Tuesday, June 5, 2012

Importance of cash outflows and cash inflows while arriving working capital

Importance of cash outflows and cash inflows while arriving working capital
Every business firm mobilizes the required capital for running the unit by issue of equity capital and preference share capital to the public and by availing long term borrowings from banks, financial institutions, friends and relatives.
However, they are deploying only some portion of the capital for the purpose of acquiring fixed assets comprising of land, buildings and machinery and such fixed assets are called as the operating assets for the firm. The remaining portion of the capital is utilized as working capital. Working capital in common parlance defines the funds required for the day to day working of the unit.
The unit may be engaged in some kinds of manufacturing activities or they may be trading the goods and services. Working capital includes the funds required for acquiring raw materials, consumables, funds blocked in work in process or semi finished goods or finished goods, stores and spares, receivables and debtors.
Normally the above items are collectively called as current assets and current assets normally consist of cash balance held with the firm, balance kept with the bankers, sundry debtors, inventory consisting of raw materials, work in process and finished goods etc.
Current assets are meant for meeting short term requirements and they are required for the following purposes namely; they provide liquid funds necessary to support realization of the expected returns from the firm’s long term investments. The long term investments namely; the land and building required for housing the factory and administrative units and machinery meant for running the units are bound to yield the returns provided they are put to use in an effective manner and for putting the fixed assets in use, current assets are required.
In fact, the cash flows associated with long term investments are found to be irregular and uncertain and it is the non synchronous nature of the cash flows that demands necessary working capital. Otherwise, the mismatch between the cash inflows and cash outflows tends to cause liquidity crisis.
This in return disrupts or reduces the long term returns expected from the firm’s investments in fixed assets. Current assets serve as a cushion or buffer in reducing the mismatch between the cash outflows for goods and services and cash inflows or receipts generated through revenue from sales.
There are certain differences between the cash outflows and cash inflows. Cash outflows can be easily predicted. The production manager knows the exact amount payable as wages, salaries and taxes and he can predict the probable date by which such payments are to be effected.
He is also very clear about the specific period by which payments are to be effected to the suppliers from whom materials were procured and to the bankers and financial institutions towards reducing the loans availed either through long term borrowings or short term working capital finance.
However, cash in flows are always uncertain and as such they are mostly unpredictable. Normally the sales depend upon demand and the demand in turn depends upon many factors namely; sale of finished goods, market trend, seasons and needs (real and perceived).
Thus demand being uncertain, the problem starts from the difficulty in forecasting the cash receipts from sales and ends in liquidity crunch for the unit at periodical intervals.
Under the circumstances as mentioned above, more investments in current assets representing the future cash inflows should be made towards meeting the more predictable (scheduled) payments for maturing liabilities.
People who are dealing with financial accounts should be in a position understand the nature of cash outflows and cash inflows and the working capital requirements of any firm purely depends upon the predictable cash outflows and unpredictable cash inflows.

No comments: