Working Capital Management

Dr. Satish Kumar Matta

 Introduction
Capital required for a business can be classified
under two main categories:
(a) Fixed Capital, and
(b) Working Capital.
 Fixed Capital
Every business needs funds for two purposes – (a)
for its establishment and (b) to carry out its day-to-
day operations.
Long-term funds are required to create production
facilities through purchase of fixed assets such as
land, building, plant and machinery, furniture etc.
Investments in these assets represent that part of
firm’s capital which is blocked on a permanent or
fixed basis and is called fixed capital.
 Working Capital
Funds are also needed for short-term purposes for the
purchase of raw materials, payment of wages, electricity,
freight and other day-to-day expenses etc. These funds are
known as working capital. Working capital refers to that
part of the firm’s capital which is required for financing
short-term or current assets such as cash, balance at bank,
marketable securities, accounts receivables and
inventories. Funds thus, invested in current assets keep
revolving fast and are being constantly converted into cash
and this cash flows out again in exchange for other current
assets. It is also known as revolving or circulating capital.
 Classification or Kinds of Working Capital

Working capital may be classified in two ways:

(a) On the basis of concept.
(b) On the basis of time.
 On the Basis of Concept
(a) Gross Working Capital
(b) Net Working Capital
 On the Basis of Time
(a) Permanent or Fixed Working Capital
(b) Temporary or Seasonal Working Capital

Rs.

Time X
 Factors Determining the Working Capital
Requirements
• Nature of business;
• Size of Business;
• Production Policy;
• Regularity of supply;
• Manufacturing Process;
• Rate of Stock Turnover;
• Credit Policy to Sales;
• Credit Policy related to Purchase;
• Business Cycle;
• Rate of Growth of Business;
• Availability of Loan;
• Earning capacity and Dividend Policy;
• Price Level Changes;
• Import Policy;
• Ability of Management
 Importance or Advantages of Adequate
Working Capital
Working capital is the life blood and nerve
centre of a business. Just as circulation of blood
is essential in the human body for maintaining
life, working capital is very essential to maintain
the smooth running of a business. No business
can run successfully without an adequate
amount of working capital. The main
advantages of maintaining adequate amount of
working capital are as follows:
 Continued:
• Solvency of the business;
• Easy availability of loan;
• Cash discount;
• Goodwill;
• Regular supply of raw materials;
• Regular payment of salaries and other day-to-day commitments’
• Ability to face crisis
• Exploitation of favourable market conditions
• Quick and regular return on investments
• High morals
 Disadvantages of Excess Working Capital
• In case of availability of excess working capital, it may lead to
unnecessary purchasing and accumulation of stock causing more
chances of theft, waste and losses.
• Excess working capital means funds are idle with firm which earn
no profits for the business.
• Excessive working capital implies excessive debtors and lucrative
credit policy which may cause higher incidence of bad debts.
• In case of excessive working capital, relations with banks and
financial institutions may not be maintained.
• Due to low rate of return on investment, the value of share may
fall.
• Excessive working capital gives rise to speculative transactions.
• It may result into overall inefficiency in the organization.
Disadvantages of Inadequate Working Capital

• A firm which has inadequate working capital cannot pay its short-
term liabilities in time,. Thus, it will lose its reputation and shall not
be able to get good credit facility.
• It becomes difficult for company to exploit favourable market
conditions and undertake profitable projects due to lack of working
capital.
• It cannot buy large quantity of goods and cannot avail discount etc.
• The firm cannot pay day-to-day expenses of its operations which
increases costs and reduces the profits of the business.
• Due to non-availability of adequate working capital it becomes
impossible for business to utilize fixed assets efficiently.
• With the shortage of funds rate of return on investments falls.
Estimate of Working Capital Requirements

