WORKING CAPITAL

It is the capital of a business which is used to carry

out day-to-day business operations of a firm
• 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 and inventory.
 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
 Concepts and Definitions of
Working Capital
There are two concepts of working capital: Gross and
Net.
Gross working capital- means the total current
assets.
Net working capital- can be defined in two ways-
oThe difference between current assets and current
liabilities.
oThe portion of current assets which is financed with
long term funds.
 Types of working capital needs
 The working capital need can be bifurcated into permanent
working capital and temporary working capital.

 Permanent working capital- There is always a minimum

level of working capital which is continuously required by a firm in
order to maintain its activities like cash, stock and other current
assets in order to meet its business requirements irrespective of the
level of operations.
 Temporary working capital- Over and above the permanent
working capital, the firm may also require additional working
capital in order to meet the requirements arising out of
fluctuations in sales volume. This extra working capital needed to
support the increased volume of sales is known as temporary or
fluctuating working capital.
 Variable Working
Amount Capital
of
Working
Capital
Permanent Working Capital

Time
 Matching approach
• The matching approach suggests that
permanent part of working capital should be
financed by long-term funds and the variable
part of the working capital should be financed
with short-term funds.
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.
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, yet
while doing so he must take care of the following factors-
o Flexibility of the mix
o Cost of financing
o Risk attached with financing mix
Aggressive approach to asset financing
Total Assets
Short-term
Debt
$
Fluctuating Current Assets

Long-term
Permanent Current Assets Debt +
Equity
capital

Fixed Assets

Time
 WORKING CAPITAL CYCLE

• OPERATING CYCLE

• CASH CYCLE
OPERATING CYCLE

CASH CYCLE
 Operating Cycle
• The operating cycle is the length of time for a
company to acquire materials, produce the
products, sell the products, and collect the
proceeds from customers. The normal
operating cycle is the average length of time
for a company to acquire materials, produce
the products and collect the proceeds from
customers
Example 1

• You have invested Rs.50,000 in your company on 1.1.2006

for buying and selling of color TVs assuming:

1. Inventory costing Rs. 50,000 is purchased at the

beginning of each month.

2. All of the TVs were sold at the end of each month on

cash for Rs. 60,000

1. What is the operating cycle of the company?

The answer is 30 days

if the sales are made on account (credit) of 30 days terms what is the
cash cycle of the company?

The answer is 60 days

Suppose when the suppliers allow 20 days term and sales are made
an account of 60 days’ term. What is the cash cycle of the company?

The answer is 70 days (30+60-20)

Find the Average Collection Period
with the help of following data-
Gross Operating Cycle = 88 Days
Net Operating Cycle = 65 Days
Raw Material Storage Period = 45 Days
Work-in-progress Conversion Period =
4 Days
Finished Goods Storage Period = 25
days
For calculating net operating cycle, various
conversion periods may be calculated as follows:
Raw material cycle period (RMCP)=
(Average Raw material stock/Total raw material Consumable) x 365

Working progress cycle period (WPCP) =

(Average work in progress/ Total cost of Production) x 365

Finished goods cycle period (FGCP) =

(Average finished goods/Total cost of goods Sold) x 365

Accounts receivable cycle period (ARCP) =

(Average Account receivable/Total of sales) x 365

Accounts payable cycle period (APCP) =

(Average account payable/ Total credit purchase) x 365
Calculate Inventory Conversion Period if-

Raw Material inventory Rs. 10,00,000

Raw Material Consumption – 50,00,000
Work-in- progress inventory – 4,00,000
Cost of Production – 56,00,000
Finished Goods Inventory 8,00,000
Cost of Goods Sold – 48,00,000
From the following data, compute the duration of the operating cycle for each of the
two years and comment on increase/decrease
Particulars Year 1 Year 2

Stocks:
Raw Materials 20,000 27,000
Work-in-process 14,000 18,000
Finished Goods 21,000 24,000

Purchase of raw materials 96,000 1,35,000

Cost of goods sold 1,40,000 1,80,000

Sales 1,60,000 2,00,000

Debtors 32,000 50,000

Creditors 16,000 18,000

Assume 360 days per year for computation purposes.

Determination of Operating Cycle
Particulars Year 1 (Days) Year 2 (Days)
i) Raw Materials holding period:
360 Days* Stock of raw material 360*20,000 360*27,000
96,000 1,35,000
Cost of Raw Material Purchased = 75 = 72

iii) Work-in Process Holding period

360 Days* Stock of WIP 360*14,000 360*18,000
__________________ 1,40,000 1,80,000
Cost of Goods manufactured = 36 = 36
iv) Finished Goods Holding Period:
360 days * Stock of Finished Goods 360*21,000 360*24,000
____________________________ 1,40,000 1,80,000
Cost of Goods Sold = 54 = 48

v) Debtor Collection Period

__________Debtor_*360_____________ 360*32,000 360*50,000
Stocks of Finished Goods ___________ __________
1,60,000 2,00,000
= 72 = 90

ii) Less- Creditors Payment period

360 days * Creditors 360*16,000 360*18,000
___________________ 96,000 = (60) 1,35,000
Purchases = (48)
The duration of the operating cycle has increased by
21 days in a year 2 compared to year 1. It will
necessitate more working capital in year 2. This
increase has been primarily caused by an increase in
debtors collection period and decrease in creditors
payment period:
Increase in debtors collection period 18 days

Decrease in creditors payment period 12

Less- Decrease in raw material holding period (3)

Less- Decrease in finished goods holding period (6)

Net Increase in Operating Cycle 21

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.
 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.
ESTIMATION OF WORKING CAPTIAL
 X & Y Ltd. Is desirous to purchase a business and has consulted you, and one point on
which you are asked to advise them, is the average amount of working capital . You
are given the following estimates and are instructed to add 10% to your computed
figures-
particulars Amount

