WORKING CAPITAL

MANAGEMENT

Introduction
Management of current assets similar to fixed assets. Both effects
risk and return.
Primary differences;
In fixed assets, time important factor, consequently discounting and
compounding techniques play important role
Large holding of current assets, strengthens the firms liquidity
position, but also reduces the profitability. Thus risk-return trade off
is involved in current assets.
Level of fixed assets and current assets depend on sales, but it is
only current assets which can be adjusted in the short run with sales
fluctuations. This current assets has flexibility

Long & Short Term Assets &

Liabilities

Net Working Capital

Working Capital includes a firms current assets,
which consist of cash and marketable securities
in addition to accounts receivable and
inventories.
It also consists of current liabilities, including
accounts payable (trade credit), notes payable
(bank loans), and accrued liabilities.
Net Working Capital is defined as total current
assets less total current liabilities.

Net Working Capital

Profitability versus
Liquidity
It is critical to point out that profitability and
liquidity (or cash flow) are not
necessarily the same.
A business can be profitable, and yet
experience
serious cash flow problems.
The key is in the length of the working capital
cycle -- or how long it takes to convert cash
back into cash.

Net Working Capital

Profitability versus
Liquidity
The Current Position of Berenson Com pany
Current Assets
Cash

Current Liabilities
$

500

A/P

M/S

200

N/P

800

A/R

800

Accruals

200

Inventories
Total

600

1,200
$

2,700

Total

1,600

Will Berenson be able to pay its

bills?

The Tradeoff Between Profitability &

Risk
Positive Net Working Capital

low
return

Current
Assets
Net Working
Capital > 0

Current
Liabilities

Long-Term
Debt

low
cost

high
cost

high
return

Fixed
Assets

Equity

highest
cost

The Tradeoff Between Profitability &

Risk
Negative Net Working Capital

low
return

Current
Assets

high
return

Fixed
Assets

Current
Liabilities
Net Working
Capital < 0

low
cost

Long-Term
Debt

high
cost

Equity

highest
cost

The Tradeoff Between Profitability &

Risk

Operating Cycle
The Operating Cycle (OC) is the time
between ordering materials and collecting
cash from receivables.
Phase 1 Cash gets converted into inventories
Phase 2 Inventories gets converted into receivables.
Phase 3 Receivables gets converted into cash.

Stage 1

Stage 2

Stage 3

Stage 4

Raw material

WIP

Finished Goods

Receivable

Importance Operating Cycle

The application of operating cycle concept is
mainly useful to ascertain the requirement of
cash working capital to meet the operating
expenses of a going concern.
This is an important concept because the longer
the operating cycle, the more working capital
funds the firm needs.
This concept more precisely measures the
working capital fund requirements, traces its
changes and determines the optimum level of
working capital requirements.

Operating Cycle
In a manufacturing firm, the operating cycle starts with the
purchase of materials. There involves Raw Materials
Conversion Period (RMCP).
Once materials are issued to production, it again involves time
gap between issue of materials and production of finished
products. This time gap is called as Work-in-progress
conversion period (WIPCP).
Till the demand for finished product materializes, the product
would remain in the store. This period is termed as Finished
Goods Conversion Period (FGCP).
The enterprise extends credit facilities to customers. This time
gap between sale and realization of cash is known as Book
Debt Conversion Period (BDCP).
Business enterprises receive credit in the purchase of raw
materials from the suppliers. This period is called as Payment
Deferral Period (PDP). This payment deferral period reduces

Operating Cycle
Raw Materials conversion period:
Average value of Raw materials stock / Average
consumption
of Raw material per day
Work-in-progress conversion period:
Average work-in-progress / Average cost of
production per
day
Finished goods conversion period:
Average stock of finished goods / Average cost of
goods sold
per day
Book debts conversion period:
Average value of receivables / Average value of sales
per day

Gross and Net Operating Cycle

1. Raw Materials conversion period
2. Work-in-progress conversion period
3. Finished goods conversion period
4. Book debts conversion period
= GROSS OPERATING CYCLE
Less:
5. Payment deferral period
= NET OPERATING CYCLE

Items
Purchase of raw material (credit)
Opening raw material
Closing raw material
Raw material consumed
Direct labour
Depreciation
Other mfr expenses
Total cost
Opening WIP
Closing WIP
Cost of production
Opening finished goods
Closing finished goods
Cost of goods sold
Selling expenses
Cost of sales
Sales
Opening debtors
Closing debtors
Opening creditors
Closing creditors

Actual

Projected
4653
523
827
4349
368
82
553
5352
185
325
5212
317
526
5003
304
5307
6087
545
735
300
454

6091
827
986
5932
498
90
704
7224
325
498
7051
526
995
6582
457
7039
8006
735
1040
454
642

Items
Purchase of raw material
(credit)

Actual

Projected

4653

6091

Opening raw material

523

827

Closing raw material

827

986

Raw material consumed

4349

5932 12.08

Direct labour

368

498

Depreciation

82

90

553

704

5352

7224

Opening WIP

185

325

Closing WIP

325

498

Other mfr expenses

Total cost

Cost of production

5212

7051 14.48

Opening finished goods

317

526

Closing finished goods

526

995

Cost of goods sold

Selling expenses

5003
304

6582 13.90
457

Days
actual

days
proj

68.46

16.48

59.84

22.45

19.59

25.43

37.85

18.28

54.42

Estimating working capital needs

Three approaches:
1. Current assets holding period
2. Ratio of sales
3. Ratio of fixed investment

Working capital needs Current assets holding period

Material cost
Raw material consumed
Less: by-product
Net material cost
Manufacturing cost
Labour
Maintenance
Power and fuel
Administration overhead
Depreciation
Total manufacturing cost
Total product cost
Annual sales
PBIT
Investment
Period
Plant life
PBDIT
ROI

