WORKING CAPITAL MANAGEMENT

OUTLINE
Characteristics of Current Assets
Factors Influencing Working Capital Requirements
Level of Current Assets
Current Assets Financing Policy
Profit Criterion for Current Assets
Operating Cycle Analysis
Cash Requirement for Working Capital
-

CHARACTERISTICS OF CURRENT ASSETS

Short life span
Swift transformation into other asset forms
Current Assets Cycle
Finished
goods

Accounts
receivable

Work-inprocess
Wages, salaries,
factory overheads
Raw materials

Cash
-

Suppliers

FACTORS INFLUENCING WORKING

REQUIREMENTS
Nature of Business
Seasonality of Operations
Production Policy
Market Conditions
Conditions of Supply
-

CAPITAL

WORKING CAPITAL POLICY

Two important issues in working capital policy are:
What should be the level of investment in current
assets?
What mix of long-term and short-term financing should
the firm employ to support current assets?

LEVEL OF CURRENT ASSETS

Liquidity
Inventories
Debtors

Flexible
(Conservative)
Policy
High
Large
High

Restrictive
(Aggressive)
Policy
Low
Small
Low

A flexible policy results in fewer production stoppages, ensures

quicker deliveries to customers, and stimulates sales .. but
HIGHER INVESTMENT IN CURRENT ASSETS
A restrictive policy leads to more production stoppages, delayed
deliveries to customers, and lost sales but
LOWER INVESTMENT IN CURRENT ASSETS
-

CAPITAL REQUIREMENTS
AND THEIR FINANCING
Fluctuating current
asset requirement
Capital
requirements
A
B
C

Permanent current
asset-requirement

Fixed asset
requirement

Time
-

CURRENT ASSETS FINANCING

POLICY
According to the matching principle, fixed assets and
permanent current assets should be supported by longterm sources of finance whereas fluctuating current assets
must be supported by short-term sources of finance.

PROFIT CRITERION FOR

WORKING CAPITAL
Investment in current assets is easily reversible.
For reversible investments, the criterion of net profit per
period (which here means residual income) is equivalent
to the criterion of net present value

OPERATING CYCLE AND CASH CYCLE

Order placed

Stock arrives

Goods sold
Inventory period

Cash received
Accounts
receivable period

Accounts
payable period
Firm receives
invoice

Cash paid for

materials
Operating cycle
Cash cycle

Average inventory
Inventory period =
Average COGS / 365
Average accounts receivable
Accounts receivable period =
Annual sales / 365
Average accounts payable
Average payable period =
Average COGS / 365
-

ILLUSTRATION
Financial Information for Horizon Limited
Balance Sheet Data
Profit and Loss
Account Data

Beginning of
20X0

End of
20X0
102

Sales

800

Inventory

96

Cost of goods

720

Accounts receivable

86

90

Accounts payable

56

60

Sold

(96 + 102) / 2
Inventory period =

= 50.1 days
720 / 365

(86 + 90) / 2
Accounts receivable period =

= 40.2 days
800 / 365
(56 + 60) / 2

Accounts payable period

= 29.4 days
720 / 365

Operating cycle

50.1
+
40.2
= 90.3 days
Inventory
Accounts
period
receivable
period

Cash cycle

90.3
29.4
= 60.9 days
Operating
Accounts
cycle
payable period
-

CASH REQUIREMENT FOR

WORKING CAPITAL
Step 1 : Estimate the cash cost of various current assets
required by the firm.
Step 2 : Deduct the spontaneous current liabilities from
the cash cost of current assets

SUMMING UP
Current assets have a short life span and are swiftly
transformed into other asset forms.
The working capital needs of a firm are influenced by
numerous factors : nature of business, seasonality of
operations, production policy, market conditions, and
supply conditions.
Determining the optimal level of current assets involves
a tradeoff between carrying costs and shortage costs.
According to the matching principle, the maturity of the
sources of finance should match the maturity of assets
being financed.
-

 The operating cycle of a firm begins with the acquisition

of raw materials and ends with the collection of
receivables.
The cash requirement of working capital is calculated by
estimating the cash cost of various current assets
required by the firm and deducting the spontaneous
current liabilities from the cash cost of current assets.