Working Capital

Management

By: Vineeta Bhati

School of Finance and
commerce
 Working Capital Concept
 Working capital is amount of funds necessary to cover the cost of operating

the enterprise.

 Working Capital refers to that part of the firm’s capital, which is required

for financing short-term or current assets like Cash, short term marketable

securities, debtors and inventories etc.

 Funds invested in current assets keep revolving fast and are constantly

converted into cash and this cash flow out again in exchange for other

current assets.

 Working Capital is also known as revolving or circulating capital or short-

term capital.
 Different Components of Working Capital
1. Current Assets:

Current assets are those assets which can be easily converted into
cash and which are required to meet the day to day operations of
the business. These includes
Cash and bank balances, Temporary investments, Temporary
investments, Inventory of raw materials, stores and spares, Work-
in-progress, Finished goods, Prepaid expenses etc.
2. Current Liabilities:
Current liabilities are those claims of outsiders which are expected
to mature for payment within an accounting year. These includes
Creditors for goods purchased, Outstanding expenses, Short-term
borrowings, Advances received against sales,
 Need of Working Capital

 For purchase of raw materials, components and spares.

 To pay wages and salaries.
 To incur day-to-day expenses and overhead costs such as fuel,
power etc.
 To meet selling costs as packing, advertisement
 To provide credit facilities to customers.
 To maintain inventories of raw materials, work in progress, stores
and spares and finished stock.
The amount of working capital needed goes on increasing with
growth and expansion of business till it attains maturity.
 Classification of Working capital

Working
capital

BASIS OF BASIS OF
CONCEPT TIME

Net Working Temporary /

Gross Permanent / Variable WC
Capital Fixed WC
Working
Capital
Seasonal Special
Regular Reserve
 On the Basis of Concept:
 Gross working capital is the capital invested in total current
assets of the enterprise. Examples of current assets are : cash
in hand and bank balances, Bills Receivable, Short term loans
and advances, prepaid expenses, Accrued Incomes etc.
 Net Working Capital = Current Assets – Current Liabilities
 When current assets exceed the current liabilities the working
capital is positive and negative working capital results when
current liabilities are more than current assets.
 Examples of current liabilities are Bills Payable, Sunday
debtors, accrued expenses, Bank Overdraft, Provision for
taxation etc. Net working capital is an accounting concept of
working capital.
Contd.
 On the Basis of Time
 Permanent or Fixed working capital
 Permanent working capital means the part of working capital which is permanently
locked up in the current assets to carry out the business smoothly. The minimum
amount of current assets which is required to conduct the business smoothly during
the year is called permanent working capital. For example, investments required to
maintain the minimum stock of raw materials or to cash balance. The amount of
permanent working capital depends upon the size and growth of company.
 Regular working capital is the capital required to ensure circulation of current
assets from cash to inventories, from inventories to receivables and from
receivables to cash and so on.
 Reserve working capital is the excess amount over the requirement for regular
working capital which may be provided for contingencies that may arise at unstated
periods such as strikes, rise in prices, depression etc.

Contd.
 Temporary or Variable working capital
 It is the amount of working capital which is required
to meet the seasonal demands and some special
exigencies.
 Variable working capital is further classified as
seasonal working capital and special working capital.
 The capital required to meet seasonal needs of the
enterprise is called seasonal working capital.
 Special working capital is that part of working
capital which is required to meet special exigencies
such as launching of extensive marketing campaigns
for conducting research etc.
 Factors determining working Capital Requirement

 Nature or Character of Business

 Size of Business
 Production Policy
 Length of Production cycle
 Credit Policy
 Rate of Growth of Business
 Position of the Business Cycle
Different approach to financing
current assets
 1. Matching approach : The firm can adopt a financial plan which
matches the expected life of assets with the expected life of the source
of funds raised to finance assets. Thus, a ten-year loan may be raised to
finance a plant with an expected life of ten years; stock of goods to be
sold in thirty days may be financed with a thirty day commercial paper
or a bank loan
 2. Conservative approach: The financing policy of the
firm is said to be conservative when it depends more on
long-term funds for financing needs. Under a conservative
plan, the firm finances its permanent assets and also a part
of temporary current assets the idle long-term funds can be
invested in the tradable securities to conserve liquidity.
 3. Aggressive Approach : An aggressive policy, is said
to be followed by the firm when it uses more short-term financing
than warranted by the matching plan. Under an aggressive policy,
the firm finances a part of its permanent current assets with short-
term financing. Some extremely aggressive firm may even
finance a part of their fixed assets with short-term financing
Short Term Sources of Finance

