Overview of Working Capital

Management (WCM):

Definition and concept

WCM Accounts
Importance of WC
Classification of WC
Operating cycle and cash conversion cycle
Factors determining WC needs
Estimation of WC requirement
WCM Policy and Risk return trade off
 Working Capital Definition and
Concepts
Working Capital refers to the firm’s investment in current
assets such a cash, marketable securities, debtors and
inventories. Funds thus, invested in current assets keep
revolving fast and are constantly converted into cash.

Net Working Capital

Current Assets - Current Liabilities.
Gross Working Capital
The firm’s investment in current assets.
Working Capital Management
The management of the firm’s current assets and the
financing needed to support current assets.
Working Capital Accounts from a
Typical Firm’s Balance Sheet
 Significance of Working Capital Management

• To deal with uncertainty

Labor and
regarding the future cash
Used in Used in material flows.
production • To purchase of raw materials
process and Used to purchase Fixed Op.
generates Exp
and spares.
WC • For payment of wages and
Inventory Cycle Used to purchase salary
via sales Cash & Mkt Sec • To meet day-to-day expenses
• To strike a balance between
Returns Used to liquidity, profitability and risk
Account Collection to capitalpurchase Fixed
Receivables Asset • Excessive levels can result in a
Ext. fin
substandard Return on
Supplier of Investment (ROI).
capital • Working capital management
affects the company’s risk,
return, and share price.
 Classifications of CA
● Components
● Cash, marketable securities,
receivables, and inventory

• Time
– Permanent Current Assets
– Temporary Short Time Investment or
Marketable Securities
Permanent CA Temporary CA

• The amount of current • The amount of current

assets required to meet a assets that varies with
firm’s long-term minimum seasonal requirements.
needs.
 Cash Conversion Cycle(CCC)/net
OC/cash operating cycle

Operating cycle (OC)/WC cycle is the summation of :

Inventory conversion period and receivables collection period.
Example: XYZ Industries has average inventory turnover period of 70 days,
an average collection period (ACP) of 45 days and average payable period
of 40 days. What is the company’s OC and CCC?
 Factors Determining Working Capital
Management
• Nature of business
• Production cycle
• Business cycle
• Production policy
• Credit policy
• Growth and expansion
• Availability of raw material
• Earning capacity
 Estimation of Working Capital Requirement
Individual Component Method: Amount of these CA and CL are not directly given, these are to
be calculated using the following formula:

From the following information calculate the working capital:

Annual production 15,600 units
Costs per unit (in Tk.):
RM 5
DL 4
O/H 2
*WIP and FG costs involves all these three costs i.e. Tk. 11 that is Total cost
Time:
RM 3 weeks
(WIP)Processing period 4 weeks
FG 5 weeks
Credit allowed by creditors 3weeks
Credit allowed to debtors 4 weeks
Lag in payment of wages 2 weeks
Lag in payments of O/H 2 weeks

Calculate the working capital requirement

 Estimation of Working Capital
Requirement
Operating Cycle Method

ABC company expects its cost of good sold for 2018 is Tk. 136 crores. The operating
cycle for the planned year is expected to be 54 days. The company wants to
maintain a desired cash balance of Tk. 1.5 crores to meet the contingencies. What is
the expected working capital requirement for the year 2019 (assume 365 days in a
year)
Pro-forma Working Capital Estimates for Trading Concern

STATEMENT OF WORKING CAPITAL REQUIREMENTS

Amount (Rs.)
Current Assets
(i) Cash ----
(ii) Receivables ( For…..Month’s Sales)---- ----
(iii) Stocks ( For……Month’s Sales)----- ----
(iv)Advance Payments if any ----
Less : Current Liabilities
(i) Creditors (For….. Month’s Purchases)- ----
(ii) Lag in payment of expenses -----_
WORKING CAPITAL ( CA – CL ) xxx
Add : Provision / Margin for Contingencies -----

NET WORKING CAPITAL REQUIRED XXX

 Pro-forma Working Capital Estimates for Manufacturing Co
STATEMENT OF WORKING CAPITAL REQUIREMENTS
.
Amount (Rs.)
Current Assets
(i) Stock of R M( for ….month’s consumption) -----
(ii)Work-in-progress (for…months)
(a) Raw Materials -----
(b) Direct Labour -----
(c) Overheads -----
(iii) Stock of Finished Goods ( for …month’s sales)
(a) Raw Materials -----
(b) Direct Labour -----
(c) Overheads -----
(iv) Sundry Debtors ( for …month’s sales)
(a) Raw Materials -----
(b) Direct Labour -----
(c) Overheads -----
(v) Payments in Advance (if any) -----
(iv) Balance of Cash for daily expenses -----
(vii)Any other item -----
Less : Current Liabilities
(i) Creditors (For….. Month’s Purchases) -----
(ii) Lag in payment of expenses -----
(iii) Any other -----
WORKING CAPITAL ( CA – CL ) xxxx
Add : Provision / Margin for Contingencies -----
Example of Estimation of WC Requirement
Working Capital Management Policy Issues and Risk Return
Trade-off and the impact of these policies on liquidity,
profitability and risk
Policy issues from 2 dimensions:
A. Investment Decisions
B. Financing Decisions

A. Investment Decisions:
1. Conservative Working Capital Policy (Policy C).
2. Moderate Working Capital Policy (Policy M).
3. Aggressive Working Capital Policy (Policy A).

