Chapter # 04

Working Capital Management

LO 01: FINANCING WORKING CAPITAL:

The nature and elements of working capital:

Working capital is the capital (finance) that an entity needs to support its everyday operations. To operate a
business, an entity must invest in inventories and it must sell its goods or services on credit. Holding
inventories and selling on credit costs money. Some of the finance required for operations is provided by taking
credit from suppliers. This means that the suppliers to an entity are helping to support the business operations
of that entity. Some short-term operating finance might also be obtained by having a bank overdraft. Cash and
short-term investments are also elements of working capital. Some cash might be held for operational use, to
pay liabilities. Surplus cash in excess of operational requirements might be invested short-term to earn some
interest. Working capital can therefore be defined as the net current assets (or net current operating assets) of
a business.).
The objectives of working capital management:
The management of working capital is an aspect of financial management, and is concerned with:
 Ensuring that the investment in working capital is not excessive.
 Ensuring the level of working capital is not low (aggressive strategy)
 Ensuring that enough working capital is available to support operating activities.
Note on surplus cash and short-term investments. For entities with surplus cash, there is also the management problem of how to use the
surplus. If the surplus is only temporary, it might be invested in short term financial assets. The aim should be to select investments that
provide a suitable return without undue risk, and that can be converted back into cash without difficulty when the money is required.

An Important Note:
The two main objectives of working capital management are to ensure it has sufficient liquid resources to continue in business and to
increase its profitability.
Every business needs adequate liquid resources to maintain day-to-day cash flow. It needs enough to pay wages, salaries and accounts
payable if it is to keep its workforce and ensure its supplies.
Maintaining adequate working capital is not just important in the short term. Adequate liquidity is needed to ensure the survival of the
business in the long term. Even a profitable company may fail without adequate cash flow to meet its liabilities.
On the other hand, an excessively conservative approach to working capital management resulting in high levels of cash holdings will harm
profits because the opportunity to make a return on the assets tied up as cash will have been missed.
These two objectives will often conflict as liquid assets give the lowest returns.
Investment in working capital – Advantages and Disadvantages:
Advantages
 Ensures prompt supply to customers
 Competitive advantage:
(Attracts customers who prefer credit terms.)
 Effective cash flow management
Disadvantages
 Opportunity cost:
(Reduced potential profits due to funds tied up in non
Income generating assets.)
 Risk of obsolescence or bad debts:
(Excessive inventory or credit may lead to losses.)
 Decreased Return on Investment (ROI):
(Lower returns compared to long-term investments.)
 Decreased liquidity:
(Funds tied up in working capital may hinder liquidity for
Other investment opportunities.)

Investing in working capital therefore involves a cost. The cost of investing in working capital is the reduction in profit that
results from the money being invested in inventories, receivables or cash in the bank account, rather than being invested in
wealth-producing assets and long-term projects. The cost of investing in working capital can be stated simply as follows:

