CORPORATE FINANCE II

MBA203B32

Prof. John Pradeep Kumar

School of Management
Kristu Jayanti College
 Unit 4 Working Capital Management
• Meaning, Concepts, Determinants of WC
• Operating cycle
• Estimation of working capital
• Meaning and importance of cash management;
• Motives for holding cash; Cash budget;
• Cost associated with inventories;
• Inventory Management techniques-Stock levels;
• Cost associated with maintaining receivables
• Credit policy variables.
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 Meaning of Working Capital
• The term ‘working capital’ refers to
• (i) Those current assets, which are convertible
into cash, within a period of one accounting
• year and
• (ii) Those funds needed for meeting day-to-
day operations.

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 Working Capital Management
• It 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.
• To enable the company to maintain sufficient
cash flow to meet its short-term operating costs
and short-term debt obligations.
• Management of WC includes management of
inventory, accounts receivables and accounts
payables.
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 Benefits of Working Capital
Management
• Working capital management can improve a
company's earnings and profitability through
efficient use of its resources.

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 Objectives of working capital
Smooth operating cycle
Optimize investment in working capital
Minimize cost of working capital financing

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 Classification of Working Capital
Working capital can be classified in two ways
I. On the basis of CONCEPT
II. On the basis of TIME

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Mr. John Pradeep K, KJSOM 8
 I. Basis of Concept
• In accountancy, working capital means net
working capital.
Net WC = Current Assets–Current Liabilities

• In finance, working capital usually refers to

gross working capital
• A firm’s investment in total current assets.
Gross WC = Total Current Assets
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 II. Basis of Time
A) Permanent (Fixed) working capital
• The minimum amount of investment required
in all current assets at all times to carry on the
day-to-day operation of firm’s business.
• The minimum level of current assets has been
given the name of ‘Core current assets’ by the
Tandon Committee.

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B) Temporary (Variable or Fluctuating) working
capital
• It is dependent on the changes in production
and sales.
• These represent the seasonal stockpiles that
arise, such as inventories before Diwali and
receivables after Diwali.
• This is over and above permanent working
capital.
• Temporary working capital is generated to
meet liquidity necessities that are of a purely
momentary or temporary in nature.
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Classification of Working Capital based on Time
and Need

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Positive and Negative Working Capital
• Positive working capital is when NWC is positive.
• Negative working capital is when NWC is
negative.
• Companies like Amazon
enjoy negative working capital
because of cash sales where buyers pay money
even before the shipping of product and there is
a time gap in making payments to suppliers.

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 Determinants of working capital
1. Nature of business
2. Length of period of manufacture
3. Volume of business
4. The proportion of the cost of raw materials to total
cost
5. Use of Manual Labour or Mechanisation
6. Need to keep large stocks of raw materials of
finished goods
7. Turnover of working capital
8. Terms of Credit
9. Seasonal Variations
10. Requirements of Cash
11. Other Factors.
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11. Other Factors:
• (i) Degree of co-ordination between
production and distribution policies.
• (ii) Specialisation in the field of distribution.
• (iii) Developments of means of transportation
and communications.
• (iv) The hazards and contingencies inherent in
the type of business.

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 Working Capital Policy
• Relaxed Policy / Conservative Policy
• Restricted Policy / Aggressive Policy
• Moderate Policy

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 Working Capital Financing Policy:
Various Approaches for Financing of Current
Assets:
• The essential characteristic of working capital management
is to resolve about the sources of funds which can be
availed to make investment in current assets.
• The two major sources of working capital finance are:
1. Short term sources:
• They provide funds for a short period say up to one year.
The main sources are: trade credit, Short term bank credit,
factoring of receivables, commercial papers.
2. Long term sources
• They provide funds for a comparatively longer period. The
main sources are equity share capital, Preference share
capital, Debentures, long term borrowings, etc.

