Module 2

Dibin K K
Assistant Professor
What is WCM?
 Management of working capital refers to using of
various strategies that are adopted by the
businesses to manage their current assets and
current liabilities to ensure that the company can
continue its day to day operations and clear its
debt due on time.
Meaning
 Working capital is the part of the company’s total
capital. This capital is required by all the
businesses for financing their short-term needs and
is a part of current assets. It is the measure of the
company’s efficiency to pay its short-term dues as
well as manage operational expenses.
Components of Working capital management

 InventoryManagement
 Accounts Receivable
 Accounts Payable
 Cash Management
Inventory management
 Inventories basically include the raw materials,
WIP products, and finished goods manufactured or
bought from the suppliers. Where the company
buys excessive stock, it places a heavy burden on
the finances. Similarly, if the inventory isn’t
available on time, it will lead to the loss of sales.
 Therefore, inventory management involves the
control of the stock that is manufactured/ bought
for sale in the normal course of business.
Accounts Receivable

 Accounts Receivable refers to the amount that is due when

sales take place and is allowed by the buyers to the seller
while conducting business on credit. It is an anticipation of
the payment that has to be received by the debtors within
the time-period allowed for making the payment.
 The process of account receivable management requires
effective and accurate handling to ensure the collection of
accounts receivable in time. As accounts receivables form
a major part of the company’s asset, it leads to the
generation of cash in-flow for the business.
Accounts Payable

 Account Payable can aptly be called a short-term debt

payable within short periods of time and is treated as a
current liability by the entity that has to make the
payment. It is the money owed by the businesses to its
suppliers for the goods purchased or services consumed.
 The accounts payable needs to be managed effectively
as it enhances the short term cash flow position of the
business. This can be done by deciding on an optimal
timing for payments to the supplier.
Cash Management

 Cash and Cash equivalents  is the most important

current assets that be managed under working capital
management. Being the most liquid form of asset, it
has to be effectively and efficiently managed to
maintain company’s financial stability ,meet the
unexpected expenses and also handle the regular
operational expenses on time (such as payroll).
Further managing cash rightly also helps to maintain
company’s’ rating and avoid insolvency.
Concepts of Working Capital
Management
 Grossworking capital
 Net working capital
Gross working Capital
 Grossworking capital is the sum of all of a
company's current assets (assets that are
convertible to cash within a year or less). Gross
working capital includes assets such as cash,
accounts receivable, inventory, short-term
investments, and marketable securities.
Current Assets
 Inventories

Raw materials
Work in Progress
Finished Goods
 Debtors
 Loans and Advances
 Cash and Bank Balance
Current Liabilities
 Sundry Creditors
 Trade advances
 Borrowing (short term)
 Provisions
Net Working Capital
 Gross working capital less current liabilities is
equal to net working capital, or simply "working
capital," a more useful measure for balance sheet
analysis.
Characteristics of current Assets
 Short life span
 Swift transformation into other asset form
Impact of Short life span and Swift
transformation
 Decisions related to WCM are repetitive and
frequent
 Efficient management of one component cannot
be undertaken without simultaneous consideration
of other components
Factors influencing(Determinants)
WCM requirements
 Nature of business
 Seasonality of operations
 Production policy
 Market Conditions
 Conditions of Supply
Operating cycle
 The time duration required to convert sales, after
the conversion of resources into inventories, into
cash
 Phases

Acquisition of resources
Manufacture of the Product
Sale of the Product
How is the length of operating cycle
determined?
 Itis the sum of
 Inventory Conversion Period
 Debtors(receivables ) conversion period
Inventory Conversion period(ICP)
 The total time needed for producing and selling
the product.
 It includes

1. Raw material conversion period(RMCP)

2. Work-in-process conversion period(WIPCP)
3. Finished goods conversion period(FGCP)
Debtors conversion period
 Thetime required to collect outstanding amount
from the customers.
 Thetotal of Inventory conversion period and
debtors conversion period is called as Gross
operating cycle(GOC)
Formula
 Grossoperating cycle=Inventory conversion
period + Debtors conversion period
Inventory conversion period
 Raw material conversion period
Average time period taken to convert material into
work in progress.
RMCP=Raw material inventory/Raw material
consumption per day
Work-in-Process conversion period
 Average time taken to complete the semi-finished
work or work in process.
 WIPCP=WIP inventory/Cost of production per
day
Finished goods conversion period
 Average time taken to sell the finished goods.
 Finished goods conversion period=Finished goods
inventory/Cost of goods sold per day
ICP formula
 RMCP+WIPCP+FGCP
Debtors Conversion Period
 DCP=Debtors/Credit sales per day
 Average time taken to convert debtors to cash.
Net operating cycle
 Difference between gross operating cycle and
payables deferral period.
 NOC=GOC-CDP (credit Deferral Period)
 It is also called as Cash conversion cycle.
Creditors Deferral Period
 Average time taken to pay creditors.
 Creditors/Credit purchases per day
Problem 1
 From the following information extracted from the
books of a manufacturing concern, compute the
operating cycle in days:
Period covered: 365 days
Average period of credit allowed by
suppliers: 16 days
Contd..
 Average total of debtors outstanding:480
 Raw material consumption: 4400
 Total production cost: 10000
 Cost of sales: 10500
 Sales(Credit):16000
 Value of average cost maintained:
 Raw materials:320
 WIP:350
 Finished Goods:260
Problem 2
 Prepare an estimate of working capital
requirement from the following information of
trading concern:
 Projected annual sales:100000 units
 Selling price:Rs.8/ unit
 Percentage of net profit on sales:25%
 Average credit period allowed: 8 weeks
 Avg credit period allowed by suppliers:4 weeks
Contd..
 Avg stock holding in terms of sales requirements:
12 weeks
 10% of working capital for contingencies
Problem 3
 Kerala Ltd. Sells its products on a gross profit of
20% on sales. The following information is
extracted from its annual accounts for the year
ended 31st march 2015.
 Sales(3 months credit): Rs.4000000
 Raw materials: 1200000
 Wages(15 days arrears):960000
 Manufacturing expenses( 1month arrears):1200000
Contd..
 Administration expenses(1 month in
arrears):480000
 Sales promotion expenses (Payable half yearly in
advances):200000
 The company enjoys one months credit from
suppliers of raw materials and maintains two
months stock of raw materials and one and half
months finished goods. Cash balance is
maintained at Rs.100000 as precautionary balance.
Contd..
 Assuming a 10% Margin, Find out the working
capital requirements .
Problem 4
 A proforma cost sheet of a company provides the
following particulars:

Elements of cost Amount /unit

Raw materials 80
Direct Labor 30
Overheads 60
Total Cost 170
Profit 30
Selling price 200
Contd..
 Raw materials are in stock on an average of one
month. Materials are in process on an average of
half month. Finished goods are in stock on an
average of one month.
 Credit allowed by suppliers =one month. Credit
allowed to customers =two months.
 Lag in payment of wages :1.5 weeks
 Lag in payment of overhead expenses:1 month
Contd..
 One fourth of output is sold against cash.
 Cash in hand:25000
 You are required to prepare a statement showing
the working capital needed to finance a level of
activity of 104000 units of production.
Permanent and variable working
capital
 The operating cycle is a continuous process and the
need for current assets are felt constantly.
 The magnitude of current assets needed is not always
the same. It increases and decreases over
time.However,there is always a minimum level of
current assets which is continuously required by firm
to carry out business operations.
 Permanent or fixed WC is minimum level of required
CA which is same as fixed assets of the firm.
Contd
 Fluctuating or variable working capital is the extra
working capital needed to support the changing
production and sales activities of the firm.
Permanent and temporary working capital
Permanent and temporary working
capital of a growing firm
Inventory Management
Objectives
 Ensure the adequate supply of inventory for
smooth operations
 Minimize investment of funds in the inventories.
 Avoid over-stocking and under-stocking
 Minimize losses on account of obsolescence,
pilferage and wastage.
Motives
 Transaction motive: for meeting the day to day
requirements.
 Precautionary motive: A firm should keep
inventory for unforeseen circumstances also. For
e.g.: Strike
 Speculative motive: Inventory is kept for
capitalizing on opportunity of making profit
Techniques of inventory management
 EOQ
 ABC analysis
 VED analysis
 JIT
 Inventory turnover ratio
 Safety stock
EOQ
 EOQ is the acronym for economic order quantity.
The economic order quantity is the optimum
quantity of an item to be purchased at one time in
order to minimize the combined annual costs of
ordering and carrying the item in inventory.
 EOQ is also referred to as the optimum lot size.
Assumptions
 Demand of material is exactly known
 Consumption rate is constant
 Purchase price of material is fixed
 Carrying cost/storage cost is fixed
 Ordering cost/order is fixed
 Quantity of material ordered is received
immediately
EOQ
EOQ=√2CO/I

