Chapter 26

THEORY OF WORKING CAPITAL MANAGEMENT

INTRODUCTION
This chapter analyses the theory of working capital management
and is divided into four section. The first section explains the nature
of working capital in terms of the basic concepts, strategies and
policies of working capital management. The trade-off between
profitability and risk is elaborated in section 2. The determination of
financing mix is explained in Section 3. The major points are
recapitulated in the last Section.

Section I 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 interrelationship that exists between them. The
term 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. The major current assets are
cash, marketable securities, accounts receivable and inventory.
Current liabilities are those liabilities which are intended, at their
inception, to be paid in the ordinary course of business, with in a
year, out of the current assets or earnings of the concern. The
basics current liabilities are accounts payable, bills payable, bank
overdraft, and outstanding expenses. 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. This is so because if the firm cannot
maintain a satisfactory level of working capital, it is likely to become
insolvent and may even be forced into bankruptcy. The current
assets should be large enough to cover its current liabilities in order
to ensure a reasonable margin of safety. Each of the current assets
must be managed efficiently in order to maintain the liquidity of the
firm while not keeping too high a level of any one of them. Each of
the short-term sources of financing must be continuously managed
to ensure that they are obtained and used in the best possible way.
The interaction between current assets and current liabilities, is
therefore, the main theme of the theory of working management.
The basic ingredients of the theory of working capital management
may be said to include its definition, need, optimum level of current
assets, the trade-off between profitability and risk which is
associated with he level of current assets and liabilities. Financing-
mix strategies and so on.

Concepts and Definitions of Working Capital

There are two concepts of working capital : gross and net.

The term gross working capital, also referred to as working
capital, means the total current assets.
The term net working capital can be defined in two ways: (i) the
most common definition of net working capital (NWC) is the
difference between current assets and current liabilities; and ii)
alternate definition of NWC is that portion of current assets which is
financed with long-term funds.1

The task of the financial manger in managing working capital

efficiently is to ensure sufficient liquidity in the operation of the
enterprise. The liquidity of business firm is measure by its ability to
satisfy short-term obligations as they become due. The three basic
measures of firm’s overall liquidity are (i) the current ratio, (ii) the
acid-test ratio, and (iii) the net working capital. The suitability of the
first two measures has already been discussed in detail in chapter
4. In brief, they are very useful in interfirm comparisons of liquidity.
Net working capital (NWC) as a measure of liquidity, is not very
useful for comparing the performance of different firms, but it is
quite of liquidity, is not very useful for comparing the performance
of different firms, but it is quite useful for internal control. The NWC
helps in comparing the liquidity of the same firm over time. For
purpose of working capital management, therefore NWC can be
said to measure the liquidity of the firm. In other words, the goal of
working capital management is to mange the current assets and
liabilities in such a way that an acceptable level of NWC is
maintained.

The common Definition of NWC and its Implications NWC is

commonly defined as the difference between current assets and
current liabilities. Efficient working capital management requires
that firms should operate with some amount of NWC, the exact
amount varying fro firm to firm and depending, among other things,
on the nature of industry The theoretical justification for the use of
NWC to measure liquidity is based on the premise that the greater
the margin by which the current assets cover the short-term
obligations, the more is the ability to pay obligations when they
become due for payment. The NWC is necessary because the
cash outflows and inflows do not coincide. In other words, it is the
non synchronous nature of cash flows that makes NWC necessary.
In general, the cash outflows resulting from payment of current
liabilities are relatively predictable. The cash inflows are, however
difficult to predict. The more predictable the cash inflows are, the
less NWC will be required. A firm, say an electricity generation
company, with almost certain and predictable cash inflows can
operate with little or no NWC. But where cash inflows are uncertain,
it will be necessary to maintain current assets at a level adequate
to cover current liabilities, that is there must be NWC.

Alternative Definition of NWC NWC can alternatively be defined

as that part of the current assets which are financed with long-term
funds. Since current represent sources of short-term funds, as long
as current assets exceed the current liabilities, the excess must be
financed with long-term funds. This alternative definition, as shown
subsequently, is more useful for the analysis of the trade-off
between profitability and risk.

