Working Capital Management

Session 8

What is working capital?
Working capital measures how much in liquid assets a company has available to build its business. The number can be positive or negative, depending on how much debt the company is carrying. Companies that have a lot of working capital will be more successful since they can expand and improve their operations. Companies with negative working capital may lack the funds necessary for growth. Working capital = Current assets - current liabilities

Purpose of Working Capital
Working capital is required to meet day to day operating expenses and for holding stocks of raw materials, spare parts, consumable, wrok in progress and finished goods. Working capital typically means the firms holding of current or short term assets such as cash, recievable,inventory and market securities. These items are also refered as circulating capital.

office and administraive.Purpose of Working Capital To hold the stock of raw materials for such a period so as to facilitate an uninterrupted supply of raw material to production process.taxes etc . To hold the stock of work in progress for process peroid To hold the stock of finished goods for such a peroid so as to meet the demands of customers on continuous basis and sudden demand from some customer To grant credit to its customers for marketing and competitive reasons. selling and distribution exp. To hold cash balances to meet the manufaturing.

working capital is required to finance operations during cycle for the business to run smoothly.Need for Working Capital It is needed because of the existence of operating cycle Operating cycle is the duration of time between acquisition of supplies and the collection of cash from receivables Basically. .

Concept of working capital There are two possible interpretation of working capital : Balance sheet concept There are two : Excess of current assets over current liabilities is called net working capital Gross or total current assets Operating cycle concept .

Operating Cycle .

OC is equal to the length of inventory and receivables conversion period. OC = R + W + F + D – C R = Raw material W = Work in process F = Finished goods waiting period D = Debtors collection period C = Creditors payment period.Operating cycle WCC is defined as the time period required for the whole operation starting with cash to cash plus (assumes profit). It expresses in month days. It helps not only in forecasting working capital requirement but . Operating cycle .

Calculation of components of operating cycle (in days) Average raw material Storage period Average work in progress holding period Average finished goods storage period Average Debtors collection period Average Creditors payment period Average time lag in payment of expenses Gross operation cycle Net operation cycle .

Current asset refer to the assets which are held for their conversion into cash within a operating cycle. .Concepts of working capital Balance sheet concept Gross Working Capital It refers to the firm’s investment in current assets. Net Working Capital It refers to the difference between current assets and current liability.

Gross Working Capital Cash + = + Inventories Raw Material Work in progress Finished goods Gross working capital Short term marketable securities and other current assets .

Inventories Raw material Work in progress Finished goods Others Trade debtors Loans and advances Cash in hand and bank Current liabilities Sundry creditors Trade advances .Gross WC = all current assets Net WC = current assets – current liabilities Current assets.

Permanent Working Capital Temporary Working Capital .


Enables a concern to face business crisis.Importance or Advantages of Adequate Working Capital: Helps in arranging loans from banks & others on easy and favourable terms Enables a concern to avail cash discount and hence reduce cost. wages and other day to day comittment. Ensures regular supply of raw material. . Regular payment of salaries.

Loss of return on investment It may lead to unnecessary purchasing & accumulation of inventories.Excess or Inadequate WC Ideal funds. It may implies to defective credit policy or liberal policy .

Disadvantages or Dangers of Inadequate WC A concern which has inadequate WC. Cannot buy its requirements in bulk & cannot avail of discounts etc. cannot pay its short term liabilities in time. . Create inefficiency Becomes difficult to use efficiently fixed assets due to non-availability of liquid funds.

Factors Determining Working Capital Nature of the business Size of Business Manufacturing Cycle / Time Demand and supply of the product Volume of sale Credit policy Growth and expansion activities Price level changes Inventory policy Dividend policy .

work in progress. finished goods.Nature of Business Nature of Business Small trading concern or retail shop Requirement of WC Small Reason Operating cycle period is small sinceMostly cash sales Carry small quantities of goods Small debtors balance Carry small amount of cash Operating cycle period is small sinceLarge quantity of stock Carry large amount of cash and debtors balance Carry large quantity of raw material. debtors and cash Large trading firm Large Manufacturing firm Large .

Restaurants and eating houses Requirement of WC Small Reason They have cash sales They supply services and not products They mostly have cash sales and only small amount of debtors balance They require large quantities of goods to be held in stock They carry large debtors balance They carry large debtors balance Small Trading firms Large Financial firms Large . water supply) Hotels.Nature of business Public utility (electricity generation and supply.


transportation Technology Management attitude Seasonality of operation eg: cold drinks Production policy Production of ceiling fan through out the year Market condition Depends on competition. . Sale of finished goods and collection of cash Conditions of supply Prompt or unpredictable.Factors influencing Working Capital Nature of business eg: manufacturing.

