Working Capital Management

By: Ayisha Shaikh

Topics Covered

 Short term investment decision or working capital management - concept,

components, Estimating working capital requirement, and cost of working
capital, management of cash
 Cash Budget, Baumol's Model, Miller and Orr's Cash Management Model,
 Management of Account Receivables - Terms of Credit,
 Inventory management - Introduction, ABC analysis, EOQ Model.
Financial Management

 Investment Decision (Unit-2&3)

 Financing Decision (Unit1&4)
 Dividend Decision (Unit5)
Investment Decision

 Long term Investment- Capital Budgeting

 Short term Investment- Working Capital Management
Working Capital Management

 1. H.G, Guttmann: “Working Capital is the surplus of current assets over

current liabilities.”
 2. Hoglend. J. Bierman, and A. K. Mc Adams: “Working Capital is descriptive
of that capital which is not fixed. But the more common use of the working
Capital is to consider it as the distinction between the book value of the
current assets and current liabilities.”
 3. Brown and Housard: “Working Capital represents the overload of current
assets over current liabilities”
 4. Weston the Brigham: “Working Capital to a firm’s investment in short term
assets cash short term securities, accounts, receivables and inventories.”
 5. Meal Baker Malott and Field: “Working Capital represents merely the
current capital assets.”
Objectives Of WCM

 Profitability vs Liquidity
 Short term borrowing cost is higher than long term borrowing cost
 Maintaining credibility
 Capacity to face crisis
 To avail cash discount
 Goodwill of the company
Types of Working Capital

 Gross Working Capital = All the current assets

 Net Working Capital= Total current Asset- total current Liabilities
 Current Assets comprises of Cash, trade debtors, bills receivables, Inventories
and Loans and advances
 Current Liabilities comprises of Trade Creditors, Bills Payable, Short term
Borrowings, and Trade advances
Factors influencing Working Capital
Requirement
 Nature of Business (eg. Service Industry v/s Manufacturing Industry)
 Seasonality of Operations (Air Conditioners v/s Washing Machine)
 Production Policy (Steady Production v/s On time Production)
 Market Condition (Competition)
 Condition of Supply ( Uninterrupted Supply v/s Logistic Issues)
Optimal Level Of WCM

 Determining the optimal level of current assets involves a trade-off between

costs that rise with current assets (carrying costs) and the costs that fall with
current assets (shortage costs).
 Carrying costs are mainly in the nature of the cost of financing higher level of
current assets, having idle cash in hand, high level of inventory and
 shortage costs are mainly in the form of disruption in production schedule,
loss of sales, loss of customer goodwill, delay in supply of raw material etc.
 Higher the Current asset higher the carrying cost and lower the shortage cost
 Lower the Current asset lower the carrying cost and higher the shortage cost
Optimal Working Capital
Operating Cycle
Formula

Inventory Period= Average Inventory

Annual Cost of goods sold/365
Accounts Receivable Period= Average Accounts Receivable
Annual Sales/365
Accounts Payable Period = Average Accounts Payable
Annual Cost of goods sold/365
Operating Cycle= Inventory Period + Accounts Receivable Period
Cash Cycle= Operating Cycle – Accounts Payable Period
Example-1

2019 2020
Account Receivable 86 90
Accounts Payable 56 60
Cost of goods sold 600 720
Sales 650 800
Inventory 90 102
Solution
Inventory Period= (90 +102) / 2 = 48.68 days
720/365
Accounts Receivable Period = (86+90)/2 = 40.18 days
800/365
Accounts Payable Period = (56+60) /2 = 29.41 days
720/365
Operating Cycle = IP+ ARP= 48.68+ 40.18= 88.86 days
Cash Cycle = OC –APP = 88.86 – 29.41 = 59.45 days
Can a company have negative Cash
Cycle

