Chapter 2: Working capital management

• Sources of short term financing

• Cash management
• Managing account receivable
• Inventory management

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 Introduction

In an organization, some funds are needed for short term purposes

for the purchase of raw materials, payment of wages, and other
day to day expenses. These funds are known as working capital. So
this funds is used on current assets such as cash and marketable
securities, debtors and inventories these assets are being constantly
converted into cash. So it is also known as revolving or circulating
capital.

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 Concept of short term financial management
(Working Capital management)
• Managing daily financial activities belongs within the purview of short –term financial
management or working capital management.
• Short-term financial management is concerned with the problems that arise in attempting to
manage the current assets, the current liabilities and the inter-relationship that exist
between them.
• Thus, the working capital management is the administration of the firm’s current assets and
the financing needed to support current assets. In the other words it is related to the
decisions of financing and investing in current assets
• Gross working capital: The firm’s investment in current assets (like cash and marketable
securities, receivables and inventory)
• Net working capital : Current assets minus current liabilities

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 The operating cycle and the cash cycle
• Inventory Conversion Period (ICP): The length of time required to convert raw
materials into finished products and then sales. = Inventory/COGS per day
• Receivable Conversion Period (RCP, DSO, or ACP): The average length of time
for collection of account receivable. = Average receivables/Credit sales per day
• Operating Cycle: The time intervals required to convert raw materials into finished
goods and then realize cash by selling them is called operating cycle. = ICP+RCP
• Payable Deferral Period (PDP): The average length of time between credit
purchase and labor employed and actual payment for them. = Average
payables/COGS per day or Credit purchase per day
• Cash Conversion Cycle (CCC): The time interval between outflow of cash and its
inflow through sales and collection from customers. In the other words, the
difference between operating cycle and the payable deferral period is known as cash
conversion cycle. =ICP+RCP-PDP
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Operating Cycle and Cash Cycle

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 Short term Investing Policy
• It is related to the decision concerned with determining level of investment in
current assets.
• It deals with maintaining optimum level of current assets, neither excess nor
less because of two reasons:
I. Holding excessive current assets are unproductive, as idle current assets
earn nothing. This results into decline in profitability of the firm.
II. On the other hand , inadequate current assets put obstruction in the process
of production and sales. The firm may not be able to pay its operating
expenses and current obligations when they are due. It increases the risk of
default.
• Thus, the level of investment in current assets should be such that a
reasonable trade-off between profitability versus risk is maintained in
working capital investing decisions.
Working Capital Management: Durga Prasad Acharya 6
Current Assets in Rs.
Conservative Investment Policy: Relatively
larger investment in current assets
CA:C

Moderate Investment Policy: In-between

Conservative and aggressive
CA:M

Aggressive Investment Policy:

Relatively smaller investment in
CA:A current assets

Output (units)
Q

Figure: Current Assets Investment policies

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 Short term Financing Policy
• It is concerned with determining the financing pattern of current assets.
• It deals with maintaining appropriate mix of long-term and short-term funds.
• The costs of long-term funds are generally higher than short-term funds.
Using costlier long-term fund reduces the firm’s profitability.
• On the other hand, the use of short-term funds is less costly, but it reduces
the liquidity of the firm and hence it is more risky.
• Therefore, the current assets financing also involves a question of risk-return
trade-off.
• There are numbers of approaches available for determining the level of risk-
return associated with current assets financing. However, we concentrate
into three alternative current assets financing policies: Aggressive financing
policy, Conservative financing policy and moderate financing policy
Working Capital Management: Durga Prasad Acharya 8
Aggressive financing Policy
Temporary Current assets
Rupees
Short-term
Debt financing

Permanent Current Assets

Long term debt financing

Plus equity financing
Fixed Assets

1 2 3 4 5 6 7

Time Period

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 Conservative financing Policy
Temporary Current assets
Rupees Short-term
Debt financing

Permanent Current Assets

Long term debt financing
Plus equity financing

Fixed Assets

1 2 3 4 5 6 7

Time Period

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Moderate financing Policy
(Hedging or Matching)

Temporary Current assets

Rupees Short-term
Debt financing

Permanent Current Assets

Long term debt financing

Plus equity financing
Fixed Assets

1 2 3 4 5 6 7

Time Period It is also called maturity matching or self liquidating.

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 Risk return trade-off under
alternative current assets
financing policy

Policies Profitability Liquidity Risk

Aggressive High Low High

Conservative Low High Low

Moderate Moderate Moderate Moderate

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Cash management
• Cash is the basic input needed to keep the business running on a
continuous basis. The firm should keep sufficient cash, neither more,
nor less.
• Cash is a non earning asset in the sense that, although it is needed to
pay for different purposes, cash itself earns no interest.
• The main goal of cash management is to reduce cash holdings to the
minimum necessary to conduct business.
• Thus cash management is concerned with the managing of cash flows
into and out of the firm, cash flows within the firm and cash balances
held by the firm at point of time by financing deficit or investing
surplus cash.

