Professional Practices Lecture 7

FINANCIAL MANAGMENT
LECTURE # 7
MUHAMMAD ASAD
INSTRUCTOR
DEPARTMENT OF COMPUTER SCIENCE
Key Learning Point :-
- Explain the concept of working capital

- Explain the types of working capital
WORKING CAPITAL
 Working capital is the part of organization’s capital, that is used
organization’s day-to-day operations.
 Working capital management is the maintenance of a sufficient balance

between a company’s current assets and current liabilities.
 Working capital is a measure of how well a company is able to manage its

short-term financial obligations.
 An effective working capital management system helps businesses not

only cover their financial obligations but also boost their earnings.
 In any organization, most of the time finance managers are concerned with
working capital management like
Ensuring that enough cash exists to pay bills.
Ensuring that enough inventory exists to make and sell products.
Ensuring that any excess cash is invested in interest-bearing securities.
Ensuring that accounts receivable are at a level that maximizes earnings.
Ensuring that accounts receivable efficiently managed.
Ensuring that short-term borrowings are used efficiently.

Gross working capital is equal to current assets --- Indicates organization’s
investment and financing of current assets.
Net working capital is current assets minus current liabilities --- Shows the
liquidity of a organization. As the result, net working capital indicates the
financing needs of a organization, both through long-term and short-term
financing sources.
CURRENT ASSETS
Current assets represent all the assets of a organization that are expected to be
conveniently sold, consumed, used, or exhausted through standard business
operations with one year.
CURRENT ASSETS
Inventories — raw materials and components, work in progress and finished
goods.
Cash — cash in hand and at bank, which are used for meeting operational
requirements.
Trade Debtors or Accounts Receivable — credit sales to customers.
Short Term Investment — short-term surplus funds invested in government

securities, shares and short-terms bonds.
Prepaid Expenses — expenses, which have been paid for goods / services in
advance.
Loan and Advances — given by the fi rm to other organizations for a short

period of time.
CURRENT LIABILITIES
Current liabilities are a company's short-term financial obligations that are due
within one year or within a normal operating cycle.
Sundry Creditors or Accounts Payable — purchase of raw materials on

credit terms usually for a period of one to three months. Money owed to suppliers.
Short Term Debt — bank loans or commercial paper issued to fund

operations.
Current Maturities Of Long Term Debt — This is the part of a long term
debt that is due in the upcoming 12 months.
Outstanding Expense — expense which is due but has not been paid. An
expense becomes outstanding when the company has taken the benefit, but
the related payment has not been made. For example, wages & salaries, rent
payable.
Bank Overdrafts — These include withdrawals in excess of credit balance

standing in the organization’s current accounts with banks.
Provisions — These include provisions for taxation, proposed dividends and

contingencies.
ABC Ltd. has the following selected assets and liabilities…
Cash: Rs 10,000 Accounts receivable: Rs 30,000
Inventory: Rs 42,000 Taxes payable: Rs 3,000
Patent : Rs 4,000 Accounts payable: Rs 12,000
Machinery: Rs 90,000 Bonds payable: Rs 50,000
Common stock: Rs 70,000
Long-term investments: Rs 36,000
Outstanding Expense: Rs 5,000

Calculate gross working capital and net working capital for ABC Ltd.
CURRENT ASSETS
Cash + Accounts Receivable + Inventory
= 10,000 + 30,000 + 42,000 = 82,000 (Total Current Assets)
CURRENT LIABILITIES
Accounts Payable + Taxes Payable + Outstanding Expense
= 12,000 + 3,000 + 5,000 = 20,000 (Total Current Liabilities)
THE GROSS WORKING CAPITAL IS: 82,000
NET WORKING CAPITAL = 82,000 — 20,000 = 62,000

NET WORKING CAPITAL = Current Assets — Current Liabilities
POSITIVE WORKING CAPITAL

 The excess of current assets over current liabilities. The situation indicates
the organizations has ability to pay its short-term financial obligation from
own pocket (no need of debt financing).
Current Assets > Current Liabilities
 It ensures no bankruptcy circumstances, obviously we should have more

financial resources in a pocket than the list of expenses we have planned.
NEGATIVE WORKING CAPITAL
 The excess of current liabilities over current assets. The situation indicates
the organizations hasn't ability to pay its short-term financial obligation
from own pocket (need of debt financing --- using the money of creditor to
finance current obligations).
Current Assets < Current Liabilities
 It leads bankruptcy risk, obviously we should have less financial

resources in a pocket than the list of expenses we have planned.
ZERO WORKING CAPITAL
 When a company has exactly the same amount of current assets and current
liabilities, there is zero working capital in place.
Current Assets = Current Liabilities
 It also leads significant bankruptcy risk, obviously we should have equal

financial resources in a pocket as the list of expenses we have planned.
Certain current assets may not be easily and quickly converted to cash when
liabilities become due, such as inventories (required some time to be sold).
 Keeping some extra current assets ensures that a company can pay its bills
on time.
NOTE
The net working capital requirement varies business to business.
The high net working capital may also mean --- The decline in an organization
sales or operational inefficiencies. Such as, the organization failed to sell his
inventory, it's slow to collect / recover his bills receivable --- The organization
isn't investing its excess cash or have cash in hand / at bank not used to
expand operations (ignoring growth opportunities).
The negative net working capital may also mean --- an organization does not
have enough financial resources to cover its obligations, financial insolvency
can result --- and --- Lead to legal troubles, liquidation of assets, and potential
bankruptcy.
TYPES OF WORKING CAPITAL
 Adequate working capital is important for any business operations.
Working capital financing, however, can be a challenge for a business,
especially for a small business.
 In order to understand the best way to finance working capital, it is