To avoid the shortage of working capital at once, an

estimate of working capital requirements should be
made in advance so that arrangement can be made to
procure adequate working capital.
Methods of Estimating Working Capital Requirements:
1. Percentage of Sales method;
2. Regression Analysis Method;
3. Cash Forecasting Method;
4. Operating Cycle Method (important);
5. Projected Balance Sheet Method.
 1. Percentage of Sales Method
This method of estimating working capital requirements is based
on the assumptions that level of working capital for any firm is
directly related to its sales. If past experience indicates a stable
relationship between the amount of sales and working capital, then
this basis may be used to determine the requirements of working
capital for future period. Suppose, if sales for the year 2018
amounted to Rs. 50 lacs and working capital required was Rs. 10
lacs, the requirement of working capital for the year 2019 on an
estimated sales of Rs. 60 lacs shall be 12 lacs; i.e., 20% of Rs. 60 lacs.
Individual items of current assets and current liabilities can also be
estimated on the basis of past experience as a percentage of sales.
This method is simple to understand and easy to operate but it
cannot be applied in all cases because the direct relationship
between sales and working capital may not be established.
 Case 1
Liabilities Rs. Assets Rs.
Equity Share Capital 2,00,000 Gross Block 3,00,000
8% Debentures 1,00,000 Inventories 1,00,000
Reserves & Surplus 50,000 Sundry debtors 70,000
Long-term loans 50,000 Cash and bank 10,000
Sundry creditors 80,000
4,80,000 4,80,000
Sales for the year ended 31-03-2019 amounted to Rs. 10,00,000 and
it is estimated that the same will amount to Rs. 12,00,000 for the
year ended 31-03-2020.
You are required to estimate the working capital requirements for
the year ended 31-03-2020 assuming a linear relationship between
sales and working capital.
 Solution
31-03-2019 % to Sales 31-03-2020
Sales 10,00,000 100 12,00,000
Current Assets
Inventories 1,00,000 10 1,20,000
Sundry Debtors 70,000 7 84,000
Cash and Bank 10,000 1 12,000
Total Current Assets 1,80,000 18 2,16,000
Current Liabilities
Sundry Creditors 80,000 8 96,000
Total Current Liabilities 80,000 8 96,000
Working Capital (CA – CL) 1,00,000 10 1,20,000
2. Regression Analysis Method/ Average Relationship
between Sales and Working Capital
This method of forecasting working capital requirements is based upon the
statistical technique of estimating or predicting the unknown value of a
dependent variable from the known value of an independent variable. It is
measure of the average relationship between two or more variables, i.e., sales
and working capital, in terms of the original units of data.
The relationship between sales and working capital is represented by the
equation
y = a + bx
where, y = Working capital (dependent variable)
a = Intercept of least square
b = Slope of regression line
x = Sales (independent variable)
For determining the value of ‘a’ and ‘b’ two normal equations are used which
can be solved as:
∑y = na +b∑x
∑xy = a∑x + b∑x2
 Case 2
The sales and working capital figures of S Ltd. for a period of 5 years
are given as follows:
Year Sales Working Capital
(Rs. Lakhs) (Rs. Lakhs)
2014-15 60 12
2015-16 80 15
2016-17 120 20
2017-18 130 21
2018-19 160 23
You are required to forecast the working capital requirements of the
company for the year 2019-20 taking the estimated sales of Rs. 200
lakhs.
 Solution
The relationship between sales and working capital can be
represented by : y = a + bx
Year Sales (x) WC (y) xy X2
2014-15 60 12 720 3,600
2015-16 80 15 1,200 6,400
2016-17 120 20 2,400 14,400
2017-18 130 21 2,730 16,900
2018-19 160 23 3,680 25,600
N=5 ∑x = 550 ∑y = 91 ∑xy = 10,730 ∑ X 2 =66,900
 Continued:
∑y = na +b∑x
∑xy = a∑x + b∑x2
Putting the values in the above equation:
91 = 5a + 550b (i)
10,730 = 550a + 66,900b (ii)
Multiplying equation (i) with 110, we get:
10,010 = 550a + 60,500b (iii)
Subtracting equation (iii) from equation (ii)
720 = 0 + 6,400b
b = 0.1125
Putting the value of b in equation (i)
91 = 5a +550 x 0.1125
91 = 5a + 61.875
5a = 91 – 61.875 = 29.125
a = 29.125/5 = 5.825
Now putting the values of a and b in the equation y = a +bx
y = 5.825 + 0.1125 X 200
y = 28.325
Thus, when estimated sales for the year 2019-20 are Rs. 200 lakhs, the amount of estimated working capital
shall be Rs. 28.325 lakhs.
 3. Cash Forecasting Method
This method of estimating working capital requirements
involves forecasting of cash receipts and disbursements
during a future period of time. Cash forecast will include
all possible sources from which cash will be received and
the channels in which payments are to be made so that
a consolidated cash position is determined. This method
is similar to the preparation of cash budget. The excess
of receipts over payments represents surplus of cash
and the excess of payments over receipts causes deficit
of cash or the amount of working capital required.
 Case 3
Roshni Ltd. Is to start production on 1st April, 2019. The prime cost of a unit is
expected to be Rs. 40 out of which Rs. 16 is for materials and Rs. 24 for labour. In
addition, variable expenses per unit are to be Rs. 8 and fixed expenses per
month Rs. 30,000. Payment for materials is to be made in the month following
the purchases. One-third of sales will be for cash and the rest on credit for
settlement in the following month. Expenses are payable in the month in which
they are incurred. The selling price is fixed at Rs. 80 per unit. The number of
units manufactured and sold are expected to be as under:
January 900
February 1200
March 1800
April2100
May 2100
June 2400
Draw up a statement showing requirements of working capital from month to
month, ignoring the question of stocks.
 Solution
Statement Showing Requirement of W. Capital
Particulars Jan. Feb. March April May June
Receipts:
Cash Sales 24000 32000 48000 56000 56000 64000
Debtors ----- 48000 64000 96000 112000 112000
Total Cash Receipts 24000 80000 112000 152000 168000 176000
Payments:
Materials ------- 14400 19200 28800 33600 33600
Wages 21600 28800 43200 50400 50400 57600
Fixed Expenses 30000 30000 30000 30000 30000 30000
Var. Expenses 7200 9600 14400 16800 16800 19200
58800 82800 106800 126000 130800 140400
W. C. Required
(Payment – Receipts) 34800 2800 (5200) (26000) (37200) (35600)
Cumulative Req. of WC 34800 37600 32400 6400
Surplus W. C. ---- ---- ----- ----- 30800 66400