Working Capital Management -

Estimation & Financing

Prof. Priyanka Oza

 Working Capital – Meaning
Working Capital refers to that part of the firm’s capital, which is
required for financing short-term or current assets such as cash,
marketable securities, debtors and inventories
Funds invested in current assets keep revolving fast and are
constantly converted into cash.
This cash flows out again in exchange for other current assets.
Working Capital is also known as revolving or circulating
capital or short-term capital
 Gross Working Capital
It refers to the total current asset quantum possessed by a company at any given point in an accounting year
It makes up all those assets which can be readily converted into cash
Gross Working Capital = Total Current Assets OR
Gross Working Capital = Receivables + Cash and marketable securities + Inventory + Short term investment
+ Other Current Asset
Financing of CA :
• Need for WC arises due to increasing level of business activity
• It is to be provided quickly, within a short time
• Sometimes surplus fund may arise
• The surplus may be invested in short term securities
• Funds should not be kept idle
 Significance of Net Working Capital

• Maintaining Liquidity position

• Judge Financial Soundness of a firm
• Helps in situation of cash crunch
• Helps in earning short term profits
• Improves creditworthiness of the entity
• Addition in the value of the business
 Concept of Operating Cycle
• Sufficient return from the operations leads to shareholders’ wealth maximization
• Sales should be converted to cash at the earliest
• There is invisible time lag between the sale of good and receipt of cash
• The time taken to convert raw material into cash is known as operating cycle,
involving the following:
- Raw material to work in progress
- Work in progress to finished goods
- Finished good into Sales (Debtors and cash)
Operating Cycle
Cash Conversion Cycle
Calculate CCC (CASH CONVERSION
CYCLE) from the following:
- Average use of Inventory 80 days
- Account receivable collection period 50 days
- Account payable period is 40 days
Solution:
CCC= OC- APP
OC = ICP +ARP = 80+50=130 days
CCC =130-40 =90 days
 Forecasting Working Capital – Factors
• Total costs incurred on materials, wages and overheads
• The length of time for which raw materials remain in stores before they are issued to production
• The length of the production cycle or WIP, i.e., the time taken for conversion of RM into FG
• The length of the Sales Cycle during which FG are to be kept waiting for sales
• The average period of credit allowed to our customers
• The amount of cash required to pay day-to-day expenses of the business
• The amount of cash required for advance payments, if any
• The average period of credit allowed by suppliers
• Time – lag in the payment of wages and other overheads
 Points to be remembered while estimating WC

(1) Profits should be ignored while calculating working capital requirements for the
following reasons.
(a) Profits may or may not be used as working capital
(b) Even if used, it may be reduced by the amount of income tax dividend paid, drawings etc.
(2) Calculation of WIP depends on the degree of completion as regards to materials,
labour and overheads. However, if nothing is mentioned in the problem, take 100%
of the value as WIP. Because in such a case, the average period of WIP must have
been calculated as equivalent period of completed units.
(3) Calculation of Stocks of Finished Goods and Debtors should be made at cost
unless otherwise asked in the question.
Inventory Management
Elements of Inventory Management
Inventory Control Systems
Economic Order Quantity
Reorder Point
Classification of Inventories: ABC, VED (Vital, Essential,
Desirable)
 Inventory
A physical resource that a firm holds in stock with the intent of selling it or
transforming it into a more valuable state
Purpose of inventory management
• How many units to order?
• When to order?
• How to bring efficiency in management?
Types of Inventories
Raw materials
Purchased parts and supplies
Finished Goods
Work-in-process (partially completed products)
Items being transported
Tools and equipment
 Nature of Inventories
• Raw Materials – Basic inputs that are converted into finished product
through the manufacturing process
• Work-in-progress – Semi-manufactured products which need some
more work / processes before they become finished goods for sale
• Finished Goods – Completely manufactured products ready for sale
• Supplies – Office and plant materials that do not directly enter
production but are necessary for production process and do not involve
significant investment
 Inventory Control System
• Inventory should be available when required
• Excess inventory carries a cost- should be avoided
• Excess can lead to loss- obsolescence
• Best is Just in time inventory
• Sufficient quantity should be available
• Reorder should be without complications
Two Methods used for ordering:
• Continuous system: (Fixed order quantity)- constant quantity ordered when
inventory declines to a pre determined level
• Periodic system: ( Fixed Time period)- order placed for varying amounts after
fixed time period)
 Costs involved in Inventory

• Carrying Cost – Cost of holding an item in inventory

• Ordering cost – Cost of replenishing inventory
• Shortage cost – Temporary or permanent loss of sales when
demand cannot be met
ABC Analysis
The ABC system is a widely-used classification technique for the purpose. On the
basis of the cost involved, the various
items are classified into three categories:

1) A, consisting of items with the largest investment.

2) C, with relatively small investments, but fairly large number
of items.
3) B, which stands mid-way between category A and C.

Category A needs the most rigorous control, C requires minimum attention, and B
deserves less attention than A but
more than C.
 Economic Order Quantity (EOQ)

EOQ refers to the level of inventory at which the total cost of inventory
comprising

1) Order/Setup cost, and

2) Carrying cost is the minimum.

Carrying Costs are cost associated with the maintenance/holding of inventory.

Ordering Costs are costs associated with acquisition of/placing

order for inventory.
 Mathematical (Short-cut) Approach

The economic order quantity can, using a short-cut method, be calculated by the
following equation:

EOQ = √2 AB/C

Where A = Annual usage of inventory in units,

B = Buying cost per order,
C = Carrying cost per unit per year.
 Reorder Point
The re-order point is that level of inventory when a fresh order should be placed with
suppliers. It is that inventory level which is equal to the consumption during the lead
time or procurement time.

