Corporate Finance

Working Capital Management

By
Sumit Gulati
Consultant and Trainer
Author of the book on Financial Management
Published by McGraw Hill Education
Facebook Page: www.facebook.com/SumitKiPaathshala

Introduction
A business venture requires two types of funds, i.e. long term

and short term.

In the case of short-term funds, the requirement fluctuates on

daily basis.
Working capital is mainly concerned with current assets and

current liabilities:
Current assets include cash, marketable securities, sundry debtors

(receivables) and inventories

Current liabilities mainly include creditors (payables)

Managing Working Capital

Managing working capital requires continuous attention as the

requirement keeps fluctuating on daily basis.

Gross working capital refers to the total investment in the current

assets.
Net working capital is defined as current assets minus current

liabilities.
There is need to finance every aspect of operations therefore we

require working capital.

Working capital of a firm has direct bearing on profitability and

even survival of the firm.

Need and Importance of Working

Capital
Cash does not come in immediately on sale, but it comes after a

certain period based on the credit policy of the firm.

All the materials, i.e. raw materials, work in progress and finished

goods constitute inventory and have to be funded.

There is need to finance every aspect of operations even when

the cash from sales has not come and therefore we require
working capital.
Working capital of a firm has direct bearing on profitability and

even survival of the firm.

Gross Operating and Cash

Conversion Cycle
Gross operating cycle means the period between receipts of raw

materials till the cash inflows from debtors towards sale of

goods.
Cash conversion cycle represents the period between spending

of money by the firm to receiving payment for supplies.

Cash conversion cycle is also called net operating cycle.

Different stages in the operating cycle are acquisition of

resources, manufacturing of goods, sale of products and

collections against debtors.
Most firms endeavour to reduce the period of cash conversion

cycle.

Gross Operating and Cash Conversion Cycle

Gross Operating and Cash Conversion Cycle

Example:
Suppose the following conversion periods are given:
Inventory conversion period = 73 days
Payables deferral period = 30 days
Receivables collection period = 24 days
Calculate the cash conversion cycle period

Gross Operating and Cash Conversion Cycle

Solution:

Gross Operating and Cash Conversion Cycle

Gross Operating Cycle
Let
GOC
=
ICP
=
DCP
=
RMCP
=
WIPCP
=
FGCP
=

We can write
GOC =
ICP =
Therefore
GOC =

(GOC):
Gross Operating Cycle
Inventory Conversion period
Debtors conversion period
Raw material conversion period
Work in progress conversion period
Finished goods conversion period

ICP + DCP
RMCP + WIPCP + FGCP
RMCP + WIPCP + FGCP + DCP

Gross Operating and Cash Conversion Cycle

Gross Operating and Cash Conversion Cycle

Gross Operating and Cash Conversion Cycle

Gross Operating and Cash Conversion Cycle

Gross Operating and Cash Conversion Cycle

Net operating cycle or cash conversion cycle:
Net operating cycle is the difference between the gross operating

cycle and delayed payment due to credit purchases.

Net Operating Cycle = Gross Operating Cycle Creditors deferral

period
NOC = GOC CDP

Gross Operating and Cash Conversion Cycle

Gross Operating and Cash Conversion Cycle

Gross Operating and Cash Conversion Cycle

Nature of Working Capital

The minimum required working capital is called permanent working
capital and the variable portion is called temporary working capital.

Nature of Working Capital

Permanent working can be financed with long-term sources of

finance.
Temporary or variable working capital also consists of current

assets
Temporary working capital can be financed from sources which

are temporary in nature.

Optimum Level of Working Capital

The level of working capital to be deployed by a firm is to be

determined carefully.
Excessive

working capital implies that excess funds are

consumed which are idling and not contributing to earnings.

Inadequate working capital leads to shortages of materials.

A progressive firm maintains right amount of working capital.

Factors Affecting Working Capital

Important factors which influence the requirement of working capital
are:
Nature of Business: For example, a firm manufacturing cars or motor cycles will

require more working capital compared to a firm supplying software solutions.

Credit Policy: If the firm is offering more credit to its customers to boost the sales it

will require larger working capital to sustain supplies while revenues will take time to
flow in.
Availing Credit from Suppliers: Suppliers credit reduces the cash conversion cycle

and accordingly reduce the working capital needed to support operations.