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Sources and uses of cash
Sources of cash
• Increasing long-term debt by
borrowing on long-term basis
• Increasing equity by selling
new shares of common stock
• Increasing current liabilities
by borrowing short term
basis
• Decreasing current assets
other than cash such as by
selling inventory for cash
• Decreasing fixed assets such
as by selling some fixed
assets for cash
Working Capital Management: Durga Prasad Acharya
Uses of cash
• Decreasing long-term debt by
repaying the long-term
borrowing
• Decreasing equity by
repurchasing the shares of
common stock
• Decreasing current liabilities by
repaying the short-term
borrowing
• Increasing current assets other
than cash such as by purchasing
some inventory for cash
• Increasing fixed assets such as
by purchasing some fixed assets
for cash
14
Motives for Holding Cash

• Transaction motive: The need to hold cash by the firm to satisfy day
to day requirement.
• Precautionary Motive: The need to hold cash by firms as a safety
margin to act as financial reserve. (pay for unpredictable events)
• Speculative motive*: The need to hold cash to take advantages of
additional investment opportunities.
• Compensating Motive: The need to hold cash to compensate banks
for providing certain services and loan.

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Cash management Technique
• Synchronizing Cash Flow (forecasting cash inflows and outflows and
maintain minimum balance)
• Speeding Up the Check-Clearing Process
• Using float: Float is defined as the difference between the balance
shown in a firm’s checkbook and the balance on the bank’s records.
(Collection float, mail float, process float, availability float)
• Speeding up Receipt (Lockbox plan, Payment by wire or automatic
debit)
• Slowing Disbursement (Centralized, by cheques, accruals)

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Lockbox Plan

• A lockbox plan is one of the oldest cash management tools. In a lock lockbox system,
incoming checks are sent to post office boxes rather than to corporate headquarters.
• For example, a firm headquartered in New York City might have its West Coast customers
send their payments to a box in San Francisco, its customers in the Southwest send their
checks to Dallas, and so on, rather than having all checks sent to New York City. Several
times a day a local bank will collect the contents of the lockbox and deposit the checks
into the company’s local account. In fact, some banks even have their lock box operation
located in the same facility as the post office. The bank then provides the firm with a daily
record of the receipts collected, usually via an electronic data transmission system in a
format that permits online updating of the firm’s account receivable.
• A lockbox system reduces the time required for a firm to receive incoming checks to
deposit them, and to get them cleared through the banking system so the funds are
available for use.
• Lockbox services can accelerate the availability of funds by 2 to 5 days over the ‘regular’
system.

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Payment by wire or automatic debit

Firms are increasingly demanding payments of larger bills by wire, or even

by automatic electronic debits. Under an electronic debit system, funds are
automatically deducted form one account and added to another. This is, of
course, the ultimate in a speed-up collection process, and computer
technology is making such a process increasingly feasible and efficient, even
for retail transactions.

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Cash Budget
• It is a schedule of cash receipts and payments during the months of a year.
• Cash budget is the primary tool in short-run financial planning
• It allows the financial manager to identify short-term financial needs and
requirements.
• It is the statement that shows the firm’s projected cash receipt and
disbursement during the plan period.
• The essence of preparing cash budget is to determine whether there will be
surplus or shortage of cash at a given point of time.
• There are three sections in Cash Budget: Cash Receipt, Cash Payment and
Cash Balance
Working Capital Management: Durga Prasad Acharya 19
 7-20

Format of the Cash Budget

The cash budget should be broken down into time periods that are as
short as feasible. It consists of four major sections:
1.The receipts section lists all cash inflows excluding cash received
from financing.
2.The disbursements section consists of all cash payments excluding
repayments of principal and interest.
3.The cash excess or deficiency section determines if the company will
need to borrow money or if it will be able to repay funds previously
borrowed.
4.The financing section details the borrowings and repayments
projected to take place during the budget period.

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Format of cash budget

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Working Capital Management: Durga Prasad Acharya 22
 Receivable management
• Credit sales enhance firm's sales revenue and the profitability, however, if
collection of credit sales is delayed for months, it increases cost of investment in
receivables and increases the chance of bad debt losses. Therefore, extension of
credit involves both cost and benefit.
• The receivable management is concerned with determining optimum credit
policy for the firm that increases the efficiency of firm’s credit and collection
department and contributes benefits from extension of credit and reduces the
cost of carrying receivables.
• In the other words, receivable management is an aspect of firm’s current assets
management, which is concerned with promoting company’s sales and profit to
the extent where return on investment in accounts receivable remains greater
than the cost of receivable.

