Chapter 8: A.

Working Capital
Management

Introduction
Working capital is required for the day to day transactions
of the organization. In simple speaking, working capital
means the firm's investment in short term assets.
1. Gross Concept: Total funds invested in current assets
like cash, marketable securities, inventories and accounts
receivables. Financial analysts use this concept.
2. Net Concept: Current asset minus current liabilities.
Accountants use this concept.
Net working capital = CA- CL

Working Capital Policy:

It refers to the firm's decision with respect to the
level of current asset and the way they are financed.
Working Capital Management: It refers to the
administration of the working capital policy into day
to day functioning.
Working capital management involves in setting the
working capital policy and carrying out that policy
in day to day operations. So, the management of
current assets and current liabilities is working
capital management.

Types of Working Capital

3

1. Permanent Working Capital

Minimum amount of working capital
which is always maintained by the firm .
2. Temporary Working Capital
Investment in additional current assets
required to support seasonal peak.

Importance of Working Capital

Management
4

1. Current assets comprise of about 50 percent of the

total assets. 30 percent of total financing is covered
by current liabilities. There fore, most of the time of
financial manager is spent (33%-60%) on managing
working capital.
2. Investment in fixed assets may be reduced by
renting or leasing.
3. For small firm's, current liabilities are the principal
source of financing.
4. The relationship between sales and working
capital is direct and positive.

Factor Affecting Working Capital

5

1. Sales Volume
2. Working capital policy
3. Credit policy
4. Nature and size of the firm
5. Cost of input materials
6. Access to the money market
7. Cash conversion cycle
8. Technology Employed
9. Predictability of cash in flows
10. Others

Cash Conversion or Working Capital

Cash Flow Cycle
Average time required to generate cash.
It consists of:

Operating cycle = ICP+RCP

Net operating cycle = ICP + RCP - PDP
CCC = ICP + RCP - PDP
Working capital financing requirement = CCC Daily Activity Per
Unit Cost.
Therefore, longer the CCC, grater the working capital financing
requirement.

Current Assets Investment Policy

9

1. Relaxed current assets investment policy

The firm holds relatively high level of current
assets.
2.Restricted current assets investment policy
The firm holds relatively lower level of current
assets.
3. Moderate current assets investment policy
It falls in between the above two policies.

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Relaxed

Moderate
Restricted

Current
Assets
Levels (Rs)

Current Assets

|
50000
Outputs (units)

|
100000

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12

Temporary current
assets

Short Term non

spontaneous debt
financing

Assets
($)
Permanent current assets
Fixed Assets

Time Period

Long Term
financing

13

Marketable securities
14

Short Term non

spontaneous debt
financing

Assets
($)

Permanent current assets

Long Term financing
Fixed Assets

Time Period

15

3. Hedging approach / Maturity

Matching approach or Self liquidating
approach.
An effort is made to match the maturity
structure of assets and liabilities.
Average liquidity, risk and return.

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Temporary current assets

Short Term
financing
Assets
(Rs.)
Permanent current assets
Long Term
financing
Fixed Assets

Time Period

17

B. Cash Management
18

To maintain the optimum level of cash by

efficiently managing the inflows and
outflows.
It also indicates financing the deficit and
investing the surplus cash.

Significance of cash
19

1.Easy in payment
2. Possible to get trade discount
3. High credit rating
4. Easy to get new loan
5. Exploitation of business opportunities
6. Overcome threats and challenges
7. Dividend payment
8. Others
But excessive cash holding is costlier to the firm.

Motives for holding cash

20

1.Transaction Motive
2. Precautionary Motive
3. Speculative Motive

How to manage cash?

21

Cash flow synchronization is the main

technique. But
1.Speeding up collections using lock box
system, concentration banking etc.
2. Slowing down disbursements using
centralized payments, zero balance accounts
and controlled disbursement account etc.
3. Playing in float( By collecting fast and paying
slow)
.

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Disbursement delay is the disbursement float.

Collection delay is the collection float.
In another way, amount in transit is float.
Therefore, amount associated with checks
written by the firm but not have been
deducted from bank account is disbursement
float.Amount associated with checks sent by
customers but which are not in usable form is
collection float.