248000
68800
179200
171200
160000
57600
240000
160000
788800
968000
1448000
480000
1600000
1 year
10 year
640000
33.30%

Inventory is 1 month supply of RM, WIP(Conversion 50%), FG. Debtors 1

month sales, cash one months total costs

Material

248000 20666.67

WIP

388800 36866.67

FG

(Assuming
Depreciation
968000 80666.67 included)

debtors
Operating cash
Total

1448000 120666.7
968000 80666.67
339533.3

Illustration Working capital finance

The following figures are available for 20 microns ltd
Sales ( 2 months credit)

36,00,000

Material consumed (suppliers extend 2 months

credit)

9,00,000

Wages paid (monthly in credit)

7,20,000

Manufacturing expenses outstanding at the

end of the year
(cash expenses are paid 1 month in arrears)
Total administration expenses, paid as above

80,000

2,40,000

Sales promotion expenses, paid quarterly in

1,20,000
The
company sells its products on GP of 25% counting
advance
depreciation as part of cost of production. It keeps 1 months
stock each of raw materials and finished goods, and cash
balance of Rs 1,00,000.
Assume 20% safety margin, calculate working capital
requirement of the company on cash cost basis. Ignore work
in progress.

Sales

360000
0

Total cash cost

Less: Margin @ 25%

900000

Total manufacturing cost 2700000

Total cost

270000
0

Less: Depreciation

Less: Material expense

900000

Less: Wages

720000

Add: Administration
expenses

240000

Manufacturing expenses

108000
0

Add: Sales promotion

expenses

120000

Cash manufacturing
expenses

960000

Depreciation

120000

120000
2580000

2940000

Current asset
Debtors
Raw material
Finished goods
Prepaid expenses
cash balance

Current liabilities
4900
00
7500
0
2350
00
3000
0
1000
00
9300
00

Creditors
Manufacturing
expenses
Wages
Administrative
expenses

WC
Add: Safety margin

15000
0
80000
60000
20000
31000
0
62000
0
12400
0
74400
0

Risk - return trade off

Firm has the following data for some future
year
Sales (10000 units @ Rs 15)
15,00,000
EBIT
1,50,000
Fixed assets
5,00,000
The three possible current assets holding
scenario of the firm are
Rs 5 lakhs, Rs 4 lakhs, Rs 3 lakhs
It is assumed that fixed assets level is
constant and profits do not vary with
current assets level.

A
sales

1500000 1500000 1500000

EBIT

150000

150000

150000

CA

500000

400000

300000

FA

500000

500000

500000

TA

1000000

900000

800000

0.15 0.166667

0.1875

ROA
CA/FA

0.8

0.6

CA/TA

.50

.44

.37

Policies for financing current assets

1. Long term financing
2. Short term financing
3. Spontaneous financing
Depending on the mix , company may adopt
one of the
following approaches:
4. Matching approach
5. Conservative approach
6. Aggressive approach

Matching approach
10 year loan to finance plant with 10 year
life.
Finished goods to be sold in 30 day to be
financed by
30 day bank loan.
Justifications: since the source of financing is
to pay
for the asset, source of financing and asset
should be
relinquished simultaneously

Conservative approach
Company depends more on long term funds
for
financing needs.
Firm finances its permanent assets and also
a part of
the short term current assets. In the period
when there
is no need for short term current assets, the
idle long
term fund will be invested in tradable
securities to
conserve liquidity.

Aggressive approach
Company uses more of short term financing
plan. Firm
finances permanent current asset with short
term
financing . In extreme cases even fixed
assets would be
financed by short term financing.

Risk - return trade of

Firm has an investment of Rs 50 crore in
assets, Rs 30 crore invested in fixed assets
and Rs 20 crore in current assets. It is
expected that assets will yield a return of 18%
before interest and taxes. Tax rate is assumed
to be 35%. Firm maintains a debt ratio of
60%. Firm has to decide whether it wants to
raise 12% short term loan or 14% long term
debt to finance its current assets. SF/TF ratio
under C, M and A approach is 12%, 30% and
60% respectively

(IN 000'S)
FA
CA
TA
SF
LF
PBIT
Interest
EBT
Tax @ 35%
Net income
ROE

C
300000
200000
500000
60000
240000
90000
40800
49200
17220
31980
0.1599

M
300000
200000
500000
150000
150000
90000
39000
51000
17850
33150
0.16575

A
300000
200000
500000
300000
0
90000
36000
54000
18900
35100
0.1755

FUNCTIONAL
CLASSIFICATION

ELEMENTWISE
CLASSIFICATION

COST COMPONENTS

DIRECT LABOUR

P
R
I
M
E

DIRECT EXPENSES

C
O
S
T

DIRECT MATERIALS
ADJUST OPENING AND
CLOSING STOCK OF
PRODUCTION RAW MATERIAL
DIRECT
COST
HERE

COST

(PRIME COST)

ACCOUNTING CLASSIFICATION

W
O
R
K
S
C
O
S
T

MANUFACTURING EXPENSES
ADMINISTRATION
COST

SELLING AND
DISTRIBUTION
COST

ADJUST OPENING AND

CLOSING
W I P HERE
ADMINISTRATION
EXPENSES

INDIRECT COST
(OVERHEAD)

C
O
S
T
O
F
P
R
O
D
U
C
T
I
O
N

T
O
T
A
L
C
O
S
T

SELLING EXPENSES

DISTRIBUTION EXPENSES
R & D COST

P
R
I
C
E

ADJUST OPENING AND

CLOSING STOCK OF
FINISHED GOODS HERE

R & D EXPENSES
N
E
T
NET PROFIT

NET PROFIT

NET PROFIT

S
E
L
L
I
N
G

P
R
O
F
I
T