Disadvantages of short Working Capital Cant pay off short term liabilities Difficult for firm to exploit favourable market conditions Improper utilisation of fixed assets. .Disadvantages of excess Working Capital Ideal funds Unnecessary purchasing Inefficiency in the organisation Due to low rate of return on investment. market value of shares may fall.

12 months or 365 days Stock of = est annual cost of goods to be produced x avg WIP holding period WIP 12 months or 365 days Stock of = est annual cost of goods to be produced x avg FG storage period Fin Goods. 12 months or 365 days Average = estimated annual cost of credit sales x avg collection period Trade debtor 12 months or 365 days Cash and bank balance = minimum as desired by the firm Estimate of future WC based on current assets and current liabilties .Step 1:Make the estimates of various current assets as follows: Stock of = est annual cost of RM to be consumed x avg RM holding period raw mat.

Estimate of future WC based on current assets and current liabilties Step 2:Make the estimates of various current Liabilities as follows: Average = Estimated annual cost of credit purchases x avg credit period availed Trade Creditors 12 months or 365 days Average Creditors = Expenses for the year x avg time lag in payment For expenses 12 months or 365 days .

Estimate of future WC based on current assets and current liabilties Step 3: make estimate of WC by taking out the difference between the current asset and current liability .


directing and controlling of receivables.Receivables Management Receivables management means planning. It answers the following questions: To whom credit should be allowed How much credit should be allowed How much amount of credit should be alloed .

Objective of Receivables Management Consequences of Excessive Receivables High opportunity cost of investment in Receivables High Risk of Bad debts High Credit Administration Cost High Risk of Liquidity Consequences of Inadequate Receivables Decrease in Sales Risk of Loosing Market Share .

Receivab les Operating Cycle Why do we need receivables? Reach sales potential Competition Cash Understanding Receivables As a part of the operating cycle Time lag b/w sales and receivables creates need for working capital Inventory .What are receivables? Receivables are sales made on credit basis.

Credit not granted . Duration of credit period (selecting the right policy) Decision based on cost-benefit analysis Positive net benefit-Credit granted (Highest Net benefit policy chosen) Negative net benefit.GRANTING CREDIT Basic decisions 1. To give credit or not S MANAGEMENT 2.

DELINQUENCY COST: Cost which arises if customers fail to meet their obligations. S MANAGEMENT . DEFAULT COST: Amounts which have to written off as bad debts.DIFFERENT TYPES OF COSTS ASSOCIATED COLLECTION COST: Administrative costs incurred in collecting the accounts receivable. CAPITAL COST: Cost incurred for arranging additional funds to support credit sales.

High administration expenses. and pay for them at a later date. Increase the sales.Credit Trade Policy Credit gives the customer the opportunity to buy goods and services. People can buy goods and pay for them at a later date. Can be used as a promotional tool. Gain goodwill and loyalty of customers. More working capital needed. Disadvantages of credit trade Risk of bad debt. Can charge more for goods to cover the risk of bad debt. . Risk of Bankruptcy. Advantages of credit trade Results in more customers than cash trade. People can buy more than they can afford.

Ability to repay( earning capacity) Capital. Track Record Capacity.Financial Position of the co. Collateral.Economic conditions & competitive factors that may affect the profitability of the customer To get info on the 5 C’s a firm may rely on: Financial statement Bank references Experience of the firm Prices and Yields on securities .The type and kind of assets pledged Conditions.Reputation.The 5 C’s Character.The 5 C’s of Credit Customer Evaluation.

Obtaining Credit Information Obtaining Credit Information is the first step in the evaluation process Application Forms Historical Financial Statements External Sources .

CIBIL Direct Credit Information Exchanges provide participants with credit information Bank Checking may provide vague credit information (from the applicant's bank) FCU check .External Sources of Credit Information Credit Interchange Bureaus can provide firms with factual data regarding the credit history.

Analyzing Credit Information Analyzing Credit Information is the next step in the evaluation process Procedures Economic Considerations The Small Business Problem Credit Scoring is a good (and inexpensive) way for firms extending credit to a large number of small accounts to address credit analysis .

Credit Policy.three decision variables Credit Policy Credit Standards Credit Terms Collection Efforts .

Credit Standard Credit Standards are the minimum requirements for extension of credit to a customer Liberal Credit Standards Push sales by attracting more customers. a larger investment in receivables. Stiff credit standards Opposite effect . higher collection expenses.1. higher incidence of bad debts loss.