Amazon is one of the few companies who have a negative conversion cycle,
meaning they are able to receive payment before paying their suppliers. Having
a negative CCC allows Amazon to borrow from its suppliers to finance its
operations, interest-free. This also frees up available cash that can be used for
the company’s growth initiatives. Compared to other retail giants such as
Walmart and Costco, Amazon have a significantly lower cash conversion cycle.
Cash Management

 Cash budgeting or short term forecasting is the principal tool of cash management
 Its helpful in estimating short term capital requirement, planning purchases,
scheduling payment, developing credit policies etc.
 The method used to forecast short term requirement of cash is also known as receipt
and payment method
 Calculation is done monthly by adjusting the net income
Example 2: Preparation of Cash Budget

 ABC Company manufactures plastic bags. Its estimated sales from January
2020 to March 2020 is estimated to be Rs.1,00,000 per month while from April
to June 2020 it is estimated to be Rs.1,20,000 per month. The Sales of
November and December 2019 was Rs. 1,00,000 each month. Cash and credit
sales are estimated to be 20% and 80% respectively. The receivables from the
credit sales is expected to be collected as follows: 50% at the end of one
month from the date of sales and balance 50% at the end of 2 months from
the date of sales, no bad debts expected. In March 2020 a sale of machine is
expected at Rs.5000 and in June Interest of Rs.2000 accrues on securities.
 ABC Company plans to purchase material worth Rs 40,000 in January and
February and materials worth Rs.48,000 for each month from March to June.
The payment for these purchases are made approximately after one month of
purchase. The credit purchase of December 2019 of Rs.40,000 has to be paid
in January 2020. Manufacturing expenses is expected to be Rs.20,000 each
month. Miscellaneous cash purchases of Rs2000 is estimated each month from
January to June. Wage payment of Rs 15,000per month, administrative
expenses of Rs10,000 per month is estimated. Dividend payment of Rs,20,000
and tax payment of Rs.20,000 is scheduled in June 2020. A machine worth Rs
50,000 is proposed to be purchased by cash in the month of March 2020.
 If the opening balance of cash in January 2020 is Rs.22,000 and the company
wants to maintain a steady balance of Rs.20,000 cash each month, estimate
the cash requirement for each month.
Solution- Forecast of cash receipt

Particulars January February March April May June

Sales 1,00,000 1,00,000 1,00,000 1,20,000 1,20,000 1,20,000

Credit Sales 80,000

Cash Sales 20,000

A/C 80,000
Receivables
Other 5000 2000
receipt
Total
Receipt
 Solution
Particulars January February March April May June

Sales 1,00,000 1,00,000 1,00,000 1,20,000 1,20,000 1,20,000

Credit Sales 80,000 80,000 80,000 96,000 96,000 96,000

Cash Sales 20,000 20,000 20,000 24,000 24,000 24,000

A/C 80,000 80,000 80,000 80,000 88,000 96,000

Receivables
Other 5000 2000
receipt
Total 1,00,000 1,00,000 1,05,000 1,04,000 1,12,000 1,22,000
Receipt
Calculation of Accounts Receivables

 January : Rs. 40000 (Nov) + Rs 40,000 (Dec)

 February :Rs. 40,000 (Dec) + Rs.40,000 (Jan)
 March : Rs. 40,000 (Jan) + Rs. 40,000 (Feb)
 April Rs. 40,000 (Feb) + Rs. 40,000 (March)
 May Rs40,000 (March) + 48,000 (April)
 June Rs.48,000 (April)+ Rs48,000 (May)
 Forecast of Cash Payments
Particulars January February March April May June

Purchases 40,000 40,000 48,000 48,000 48,000 48,000

A/C 40,000
Payable
Manufacturi 20,000
ng Expenses
Misc. 2000
Purchases
Wages 15000
Administrat 10,000
ive Expense
Other 50,000 40,000
Expenses
Total
Forecast of Cash Payments
Particulars January February March April May June

