Introduction to Working Capital

Management (WCM):

Definition and concept

WCM Accounts
Importance of WC
Classification of WC
Operating cycle and cash conversion cycle
Factors determining WC needs
Estimation of WC requirement
WCM Policy and Risk return trade off
 Working Capital Concepts
Net Working Capital/Working capital
Current Assets - Current Liabilities.
Gross Working Capital
The firm’s investment in current assets.
Working Capital Management
The administration of the firm’s current assets and the
financing needed to support current assets.
Working Capital Accounts
 Significance of Working Capital
Management
• Deal with uncertainty regarding the future cash
flows.
• Purchase of raw materials and spares.
• Payment of wages and salary
• Day-to-day expenses
• Excessive levels can result in a substandard
Return on Investment (ROI).
• Working capital management affects the
company’s risk, return, and share price.
 Classifications of CA
 Components

 Cash, marketable securities,

receivables, and inventory

• Time
– Permanent Current Assets
– Temporary Short Time Investment or
Marketable Securities
 Permanent CA
• The amount of current assets required to
meet a firm’s long-term minimum needs.
 Temporary CA
• The amount of current assets that varies with
seasonal requirements.
 Operating Cycle/WC Cycle
Operating cycle (OC) is the summation of :
Inventory conversion period and receivables
collection period
Cash Conversion Cycle(CCC)/net
OC/cash operating cycle
 Factors Determining Working Capital
Management
• Nature of business
• Production cycle
• Business cycle
• Production policy
• Credit policy
• Growth and expansion
• Availability of raw material
• Earning capacity
 Estimation of Working Capital
Requirement
Individual Component Method: Amount of these CA and CL are not directly given, these are to be
calculated using the following formula:

From the following information calculate the working capital:

Annual production 15,600 units

Costs per unit (in Tk.):
RM 5
DL 4
O/H 2
*WIP and FG costs involves all these three costs i.e. Tk. 11 that is Total cost
Time:
RM 3 weeks
(WIP)Processing period 4 weeks
FG 5 weeks
Credit allowed by creditors 3weeks
Credit allowed by debtors 4 weeks
Lag in payment of wages 2 weeks
Lag in payments of O/H 2 weeks

Calculate the working capital requirement

 Estimation of Working Capital
Requirement
Operating Cycle Method

ABC company expects its cost of good sold for 2018 is Tk. 136 crores. The operating
cycle for the planned year is expected to be 54 days. The company wants to
maintain a desired cash balance of Tk. 1.5 crores to meet the contingencies. What is
the expected working capital requirement for the year 2019 (assume 360 days in a
year)
 Pro-forma Working Capital
Estimates for Trading Concern
STATEMENT OF WORKING CAPITAL REQUIREMENTS
Amount (Rs.)
Current Assets
(i) Cash ----
(ii) Receivables ( For…..Month’s Sales)---- ----
(iii) Stocks ( For……Month’s Sales)----- ----
(iv)Advance Payments if any ----
Less : Current Liabilities
(i) Creditors (For….. Month’s Purchases)- ----
(ii) Lag in payment of expenses -----_
WORKING CAPITAL ( CA – CL ) xxx
Add : Provision / Margin for Contingencies -----

NET WORKING CAPITAL REQUIRED XXX

Pro-forma Working Capital Estimates for Manufacturing Co .
STATEMENT OF WORKING CAPITAL REQUIREMENTS
Amount (Rs.)
Current Assets
(i) Stock of R M( for ….month’s consumption) -----
(ii)Work-in-progress (for…months)
(a) Raw Materials -----
(b) Direct Labour -----
(c) Overheads -----
(iii) Stock of Finished Goods ( for …month’s sales)
(a) Raw Materials -----
(b) Direct Labour -----
(c) Overheads -----
(iv) Sundry Debtors ( for …month’s sales)
(a) Raw Materials -----
(b) Direct Labour -----
(c) Overheads -----
(v) Payments in Advance (if any) -----
(iv) Balance of Cash for daily expenses -----
(vii)Any other item -----

Less : Current Liabilities

(i) Creditors (For….. Month’s Purchases) -----
(ii) Lag in payment of expenses -----
(iii) Any other -----
WORKING CAPITAL ( CA – CL )xxxx
Add : Provision / Margin for Contingencies -----

NET WORKING CAPITAL REQUIRED XXX

Example of Estimation of WC
 Working Capital Management Policy
Issues
1. Conservative Working Capital Policy (Policy C).
2. Moderate Working Capital Policy (Policy M).
3. Aggressive Working Capital Policy (Policy A).
 Optimal Amount (Level) of Current Assets

Assumptions
• 50,000 maximum units Policy A

of production Policy M

ASSET LEVEL ($)

• Continuous Policy C
production
• Three different Current Assets
policies for current
asset levels are
possible 0 25,000 50,000
OUTPUT (units)
 Impact on Liquidity
Optimal Amount (Level) of Current Assets

Liquidity Analysis
Policy Liquidity Policy C

C High Policy M

M Moderate ASSET LEVEL ($) Policy A

A Low
Current Assets
Greater current asset
levels generate more
liquidity; all other factors
held constant. 0 25,000 50,000
OUTPUT (units)
 Impact on
Expected Profitability
Optimal Amount (Level) of Current Assets
Return on Investment =
Policy A
Net Profit
Total Assets Policy B

