Working Capital Management

Prof. Namrata Acharya

Session Objective
• To understand the meaning of working capital
• To know types of working capital
• To understand the working capital cycle
• To understand factors determining the need for
working capital
Definition
• Working Capital refers to that part of the firm’s
capital, which is required for financing short-
term or 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 and this cash flow out again in exchange for
other current assets.
• Working Capital is also known as revolving or
circulating capital or short-term capital.
TYPES OF WORKING CAPITAL

WORKING CAPITAL

BASIS OF BASIS OF
CONCEPT TIME

Gross Net Permanent Temporary

Working Working / Fixed / Variable
Capital Capital WC WC

Seasonal Special
WC WC
Regular Reserve
WC WC
Types of Working Capital
• Gross Working Capital
• Net Working Capital
• Positive Working Capital
• Negative Working Capital
• Zero Working Capital
• Permanent Working Capital (Initial Working Capital
& Regular Working Capital)
• Variable Working Capital (Seasonal & Special
Working Capital)
• Peak Working Capital
• Balance Sheet Working Capital
• Cash Working Capital
Dangers of Excessive Working
Capital
• It results in unnecessary accumulation of
inventories, thus chances of mishandling, loss and
theft is high.

• It is an indication of defective credit policy and slack

collection period.

• Excessive WC makes management complacent

which degenerates into managerial inefficiency.

• Tendencies of accumulating inventories tend to

make speculative profits grow.
Inadequate Working Capital is also
bad because
• It stagnates growth as it becomes difficult for the firm to undertake
profitable projects for non availability of WC funds.

• It becomes difficult to implement operating plans and achieve the

firm’s profit target.

• Operating inefficiencies creep in when it becomes difficult even to

meet day to day commitments.

• Fixed assets are not efficiently utilized for the lack of working capital
funds.

• Paucity of working capital funds render the firm unable to avail

attractive credit opportunities etc.

• Firm loses reputation when the firm is not in a position to honour

its short term obligations.
• The most important challenge in working capital
management is maintaining a tradeoff between
Liquidity & Profitability.
Determinants of Working Capital
• Nature of business
• Size of business unit
• Time consumed for manufacture
• Need to Stock pile Raw Materials
• Need to Store Finished Goods
• Cost and Time involved in the Manufacturing process
• Market and demand conditions
• Technology and manufacturing policy
• Credit policy
• Availability of credit from suppliers
• Operating efficiencies
• Price level changes
• Dividend policy
• Inflation and Taxation Policy.
Working Capital Cycle
• The working capital cycle is also known as
operating cycle.
• Operating cycle is the duration between outflow
of cash and this may be evidenced from the
working capital cycle.
Operating and Cash Conversion Cycle
• Operating cycle is the time duration required to
convert sales after conversion of resources into
inventories, into cash.

• The operating cycle of a manufacturing

company involves three phases
1. Acquisition of resources such as raw material, labour,
power, fuel etc
2. Manufacture of the product which includes conversion
of raw material into work in progress into finished
goods
3. Sale of the product either for cash or credit. Credit
sales create accounts receivable for collection.
 Accounts Payable Value Addition

Raw WIP
Materials

THE WORKING CAPITAL

Cash CYCLE Finished
(OPERATING CYCLE) Goods

Accounts SALES
Receivable
Operating cycle
• Period of Gross operating cycle = inventory
conversion period + debtors conversion period

• Inventory conversion period = raw material

conversion period + work in process conversion
period + finished goods conversion period

• Net operating cycle = gross operating cycle-

creditors deferral period.
Important formulas
• Advance Money = (Advance/(Raw Material + Stores)) 365 Days
• Raw material conversion period =
raw material inventory * 365
raw material consumption
• Work in progress conversion period =
work in progress inventory * 365
cost of production
• Finished goods conversion period =
finished goods inventory *365
cost of goods sold
• Debtors conversion period =
debtors * 365
credit sales
• Creditors deferral period = creditors * 365
credit purchase
• Net operating cycle = gross operating cycle – creditors deferral
period
OC = A + R + W + F + D – C
Number of OC in a year = 365 days / OC = ________
AWCR = Total of Operating Cost / Number of OC in a year = Rs. ____
Illustration
Calculate the operating cycle of a company which gives the following details
of its operation. The company gets 30 days credit from its suppliers. All sales
made by the firm are on credit.

