04/10/ 2018

WORKING CAPITAL
FINM321 FINANCIAL MANAGEMENT II

WORKING CAPITAL

Capital budgeting is the ENGINE that drives the firm. But working
capital management provides the FUEL that moves it forward.

1
 04/10/ 2018

WORKING CAPITAL
- CAPITAL needed for meeting day to day requirement of the business concern
- payment to creditors, salary paid to workers, purchase of raw materials etc.
- recurring in nature
- can easily be converted into cash
- short-term capital

CONCEPT OF WORKING CAPITAL

1. Gross Working Capital (general concept)

- the gross working capital is the capital invested in total current assets of the business concern
GWC = CA

2. Net Working Capital (specific concept)

- considers both current assets and current liability of the concern
- NWC is the excess of current assets over the current liability of the concern during a particular period
NWC = CA - CL

TYPES OF WORKING CAPITAL

• PERMANENT WORKING CAPITAL

- THE LEVEL OF PERMANENT CAPITAL DEPENDS UPON THE _______________ OF THE BUSINESS.
- PERMANENT OR FIXED WORKING CAPITAL WILL NOT ___________ IRRESPECTIVE OF TIME OR
VOLUME OF SALES.
• TEMPORARY WORKING CAPITAL (VARIABLE WORKING CAPITAL)
• SEASONAL WORKING CAPITAL – SEASONAL DEMANDS/NEEDS
• SPECIAL WORKING CAPITAL – SOME SPECIAL PURPOSES
• SEMI-VARIABLE WORKING CAPITAL
- CERTAIN AMOUNT OF WORKING CAPITAL IS IN THE FIELD LEVEL UP TO A CERTAIN STAGE AND AFTER THAT IT WILL
INCREASE DEPENDING UPON THE CHANGE OF SALES OR TIME

2
 04/10/ 2018

NEEDS OF WORKING CAPITAL

- WORKING CAPITAL IS AN ESSENTIAL PART OF THE BUSINESS CONCERN.

- WORKING CAPITAL IS NEEDED FOR THE FOLLOWING PURPOSES:

1. PURCHASE OF RAW MATERIALS AND SPARES

2. PAYMENT OF WAGES AND SALARY

3. DAY-TO-DAY EXPENSES

FACTORS DETERMINING WORKING CAPITAL REQUIREMENTS

1. NATURE OF BUSINESS
2. PRODUCTION CYCLE
3. BUSINESS CYCLE
4. PRODUCTION POLICY
5. CREDIT POLICY
6. GROWTH AND EXPANSION
7. AVAILABILITY OF RAW MATERIALS
8. EARNING CAPACITY

3
 04/10/ 2018

COMPUTATION (ESTIMATION) OF WORKING CAPITAL

- COMMON METHODS TO ESTIMATE WORKING CAPITAL

(1) Working capital as a Percentage of Net Sales

- based on the fact that the working capital of any firm is directly related to the sales volume of the firm.
- this approach is based on the assumption that higher sales level, the greater would be the need for
working capital
There are three steps involved in the estimation of working capital.
a) To estimate total current assets as a % of estimated net sales.
b) To estimate current liabilities as a % of estimated net sales, and
c) The difference between the two above, is the net working capital as a % of net sales.

(2) Working capital as a Percentage of Total Assets or Fixed Assets

- This approach of estimation of working capital requirement is based on the fact that the total assets of
the firm are consisting of fixed assets and current assets. On the basis of past experience, a relationship
between
(i) total current assets i.e., gross working capital; or net working capital i.e. Current assets – Current
liabilities; and
(ii) total fixed assets or total assets of the firm is established.

(3) Working Capital based on OPERATING CYCLE

- The operating cycle begins with the acquisition of raw material and ends with the collection of receivables.
- A detailed analysis is made for each component of working capital and estimation is made for each of
these components.

The different components of working capital may be enumerable as follows:

CURRENT ASSETS CURRENT LIABILITIES

Cash and cash equivalent Creditors for Purchases
Inventory of Raw Material Creditors for Expenses
Inventory of WIP
Inventory of FG
Accounts Receivables
Prepaid Expenses

4
 04/10/ 2018

(4) Regression Analysis Method

- This method of forecasting working capital requirements is based upon statistical technique of
estimating or predicting the unknown value of a dependent variable from the known value of an
independent variable.
y = a +bx

(5) Cash Forecasting Method

- This method of estimating working capital requirement involves forecasting cash receipts and
disbursements during a future period of time.

Working Capital Required = Payments - Receipts

For manufacturing organization, the following factors have to be taken into consideration
while making an estimate of working capital requirements.

Factors Requiring Consideration While Estimating Working Capital

1. Total costs incurred on material, wages and overheads

2. The length of time for which raw material are to remain in stores before they are issued for production.

3. The length of production cycle or work in process i.e. the time taken for conversion of raw material into finished
goods.

4. The length of sales cycle during which finished goods are to be kept waiting for sales.

5. The average period of credit allowed to customers.

6. The amount of cash required to pay day to day expenses of the business.

7. The average amount of cash required to make advance payments, if any.

8. The average credit period expected to be allowed by suppliers.

9. Time lag in the payment of wages and other expenses.

5
 04/10/ 2018

Operating cycle consists of the following important stages:

1. Raw Material and Storage Stage, (R)
2. Work in Process Stage, (W)
3. Finished Goods Stage, (F)
4. Debtors Collection Stage, (D)
5. Creditors Payment Period Stage. (C)

Each component of the operating cycle can be calculated by the following formula:
R = Average Stock of Raw Material
Average Raw Material Consumption Per Day

W= Average Work in Process Inventory

Average Cost of Production Per Day

F = Average Finished Stock Inventory

Average Cost of Goods Sold Per Day

D =Average Book Debts

Average Credit Sales Per Day

C = Average Trade Creditors .

Average Credit Purchase Per Day

 Working Capital Required = COGS X Operating cycle (days)/365 or 360 days) + Desired Cash
balance

TOTAL OPERATING CYCLE PERIOD = R + W +F+D-C

Number of operating cycles in a year = 365 or 360/TOCP
 Amount of Working Capital Required = Total Operating Cost/Number of operating cycles in a year

6
 04/10/ 2018

WORKING CAPITAL MANAGEMENT POLICY

Working Capital Management formulates policies to manage and handle efficiently; for that purpose, the
management established three policies based on the relationship between Sales and Working Capital

1. Conservative Working Capital Policy

2. Moderate Working Capital Policy
3. Aggressive Working Capital Policy

SOURCES OF WORKING CAPITAL

1. Long-term
2. Short-term
3. Internal Sources
4. External Sources

BASIC APPROACHES FOR DETERMINING AN APPROPRIATE WORKING CAPITAL FINANCE

MIX

1. HEDGING APPROACH (MATCHING APPROACH)

2. CONSERVATIVE APPROACH
3. AGGRESSIVE APPROACH