Risk proxy ratio measured by CA/TA (relative asset

liquidity)
 Optimal Amount (Level) of Current Assets

Assumptions
• 50,000 maximum units Policy C
of production Policy M

ASSET LEVEL ($)

• Continuous production
Policy A
• Three different
policies for current
Current Assets
asset levels are
possible

0 25,000 50,000
OUTPUT (units)
 Impact on Liquidity
Optimal Amount (Level) of Current Assets

Liquidity Analysis
Policy Liquidity Policy C

C High Policy M

M Moderate ASSET LEVEL ($) Policy A

A Low
Greater current asset Current Assets
levels generate more
liquidity; all other factors
held constant. 0 25,000 50,000
OUTPUT (units)
 Impact on
Expected Profitability
Optimal Amount (Level) of Current Assets
Return on Investment =
Net Profit Policy C
Total Assets Policy M

ASSET LEVEL ($)

Let Current Assets = (Cash + Policy A
Rec. + Inv.)
Return on Investment = Current Assets

Net Profit
Current + Fixed Assets
0 25,000 50,000
OUTPUT (units)
 Impact on
Expected Profitability
Optimal Amount (Level) of Current Assets

Profitability Analysis
Policy Profitability Policy C

A High Policy M

M Moderate ASSET LEVEL ($) Policy A

C Low
As current asset levels Current Assets
decline, total assets will
decline and the ROI will rise.
0 25,000 50,000
OUTPUT (units)
 Impact on Risk
Optimal Amount (Level) of Current Assets
• Decreasing cash reduces the
firm’s ability to meet its Policy C
financial obligations. More
risk! Policy M

ASSET LEVEL ($)

• Stricter credit policies reduce Policy A
receivables and possibly lose
sales and customers. More
risk! Current Assets
• Lower inventory levels
increase stockouts and lost
sales. More risk!
0 25,000 50,000
OUTPUT (units)
 Impact on Risk
Optimal Amount (Level) of Current Assets

Risk Analysis
Policy Risk Policy C

A High Policy M

M Moderate ASSET LEVEL ($) Policy A

C Low
Current Assets
Risk increases as the level of
current assets are reduced.

0 25,000 50,000
OUTPUT (units)
 Summary of the Optimal
Amount of Current Assets
SUMMARY OF OPTIMAL CURRENT ASSET ANALYSIS
Policy Liquidity Profitability Risk
C High Low Low
M Moderate Moderate Moderate
A Low High High

1. Profitability varies inversely with liquidity.

2. Profitability moves together with risk.
(risk and return go hand in hand!)
 B. Financing Decisions of
Current Assets and risk return trade
off

Hedging approach
Conservative approach
Aggressive approach
Risk proxy ratio measured by CL/TF
(relative financing liquidity)
 Hedging (or Maturity Matching) Approach

long-term finance shall be used to finance fixed assets and permanent current
assets and short-term financing to finance temporary or variable assets.

Short-term financing**
DOLLAR AMOUNT

Current assets*

Long-term financing
Fixed assets

TIME
 Conservative Approach
Under this approach, the entire estimated finance in current assets should be financed
from long-term sources and the short-term sources should be used only for emergency
requirements. This approach is called as “Low Profit – Low Risk” concept.

Firm can reduce risks associated with short-term borrowing by using a

larger proportion of long-term financing.

Short-term Investment

Short Term Financing

DOLLAR AMOUNT

Current assets

Long-term financing
Fixed assets

TIME
 Aggressive Approach
Under this approach, the entire estimated requirement of current assets should be
financed from short-term sources and even a part of fixed assets financing be financed
from short- term sources. This approach makes the finance mix more risky, less costly and
more profitable.

Firm increases risks associated with short-term borrowing by using a

larger proportion of short-term financing.

Short-term financing

Current assets
DOLLAR AMOUNT

Long-term financing
Fixed assets

TIME
 Interaction of Investment (CA/TA)
and Financing Decisions (CL/TF)

Financing
Maturity
SHORT-TERM LONG-TERM
Asset
Maturity

SHORT-TERM Moderate Low

(Temporary) Risk-Profitability Risk-Profitability
(Conservative)

High
LONG-TERM Moderate
Risk-Profitability
(Permanent) Risk-Profitability
(Aggressive)
(Moderate)
Disadvantages of Redundant or Excess Working Capital

Idle funds, non-profitable for business, poor ROI.

Unnecessary purchasing & accumulation of inventories
over required.
Excessive debtors and defective credit policy, higher
incidence of bad debt.
Credit worthiness suffers.
Due to low rate of return on investments, the market
value of shares may fall.
Disadvantages or Dangers of Inadequate or Shortage of
Working Capital 



Inability to pay off its short-term liabilities on time.
Difficult for the firm to exploit favorable market
situations.
Day-to-day liquidity worsens.
Improper utilization the fixed assets and ROA/ROI falls
sharply.
 Ratios associated with WCM
Stock Turnover Ratio COGS
(Times) AVERAGE STOCK
Stock Turnover Ratio (Days) Average Stock x 365
COGS
Receivables Turnover Ratio Net Credit Sales
(Times) Average Accounts
Receivable
Average Receivables Period Avg A/C Receivable x 365
(Days) Net Credit Sales
Payables Turnover Ratio Net Credit Purchases
(Times) Average Accounts payables

Average Payables Period Avg A/C payable x 365

(Days) Net Credit purchase
Current Ratio Current Assets
Current Liabilities
Quick Ratio CA – Stock of inventory
Current Liabilities
Working Capital Turnover Net Sales
Ratio Net Working Capital