Purchases 40,000 40,000 48,000 48,000 48,000 48,000

A/C Payable 40,000 40,000 40,000 48,000 48,000 48,000

Manufacturi 20,000 20,000 20,000 20,000 20,000 20,000

ng Expenses
Misc. 2000 2000 2000 2000 2000 2000
Purchases
Wages 15,000 15,000 15,000 15,000 15,000 15,000

Administrati 10,000 10,000 10,000 10,000 10,000 10,000

ve Expense
Other 50,000 40,000
Expenses
Total 87,000 87,000 137,000 95,000 95,000 135,000
 Cash Budget
Particulars January February March April May June

Opening 22,000
Balance
Cash Receipt 1,00,000

Cash 87,000
Payment
Net Cash
flow
Cumulative
Balance
Required
Balance
Surplus/Defi
cit
 Cash Budget
Particulars January February March April May June

Opening 22,000
Balance
Cash Receipt 1,00,000 1,00,000 1,05,000 1,04,000 1,12,000 1,22,000

Cash 87,000 87,000 137,000 95,000 95,000 135,000

Payment
Net Cash 13,000 13,000 (32,000) 9000 17,000 (13,000)
flow
Cumulative 35,000 48,000 16,000 25,000 42,000 29,000
Balance
Required 20,000 20,000 20,000 20,000 20,000 20,000
Balance
Surplus/Defi 15,000 28,000 (4000) 5000 22,000 9000
cit
Inventory Management

 Inventory management is an approach for

keeping track of the flow of inventory. It
starts right from the procurement of goods
and its warehousing and continues to the
outflow of the raw material or stock to reach
the manufacturing units or to the market,
respectively. The process can be carried out
manually or by using an automated system.
Objectives of Inventory Management
Techniques of Inventory Management

 EOQ Model
 ABC Analysis
Understanding EOQ

 You are the manager of Raymond's Outlet Store in New Delhi which is an
exclusive store for premium shirts. With an annual demand of 10,000 shirts
equally spread out through out the year. How much stock of shirts should you
maintain for efficient inventory management if the annual cost of holding a
shirt is Rs100 while the cost of ordering a consignment is Rs 200 per order
irrespective of the number of shirts you order.
Economic Order Quantity

 The firm here will have to get a tradeoff between the ordering cost and the
holding cost
 If the firm wants to save on ordering cost it can order one time 10,000 shirts
and incur storage cost of Rs,10,00,000 (100 x 10,000) plus Rs.200 for the
single order
 If the firm wants to save on its holding cost it can order each shirt separately
as and when the order comes in where the firm will incur 0 holding cost and
20,00,000 (200 x 10,000) as ordering cost.
 How much should the firm order to manage the inventory cost efficiently
Economic Order Quantity

EOQ is where the holding cost= Ordering cost

EOQ Assumptions

 Demand for the product is known and constant

 Lead time is known and constant.
 The receipt of inventory is instantaneous.
 Quantity discounts are not availed.
 Stock outs and shortages are not considered.
EOQ Formula

Calculation of total cost

Ordering cost = D/ EOQ x S
Holding cost = EOQ/2 x H
Total cost = Ordering cost + Holding cost

S= Setup cost for each order (includes shipping freight etc)

D= Annual demand (quantity sold per year)
H= Holding cost/storage cost( per year, per unit)
Example 3

 You are the manager of Raymond's Outlet Store in New Delhi which is an
exclusive store for premium shirts. With an annual demand of 10,000 shirts
equally spread out through out the year. How much stock of shirts should you
maintain for efficient inventory management if the annual cost of holding a
shirt is Rs100 while the cost of ordering a consignment is Rs 200 per order
irrespective of the number of shirts you order. Calculate the EOQ, the
number of orders per year, the time gap between two orders.
 S=200
 D= 10,000
 H= 100
Solution

 EOQ

EOQ= 200 shirts

Number of Order per year = D/EOQ= 10,000/200 = 50 orders per year

Time gap between orders = 365/ no. of orders per year = 365/50 = 7.3 days
Calculation of total cost
Ordering cost = D/ EOQ x S = 10,000/200 x 200 = Rs.10,000
Holding cost = EOQ/2 x H = 200/2 x 100 = Rs.10,000
Total cost = Ordering cost + Holding cost= Rs.20,000
ABC Analysis for Inventory Management

