Working capital

Nature of Working Capital

• Working capital management is concerned with
the problems that arise in attempting to manage
the current assets, the current liabilities and the
interrelations that exist between them
• Current assets refer to those assets which in the
ordinary course of business can be, or will be,
converted into cash within one year without
undergoing a diminution in value and without
disrupting the operations of the firm. Examples-
cash, marketable securities, accounts receivable
and inventor
 Current liabilities
• Are those liabilities which are intended, at
their inception, to be paid in the ordinary
course of business, within a year, out of the
current assets or the earnings of the concern.
Examples- accounts payable, bills payable,
bank overdraft and outstanding expenses.
 Objective of Working Capital
Management
• The goal of working capital management is to
manage the firm’s current assets and liabilities
in such a way that a satisfactory level of
working capital is maintained. The
interaction between current assets and
current liabilities is, therefore the main theme
of the theory of the working capital
management.
 Concepts and Definitions of Working
Capital
• There are two concepts of working capital:
Gross and Net.
• Gross working capital- means the total
current assets
• Net working capital- can be defined in two
ways-o The difference between current assets
and current liabilities. The portion of current
assets which is financed with long term funds.
 The Operating-cycle and Working
Capital Needs
• The working capital requirements of a firm
depends, to a great extent upon the operating
cycle of the firm. The operating cycle may be
defined as the time duration starting from the
procurement of goods or raw materials and
ending with the sales realization.
• The length and nature of the operating cycle may
differ from one firm to another depending upon
the size and nature of the firm.
 Cont--
• The operating cycle of a firm consists of the
time required for the completion of the
chronological sequence of some or all of the
following- Procurement of raw materials and
services. Conversion of raw materials into
work-in-progress. Conversion of work-in-
progress into finished goods. Sale of finished
goods. Conversion of receivables into cash.
 Determinants of Working capital
Requirement
• General nature of business
• Production cycle
• Business cycle fluctuations
• Production policy
• Credit policy
• Growth and expansion
• Profit level
 Cont--
• Level of taxes
• Dividend policy
• Depreciation policy
• Price level changes
• Operating efficiency
 Types of working capital need
• The working capital need can be bifurcated into permanent
working capital and temporary working capital.
• Permanent working capital- There is always a minimum
level of working capital which is continuously required by a
firm in order to maintain its activities like cash, stock and
other current assets in order to meet its business
requirements irrespective of the level of operations.
Temporary working capital- Over and above the permanent
working capital, the firm may also require additional
working capital in order to meet the requirements arising
out of fluctuations in sales volume. This extra working
capital needed to support the increased volume of sales is
known as temporary or fluctuating working capital.
 Need for Working Capital
• i. Manufacturing cycle i.e. time required for converting the raw material into
finished
• product; and
• ii. Credit policy i.e. credit period given to Customers and credit period allowed by
creditors.
• Thus, the sum total of these times is called an “Operating cycle” and it consists of
the
• following six steps:
• i. Conversion of cash into raw materials.
• ii. Conversion of raw materials into work-in-process.
• iii. Conversion of work-in-process into finished products.
• iv. Time for sale of finished goods—cash sales and credit sales.
• v. Time for realisation from debtors and Bills receivables into cash.
• vi. Credit period allowed by creditors for credit purchase of raw materials,
inventory and
• creditors for wages and overheads
MEASUREMENT OF WORKING CAPITAL
• a) Percent of Sales Method
• b) Regression Analysis Method
• c) Operating Cycle Method
 c) Operating Cycle Method
• i) Inventory period: Number of days
consumption in stock
• I÷M/365

• Where I – Average inventory during the year

• M = Materials consumed during the year
• ii) Work-in-process: Number of days of work-
in-process =
• W=K÷365
• Where W = Average work-in-process during
the year
• K = Cost of work-in-process i.e., Material +
Labour + Factory overheads
• Finished products inventory period =
• G ÷F/365
• Where G = Average finished products
inventory during the year
• F= Cost of finished goods sold during the year
• iv) Average collection period of Debtors =
• D ÷S/365
• Where D = Average Debtors balances during the year
• S= Credit sales during the year
• v) Credit period allowed by Suppliers =
• C ÷P/365
• Where C= Average creditors’ balances during the year
• P = credit purchases during the year
• vi) Minimum cash balance to be kept daily.
• Formula: O.C. = M + W + F + D – C
 Financing and Policies of Working
Capital, and their Impact
• Matching Approach
• Conservative Financing Policy
• Aggressive Financing Policy
 From the following data, compute the
duration of operating cycle for each of the two years and comment on the
increase/decrease:

• Stock: Year 1 Year 2

•
• Raw materials 20000 27000
• Work-in-progress 14000 18000
• Finished goods 21000 24000
• Purchases 96000 135000
• Cost of goods sold 140000 180000
• Sales 160000 200000
• Debtors 32000 50000
• Creditors 16000 18000
• Assume 350 Days per year for computational purposes
• Ans 1 Year 177 days
• 2 Year 198 days