1) Average amount backed up for stocks:

Stocks of finished product 5,000
Stock of stores & Materials 8,000
2) Average Credit Given :
Inland Sales, 6 weeks credit 3,12,000
Export Sales, 1.5 weeks credit 78,000
3) Average time lag in Payment of Wage & Other Outgoings
Wages, 1.5 weeks 2,60,000
Stock & Materials 1.5 Months 48,000
Rent & Royalties, 6 months 10,000
Clerical Staff, 0.5 months 62,400
Manager, 0.5 Months 4,800
Misc. Expenses 1.5 Months 48,000

4) Payment in Advance-
Sundry Expenses (paid quarterly) 8,000
Undrawn Profits on an average throughout the year 11,000
 Statement to determine for the net working capital
Current Assets :
1) Stocks of finished product 5,000
2) Stock of Stores & Materials 8,000
3) Debtors:
Inland sales (Rs. 3,12,000 * 6/52) 36,000
Export Sales (Rs. 78,000* 3/104) 2,250
4) Advance payment of sundry expenses (Rs. 8,000*1/4) 2,000

53,250
Current Liabilities
1) Wages (Rs. 2,60,000 *3/104) 7,500
2) Stocks (48,000 *3/24) 6,000
3) Rent, royalties (Rs 10,000*6/12) 5,000
4) Clerical Staff (62,400* 1/24) 2,600
5) Manager (Rs 4,800 * 1/24) 200
6) Misc. Expenses(48,000*3/24) 6,000
Total Estimates of Current liabilities 27,300

Net Working Capital 25,950

Add 10% Contingency 2,595
Average Amount of Working Capital Required
While preparing a project report on behalf of client, you have collected the
following facts. Estimate the net working capital for the firm. Add 10% to your
computed figures to allow contingencies:
Estimated Cost per unit of Production
Raw Material- Rs 80
Direct Material- Rs 30
Overheads – Rs 60
Additional Information-
Selling Price Rs. 200 per unit
Level of Activity 1,04,000 units of Production
Raw Material in stock, average 4 weeks
Work in progress (assume 50% completion stage in respect of
conversion cost and 100% completion in respect of materials) average 2
weeks
Finished Goods in stock, average 4 weeks
Credit allowed by suppliers, average 4 weeks
Credit allowed to debtors average 8 weeks
Lag in Payment of wages, average 1.5 weeks
Cash at bank is expected to be Rs 25,000
You may assume the year of 52 weeks. All sales are on credit basis only.
Current assets
i) Raw Material in Stock (1,04,000*80*4/52) 6,40,000
ii) Work in progress (1,04,000* 125*2/52) 5,00,000
iii) Finished Goods Stock (1,04,000*Rs 170*4/52) 13,60,000
iv) Debtors (1,04,000* Rs 200*8/52) 32,00,000
v) Cash at Bank 25,000
Total Investment in current assets ,000
Current Liabilities
i) Creditors, average 4 weeks (1,04,000* Rs. 80 * 4/52) 6,40,000
ii) lag in payment of wages (1,04,000* Rs. 30* 1.5/52) 90,000
Total Current Liabilities 7,30,000

Net Working Capital ,000

Add- Contingency of 10% ,500
Net Working Capital Required 00
 Bank Finance for Working
Capital
While Bank credit is considered as a major source of meeting the working capital
requirement of the industry, the banks have to consider the following factors before
meeting their requirements.
•What should be the amount of working
capital assistance?
•What should be the form in which
working capital assistance may be
extended?
•What should be the security that should
be obtained for extending the working
capital assistance?
 Amount of Assistance
• On the basis of estimates submitted by the
company, the bank may decide the amount of
assistance which may be extended after
considering the margin requirement. The
percentage of margin money may depend
upon the credit standing of the company,
fluctuation in the price of security or as per
the directions of Reserve Bank.
 Form of assistance
• Loan- In this, the amount of assistance is
disbursed at one time only.
• Overdraft- In this case, the amount is allowed
to be withdrawn by company in excess of
balance standing in its bank account. It is in
the form of a continuous type of assistance
due to annual renewal of the limit. Interest is
payable on actual amount drawn and is
calculated on daily product basis.
• Cash Credit- cash credit is also a demand
facility, but it is on continuous basis. It is
normally given on security of stock, debtors
etc. Balance Sheet, P & L account is required
be submitted to bank generally annually or
quarterly. Interest rate is normally lower than
overdraft account.
• Bills Purchased/ Discounted- this facility
enables the company to get the immediate
payment against the credit bills /invoices
raised by the company. The bank holds the
bills as a security till the payment is made by
the customer. On maturity, bank collects the
full amount of bills from the customer.
• Working capital Term Loans- To meet the
working capital needs of the company, banks
may grant the working capital term loans for a
period of 3 to 7 years, payable in yearly or half
yearly instalments.
• Packing Credit- Packing credit is a facility given
by the bank to enable the company to
company to buy/manufacture the goods to be
exported. If the company hold the export
order placed by the overseas buyer ir an
irrevocable letter of credit in its favour, it can
approach the bank for packing credit facility.
• Pre-shipment Packing Credit
• Post-shipment Packing Credit
 Letter of Credit as a Mode of Payment
• A letter of credit is a document from a bank or a
financial institution on the buyer’s behalf that assures
the payment to the seller. The bank needs to have
certain documents in possession before it issues the
LC. This letter is as good as a guarantee to the seller
that the payment will be cleared even if the buyer fails
to do so. The risk of non-payment shifts from the seller
to the bank. Generally, the entire process also involves
another bank that works as an advisor to the seller. The
issuing bank authorizes the advisory bank to pay the
seller.