Raw material consumption per annum 8,42,000

Annual cost of production 14,25,000

Annual cost of sales 15,30,000

Annual sales 19,50,000

Average value of current assets held

Raw material 1,24,000

Work in progress 72,000

Finished goods 1,22,000

Debtors 2,60,000
Management of Working Capital
• Management of working capital involves
managing the four important components. They
are:
• Cash management
• Receivables management
• Inventory management
• Creditors management
Receivables Management
A credit sale has three characteristic
1. It involves an element of risk that should be
carefully analyzed.

2. It is based on economic value . To the buyer the

economic value of goods and services passes
immediately at the time of sale, while the seller
expects an equivalent value later.

3. It implies futurity. The buyer will make cash

payment for goods or services received by him
in future period.
Credit policy
• Investment in receivables = debtors * average
collection

• Credit policy comprises of three decision variables.

They are
1. Credit standard: these are criteria to decide the type of
customer to whom goods will be sold on credit.

2. Credit terms: they specify the duration of credit and

terms of payment by customers

3. Collection effort: they determine the actual collection

period.
Credit standard and analysis
• These are standards which a firm follows in selecting
customers for the purpose of credit extension.
• The firm may have tight or liberal credit standards
• They influence the quality of firm’s customers

• Quality of customer can be judged by

i. Average collection period: it determines the speed of
payment by customers.
ii. Default rate: this can be measured in terms of bad debt
losses ratio. The probability of default can be
measured by 3 Cs
- character: refers to customer’s willingness to pay.
- Capacity: refers to customers ability to pay
- Condition: refers to prevailing economic and other
conditions which may affect customers’ ability to pay.
Credit terms
• The stipulations under which the firm sells on credit to
customers is called credit terms.
• These stipulations include
a. Credit period
b. Cash discount
• Credit period is the length of time for which credit is
extended to customers.
• A cash discount is a reduction in payment offered to
customers to induce them to repay credit obligation
within a specified period of time, which will be less
than the normal credit period.
Collection policy and procedure
• It is needed because all customers do not pay on time.
• A collection policy should ensure prompt and regular
collection.
• The collection policy should lay down clear cut
collection procedure.
• Credit evaluation procedure of individual account
should comprise of following steps
1. Credit information
2. Credit investigation
3. Credit limit
4. Collection procedure
Inventory Management
Nature of inventory
• Raw material

• Work In Progress

• Finished Goods
Need to hold inventory
• Transaction motive

• Precautionary motive

• Speculative motive
Objective of inventory management
• To maintain a large size of inventory of raw
material and work in progress for efficient and
smooth production and of finished goods for
uninterrupted sales operation.

• To maintain a minimum investment in

inventories to maximise profitability.
An effective inventory management
should
• Ensure a continuous supply of raw material to facilitate
uninterrupted production.

• Maintain sufficient stock of raw material in periods of

short supply and anticipate price change.

• Maintain sufficient finished goods inventory for smooth

sales operation and efficient customer service.

• Minimise carrying cost and time

• Control investment in inventory and keep it minimum.

Inventory management technique
• Two important questions should be answered

1. How much should be ordered?

2. When should it be ordered?

Economic Order Quantity
it is that inventory level that minimizes
the total of ordering and carrying cost
Ordering Cost Carrying Cost
Requisitioning Warehousing

Order placing Handling

Transportation Clerical and staff

Receiving, inspecting and Insurance

storing
Clerical and staff Deterioration and
obsolescesnce
• Reorder point
= lead time * average usage + safety stock

• Reorder level = maximum usage * maximum

lead time

• Minimum stock level = re-order level – (average

usage * average lead time)

• Maximum stock level = reorder level + EOQ –

minimum usage * minimum lead time

• Average stock level = (minimum stock level +

maximum stock level)/2
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Inventory Management
• Inventory management involves reconciling
the interests of the different departments
involved in the production distribution
function.
• Basic issues in inventory management are:
 Optimal level of inventory,
 Reorder point,
 Should the inventory level be changed, and
 Monitoring and control of inventory.
• Inventory management is guided by the
principles of cost minimisation.
 32

