Working Capital Management

The goal of working capital management is to manage the firm’s current assets and current liabilities in such a way that a satisfactory level of working capital is maintained. This is so because if the firm cannot maintain satisfactory level of working capital, it is likely to become insolvent and may even be forced into bankruptcy.

• Net working capital is the difference
between current assets and current liabilities. • Net working capital is that portion of a firm’s current assets which is financed with long term funds. Every firm operate with some level of working capital depending upon the size and nature of the industry and various other factors.

Trade-off between profitability & Risk
The level of firm’s has a bearing on its profitability as well as risk. The term profitability used in this context is measured by profits after expenses. The term risk is defined as the probability that a firm will become insolvent.

Nature and assumption
The basic assumptions are as follows •We are dealing with a manufacturing firm •Current assets are less profitable than fixed assets •Short term funds are less expensive than long term funds Total Assets=Current Assets +Fixed Assets
Net Working Capital = Current Assets- Current Liabilities

For this two ratios are calculated and analyzed on the criteria of risk and profitability: •Effect of level of current assets on profitability and risk •Effect of level of current liability.

Current Assets/Total Assets Ratio
This ratio indicates the percentage of total assets that are in the form of current assets. A change in the ratio will reflect a change in the amount of current assets. • Effect of higher ratio • Effect of Decrease

Current Liability/Total Assets ratio
This ratio will indicate the percentage of total assets financed by current liabilities. The effect of in the level of current liabilities would reflect in the profitability. • Effect of increase • Effect of decrease

Planning of working Capital




Operating Cycle
“The continuing flow from cash to suppliers, to inventory, to accounts receivables and back into cash is called the operating cycle”. Since the cash outflow and cash inflow do not match, firms have to necessarily keep or invest in short term liquid securities so that they will be in a positions to meet obligations when they become due.

Types of working capital
• Permanent working capital (fixed) • Temporary working capital (variable)

Estimating Working Capital Requirement
For this purpose the length of cash to cash cycle is measured: Gross operating cycle=inventory Conversion period + Debtors conversion Period =(RMCP+WIPCP+FGCP) + DCP Conversion period depends on • Consumption per day • Inventory

RMCP=Raw Material Inventoryx360/RMC Similarly, WIPCP= WIPIx360/COP FGCP = FGIx360/COGS Debtors conversion period =Debtors x360/Credit Sales Payment Deferral Period (PDP) = Creditors x 360/credit purchases Net Operating Cycle= Gross operating cycle- Payment Deferral Period.

Factors affecting Working Capital
• Nature of Business:Public utility and trading • • • • • • • • •
company Production Cycle: Distillery and Bakery Business Cycle: recession and boom Production Policy: seasonal variations Credit Policy: liberal and strict Growth and expansion:growing and static Comp Availability and fluctuations in raw material Profit Level: extent of cash profit Price level changes: rise in level high W.Cap Operating Efficiency

Cash Management
Motives: Transaction motive Precautionary Motive Speculative Motive Compensation Motive

Factors determining Cash needs
• Synchronization of cash needs • Short costs • Excess cash balance cost • Procurement & management
cost • Uncertainty cost

Cash Management Techniques
• Efficient Inventory Management • Speedy collection of accounts
receivable 4. Prompt payment by customers 5. Early conversion of payment into cash

Speedy collection techniques
• Concentration Banking • Lockbox System

Receivables Management
Receivables management is done to evaluate the credit policy of the organization as the credit policy affects the working capital position indirectly. It is also known as Trade-Credit Management because it has to strike a balance between liquidity and profitability.

Cost associated with Debtors Management
• Collection cost • Capital cost (additional capital) • Delinquency Cost (blocking of funds) • Default Cost

• IT is oriented to sales expansion • Protection to current sales against

Decision Areas
• Credit Standard- character, capacity
and condition • Credit Terms- credit period and discount • Collection policies

Inventory Management
Inventory is of three types: • Raw Material • Work in Process • Finished Goods

• To minimize the firm’s investments in
inventory • To meet demand for the product by efficiently organizing the firm’s production and sales operations.

Cost of Holding Inventory
• Ordering cost: it is the cost associated with
the ordering of inventory from suppliers. It is inversely related to the size of inventory ordered. • Carrying cost: the cost associated with maintenance or carrying of inventory such as storage, insurance and opportunity cost of funds. Carrying cost and size of the inventory are positively related.

Inventory Control/management
• The classification problem (ABC
analysis) • The order quantity problem (EOQ) • The order point problem (Reorder point) • Safety Stock

Economic Order Quantity
It is the level of inventory order that minimizes the total cost associated with inventory management.

Where, s=usage unit for the inventory planning period O=the ordering cost per unit C=the carrying cost per unit

Reorder point
That level of inventory when fresh order should be placed with the suppliers for procuring additional inventory equal to the EOQ. Reorder point=Safety Stock + (lead time in days X avg. daily usage of inventory) Lead time refers to the time normally taken in receiving the delivery of inventory after placing the order with the suppliers. Average usage means the quantity of inventory consumed daily.

Safety Stock
The effect of increased usage and/or slower delivery would be a shortage of inventory. The firm may face stock-out situation. Therefore, firm keeps a sufficient safety margin by having additional inventory to guard against stock-out situation. Safety stock is defined as the minimum additional inventory to serve as a safety margin or buffer or cushion to meet contingent needs.

Sign up to vote on this title
UsefulNot useful