SECTION 2, TRADE_ OFF BETWEEN PROFITABILITY AND

RISK
In evaluating a firms NWC position an important consideration is
the trade-off between profitability and risk. IN other words, the level
of NWC has a bearing on profitability as well as risk. The term
profitability used in this context is measured by profits after
expense. The term risk is defined as the probability that a firm will
become technically insolvent so that it will not be able to meet its
obligations when they become due for payment.
The risk of becoming technically insolvent is measured using NWC.
It is assumed that the greater the amount of NWC, the less risk-
prone the firm is. Or, the greater the NWC, the more liquid is the
firm and, therefore, the less likely it is to become technically
insolvent. Conversely, lower of NWC and liquidity are associated
with increasing levels of risk. The relationship between liquidity,
NWC and risk is such that if either NWC or liquidity increases, the
firm’s risk decreases.

Nature of Trade-off
If a firm wants to increase its profitability, it must also increase its
risk. If it is to decrease risk, it must decrease profitability. The trade-
off between these variables is that regardless of how the firm
increases its profitability through the manipulation of working
capital, the consequence is a corresponding increase is a
corresponding increase in risk as measured by the level of NWC.

The effects of changing current assets and current liabilities on

profitability-risk trade-off are discussed first and subsequently they
have been integrated into an overall theory of working capital
management.
In evaluating the profitability-risk trade-off related to the level of
NWC, three basic assumptions, which are generally true, are : (i)
that we are dealing with a manufacturing firm; (i) that we are
dealing with a manufacturing firm: (ii) that current assets are less
profitable than fixed assets; and (iii) that short-term funds are less
expensive than long-term funds.

Effect of the level of current assets on the profitability-risk

trade-off The effect of the level of current assets on profitability-risk
and trade-off can be shown, using the ratio of current assets to total
assets. This ration indicates the percentage of total assets that are
in the form of current assets. A change in the ration will reflect a
change in the amount of current assets. It may either increase or
decrease.

Effect of Higher Ratio An increase in the ratio increase / of

current assets to total assets will leads to a decline in profitability
because current assets are assumed to be less profitable than
fixed assets. A second effect of the increase in the ratio will be that
the risk of technical insolvency insolvency would also decrease
because the increase in current assets, assuming no change in
current liabilities, will increase NWC. This is shown in example 26.1

Balance sheet of Hypothetical ltd.

Liabilities Amount (in lacks) Asset

Amount
current liabilities Rs. 3,200 current assets
Rs 5,400
Long-term debt 4,800 Fixed assets
8,600
Equity capital 6,000
14,000
14,000
If the company earns approximately 2 per cent on its current assets
and 12 per cent on its fixed assets, it can currently earn
approximately Rs. 1,140 {(0.02 x Rs 5,400) + (0.12 x Rs 8,600) on
its total assets. The NWC currently is Rs 2,200 (Rs 5,400 - Rs
3,200). The current assets to total assets ratio is 0.386 (Rs. 5,400 -
Rs 14,000).
Assuming the company increase the investment in current assets
by investing an additional Rs 600 in current assets (and thus 600
less in fixed assets), the ratio of current assets to total assets would
be 0.429 (Rs. 6,000 - Rs. 14,000). The profits on total assets would
Rs 1,080 {(0.02 x Rs 6,000) + (0.12 x Rs 8,000)}. Thus, as the
current-total asset ratio increases from 0.386 to 0.429, the total
profits decrease from Rs 1,140 to Rs 1080. The risk measured by
the amount of NWC decreases, since NWC increases from Rs
2,200 to Rs 2,800 leading to a improvement in liquidity.

Effect of Decrease / Lower Ratio A decrease in the ratio of

current assets to total assets will result in an increase in profitability
as well as risk. The increase in profitability will primarily be due to
the corresponding increase in fixed assets which are likely to
generate higher returns. Since the current assets decrease without
a corresponding reduction in current liabilities, the amount of NWS
will decrease, thereby increasing risk.
To illustrate the effect of a decrease in the level of current assets,
let us assume that in the case of the Hypothetical Ltd in Example
15.1, the investment in fixed assets is increased by Rs 600
(implying thereby a decrease in current assets by a similar
amount). As a result, the ratio of current assets to total assets
would be 0.343 (Rs. 4,800 - Rs 14000). The profits on total assets
will be Rs 1,200 {(0.02 x Rs 4,800) + (0.12 x Rs 9,200)}. The NWC
will be Rs 1,600 (Rs 4,800 - 3,200). It is, thus, evident that a
decrease in the current total assets ratio leads to an increase in
both profitability and risk. The effect of changes (increase as well
as decrease) in current assets are tabulated in Table 26.1.