Factors Affecting Working Capital

Important factors which influence the requirement of working capital
are:
Inventory: Excess materials may be increasing the production cost and in turn,

reducing the profit margin.

Growth and Expansion: A growing business requires increasing working capital for

its operations is obvious. However, what is not obvious is that the working capital
increase is required much before the actual growth takes place.
Inflation: On the whole it has been observed that the requirement of working capital

goes up due to inflation

Factors Affecting Working Capital

Market Competitiveness: In highly competitive markets the working capital

requirement will be more.

Demand Condition: Working capital requirement of a firm is linked to sale, which in

turn depends upon the demand for the product. Many firms experience cyclic and seasonal
demand for their products and services. These variations affect the temporary working
capital.
When demand goes up due to better general economic conditions, sales will increase and

accordingly the firms investment in inventories and debtors will go up.

Factors Affecting Working Capital

Technology and Manufacturing Cycle: The firms would always be on the lookout

for newer and better technologies which would shorten the manufacturing cycle and hence
working capital requirement.
Operating Efficiency: Good operating efficiency will reduce the requirement of

working capital.
Lean Manufacturing: There is a Japanese word muda which means waste and lean is

antidote to muda.
With implementation of lean concept the manufacturing cycle time shortens,

transportation costs are reduced and required inventory levels go down. All these result in

reduction of working capital requirement.

Level of Current Assets

There are three approaches for level of current assets:
The Conservative Approach
In this approach, the firm would like enough current assets to be available so that the

possibility of material stock out is reduced to the minimum level

The Aggressive Approach

This approach is just opposite of the conservative approach. In this approach, the firm

would manage with minimum level of current assets at all production levels.

The Normal Approach

Between the conservative approach and the aggressive approach lies the normal

approach.

Level of Current Assets

Liquidity and Profitability: Risk-Return Trade-Off

There is a need to optimise between liquidity and profitability.
The balancing is not constant and it changes from period to

period.
If the current assets are too high it implies that the firm is holding

more cash, too much funds are tied up in excessive inventories

and the money due from debtors is on high side.
All these require excess funds which are not earning any income

for the firm and thus earnings are reduced.

On the other hand if the level of current assets is very low it will

involve shortage of cash to meet the commitment to creditors.

Liquidity and Profitability: Risk-Return Trade-Off

If we call the cost of holding too high current assets as the cost

of high liquidity and the cost of holding too little current assets as
the cost of low liquidity and plot these against the increasing
levels of current assets the curves are as shown in figure given
below

Estimating Working Capital Requirements

To estimate the requirement of current assets, there are three

main methods.
1.

Current Assets Holding Period Method:

This method is based on the concept of operating cycle.

In this method the average holding period of various elements of

current assets based on recent years experience of the firm is taken

as reference and then the associated costs are worked out.

Estimating Working Capital Requirements

There are two components of WC, namely, CA and CL. Each

component is to be separately estimated to determine the correct
amount of WC.

The relevant factors are the holding periods of the various types of
inventories, debtors collection period, creditors payment period,
budgeted yearly production/sales, cost of goods produced, cost of
sales, average time-lag in payment of wages and other overheads,
minimum cash balances and so on.

Estimation of Current Assets: Raw Materials Inventory. The investment in raw

materials inventory is estimated on the basis of:
Budgeted
production (in units)

Cost of raw material(s)

per unit

Average inventory
holding period
(months/days)

12 months/365 days
Work-in-Process (WIP) Inventory The relevant costs to determine work-in-process
inventory are the proportionate share of cost of raw materials and conversion costs
(labor and manufacturing overhead costs).
In case, full unit of raw material is required in the beginning, the unit cost of WIP
would be higher, that is, cost of full unit + 50 per cent of conversion cost, compared to
the raw material requirement throughout the production cycle; WIP is normally
equivalent to 50 per cent of total cost of production. Symbolically,
Budgeted production
(in units)

Estimated workin-process cost

per unit
12 months/365 days

Average time span

of work-in-progress
inventory
(months/days)

Finished Goods Inventory

Working capital required to finance the finished goods inventory is given by factors
summarized in below given equation.
Budgeted
production
(in units)

Cost of goods produced

per unit (excluding
depreciation)

