WORKING

CAPITAL
MANAGEMENT
Elements of Working Capital

■ Working Capital is the capital available for conducting the day-to-day operations
of an organization.
■ In other words it is the excess of current assets over current liabilities.
■ Working Capital Management is the management of all aspects of both current
assets and current liabilities.
■ It the minimization of the risk of insolvency while maximizing the return on assets.
Cost involved in working capital

■ The cost of funding it.

■ The opportunity cost of lost investment opportunities because cash is tied up and
unavailable for other uses.
Working capital and cash flows

■ When inventory is purchased, cash is paid to acquire it.

■ Receivables represent the cost of selling goods or services to customers. It includes
the cost of materials and the labour incurred.
■ The cash tied up in WC is reduced to the extent that inventory is financed by trade
payables. If suppliers give a firm time to pay, the firm’s cash flows are improved
and working capital is reduced.
Objectives of Working Capital
Management
■ The main objective of WCM is to get the balance of current assets and current
liabilities right.
■ It is a balancing act between Liquidity and Profitability.
■ Liquidity – Ensuring current assets are sufficiently liquid to minimize the risk of
INSOLVENCY.
■ Profitability – Investing in less liquid assets in order to maximize return.
■ The objective is to have a trade-off between cash flows versus profits.
Continued…

■ Current assets are a major financial position statement item and therefore, it is
significant to smaller firms.
■ Mismanagement of WC is therefore a common cause of business failure.
■ Examples – Inability to meet the bills as they fall due, demands on cash during
growth period being too high (overtrading), overstocking.
Cash flow versus profits

■ Cash flows is as important as profit.

■ Unprofitable companies can survive if they have liquidity.
■ Profitable companies can fail if they run our of cash to pay off their liabilities
( wages, amount due to suppliers, OD interest etc…)
■ Example:
– Purchase of non-current assets for cash – The cash is paid in full to the supplier
when the asset is delivered. But, profits will be charged gradually over the life of
the asset in the form of depreciation.
– Sale of goods on Credit – Profits will be credited in full once the sale has been
confirmed. But, cash may not be received for a considerable period afterwards.
Continued…

– Timing difference – With some payments such as tax there may be a

significant timing difference between the impact on reported profit and the
cash flow.
Profitability versus liquidity

■ In WCM liquidity means having enough cash or ready access to cash to meet all
payment obligations when they are due.
■ The main sources of liquidity are:
– Cash in bank.
– Short-term investments that can be cashed in easily and quickly.
– Cash flows from normal trading operations (Cash sales and payments by
receivables for credits sales).
– An overdraft facility or other ready sources of extra borrowing.
Continued…

■ The basis of trade off is where a company is able to improve its profitability but at
the expense of tying up cash. For example:
– Receiving a bulk purchase discount (improved profitability) for buying more
inventory than is currently required (reduced liquidity).
– Offering credit to customers (attracts more customers so improves profitability
but reduces liquidity).
■ Sometimes, the opposite situation can be seen where a company can improve its
liquidity position but at the expense of profitability. For example:
– Offering an early settlement discount to customers.
POLICIES REGARDING WORKING
CAPITAL MANAGEMENT
1. AGGRESSIVE VERSUS CONSERVATIVE APPROACH
2. OVERCAPITALIZATION AND WORKING CAPITAL
3. OVERTRADING
AGGRESSIVE VERSUS
CONSERVATIVE APPROACH
■ A firm choosing to have a lower level of working capital than its rivals is said to
have a ‘aggressive’ approach.
■ A firm with a higher level of working capital has a ‘conservative’ approach.
■ An aggressive approach will result in higher profitability and higher risk.
■ A conservative approach will result in lower profitability and lower risk.
OVER-CAPITALIZATION AND
WORKING CAPITAL
■ If there are excessive inventories, accounts receivables and cash, and very few
accounts payable, there will be an over- investment by the company in current
assets.
■ Working capital will be excessive and the company will be over-capitalized.
OVERTRADING

■ Effective and efficient management of working capital investment is essential to

maintain control of business cash flow.
■ Management must have full awareness of the profitability versus liquidity trade-off.
■ Healthy trading growth typically produces:
– Increased profitability.
– The need to increase investment in non-current assets and working capital.
■ If the business does not have access to sufficient capital to fund the increase in
activities, then it is said to be ‘overtrading’.
■ This can cause serious trouble to the business as it is unable to pay its business
creditors.
WORKING CAPITAL RATIOS
(LIQUIDITY)
■ 1. Current ratio
■ 2. Quick Ratio.
CURRENT RATIO

■ It measures how much of the total current assets are financed by

current liabilities.