Let Current Assets = (Cash + ASSET LEVEL ($) Policy C

Rec. + Inv.)
Current Assets
Return on Investment =
Net Profit
Current + Fixed Assets
0 25,000 50,000
OUTPUT (units)
 Impact on
Expected Profitability
Optimal Amount (Level) of Current Assets

Profitability Analysis
Policy Profitability Policy A

A High Policy M

M Moderate ASSET LEVEL ($) Policy C

C Low
Current Assets
As current asset levels
decline, total assets will
decline and the ROI will rise.
0 25,000 50,000
OUTPUT (units)
 Impact on Risk
Optimal Amount (Level) of Current Assets
• Decreasing cash reduces the
firm’s ability to meet its Policy A
financial obligations. More
risk! Policy M

ASSET LEVEL ($)

• Stricter credit policies reduce Policy C
receivables and possibly lose
sales and customers. More
risk! Current Assets
• Lower inventory levels
increase stockouts and lost
sales. More risk! 0 25,000 50,000
OUTPUT (units)
 Impact on Risk
Optimal Amount (Level) of Current Assets

Risk Analysis
Policy Risk Policy A

A High Policy M

M Moderate ASSET LEVEL ($) Policy C

C Low
Current Assets
Risk increases as the level of
current assets are reduced.
0 25,000 50,000
OUTPUT (units)
 Summary of the Optimal
Amount of Current Assets
SUMMARY OF OPTIMAL CURRENT ASSET ANALYSIS
Policy Liquidity Profitability Risk
C High Low Low
M Moderate Moderate Moderate
A Low High High

1. Profitability varies inversely with liquidity.

2. Profitability moves together with risk.
(risk and return go hand in hand!)
 Financing Current Assets and risk
return trade off

Hedging approach
Conservative approach
Aggressive approach
 Hedging (or Maturity Matching) Approach
* Less amount financed spontaneously by payables and accruals.
** In addition to spontaneous financing (payables and accruals). Hedging
Approach
long-term finance shall be used to fixed assets and permanent current assets
and short-term financing to finance temporary or variable assets.

Short-term financing**
DOLLAR AMOUNT

Current assets*

Long-term financing
Fixed assets

TIME
 Risks vs. Costs Trade-Off (Conservative Approach)
Under this approach, the entire estimated finance in current assets should be financed
from long-term sources and the short-term sources should be used only for emergency

requirements. This approach is called as “Low Profit – Low Risk” concept .

Firm can reduce risks associated with short-term borrowing by using a
larger proportion of long-term financing.

Short-term Investment

Short Term Financing

DOLLAR AMOUNT

Current assets

Long-term financing
Fixed assets

TIME
 Risks vs. Costs Trade-Off (Aggressive Approach) Aggressive Approach
Under this approach, the entire estimated requirement of current assets should be
financed from short-term sources and even a part of fixed assets financing be financed
from short- term sources. This approach makes the finance mix more risky, less costly

and more profitable .

Firm increases risks associated with short-term borrowing by using a
larger proportion of short-term financing.

Short-term financing

Current assets
DOLLAR AMOUNT

Long-term financing
Fixed assets

TIME
 Comparison with an
Aggressive Approach
• Short-Term Financing Benefits
– Financing long-term needs with a lower interest cost than
short-term debt
– Borrowing only what is necessary
• Short-Term Financing Risks
– Refinancing short-term obligations in the future
– Uncertain future interest costs
• Result
– Manager accepts greater expected profits in exchange for
taking greater risk.
 Summary of Short- vs. Long-
Term Financing
Financing
Maturity
SHORT-TERM LONG-TERM
Asset
Maturity

SHORT-TERM Moderate Low

(Temporary) Risk-Profitability Risk-Profitability

High
LONG-TERM Moderate
Risk-Profitability
(Permanent) Risk-Profitability
Disadvantages of Redundant or Excess Working Capital

 Idle funds, non-profitable for business, poor ROI

 Unnecessary purchasing & accumulation of
inventories over required level
 Excessive debtors and defective credit policy, higher
incidence of B/D.
Overall inefficiency in the organization.
When there is excessive working capital, Credit
worthiness suffers
 Due to low rate of return on investments, the market
value of shares may fall
 Disadvantages or Dangers of Inadequate or Short
Working Capital

 Can’t pay off its short-term liabilities in time.

 Economies of scale are not possible.
 Difficult for the firm to exploit favourable market
situations
 Day-to-day liquidity worsens
 Improper utilization the fixed assets and ROA/ROI
falls sharply
 Ratios associated with WCM
Stock Turnover Ratio COGS
(Times) AVERAGE STOCK
Stock Turnover Ratio (Days) Average Stock x 365
COGS
Receivables Turnover Ratio Net Credit Sales
(Times) Average Accounts
Receivable
Average Receivables Period Avg A/C Receivable x 365
(Days) Net Credit Sales
Payables Turnover Ratio Net Credit Purchases
(Times) Average Accounts payables

Average Payables Period Avg A/C payable x 365

(Days) Net Credit purchase
Current Ratio Current Assets
Current Liabilities
Quick Ratio CA – Stock
Current Liabilities
Working Capital Turnover Net Sales
Ratio Net Working Capital