Effect of change in current liabilities on profitability-risk trade-

off As in the case of current assets, the effect of a change in
current liabilities can also be demonstrated by using the ratio for
current liabilities to total assets. This ratio will indicate the
percentage of total assets financed by current liabilities.
The effect of a change in the level of current liabilities would be that
the current liabilities-total asset ratio will either (i) increase, or (ii)
decrease.

Effect of an increase in the ratio one effect of an increase in the

ratio of current liabilities to total assets would be that profitability will
increase. The reason for the increased profitability lies in the fact
that current liabilities, which are a short-term source of finance, will
increase, whereas the long-term sources of finance will be reduce.
As short-term sources of finance are less expensive than long-run
sources, increase in the ratio will, in effect, mean substituting less
expensive sources for more expensive sources of financing. There
will, therefore, therefore be a decline in cost and a corresponding
rise in profitability.
The increased ratio will also increase the risk. Any increase in the
current liabilities, assuming no change in current assets, would
adversely affect the NWC. A decrease in NWC leads to an increase
in risk. Thus, as the current liabilities-total assets ratio increase,
profitability increases, but so does risk.

For the Hypothetical Ltd in Example 15.1 let us assume that the
current liabilities cost approximately 3 percent, while the average
cost of long-term funds is 8 per cent. The cost would be Rs. 960
{(0.03 x Rs 3,200) + (0.08 x Rs 10800)}. The NWC will be Rs.
2,200. The initial ratio of current liabilities to total assets is 0.229
(Rs. 3,200 - Rs 14,000).
Further assume that the company shifts Rs 600 from long-term
funds to current liabilities so that the forme will decline, while the
latter will increase by the amount. As an result, the ratio of current
liabilities to total assets will increase to 0.271 (Rs 3,800 - Rs
14,000); the cost will decline to Rs 930 {0.03 x Rs 3,800) + (0.08 x
Rs 10800)} and the NWC will be lower at the leave of Rs 1,600 (Rs
5,400 - 3,800). These figures amply demonstrate that the increase
in the ratio of current liabilities to total assets causes a decline in
cost and, therefore, a rise in profitability. At the same time, risk
measured by the level of NWC increases, since the NWC, or
liquidity, decreases.

Effect of a decrease in the ratio The consequences of a decrease

in the ratio are exactly opposite to the results of an increase. That
is, it will lead to a decrease in profitability as well as risk. The use of
more long-term funds which, by definition, are more expensive will
increase the cost; by implication, profits will also decline. Similarly,
risk will decrease because of the lower level of current liabilities on
the assumption that current assets remain unchanged.

Suppose the Hypothetical Ltd of Example 26.1 reduces its current

liabilities by Rs 600 as compared to the initial level of Rs 3,200.
The reduction in the current liabilities is naturally associated with an
increase in the long-term funds by a similar amount. The resulting
ratio will be 0.186, that is, slightly lower than the initial ratio of 0.229
(Rs 3,200 - Rs 14,000). A reduction in the ratio causes a rise in
cost which will now be Rs 990 (0.03 x Rs 2,600) + (0.08 x Rs
11,400)}; the NWC will also rise to Rs 2,800 (Rs 5,400 - Rs 2,600).
While the increase in cost logically denotes a decline in profitability,
the increase in NWC reflects an improvement in liquidity and
reduction inrisk.
The effect of changes in the current liabilities -to a assets ratio may
be summarized in Table 26.2.

Effect of changes in current liabilities of Hypothetical Ltd

Combined Effect of Changes in Current Assets and Current

Liabilities on Profitability-Risk Trade off The combined effects of
changes in current assets and current liabilities can be measured
by considering them simultaneously. We have shown in the
preceding sections the effects of a decrease in the current assets-
total assets ratio and the effects of an increase in the current
liabilities - total assets ratio. These changes, when considered
independently, lead to an increased profitability coupled with a
corresponding increase in risk. The combined effect of these
changes should, logically, be to increase over all profitability as
also risk at the same time decrease NWC. This is depicted in Table
26.3.

Combined Effects of Changes in Current Assets and Liabilities

on Hypothetical Ltd on Profits and NWC.