 In this technique, review your inventory and sort all products into three
categories: A, B, and C. As shown above, the standard categorization is: “A”
category includes 20% volume of inventory which is high selling having 80%
value, “B” category includes 30% of the volume having 15% value, and “C”
category includes 50% volume having just 5% value.
 ABC analysis is a method in which inventory is divided into three categories, i.e. A,
B, and C in descending value.
 The items in the A category have the highest value, B category items are of lower
value than A, and C category items have the lowest value.
 Inventory control and management are critical for a business. They help to keep
their costs under control.
 The ABC analysis helps the business to control inventory by letting the
management focus on the highest value goods (the A-items) and not on the many
low-value goods (the C-items).
Need for Prioritizing Inventory
Item A:
 In the ABC model of inventory control, items categorized under A are goods that
register the highest value in terms of annual consumption. It is interesting to note
that the top 70 to 80 percent of the yearly consumption value of the company comes
from only about 10 to 20 percent of the total inventory items. Hence, it is crucial to
prioritize these items.
Item B:
 These are items that have a medium consumption value. These amount to about 30
percent of the total inventory in a company which accounts for about 15 to 20 percent
of annual consumption value.
Item C:
 The items placed in this category have the lowest consumption value and account for
less than 5 percent of the annual consumption value that comes from about 50
percent of the total inventory items.
Note: The annual consumption value is calculated by the formula: (Annual demand) ×
(item cost per unit)
ABC Analysis
Advantages of Implementing the ABC
Method of Inventory Control

 This method helps businesses to maintain control over the costly items which
have large amounts of capital invested in them.
 It provides a method to the madness of keeping track of all the inventory. Not
only does it reduce unnecessary staff expenses but more importantly it
ensures optimum levels of stock is maintained at all times.
 The ABC method makes sure that the stock turnover ratio is maintained at a
comparatively higher level through a systematic control of inventories.
 The storage expenses are cut down considerably with this tool.
 There is provision to have enough C category stocks to be maintained without
compromising on the more important items.
Disadvantages of using the ABC Analysis

 For this method to work and render successful results, there must be proper
standardization in place for materials in the store.
 It requires a good system of coding of materials already in operation for this
analysis to work.
 Since this analysis takes into consideration the monetary value of the items,
it ignores other factors that may be more important for your business. Hence,
this distinction is vital.
Examples
H&M
 H&M prefers to stay on the safe side by manufacturing 80% of its retail
inventory in advance and introducing the remaining 20% based on the most
current market trends.To apply it to your business, you need to divide your
on-hand inventory into categories based on the 80-20 rule and prioritize and
manage these groups separately when it comes to manufacturing,
distribution, and fulfillment.
Amazon
 Amazon does not stock every single item offered on its site. It stocks only the
items that are popular and frequently purchased. If an ‘unpopular’ item is
ordered, Amazon would then request it from its distributor who then ships it
to the company. The item would then be unpacked and shipped to the
respective customer.
Optimum Cash Balance

 Generally firm maintains liquidity through cash and marketable securities

 If the firm maintains small cash balance it will have to sell its marketable
securities more frequently to maintain liquidity. It will have to incur
transaction cost
 On the other hand if it maintains high cash balance it misses the opportunity
to earn by investing it in marketable securities.
 Hence the firm has to maintain a trade off between the transaction cost and
opportunity cost to maintain the optimal cash balance
Optimum Cash Balance
Baumol Model of Cash Management