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The specific purposes of receivable management are as follows:

• To evaluate the creditworthiness of customers before granting or

extending the credit.
• To minimize the cost of investment in receivables.
• To minimize the possible bad debt losses
• To formulate the credit terms that maximize of sales revenue and still
maintain minimum investment in receivables.
• To minimize the cost of running credit and collection department.
• To maintain a trade-off between costs and benefits associated with
credit policy

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The process of receivable management:
• Set up credit standard and terms,
• Analyzes and evaluates the credit worthiness of
customers,
• Controls account receivables

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 Components of Credit policy

A credit policy refers to a firm’s policy about granting and collecting credit. It guides
for determining whether to extend credit to a customer and how much credit to
extend.
Generally a firm’s credit policy includes following three components:
I. Terms of sale: The terms and condition on the basis of which credit is granted to
customers. Particularly, it covers three components: cash discount, discount
period and credit period. For example 3/10 net 30, in this terms of credit sale, 10
days is discount period and 30 days is credit period and 3% is discount on full
price.
II. Credit standard and analysis: The minimum criteria set by a firm for the
extension of credit to a customer. 5Cs: Character, Capacity, Capital, Collateral
and Condition.
III. Collection policy: The procedures for collecting accounts receivable when they
are due. Some expenditure incurred while collecting account receivable this is
called collection expenditure.
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Credit Analysis
Credit analysis particularly involves two steps:
I. Gathering relevant credit information: Financial statements of
customer’s business, Report of customer’s payment history and
Banks and financial institution etc.
II. Evaluation of creditworthiness (Credit evaluation and scoring):
Character, Capacity, Capital, Collateral and Conditions.

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 Collection Policy
 Collection policy is the procedures for collecting accounts receivable when they
are due:
 There are two important tools for monitoring receivables position: Days sales
outstanding and Aging schedule
 DSO: Also known as average collection period, it represents the average length of
time for which credit sales remain outstanding for collection.
 Aging schedule: A schedule showing a detailed breakdown of account receivable
on the basis of time for collection is called aging schedule. DSO has one serious
limitation that it only provides an average of collection days based on aggregate
data. It does not give specific information about the age of account receivable in
detail. The aging schedule eliminates this drawback because it gives a detail
breakdown of account receivable on the basis of age of accounts. Therefore it is
also called a report showing how long accounts receivable have been outstanding.
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Aging schedule

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Inventory Management
• Inventory management is concerned with maintaining optimum
investment in inventory and applying effective control system so as to
minimize the total inventory cost.
• The twin goals of inventory management are: (1) to ensure that the
inventories needed to sustain operations are available and (2) to hold
the cost of ordering and carrying inventories to the lowest possible
level.

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Purpose of inventory management
• To maintain sufficient inventory
• To minimize cost of inventory
• To maintain steady production set up
• To minimize wastes and losses
• To maintain proper storage
• To gain quantity discounts.

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 Basic inventory costs

 Carrying cost: The costs of holding inventory in stocks, Carrying cost = (C*Q/2)
 Ordering cost: The cost of placing the order of inventory, which includes all the costs
associated with the administrative and processing of order. Ordering cost: (O*R/Q)
 Total inventory costs: It is the sum of carrying costs and ordering costs.
 TC = (C*Q/2)+(O*R/Q)
Where, TC = Total cost,
C = Carrying cost per unit,
Q=Quantity,
O=Ordering cost per order,
R =Annual Requirement
Average inventory = Q/2
Number of order = R/Q
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 Inventory Management Technique: ABC
Approach
• ABC approach is used to make selective control upon the inventories on
the basis of their relative value to the firm. It attempts to classify all the
inventories into three categories as A, B and C on the basis of their value.
• Category A: It consists of those items of inventories, which are about 15
percent in terms of quantity but covers 70 percent of investment value.
• Category B: It consists of those items, which covers about 30 Percent in
quantity but involves 20 percent investment.
• Category C: It consists of those items, which have about 55 percent
quantity but covers only 10 percent of investment value.

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Inventory management Technique : Economic Order Quantity(EOQ)

• EOQ refers to the optimal order size of inventory at which total

inventory costs is minimum. The EOQ model enables a firm to
determine the order quantity of inventory at which the total of the
ordering cost and carrying cost is minimum.
• EOQ can be determined algebraically, graphically and by preparing
order quantity table. Or Formula method, Tabulation method and
Graphical method

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 EOQ Formula Derivation
R = Annual requirements (units)
P = Price(Cost)per unit (Rs)
Q = Order quantity (units) Total cost = (Q/2) x C + O x (R/Q)
O = Cost per order (Rs) (carry cost) ( order cost )
C = Carrying cost per unit
EOQ derivation:
TCC = TOC
C*Q/2 = O*R/Q
Number of Orders = R / Q Q2 C = 2RO
Ordering costs = Ox (R / Q)
Q or EOQ =
Average inventory units = Q / 2
Cost to carry average inventory Rs = (Q / 2) x C

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EOQ Graphical Representation

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Re-order point, Lead time, Safety stock and
Goods in transit
• Re-order point is the level of inventory according to previous order at
which re-order is made.
• Once the order is placed, it will take some time to receive the delivery. The
time consumed between the placing an order and receiving the delivery is
known lead-time or delivery time.
• Safety stock: The minimum level of stock of inventory to be maintained to
avoid the stock out problem.
• Goods In Transit: The level of inventory for which order has been placed
but not actually received.
• Re-Order Point (ROP) = Average lead time*Average usage or
consumption.
• Re-Order Point (ROP) = (Average lead time *Average usage)+ Safety
stock
• Re-Order Point (ROP) = (Average lead time*Average usage)+Safety
stock-Goods in transit)

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Re-order point and Lead Time

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