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 Approaches to determine a suitable
financing mix
I. Hedging Approach
II. Conservative Approach
III. Aggressive Approach

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 I. Hedging Approach/ Matching
Approach
• Maturity matching or hedging approach is a
strategy of working capital financing wherein
short term requirements are met with short-
term debts and long-term requirements with
long-term debts.
• The underlying principal is that each asset
should be compensated with a debt
instrument having almost the same maturity.

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 FINANCING STRATEGY IN EQUATION
• Long Term Funds will Finance
= Fixed Assets + Permanent Working Capital
• Short Term Funds will Finance
= Temporary Working Capital

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Hedging Approach to Working Capital

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Mr. John Pradeep K, KJSOM 22
 Conclusion
• After all the discussion, in situation A, the costs
may be low but the risk is too high and situation
B concludes cost is high with low risk.
• Situation A is not acceptable because of such a
high risk and situation B hits the profitability
which is the primary goal of doing business and
basis of survival.
• Therefore, the hedging or matching maturity
approach to finance is ideal for effective working
capital management.
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 Conservative Approach
• Conservative approach is a risk-free strategy
of working capital financing.
• A company adopting this strategy maintains a
higher level of current assets and therefore
higher working capital also.
• The major part of the working capital is financed
by the long-term sources of funds such as
equity, debentures, term loans etc.
• So, the risk associated with short-term financing
is abolished to a great extent.
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 FINANCING STRATEGY IN EQUATION
• Long Term Funds will Finance
= Fixed Assets + Permanent Working Capital +
Part of Temporary Working Capital

• Short Term Funds will Finance

= Remaining Part of Temporary Working
Capital

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 Aggressive Approach
• The aggressive approach is a high-risk strategy
of working capital financing
• Short-term finances are utilized not only to finance the
temporary working capital but also a reasonable part
of the permanent working capital.
• In this approach of financing, the levels of inventory,
accounts receivables and bank balances are just
sufficient with no cushion for uncertainty.
• There is a reasonable dependence on the trade credit.

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 FINANCING STRATEGY IN EQUATION
• Long Term Funds will Finance
• = Fixed Assets + Part of Permanent Working
Capital

• Short Term Funds will Finance = Remaining

Part of Permanent Working Capital +
Temporary Working Capital

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Aggressive Approach to Working
Capital

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Mr. John Pradeep K, KJSOM 31
 Operating Cycle (OC)
• Operating cycle is the length period required to convert
sales, after acquisition of the resources such as
materials, power etc, into cash. The operating cycle of
a manufacturing firm, typically, involves three phases:
• Acquisition of Resources such as raw material, labour,
power and fuel, etc.
• Manufacture of the Product which includes conversion
of raw material into work-in-process into finished
products.
• Sale of the product either for cash or credit sales.
Credit sales result into debtors or accounts receivable.

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Operating Cycle of Manufacturing Business

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Operating Cycle of a Trading Concern

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 Service Concerns
• In case of service concerns, the operating
cycle embraces the length of time taken for
transformation of cash into debtors and from
debtors to cash again.

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Typical Operating Cycle for a Service Firm. (attribution: Copyright
Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

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 Computation of Operating Cycle
Operating Cycle = Inventory Conversion Period + Accounts Receivable Period

OC = ICP + ARP

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 Cash Conversion Cycle (CCC)
• The amount of time a firm’s resources are tied
up; calculated by subtracting the average
payment period from the operating cycle.
• In other words, the time period between the
dates a firm pays its suppliers and the date it
receives cash from its customers.