C=Annual consumption or usage of material

O=Cost of placing an order
I= Annual carrying or storage cost per unit
Costs of inventory
 Ordering costs:
 Cost of placing orders.
 It depends upon the number of orders and not on
quantity of inventory ordered
 Ordering costs include: Cost of preparation of
purchasing order, cost of receiving goods,
transport cost, document processing costs etc.
Carrying costs:
 Cost incurred for keeping or holding inventory
 Eg: storage cost(Rent,Lighting etc.),handling
cost,insurance,security costs etc.
Points to be noted:
 If in question, requirement of material is given as
weekly, monthly or halfyearly,it should be
converted into annual requirement.
 If the carrying cost or storage cost is given as
percentage of average stock price per unit per year,
calculate the carrying cost by multiplying the
percentage with purchase price of material per
unit.
Problem: 5
 Calculate the EOQ from the following
information. Also calculate the number of orders
to be placed:
 Annual Consumption:10000 Kg
 Cost of placing an order:Rs.50
 Cost per kg of material: Rs.2
 Storage cost – 8%
Cash Budget
 A cash budget is an estimation of the cash flows
 for a business over a specific period of time. This
budget is used to assess whether the entity has
sufficient cash to operate.
How cash Budget Works?
 Companies use sales and production forecasts to
create a cash budget, along with assumptions
about necessary spending and accounts
receivable collections.
 A cash budget is necessary to assess whether a
company will have enough cash to continue
operations. If a company does not have
enough liquidity to operate, it must raise more
capital by issuing stock or taking on more debt.
Optimum Cash Balance
 Every firm needs an optimum level of cash to
ensure smooth operations.
 The aim of efficient cash management is to
maintain an optimum level of cash.
 Optimum level is that level of cash at which there
is trade-off between cost of maintaining the cash
surplus and cost of deficit financing.
Contd..
 Optimum level of cash should be adequate enough
to manage the contingencies and basic cash
requirements of the firm.
Baumols Model
 William J. Baumol developed a model which is
usually used in inventory management but has its
application in determining the optimal cash
balance under certainty.
 Baumol found similarities between inventory
management and cash management.
Contd..
 As Economic Order Quantity (EOQ) in inventory
management involves tradeoff between carrying
costs and ordering cost, the optimal cash balance
is the tradeoff between opportunity cost or cost of
borrowing or holding cash and the transaction cost
(i.e. the cost of converting marketable securities
into cash etc.) The optimal cash balance is reached
at a point where the total cost is the minimum.
Assumptions
 Firm is able to forecast its cash needs with
certainty.
 Firms cash payment occurs uniformly over a
period of time.
 Opportunity cost of holding cash is known and it
does not change over time.
 Same transaction cost whenever it converts
security to cash.
Formula
 C=√2cT/k
 C=optimum cash balance
 c= cost per transaction
 T=total cash requirement during the period
 k=opportunity cost for holding cost
Miller-Orr model
 The Miller-Orr model of cash management is
developed for businesses with uncertain cash
inflows and outflows. This approach allows lower
and upper limits of cash balance to be set and
determine the return point (target cash balance).
This is different from the Baumol-Tobin model,
which is based on the assumption that the cash
spending rate is constant.
Assumptions
 The cash inflows and cash outflows are stochastic.
In other words, each day a business may have both
different cash payments and different cash receipts.
 The daily cash balance is normally distributed, i.e.,
it occurs randomly.
 There is a possibility to invest idle cash in
marketable securities.
 There is a transaction fee when marketable
securities are bought or sold.
 According to Miller model ,upward changes in cash
balance are allowed till the cash balance reaches an
"upper control limit”(UL).As this level is attained the
cash balance is reduced to the return point(RP) by
investing.
 While the value of lower control level (LL) is set by the
management based on what it considers to be the
minimum below which the cash balance should not fall,
the values of RP and UL have been derived by Miller
and Orr
RP Formula
Formula
 Rp=return point
 b=fixed cost per order for converting marketable
securities into cash
 I= daily interest rate earned on marketable securities
 Variance of daily changes in the expected cash
balance.
 LL=Lower control limit
 UL=Upper control limit
Diagram
Reference

 FinancialManagement Theory and Practice:

Prasanna Chandra
 FM-IM Pandey
 Investopedia