Re-order level = (Daily usage × Lead time) + Safety stock.

Minimum level = Re-order level – (Normal usage × Average delivery time).

Maximum level = Reorder level – (Minimum usage × Maximum delivery time) +

Re-order quantity.
Average stock level = Minimum level + (Re-order quantity)/2.
Danger level = (Average consumption per day × Lead time in days for emergency
purchases).
Receivables
When a firm makes an ordinary sale of goods or service and does
not receive payment immediately, it grants trade credit and creates
accounts receivables which would be collected in future.
It is sales of goods and services on credit basis on the basis of the
promise to be paid later
 Receivables Management
Reasons to Offer Credit
• Competition
• Better Market Share
• Promotion
• Credit Availability to Customers
• Customer Convenience
• Earn better Profit
Receivables Management involves the following:
• Establishing and communicating credit policies
• Evaluation of customers and setting credit lines
• Ensuring prompt and accurate billing
• Maintaining up-to-date records of accounts receivables
• Initiating collection procedures on overdue accounts
 Receivables Management
Costs Associated with Receivables:
• Credit Department Costs
• Credit Evaluation Costs
• A/R Carrying Cost
• Cost of Discounted Payments
• Collection Expenses
• Bad Debts
Factors which determine Receivables:
• Collection cost
• Average collection period
• Level of bad debt
• Level of sales
• Credit Terms
Credit Terms
An important decision area in accounts receivable management is the credit terms. After
the credit standards have been established and the creditworthiness of the customers has
been assessed, the management of a firm must determine the terms and conditions on
which trade credit will be made available. The stipulations under which goods are sold
on credit are referred to as credit terms. These relate to the repayment of the amount
under the credit sale. Thus, credit terms specify the repayment terms of receivables.
Credit period, in terms of the duration of time for which trade credit is extended–during this
period the overdue amount must be paid by the customer;

Cash discount, if any, which the customer can take advantage of, that is, the overdue amount
will be reduced by this amount; and
Cash discount period, which refers to the duration during which the discount can be availed
of. These terms are usually written in abbreviations, for instance, ‘2/10 net 30’. The three
numerals are explained below:
❖ 2 signifies the rate of cash discount (2 per cent), which will be available to the customers
if they pay the overdue within the stipulated time;
❖ 10 represents the time duration (10 days) within which a customer must pay to be entitled
to the discount;
❖ 30 means the maximum period for which credit is available and the amount must be paid
in any case before the expiry of 30 days.
Cash Discount
The cash discount has implications for the sales volume, average collection period/average
investment in receivables, bad debt expenses and profit per unit. The implications of increasing or
initiating cash discount are as follows:

❖ The sales volume will increase. The grant of discount implies reduced prices. If the demand for
the products is elastic, reduction in prices will result in higher sales volume.
❖ Since the customers, to take advantage of the discount, would like to pay within the discount
period, the average collection period would be reduced. The reduction in the collection period
would lead to a reduction in the investment in receivables as also the cost. The decrease in the
average collection period would also cause a fall in bad debt expenses. As a result, profits
would increase.
❖ The discount would have a negative effect on the profits. This is because the decrease in prices
would affect the profit margin per unit of sale.
Cash Management
• Cash is the most liquid asset.
• Cash is common denominator to which all other current assets can
be reduced because receivables and inventories get converted into
cash.
• Cash is lifeblood of any firm needed to acquire supply resources,
equipment and other assets used in generating the products and
services.
• Marketable securities also come under near cash, serve as back
pool of liquidity which provide quick cash when needed
• Although cash is only 1-3% of total current assets, but its
management is very important
Cash Management
Management of cash includes
Determination of optimum amount of cash required in the business
To keep the cash balance at optimum level and investment of
surplus cash in profitable manner
Prompt collection of cash from receivables and efficient
disbursement of cash
Motives for holding Cash
• Transaction Motive
• To purchase raw material & to pay for operating expenses
• Precautionary Motive
• To meet the future contingencies such as :
a. Floods, strikes and failures of important customers
b. Bills may be presented for settlement earlier than expected
c. Unexpected slow down in collection of accounts receivables
d. Cancellation of some order for goods as the customer is not satisfied
e. Sharp increase in cost of raw materials
Motives for holding Cash
• Speculative Motive
• It helps to take advantages of:
a. An opportunity to purchase raw materials at a reduced price on payment of
immediate cash
b. A chance to speculate on interest rate movements by buying securities, when
interest rates are expected to decline
c. Delay purchase of raw materials in bulk, on the anticipation of decline in prices
d. Make purchase at favorable prices

• Compensating Motive
• Yet another motive to hold cash balances is to compensate banks for
providing certain services and loans
Objectives of Cash Management

The basic objectives of cash management are two-fold:

(a) to meet the cash disbursement needs

(payment schedule)
(b) to minimize funds committed to cash
balances.
EXHIBIT 3 Details of Cash Cycle

A B C D E F G H I
A = Materials ordered; B = Materials received;
C = Payments; D = Cheque clearance; E = Goods sold;
F = Customer mails payments; G = Payment received;
H = Cheques deposited; I = Funds collected
In addressing the issue of cash management strategies, we are concerned with the time periods
involved in stages B, C, D, and F, G, H, I. A firm has no control over the time involved
between stages A and B. The lag between D and E is determined by the production process and
inventory policy. The time period between stages E and F is determined by credit terms and the
payments policy of customers.
THANK
YOU