IMPORTANCE OF INVENTORY MANAGEMENT

• Inventories form a link between
production and sale.
• Inventory allows the firm to service
customer needs adequately.
• Due to the sheer size of funds blocked in
inventory its management assumes
significance.
 33

DECIDING OPTIMAL LEVEL OF INVENTORY

• Optimal level of inventory involves a trade-off
between
▫ carrying costs and
▫ ordering costs.
• At this trade-off point the total cost is minimum.
• This point is referred to as Economic Ordering
Quantity (EOQ)
 34

Deciding Optimal Level Of Inventory

 35

Carrying Costs
• Carrying Costs are the cost of maintaining
inventory in a company's warehouse. It is
alternatively referred to as holding cost.
• They include both, costs associated with
physically carrying inventories, such as
▫ warehouse rent,
▫ insurance of inventory and
▫ financial cost of funds tied up in the
inventory i.e. the opportunity cost of
alternative investments.
• Such costs have a positive correlation with the
level of inventory, and hence are assumed to
be a variable cost in inventory management.
 36

Ordering Costs
• Ordering cost refer to the costs that are
incurred at the time an order is placed.
• These costs are periodic and are
regardless of the size of the order.
• The examples include
▫ cost of processing orders,
▫ cost of follow up with the vendors,
▫ cost of receiving new shipment,
▫ cost incurred on handling the accounts
payable invoice.
 37

Ordering Costs
• These costs do not vary with the size
of the order but with the number of
orders.
• Total order costs decrease as the
number of units ordered each time
increases.
• With more units being ordered each
time, the number of orders placed
decreases.
 38

Stock-out Costs
• The stock-out costs involve implicit costs of
lost sales due to shortage in the finished
goods inventory.
• They are alternately called backorder cost.
• They include discrete costs such as
▫ lost profit due to loss of present sales,
▫ cost of replacing a specific piece of
inventory, and
▫ certain intangible costs such as loss of
goodwill.
• Such costs vary inversely with the inventory.
• The relationship between stock-out costs and
carrying costs of inventory determines
whether a company should over - or under-
produce.
 39

The Economic Order Quantity (EOQ) Model

• The two questions that the inventory theory tries
to address are:
 How much should be ordered?
 When should it be ordered?
• The EOQ model of inventory management
provides answer to the first question.
• Economic Order Quantity (EOQ) refers to the lot
size of inventory that is most economical to
procure and hold.
 40

Inventory Monitoring And Control

• The issue of monitoring and control of
inventory assumes importance.
• The funds that are blocked in the production–
distribution system incur costs.
• To the extent that a firm is able to untie the
blocked funds it can divert them to alternate
uses. This creates value for shareholders.
• Inventory control has emerged as one of the
prominent issues in cost management and
control.
 41

Inventory Monitoring And Control

• On the one hand, we have a simple
two-bin system of inventory control
that is suited for small firms.
• On the other hand, we have a
comprehensive material requirement
planning (MRP) system.
• Computerization and networking of all
the activities in the production–
distribution channel has facilitated the
process of regular tracking of
inventory.
 42

Techniques Of Inventory Control

And Reduction

• Ratio analysis
• ABC Analysis
• Vendor Managed Inventory (VMI)
• Just-In-Time (JIT)
• Outsourcing
• Improving supply chain
management
• Re-engineering
• Flexible manufacturing
Cash Management
Important facets of cash management
• Cash planning

• Managing the cash flows

• Optimum cash level

• Investing surplus cash.

Motives for holding cash
• Transaction motive

• Precautionary motive

• Speculative motive.
Cash planning
• Cash budget is the tool used for planning cash
position of a company.
Cash Management Cycle

Cash
collection

Business
operations
Deficit Borrow

Surplus Invest

Information
and control
Cash
payments
Managing cash
• Accelerating cash collection

• Decentralized collection

• Lock box system

Investing surplus cash
• Treasury bills
• Commercial paper
• Certificates of deposit
• Bank deposits
• Inter corporate deposit
• Money market mutual fund.
Problems