Chapter 7 Working Capital Management For MBA

Chapter 7
WORKING
CAPITAL
MANAGEMENT
Chapter 6 Working Capital Mgt. for MBA
1
Tadele H. (PhD)
Overview of Working Capital
• Working Capital is the capital of a business which
is used in its day-by-day trading operations,
calculated as the current assets minus the current
liabilities. It is also called operating assets or net
current assets.
• Working capital can be viewed as a whole but
interest is usually focused on the individual
components such as inventories or trade
receivables. Working capital is effectively the net
current assets of a business.
• WC= CA-CL
2
Tadele H. (PhD)
…Overview of Working Capital
• There are two major concepts of working capital – net
working capital and gross working capital.
• When accountants use the term working capital, they are
generally referring to net working capital, which is the
dollar difference between current assets and current
liabilities. This is one measure of the extent to which the
firm is protected from liquidity problems.
• Financial analysts, on the other hand, mean current assets
when they speak of working capital. Therefore, their focus
is on gross working capital. Because it does make sense
for the financial manager to be involved with providing the
correct amount of current assets for
the firm at all times, we will adopt the concept of gross
working capital. Chapter 6 Working Capital Mgt. for MBA
3
Tadele H. (PhD)
…Overview of Working Capital
• Net Working Capital =Current assets minus
current liabilities.
• Gross working capital =The firm’s investment in
current assets (like cash and marketable
securities, receivables, and inventory).
• Permanent working capital The amount of
current assets required to meet a firm’s long-term
minimum needs
• Temporary working capital The amount of
current assets that varies with seasonal
requirements
4
Tadele H. (PhD)
Working Capital Management
• Working capital management is the
administration of the firm’s current assets
and the financing needed to support current assets
• Working capital management refers to a
company’s managerial accounting strategy
designed to monitor and utilize the two
components of working capital, current assets
and current liabilities, to ensure the most
financially efficient operation of the company

5
Tadele H. (PhD)
…Working Capital Management
• The control of working capital is ensuring that
the company has enough cash in its bank. This
will save on bank interest and charges on
overdrafts.
• The company also needs to ensure that the
levels of inventories and trade receivables is
not too great, as this means funds are tied up in
assets with no returns (known as the
opportunity cost).
6
Tadele H. (PhD)
Significance of Working Capital
Management
The management of working capital is important for
several reasons.
• For one thing, the current assets of a typical
manufacturing firm account for over half of its
total assets. For a distribution company, they
account for even more.
• Excessive levels of current assets can easily result
in a firm realizing a substandard return on
investment. However, firms with too few current
assets may incur shortages and difficulties in
maintaining smooth operations.
7
Tadele H. (PhD)
…Significance of Working Capital
• For small companies, current liabilities are the principal
source of external financing. These firms do not have
access to the longer-term capital markets, other than to
acquire a mortgage on a building.
• The fast-growing but larger company also makes use of
current liability financing. For these reasons, the financial
manager and staff devote a considerable portion of their
time to working capital matters.
• The management of cash, marketable securities, accounts
receivable, accounts payable, accruals, and other means of
short-term financing is the direct responsibility of the
financial manager; only the management of inventories is
not.
8
Tadele H. (PhD)
…Significance of Working Capital
• Moreover, these management responsibilities
require continuous, day-to-day supervision.
Unlike dividend and capital structure decisions, you
cannot study the issue, reach a decision, and set the
matter aside for many months to come.
• Thus working capital management is important, if
for no other reason than the proportion of the
financial manager’s time that must be devoted to it.
• More fundamental, however, is the effect that
working capital decisions have on the company’s
risk, return, and share price.
9
Tadele H. (PhD)
Optimum Working Capital
• If a company’s current assets do not exceed its current
liabilities, it means it is not in a position to pay its short
term obligations and it may run into trouble with creditors
that want their money quickly.
• Current ratio (current assets/current liabilities) (along with
acid test ratio to supplement it) has traditionally been
considered the best indicator of the working capital
situation.
• It is understood that a current ratio of 2 (two) for a
manufacturing firm implies that the firm has an optimum
amount of working capital. This is supplemented by Acid
Test Ratio (Quick assets/Current liabilities) which should
be at least 1 (one).
• Thus it is considered that there is a comfortable liquidity
position if liquid Chapter
current assets are equal to current
6 Working Capital Mgt. for MBA
liabilities. Tadele H. (PhD)
10
…Optimum Working Capital
• However, it should be remembered that optimum
working capital can be determined only with reference
to the particular circumstances of a specific situation.
• Thus, in a company where the inventories are easily
salable and the sundry debtors are as good as liquid cash,
the current ratio may be lower than 2 and yet firm may
be sound.
• In nutshell, a firm should have adequate working capital to
run its business operations. Both excessive as well as
inadequate working capital positions are dangerous.
• Firms use different approaches or Policies to determine
the optimum level of working capital.
11
Tadele H. (PhD)
Working capital Policies
• In determining the appropriate amount
(Optimum amount), or level, of current assets,
management must consider the trade-off
between profitability and risk.

