the

company Sometimes a concern may operate profitably and yet its cash position

may become more and more worse The funds flow statement gives a clear answer

to such a situation explaining what has happened to the profits of the firm

26

Working Capital Management 2 It throws light on many perplexing questions of general interest which otherwise

may be difficult to be answered, such as:

a) Why were the net current assets lesser in spite of higher profits and versa?

vice-b) Why more dividends could not be declared in spite of available profits?

c) How was it possible to distribute more dividends than the present earnings? d) What happened to the net profit? Where did they go?

e) What happened to the proceeds of sale of fixed assets or issue of shares, debentures, etc.?

f) What are the sources of the repayment of debt?

g) How was the increase in working capital financed and how will it be financed

in future?

3 It helps in the formation of a realistic dividend policy Sometimes a firm has sufficient profits available for distribution as dividend but yet it may not be advisable to distribute dividend for lack of liquid or cash resources In such cases,

a funds flow statement helps in the formation of a realistic dividend policy

4 4 It helps in the proper allocation of resources The resources of a concern are always limited and it wants to make the best use of these resources A projected funds flow statement constructed for the future helps in making managerial decisions The firm can plan the deployment of its resources and allocate them among various applications

5 It acts as a future guide A projected funds flow statement also acts as a guide for future to the management The management can come to know the various problems it is going to face in near future for want of funds The firm’s future needs of funds can be projected well in advance and also the timing of these needs The firm can arrange to finance these needs more effectively and avoid future problems

6 It helps in appraising the use of working capital A funds flow statement helps in explaining how efficiently the management has used its working capital and also suggests ways to improve working capital position of the firm

7 It helps knowing the overall creditworthiness of firm The financial institutions and banks such as State Financial Institutions Industrial Development Corporation Industrial Finance Corporation of India, Industrial Development Bank of India, etc all ask for funds flow statement constructed for a number of years before granting loans to know the creditworthiness and paying capacity of the firm Hence, a firm seeking financial assistance from these institutions has no alternative but to prepare funds flow statements

1.10.4 Limitations of Funds Flow Statement

The funds flow statement has a number of uses, however, it has certain limitations also, which are listed below:

1 It should be remembered that a funds statement is not a substitute of an income statement or a balance sheet It provides only some additional information as regards changes in working capital

2 It cannot reveal continuous changes

3 It is not an original statement but simply are-arrangement of data given in the financial statements

27 Working Capital Management:

An Introduction

4 It is essentially historic in nature and projected funds flow statement cannot be

prepared with much accuracy

5 Changes in cash are more important and relevant for financial management than

the working capital

1.10.5 Procedure for Preparing a Funds Flow Statement

Funds Flow statement is a method by which we study changes in the financial position

of business enterprise between beginning and ending financial statements dates

Hence, the funds flow statement is prepared by comparing two balance sheets and

with the help of such other information derived from the accounts as may be needed

Broadly speaking, the preparation of a funds flow statement consists of two parts:

1 Statement or Schedule of Charges in Working Capital

2 Statement of Sources and Application of Funds

1 Statement or Schedule of Changes in Working Capital

Working Capital means the excess of current assets over current liabilities Statement

of changes in working capital is prepared to show the changes in the working capital

between the two balance sheet dates This statement is prepared with the help of

current assets and current liabilities derived from the two balance sheets

As Working Capital = Current Assets-Current Liabilities

(iv) A decrease in current liabilities increases working capital

(iii) An increase in current liabilities decreases working capital; and

(ii) A decrease in current assets decreases, working capital

So, (i) An increase in current assets increases working capital

The change in the amount of any current asset or current liability in the current

balance sheet as compared to that of the previous balance sheet either results in

increase or decrease in working capital The difference is recorded for each individual

current asset and current liability In case a current asset in the current period is more

than in the previous period, the effect is an increase in working capital and it is

recorded in the increase column But if a current liability in the current period is more

than in the previous period, the effect is decrease in working capital and it is recorded

in the decrease column or vice versa The total increase and the total decrease are

compared and the difference shows the net increase or net decrease in working capital