■ Current Ratio = Current assets/Current Liabilities.

■ A measure of 2:1 means that current liabilities can be paid twice over
out of existing current assets.
QUICK(ACID TEST) RATIO

■ It measures how well current liabilities are covered by liquid assets.

■ It is useful where inventory holding periods are long.

■ Quick ratio = (Current assets – Inventory)/ Current liabilities.

■ A measure of 1:1 means that the company is able to meet existing

liabilities if they all fall due at once.
Note on Liquidity Ratios

■ Liquidity ratios are a guide to the risk of cash flow problems and insolvency.
■ If a company suddenly finds that it is unable to renew its short term liabilities
(suspension of Bank O/D facility) there will be a danger of insolvency unless the
company is able to turn enough of its current assets into cash quickly.
■ In general, high current and quick ratios are considered ‘good’. It means that the
organization has the resources to meet its commitments as they fall due.
■ But, it may indicate that the working capital is not being used efficiently. Example:
there is too much idle cash that should be invested to earn a return.
Continued…

■ Conventional wisdom has it that an ideal current ratio is 2 and an ideal quick ratio
is 1.
■ But, this is not very meaningful without taking into account the type of ratio
expected in a similar business or within a business sector.
■ Assessment of WC ratios must take into account the nature of business involved.
■ Example: A supermarket business operating a JIT system will have little inventory
and since most of sales are for cash they will have few receivables. In addition, the
ability to negotiate long credit periods with suppliers can result in large payables
figure. This results in the net current liabilities and the current ratio will be below
1. This doesn’t mean that the business has liquidity problem.
THE CASH OPERATING CYCLE
■ The cash operating cycle is the length of time between the company’s outlay
(outflow of cash) on raw materials, wages, and other expenditure and the inflow of
cash from the sale of goods.
Continued…

■ The faster a firm can push items around the cycle the lower would be its
investment in working capital.
■ The cash operating cycle reflects a firm’s investment in working capital as it moves
towards the production process towards sales.
■ The investment in working capital gradually increases, first being only in raw
materials, but later in labor and overheads as the production progresses.
■ This investment must be maintained throughout the production process, till the
holding period of finished goods and up to the final collection of cash from
receivables.
■ The net investment can be reduced by taking trade credit from suppliers.
CALCULATION OF CASH
OPERATING CYCLE
■ Refer notes.
Illustration #1

■ A company has provided the following information.

– Receivables collection period 56 days.
– Raw material inventory holding period 21 days.
– Production period (WIP) 14 days.
– Supplier’s payment period 42 days.
– Finished goods holding period 28 days.
■ Calculate the length of operating cycle.
FACTORS AFFECTING THE LENGTH
OF THE OPERATING CYCLE
■ Liquidity versus profitability decisions.
■ Terms of trade.
■ Management efficiency.
■ Industry norms (Retail versus construction)

The optimum level of working capital is the amount that results in no idle cash or
unused inventory.
WORKING CAPITAL RATIOS –
OPERATING CYCLE
■ The time period used to determine the cash operating cycle are calculated by using
a series of working capital ratios.
■ The ratios for the individual components (inventory, receivables and payables) are
normally expressed as the number of days/weeks/months.
1. Inventory holding period

■ It is calculated as follows:
(Inventory/Cost of sales) X 365
2. RAW MATERIAL HOLDING
PERIOD
■ It is calculated as follows:
– (Raw material inventory/Material Usage) X 365
3. WIP HOLDING PERIOD

■ It is calculated as follows:
– (WIP inventory held/Production cost) X 365
4. FINISHED GOODS INVENTORY
PERIOD
■ It is calculated as follows:
– (Finished goods inventory/Cost of goods sold) X 365
ILLUSTRATION #2

■ X Ltd has the following figures from its most recent accounts:
– Receivables $4 million
– Trade payables $ 2 million
– Inventory $ 4.3 million
– Sales (80% on credit) $ 30 million
– Materials purchases (all on credit) $ 18 million
– Cost of Sales $ 25 million
REQUIRED: Calculate the relevant working capital ratios. Round your answers to
the nearest day.