It can, thus, be seen from these figures that the net effect of the two
changes taken together is that profits have increased by Rs 90 and
NWC (liquidity) has decreased by Rs 1,200. The trade-off is clear;
the company has increased its profitability by increasing its risk.
The NWC has been reduced from its initial level of Rs 2,200 to Rs
1,000. The initial net profit of the company (i.e. the difference
between initial profits on total assets and the initial cost of
financing) was Rs. 180 (Rs. 1,140 - Rs 960). After the change in
the current assets and liabilities, the profits on total assets
increased to Rs 1,200 while the cost of financing decreased to Rs
930; its net profits, therefore, increased to Rs 270 (Rs. 1,200 - Rs
930).

Section 3 Determining Financing Mix

Apart from the profitability-risk trade-off, another important

ingredient of the theory of working capital management is
determining the financing is. One of the most important decisions,
in other words, involved in the management of working capital is
how current assets will be financed. There are, broadly speaking,
two sources from which funds can be raised for current asset
financing; (i) short-term sources (current liabilities), and (ii) long-
term sources, such as share capital, long-term borrowings,
internally generated resources like retained earning and so on.
What proportion of current assets should be financed by current
liabilities and how much by long-term resources? Decisions on
such questions will determine the financing mix.

There are three basic approaches to determine an appropriate

financing mix; (a) Heading approach, also called the Matching
approach; (b) Conservative approach, and (c) Trade-off between
these two.

Hedging Approach

There term ‘hedging’ is often used in the sense of a risk-reducing

investment strategy involving transactions of a simultaneous but
opposing nature so that the effect of one is likely to counterbalance
the effect of the other. With reference to an appropriate financing-
mix, the term hedging can be said to refer to the process of
matching maturities of debt with the maturities of financial needs.
This approach to the financing decision to determine an appropriate
financing mix is, therefore, also called as matching approach.
according to this approach, the maturity of the sources of funds
should match the nature of the assets to be financed. For the
purpose of analysis, the current assets can be broadly classified
into two classes;

1. Those which are required in a certain amount for a given

level of operation and, hence, do not vary over time.

2. Those which fluctuate over time.

The hedging approach suggests that long-term funds should be

used to finance the fixed portion of current assets requirements as
spelt out in (1) above, in a manner similar to the financing of fixed
assets. The purely temporary requirements, that is the seasonal
variations over and above the permanent financing needs should
be appropriately financed with short-term funds (current liabilities).
This approach, therefore, divides the requirements of total funds
into permanent and seasonal components, each being financed by
a different source. This has been illustrated in Table 26.4

Estimated total funds requirements of Hypothetical Ltd

According to the hedging approach, the permanent portion of funds

required (col.3) should be financed with long-term funds and the
seasonal portion (col.4) with short-term funds. With this approach,
the short-term financing requirements (current assets) would be
just equal to the short-term financing available (current liabilities).

Conservation approach
This approach suggest that the estimated requirement of total
funds should be met from long-term sources; the use of short-term
funds should be restricted to only emergency situation or when
there is an unexpected outflow of funds. In the case of the
Hypothecate Ltd in Table 26. 4 the total requirements, including the
entire Rs 9,000 needed in October, will be financed by long-run
sources. The short-term funds will be used only to meet
conductances. The amounts given in column 4 of Table 26.4
represent the extent to which short-term financial needs are being
financed by long-term funds, that is, the NWC. The NWC reaches
the highest level (Rs 2,100) in October (Rs. 9,000 - Rs 6,900). Any
long-term financing in excess of Rs 6,900 in permanent financing
the needs of the company represents NWC.

Comparison of Hedging approach with conservative approach

A comparison of the two approaches can be made on the basis of
(i) cost considerations, and (ii) risk consideration.

Cost considerations The cost of these financing plans has a

bearing on the profitability of the enterprise. We assume that the
cost of short-term funds and long-term funds, as in the preceding
Section dealing with profitability-risk trade-off, is 3 per cent and 8
per cent respectively.

Hedging Plan The cost of financing under the digging plan can be
estimated as follows : (i) Cost of short-term funds: The cost of
short-term funds = average annual short-term loan x interest rate.

Average annual shorterm loan = total of monthly seasonal

requirements (Col.4) divided by the number of months.
Average annual short-term loan = Rs 11,600 - 12 = Rs 966.67
Short-term cost = Rs 966.67 x 0.03 = Rs 29.

