Working Capital

Management
 Working Capital Management
Learning outcomes:
You should be able to understand the;

Meaning and Concept of Working Capital

Objectives of Working Capital Management
Management of Working Capital Principles
Determining Working Capital Financing Mix
Importance of Adequate Working Capital
Excess or Inadequate Working Capital
Factors determining Working Capital Requirements
 Meaning of Working Capital

 Capital required for a business can be classified under two main

categories namely; Fixed capital and Working capital.

 Every business needs funds for two purposes; for its establishment
and to carry out its day-to-day operations. Long-term funds are
required to create production facilities through purchase of fixed
assets such as plant and machinery, land, Building etc. Investments
in these assets represent that part of firm’s capital which is blocked
on permanent basis and is called fixed capital.

 Funds are also needed for short-term purposes for purchase of raw
materials, payment of wages and other day-to-day expenses etc.
These funds are known as working capital which is also known
as Revolving or circulating capital or short term capital. According
to Shubin, “Working capital is amount of funds necessary to
cover the cost of operating the enterprise”.
Nature of Working Capital
 Working capital management is concerned with the problems that arise in
attempting to manage the current assets, the current liabilities and the
interrelations that exist between them.

 Current assets refer to those assets which in the ordinary course of business
can be, or will be, converted into cash within one year without undergoing
a diminution in value and without disrupting the operations of the firm.
Examples- cash, marketable securities, accounts receivable, Inventory and
prepaid expenses

 Current liabilities are those liabilities which are intended, at their inception,
to be paid in the ordinary course of business, within a year, out of the
current assets or the earnings of the concern.
Examples- accounts payable, bills payable, bank overdraft and outstanding
expenses.
Concept of working Capital

There are two concepts of working capital:

(i) Gross working capital
(ii) Net working capital.
Gross working capital is the capital invested in total current
assets of the enterprise.
Net working capital is excess of Current Assets over Current
liabilities.
Net Working Capital = Current Assets – Current Liabilities

When current assets exceed the current liabilities the working

capital is positive. Negative working capital results when current
liabilities are more than current assets.
 Classification of Working Capital
On the basis of time, working capital may be classified as Permanent or fixed
working capital and Temporary or variable working

1)Permanent or Fixed working capital

It is the minimum amount which is required to ensure effective utilisation of
fixed facilities and for maintaining the circulation of current assets from cash
to inventories, from inventories to receivables and from receivables to cash
and so on. As the business grows, the requirements of permanent working
capital also increase due to increase in current assets.

The permanent working capital can further be classified as regular working

capital and reserve working capital. Regular Working Capital is the
permanent working capital which is normally required in the normal course of
business for the Working capital cycle to flow smoothly.
Reserve working capital is the excess mount over the requirement for regular
working capital which may be provided for contingencies that may arise at
unstated periods such as strikes, rise in prices, depression etc.

 Classification of Working Capital
2) Temporary or Variable working capital
 It is the amount of working capital which is required to meet the seasonal
demands and some special exigencies. In simple terms, it is the difference
between net working capital and permanent working capital.

 Variable working capital is further classified as seasonal working capital and

special working capital. The capital required to meet seasonal needs of the
enterprise is called seasonal working capital. For example, the manufacturer
of sweaters for whom relevant season is the winters. Normally, their working
capital requirement would increase in that season due to higher sales in that
period and then go down as the collection from debtors is more than sales.

 Special working capital is that part of working capital which is required to

meet special exigencies. It has no basis to forecast and has rare occurrence
normally. For example, a country where Olympic Games are held, all the
business require extra working capital due to a sudden rise in business activity
.
 Variable Working Capital
Amount
of
Working
Capital
Permanent Working Capital

Time
 Management of Working Capital

Working capital refers to excess of current assets over current liabilities.

Management of working capital therefore is concerned with the
problems that arise in attempting to manage current assets, current
liabilities and inter relationship that exists between them.

The basic goal of working capital management is to manage the current

assets and current liabilities of a firm in such a way that satisfactory
level of working capital is maintained i.e. it is neither inadequate nor
excessive.

This is so because both inadequate as well as excessive working capital
positions are bad for any business. Inadequacy of working capital may
lead the firm to insolvency and excessive working capital implies idle
funds which earns no profits for the business. Working capital
Management policies of a firm have a great effect on its profitability,
liquidity and structural health of organization.
 Liquidity versus Profitability- A Risk-
Return Trade-off
 An important aspect of a working capital policy is to maintain and provide
sufficient liquidity to the firm.

 The term risk is defined as the probability that a firm will become technically
insolvent so that it will be not able to meet its obligations when they become
due for payment. The greater the net working capital, the more liquid is the firm
and, therefore, the less likely it is to become technically insolvent. Conversely,
lower levels of net working capital and liquidity will be increased levels of risk.