important to understand the difference between the two types of working
capital.
1: PERMANENT WORKING CAPITAL
2: TEMPORARY WORKING CAPITAL
1: PERMANENT WORKING CAPITAL
 The minimum level of current assets required by a organization to

carry-on its business operations. Such as, money that is spent to
purchase inventory, pay rent, wages, electricity & gas bills and other
routine day to day expenses.
 Permanent working capital is also called fixed working capital ---

Because it is similar, in some sense to fixed assets. (Building rent, raw
material suppose we made 200 tables in a month, that required 3 ton
wood @ 35 RS per ton. So purchased fixed quantity of wood inventory
3*1000*35=1,05,000 every month).
 Important to note, that permanent working capital is not literally fixed, its
level can change over time --- The level of permanent working capital
depends on the business cycle as well as the growth of a organization.
 In simple words, There is a positive correlation between the size of

business and the amount of permanent working capital.
Permanent working capital can be further divided into the following categories.
REGULAR WORKING CAPITAL — minimum level of working capital

required to circulate from one procedure to another --- Such as
From cash to inventory, from inventory to receivables, from receivables to cash,

and so on.
RESERVE WORKING CAPITAL — permanent working capital in excess of

regular working capital. Reserve working capital used to meet uncertainties.
Such contingencies as union strikes, recession, court penalty and etc.
2: TEMPORARY WORKING CAPITAL
 The excess of working capital over the permanent working capital.
 A business does not need the same level of current assets throughout the
year.
FOR EXAMPLE
During a slack time a manufacturing company does not need to invest as much
into raw materials, work-in-process, or finished goods inventory because of the
decrease in sales.
On the other hand, during a peak season (On EID events, retail stores need
higher levels of merchandise).
 As we can see, during the year the level of production and sales fluctuates
--- and thus, the need for current assets also fluctuates.
 Temporary working capital is also called variable, fluctuating, or cyclical

working capital. Temporary working capital can be further divide into the
following categories.
SEASONAL WORKING CAPITAL — temporary working capital required to
meet seasonal demands. (Sugar industry in production season)
SPECIAL WORKING CAPITAL — temporary working capital required to

meet special demands. Special program for business development, may be
advertisement campaign, sales promotion activities, marketing research activities
and etc.
ANY QUESTION
You can contact me at: [email protected]
Your query will be answered within one working day.

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FINANCIAL MANAGMENT

- Explain the concept of working capital

 Working capital management is the maintenance of a sufficient balance

 Working capital is a measure of how well a company is able to manage its

 An effective working capital management system helps businesses not

Ensuring that enough cash exists to pay bills.

Ensuring that enough inventory exists to make and sell products.

Ensuring that any excess cash is invested in interest-bearing securities.

Ensuring that accounts receivable are at a level that maximizes earnings.

Ensuring that accounts receivable efficiently managed.

Ensuring that short-term borrowings are used efficiently.

Trade Debtors or Accounts Receivable — credit sales to customers.

Short Term Investment — short-term surplus funds invested in government

Loan and Advances — given by the fi rm to other organizations for a short

Sundry Creditors or Accounts Payable — purchase of raw materials on

Short Term Debt — bank loans or commercial paper issued to fund

Bank Overdrafts — These include withdrawals in excess of credit balance

Provisions — These include provisions for taxation, proposed dividends and

Cash: Rs 10,000 Accounts receivable: Rs 30,000

Inventory: Rs 42,000 Taxes payable: Rs 3,000

Patent : Rs 4,000 Accounts payable: Rs 12,000

Machinery: Rs 90,000 Bonds payable: Rs 50,000

Common stock: Rs 70,000

Long-term investments: Rs 36,000

Outstanding Expense: Rs 5,000

THE GROSS WORKING CAPITAL IS: 82,000

NET WORKING CAPITAL = 82,000 — 20,000 = 62,000

POSITIVE WORKING CAPITAL

Current Assets > Current Liabilities

 It ensures no bankruptcy circumstances, obviously we should have more

Current Assets < Current Liabilities

 It leads bankruptcy risk, obviously we should have less financial

Current Assets = Current Liabilities

 It also leads significant bankruptcy risk, obviously we should have equal

 In order to understand the best way to finance working capital, it is

 The minimum level of current assets required by a organization to

 Permanent working capital is also called fixed working capital ---

 In simple words, There is a positive correlation between the size of

REGULAR WORKING CAPITAL — minimum level of working capital

From cash to inventory, from inventory to receivables, from receivables to cash,

RESERVE WORKING CAPITAL — permanent working capital in excess of

 Temporary working capital is also called variable, fluctuating, or cyclical

SPECIAL WORKING CAPITAL — temporary working capital required to

You can contact me at: [email protected]

Your query will be answered within one working day.

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