Formula: Annual cost of investment in working capital

Average investment in working capital X Annual cost of finance (%) = Annual cost of working capital investment
Determining the required level of working capital investment:
Determining the required level of working capital investment is fundamental for businesses to sustain
operations and meet financial obligations effectively. It involves striking a balance between maintaining
sufficient liquidity to support day-to-day activities and minimizing excess capital tied up in non-income
generating assets. This process entails assessing factors such as industry dynamics, market demand, seasonal
fluctuations, and the organization's unique operating cycle. By carefully evaluating these variables, businesses
can optimize their working capital allocation to enhance profitability and long-term sustainability.
The target level of working capital investment in an organization is a policy decision which is dependent on
several factors including:
 The length of the working capital cycle
 Management attitude to risk
(a) The length of the working capital cycle:
The length of the working capital cycle is a critical aspect of financial management for businesses across various industries.
It denotes the time taken from the initial payment made to suppliers for raw materials to the eventual receipt of payments
from customers. This cycle encompasses several stages, including inventory holding, production processes, sales, and
customer payment periods. Understanding and optimizing the duration of this cycle is essential for ensuring efficient cash
flow management and operational effectiveness. Factors affecting working capital cycle length are given below:
Factors Affecting Working
Description
Capital Cycle Length
Components of Working - The duration between payment to suppliers and receipt from customers.
Capital Cycle
- Includes holding raw materials, production time, finished goods inventory, and customer
payment duration.
Impact of Industry Differ. - Manufacturing: Typically has a longer cycle due to inventory holding, production, and sales terms.
- Retailing: Generally experiences a shorter cycle as goods turnover faster and sales are cash-
based.
Impact of Terms of Trade - Longer customer credit and shorter supplier credit may extend the cycle
- Reflects bargaining power: Stronger position with longer customer credit and shorter supplier
credit.
- Weak bargaining power: Shorter customer credit & longer supplier credit
(b) Management attitude to risk:
There are two type of policies to make investment in working capital:
An aggressive working capital policy A conservative/Defensive working capital policy
 It will seek to keep working capital to a minimum.  It aims to keep adequate working capital for the
organization’s needs.
 Low finished goods inventory will run risk that customers  Inventories are held at a level to ensure customers will be
will not be supplied and will buy from competitors. supplied and stock-outs will not occur.
 Low raw material inventory lead to stock-outs and  Generous terms are given to customers which may attract
therefore high costs of idle time or expensive more customers.
replacement suppliers having to be found.
 Tight credit control may alienate customers and  Suppliers are paid on time.
taking long periods of credit from suppliers may
run the risk of them refusing to supply on credit
at all.
Low level of working capital will be cheap to finance and if
managed effectively could increase profitability.

Conclusion:
Risk-seeking managers may prefer to follow a more aggressive working capital policy and risk-averse managers a
more conservative working capital policy.
Types of Working Capital:
Working capital may be permanent or fluctuating.

Permanent Working Capital Fluctuating Working Capital

 Permanent working capital refers to the minimum level of  Fluctuating working capital refers to working capital
working capital which is required all of the time. which is required at certain times in the trade cycle.
(Temporary)
 It includes minimum levels of inventories, trade  E.g. it may be economic for companies to purchase raw
receivables and trade payables. materials in bulk. Required if companies have seasonal
demand.
 Minimum Working Capital  Difference between Maximum and Minimum Working
Capital
 Medium / Long Term sources of finance are suitable to  Short Term sources of finance are suitable to finance
finance permanent net current assets. temporary net current assets.
Financing working capital – Short-Term or Long-Term Finance:
 Long-term finance, such as equity and debt, is expensive but low risk.
 Short-term finance is less expensive but there is a higher risk of it being withdrawn.
The type of financing used within the business may depend on management attitude to risk.
Conservative Funding Policy Moderate Funding Policy Aggressive Funding Policy
This is where finance all Permanent and Finance all Permanent net current This is where finance all Fluctuating /
part of Fluctuating net current assets assets through long/medium Temporary net current assets and part of
through Long / Medium term sources of term sources of finance and all Permanent net current assets through
finance. Fluctuating / Temporary net short term sources of finance
This policy is the least risky but also results current assets through short term This policy carries the greatest risk of
in the lowest expected return. sources of finance. This policy illiquidity, as well as the greatest return.
falls between the two extremes. (Because short term debt costs are
Also called Matching or maturity typically less than long-term costs).
Need to manage Risk (Risk Averse) matching policy Need more Finance / Return (Risk Seeker)
Focus on long / medium term sources of Focus on short term sources of fiancé.
finance.
Case – 01
Considering a manufacturing company, analyze how the management of working capital impacts its day-to-day operations
and long-term sustainability. Discuss the potential consequences of excessive or insufficient working capital on the
company's profitability and liquidity.

Case – 02
Imagine a retail business experiencing rapid growth in sales. Evaluate the challenges the company might face in managing
its working capital effectively to support this growth. Discuss strategies the company could employ to ensure sufficient
liquidity while maximizing profitability.
Case – 03
Explore the dilemma faced by a company with surplus cash regarding the management of short-term investments. Discuss
the factors the company should consider when selecting suitable investment options to optimize returns while maintaining
liquidity.

