Working Capital Management
Working Capital refers to current assets which represent the portion of investment that
circulates from one form to another in the ordinary conduct of business. -Khan and Jain
Working capital means a firm’s in short term assets like- cash, marketable securities,
inventories and accounts receivables. -Brigham
Working capital refers to the firm’s current assets and current liabilities which represents
the portion of short term investment and short term financing that circulates from one
form to another in the ordinary course of business. Working capital management involves
management of firm’s short term assets and short term liabilities individually and in
aggregate.
Working capital management is one of the major financial management decision which
concerns about the management of current assets (cash, Bank balances, marketable
securities, inventories, accounts receivables, prepaid expenses etc) and current liabilities
(accounts payable, notes payable, accruals etc) that comprises the top half of the balance
sheet.
Working capital management involves dealing with the following decisions:
(a) How should the firm manage it’s cash?
(b) To whom should the firm grant credit?
(c) How much inventory should the firm carry?
(d) What should be the composition of firm’s current debt?
There is difference in opinion about the definition of working capital. Considering the
objectives and scope of working capital it can be defined in two ways:
a) Gross concept: According to the gross concept, working capital means total of all
the current assets of a business. It is also called gross working capital.
Gross Working Capital = Total Current Asset
b) Net concept: According to net concept of working capital, net working capital
means the excess of current assets over current liabilities. if current assets are
equal to current liabilities then according to this concept working capital will be
zero.
Net Working Capital = Current Assets – Current Liabilities
Under this concept the relationship between current assets and current liabilities are is
established or their liquidity is determined. When the current assets exceeds the
current liabilities the firm has positive net working capital, in other words the firm
has negative working capital when current asset is less than the current liabilities.
In evaluating a firm’s net working capital position, an important consideration is the
trade-off between profitability and risk. In other words the level of net working
TASNIM UDDIN CHOWDHURY, Assistant Professor, Department of Finance, FBS
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capital has an impact on profitability as well as risk. It is assumed that the greater the
amount of net working capital the less risk prone the firm has i.e. the more liquid the
firm is the less possibility to become technically insolvent. But it is evident that when
current asset increases profitability decreases because current assets are less profitable
than fixed assets. Fixed assets add more value to the firm, as without such asset a firm
can not produce the product. Therefore, though current assets increase net working
capital and liquidity thereby reducing the risk of insolvency, it also reduces the
profitability of a firm.
Brigham defines net working capital as the “difference between current assets and
current liabilities, the portion of current assets financed by long term funds”.
The Difference between the gross working capital and the net working capital can be
understood with the help of the following illustration.
Problem: 1 from the following balance sheet, you are required to calculate the
amount of gross working capital and the net working capital.
Liabilities & OE Tk. Assets Tk.
Bills payable 10000 Cash & Bank Balance 10000
Accounts payable 40000 Marketable Securities 90000
Short term loan 50000 Accounts receivable 100000
Debentures 400000 Bills Receivable 40000
Reserves 100000 Inventory 70000
Share Capital 1000000 Plant and Machinery 290000
Land and Building 1000000
Total 1600000 Total 1600000
Importance of working capital
Every business needs some amount of working capital. The need for working capital
arises due to the time gap between the production and realization of cash from sales. Thus
working capital is needed for the following purposes:
1. For the purchase of raw material, components and spares parts.
2. To pay wages and salaries
3. To incur day-to-day expenses.
4. To meet the costs of selling, packing and advertising.
5. To provide the credit facilities to the customers.
6. To maintain the inventories of Raw material, work in progress and finished stock
7. To overcome the liquidity problem.
8. To reduce uncertainty regarding the demand, market price, quality etc.
9. For the transaction, speculation and precautionary motive.
10. To pay notes / bills payable and other obligations in a planned manner.
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Working Capital Cycle:
There is an operating cycle involved in the sales and realization of cash. The cycle starts
with the purchase of raw material and ends with the realization of cash from sales of
finished foods. It involves purchase of raw material and stores, it conversion in to stock
of finished goods through work-in- progress, conversion of finished stock in to sales,
debtors and receivables and ultimately in cash and this cycle continues again from cash to
purchase of raw material and so on.
