WORKING CAPITAL MANAGEMENT

UNIT I

Concepts of Working Capital

Based on balance sheet concept, working capital is of two types; Gross working capital (GWC) and Net
working capital (NWC)

Based on Operating Cycle or Circular Flow Concept, working capital is of two types; Gross Operating
Cycle and Net Operating Cycle

Based on time, working capital is of two types; Permanent or Fixed Working Capital and Temporary or
Variable Working Capital

Gross working capital (GWC)

GWC refers to the firm’s total investment in current assets.

Current assets are the assets which can be converted into cash within an accounting year (or operating
cycle) and include cash, short-term securities, debtors, (accounts receivable or book debts) bills
receivable and stock (inventory).

GWC focuses on Optimization of investment in current and financing of current assets

Net working capital (NWC)

NWC refers to the difference between current assets and current liabilities.

Current liabilities (CL) are those claims of outsiders which are expected to mature for payment within an
accounting year and include creditors (accounts payable), bills payable, and outstanding expenses.

NWC can be positive or negative.

Positive NWC = CA > CL

Negative NWC = CA < CL

NWC focuses on Liquidity position of the firm, Judicious mix of short-term and long-term financing
Operating Cycle

Operating cycle is the time duration required to convert sales, after the conversion of resources into
inventories, into cash. The operating cycle of a manufacturing ccompany
ompany involves three phases:

Acquisition of resources: such as raw material, labour, power and fuel etc.

Manufacture of the product: which includes conversion of raw material into work-in-progress
work into
finished goods?

Sale of the product: either for cash or on credit. Credit sales create account receivable for collection.

Gross Operating Cycle

Gross Operating Cycle = RMCP + WIPCP + FGCP+ RCP

Net Operating Cycle

Net Operating Cycle = Gross Operating Cycle – Payable Deferral Period

PERMANENT AND VARIABLE WORKING CAPITAL

Permanent or fixed working capital

A minimum level of current assets assets, which is continuously required by a firm to carry on its
business operations,, is referred to as permanent or fixed working capital.

Fluctuating or variable working capi

capital

The extra working capital needed to support the changing production and sales activities of the
firm is referred to as fluctuating or variable working capital
capital.

Objectives of Working Capital Management

1. Purchase of raw material, components and spares

2. To incur day to day expenses and overhead costs
3. To meet the selling costs
4. To provide credit facilities to custome
customers
5. To maintain the inventories
Determinants of Working Capital

• Nature of Business

• Market and Demand Conditions

• Technology and Manufacturing Policy

• Credit Policy

• Availability of Credit from Suppliers

• Operating Efficiency

• Price Level Changes

Issues in Working Capital Management

Current Assets to Fixed Assets Ratio

• The financial manager should determine the optimum level of current assets.

• Conservative Current Asset Policy: higher CA/FA – implies greater liquidity and lower risk

• Aggressive Current Asset Policy: lower CA/FA – implies poor liquidity and higher risk

Liquidity vs. Profitability: Risk–Return Trade-off

• Liquidity refers to the firm’s continuous ability to meet maturing obligations.

• To have higher profitability, the firm may sacrifice liquidity and maintain a relatively low level of
current assets.

• When the firm does so, its profitability will improve as fewer funds are tied up in idle current
assets, but its liquidity would be threatened.

• That means greater risk of cash shortage and stock -outs

Estimating Working capital

Current assets holding period

To estimate working capital requirements on the basis of average holding period of current assets and
relating them to costs based on the company’s experience in the previous years. This method is
essentially based on the operating cycle concept.
Ratio of sales

To estimate working capital requirements as a ratio of sales on the assumption that current assets
change with sales.

Ratio of fixed investment

To estimate working capital requirements as a percentage of fixed investment.

Working Capital Finance Policies/ Determining the Working Capital Financing Mix

Matching Approach

• Under this approach the firm matches the expected life of assets with the expected life of the
source of funds raised to finance assets.

• A ten year loan may be raised to finance a plant with an expected life of ten years; stock of
goodss to be sold in thirty days may be financed with a thirty day bank loan.