Case – 04
Analyze the conflicting objectives of working capital management for a service-oriented business compared to a
manufacturing company. Discuss how these objectives might differ due to variations in operating cycles and revenue
streams.
Case – 05
A manufacturing company faces a dilemma in determining its working capital investment strategy. Discuss the advantages
and disadvantages of investing in working capital for this company. Evaluate how the company's choice between aggressive
and conservative funding policies could impact its profitability and liquidity.

Case – 06
A retail business experiences seasonal fluctuations in demand, requiring fluctuating working capital throughout the year.
Analyze the types of working capital financing options available to the company and the associated risks and benefits of
each. Propose a funding strategy that balances the company's need for liquidity with its profitability goals.
Case – 07
A startup company is unsure whether to adopt an aggressive or conservative working capital policy. Evaluate the
implications of each policy on the company's risk exposure and potential returns. Discuss how the company's management
attitude towards risk should influence its decision-making process regarding working capital financing.

Case – 08
A manufacturing company faces challenges in managing its working capital cycle efficiently. Explore the factors affecting
the length of the company's working capital cycle and how these factors impact its cash flow management. Propose
strategies the company could implement to optimize its working capital cycle and enhance operational effectiveness.
LO 02: CASH OPERATING CYCLE:
The nature of the cash operating cycle:
An important way of assessing the adequacy of working capital and the efficiency of working capital management is to
calculate the length of the cash operating cycle.
This cycle is the average length of time between paying suppliers for goods and services received to receiving cash from
customers for sales of finished goods or services.
The cash operating cycle is linked to the business operating cycle. A business operating cycle is the average length of time
between obtaining goods and services from suppliers to selling the finished goods to suppliers.
The cash operating cycle varies significantly across different industries. For instance, service industries like holiday tour
operators typically have minimal inventory and may collect payments from customers upfront, resulting in a short cash
operating cycle. Conversely, manufacturing companies often maintain substantial inventories and rely heavily on credit
sales, leading to a longer cash operating cycle.
Retail companies also exhibit diverse cash operating cycles. Supermarkets, with their fast turnover and cash sales, typically
have short cycles as they sell goods to customers before paying suppliers. Conversely, furniture retailers may hold inventory
longer and offer installment payment options, resulting in a longer cash operating cycle.
Cash operating cycle and working capital requirements:
The cash operating cycle is a key factor in deciding the minimum amount of working capital required by a
company. A longer cash operating cycle means a larger investment in working capital.
The cash operating cycle, and each of the elements in the cycle, must be managed to ensure that the
investment in working capital is not excessive (i.e. the cash cycle is not too long) nor too small (i.e. the cash
cycle too short, perhaps because the credit period taken from suppliers is too long).
Cash operating cycle and working capital requirements:
The cash operating cycle is a key factor in deciding the minimum amount of working capital required
by a company. A longer cash operating cycle means a larger investment in working capital.
The cash operating cycle, and each of the elements in the cycle, must be managed to ensure that the
investment in working capital is not excessive (i.e. the cash cycle is not too long) nor too small (i.e.
the cash cycle too short, perhaps because the credit period taken from suppliers is too long).
Elements in the cash operating cycle:
There are three main elements in the cash operating cycle:
 The average length of time that inventory is held before it is used or sold.
 The average credit period taken from suppliers.
 The average length of credit period taken by (or given to) credit customers. A cash cycle or operating cycle is measured
as follows.

Days / Weeks / Months

Average inventory holding period XX
Average trade receivables collection period XX
Average period of credit taken from suppliers (XX)
Operating cycle XX
The working capital ratios and the length of the cash cycle should be monitored over time. The cycle should not be
allowed to become unreasonable in length, with a risk of over-investment or under-investment in working capital.
Measuring the cash operating cycle:
For a manufacturing business, it might be appropriate to calculate the inventory turnover period as the sum of
three separate elements:
 The average time raw materials and purchased components are held in inventory before they are issued to
production (raw materials inventory turnover period), plus
 The production cycle (which relates to inventories of work-in-progress), plus
 The average time that finished goods are held in inventory before they are sold (finished goods inventory
turnover).
1. Calculating the Inventory Turnover & the Turnover Period:

Ratio Formula Interpretation

Average Inventory It measures the number days required to sell the

Inventory Turnover Days x 365
Cost of Goods Sold inventory during the year.
A small number of days indicate that a company is more
(Average Time for holding
(Answer in days) efficient at selling its inventory. The lower the days, the
inventory/
better it is. A lengthy inventory period may indicate
Inventory days)
excessive buildup of inventories.