It is worth noting that schedule of changes in working capital is prepared only from

current assets and current liabilities and the other information is not of any use for

preparing this statement A typical form of statement or schedule of changes in

working capital is as follows:

Effect on Working Capital Increase/Decrease

Current Assets:

Cash in hand Cash at bank Bills Receivable Sundry Debtors Temporary Investments Stocks/Inventories Prepaid Expenses Accrued Incomes

Total Current Assets

Current Liabilities:

Bills Payable Sundry Creditors Outstanding Expenses Bank Overdraft Short-term advances Dividends Payable Proposed dividends Provision for taxation Total Current Liabilities Working Capital (CA-CL) Net Increase or Decrease in Working Capital

Illustration 3

Prepare a Statement of changes in Working Capital from the following Balance Sheets

of Manjit and Company Limited

Accounts Payable 96,000 1,92,000 Work-in-progress 80,000 90,000 Interest Payable 37,000 45,000 stock-in-trade 1,50,000 2,25,000 Dividend Payable 50,000 35,000 Accounts Receivable 70,000 1,40,000

29 Working Capital Management:

An Introduction

Solution:

Statement of Schedule of changes in Working Capital

3,30,000

30,000 1,40,000 2,25,000 90,000

4,65,000

10,000 70,000 75,000

43,000 1,92,000 45,000 35,000 3,15,000

34,000

15,000

96,000 8,000

Working Capital (CA-CL) 70,000 1,50,000

Net Increase in Working

Capital

1,50,000 1,50,000 2,04,000 2,04,000

1.10.6 Statement of Sources and Application of Funds

Funds flow statement is a statement which indicates various sources from which funds

(working capital) have been obtained during a certain period and the uses or

applications to which these funds have been put during that period Generally, this

statement is prepared in two formats:

a) Report Form

b) T Form or An Account Form or Self Balancing Type

Specimen of Report Form of Funds Flow Statement

Sources of Funds: Rs

Funds from Operations

Issue of Share Capital

Raising of long-term loans

Receipts from partly paid shares, called up

Sales of non current (fixed) assets

Non-trading receipts, such as dividends received

Sale of Investments (long-term)

Decrease in Working Capital (as per schedule of changes

In Working Capital)

Total

Applications or Uses of Funds:

Funds Lost in Operations

Redemption of Preference Share Capital

Redemption of Debentures

Repayment of long-term loan

Purchase of non-current (fixed) assets

Purchase of long-term Investments

Non-trading payments

Payments of dividends

Contd…

30

Working Capital Management

Payment of tax Increase in Working Capital (as per schedule of changes in Working Capital)

Sale of long-term Investments Payment of Dividends Net Decrease in Working Payment of tax Net Increase in Working Capital

Note: Payment of dividend and tax will appear as an application of funds only when these items are appropriations of

profits and not current liabilities

Sources of Funds

The following are the sources from which funds generally flow (come), into the business:

1 Funds from Operations or Trading Profits: Trading profits or the profits from

operations of the business are the most important and major source of funds Sales are the main source of inflow of funds into the business as they increase current assets (cash, debtors or bills receivable) but at the same time funds flow out of business for expenses and cost of goods sold Thus, the net effect of operations will be a source of funds if inflow from sales exceeds the outflow for expenses and cost of goods sold and vice-versa But it must be remembered that funds from operations do not necessarily mean the profit as shown by the profit and loss account of a firm, because there are many non-fund or non-operating items which may have been either debited or credited to profit and loss account The examples

of such items on the debit side of a profit and loss account are: amortization of fictitious and intangible assets such as goodwill, Preliminary expenses and Discount on issue of shares and debentures written off; Appropriation of Retained Earnings, such as Transfers to Reserves, etc., Depreciation and depletion; Loss on sale of fixed assets; Payment of dividend, etc The non-fund items are those which may be operational expenses but they do not affect funds of the business, e.g., for depreciation charged to profit and loss account, funds really do not move out of business Non-operating items are those which although may result in the outflow

of funds but are not related to the trading operations of the business, such as loss

on sale of machinery or payment of dividends The methods of calculating funds from operations have been discussed in the following pages

