A ratio is a simple arithmetical expression of the relationship of one number to another.
5 : Other techniques
A ratio is a simple arithmetical expression of the
relationship of one number to another. The technique of ratio analysis can be
employed for measuring short-term liquidity or working capital position of a
firm. The following ratios may be calculated for this purpose:
3. Inventory turnover ratio
4. Receivable turnover ratio 5. Payable turnover ratio
6. Working capital turnover ratio
Overtrading and undertrading
The concepts of overtrading and undertrading are intimately connected with the net working capital position of the business. To be more precise they are connected with the liquidity position of the business.
Sometimes students may confuse over capitalization and under capitalization with over trading and under trading. They are entirely different. The former is concerned with investment on fixed assets where as the latter is concerned with investment into working capital. In this chapter since we are particular about working capital management we can concentrate on overtrading and undertrading.
For sound working capital management one should understand what is overtrading and undertrading and how it can be overcome and hence it is discussed in detail below:
Overtrading Overtrading is an aspect of under
capitalization, which means an attempt being made by business concern to
increase value of operation with insufficient amount working capital. As a
result the turnover ratio will be more, current and liquidity ratio will be
less under this situation, the firm may not be in a position to maintain the
sufficient amount of current assets like cash, bills receivables, inventories
etc., and have to depend upon the mercy of the suppliers to supply them at the
right time. The firm is also not in a position to extend credit to its
customers on one side and on the other side the firm may delay the payment too
the creditors. This situation should not be continued for a longer period, as
it is dangerous for the business since disproportionate increase in the
operations of the business without adequate working capital may bring a sudden
collapse. The over trading should be
carefully identified and overcome in the early stage itself in order to place
the firm in the right direction. In the case of over trading, 1. A firm can
witness higher amount of creditors than the debtors. 2. A firm may buy the
fixed assets with the help of short-term sources such cash credit, overdraft, Trade
creditors etc, and 3. The firm will have a low current ratio and a high turn over ratio. The cure for overtrading is very simple (1) the firm can go for sufficient amount of long-term sources like issue of share, issue of debenture, term loans etc. (2) In case if the above is not possible the operations have to be reduced to manage with the help of present sources of funds available. (3). Sell the business as a going concern.
It is just the reverse to over trading. It means improper utilisation of working capital. Under this situation the firm’s turnover ratio will be less current ratio and liquidity ratio will be high. As a result the level of trading is low as compared to capital employed. It results in increase in current assets like cash balance, bills receivable, inventories etc.,
This situation arises because of under utilisation of firm’s resources. Under trading is an aspect of overcapitalization.
Higher current ratio and low turnover results in decreased return on investment. This can be improved by the firm’s policy of adopting a more dynamic and result oriented approach. The firm may go for diversification, expansion by under taking new profitable jobs, projects etc. If a firm is not able to do the above steps then it can try to return a part of the debt, which is idle.
Working Capital Leverage The ultimate aim of business is
increasing return on investment (ROI). How to increase the ROI? This can be
possible only with the help of increased turnover. How this can be possible.
This is possible only by increasing the operating cycle as much as possible.
For example, if the cycle of cash –> RM –> WIP –> FG –> Debtors can
be rotated 8 times instead of 6 times, naturally the ROI will increase. This
can be illustrated as given below. Suppose the operating profit
margin is 6% and Working capital turnover represented by operating cycle is 6
times then ROI is 36% supposes it increase by 2 times, the ROI will increase by
6x2 = 12%. However the turnover ratio not only depends upon the current assets
but it also takes the fixed assets but we can’t forget current assets also one
of the important element to increase to turnover. Working
Capital Leverage expresses the relationship between efficiency of WCM and ROI. Insufficient Working
Capital Management leads to decrease in the turn over which results in decrease
profit which in turn results in decreased ROI. On the other hand increase in
operating cycle of the business efficiently will lead to increase in turnover
and hence higher profitability.
Tags : Financial Management - WORKING CAPITAL MANAGEMENT
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