Cost of Goods Sold It shows how many times stock is converted into sales.
Average Inventory A high ratio indicates inventory is selling quickly.
Inventory Turnover
If the ratio is low, it suggests overstocking, obsolete
(Answer is in times) inventory or selling issues.
The higher the turnover the better it is.
Exam Focus Points:
 Average inventory should be used to calculate the ratio because the year-end inventory level might not be
representative of the average inventory in the period.
 Average inventory is usually calculated as the average of the inventory levels at the beginning and end of the
period.
 The year-end inventory should be used when opening inventory is not given and average inventory cannot be
calculated.
 For a manufacturing company, the total inventory turnover period is the sum of the raw materials turnover
period, production cycle and finished goods turnover period, calculated as follows.

Days
Raw Material = (Average RM Inventory / Annual RM Purchases)  365 days XX
WIP = (Average WIP / Annual COGM)  365 days XX
Finished inventory = (Average Finished Inventory / Annual COS)  365 days (XX)
TOTAL XX

 Inventory turnover is the inverse of the inventory turnover period.

 If the average inventory turnover period is 2 months, this means that inventory is ‘turned over’ (used) on
average six times each year (= 12 months/2 months).
 If the inventory turnover is 8 times each year, we can calculate the average inventory turnover period as 1.5
months (= 12 months/8) or 46 days (= 365 days/8).
Example # 01:
Company A has sold goods costing Rs. 850,000 and average inventory having cost of Rs. 75,000. Company B has sold goods
costing Rs. 8,500,000 and average inventory having cost of Rs. 75,000.

Answer:

Ratio Formula Company A Company B

Inventory Cost of Goods Sold 850,000 8,500,000

= 113.33 Times
Turnover = … 𝐓𝐢𝐦𝐞𝐬 = 𝟏𝟏. 𝟑𝟑 𝐓𝐢𝐦𝐞𝐬 75,000
Average Inventory 75,000
Ratio

Interpretation
Company B has better performance than Company A because activity level of company B is 113 times whereas
company A has only 11 times.
Example # 02:
Company A has sold goods costing Rs. 850,000 and average inventory having cost of Rs. 75,000.
Company B has sold goods costing Rs. 8,500,000 and average inventory having cost of Rs. 75,000.
There are 365 days in a year.

Answer:

Ratio Formula Company A Company B

75,000 75,000
Inventory = 𝟑𝟐 𝐝𝐚𝐲𝐬 x 𝟑𝟔𝟓 = 𝟑 𝐝𝐚𝐲𝐬
Turnover Average Inventory 850,000 8,500,000
x 365 (We sell the stock within 32 days (we sell the stock within 3 days
period Cost of sales
after purchasing) after purchasing)

Interpretation
Company B has better sales volume as it sells its inventory within 3 days after purchasing whereas
Company A sells its inventory within 32 days which is very long. The minimum the days, the better it is.
2. Calculating the Receivables Turnover and the Average Collection Period:

Ratio Formula Interpretation

Debtor Turnover Days Average Debtor Measures the average number of days taken by an
(Average time to collect debtors x 365 entity to collect its receivables.
Credit Sales
/Receivable days/ Debtor A long average time suggests inefficient collection from
collection period/ Days sales (Answer in days) debtor.
outstanding) The lower the days the better it is.

Debtor/Receivable turnover Net Credit Sales It shows speed within which debtors are collected.
Avg Trade Debtors The higher the turnover, the shorter the time between
sales and collecting cash.
(Answer is in times) Higher turnover ratio shows speedy and effective
collection.
Exam Focus Points:
 When normal credit terms offered to customers are 30 days (i.e. the customer is required to pay within 30 days of
the invoice date). The average collection period should be about 30 days.
 If it exceeds 30 days, this would indicate that some customers are taking longer to pay than they should, and this
might indicate inefficient collection procedures for receivables.
 Receivables turnover is the inverse of the average collection period.
 If the average collection period is 2 months, this means that receivables are ‘turned over’ on average six
times each year (= 12 months/2months).
 If the receivables turnover is 8 times each year, we can calculate the average collection period as 1.5 months
(= 12 months/8) or 46 days (= 365 days/8).
Example # 03:
Company A has net credit sales of Rs. 1,300,000 and average trade debtors of Rs. 800,000. Company B has net credit sales
of Rs. 1,300,000 and average trade debtors of Rs. 80,000.