Basically, there are two methods of calculating funds from operations:

a) The first method is to prepare the profit and loss account afresh by taking into consideration only fund and operational items which involve funds and are related to the normal operations of the business The balancing figure in this case will be either funds generated from operations or funds lost in operations depending upon whether the income or credit side of profit and loss account exceeds the expense or debit side of profit and loss account or vice-versa

31 Working Capital Management:

An Introduction

b) The second method (which is generally used) is to proceed from the figure of

net profit or net loss as arrived at from the profit and loss account already prepared Funds from operations by this method can be calculated as under:

(iii) Appropriation of Retained Earnings, such as:

(a) Transfer to General Reserve (b) Dividend Equalization Fund (c) Transfer to Sinking Fund (d) Contingency Reserve, etc

(iv) Loss on Sale of any non-current (fixed) assets such as:

(a) Loss on sale of land and building (b) Loss on sale of machinery (c) Loss on sale of furniture (d) Loss on sale of long-term investments, etc

(v) Dividends including:

(a) Interim Dividend (b) Proposed Dividend (if it is an appropriation of profits and not taken as current liability (vi) Provision for Taxation (if it is not taken as current liability)

(vii) Any other non-fund/non-operating items which have been debited to P/L A/c

Total (A)

Less Non-fund or Non-operating items which have already been credited to P & L A/c

(i) Profit or Gain from the sale of non-current (fixed) assets such as:

(a) Profit on sale of land and building (b) Profit on sale of plant & machinery (c) Profit on sale of long-term investments, etc

(ii) Appreciation in the value of fixed assets, such as increase in the value of land if it has been

Credited to P/L A/c (iii) Dividends Received

(iv) Excess Provision retransferred to P/L A/c or written off

(v) Any other non-operating item which has been credited to P/L A/c

(vi) Opening balance of P & L A/c or Retained Earnings (as given in the balance sheet)

Total (B)

Total(A)-Total(B) = Funds generated by operations

(b) Patents (c) Trade Marks (d) Preliminary Expenses

(e) Discount on Issue of Shares, etc

(a) Good will (ii) Amortization of fictitious and Intangible Assets such as:

(i) Depreciation and Depletion

Add: Non-fund and Non-operating items which have been already debited to P & L A/c:

Closing Balance of P & L A/c or Retained Earnings (as given in the balance sheet)

(a) Calculation of Funds From Operation Rs

32

Working Capital Management Illustration 4

B.M Company presents the following information and you are required to calculate funds from operations:

Profit and Loss Account

Depreciation 40,000

To Discount (allowed to customers) 500

To Discount on Issue of Shares

To Advertisement Suspense A/c 5,000 By Funds from Operations

Add: Non-fund or non-operating items which have been debited to P/L A/c:

Depreciation 40,000

67,500

33 Working Capital Management:

To Provision for taxation 1,50,000

To Loss on sale of investments 10,000

To Cost of issue of shares

To Depreciation & Depletion or amortization By Opening Balance (of P & L A/c

of fictitious and intangible assets Such as: By Transfers from excess provisions

Good will, patents, Trade Marks, By Appreciation in the value of

Preliminary Expenses etc fixed assets

To Appropriation of Retained Earnings, such as: By Dividends received

Transfers to General Reserve, Dividend By Profit on sale of fixed or

Equalisation Fund, Sinking Fund, etc non-current assets

To Loss on sales of any non-current or fixed asset By Funds from Operations

To Dividends (including interim dividend) (balancing figure in case debit

To Proposed Dividend (if not taken as a current side exceeds credit side)

Liability)

To Provision for taxation (if not taken as a current

Liability)

To Closing balance (of P & L A/c)

To Funds lost in Operations (balancing figure, in

Case credit side exceeds the debit side)

Solution:

[Funds from Operation = Rs 3,70,000]

1.11 APPLICATION OR USES OF FUNDS

1 Funds lost in operations Sometimes the result of trading in a certain year is a loss

and some funds are lost during that period in trading operations Such loss of

funds in trading amounts to an outflow of funds and is treated as an application of

funds

2 Redemption of preference share capital If during the year any preference shares

are redeemed, it will result in the outflow of funds and is taken as an application

of funds When the shares are redeemed at premium or discount, it is the net

34

Working Capital Management amount paid (including premium or excluding discount, as the case may be)

However, if shares are redeemed in exchanges of some other type of shares or debentures, it does not constitute an outflow of funds as no current account is involved in that case

3 Repayment of loans or redemption of debentures, etc In the same way as redemption of preference share capital, redemption of debentures or repayment of loans also constitute an application of funds

4 Purchase of any non-current or fixed asset: When any fixed or non-current asset like land, building, plant and machinery, furniture, long-term investments, etc, are purchased, funds outflow from the business However, if fixed assets are purchased for a consideration of issue of shares or debentures or if some fixed asset is exchanged for another, it does not involve any funds and hence not an application of funds

5 Payments of dividends and tax Payments of dividends and tax are also applications of funds It is the actual payment of dividend (may be interim dividend) and tax which should be taken as an outflow of funds and not the mere declaration of dividend or creating of provision for taxation

6 Any other non-trading payment Any payment or expense not related to the trading operations of the business amounts to outflow of funds and is taken as an application of funds

Check Your Progress 4

Fill in the blanks:

1 Working capital is equals to _

2 Sales- cost of sales is equals to

3 Working capital is categorized into _ concepts

1.12 CASH FLOW STATEMENT

There are changes in financial position that do not affect funds flow, yet should be included in the funds flow statement These changes result from such transactions as exchanges of debentures or share capital for bounds For example, assume that a company needed money to expand its physical facilities and whished to borrow the money One procedure would be to sell bonds (a source of funds) and use the funds to purchase the physical equipment ( a use of fund) If, instead, the company exchanged the bonds directly with the owner of the acquired facilities, the net result would be precisely the same Yet, in this instance, there would have been no funds flow because the bonds were never sold for cash In cases like this, we assume an implicit funds flow As a general rule, any time long-term debt or share capital is exchange, it should appear on the funds flow statement

If funds are defined as cash, the statement of changes in financial position disclose individual sources and use of cash The analysis of cash flow is very similar to the analysis which was described for the working capital concept of funds Additional adjustments, however, are necessary to convert the net income for the period to the amount of cash which was provided by operations

1.12.1 Cash Flow from Operations

Several adjustments are required to convert a firm’s net income to cash flow operations As illustrated previously, a non-fund expens4, such as depreciation, is an allocation of a past cost and thus does not result in an outlay of cash during the current period Therefore, non-fund expenses must be added back to net income in

35 Working Capital Management:

An Introduction

determining cash provided by operations The calculation of cash generated by

operations of the business can be better understood with the help of below

Computation of Cash from Operations

Net income as per Income statement (P and L A/c)

Depreciation

Amortization/write off of patents, preliminary Expenses or loss on sale

of fixed assets

Deduct: Profit on sale of fixed assets

Cash generated by operation (a) + (b)

Cash received from Customers: since many firms make sales on a credit basis, cash

receipts depend on the collection from customers If the sundry debtors balance

increases during the period, credit sales must have exceeded collections from

customers Similarly, a decrease in accounts receivable during the year indicates that

cash collected form customers exceeded net credit sales by the amount of the decrease

in accounts receivable Therefore, cash received from customers may be computed

thus:

Cash Disbursement Associated with Cost of Goods Sold: The initial step in computing

the cash disbursements associated with cost of goods sold is determining purchases

for the period Purchases will differ from cost of goods sold if the inventory balance

increases or decreases during the year If inventories decreased, then a part of the cost

of goods sold came from the reduction of the beginning inventory and did not

represent goods purchased during the year Similarly, if inventories increased,

purchases exceeded the cost of goods sold by the amount of the increase in the

inventory balance

+ Increase in Inventory

Cost of goods sold or = Purchases

– Decrease in Inventory

since purchases are often made on a credit basis, purchases for a period may differ

from cash disbursements if the creditors balance increas4d or decreased during the

year For example, if a firm increases its creditors, it paid out less cash than the

amount of its purchases for the period

Thus, the procedure for computing cash disbursements for purchases is as follows:

Purchases or = Cash Disbursements for purchases

36

Working Capital Management 1.12.2 Cash Disbursements for Expenses

Expenses incurred during the current period may differ from cash outlays because of changes in either prepaid expenses or accrued liability balances

If an accrued liability related to an expense increased during the year, then only a portion of the expense represented as expenditure of cash during the period Thus, if

an expense has a related accrued liability account, the cash disbursement associated with the expense may be determined as follows:

+ Decrease in Accrued Liability

– Increase in Accrued Liability Similarly, if an expense has a related prepaid expense account an increase in the prepaid account indicates that the cash outlay exceeded the amount of the expenses The cash outlay is computed as follows:

+ Increase in Prepaid Expense Account

– Decrease in Prepaid Expense Account

Cash used for Dividends: The computation of the cash used for dividends may also

differ if there was a change in the dividends payable account from the beginning to the ends of the year The declaration of dividends would constitute a decrease in working capital because a current liability; dividends payable, is increased The use of cash, however, would occur during the following year when the dividends are actually paid

1.13 LET US SUM UP

Until now this lesson has analyzed the working capital the working capital investment and financing decisions independent of one another in order to examine the profitability–risk tradeoffs associated with each, assuming that all other factors are held constant Effective working capital, policy, however, also requires the consideration of the joint impact of these decisions on the firm’s profitability and risk

1.14 LESSON END ACTIVITY

“Uncertainty makes it difficult for a financial manager to predict the company’s requirements for short-term funds” Discuss What steps can the financial manager take to minimize the resulting risks to the company?

1.15 KEYWORDS

Working capital: It means the firm’s holdings of current or short-term asset

Balance Sheet Concept: It is represented by the excess of current assets over current

liabilities and is the amount normally available to finance current operations

1.16 QUESTIONS FOR DISCUSSION

1 Define and describe the difference between the operating cycle and cash conversion cycle for a typical manufacturing company

2 Discuss the profitability versus risk tradeoffs associated with alternative levels of working capital investment

3 Describe the difference between pertinent current assets and fluctuating current assets

37 Working Capital Management:

An Introduction

4 Why is it possible for the effective cost of long-term debt to exceed the cost of

short-term debt, even when short-term interest rates are higher than long-term

rates?

5 Describe the matching approach for meeting the financing needs of a company

What is the primary difficulty in implementing this approach?

6 Discuss the profitability versus risk tradeoffs associated with alternative

combinations of short-term and long-term debt used in financing a company’s

assets

7 As the difference between the costs of short-and long-term debt becomes smaller,

which financing plan, aggressive or conservative, becomes more attractive?

8 Why is no single working capital investment and financing policy necessarily

optimal for all firms? What additional factors need to be considered in

establishing a working capital policy?

9 Define and contrast the terms working capital and net working capital

10 Why is working capital management considered so important by shareholders,

creditors, and the firm’s financial manager? What is the definition of net working

capital?

11 Given that a firm’s net working capital is sometimes defined as the portion of

current assets financed with long-term funds, can you show diagrammatically why

this definition is valid?

12 How can the differences between the returns on current and fixed assets and the

cost of current liabilities and long-term funds be used to determine how best to

change a firm’s net working capital?

Check Your Progress: Model Answers

CYP 1

1 There are two interpretations of working capital under the balance sheet

concept It is represented by the excess of current assets over current

liabilities and is the amount normally available to finance current

operations But, some-times working capital is also used as a synonym for

gross or total current assets

2 Cash conversion cycle represents the net time interval between the

collection of cash receipts from product sales and the cash payments for

the company’s various resource purchases

CYP 2

1 In certain industries the demand is subject to wide fluctuations due to

seasonal variations The requirements of working capital in such cases

depend upon the production policy

2 Business cycle refers to alternate expansion and contraction in general

business activity In a period of boom i.e., when the business is

prosperous, there is a need of larger amount of working capital due to

increase in sales, rise in prices, optimistic expansion of business contracts

sales decline, difficulties are faced in collection from debtors and firms

may have a large amount of working capital lying idle

CYP 3

Working capital is defined as current assets minus current liabilities It is a

broader definition of “funds” than just cash, but bear in mind that cash is one

component of working capital Since working capital is the difference

Contd…

38

Working Capital Management between current assets and current liabilities, a change in either or both results