In brief, working capital cycle shows how cash and marketable securities transit into and
leave from the firm through different stages.
Direct Labor
& Raw
Used in
Material
Production
Process Used to Purchase
Generates Cash & Return to capital
Suppliers
Marketable
Cash sales Securities Financing of capital
Inventory
Collection Process
Accounts
Via sales Receivable
generates
Working capital cycle involves conversions and rotation of various
constituents/components of the working capital. Initially ‘cash’ is converted into Raw
materials. Subsequently, the raw materials get converted into work in process and then
into finished goods. When sold on credit, the finished goods assume the form of debtors
who give the business cash on due date. Thus ‘cash’ assumes its original form again at
the end of one such working capital cycle but in the course it passes through various other
forms of current assets too. This is how various components of current assets keep on
changing their forms due to value addition.
Working Capital Policy:
This involves policy regarding the level of current assets and current liabilities to strike a
balance between profitability and liquidity that contributes positively to the firm’s value.
Working capital policy refers to the decision relating to the level of current assets and the
way they are financed.
Working capital policy involves decision regarding (a) the target levels for each current
asset account & (b) how these current assets will be financed.
There are three alternative policies regarding the level of current assets carried.
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1. Conservative Working capital Policy: also referred as “fat cat” or “relaxed
Current Asset Investment Policy”. It is the policy under which relatively large
amounts of cash, marketable securities and inventories are carried and under
which sales are stimulated by a liberal credit policy, resulting a high levels of
receivables.
2. Aggressive Working capital Policy: also referred as “lean and mean” or
“restricted Current Asset Investment Policy”. It is the policy under which
holdings of cash, marketable securities and inventories are minimized.
3. Matching Working capital Policy: also referred as “Moderate Current Asset
Investment Policy”. Its a policy between the Conservative Working capital Policy
& Aggressive Working capital Policy.
The aforementioned figure shows three alternative policies regarding the size of current
asset holdings. The top line has the steepest slope, which indicates that the firm holds a
great deal of cash, marketable securities, receivables, and inventories relative to its sales.
When receivables are high, the firm has a liberal credit policy, which results in a high
level of accounts receivable. This is a relaxed investment policy. On the other hand, when
a firm has a restricted (or tight or “lean-and mean”) investment policy, holdings of
current assets are minimized. A moderate investment policy lies between the two
extremes.
Problem: 2
Crystal Ltd is considering to develop a current asset policy. It’s fixed assets are amounted
to tk. 12,00,000 and the company plans to maintain 50% debt in it’s capital structure. The
rate of interest on debt is 10%. The three current asset policies under consideration are to
carry current assets that total 40%, 50% and 60% of projected sales of Tk. 45,00,000. The
TASNIM UDDIN CHOWDHURY, Assistant Professor, Department of Finance, FBS
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company expects an EBIT of 15% of it’s sales. The tax rate is 40% . you are required to
assist the company to determine the working capital level of the company.
Determinants of W/C levels:
The working capital needs of a business are influenced by numerous factors. The
important ones are discussed in brief as given below:
i. Nature of Enterprise
The nature and the working capital requirements of an enterprise are interlinked. While a
manufacturing industry has a long cycle of operation of the working capital, the same
would be short in an enterprise involved in providing services. The amount required also
varies as per the nature; an enterprise involved in production would require more working
capital than a service sector enterprise.
ii. Manufacturing/Production Policy
Each enterprise in the manufacturing sector has its own production policy, some follow
the policy of uniform production even if the demand varies from time to time, and others
may follow the principle of 'demand-based production' in which production is based on
the demand during that particular phase of time. Accordingly, the working capital
requirements vary for both of them.
iii. Operations
The requirement of working capital fluctuates for seasonal business. The working capital
needs of such businesses may increase considerably during the busy season and decrease
during the slack season. Ice creams and cold drinks have a great demand during summers,
while in winters the sales are negligible.
iv. Market Condition
If there is high competition in the chosen product category, then one shall need to offer
sops like credit, immediate delivery of goods etc. for which the working capital
requirement will be high. Otherwise, if there is no competition or less competition in the
market then the working capital requirements will be low.
v. Availability of Raw Material
Major part of the Working Capital requirements are largely depend on the availability of
raw materials. If raw material is readily available then one need not maintain a large
stock of the same, thereby reducing the working capital investment in raw material stock.