Answer:

Ratio Formula Company A Company B

Debtor
Net Credit Sales 1,300,000 1,300,000
Turnover = 𝟏. 𝟔 𝐭𝐢𝐦𝐞𝐬 = 𝟏𝟔. 𝟑 𝐭𝐢𝐦𝐞𝐬
Avg. Trade Debtors 800,000 80,000
Ratio

Interpretation
Company B has better performance because company B has speedy and effective collection policies which are
16.3 times whereas Company A has only 1.6 times. The higher the ratio the better it is.
Example # 04:
Company A has net credit sales of Rs.1,300,000 and average trade debtors of Rs.800,000.
Company B has net credit sales of Rs. 1,300,000 and average trade debtors of Rs.800,000.
A year has 365 days.

Answer:

Ratio Formula Company A Company B

Debtor
Average Debtors 80,000 80,000
Turnover x 365 x 365 = 𝟐𝟐𝟓 𝐝𝐚𝐲𝐬 x 365 = 𝟐𝟐 𝐝𝐚𝐲𝐬
Period Net credit sales 1,300,000 1,300,000

Interpretation
The lower the days the better it is. The number of days Company B needs to recover from its debtors is 22 days
which are far less than the number of days Company A needs which are 224 days. So company B is performing
better than company A.
3. Calculating the Payables Turnover and the Average Payables Period:

Ratio Formula Interpretation

Creditor Turnover Days
(Time to pay suppliers/ Creditor
days)
Avg Creditor It measures the average number of days in which a
x 365 company makes payment to its suppliers.
Credit Purchase
It is compared with agreed credit period.
If it’s too high then there is a risk of the suppliers not
(Answer in days)
extending credit in future and may lose goodwill.

Creditor/ Payable turnover
Net Credit Purchases It shows speed within which we are making payment to
creditors.
Avg Trade creditors
The higher the turnover, the shorter the period
between purchases and payment.
(Answer is in times) Higher turnover on one side shows that our creditors
are happy however on other side we are not using
supplier funds to finance our operations.
A low turnover may be a sign of cash flow problems.
Exam Focus Points:
 Average payment period should be close to the normal credit terms offered by suppliers in the industry.
 If the average payment period is much shorter than the industry average, this might suggest that the
company has not negotiated reasonable credit terms from suppliers or that invoices are being paid much
sooner than necessary, which is inefficient working capital management. This could also be due to the fact
that the company is new to the business and is not getting a reasonable credit period from the suppliers due
to perceived credit risk.

 If the average payment period is much longer than the industry average, this might indicate that the
company has succeeded in obtaining very favorable credit terms from its suppliers. Alternatively, it means
that the company is taking much longer credit than it should, and is failing to comply with its credit terms.
This might be an indication of either cash flow problems or (possibly) unethical business practice. This may
also be because the company enjoys a sound bargaining position on the back of a sound and profitable past
track record.
Example # 05:
Company A has purchased goods on credit of Rs. 150,000 and average creditors are Rs.40,000.
Company B has purchased goods on credit of Rs.170,000 and average creditors are Rs.30,000.

Answer:

Ratio Formula Company A Company B

Creditor
Net Credit Purchases 150,000 170,000
turnover = Times = 𝟑. 𝟕𝟓 𝐭𝐢𝐦𝐞𝐬 = 𝟓. 𝟔𝟕 𝐭𝐢𝐦𝐞𝐬
Avg. Trade Creditors 40,000 30,000
Ratio

Interpretation:

‫سر لکھوا دیں گے‬

Example # 06:
Company A has purchased goods on credit of Rs. l50,000 and average creditors are Rs. 40,000.
Company B has purchased goods on credit of Rs. l70,000 and average creditors are Rs. 30,000.
A year has 365 days.