Finished goods
holding period
(months/days)

12 months/365 days
Debtors

The WC tied up in debtors should be estimated in relation to total cost price

(excluding depreciation) Symbolically,
Budgeted
credit sales
(in units)

Cost of sales per

unit excluding
depreciation

12 months/365 days

Average debt
collection period
(months/days)

Cash and Bank Balances

Apart from WC needs for financing inventories and debtors, firms also find it useful to have
some minimum cash balances with them.
Estimation of Current Liabilities

The important current liabilities (CL) are, trade-creditors, wages and overheads:

Trade Creditors
Budgeted yearly
production
(in units)

Raw material
cost
per unit

Credit period
allowed by creditors
(months/days)

12 months/365 days

Note: Proportional adjustment should be made to cash purchases of raw materials.

Direct Wages
Budgeted yearly
production
(in units)

Direct labor
cost per unit
12 months/365 days

Average time-lag in
payment of wages
(months/days)

The average credit period for the payment of wages approximates to a half-amonth in the case of monthly wage payment.
Overheads (Other Than Depreciation and Amortization)

Budgeted yearly
production
(in units)

Overhead cost
per unit

Average time-lag in
payment of overheads
(months/days)

12 months/365 days

The amount of overheads may be separately calculated for different types of

overheads. In the case of selling overheads, the relevant item would be sales volume
instead of production volume.

Determination of Working Capital

(I) Estimation of Current Asset:

Amount

(a) Minimum desired cash and bank balances

(b) Inventories
Raw material
Work-in-process
Finished Goods
(c) Debtors*
Total Current Assets
(II) Estimation of Current Liabilities:
(a) Creditors**
(b) Wages
(c) Overheads

Total Current Liabilities

(III)Net Working Capital (I II)
Add margin for contingency

(IV)Net Working Capital Required

*If payment is received in advance, the item would be listed in CL.
**If advance payment is to be made to creditors, the item would appear under CA. The same
would be the treatment for advance payment of wages and overheads.

Estimating Working Capital Requirements

Example:
The expected cost of goods for a firm is given below:

Rs per unit
Raw Material

200

Manufacturing expenses

50

Selling and administration

expenses

40

Selling Price

350

Estimating Working Capital Requirements

The expected duration of the operating cycle at various stages is

given below:

Stage

Duration (in months)

Raw material

1.5

Work in progress (WIP)

1.0

Finished goods

0.5

Debtors

1.0

Estimating Working Capital Requirements

The desired cash balance is 10% of the required gross working

capital and the work in progress is 30% complete with respect to

manufacturing expenses.
Considering the firm wants to sell 36,000 units next year estimate the

gross working capital requirement. You may assume the monthly

sales level 3,000 units.

Solution: Working capital requirement statement:

Current Assets:

Amount (Rs)

Raw material stock (3,000 * 1.5

* 200)

Amount (Rs)
9,00,000

WIP:
Raw material (3,000 * 200)

6,00,000

Manufacturing expense @
30% of (3,000 * 50)

45,000

6,45,000

Finished goods:
Raw material (3,000 * 0.5 * 200)

3,00,000

Manufacturing expense (3,000

* 0.5 * 50)

75,000

3,75,000

Debtors (3,000 * 290)

8,70,000

Total

27,90,000
3,10,000

Gross working capital

requirement

31,00,000

While preparing a project report on behalf of a client you have collected the following facts.
Estimate the net working capital required for that project. Add 10 per cent to your computed
figure to allow contingencies:

Particulars

Amount per unit

Estimated cost per unit of production:

Raw material
Direct labor
Overheads (exclusive of depreciation, Rs 10 per unit)
Total cash cost

Rs 80
30
60
170

Additional information:
Selling price, Rs 200 per unit
Level of activity, 1,04,000 units of production per annum
Raw materials in stock, average 4 weeks
Work in progress (assume 50 per cent completion stage in respect of conversion
costs and 100 per cent completion in respect of materials), average 2 weeks
Finished goods in stock, average 4 weeks

Credit allowed by suppliers, average 4 weeks

Credit allowed to debtors, average 8 weeks
Lag in payment of wages, average 1.5 weeks
Cash at bank is expected to be, Rs 25,000.
You may assume that production is carried on evenly throughout the year (52 weeks)
and wages and overheads accrue similarly. All sales are on credit basis only.