 a) Trade credit
 b) Bank credit
 c) Overdraft
 d) Cash credit
 e) Letter credit
Working Capital Leverage
 Working capital leverage highlights the variation in the rate of return on
investment due ;to the change in the level of current assets/ working capital.
This fact was first developed by Walker. According to him,” if the amount of
working capital varies in relation to fixed capital, the amount of risk that a firm
assumes is also varied and the opportunity for gain or loss increases”. This can
also be termed as the impact of working capital management on the return of
capital employed.
 Percentage change in return on
investment
 Working capital leverage = ------------------------------------------------------------
 Percentage change in current assets.
 . The working capital leverage is always positive i.e., WCL >0 and indicates the
inverse relationship between the return on capital employed and the level of
changes in working capital, provided that the total return remains constant
irrespective of any change in the level of current assets / working capital. The
working capital leverage may be greater than or less than or equal to one. WCL
>1 indicates the increase in return on capital in a high percentage than the given
percentage decline in current assets / working capital. WCL.
Significance of Working Capital Management

 In a typical manufacturing firm, current assets exceed one-half

of total assets.
 Excessive levels can result in a substandard Return on
Investment (ROI).
 Current liabilities are the principal source of external financing
for small firms.
 Requires continuous, day-to-day managerial supervision.
 Working capital management affects the company’s risk, return,
and share price.
 Accounts Payable Value Addition

Raw WIP
Materials

THE WORKING CAPITAL

Cash CYCLE Finished
(OPERATING CYCLE) Goods

Accounts SALES
Receivable
 Various component of operating cycle can be calculated as follows:

1. Raw material: Average Value of Raw material Stock

Average Consumption of raw material per day

Less:
Period of credit granted = Average level of creditors
Purchase of raw materials per day
2. Period of Production(WIP) =
Average value of work in progress
Average cost of production per day
[Link] of turnover of finished goods stock =
Average stock of finished goods
Average cost of goods sold per day
4. Period of credit taken by customers:
= Average receivable
Average value of credit sales per day
 Total operating cycle period= 1+2+3+4
 Calculate the operating cycle from the following
figures related to company X
Particulars Average amount Rs Average value per
day(340 days
assumed)Rs
Raw material inventory 180,000
Work- in- progress inventory 96,000
Finished goods inventory 1,20,000
Debtors 1,50,000
Creditors 100,000
Purchase of raw material 2500
Cost of sales 4000
Sales 5000
 Calculation of operating cycle

Days

1. Period of raw material 180,000/2500 72

stock
Less: credit granted by 100,000/2500 40 32
supplier
Period of production(WIP) 96000/4000 24

Turnover of Finished 120,000/4000 30

Goods
Credit taken by customers 150,000/5000 30

Operating cycle period 116

 The following information is available for Swati
Ltd. Calculate the duration of operating cycle.

Average stock of raw materials and stores 200,000

Average work-in-progress 3,00,000
Average finished goods inventory 180,000
Average accounts receivable 3,00,000
Average accounts payable 180,000
Average raw materials and stores purchased on credit and 10,000
consumed per day
Average WIP and value of raw materials committed per day 12500
Average cost of goods sold per day 18000
Average sales per day 20000
1. Period of raw 200,000/10,000 20 days
material stock
Less: credit granted 180,000/10,000 18 days
by supplier
Period of 300000/12,500 24 days
production(WIP)
Turnover of 180,000/18000 10 days
Finished Goods
Credit taken by 300,000/20000 15 days
customers
Operating cycle 51 days
period
 Cash management

 is the efficient collection, disbursement, and investment of cash in an

organization while maintaining the company’s liquidity. In other
words, it is the way in which a particular organization manages its
financial operations such as investing cash in different short-term
projects, collection of revenues, payment of expenses, and liabilities
while ensuring it has sufficient cash available for future use.
 The cash cycle refers to the timing between when a company makes an
investment in inventory and the time it actually collects cash with
respect to sales of that inventory. For any company, whether profitable,
distressed or in bankruptcy, the quicker it can get cash in the door the
better
Motives for holding cash