in a changes in working capital

P Gopala Krishan and M.S Sandilya, Inventory Management, McMillan, 1978

D.R Mehta, Working Capital Management, Prentice-Hall Inc., 1974

K.V Smith, Management of Working Capital, McGraw-Hill, New York

E.S Buffa, Modern Production/Operation Management, Wiley, 1980

39 Cash Flows Forecasting

2.2 The Need to Focus on Cash

2.3 Cash Forecasting Horizons

2.3.1 Long Range Forecasts

2.3.2 Medium-Range Forecasts

2.3.3 Daily Cash Forecasts

2.4 Objectives of Cash Forecasting

2.5 Methods of Financial Forecasting

2.5.1 Spot Method

2.5.2 Proportion of another Account

2.5.3 Compounded Growth

2.5.4 Multiple Dependencies

2.6 Forecasting Daily Cash Flows

2.7 Sources of Uncertainty in Cash Forecasting

2.7.1 Estimating Uncertainty in Cash Forecasts

2.8 Hedging Cash Balance Uncertainties

2.8.1 Holding a Stock of Extra Cash

2.9 Let us Sum up

2.10 Keywords

2.11 Questions for Discussion

2.12 Suggested Readings

2.0 AIMS AND OBJECTIVES

After studying this lesson, you should be able to understand:

z Objective of cash management

z Motive of holding cash

z Methods of cash forecasting

z Hedging and options

40

Working Capital Management 2.1 INTRODUCTION

The cash forecast is an estimation of the flows in and out of the firm's cash account over a particular period of time, usually a quarter, month, week, or day The cash forecast is primarily intended to produce a very useful piece of information: an estimation of the firm's borrowing and lending needs and the uncertainties regarding these needs during various future periods

Cash forecasting is extremely important to most firms It enables them to anticipate periods of surplus cash and periods where financing will be necessary This anticipation is the reason that cash forecasts are generated Anticipation enables the firm to plan much more effectively for investment and financing, and via this planning, produce superior returns

This lesson highlights design issues relating to forecasting short-term cash flows We consider both medium-term monthly and quarterly forecasts and daily cash forecasts

We first discuss the benefits and costs of forecasting and then introduce some of the techniques used in cash forecasting systems

2.2 THE NEED TO FOCUS ON CASH

In this lesson we focus forecasting efforts on cash flow Because of the availability of accounting data, managers are sometimes tempted to focus on earnings Unfortunately, earnings are not very useful numbers for cash management Earnings represent an important accounting concept that attempts to match revenues with the expenses that generated them The matching concepts requires that cash outflows be stored up (in inventory or other assets) until a matching revenue occurs, at which time

an expense is realised Revenues, in turn, are often recognised on accounting statements before a cash inflow actually occurs (as in credit sales, which result in accounts receivable) The result of following generally accepted accounting principles

is a number called earnings cannot be spent They cannot be paid out in dividends They cannot be invested The only thing management can do with earnings is report them!

To obtain cash flows from earnings, we must unravel all of the effects of accrual accounting Alternatively, we can start with cash flows in the first place and avoid the confusing effects of accounting We use both approaches in this lesson

2.3 CASH FORECASTING HORIZONS

Cash forecasting may be divided into roughly three sub problems Depending on the horizon the forecaster wishes to consider Different techniques and purposes are associated with each horizon

2.3.1 Long Range Forecasts

Cash forecasts of 1 or more years into the future are needed primarily to assess the viability of the firm's long-range financing and operating policies Long-range forecasts give planners an idea of how much cash the firm needs to raise through debt

or equity issues, internally generated cash, or other cash sources These forecasts also assist managers in establishing dividend policies, determining capital investments, and planning a mergers and acquisitions (or divestitures) programme It is typical for a firm to have a 5 or 10-year forecast that is updated annually

Long-range forecasts are generally based on accounting projections and typically involved the generation of various scenarios for future economic and technological environments Such forecasts are considered strategic in the sense that possible major changes are examined