On the other hand, if raw material is not readily available then a large inventory/stock
needs to be maintained, thereby calling for substantial investment in the same.
vi. Growth and Expansion
Growth and expansion in the volume of business results in enhancement of the working
capital requirement. As business grows and expands, it needs a larger amount of working
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capital. Normally, the need for increased working capital funds precedes growth in
business activities.
vii. Price Level Changes
Generally, rising price level requires a higher investment in the working capital. With
increasing prices, the same level of current assets needs enhanced investment.
viii. Manufacturing Cycle
The manufacturing cycle starts with the purchase of raw material and is completed with
the production of finished goods. If the manufacturing cycle involves a longer period, the
need for working capital would be more.
ix. Credit policy
Credit policy of sales and purchase also affect the Working Capital requirements of the
business concern. If the company maintains liberal credit policy to collect the payments
from its customers, they have to maintain more Working Capital. If the company pays the
dues on the last date it will create the cash maintenance in hand and bank.
x. Growth and expansion
During the growth and expansion of the business concern, Working Capital requirements
are higher, because it needs some additional Working Capital and incurs some extra
expenses at the initial stages.
8. Earning capacity: If the business concern consists of high level of earning capacity,
they can generate more Working Capital, with the help of cash from operation. Earning
capacity is also one of the factors which determines the Working Capital requirements of
the business concern.
Cash Conversion Cycle (CCC)
The net number of days or length of time from the purchase of raw materials to
manufacture a product until the collection of the accounts receivables associated
with the sale of the product. - Brigham
Cash conversion cycle model focuses on the length of time between when the
company makes payment or invests in the manufacture of inventory and when it
receives cash inflows or realizes a cash return from it’s investment in production.
The following periods are considered while determining CCC:
1. Inventory Conversion Period (ICP): The net number of days or length of time
required to convert raw materials into finished goods and to sell those goods. It is the
time number of days a product remains in inventory in various stages of production.
The faster it completes the cycle is better.
ICP = Inventory / COGS per day
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2. Receivables Collection Period (RCP): The average length of time required to
convert the firm’s receivables into cash. The RCP is also called “The Days Sales
Outstanding (DSO)” and is calculated as follows:
RCP = Receivables / Credit Sales per day
3. Payables Deferral Period (PDP): The average length of time between the purchase of
raw materials and labor and the payment of cash for them. It is computed by dividing
accounts payable by the daily purchases.
PDP = Accounts payable / Credit Purchase per day
Therefore,
Cash Conversion Cycle (CCC) = Inventory Conversion Period (ICP) + Receivables
Collection Period (RCP) – Payables Deferral Period (PDP)
The cash conversion cycle can be shortened by-
1. Reducing the Inventory Conversion Period by processing and selling goods more
quickly.
2. Reducing the receivables collection period by speeding up collections.
3. Lengthening the payables deferral period by slowing down own payments, but the
firm should be careful about it’s reputation.
Problem: 3
ABC Ltd. has been in business for several years and is now in a stable position—placing
orders, making sales, obtaining collections, and making payments on a recurring basis.
The following data were taken from its latest financial statements:
Credit sale = tk.4,50,000
Credit purchase = tk.3,80,000
Inventory = tk.90,000
Cost of Goods Sold = 60% of total sale of tk.6,00,000
Accounts payable = tk.1,45,000
Accounts Receivable= tk. 3,60,000
Required: a) Cash Conversion Cycle b) Net Working Capital
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