Answer:

Ratio Formula Company A Company B

Creditor
Avg. Trade Creditors 40,000 30,000
Turnover x 365 = x 365 = 𝟗𝟕 𝐝𝐚𝐲𝐬 = x 365 = 𝟔𝟒 𝐝𝐚𝐲𝐬
Net Credit purchase 150,000 170,000
Period

Interpretation:

‫سر لکھوا دیں گے‬

Example # 07:
The following information pertains to Shale Distributors Limited (SDL):

Rs. in million
Sales 300
Purchases 140
Cost of goods sold 150
Trade receivables 50
Trade payables 21
Inventories 30

All the purchases and sales are on credit.

Required:
Calculate the cash operating cycle of SDL and explain briefly its significance.
(Assume 360 days per year)
Analysis of the Cash Operating Cycle:
The cash operating cycle can be analyzed to assess whether the total investment in working capital is too large or possibly too small. The
analysis can be made by comparing each element of the cash operating cycle, and the cash operating cycle as a whole, with:

 The cash operating cycle of other companies in the same industry.

 The company’s own cash operating cycle in previous years, to establish whether it is getting longer or shorter

Comparisons with other companies in the industry Comparisons with previous years: trends
As a general rule, the inventory turnover period, average collection There might be a noticeable trend over time in a company’s turnover
period and average payment period should be about the same for all ratios from one year to the next. A trend towards longer or shorter
companies operating in the same industry. If there are differences, turnover and cycle times should be investigated.
there might be reasons. For example, a company with an unusually A particular cause for concern might be a trend towards longer
large proportion of sales to other countries might have a longer inventory turnover periods and longer average collection times,
average collection period because of the longer time that it takes to which might be an indication of excessive inventories (inefficient
deliver goods to customers. inventory management) or inefficient collection procedures for trade
If it is not possible to explain significant differences in any ratio payables.
between a company’s own turnover periods and the industry
average, the differences might be due to inefficient working capital
management (efficient management). For example, an unusually long
inventory turnover period compared with the industry average might
indicate inefficiency due to excessive holding of inventory. Slow-
moving inventory might also indicate that a write off of obsolete
inventory might be necessary at some time in the near future.
Question # 05:
Marlboro has the following estimated figures for the coming year:
Rs. In “000”
Sales 3,600
Debtors 306
Finished Goods 200
Work in Process 350
Raw Material 150
Creditors 130
Gross Profit 25% Margin
Raw material represents 60% of total production cost.
Required:
Calculate the working capital cycle.
LO 03: OTHER WORKING CAPITAL RATIOS:
Other working capital ratios can also be used to analyse whether a company has too much or too little working capital, and
whether it has adequate liquidity.
Liquidity:
Liquidity for an entity is the ability to access sufficient cash to meet payment obligations promptly. Sources of liquidity
include cash flows from operations, holding liquid assets like cash or easily sellable investments, and having access to
committed borrowing facilities like revolving credit. Managing working capital ensures adequate liquidity to meet payment
commitments, crucial for business survival. Insufficient liquidity, even with profits, can lead to bankruptcy, with unpaid
creditors often initiating liquidation. Assessing liquidity involves analyzing the cash operating cycle length and liquidity
ratios. The liquidity of a business entity can be assessed by analysing:
 The length of its cash operating cycle (explained earlier).
 Its liquidity ratios
Liquidity Ratios:
Liquidity ratios are fundamental metrics used in financial analysis to evaluate a company's ability to meet its
short-term obligations efficiently. These ratios provide insights into the organization's liquidity position by
comparing its liquid assets to its current liabilities. Essentially, they gauge how easily a company can convert its
assets into cash to cover its immediate financial commitments. There are two types of liquidity ratios:

Liquidity Ratios

Current Ratio Quick Ratio

Question # 09:
Ahmed limited has the following figures from its most recent accounts:
Rs. In Million
Receivables 4
Trade Payables 2
Inventory 4.3
Sales (80% on Credit) 30
Material Purchase (All on Credit) 18
Cost of Sale 25

Required:
Compute relevant working capital ratios.