 The decision on how much working capital be maintained involves a trade-off
i.e., having a large net working capital may reduce the liquidity-risk faced by
the firm, but it can have a negative effect on the cash flows. Holding excess
working capital is not very profitable. This is because cash account is paid
no interest and accounts receivable earns no return.
 Therefore, the net effect on the value of the firm should be used to determine the
optimal amount of working capital.
 Determining Financing-mix
There are two sources from which funds can be raised for
current assets financing-
o Short term sources, like current liabilities and,
o long term sources, such as share capital, long term
borrowings, internally generated resources like retained
earnings, etc.
 The need of Working Capital

The need for working capital arises due to time gap between
production and realization of cash from sales. There is an
operating cycle involved in sales and realization of cash. There
are time gaps in purchase of raw materials and production,
production and sales, and sales and realization of cash. Thus,
working capital is needed for following purposes.
For purchase of raw materials, components and spares.
To pay wages and salaries.
To incur day-to-day expenses and overhead costs such as fuel,
power etc.
To meet selling costs as packing, advertisement
To provide credit facilities to customers.
To maintain inventories of raw materials, work in progress, stores
and spares and finished stock.
The working capital requirements of a firm depends, to a great extent
upon the operating cycle of the firm. The operating cycle may be defined
as the time duration starting from the procurement of goods or raw
materials and ending with the sales realization.
The length and nature of the operating cycle may differ from one firm to
another depending upon the size and nature of the firm.
The operating cycle of a firm consists of the time required for the
completion of the chronological sequence of some or all of the following-
o Procurement of raw materials and services.
o Conversion of raw materials into work-in-progress.
o Conversion of work-in-progress into finished goods.
o Sale of finished goods.
o Conversion of receivables into cash.
Operating cycle of a typical company
.
Receive
Purchase Sell
Cash
resources Product
On credit
Pay for
Resources
purchases

Receivable
Inventory conversion
Conversion period
period

Cash conversion
Payable
cycle
Deferral period

Operating
cycle
 Approaches to determine an
appropriate Financing-mix
The working capital management includes and refers to the
procedures and policies required to manage the working capital.
There are three basic approaches to determine an appropriate
financing mix:

1. Hedging approach, also called the matching approach,

2. Conservative approach,
3. Aggressive approach.
 Hedging Approach/ Matching Approach
 According to this approach, the maturity of the sources of the funds should
match the nature of the assets to be financed. For the purpose of analysis,
the current assets can be broadly classified into two classes-
o those which are required in a certain amount for a given level of operation
and, hence, do not vary over time.
o those which fluctuate over time.

 The Hedging approach suggests that long term funds should be used to
finance the fixed portion of current assets requirements in a manner similar
to the financing of fixed assets.

 The purely temporary requirements, that is, the seasonal variations over
and above the permanent financing needs should be appropriately financed
with short term funds.

 This approach, therefore, divides the requirements of total funds into

permanent and seasonal components, each being financed by a different
source.
Matching approach to asset financing
Total Assets
Short-term
Debt
$
Fluctuating Current Assets

Long-term
Permanent Current Assets Debt +
Equity
Capital

Fixed Assets

Time
 Conservative Approach
This approach suggests that the estimated requirement of total
funds should be met from long term sources; the use of short
term funds should be restricted to only emergency situations or
when there is an unexpected outflow of funds.
The distinct features of this approach are:
i. Liquidity is greater
ii. Risk is minimised
iii. The cost of financing is relatively more as interest has to
be paid even on seasonal requirements for entire period.
iv. Profitability is lower since the cost of long term finance
will be higher than that on short-term deposits
Conservative approach to asset financing
Total Assets
Short-term
Debt
$
Fluctuating Current Assets

Long-term
Permanent Current Assets Debt +
Equity
capital

Fixed Assets

Time
 Aggressive approach
 A working capital policy is called an aggressive policy if the firm
decides to finance a part of the permanent working capital by short
term sources. The aggressive policy seeks to minimize excess
liquidity while meeting the short term requirements. The firm may
accept even greater risk of insolvency in order to save cost of long
term financing and thus in order to earn greater return.