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Net float is the differences between

disbursement float and collection float.
N. F.= Dis. Float - Coll. Float
The more the net float, lesser the cash
balance the firm must maintain.
In cash management, the firm tries to control
the cash holdings.

Cash balance to maintain

24

Cash is required to run the firm but both

excessive and inadequate level of cash is
harmful.
Excessive cash becomes costly.
Inadequate cash increases risk.
Therefore, optimum level is to be maintained.
Regarding this, Baumol model and Miller and
Orr model can be used.
Optimum level is that which ensures smooth
functioning with minimum cost.

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Marketable securities
The short term securities which are easily
convertible into cash are marketable
securities. In case when firm has excess
cash, can purchase such securities. In
case when the firm face cash problem, can
liquidate such securities. e.g. Treasury
bills, certificate of deposits, commercial
paper, bankers acceptance, Eurodollar
CDs and others.

Cash budgeting
26

It is a report which shows the firms

planned inflows, outflows and ending cash
position over a specified time period.
Besides this, it indicates either surplus or
shortages of cash.

How to prepare cash budget?

27

Steps
1.Cash receipts ( cash sales, collections, and
other receipts)
2.Cash disbursements ( cash purchases,
payments, and others)
3. Net cash flows ( differences between total
cash receipts and disbursements)
4. Ending cash ( net cash flows plus
beginning cash balance)

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5.Cumulative financing requirements (ending

balance minus minimum balance)
6.Cumulative excess cash balance if ending
balance exceeds minimum balance.
Excess balance should be invested and
deficit amount should be financed.
NOTE: Depreciation and other non cash
items are not included in the cash budget.

General format of cash budget

29

Jan
Feb .
Cash receipts $XXX XXG
Less: Disburse XXA XXH
Net cash flow XXB XXI
Add: Beginning XXC XXD XXJ
Ending bal
XXD XXJ
Less: Min. bal XXE XXK
Cum. Financing .
XXL
Cum. Surplus XXF .

Nov
Dec
XXM XXT
XXN XXU
XXO XXV
XXP XXQ
XXQ XXW
XXR XXY
XXS
.
.
XXZ

C. Receivables Management
30

Receivables are the result of credit sales.

Carrying receivables involves cost and
benefit.
So, it requires efficient management.
A/R= Daily credit sales DSO
Receivables management begins with the
decision of whether or not to grant credit and
ends at collection and monitoring.

Credit Policy
31

It refers to a set of decisions that includes

firms credit standards, credit terms,
Collection procedures and monitoring
procedures.
1. Credit Standards: Required financial
strength of a customer.( character, capacity,
capital, collateral and condition)
The tight the standards, lower the sales, bad
debts, receivable investment and Collection
cost and vice versa.

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2. Credit Terms: Terms and conditions of sales.

(i) Credit Period: Length of time for which credit is granted.
Example Net 30
Longer the period, higher the sales, receivables, bad
debts and profit and vice versa.
(ii) Cash Discount: A reduction in price to encourage
early payments. It boost up sales, discount cost but
lowers DSO.
3. Collection Policy: Procedures followed by firm to
Collect receivables.
Tight the policy, lower the sales, DSO, Bad debts but higher
the collection costs.
4. Monitoring A/R: To ensure the success of collection efforts.

Aging Schedule
33

A report which shows how long account

receivables have been outstanding. It breaks
down receivables by age of account. So, it
shows the proportion of receivables that are
current and proportion that are due for a
given length of time.

Aging Schedule
34

Age of Account
0-10
11-30
31-60
61-90
Above 90
Total

Amount
60,000
40,000
66,000
26,000
8,000
200,000

%
30
20
33
13
4
100

Analysis of change in credit policy

35

If firm adopts a loose credit policy, sales

increases but associated costs also
increase. Therefore, while changing credit
policy, incremental benefit should be
compared with incremental costs. If new
policy gives net benefits, then new policy
can be adopted.

