BA I

FINANCIAL MANAGEMENT
WORKING CAPITAL MANAGEMENT
 Learning outcomes
• At the end of the topic each student should be able to
✓ Identify components of working capital
✓ Identify and explain determinants of working capital levels
✓ Manage inventory, debtors, creditors and cash

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 Working capital
• Working Capital is the amount of Capital that a Business has available to meet the day-to-day
cash requirements of its operations.
• Working Capital is the difference between resources in cash or readily convertible into cash
(Current Assets) and organizational commitments for which cash will soon be required
(Current Liabilities). It refers to the amount of Current Assets that exceeds Current Liabilities
(i.e. CA - CL).
• Working Capital refers to that part of the firm’s Capital, which is required for Financing Short-
Term or Current Assets such as Cash, Marketable Securities, Debtors and Inventories.
• Working Capital is also known as Revolving or Circulating Capital or Short-Term
Capital

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 Working capital management
• Working Capital Management involves managing the balance between firm’s short-term assets
and its short-term liabilities. The goal of working capital management is to ensure that:
(a) The firm is able to continue its operations
(b) The firm has sufficient cash flow to satisfy both maturing short-term debt and upcoming
operational expenses.
• The interaction between current assets and current liabilities is, therefore, the main
theme of the theory of working capital management.
• Management of working capital is an essential task of the finance manager. He has to ensure
sound working capital position that is; the amount of working capital available is neither
too large nor too small for its requirements.
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 Cont..
• A large amount of working capital would mean that the company has idle funds.
Since funds have a cost, the company has to pay huge amount as interest on such
funds. However, if the firm has inadequate working capital, such firm runs a risk of
insolvency. Scarcity of working capital may lead to a situation where the firm may
not be able to meet its liabilities, production interruptions and reduction of sales
and, in turn, will adversely affect the profitability of the business
• The various studies have shown that, one of the reasons for the poor performance
of public sector undertakings has been the large amount of funds locked up in
working capital. This results in over capitalization. Over capitalization implies that a
company has too large funds for its requirements, resulting in a low rate of return a
situation which implies a less than optimal use of resources. A firm has, therefore,
to be very careful in estimating its working capital requirements.
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The concept of working capital can also be
explained through two angles

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 VALUE
• From the value point of view, Working Capital can be defined as Gross Working Capital or Net
Working Capital.
• Gross working capital refers to the firm’s investment in current assets. Current assets are those
assets which can be converted into cash within an accounting year. Current assets include Stocks of
raw materials, Work-in-progress, Finished goods, Trade debtors, Prepayments, Cash balances etc.
• Net working capital refers to the difference between current assets and current liabilities. Current
liabilities are those claims of outsiders which are expected to mature for payment within an
accounting year. Current Liabilities include: Trade creditors, Accruals, Taxation payable, Bills
Payables, Outstanding expenses, Dividends payable, short term loans. A positive working capital
means that the company is able to pay off its short-term liabilities while a negative working capital
means that the company currently is unable to meet its short-term liabilities.
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 TIME
• From the point of view of time, the term working capital can be divided into two
categories i.e. Permanent and temporary.
• Permanent or Fixed Working Capital; The need for working capital fluctuates
from time to time. However, to carry on day-today operations of the business
without any obstacles, a certain minimum level of raw materials, work-in-progress,
finished goods and cash must be maintained on a continuous basis. The amount
needed to maintain current assets on this minimum level is called permanent or
regular working capital.
• The amount involved as permanent working capital has to be met from long-
term sources of finance, e.g.
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 Cont..
• (i) Share capital
• (ii) Debentures
• (iii) Long-term loans
• Temporary or Variable or Fluctuating Working Capital; Depending upon the changes in
production and sales, the need for working capital, over and above the permanent level of
working capital is called temporary, fluctuating or variable working capital. It is categorized
into two:
1. Seasonal - Due to seasonal changes, level of business activities is higher than normal during
some months of year and therefore additional working capital will be required along with the
permanent working capital. It is so because during peak season, demand rises and more stock
is to be maintained to meet the demand.
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 Cont..
2. Special- Additional doses of working capital may be required to face cut throat
competition in the market or other contingencies like strikes, theft etc.
• Since the volume of temporary working capital keeps on fluctuating from time to
time according to the business activities it may be financed from short-term sources.
• A firm having constant annual production will also have constant Permanent work-
ing capital and only Variable working capital changes due to change in production
caused by seasonal changes.
• The following diagrams shows Permanent and Temporary or Fluctuating or variable
working capital
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Similarly, a growth firm is the firm having unutilized capacity, however, production and
operation continues to grow naturally. As its volume of production rises with the passage of
time so also does the quantum of the Permanent working capital.
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Both kinds of working capital i.e. permanent and fluctuating (temporary) are necessary to
facilitate production and sales through the operating cycle
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 Excess working capital has its disadvantages in terms of:

• 1. Funds not being put to productive use and impact on company earnings
• 2. Excess inventory
• 3. Diluted focus on debtor control
• 4. Leakages in the system which might go unnoticed due to excess liquidity
• 5. Inefficiency in the organization ultimately affecting market value of the
firm.

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 On the other hand, inadequate working capital
would be disadvantageous in terms of
• 1. Impact of liquidity and non-availability of liquid funds for fulfilling
various obligations
• 2. Impact on company reputation due to danger of non-fulfillment of
commitments.
• 3. No benefits of economies of scale
• 4. Impact on sales, i.e. needing to sell below target prices on account of
liquidity pressure
• 5. Delay in implementation of certain growth strategies affecting profit goals
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 Importance / need / advantage of adequate working
capital
(1) Availability of Raw Materials; Adequacy of working capital makes it possible for
a firm to pay the suppliers of raw materials on time. As a result it will
continue to receive regular supplies of raw materials and thus there will be no
disruption in production process.
(2) Full Utilization of Fixed Assets; Adequacy of working capital makes it possible for a
firm to utilize its fixed assets fully and continuously. For example, if there is inadequate stock
of raw material, the machines will not be utilized in full and their productivity will be reduced.
(3) Discount; A firm having the adequate working capital can benefit from the cash
discount by purchasing the goods for cash or by making the payment before or on the due
date.

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 Cont..
(4) Increase in Credit Rating; Paying its short-term obligations in time leads to a
strong credit rating which enables the firm to purchase goods on credit on favorable
terms and to maintain its line of credit with banks etc. it facilities the taking of loan in
case of need.
(5) Exploitation of Favorable Market conditions; Whenever there are chances of
increase in prices of raw materials, the firm can purchase sufficient quantity if it
has adequate working capital. Similarly, if a firm receives a bulk order for the supply of
goods it can take advantage of such opportunity if it has sufficient working capital.
(6) Facilitates in Obtaining Bank Loans ; Banks do not hesitate to advance even
the unsecured loan to firms which have sufficient working capital. This is because the
excess of current assets over current liabilities itself is a good security.
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 Determinants of working capital management

• Nature of business: If the business concerns follow rigid credit policy and
sell goods only for cash, they can maintain lesser amount of Working
Capital. i.e Manufacturing organizations will hold high levels of inventory in
the form of raw materials, work in progress and finished goods. They may
also benefit from high levels of credit from suppliers, Supermarkets and
retailers receive most of their sales in cash, by credit card or by debit card.

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 Cont..
• Thus the level of trade receivables tends to be relatively low. Trade payables,
on the other hand, tend to be quite high as they purchase from suppliers
mainly on credit
• Production cycle: Amount of Working Capital depends upon the length of
the production cycle. If the production cycle length is small, they need to
maintain lesser amount of Working Capital. If it is not, they have to maintain
large amount of Working Capital.

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 Cont..
• Raw material availability: In case certain inputs / raw materials are not available
on a continuous basis, it becomes necessary to stock them. They can then be
utilized in the periods of short supply. This would require an increase in the
quantum of working capital. Hence the firm should have ready funds when the raw
materials are available in the market.
• Business cycle: Business fluctuations lead to cyclical and seasonal changes in the
business condition that affect the requirements of the Working Capital. In the
booming conditions, the Working Capital requirement is larger and in the
depression condition, requirement of Working Capital will reduce.

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 Cont…
• Production policy: If the company maintains the continues production
policy, there is a need of regular Working Capital. If the production policy
of the company depends upon the situation or conditions, Working Capital
requirement will depend upon the conditions laid down by the company
• Earning capacity: If the business concern consists of high level of earning
capacity, they can generate more Working Capital, with the help of cash from
operation

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 Cont..
• Growth and expansion: During the growth and expansion of the business
concern, Working Capital requirements are higher, because it needs some additional
Working Capital and incurs some extra expenses at the initial stages.
• Terms of credit: Working capital policies are influenced by the terms of credit
which are offered to customers and received from suppliers. Sometimes, due to the
prevailing market practices, the firm is required to offer credit terms to all
customers. Also, due to fierce competition, the firm would need to stock a variety
of products, requiring an increase in the level of working capital.

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 Working capital policies

• Working capital policy is concerned with policy decisions such as:

1. Maintaining an adequate amount of working capital (current assets and
current liabilities)
2. Deciding on the sources of finance of working capital

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 Cont…
1. Maintaining an adequate amount of working capital (current assets
and current liabilities)
• In order to assess a company’s liquidity and how efficiently it is managing its
working capital the following ratios can be used.
(a) Current Ratio: This ratio indicates whether the current assets will be able
to generate sufficient cash to pay off the current liabilities as and when
they fall due.
CR = CA/CL
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 Cont..
(b) Quick ratio / Acid test ratio: This ratio illustrates how the company’s
liquid current assets can cover its current liabilities. Since stocks or inventory
are the least liquid of the current assets, they are excluded.
Acid test ratio ={ CA- stock} /CL
• Ratios that are ideal for a company depend upon the industry in which the
company operates. Generally a current ratio of 1.5:1 is considered to be
reasonable. If inventories can be quickly converted into cash then a lower
current ratio of around 1 is acceptable

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 Cont…
• Similarly, a quick ratio of 1:1 is considered to be reasonable; however, it
again depends on the business sector concerned. Acid test ratio i.e. quick
ratio is a precise test that indicates whether a firm has enough short-term
assets to cover its immediate liabilities without selling inventory.

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 Cont..
2. Deciding on the sources of finance of working capital
• The working capital can be financed either through short term or long-term sources
of finance.
Short term sources of finance include:
(a) Short term credit lines offered by banks in terms of bank overdraft, cash credit
(b) Trade creditors
(c) Short term debt instruments
(d) Customer advances (if the business practice permits)

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 Cont..
Long term sources of finance include
(a) Equity – issue of additional share capital
(b) Retained earnings ploughed back into business
(c) Secured debt in terms of debentures
(d) Long term loans from banks / financial institutions
(e) Public deposits (subject to the laws of the land)

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 Working capital investment policies
• Working capital financing policy basically deals with the sources and the amount of
working capital that a company should maintain. A firm is not only concerned
about the amount of current assets but also about the proportions of short-term
and long-term sources for financing the current assets. There are several working
capital investment policies a firm may adopt after taking into account the variability
of its cash inflows and outflows and the level of risk.
• However, the choice of an overall working capital policy would depend on the risk
disposition of management. An overall conservative working capital policy reduces
risk and offers low return. An overall hedging working capital policy offers medium
return accompanied with medium risk. An overall aggressive working capital policy
provides a package of high risk and high return.

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 Hedging policy
• One of the policies by which a firm finances its working capital needs is the hedging
policy, also known as matching policy. This policy works in an arrangement where
the current assets of the business are used perfectly to match the current liabilities.
As per this approach, fixed and permanent current assets are financed through long-
term sources and fluctuating current assets are financed through short-term sources.
• This policy is a medium risk proposition and requires a good amount of attention.
For example, if a bank loan is due to be paid after six months, the company will
ensure that sufficient amount of cash will be available to repay the loan on the date
of maturity even though it may or may not currently have sufficient cash.
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 Cont..
• In case of a growing firm, the amount of fixed assets and permanent current
asset go on increasing with the passage of time but the volume of
fluctuating current assets change with the change in production level. In
Figure below, Line A and Line B are upward slopping indicating that they go
on increasing with the passage of time and as per hedging principle they are
financed through long-term sources like equity and long-term debt.
• Fluctuating current assets, which are shown by the curved Line C, should be
financed through short term sources.
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 Conservative policy
• As the name suggests, this policy tries to avoid the risk involved in financing of
current assets. Here, relatively high proportions of long-term sources are to be used
for financing current assets. The firm not only matches the current assets with
current liabilities but also keeps some excess amount to meet any uncertainty.
• This is the lowest risk working capital policy and fails to ensure optimum utilization
of funds. Hence it cuts down the expected returns of the shareholders. This policy
is illustrated in Figure below. Line A denotes the fixed assets and Line B denotes the
permanent working capital, which is financed through long-term sources. Certain
portion of fluctuating current assets, which is shown by dashed Line C, is also
financed by long-term sources. Under this policy some part of fluctuating current
assets is financed through short-term sources
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 Aggressive policy
• Aggressive working capital financing policy is a risky policy that requires minimum
amount of investment in current assets. Fluctuating as well as permanent current
assets under this policy will be financed through short-term debt. In this policy debt
is collected on time and payments to the creditors are made as late as possible.
• This policy has been illustrated in Figure below. According to this approach long-
term sources are used to finance the fixed assets, which are shown by Line A; but a
portion of permanent current assets, shown by the dotted Line B, is also financed
through long-term sources. The remaining part of permanent current assets,
depicted by Line C, and the entire amount of fluctuating current assets, shown by
the curved Line D, are financed by short-term debt.
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 Highly aggressive policy
• This is a highly risky policy for financing the working capital. As per this policy,
even some part of fixed assets is financed through short-term sources. Excessive
reliance on short-term sources makes this policy highly risky.
• This policy has been illustrated in Figure below. A major proportion of fixed assets
as shown by dotted Line A are financed through long-term sources and the
remaining part of the fixed assets are financed by short-term sources shown by Line
B. Short-term sources are also used for financing permanent current assets Line C;
as well as fluctuating current assets as shown by the curved Line D.

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 Liquidity versus profitability
• Risk return trade off
• Finance manager has to pay particular attention to the levels of current
assets and their financing. To decide the levels and financing of current
assets, the risk return trade off must be taken into account.
• A firm may follow a conservative, aggressive or moderate policy as discussed
above. However, these policies involve risk - return trade off. A conservative
policy means lower return and risk. While an aggressive policy produces
higher return and risk
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 Cont..
• The two important aims of the working capital management are profitability and
solvency.
• A liquid firm has less risk of insolvency that is, it will hardly experience a cash shortage or a
stock out situation. However, there is a cost associated with maintaining a sound liquidity
position.
• To have higher profitability the firm may have to sacrifice solvency and maintain a relatively
low level of current assets. This will improve firm’s profitability as little funds will be tied up
in idle current assets, but its solvency would be threatened and exposed to greater risk of
cash shortage and stock outs.
• The following illustration explains the risk-return trade off of various working capital
management policies i.e. conservative, aggressive and moderate.

