Unit III

Working Capital Management

 Introduction
• Working capital management (WCM) is a
business strategy designed to ensure that a
company operates efficiently by monitoring and
using its current assets and liabilities to the best
effect.
• The primary purpose of working capital
management is to enable the company to
maintain sufficient cash flow to meet its short-
term operating costs and short-term debt
obligations.
 Components of Working Capital
• A company's working capital =
current assets - current liabilities.
• Current assets include anything that can be
easily converted into cash within 12 months.
These are the company's highly liquid assets.
• Current liabilities are any obligations due
within the following 12 months. These include
operating expenses and long-term debt
payments.
 Cont….
• Current Assets
Inventories or Stocks, Raw materials, Work in
progress, Consumable Stores, Finished goods, Bills
Receivable, Pre-payments, Short-term Investments,
Accrued Income and, Cash and Bank Balances.

• Current Liabilities
Bills Payable, Accrued Expenses, Bank Overdrafts,
Bank Loans (short-term), Proposed Dividends,
Short-term Loans, Tax Payments Due
 Characteristics of WCM
• Working capital management commonly involves
monitoring cash flow, current assets, and current
liabilities through ratio analysis of the key
elements of operating expenses, including the
working capital ratio, collection ratio, and
inventory turnover ratio.
• Working capital management helps maintain the
smooth operation of the net operating cycle, also
known as the cash conversion cycle (CCC)—the
minimum amount of time required to convert net
current assets and liabilities into cash.
 IMP Concepts in WCM
• Gross Working Capital
- The sum total of all current assets of a business concern is
termed as gross working capital. So,
Gross working capital = Stock + Debtors + Receivables + Cash.

• Net Working Capital

-The difference between current assets and current liabilities
of a business concern is termed as the Net working capital.
Hence,
Net Working Capital = Stock + Debtors + Receivables + Cash –
Creditors – Payables.
 Nature of WCM
• It is used for purchase of raw materials, payment of wages and
expenses.
• It changes form constantly to keep the wheels of business moving.
• Working capital enhances liquidity, solvency, creditworthiness and
reputation of the enterprise.
• It generates the elements of cost namely: Materials, wages and
expenses.
• It enables the enterprise to avail the cash discount facilities offered
by its suppliers.
• It helps improve the morale of business executives and their
efficiency reaches at the highest climax.
• It facilitates expansion programmes of the enterprise and helps in
maintaining operational efficiency of fixed assets.
 Need for Working Capital
• Adequate working capital is needed to maintain a regular supply of raw
materials, which in turn facilitates smoother running of production
process.
• Working capital ensures the regular and timely payment of wages and
salaries, thereby improving the morale and efficiency of employees.
• Working capital is needed for the efficient use of fixed assets.
• In order to enhance goodwill a healthy level of working capital is needed.
It is necessary to build a good reputation and to make payments to
creditors in time.
• Working capital helps avoid the possibility of under-capitalization.
• It is needed to pick up stock of raw materials even during economic
depression.
• Working capital is needed in order to pay fair rate of dividend and interest
in time, which increases the confidence of the investors in the firm.
 Importance of Working Capital
• It helps measure profitability of an enterprise. In its absence, there
would be neither production nor profit.
• Without adequate working capital an entity cannot meet its short-
term liabilities in time.
• A firm having a healthy working capital position can get loans easily
from the market due to its high reputation or goodwill.
• Sufficient working capital helps maintain an uninterrupted flow of
production by supplying raw materials and payment of wages.
• Sound working capital helps maintain optimum level of investment
in current assets.
• It enhances liquidity, solvency, credit worthiness and reputation of
enterprise.
• It provides necessary funds to meet unforeseen contingencies and
thus helps the enterprise run successfully during period of crisis.
 Classification of Working Capital
• Gross Working Capital
Gross working capital refers to the amount of funds invested in various
components of current assets. It consists of raw materials, work in
progress, debtors, finished goods, etc.

• Net Working Capital

The excess of current assets over current liabilities is known as Net
working capital. The principal objective here is to learn the
composition and magnitude of current assets required to meet current
liabilities.

• Positive Working Capital

This refers to the surplus of current assets over current liabilities.
 Cont….
• Negative Working Capital
Negative working capital refers to the excess of current liabilities over
current assets.

• Permanent Working Capital

The minimum amount of working capital which even required during
the dullest season of the year is known as Permanent working capital.

• Temporary or Variable Working Capital

It represents the additional current assets required at different times
during the operating year to meet additional inventory, extra cash, etc.
 Types of WCM Ratios
• Collection Ratio
- The collection ratio is a measure of how efficiently a
company manages its accounts receivables.
- The collection ratio calculation provides the average
number of days it takes a company to receive payment
after a sales transaction on credit.
- If a company's billing department is effective at
collections attempts and customers pay their bills on
time, the collection ratio will be lower. The lower a
company's collection ratio, the more efficient its cash
flow.
 Cont….
• Inventory Turnover Ratio
- The final element of working capital management is
inventory management.
- To operate with maximum efficiency and maintain a
comfortably high level of working capital, a company must
keep sufficient inventory on hand to meet customers'
needs while avoiding unnecessary inventory that ties up
working capital.
- Companies typically measure how efficiently that balance is
maintained by monitoring the inventory turnover ratio.
- A relatively low ratio compared to industry peers indicates
inventory levels are excessively high, while a relatively high
ratio may indicate inadequate inventory levels.
Operating Cycle of Working Capital
• Working capital is also called a circulating capital or revolving
capital. That is the money/capital which circulates in various forms
of current assets in a continued manner.
For example, at a point of time, funds may be tied up in raw materials,
then later converted into semi-finished products, then into finished/
final products and when these finished products are sold, it is
converted either into account receivables or cash.

• This cash is reinvested in current assets. Thus, the amount always

keeps on circulating or revolving from cash to current assets and
back again to cash. That is why some people prefer to use the term
liquidity management instead of working capital management.
Although this circulation takes place at short intervals, the money is
required again and again.
 Cont….
• The American Institute of Certified Public
Accountants defined the operating cycle as: “the
average time intervening between the acquisition
of material or services entering the process and
the final cash realisation.”
• “Operating cycle is the time duration involved in
the acquisition of resources, conversion of raw
materials into work- in-process into finished
goods, conversion of finished goods into sales
and collection of sales.”
 Cont….
The operating cycle of a manufacturing enterprise
involves three phases:
1. Acquisition of resources such as raw material,
labour, power and fuel etc.
2. Manufacture of the product which includes
conversion of raw material into work-in-progress
into finished goods.
3. Sale of the product either for cash or on credit.
Credit sales create account receivable for collection.
Cont….
 Cont….
• Capital/finance is regarded as life-blood of any
enterprise. Therefore, the significance of working
capital in an enterprise lies in the fact that its
circulation has to be properly regulated in the
business.
• Because, any over-circulation or under-circulation
may create problems just as improper blood
circulation called high or low blood pressure, in
the human body may create problems.
 Cont….
• Working Capitals composed of two parts are
known as:
(a) Regular/ Fixed- the amount which is needed,
at short intervals to invest again and again in
current assets
(b) Variable- it varies due to the fluctuations (rise
or fall) in the volume or business.
 Estimation of Working Capital
Requirement
• Percentage of Sales Method
- This method of estimating working capital requirements is based on
the assumption that the level of working capital for any firm is
directly related to its sales value.

- 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.

- The individual items of current assets and current liabilities can also
be estimated on the basis of the 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.
 Cont….
• 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 the measure of the average relationship
between two or more variables, i.e.; sales and
working capital, in terms of the original units of
the data.
 Cont….
• 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 a 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.
 Cont….
• Operating Cycle Method
- This method of estimating working capital requirements is based upon the
operating cycle concept of working capital.

- The cycle starts with the purchase of raw material and other resources
and ends with the realization of cash from the sale of finished goods.

- It involves purchase of raw materials and stores, its conversion into stock
of finished goods through work-in-process with progressive increment of
labour and service costs, conversion of finished stock into sales, debtors
and receivables, realization of cash and this cycle continues again from
cash to purchase of raw material and so on.

- The speed/time duration required to complete one cycle determines the

requirement of working capital – longer the period of cycle, larger is the
requirement of working capital and vice-versa.
 Cont….
• Projected Balance Sheet Method
- Under this method, projected balance sheet for
future date is prepared by forecasting of assets
and liabilities by following any of the methods
stated above.

- The excess of estimated total current assets over

estimated current liabilities, as shown in the
projected balance sheet, is computed to indicate
the estimated amount of working capital
required.
 Account Receivable Management
• Accounts receivable management
incorporates is all about ensuring that
customers pay their invoices.
• Good receivables management helps prevent
overdue payment or non-payment.
• It is therefore a quick and effective way to
strengthen the company’s financial or liquidity
position.
 Importance of Account Receivable
Management (ARM)
• Every company wants to buy low and sell high. But they can lose
everything with poor receivables management during the last phase of the
sales process (payment).

• Over half of all bankruptcies can be attributed to poor receivables

management, which demonstrates its importance.

• Receivables management involves much more than reminding customers

to pay. It is also about identifying the reason for non-payment.

• Good receivables management directly contributes to a company’s profit

because it reduces bad debt. The company also has a better cash flow and
higher available liquidity for use in investments or acquisitions.
Furthermore, good receivables management boosts a company’s
professional image.
 Cont….
• Determining the customer’s credit rating in
advance
• Frequently scanning and monitoring customers
for credit risks
• Maintaining customer relations
• Detecting late payments in due time
• Detecting complaints in due time
• Reducing the total balance outstanding (DSO)
• Preventing any bad debt in receivables
outstanding.
 Preparing Good Receivable
Management
Step 1. Determine the strategy
• Which customers do you accept and under which conditions?
• Which customers do you monitor?
• Who should no longer be accepted, and when is the exit?

Step 2. Prepare appropriate procedures

• What is your invoicing process like?
• What is your invoice like?
• When do you remind a customer by phone?
• When do you remind a customer in writing?
• What does the reminder look like?
• When do you engage a debt collection agency?
• When will you start legal proceedings?
• What is the role of your employees in this respect?
• Will you choose outsourcing or in-house management?
 Systems Required- ARM
• Acceptance system. Based on credit information, you
determine whether a new customer is accepted or not.
This may be a manual or automated process.

• Monitoring system. This system checks the entire

portfolio for continuous insight into existing customers
and suppliers. This is essential, particularly with regard
to chain parties.

• Invoicing system. Invoices may be sent manually or

automated (sometimes as a digital invoice) and
reminders must be logically aligned.
 Cont….
• Bookkeeping system. All receivables and
payables are booked in this system, which
provides insight into the cash flow and
receivables risk.

• CRM system. The Customer Relationship

Management (CRM) system lists information
relating to agreements, contact and contracts
with customers. Complaints can also be
processed in this system to improve insight into
the background of non-payment.
 Automatic Receivable Management
• Automating receivables management allows you
to link all the above systems.
• This improves workflow efficiency and provides
better insight by generating cash flow and
customer reports.
• Automatically linking credit information reduces
the percentage of non-paying new customers. By
automatically integrating the debt collections in
the process, the percentage of non-paying
existing customers also falls.
 Cash Budget
• Cash budget is a written estimate of a firm’s future cash position.
• It predicts for some future period the cash receipts from different
sources, cash disbursements for different purposes and the
resulting cash position generally on a monthly basis as the budget
period develops.
• It is, thus, a formal presentation of-expected circular flow of cash
through the business.
• The usual forecast period of a cash budget is one year broken down
by monthly periods or weekly periods. This allows incorporation of
seasonal variations in cash flow.
• When cash flows are relatively stable, the finance manager may
prepare budget for full one year period. When the outlook is very
uncertain, he may have to be satisfied with a projection for only
quarterly.
 Forecasting of Cash Budget
• The forecast of cash inflow

• The forecast of cash outflows

• The forecast of cash balance.

 Objectives of Cash Budget
• To project firm’s cash position in future period.

• To predict cash surplus or deficit for the ensuing

months.

• To permit planning for financing in advance of

need. By indicating when cash will be required,
the budget helps the management to arrange in
advance bank loans or other short-term credits,
to prepare for a sale of securities or to make
other preparations for new financing.
 Cont….
• To help in selection of proper source of financing
cash requirements of the firm.

• To permit proper utilization of idle cash.

• To maintain adequate balance between cash and

working capital, sales, investments and loans.

• To exercise control over cash expenditure by

limiting the spending of various departments.
All the Best….
• 2,3,5,6,12,13,16,25,27,35,38,43,45,49,54,55,5
9,60,61,63,64,65,66,