Page 34 - DCOM505_WORKING_CAPITAL_MANAGEMENT

Unit 2: Planning of Working Capital

Profit Level Notes

The level of profits earned differs from enterprise to enterprise. In general, the nature of the
product, hold on the market, quality of management and monopoly power would by and large
determine the profit earned by a firm. A priori, it can be generalised that a firm dealing in a high
quality product, having a good marketing arrangement and enjoying monopoly power in the
market, is likely to earn high profits and vice-versa. Higher profit margin would improve the
prospects of generating more internal funds thereby contributing to the working capital pool.
The net profit is a source of working capital to the extent that it has been earned in cash. The cash
profit can be found by adjusting non-cash items such as depreciation, outstanding expenses and
losses written off, in the net profit. But, in practice, the net cash inflows from operations cannot
be considered as cash available/or use at the end of cash cycle. Even as the company’s operations
are in progress, cash is used for augmenting stock, book debts and fixed assets. It must, therefore,
be seen that cash generation has been used for furthering the interest of the enterprise. It is in
this context that elaborate planning and projections of expected activities and the resulting cash
inflows on a day-to-day, week-to-week and month-to-month basis assume importance because
steps can then be taken to deal with surplus and deficit cash.
The availability of internal funds for working capital requirements is determined not merely by
the profit margin but also by the manner of appropriating profits. The availability of such funds
would depend upon the profit appropriations for taxation, dividend, reserves and depreciations.

Level of Taxes

The first appropriation out of profits is payment or provision for tax. The amount of taxes to be
paid is determined by the prevailing tax regulations. The management has no discretion in this
respect. Very often, taxes have to be paid in advance on the basis of the profit of the preceding
year. Tax liability is, in a sense, short-term liability payable in cash. An adequate provision for
tax payments is, therefore, an important aspect of working capital planning. If tax liability
increases, it leads to an increase in the requirement of working capital and vice-versa.

Dividend Policy

Another appropriation of profits which has a bearing on working capital is dividend payment.
The payment of dividend consumes cash resources and, thereby, affects working capital to that
extent. Conversely, if the firm does not pay dividend but retains the profits, working capital
increases. In planning working capital requirements, therefore, a basic question to be decided is
whether profits will be retained or paid out to shareholders. In theory, a firm should retain
profits to preserve cash resources and at the same time, it must pay dividends to satisfy the
expectations of investors. When profits are relatively small, the choice is between retention and
payment. The choice must be made after taking into account all the relevant factors.
There are wide variations in industry practices as regards the interrelationship between working
capital requirements and dividend payment. In some cases, shortage of working capital has
been a powerful reason for reducing or even skipping dividends in cash. There are occasions, on
the other hand, when dividend payments are continued in spite of inadequate earnings in a
particular year because of sound liquidity. Sometimes, the dilemma is resolved by the payment
of bonus shares. This enables the payment of dividend without draining away the cash resources
and, thus, without reducing working capital. Dividend policy, is thus, a significant element in
determining the level of working capital in an organisation.

LOVELY PROFESSIONAL UNIVERSITY 29