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 Calculation of Cash Conversion Cycle
(CCC)
CCC = OC – APP
Where: OC = Operating Cycle
APP = Accounts Payable Period
OC = AAI + ARP
AAI = Average Age of Inventory
ARP = Average Collection (receivables) Period
• From the financial statements we can determine the constituents of
Cash Conversion Cycle i.e., AAI, ARP, APP
• AAI = Average Inventory (Cost of Goods sold / 365)
• ARP = Average Accounts Receivables (Annual Sales / 365)
• APP = Average Accounts Payables (Cost of Goods Sold / 365)

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 OC + CCC

Problems Q.2
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 Approaches to Working Capital Estimation:

A) Total Approach: In this method of estimation all

costs including depreciation and profit margin are
included. Unless it is asked specifically, the
estimation of working capital under total
approach is suggested.
B) Cash Cost Approach: Under this approach,
working capital is estimated on the basis of cash
cost. Depreciation is excluded from the cost of
sales. The profit margin is also not considered
while estimation of investment in debtors
balances.

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Mr. John Pradeep K, KJSOM 42
 Statement of Working Capitla Requirement
Current Assets (A) Amount (Rs)
Cash Balance XXX
Inventories
Raw materials (BP x RMC x AHP/T) xxx
Work-in-progress (BP x WIPC x AHP/T) xxx
Finished Goods (BP x COP x AHP/T) xxx XXX
Debtors (BP x *COS or **SP x ACP/T) XXX
AAA
Current Liabilities (B)
Creditors of raw materials (BP x RMC x APP/T) XXX
Creditors of wages (BP x W x LIP/T) XXX
Creditors of Overheads (BP x O x LIP/T) XXX
BBB
Net Working Capital (C = A-B) XXX
Add: Contingencies (% of C) XX
Net Working Capital Requirement
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• BP = Budgeted Production per annum
• RMC = Raw Material Cost per unit
• WIPC = Work in Progress Cost per unit=(Raw Material + 50% of Conversion
Cost excluding Depreciation, if completion rate of material and other cost
are not given)
• COP = Cost of Production per unit
• *COS = Cost of Sales per unit ( In case of Cash Cost Approach)
• **SP = Sale Price per unit (In case of Total Cost Approach)
• W = Wages per unit
• O = Overheads per unit
• T = Time in Days /Weeks/Months in a Year
• AHP = Average Holding Period
• ACP = Average Collection Period
• APP = Average Payment Period
• LIP = Lag in Payment
• # If payment is received in advance, the item would appear under Current
Liabilities.
• ## If any advance payment is to be made to creditors, the item would
appear under Current Assets.
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 Analysis of working capital
• Determining the working capital is just not
sufficient for a better performance. It should
be analysed. It may be analysed with a view to
gross and net angles i.e., quantitative and
qualitative.
• The quantitative aspect of working capital
refers to the quality of current assets while
the qualitative aspect of working capital refers
to the liquidity and its adequacy.

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 The following are the aspects of working capital:
A. Structure of working capital: It helps to have a
better perspective of the working capital
position of any company.
B. Working capital status: In order to ascertain
the trends in working capital, indices of
current assets, current liabilities and net
working capital of the firm may be computed.
i. First year of the selected period may be
taken as base, for computing trends in
current assets, current liabilities and net
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ii. Working capital position in a concern would be
satisfactory, provides the pace of increase in
current assets is more than that of the current
liabilities and vice-versa.
iii. If the net working capital indices also increase, it
will further confirm that strength of working
capital position in a firm.
C. Working Capital Leverage: It measures the
sensitivity of return on investment (ROI) to the
changes in ROI of current assets.
D. Working capital leverage (WCL) may be defined
as the percentage change in ROI with given
percentage change in current assets.
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 Symbolically:
WCL = Percentage Change in ROI ÷ Percentage
Change in Current Assets

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 References
• https://www.investopedia.com/terms/w/workingcapitalma
nagement.asp
• https://www.slideserve.com/nissim-mercer/working-
capital
• http://www.yourarticlelibrary.com/finance/11-
determinants-of-working-capital-financial-
management/26230
• https://efinancemanagement.com/working-capital-
financing/working-capital
• https://bbamantra.com/working-capital-requirement/
• This book is a part of the course by uts, Pune. This book
contains the course content for Financial Management
(www.utsglobal.edu.in).

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