 The trade-off between risk and profitability depends largely on the

financial manager’s attitude towards risk.
Aggressive approach to asset financing

Total Assets
Short-term
Debt
$
Fluctuating Current Assets

Long-term
Permanent Current Assets Debt +
Equity
capital

Fixed Assets

Time
 DETERMINANTS OF WORKING
CAPITAL
1. Nature and size of the business: Size may be measured in
terms of the scale of operations. A firm with larger scale of
operations will need more working capital than a small firm.
Trading and financial firms have less investment in fixed
assets. But require a large sum of money to be invested in
working capital. Retail stores, business units require larger
amount of working capital, where as, public utilities need less
working capital and more funds to invest in fixed assets.
 DETERMINANTS OF WORKING
CAPITAL
2. Firm’s production policy: The firm’s production policy
(manufacturing cycle) is an important factor to decide the
working capital requirement of a firm. The production cycle
starts with the purchase and use of raw material and completes
with the production of finished goods. The larger the
manufacturing cycle and uniform production policy the larger
will be the requirement of working capital.
3. Firm’s credit policy: The credit policy of a firm influences
credit policy of working capital. A firm following liberal credit
policy to all customers requires funds. On the other hand, the
firm adopting strict credit policy and grant credit facilities to
few potential customers will require less amount of working
capital.
DETERMINANTS OF WORKING CAPITAL
4. Availability of credit: The working capital requirements of a
firm are also affected by credit terms granted by its suppliers – i.e.
creditors. A firm will need less working capital if liberal credit
terms are available to it. Similarly, the availability of credit from
banks also influences the working capital needs of the firm. A
firm, which can get bank credit easily on favorable conditions,
will be operated with less working capital than a firm without
such a facility.

5. Growth and expansion of business: Working capital

requirement of a business firm tend to increase in correspondence
with growth in sales volume and fixed assets. A growing firm may
need funds to invest in fixed assets in order to sustain its growing
production and sales. This will, in turn, increase investment in
current assets to support increased scale of operations. Thus, a
growing firm needs additional funds continuously.
DETERMINANTS OF WORKING CAPITAL
 6. Profit margin and dividend policy: The magnitude of working
capital in a firm is dependent upon its profit margin and dividend
policy. A high net profit margin contributes towards the working
capital pool. To the extent the net profit has been earned in cash, it
becomes a source of working capital. This depends upon the dividend
policy of the firm. Distribution of high proportion of profits in the
form of cash dividends results in a drain on cash resources and thus
reduces company’s working capital to that extent.
 7. Taxation policy: The tax policies of the Government will
influence the working capital decisions. If the Government follows
regressive taxation policy, they are left with very little profits for
distribution and retention purpose. Consequently the firm has to
borrow additional funds to meet their increased working capital
needs. When there is a liberalized tax policy, the pressure on working
capital requirement is minimized.
DETERMINANTS OF WORKING CAPITAL
8. Business fluctuations: Most firms experience fluctuations
in demand for their products and services. These business
variations affect the working capital requirements. When there
is an upward swing in the economy, sales will increase,
correspondingly, the firm’s investment in inventories and book
debts will also increase. Under boom, additional investment in
fixed assets may be made by some firms to increase their
productive capacity. This act of the firm will require additional
funds. On the other hand when, there is a decline in economy,
sales will come down and consequently the conditions, the firm
try to reduce their short-term borrowings. Similarly the
seasonal fluctuations may also affect the requirement of
working capital of a firm.
 DETERMINANTS OF WORKING
CAPITAL
9. Changes in the technology: The technological changes and
developments in the area of production can have immediate
effects on the need for working capital. If the firm wish to
install a new machine in the place of old system, the new
system can utilize less expensive raw materials, the inventory
needs may be reduced there by working capital needs.
10. Operating efficiency of the firm: Operating efficiency
means the optimum utilization of a firm’s resources at
minimum cost. If a firm successfully controls operating cost, it
will be able to improve net profit margin which, will, in turn,
release greater funds for working capital purposes.
 Forecasting / Estimation of Working Capital Requirements

Factors to be considered;
• Total costs incurred on materials, wages and overheads
• The length of time for which raw materials remain in stores
before they are issued to production.
• The length of the production cycle or WIP, i.e., the time taken for
conversion of RM into FG.
• The length of the Sales Cycle during which FG are to be kept
waiting for sales.
• The average period of credit allowed to customers.
Forecasting / Estimation of Working
Capital Requirements
• The amount of cash required to pay day-to-day expenses of the
business.
• The amount of cash required for advance payments if any.
• The average period of credit to be allowed by suppliers.
• Time – lag in the payment of wages and other overheads.
 PROFRMA – WORKING CAPITAL ESTIMATES

1. TRADING CONCERN
STATEMENTOF
STATEMENT OFWORKING
WORKINGCAPITAL
CAPITALREQUIREMENTS
REQUIREMENTS
Amount(Rs.)
Amount (Rs.)
CurrentAssets
Current Assets
(i)Cash
(i) Cash ----
----
(ii)Receivables
(ii) Receivables((For…..Month’s
For…..Month’sSales)----
Sales)---- ----
----
(iii)Stocks
(iii) Stocks((For……Month’s
For……Month’sSales)-----
Sales)----- ----
----
(iv)AdvancePayments
(iv)Advance Paymentsififany
any ----
----
Less::Current
Less CurrentLiabilities
Liabilities
(i)Creditors
(i) Creditors(For…..
(For…..Month’s
Month’sPurchases)-
Purchases)- ----
----
(ii)Lag
(ii) Lagininpayment
paymentofofexpenses
expenses -----_
-----_
WORKINGCAPITAL
WORKING CAPITAL((CA CA––CLCL)) xxx
xxx
Add::Provision
Add Provision //Margin
MarginforforContingencies
Contingencies -----
-----