Solution
Net working capital estimate of a project
(A) Current assets:
(i) Raw materials in stock, (1,04,000 Rs 80 4/52)
(ii) Work-in-progress
(a) Raw material (1,04,000 Rs 80 2/52)
(b) Direct Labor (1,04,000 Rs 15 2/52)
(c) Overheads (1,04,000 Rs 30 2/52)
(iii) Finished goods stock: (1,04,000 Rs 170 4/52)
(iv) Debtors: (1,04,000 Rs 170 8/52)
(v) Cash at bank
Total investment in current assets
(B) Current liabilities:
(i) Creditors, average 4 weeks: (1,04,000 Rs 80 4/52)
(ii) Lag in payment of wages (1,04,000 Rs 30 1.5/52)
Total current liabilities
Net working capital: Current assets Current liabilities
Add: 10 per cent contingencies
Net working capital required
(C)

Rs 6,40,000
3,20,000
60,000
1,20,000
13,60,000
27,20,000
25,000
52,45,000
6,40,000
90,000
7,30,000
45,15,000
4,51,500
49,66,500

Note:
A full unit of raw material is required at the beginning of the

manufacturing process and, therefore, total cost of the material, that

is, Rs 80 per unit has been taken into consideration, while in the
case of expenses, viz. direct labor and overheads, the unit has
been finished only to the extent of 50 per cent. Accordingly, Rs 15
and Rs 30 have been charged for direct labor and overheads
respectively in valuing work-in-process.

Estimating Working Capital Requirements

2: Ratio of Sales Method:
This method is based on previous years figures of annual sales and
average working capital.

If the average working capital was 20 % of the annual sales, the same
ratio is taken to estimate the working capital requirement of the current
year.

Estimating Working Capital Requirements

Example:
Assume that in the previous year;
Annual sales = Rs 48,00,000
Average working capital = Rs 15,00,000
Determine the expected average working capital if the expected

sales in the current year in Rs 55,00,000.

Estimating Working Capital Requirements

Estimating Working Capital Requirements

3. Ratio of Fixed Investment Method:
Generally the working capital investment and fixed investment of a

given firm move in a specific ratio.

Therefore if the fixed investment goes up, working capital investment

is also expected to go up in the same proportion.

Estimating Working Capital Requirements

Example:
Give the following figures for a firm
Fixed investment = Rs 20,00,000
Average working capital = Rs 3,50,000
Calculate the required of average working capital, if the fixed

investment goes up to Rs 25,00,000

Estimating Working Capital Requirements

Financing of Current Assets

Three main financing methods of current assets generally

adopted are:
Long-term Financing
Generally, long-term requirements are financed by long-term sources

of equity or long-term loans.

Short-term Financing
If the requirement of varying nature is financed by long-term debt,

there will be periods when we do not require funds but debt cannot
be returned since it is long-term.
Spontaneous Financing
This means, automatic generation of short-term funds during the

normal operations of the firms.

Financing of Current Assets

In order to decide the use of method for financing current assets, a firm may adopt
any of the three approaches.

Maturity Matching or Hedging Approach

In this approach all fixed assets and permanent current assets are financed
through equity or long-term loans.

Financing of Current Assets

Conservative Approach
In this approach the firm finances the permanent current assets and a part

of the temporary current assets with long-term financing.

Financing of Current Assets

Aggressive Approach
In this, the firm also finances a part of its permanent current assets by

short-term financing.

Short Term Vs Long Term Financing

It is an important aspect for the firm to decide as to how much

proportion of current assets it plans to finance by short-term sources.

The advantages of short-term sources of finance are
Generally these are cheaper sources compared to long-term finance.
Flexibility is maintained so that we can use appropriate level of finance in case of

fluctuating requirements.
However, it is more risky to use short-term sources of finance, as

sometimes the firm may find it difficult to procure the finance or it

may be available at very high rates.

The Concept of Zero Working Capital

Some global firms are aiming at zero working capital.
Reducing investment in working capital reduces the cost of

financing and hence improves earnings and profitability.

The most important factor for zero working capital is the

increased speed of operations.

It may not be possible for all firms to achieve zero working

capital.

Thank You