• The hedging approach suggests that the permanent working capital requirements should be
financed with funds from long term sources while the temporary or seasonal working capital
requirement
irement should be financed with short term funds

Conservative Approach

This approach suggests that the entire estimated investment in current assets should be
financed from long term sources and short term sources should be used only for emergency
requirements.
Aggressive Approach

• The aggressive approach suggests that the entire estimated requirements of current assets
should be financed from short term sources and even a part of fixed assets investment be
financed from short term sources.

• This approach makes the finance

finance- mix more risky, less costly and more profitable.

Financing of Working Capital

• Equity Financing

• Debt Financing

• Informal Forms of Credit

 Trade Credit
 When firms purchase goods and services on credit terms, it is known as trade credit.
 Stretching Accounts Payable
 Accrued Expenses and Deferred Income
 Accrued
rued expenses such as wages payable, taxes payable, interest payable etc that are accrued
but not yet due. From the time when these charges accrue up to the point that they become
due, they are available as sources of funds.
 Deferred income consists of payments received from customers for goods and services yet to be
delivered, hence constitute a source of funds.

• Formal Credit Arrangements

 Commercial Paper (CP)

CP is a short term unsecured promissory note issued by large corporations. The maturity could
range from days to months.

 Bank Credit Arrangements

Bank credit is available in several different forms such as working capital term loan, cash credit,
overdraft, bill discounting etc

 Line of Credit

Line of credit is an agreement between the bank and the borrower wherein the bank commits a
certain line of credit permitting the company to borrow upto that limit during a specified period.

 Revolving Credit Arrangement

It is similar to line of credit, but is revolving in nature as name suggests. This means that as and
when the amounts drawn are repaid, the facility becomes available once again.

 Unsecured and Secured Borrowings

Unsecured borrowings are those loans that are advanced on the strength of the borrower’s
financial statement and expectation of future cash flows

Secured loans are loans, where as part of loan agreement, the lender has claim on a specific set
of assets in case of default by borrower.

 Funding Receivables

Companies get their receivables funded either by pledging their receivables and taking a loan
against the same by factoring receivables.

 Bill Discounting

Bill of exchange may be discounted by the firm from a bank to meet urgent needs.

UNIT II

Cash Management

Cash management is concerned with the managing of:

 cash flows into and out of the firm,

 cash flows within the firm, and
  cash balances held by the firm at a point of time by financing deficit or investing
surplus cash

Cash management cycle

Objectives of Cash Management

Cash planning:: cash budget should be prepared for this purpose

Managing the cash flows:: positive cash flows should be increased and negative cash flows
should be decreased

Optimum cash level: trade off between excess cash and cash deficiency

Investing surplus cash:: exploring short term investment opportunities

Motives for Holding Cash

The transactions motive - Hold cash to conduct day to day business.

The precautionary motive - Hold cash to meet contingencies in future.

The speculative motive- holding cash for investing in profit making opportunities.

Managing cash flows

Methods of accelerating cash inflows

1. prompt payment by customers

2. quick conversion of payment into cash
3. decentralized collection
4. lock box system

Methods of slowing cash outflows

1. paying on last date

2. payment through drafts
3. adjusting payroll funds
4. centralized collections
 5. inter bank transfer
6. making use of float

Cash Forecasting and Budgeting

Cash budget is the most significant device to plan for and control cash receipts and payments.

Cash forecasts are needed to prepare cash budgets.

Cash budget:

A cash budget is an estimate of cash receipts and disbursements of cash during a future period of time.

In the words of Soloman Ezra, a cash budget is “an analysis of flow of cash in a business over a future,
short or long period of time. It is a forecast of expected cash intake and outlay.”

Optimum Cash Balance

Optimum Cash Balance under Certainty: Baumol’s Model

Optimum Cash Balance under Uncertainty: The Miller–Orr Model

Baumol’s Model–Assumptions:

 The firm is able to forecast its cash needs with certainty.

 The firm’s cash payments occur uniformly over a period of time.

 The opportunity cost of holding cash is known and it does not change over time.

 The firm will incur the same transaction cost whenever it converts securities to cash.