12
Tadele H. (PhD)
…Working capital Policies
• Based on the organizational policy and risk-

return trade off, working capital investment
decisions are categorized into three approaches
i.e.
A. Conservative
B. Moderate
C. Aggressive

13
Tadele H. (PhD)
A. Conservative Policy In this approach high
capital is invested in current assets. Management
keeps inventory level higher, and cash balance as
high as to meet any current liabilities
immediately.
Policy A provides for more current assets than any
other policy. The greater the level of current
assets, the greater the liquidity of the firm, all
other things equal.
• Policy A is seen as preparing the firm for almost
any conceivable current asset need; it is the
financial equivalent to wearing a belt and
suspenders. Chapter 6 Working Capital Mgt. for MBA
14
Tadele H. (PhD)
• The advantage of this approach are
– higher sales volume
– increased demand due to liberal credit policy and
– increase goodwill among the suppliers due to
payment in short time.
• The disadvantages are
– increase cost of capital
– higher risk of bad debts
– shortage of liquidity in long run to longer
operating cycles.
Tadele H. (PhD)
15
B Moderate Policy This approach is in between
the two approaches (Conservative and
Aggressive).
• Under this approach a balance between the risk
and return is maintained to gain more by using
the funds in very efficient manner.

16
Tadele H. (PhD)
C. Aggressive Policy Here investment in
current assets is kept at minimal which
means the entity does hold lower level of
inventory, follow strict credit policy, keeps
less cash balance etc.
• This Policy is least liquid and that is why
labeled as “aggressive.” We should keep in
mind that for every output level there is a
minimum level of current assets that the firm
needs just to get by.
17
Tadele H. (PhD)
• The advantage of this approach is that lower
level of fund is tied in the working capital
which results in lower financial costs
• But the flip side could be that the
organization could not grow which leads to
lower utilization of fixed assets and long
term debts. In the long run firm stays behind
the competitors.

18
Tadele H. (PhD)
Optimal Amount (Level)
Liquidity Analysis of Current Assets
ASSET LEVEL ($)

Policy Liquidity
Policy A
A High
Policy B
B Average
Policy C
C Low
Current Assets
Greater current asset

levels generate more 0 25,000 50,000
liquidity; all other
OUTPUT (units)
factors held constant.
of Current Assets
Profitability Analysis
ASSET LEVEL ($)

Policy Policy A
Profitability Policy B
A Low Policy C
B Average
C High Current Assets
As current asset
levels decline, total 0 25,000 50,000
assets will decline OUTPUT (units)
and the ROI will rise.

Risk Analysis of Current Assets
Policy Risk
Policy A
ASSET LEVEL ($)

A Low
Policy B
B Average Policy C
C High
Current Assets
Risk increases as the
level of current assets
are reduced. 0 25,000 50,000
OUTPUT (units)
• The alternative working capital policies in
respect to liquidity can be ranked as follows:

22
Tadele H. (PhD)
• With regards to profitability, we measure
Profitability from the point of view of assets as
(Where ROI is Return on Investment also termed as
ROA i.e. Return On Assets)
• Summary

23
Tadele H. (PhD)
• It can therefore be summarized as follows
1. Profitability varies inversely with liquidity.
Notice that for our three alternative working
capital policies, the liquidity rankings are the
exact opposite of those for profitability.
Increased liquidity generally comes at the
expense of reduced profitability.
2. Profitability moves together with risk (i.e., there
is a trade-off between risk and return). In
search of higher profitability, we must expect to
take greater risks. Notice how the profitability
and risk rankings for our alternative working
capital policies are identical. You might say that
risk and return walk hand in hand.
Tadele H. (PhD)
24
Example 1
• A firm has the following data for the year ending
January 31, 2021: Sales of 100,000 units @Br 20 each
=Br. 2,000,000, Earning after tax Br 200,000 and Fixed
Asset 500,000,
• Assume current assets amount
A. Br 500,000 - Conservative
B. Br 400,000 – Moderate
C. Br 300,000- Aggressive and fixed assets level is
constant and profits do not vary with current assets
levels.
ANALYSE the effect of the three alternative current
assets policies.
25
Tadele H. (PhD)
Working Capital Policy Conservativ Moderate Aggressiv
e e
Sales 2000,000 2,,000,000 20,00,000
Earning after tax 200,000 2,00,000 200,000

