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Unit-4 Liquidity Decisions

The document discusses liquidity and working capital management. It defines liquidity as the ability to satisfy short-term obligations using readily convertible assets. Working capital refers to the difference between current assets and current liabilities and is necessary to ensure sufficient resources are available to meet daily operational needs. The document outlines sources of working capital like cash balances, short-term financing, and cash flow management. It also discusses factors that influence working capital requirements like production levels, credit terms, and inventory holding periods.

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37 views35 pages

Unit-4 Liquidity Decisions

The document discusses liquidity and working capital management. It defines liquidity as the ability to satisfy short-term obligations using readily convertible assets. Working capital refers to the difference between current assets and current liabilities and is necessary to ensure sufficient resources are available to meet daily operational needs. The document outlines sources of working capital like cash balances, short-term financing, and cash flow management. It also discusses factors that influence working capital requirements like production levels, credit terms, and inventory holding periods.

Uploaded by

Grubber grub
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LIQUIDITY DECISIONS

Liquidity and
Liquidity Management
 Liquidity is the ability of the company to satisfy
its short-term obligations using assets that are
readily converted into cash.
 Liquidity management is the ability of the
company to generate cash when and where
needed.
Liquidity Management

 Drags on liquidity are forces that delay the


collection of cash, such as slow payments by
customers and obsolete inventory.
 Pulls on liquidity are decisions that result in
paying cash too soon, such as paying trade
credit early or a bank reducing a line of credit.
Sources of liquidity
 Primary sources of liquidity
 Ready cash balances (cash and cash equivalents)

 Short-term funds (short-term financing, such as trade


credit and bank loans)
 Cash flow management (for example, getting
customers’ payments deposited quickly)
 Secondary sources of liquidity
 Selling assets

 Issue of debentures
Working Capital Management

 The management of the short-term investment and


financing of a company.
 The amount of Capital that a Business has available to
meet the day-to-day cash requirements of its operations.
 The difference between resources in cash or readily
convertible into cash (Current Assets) and organizational
commitments for which cash will soon be required
(Current Liabilities).

https://www.youtube.com/watch?v=2yrI2sM8L
hI
Classification of Working Capital

Basis on Concept Basis of time or Need

Gross Working Net Working Permanent Temporary


Capital Capital Working Capital Working Capital

Seasonal Special
Concepts of Working Capital

 Gross Working Capital Concept


 Total of Current Assets

 Net Working Capital Concept

 The difference between current assets


and current liabilities
 Zero Working Capital Concept

 (Inventory + Receivables) - Payables


Permanent working capital

 The hard core working capital.


 Minimum level of investment in

the current assets that is carried by


the business at all times to carry
out minimum level of its
activities.
Temporary working capital

 Part of working capital,


which is required by a
business over and above
permanent working capital.
 Variable working capital.
Normal Firm Growth Firm
Importance of Working Capital
 Availability of Raw Materials Regularly
 Full Utilization of Fixed Assets
 Cash Discount
 Increase in Credit Rating
 Exploitation of Favorable Market conditions
 Facility in Obtaining Bank Loans
 Increase in Efficiency of Management
 Ability to face crisis
 Solvency of the business
Disadvantage of Excessive Working Capital

 Excessive Inventory
 Excessive Debtors
 Adverse Effect on Profitability
 Inefficiency of Management
Disadvantage of Inadequate Working Capital

 Difficulty in Availability of Raw-Material


 Full Utilization of Fixed Assets not Possible
 Difficulty in the Maintenance of Machinery
 Decrease in Credit Rating
 Non Utilization of Favorable Opportunities
 Decrease in Sales
 Difficulty in the Distribution of Dividends
 Decrease in the Efficiency of Management
Operating Cycle

Cash

Receivables Raw-Material

Finished goods Work-in-process


Operating Cycle

Cash If the length of


the operating
Receiv Raw- cycle is long,
ables Material firm require high
working capital,
if it is short, firm
Finishe Work-in- requires low
d goods process working capital.
Determinants of Working Capital

 Cash
 Inventory (JIT & EOQ)

 Debtors (appropriate credit policy)

 Short-term financing options

 Nature of Business (Restaurant)

 Market and demand conditions

 Technology and manufacturing policies


Estimation of Working Capital

 Estimation of Current Assets


 Estimation of Current Liabilities
Estimation of Current Assets

 Raw-material inventory
 Work-in-progress Inventory
 Finished Goods Inventory
 Debtors
 Cash or Bank Balances
Raw-material Inventory
Work-in-progress Inventory

Average WIP Period


Budgeted Production (in Units) x Cost of WIP per unit x---------------------------------
365 days
Finished Goods Inventory

Budgeted Production (in Units) x Cost of Production per unit x

Average Finished Goods Holding Period


----------------------------------------------------
365 days
Debtors

Budgeted Credit Sales (in Units) x Cost of Sales per unit x

Average Debtors Collection Period


----------------------------------------------------
365 days
Estimation of Current Liabilities
 Direct Wages
 Overheads
Direct Wages

Budgeted production (in Units) x Direct labour Cost per unit x

Average Lag in payment of wages


----------------------------------------------------
365 days
Overheads

Budgeted Production (in Units) x Overhead Cost per unit x

Average Lag in payment of overheads


----------------------------------------------------
365 days
Example - 1

Note: Selling, administration and financial expenses have not been included in valuation of closing stock.
Example – 2
Solution
Example – 3
Estimate the working capital requirement of a firm from the following
information.
a) Estimated cost of production (per unit)
Raw-material: Rs.45
Labour : Rs.15
Overhead : Rs.10
Total : Rs.70
b) Annual Production : 10,000 units
c) Average Raw-material holding period : 15 days
d) Average Work-in-process period : 20 days

e) Average Finished goods holding period : 30 days

f) Credit period allowed to customers : Avg. 25 days

g) Credit period allowed by suppliers : Avg. 20 days


h) Avg. time lag in payment of wages : 15 days

i) Cash at bank : Rs.10,000


Assume the production is carried on evenly through out the year (360
days).
Working Note
 Cost of WIP will be 100% of raw-material cost +
50% of other costs
 45 + .5 (15+10) = 45 + 12.5 = 57.5
 Cost of Finished goods will be 100% of total cost.
 70
 Cost of Debtors based on selling price per unit
 70
Example – 4
Working Notes
Solution
Sources
 http://www.universityofcalicut.info/SDE/VISem_B
BA_working_capital_mgmnt.pdf

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