Baumol’s Model

 The firm incurs a holding cost for keeping the cash balance. It is an opportunity cost; that is, the
return foregone on the marketable securities. If the opportunity cost is k, then the firm’s holding
cost for maintaining an average cash balance is as follows:

Holding cost = k (C / 2)
 The firm incurs a transaction cost whenever it converts its marketable securities to cash. Total
number of transactions during the year will be total funds requirement, T, divided by the cash
balance, C, i.e., T/C. The per transaction cost is assumed to be constant. If per transaction cost is
c, then the total transaction cost will be:
Transaction cost = c(T / C )
  The total annual cost of the demand for cash will be:

Total Cost = K(C/2 + c(T/C)

 The optimum cash balance, C*, is obtained when the total cost is minimum. The formula for the
optimum cash balance is as follows:

2cT
C* 
k

The Miller–Orr Model

The MO model provides for two control limits–the upper control limit and the lower control
limit as well as a return point.

If the firm’s cash flows fluctuate randomly and hit the upper limit, then it buys sufficient
marketable securities to come back to a normal level of cash balance (the return point).

Similarly, when the firm’s cash flows wander and hit the lower limit, it sells sufficient marketable
securities to bring the cash balance back to the normal level (the return point).

The Miller-Orr Model

 The difference between the upper limit and the lower limit depends on the following factors:

1. the transaction cost (c)

2. the interest rate, (i)
3. the standard deviation (s) of net cash flows.

 The formula for determining the distance between upper and lower control limits (called Z) is as
follows:

(Upper Limit – Lower Limit) = (3/4 x Transaction Cost x Cash Flow Variance/ Interest Rate) 1/3

INVESTING SURPLUS CASH

While selecting Investment Opportunities three things should be kept in mind; Safety, Maturity, and
Marketability.

Short-term Investment Opportunities: Treasury bills, Commercial papers, Certificates of deposits, Bank
deposits, Inter-corporate deposits, Money market mutual funds.
 UNIT III

Inventory: Stocks of manufactured products and the material that make up the product.

Inventory Types

 raw materials
 work-in-process
 finished goods
 stores and spares (supplies)

Objectives of Inventory Management

1. To maintain a large size of inventories of raw material and work-in-process for efficient and
smooth production and of finished goods for uninterrupted sales operations.
2. To maintain a minimum investment in inventories to maximize profitability.

An effective inventory management should:

 Ensure a continuous supply of raw materials, to facilitate uninterrupted production

 Maintain sufficient stocks of raw materials in periods of short supply and anticipate
price changes
 Maintain sufficient finished goods inventory for smooth sales operation, and efficient
customer service.
 Minimize the carrying cost and time, and
 Control investment in inventories and keep it at an optimum level.

Inventory Management Techniques

 Economic order quantity (EOQ)

ordering costs: requisitioning, order placing, transportation, receiving, inspecting and

storing, administration

carrying costs: warehousing, handling, clerical and staff, insurance, depreciation and
obsolescence

ordering and carrying costs trade-off:

2 AO
EOQ 
C

Where A= Annual Consumption, O= Ordering Cost and C= Carrying Cost

Inventory Management Techniques

Reorder point under certainty

Reorder point = Lead time x average usage

Reorder point under uncertainty

Reorder point = (Lead time x average usage) + safety stock

INVENTORY CONTROL SYSTEMS

ABC Inventory Control System

 ABC technique is an Inventory Control System

 ABC analysis tends to measure the significance of each item of inventories in terms of its value.

 The high value items are classified as ‘A items’, and would be under tightest control

 ‘C items’ represent relatively least value and would be under simple control.

 ‘B items’ fall in between ‘A’ and ‘C’ categories and require reasonable attention of management.

 ABC Analysis concentrates on important items and is also known as Control by importance and
exception (CIE).

 In ABC Analysis items are classified in the importance of their relative value, hence this approach
also called as Proportional value Analysis.

VED Analysis

• The VED analysis is used generally for spare parts.

• The requirements and urgency of spare parts is different from that of materials

• The demand for spare parts depends upon the performance of the plant and machinery.

• Spare parts are classified as;

• V – Vital

• E – Essential

• D – Desirable

• The Vital spares are a must for running the concern smoothly and these must be stored
adequately.

• The E Type of spares is also necessary but their stocks may be kept at low figures.
 • The stocking of D Type of spares may be avoided at times.

References:

I M Pandey, Financial Management, Vikas Publication.

Gupta and Sharma, Management Accounting, Kalyani Publishers