Current Assets 500,000 4,00,000 300,000
Fixed Assets 500,000 5,00,000 500,000
Total Assets 1000,000 9,00,000 800,000
Return on Total Assets 20% 22.22% 25%

(Earning after tax÷ Total
Assets)
Current Assets/Fixed Assets Tadele H. (PhD) 1.00 0.80 0.60
26
• The above computation shows that the conservative
policy provides greater liquidity (solvency) to the
firm, but lower return on total assets.
• On the other hand, the aggressive policy gives higher
return, but low liquidity and thus is very risky.
• The moderate policy generates return higher than
Conservative policy but lower than aggressive policy
which is less risky than aggressive policy but riskier
than conservative policy.
• In determining the optimum level of current assets,
the firm should balance the profitability – solvency
tangle by minimizing total costs – Cost of liquidity
and cost of illiquidity.
27
Tadele H. (PhD)
Working capital cycle
• The working capital cycle measures the time
between paying for goods supplied to you and the
final receipt of cash to you from their sale.
• It is desirable to keep the cycle as short as possible
as it increases the effectiveness of working capital.
• Working capital cycle is also known as
(operating/trading/cash cycle)

28
Tadele H. (PhD)
…Working capital cycle
• The operating cycle analyzes the accounts receivable,
inventory and accounts payable cycles in terms of
number of days.
• For example, Accounts receivables are analyzed by the
average number of days it takes to collect an account.
• Inventory is analyzed by the average number of
days it takes to turn over the sale of a product (from
the point it comes in the store to the point it is
converted to cash or an account receivable).
• Accounts payables are analyzed by the average
number of days it takes to pay a supplier invoice.
• The diagram on the next slide shows how the cycle
works.
29
Tadele H. (PhD)

30
Tadele H. (PhD)
• The table below shows how the activities of a
business have an impact on the cash flow.

31
Tadele H. (PhD)

32
Tadele H. (PhD)
• The duration of working capital cycle may vary depending
on the nature of the business.
• In the form of an equation, the operating cycle process can
be expressed as follows:
Operating Cycle = R + W + F + D – C
Where,
• R = Raw material storage period
• W =Work-in-progress holding period
• F = Finished goods storage period
• D = Receivables (Debtors) collection period.
• C = Credit period allowed by suppliers (Creditors).
• The various components of Operating Cycle may be
calculated as shown below:
33
Tadele H. (PhD)
Raw Material =Average stock of raw material
Storage Period Average Cost of Raw Material Consumption per
day
Work-in-Progress = Average Work - in- progress inventory
holding period Average Cost of Production per day
Finished = Average stock of finished goods

Goods Average Cost of Goods Sold per day
storage period
Receivables = Average Receivables
(Debtors) collection Average Credit Sales per day
period
Credit period = Average Payables
Average Credit Purchases per day
allowed by
suppliers
(Creditors) Tadele H. (PhD)
34
Working Capital Based on Operating Cycle
• One of the methods for forecasting working
capital requirement is based on the concept of
operating cycle.
• The calculation of operating cycle and the
formula for estimating working capital on its
basis has been demonstrated with the help of
following illustration:

35
Tadele H. (PhD)
Example 1 The following information of XYZ Ltd.,
• Raw material inventory consumed during the year Br
600,000, Average stock of raw material Br 50,000, Cost
of production Br 500,0000, Average work-in-progress
inventory Br 30,000, Cost of Goods aold Br 800,000,
Average finished goods stock held Br 40,000, Average
collection period from debtors 45 days, Average credit
period availed 30 days, No. of days in a year 360 days
you are required to CALCULATE:
A.Net operating cycle period.
B.Number of operating cycles in a year.
36
Tadele H. (PhD)
Solution:
A. Net Operating Cycle
• Raw Materials storage Period (R)=
Average stock of raw material/Average Cost of Raw
Material Consumption per day
= 50,000 /(50,000/360days) = 30 days
• Work-in-progress holding period (W) =
Average Work - in- progress inventory
Average Cost of Production per day
30,000
500,000÷360 days
• = 22 days Chapter 6 Working Capital Mgt. for MBA
37
Tadele H. (PhD)
• Finished Goods storage period (F) =
• = Average stock of finished goods
Average Cost of Goods Sold per day
= `40,000 / (800,000÷360 days) =18 days
• Receivables (Debtors) collection period (D) = 45
days
• Credit Period allowed by creditors (C) = 30 days
• Net Operating Cycle = R + W + F+ D – C
= 30 + 22 + 18 + 45 – 30 = 85 days
•
38
Tadele H. (PhD)
B. Number of Operating Cycles in a year =
No. of days in a year /Operating Cycle period
=360 days/85days
= 4.23 times

39
Tadele H. (PhD)
Financing Current Assets
• There are three approaches to financing
Current Assets
A. Hedging approach (Maturity Matching)
B. Aggressive approach and
C. Conservative approach.

40
Tadele H. (PhD)
…Financing Current Assets
A. Hedging (Maturity Matching) approach
• Is a method of financing where each asset would be
offset with a financing instrument of the same
approximate maturity. The firm can adopt a financial
plan which involves the matching of the expected life of
assets with the expected life of the source of funds raised
to finance assets.
• Thus, a ten years loan may be raised to finance a plant
with an expected life of ten years; stock to be sold thirty
day may be financed with a thirty-day bank loan or so on.
• Thus, when the firm follows matching approach, long-
term financing will be used to finance fixed assets and
permanent current assets.

41
Tadele H. (PhD)

42
Tadele H. (PhD)
B. Conservative Approach- Is an approach that
uses more long-term financing than is needed
under a matching approach. In this approach, a
firm is financing a portion of its temporary
current assets requirement with long term
financing. Also in periods where the firm has no
temporary current assets, the firm has excess
financing available that will be invested in
marketable securities. These plans are called
conservative because they involve relatively
heavy use of long-term financing.

43
Tadele H. (PhD)

44
Tadele H. (PhD)
C. Aggressive approach -Use less long-term
and more short-term financing than the
conservative approach. Under an aggressive
policy, the firm finances a part of its
permanent current assets with short-term
financing. Some extremely aggressive firms
may even finance a part of their fixed assets
with short-term financing. The relatively more
use of short-term financing makes the firm
more risky.
45
Tadele H. (PhD)
Financing Current Assets

46
Tadele H. (PhD)
Reading/Actual
Assignment
• Management of Cash and Marketable
Securities
• Receivable Management
• Inventory Management

47
Tadele H. (PhD)
End Of
Chapter
48
Tadele H. (PhD)

Chapter 7 Working Capital Management For MBA

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Chapter 7

Chapter 6 Working Capital Mgt. for MBA

Chapter 6 Working Capital Mgt. for MBA

• Based on the organizational policy and risk-

Chapter 6 Working Capital Mgt. for MBA

Chapter 6 Working Capital Mgt. for MBA

Chapter 6 Working Capital Mgt. for MBA

ASSET LEVEL ($)

Greater current asset

ASSET LEVEL ($)

Optimal Amount (Level)

ASSET LEVEL ($)

Chapter 6 Working Capital Mgt. for MBA

Chapter 6 Working Capital Mgt. for MBA

Earning after tax 200,000 2,00,000 200,000

Fixed Assets 500,000 5,00,000 500,000

Total Assets 1000,000 9,00,000 800,000

Return on Total Assets 20% 22.22% 25%

Chapter 6 Working Capital Mgt. for MBA

Chapter 6 Working Capital Mgt. for MBA

Chapter 6 Working Capital Mgt. for MBA

Chapter 6 Working Capital Mgt. for MBA

Finished = Average stock of finished goods

Chapter 6 Working Capital Mgt. for MBA

Chapter 6 Working Capital Mgt. for MBA

Chapter 6 Working Capital Mgt. for MBA

Chapter 6 Working Capital Mgt. for MBA

Chapter 6 Working Capital Mgt. for MBA

Chapter 6 Working Capital Mgt. for MBA

Chapter 6 Working Capital Mgt. for MBA

Chapter 6 Working Capital Mgt. for MBA

Chapter 6 Working Capital Mgt. for MBA

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