 William J. Baumol developed a model which is usually used in inventory

management (EOQ) but has its application in determining the optimal cash
balance also.
 Baumol found similarities between inventory management and cash
management.
 The optimal cash balance is the tradeoff between opportunity cost or cost of
borrowing or holding cash and the transaction cost (i.e. the cost of converting
marketable securities into cash etc.)
 The optimal cash balance is reached at a point where the total cost is the
minimum.
Baumol Model
ASSUMPTIONS
 The cash needs of the firm is known with certainty
 The cash usage of the firm occurs uniformly throughout the time and its
known with certainty
 The opportunity cost of holding cash is known and it remains constant
 The transaction cost of converting securities to cash is known and remains
constant
 Any excess cash is invested in marketable securities
 The minimum cash balance is zero
Formula

Holding cost = C/2 x O

Conversion cost = A/C x F
Total cost= Holding cost + Conversion cost
Example-3

 The cashflow of Gemini Ltd. are estimated to be Rs. 5,00,000 per annum,
spread evenly throughout the year. The interest on marketable securities
earns 12% p.a. The costs per transaction is Rs. 150. Calculate the optimum
cash balance for the firm using Baumol model. Also calculate the total cost
Solution

 A= 5,00,000
 F= 150
 O= 0.12

Holding cost = C/2 x O = 35,355/2 x 0.12= 2121.3

Conversion cost = A/C x F = 5,00,000/35,355 x 150 = 2121.3
Total cost= 4242.6
Example 4

 ABC Ltd requires Rs.15,00,000 in the next year. The conversion cost of
marketable securities is Rs.30 per transactions, which earns an interest of 8%
per annum? What is the optimum level of cash holding that the company
should keep? Also calculate the holding cost and conversion cost

 C=Rs.33541
 Holding cost= 1341.64
 Conversion cost= 1341.64
Miller & Orr Model of Cash Management

 M.H Miller and Daniel Orr came up with a stochastic Model

 The Miller-Orr model of cash management is developed for businesses with
uncertain cash inflows and outflows.
 Unlike the Baumol Model which assumes steady flow of cash, this is more
realistic approach
 This approach allows lower and upper limits of cash balance to be set and
determine the return point (target cash balance).
Assumptions

 The cash inflows and cash outflows are stochastic. In other words, each day a
business may have both different cash payments and different cash receipts.
 The daily cash balance is normally distributed, i.e., it occurs randomly.
 There is a possibility to invest idle cash in marketable securities.
 There is a transaction fee when marketable securities are bought or sold.
 A business maintains the minimum acceptable cash balance, which is called
the lower limit.
Formula

 Spread = 3x 3 Fσ2
3 4i
Return Point= Lower limit + Spread (Z)
3
Upper Limit= Lower limit + Spread
Where F= Transaction cost
σ2 = Variance of daily cash balance (Square of standard deviation)
i = opportunity cost of holding cash (DAILY Interest rate)
Example-5

 If a company must maintain a minimum cash balance of Rs.8,000, and the

variance of its daily cash flows is Rs 4m (ie std deviation Rs.2,000). The cost
of buying/ selling securities is Rs. 50 & the daily interest rate is 0.025%.
Calculate the spread, the upper limit and the return point
Lower Level = Rs.8000
σ2 = 40,00,000
F= Rs. 50
i = 0.025% or 0.00025
Solution

 Spread =3x 3 Fσ2

3 4i
Spread= 23115.9192
Return Point = Lower limit + Spread/3= Rs.15,705
Upper limit = Lower limit + Spread = 31115.9192
Example-6

 The management of Stilmill Inc. has set a safety cash balance of Rs.50,000.
The standard deviation (σ) of the daily cash balance during the last year was
Rs.37,500, and the transaction cost was Rs.75. The company also has the
opportunity to invest idle cash in marketable securities at an annual interest
rate of 8%. Calculate the spread, return point and upper limit for the firm.