Credit Standard Standard Effect on sales Effect on Effect on credit bad debts administration cost Increase in credit administration cost Soft Increase in Increase standards sales in Bad debts Tight Decrease standards in sales Decrease Decrease in credit in Bad administration cost debts .

Making The Credit Standard Decision Two factors should be considered: Average collection peroid Default risk Character Capacity Condition History of customer Good Marginal Bad Average collection period Within credit period Moderate collection period Very large collection period Default risk 0 Moderate High .

Credit Term Credit Period It is the length of time for which credit is granted “net 60” Cash Discount “2/20 net 60” .

Type of term Effect on sales Effect on Effect on investment bad debts in accounts receivables Increase in Increase in investment bad debts in accounts receivables Effect on credit administrati on cost Increase Soft Term Increase in sales Tight Term Decrease in Decrease in Decrease in Decrease sales investment bad debts in accounts receivables .

shorten the average collection period. Threat of legal action to overdue accounts.Collection Efforts Monitoring the state of receivables Dispatch of letter to customers whose due date is approaching Telegraphic and telephone advice around due date. reduce bad debts %. A lax collection programme Opposite influence . A rigorous collection programme Decreases sales. increase the collection expenses. Legal action against overdue accounts.

Collection Policy Collection Policy is the set of procedures for collecting a firm's accounts receivable when they are due Introduction Bad debt expenses are a function of both credit policy and collection policy In general. increasing collection expenditures reduce bad debt .

Types Of Collection Techniques Letters of Reminder Phone Calls Personal Visits Collection Agencies or Attorneys Legal Action .

Factors which influence credit conditions Nature of the business's activities Financial position Product durability Length of production process Competition and competitors' credit conditions Country's economic position Conditions at financial institutions Discount for early payment .

Effective credit control Increases sales Reduces bad debts Increases profits Builds customer loyalty Builds confidence of financial industry Educating customers for credit history Sources of information on creditworthiness Business references Bank references credit agencies Chambers of commerce Employers Credit application forms .

Opportunity Cost & its calculation .

Net Benefits (A-B) policy . Less tax 7. Bad debts 4. Credit sales 2. Expected profit 6. Total Cost VC & FC 3. Opportunity cost of investments in receivables locked up in collection period C. Profit after tax B.Debtors Policy-Total Approach (Proforma) Particular Present Proposed policy A. Cash discount 5. Expected Profit: 1.

Less tax 7. Incremental Expected profit 6. Incremental Cash discount 5. Cost of credit sales 2. Incremental investment in rec. Collection period 3. Incremental Credit Cost( VC & FC) 3. Incremental Profit after tax B. Incremental Net Benefits (A-B) . Incremental Bad debts losses 4. Incremental Expected Profit: 1. Investment in recievabless (1 x 2/365) 4. 5.Particular Debtors Policy-Incremental Approach Pres. Incremental Credit sales 2.policy Pro policy A. Req rate of return on incremental investment (4 x 5) C.Req return on incremental investments: 1. Req rate of return 6.

Inventory Management .

How much inventory should be ordered at a particular point of time? It answers: How much to order When to place an order . directing and controlling of inventory.Inventory Management It means planning. organising.

insurance etc Risk of liquidity Consequences of Inadequate Inventory Interruption in production Excessive stock out costs . handling cost.Objective of Inventory Management To avoid the situation of excessive and inadequate inventory & to maintain optimum level of inventory Consequences of Excessive Inventory Opportunity cost of funds ties up in inventory Excessive carrying costs such as storage cost.

Need for Holding Inventory Transaction Motive Precautionary motive Speculative motive .

Techniques of managing inventory ABC Analysis Economic Order Quantity (EOQ) .

The objective of EOQ is to determine that order size which is most economical to order . EOQ refers to the quantity of inventory.EOQ It is the order which is placed when the stock reaches re-order level. at which total of ordering and carrying cost is minimum.

Cost of placing an order 2. Cost of store staff cost and ordering size There is positive relationship between order size and carrying cost Larger the order size Lower the ordering Larger the order costs because of size fewer order Higher the carrying costs because of high average inventory Lower the carrying costs because of low average inventory Smaller the order size Higher the ordering costs because of more order Smaller the order size . Cost of inspecting goods 3.Ordering cost Carrying cost The term ‘ordering cost’ refers to the cost The term ‘carrying cost’ refers to the cost incurred for aquiring inputs. Cost of handling material 4. Cost of receiving goods 2. Cost of transportation 1. Cost of Insurance 4. These cost incurred in maintaining a given level of includes: inventory. Cost of storage cost 3. Cost of obsolescence There is inverse relation with ordering 5. These cost includes: 1.