(ii) Cost of long-term funds = ( Average annual long - term fund

requirement ) X
(annual interest rate )
= Rs 6,900 X 0,08 = Rs 552.
(iii) Total cost under hedging plan = total of (i) + (ii) = Rs 29 + Rs
552 = Rs 581
Conservative plan The cost of financing under the conservative
plan is equal to the cost of the long - term fund, that is, annual
average loan, multiplied by the long -term rate of interest = Rs
9,000 X 0.08 = Rs 720
Thus, the of financing under the conservative approach (Rs 720 ) is
higher than the cost using the hedging approach (Rs 581). The
conservative plan for financing is more expensive because the
available funds are not fully utilized during certain periods;
moreover, interest has to be paid for funds which are not actually
needed (i.e. the period when there is NWC ).

Risk considerations The two approaches can also be contrasted

on the basis of the risk involved.

Hedging Approach The hedging approach is more risky in

comparison to the to the conservative approach. There are two
reasons for this. First, there is, as already observed, no NWC with
the hedging approach because no long-term funds are used to
finance short-term seasonal needs, that is, current assets are just
equal to current liabilities. One the other hand, the conservative
approach has a fairly high level of NWC. Secondly, the hedging
plan is risky because it involves almost full utilization of the capacity
to use short-term funds and in emergency situations it may be
difficult to satisfy the short-term needs.
Conservative approach with the conservative approach, in
contrast, the company does not use any of its short-term
borrowings. Therefore, the firm has sufficient short-term borrowing
capacity to cover unexpected financial needs and avoid technical
insolvency.

To summaries, the hedging approach is a high profit (low cost)high

risk (no NWC) approach to determine an appropriate financing-mix.
In contrast, the conservative approach is low profit (high cost) low
risk (high NWC). The contrast between these approaches is
indicative of the need for trade-off between profitability and risk.

A trade-off between the hedging and conservative approaches

It has been shown that the hedging approach is associated with
high profits as well as high risk, while the conservative approach
provides low profits and low risk. Obviously, neither approach by
itself would serve the purpose of efficient working capital
managemental. A trade-off between these two extremes would give
an acceptable financing strategy. The third approach -trade-off
between the two approaches-strikes a balance and provides a
financing plan that lies between these two extremes.

The exact trade-off between risk and profitability will differ from
case depending on risk perception of the decision makers. One
possible trade-off could be assumed to be equal to the average of
the minimum and maximum monthly requirements of funds during a
given period of time. This level of requirements of funds may be
financed through long-run sources and for any additional financing
need, short-term funds may be used. The breakdown of the
requirement of funds of the Hypothetical Ltd between long-term and
short-term sources under the trade-off plans is shown in Table
26.5.

The figures in Table 26.5 reveal that the maximum fund required is
Rs 9,000 (october) and the minimum is Rs 6,900 (May). The
average (Rs. 9000 + 6,900)/2 = Rs 7,950. In other words, the
company should use Rs 7,950 each month (Col. 3) in the form of
long-term funds and raise additional funds, if needed, thorough
short-term resources (Current Liabilities). IT is clear from the table
 that no short-term funds are required during 5 months, namely,
March, APril, May, June an December, because long-term funds
available exceed the total requirements for funds. In the remaining
7 months, the company will have to use short-term funds totalling
Rs. Rs 2,700 (Col 4)

(i) Cost of short-term funds: = (average annual short-term funds

required) x (rate of short-tern interest ) = Rs 2,700/12 = Rs 225 x
0.03 = Rs 6.75

(ii) Cost of long-term funds = (Average long-term funds required ) x

(Rate of interest on long-term funds ) = Rs. 7,950 x 0.08 = Rs 636

(iii) Total cost of the trade -off plan = Rs 6.75 + 636 = Rs. 642.75

Risk consideration The NWC under this plan would be Rs. 1,050
(Rs 7,950 - Rs 6,900)

Comparison of the Trade-off plan with the hedging and

conservative approaches

For a comparison of the three approaches to determine an

appropriate financing -mix, the summary of the result of these
approaches on profitability and risk is give in Table. 26.6

Comparison of Trade-off plan

Interpretation From the summary of results in Table 26.6. It can be seen

clearly that the hedging approach is the most risky while the conservative
approach is the least risky. The trade-off plan stands midway; less risky than
the hedging approach by more risky than the conservative approach. The
measure of risk is the level of NWC. From the point of view of profitability (as
reflected in the level of total cost of financing plan) a similar kind of
relationship is found to exist, the trade-off plan lying between the other two
approaches. The preceding analysis, thus established the trade-off between
profitability and risk. In this connection two generalizations are warranted; (i)
the lower the NWC, the higher is the risk present, and (ii) the higher the risk of
.insolvency, the higher is the expected profits