 Lower limit = Rs.50,000

 F = 75
 Variance = 1406250000
 i = 0.08/365 =0.00022
Solution

 Spread =190775.6
 Return Point =113591.86
 Upper limit= 2,40,775.6
Accounts Receivables Management

 Accounts receivable management is the process of ensuring that customers

pay their dues on time.
 It helps the businesses to prevent themselves from running out of working
capital at any point of time.
 It also prevents overdue payment or non-payment of the pending amounts of
the customers.
 It builds the businesses financial and liquidity position.
 A good receivable management contributes to the profitability by reducing
the risk of any bad debts.
 Management is not only about reminding the customers and collecting the
money on time.
 It also involves identifying the reasons for such delays and finding a solution
to those issues.
Terms of Payment

 Cash
 Open Account- Credit period
 Cash discount- 2/10 net 30
 Monthly Billing
 Demand Draft
 Letter of Credit
 Collection Effort for bad debts – legal method and collection officers
Example-7
ABC Ltd. Has the following details. Calculate the ARP,
a) if the company wants to maintain its ARP at 30 days how much should it reduce
its Accounts receivables to?
b) How rapidly should the accounts receivables be collected if the company wants
to maintain an account receivable of 60 at the end of the period?

2019 2020
Account Receivable 86 90
Accounts Payable 56 60
Cost of goods sold 600 720
Sales 650 800
Inventory 90 102
Reducing ARP

a) Accounts Receivable Period = (86+x )/2 = 30 days

800/365
Hence Accounts receivable should be reduced to Rs. 45.4

b) Accounts Receivable Period = (86+60 )/2 = 33.33 days

800/365
Example-8

 Dharma Corp. sells on terms of net/60. Its accounts are on the average 30
days past due. Annual credit sales are Rs. 500,000. How much is the accounts
receivable?
 Solution
Accounts Receivable Period= Average Accounts Receivable
Annual Sales/365
90= Av. Accounts Receivables
5,00,000/365
Accounts Receivables = Rs. 123,287
Example 9

 Pioneer Ltd. provides the following data:

 Current annual credit sales = Rs120,00,000
 Av receivables period = 2 months
 Terms = net/30
 Rate of return = 15%
 The company proposes to offer a 3/10, net/30 discount. The corporation
anticipates 25 percent of its customers will take advantage of the discount. As
a result of the discount policy, the collection period will be reduced to 1.5
months. Should the company offer the cash discount?
Solution

Accounts Receivable Period= Average Accounts Receivable

Annual Sales/365
 Av Receivables without the discount = Rs.19,72,602.74
 Av Accounts Receivables with the discount = Rs. 14,79,452.05
 Amt received by the investment of the excess amount in hand @15%=Rs73972.06
 Cost of Providing discount = 120,00,000 x 0.25 x 0.03 = Rs.90,000

Since the cost of discount is more than the benefit of excess account receivables the
company should not provide the discount
Example-10

 American Pharma is a multinational pharmaceutical company selling certain

premium tablets in the domestic market for the last three years. The
company has not offered any credit on sales and the annual turnover for the
year was Rs. 10 cr. Due to increased competition, the company is now
evaluating new credit policy, which it intends to introduce. As per the policy,
the company will offer 30 days credit and a discount of 2% if the amount is
paid within a day (i.e., 2/1 net 30). Without this new credit policy, the sales
are expected to increase to Rs. 12 crore and with the new policy, the sales
will be Rs. 15 cr. It is estimated that 40% of the customers would avail the
discount. The profit margin for its sales is 30%. The new credit policy will
cause additional costs in terms of collection charges at 1% and bad debts at
0.5%. The interest cost is 16%. Should the firm go with its new credit policy?
Solution

 Benefit from the new credit policy

 Profit from increased sales =
 15,00,00,000- 12,00,00,000= 3,00,00,000 x 0.3= Rs90,00,000
 Cost from the new credit policy
 Discount cost + collection charges + bad debts+ opportunity cost
 (15,00,00,000x0.40x0.02)+(15,00,00,000x0.01)
+(15,00,00,000x0.005)+(15,00,00,000x0.60x30/365x0.16)
 12,00,000+ 15,00,000+ 7,50,000+11,83,561.64
 = Rs.4633561.64
 Since the benefit of the new credit policy is greater than the cost the
company should offer the credit period