NETWORKING
NET WORKINGCAPITAL
CAPITALREQUIRED
REQUIRED XXX
XXX
 The Operating-cycle and Working Capital
Needs
The operating cycle of a firm consists of the time required for
the completion of the chronological sequence of some or all of
the following-
o Procurement of raw materials and services.
o Conversion of raw materials into work-in-progress.
o Conversion of work-in-progress into finished goods.
o Sale of finished goods.
o Conversion of receivables into cash.
 Operating cycle of a typical company
.
Receive
Purchase Sell
Cash
resources Product
On credit
Pay for
Resources
purchases

Receivable
Inventory conversion
Conversion period
period

Cash conversion
Payable
cycle
Deferral period

Operating
cycle
 Inventory conversion period
Avg. inventory
= _________________
Cost of sales/365

Inventory can be dividend into; Raw material, work in progress and finished goods.
The days invested in each component can be calculated as follows;
 Raw material inventory days =(Raw material inventory/purchases)x365

 Work in progress inventory days = (WIP inventory/Cost of sales)x365

 Finished goods inventory days = (finished goods inventory/cost of sales) x 365

 Inventory conversion period = raw materials inventory days + work in progress

inventory days + Finished goods inventory days.

 Receivable conversion period

Accounts receivable
= ___________________
Annual sales/365
Cash conversion cycle = operating cycle – payables
deferral period.

Payables deferral period

Accounts payable + Salaries, etc
= ___________________________
(Cost of sales + selling, general and admn.
Expenses)/365

The payables deferral period also known as creditors

days can be also calculated as;
 Payable deferral period =
(Accounts payable/purchases)x365
 Operating Cycle Versus Cash Conversion Cycle
The operating cycle is the length of time it takes a company’s
investment in inventory to be collected in cash from
customers.
The cash conversion cycle (or the net operating cycle) is the
length of time it takes for a company’s investment in
inventory to generate cash, considering that some or the entire
inventory is purchased using credit.
Worked Example
 Extracts from the financial statements of XYZ Ltd are set out below;
 $
 Inventory:
• Raw Materials 844,000
• Work-In-Progress 448,128
Finished Goods 1,567,898
 Trade receivables 1,425,600
 Trade payables 604,800
 Annual Purchase 1,745,000

 Annual cost of sales 5,272,128

 Annual sales 5,802,400
Worked Example

Required;
i) Calculate the length of the Operating Cycle (OC) and the
Cash Conversion Cycle (CCC) for the company.

ii) The average CCC for firms in XYZ’s industry is 154 days.
Critically evaluate XYZ’s period.
 Operation Cycle
 Operation Cycle = Inventory conversion period + receivable conversion
period
 Inventory conversion period
 Raw material inventory days =(Raw material inventory/purchases)x365
= (844,000/1,745,000)x365 = 176.5 days

 Work in progress inventory days = (WIP inventory/Cost of sales)x365

= (448,128/5,272,128)x365 = 31 days

 Finished goods inventory days = (finished goods inventory/cost of sales) x

365
=(1,567,898/5,272,128)x365= 108.5

Inventory conversion period = raw materials inventory days + work in

progress inventory days + Finished goods inventory days.
= 176.5 + 31 +1o8.5 = 316 days
Operation Cycle = Inventory conversion period + receivable
conversion period
=316 days+ 89.7 days =405.7 days
 Cash Conversion cycle
Cash Conversion Cycle = Operating Cycle – Payables deferral
period

Cash Conversion Cycle = Operating Cycle – Payables deferral

period:
= 405.7 – 126.5 = 279.2 days
 Cash conversion Cycle
ii) The average CCC for firms in XYZ’s industry is 154 days.
Critically evaluate XYZ’s period.

 Firm XYZ has a longer Cash Conversion Cycle (279.2 days)

compared to the average CCC for firms in XYZ’s industry (154
days). XYZ’s CCC is above the average by 125.2 days. This
implies that XYZ is not efficiently utilizing its resources compared
to its competitors
iii) List strategies which a company could use to reduce the cash
conversion cycle indicating the implication of each strategy.
 Delaying payment of payable – this can lead to low credit rating
 Reducing trade receivable days – it may results in loss of sales
 Reducing inventory level – lead to disruption in production and stock
outs, causing a reduction in sales.