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 Cont..
• Illustration 1
• A firm has the following data for the year ending 31st March, 2013:
• Sales (100,000 @ 20/=)…………………………………..…………2,000,000
• Earnings before Interest and Taxes………………..………………..200,000
• Non-current Assets………………………………..……………….500,000
• The three possible current assets holdings of the firm are 500,000/=, 400,000/=
and 300,000/=. It is assumed that non-current assets level is constant and profits do
not vary with current assets levels. The effect of the three alternative current assets
policies is as follows:
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Effect of Alternative Working Capital Policies
Working Capital Policy Conservative Moderate Aggressive
Sales 2,000,000 2,000,000 2,000,000

Earnings before Interest and Taxes 200,000 200,000 200,000

(EBIT)

Current Assets 500,000 400,000 300,000

Non-current Assets 500,000 500,000 500,000
Total Assets 1,000,000 900,000 800,000

Return on Total Assets (EBIT/Total 20% 22.22% 25%

Assets)

Current Assets/Fixed Assets 1.00 0.80 0.60

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 Cont..
• The aforesaid calculations show that the conservative policy provides greater
liquidity (solvency) to the firm, but lower return on total assets. On the other
hand, the aggressive policy gives higher return, but low liquidity and thus is
very risky. The moderate policy generates return higher than Conservative
policy but lower than aggressive policy. This is less risky than Aggressive
policy but more risky than conservative policy.
• In determining the optimum level of current assets, the firm should
balance the profitability–Solvency tangle by minimizing cost of
liquidity and cost of illiquidity.
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Estimate the working capital requirements of a firm.

Operating or working capital cycle

• Working capital cycle is the time taken from the procurement of raw
materials and conversion to finished goods to realization of proceeds from
sales.
• For example, if a firm holds raw material on an average for 45 days,
production process takes 10 days, finished goods are held for 20 days,
debtors are realized in 25 days and supplier’s credit is 10 days, then the
operating cycle is (45+10+20+25-10) i.e. 100-10 days. The working capital
cycle is 90 days.
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Estimation of working capital on the basis
of current assets and current liabilities
• Operating cycle consists of the following
important stages:
1. Raw Material and Storage Period (R)
2. Work in Process Holding Period (W)
3. Finished Goods Holding Period (F)
4. Debtors Collection Period (D)
5. Creditors Payment Period. (C)
• O = R + W + F + D–C
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Each component of the operating cycle can be
calculated by the following formula:
• R =Average Stock of Raw Material
Average Raw Material Consumption Per Day
• W=Average Work in Progress Inventory
Average Cost of Production Per Day
• F =Average Finished Goods Inventory
Average Cost of Goods Sold Per Day
• D =Average Trade Debtors
Average Credit Sales Per Day
• C =Average Trade Creditors
Average Credit Purchase Per Day
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 Illustration 2
From the following information of XYZ Ltd., you are required to
calculate:
(a) Net operating cycle period.
(b) Number of operating cycles in a year.
S/No PARTICULARS TSHS
1 Raw material inventory consumed during the year 600,000
2 Average stock of raw material 50,000
3 Work-in-progress inventory 500,000
4 Average work-in-progress inventory 30,000
5 Finished goods inventory 800,000
6 Average finished goods stock held 40,000
7 Average collection period from debtors 45 days
8 Average credit period availed 30 days
9 No. of days in a year 360 days
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 Solution
• CALCULATION OF NET OPERATING CYCLE PERIOD OF XYZ LTD
• DAYS
• 1. Raw material storage period
• Raw materials storage period=Average stock of Raw materials
Average cost of raw material consumption per day
• (50,000/1667)………………………………………………………………………………………..30
• (600,000/360 days)=1667
• 2. Work in progress holding period
• Work in progress holding period =Average work in progress inventory
Average production cost per day
• (30,000/1,388)………………………………………………………………………………………22
• (500,000/360 days)=1388
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 Cont..
• 3. Finished goods storage period
• Finished goods storage period= Average stock of finished goods
• Average cost of goods sold per day
• (40,000/2222)……………………………………………………………………………………….18
• (800,000/360 days)
• 4. Debtors collection period……………………………………………………………………..45
• Total operating cycle period: 115
• Less: Average credit period availed……………………………………………………………30
• Net operating cycle………………………………………………………….………………………85
• Number of operating cycle in a year (360 days/85 days)………….………………………..…4.2

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END