 A) Transactional Motive
 B) Speculative motive
 C) Contingency Motive
1) Transaction motive
 – The firms need a cash to carry out the day-to-day functions of the
business.
 Just as the firm’s level of operations affects working capital
requirements, it affects the need of cash. The volume of sales increases
cash will be received from customers and will be expended for
materials and wages in larger amount
 Adequate cash to cover these and other transactions allows the firm to
pay bills on due time.
 The firm needs cash primarily to make payments for purchases, wages,
operating expenses, taxes, dividend etc. A firm may invest its cash in
marketable securities whose maturity corresponds with some
anticipated payments such as dividend, taxes etc. in future.
 However, the transaction motive mainly refers to holding cash to meet
anticipated payments whose timing is not perfectly matched with cash
receipts.
[Link] motive
 – If the firm could perfectly forecast its need for cash, but it is not
possible to forecast for unexpected occurrence or emergencies
requirement of cash. The firm must be prepared for contingencies.
 If suddenly a major customer does not pay outstanding, the cash
inflows will be reduce below the forecast level. The firms must
have money to pay its own bills until the customer’s check arrives.
 A supplier may be having difficulties and may be forced to
eliminate the firms a credit purchases. The unanticipated cash to
buy raw material a contingency need related to cash outflows. It
proceeds a cushion or buffer to withstand unexpected emergency.
 The precautionary amount of cash depends upon the predictability
of cash flows. Stronger the ability of the firm to borrow at short
notice, less the precautionary balance required. Precautionary
balance may be kept in cash and marketable securities.
3. Opportunity motive

 It involves the chances of profit from cash available. For example, a supplier
may have several cancellations of orders and may wish to move a large
unwanted inventory of raw materials from his warehouse.
 If a supplier offers a large discount of purchasing of the materials, the firm will
have the opportunity to avail of a substantial saving on its purchases and
consequent profits from the sale of finished goods.
 The firm will hold cash when it is expected that interest rates will rise and
security price will fall. Securities can be purchased when the interest rates are
expected to fall. The firm will benefit by the subsequent fall in interest rates and
increases in security prices.
 The firm may also speculate on materials prices. If it is expected that material
price will fall, the firm can postpone materials purchasing and make purchases
in future when price actually falls. In addition to these needs of cash, several
important factors may be identified, which affects the size of cash balance
maintained by the firm
 Inventory Management

 The term ‘inventory’ refers to the stockpile of production a firm is

offering for sale and the components that make up the production.
 The maintenance of inventory means blocking of funds and so it
involves the interest and opportunity cost to the firm. In many
countries specially in Japan great emphasis is placed on inventory
management.
 Efforts are made to minimize the stock of inputs and outputs by
proper planning and forecasting of demand of various inputs and
producing only that much quantity which can be sold in the market
Economic Order Quantity(EOQ)

 The EOQ refers to the order size that will result in the lowest total of
order and carrying costs for an item of inventory. If a firm place
unnecessary orders it will incur unneeded order costs. If a firm
places too few order, it must maintain large stocks of goods and will
have excessive carrying cost.

 EOQ=

 A= Total annual requirement for the item

 O= Ordering cost per order of that item
 C= Carrying cost per unit per annum.
 The constraints and assumption followed:

 1. Demand is known-- Using past data and future plans a reasonably

accurate prediction of demand can often be made. This is expressed in
unit sold in a year.
 2. Sales occur at a constant rate-- This model may be used for goods
that are sold in relatively constant amount throughout the year. A more
complicated model is needed for firms whose sales fluctuate in
response to there seasonal cyclical factors.
 3. Cost of running of goods are ignored-- Cost associated with
storage, delays or lost sales are not considered. These costs are
considered in the determination of safety level in the re-order point
subsystem.
 4. Safety stock level is not considered-- The safety stock level is the
minimum level of inventory that the firm wishes to hold as a protection
against running out
 Re- order level= Normal Lead Time- Normal Usage
 Normal Usage= Annual usage/ Normal working days in a year
 Lead Time has been defined as the interval between the placing
of an order (with a supplier) and the time at which the goods are
available to meet the consumer needs
 Re-Order Level
 Also known as the ‘ordering level’ the reorder level is that level
of stock at which a purchase requisition is initiated by the
storekeeper for replenishing the stock.
 The following details are available in respect of
a firm:
i) Annual requirement of inventory 40,000 units
Ii) Cost per unit(other than carrying and
Ordering cost) Rs 16
iii) Carrying cost are likely to be 15% per year
iv) Cost of placing order Rs 480 per order
Determine the Economic ordering quantity.
 Carrying cost per unit per annum
 =cost per unit*carrying cost % p.a.
 =Rs 16*0.15= Rs 2.40
 EOQ=
 = = 4000 units