Assumptions of EOQ Annual usage (consumption) of inventory is known Rate of usage is known and constant Ordering cost are known and constant Carrying cost are known and constant Zero lead time/ delivery peroid. .

of orders per year = total annual consumption (in units) / order size Frequency of orders = 365 days / No.Formula EOQ = AO C A = annual consumption of Input O = ordering cost per order C = carrying cost per unit No. of orders in a year Total annual ordering & carrying cost at EOQ = 2AOC .

Inventory Management Session 7 .

Re-order Quantity EOQ .

Reorder Level The objective of fixing re order level is to determine when fresh order should be placed. ROL = Maximum rate of consumption X max re order period .

insurance.risk etc .Maximum level It is that level of stock above which the stock in hand should not normally be allowed to exceed. Objective is to avoid the cost of over stocking – cost of storage. It is the largest quantity of a particular material which may be held in the store at anytime.

The level is fixed after considering following factors:
Re order level & quantity Min. rate of consumption & reorder peroid Availability of working capital & storage space Extra cost of storage and insurance Price fluctuation Risk of deterioration

Max level = Re-order level + Re-order quantity – (minimum consumption x min reorder period)

Minimum level
It is the lowest quantity of a particular material which must be held in the store at all time. The objective of fixing the min. level is to avoid the costs of under stockingsuch ascost of stoppage of production, cost of idle labour , cost of idle plant & machinery.

The level is fixed after considering following factors:
Re-order level Normal rate of consumption Normal Re-order peroid

Formula: Min level = Re-order Level – (Normal consumption x normal re-order period)

Average Stock Level Formula: Avg stock level = Max level + Min level 2 .

Danger level It is the level at which normal issues of the raw material inventory are stopped and emergency issues are only made on special requisition approved by the authority The level is fixed after considering following factors: Average consumption Max re-order period for emergency purchases Formula =Average consumption x max re-order peroid for emergency purchases .

. It exercises discriminating control over different items of stores classified on the basis of the investment involved.ABC Analysis ABC analysis is a system of inventory control.

Catego Composition ry A Working of ABC Analysis It consist of those items which require large investments ( say about 70% of total value of stores) but constitute a small percentage (say 10%) of total items of stores Degree of control High degree of control is exercised by use of various techniques such as fixing stock level like max level. Moderate degree of control is exercised. min level. Order of large size are placed either after 6 months or once in a year to minimize ordering costs and to take advantage of bulk purchase . reorder level. Order are placed on a periodic review basis B It consist of those items which require relatively moderate investments ( say about 20% of total value of stores) but constitute relatively moderate percentage (say 20%) of total items of stores It consist of those items which require small investments ( say about 10% of total value of stores) but constitute a large percentage (say 70%) of total items of stores C Lower degree of control is exercised.

weekly) basis. 'C' group items are often controlled by a red-line method under which a reorder is placed when a redline drawn inside an inventory bin is exposed . 'B' group items are controlled on a periodic (e.Techniques for Managing Inventory The ABC System The ABC System is a technique that divides inventory into three categories of descending importance based on the dollar investment in each category Group % of Items % of Investment Degree of Control A 20 70-80 Tight B 30 10-20 Average C 50 <10 Loose 'A' group items are controlled on a daily basis.g.

ABC Analysis .

which requires large investment (A) It saves time and cost by exercising economic systems of control over low value items (C) It ensures optimum investment in inventory considering the operational requirements and financial resources with use of EOQ It ensures minimum total cost .Advantages of ABC Analysis It ensures effective control on costly items.


Inventory Management Inventory is necessary to permit the production-sale process to operate with a minimum of disturbance Inventory may represent as much as 42% of a typical manufacturing firm's current assets and about 18% of its total assets Inventory is commonly under the control of the production/operations manager. but the financial manager generally acts as a “watchdog” and advisor in matters concerning inventory .

Inventory Fundamentals Types of Inventory include: Raw materials used in the manufacture of finished products Work-in-process which consists of items in production Finished goods which are produced but not yet sold Differing Viewpoints About Inventory Level Financial Manager: low levels to minimize cost Marketing Manager: high levels to minimize stockouts and maximize customer service Manufacturing Manager: high levels to ensure timely and low-cost production Purchasing Manager: high levels (of raw materials) to secure low cost per unit and ensure ready availability .

The Relationship Between Inventory And A/cs Receivable Inventory often becomes an account receivable before it becomes spendable cash. storage. which will in turn be supported by higher levels of inventory and accounts receivable Generally the cost of carrying accounts receivable is less than the cost of carrying inventory since physical handling. A decision to extend credit to a customer may increase sales. and insurance costs are reduced .

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