Costs associated with receivables

36

1.Receivables carrying costs

= [ DSO ( Sales/360) V ] K
Where,
v = variable cost ratio
k = opportunity cost
2. Bad debt = Sales B/D percentage
3. Discount cost = Sales d% % customer
taking discount.

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If bad debts are given,

Discount cost = Sales (1- B/d %) d% %
customer taking discount.
4. Collection cost = Given
5. DSO = % customer taking discount
discount period + % customer not taking
discount net period.

Analyzing Approaches
38

Income statement approach

Under this, simply net income is computed
under various policies and decision is made.

1.

Format
Current

change

New

39

Gross sales
Less: Disc.
Net sales
Less: Prod. cost
Less: F. cost
Profit before
Credit cost and
taxes
Less: credit
Related costs:
Rec. carrying cost
Coll. cost
Bad debts
Profit bef. Taxes
Less: Taxes
Net Income

Decision Rule: If net income increases under new policy,

changes should be made .

D. Inventory Management
40

Introduction
Various types of materials and goods
held by the firm for reselling purpose are
inventories.
Types
1. Raw Materials
2. Work-in-progress
3. Finished goods

Motives
41

1.Transactive motive: Level of inventory maintained

for smooth functioning.
2.Precautionary motive: Extra stock above transaction
level kept to prevent from unforeseen fluctuations.
3.Speculative motive: Additional stock maintained to
earn extra profit.
Inventory Management: Process of determining
optimum level and administering in to operation.
Optimum level is to be determined because
investment in inventory involves cost and risk.

Types of Inventory cost

42

1. Ordering cost: cost associated with placing and

receiving an order like ordering cost, shipping and
handling cost, receiving cost etc.
If ordering cost per order is given, total ordering
costs is given by:
TOC= ordering cost per order No. of order
= ON
= OA/Q
Where,
A=Annual requirement
Q=Quantity demand each time

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2.Carriying cost: costs associated with

holding inventories, such as, cost of
capital tied-up, storage and holding
cost, insurance, property taxes,
depreciation and obsolescence.
If it is given in the percent of price,
Carrying cost per unit (c)=% cost per
unit price
= % cost P
TCC= % cost PQ/2

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3. Stock out cost: It occurs When a firm runs

out of inventory but customer arrives to
purchase the goods.
Total Cost = TOC + TCC
= O A/Q + % cost Price Q/2
If safety stock is given,
TIC= TOC + TCC + holding cost of safety stock
= A/Q O + %C Price Q/2 + SS %C

Issues in inventory management

45

1.
2.

How much to order?

When to place order?

Economic order quantity

The optimum quantity which minimizes total cost.
Methods:

1.Formula Method
EOQ =

2
AO
Where,
C=Carrying costC
per unit
A=Annual Requirement

O=ordering cost per order

Q=EOQ

46

Total cost curve

Carrying cost curve

Cost
(Rs)
Ordering cost curve

Quantity
47

2. Trial and Error Method

48

Under this method, total cost at various lot

sizes are calculated and total cost
minimizing quantity is picked-up as
economic order quantity.

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Reorder Level
The level at which reorder should be placed.
ROL=Lead Time Usage Rate
ROL=Lead Time Usage Rate + Safety Stock
ROL=Lead Time Usage Rate + Safety Stock - Goods
in Transit
Where,
Lead Time = Time taken to receive delivery after
placing an order.
Goods in Transit = Goods which have been ordered but
have not been received yet. GIT exist if lead time is
longer than time between two orders.
Time between two orders= 365 No of orders.

Other Formulas
50

1.
2.
3.

Maximum inventory = EOQ + Safety Stock

Average Inventory = Safety stock + EOQ/2
Inventory Cycle = Days in a year/ No of
orders

Quantity Discount
51

Sometimes supplier offers a quantity discount

on bulk purchases. When such discount is
offered, we should compare the total cost
(including purchase price) of EOQ with the
total cost (including purchase price) of offered
quantity. The total cost minimizing quantity
should be ordered.
Note: If carrying cost is given in amount, it is
equally applicable to all the order size. If
Carrying cost is given in percentage term,
carrying cost on offered lot size should be
calculated on new price.

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The End