Working Capital

Management

Dr. Ajay Kumar Chauhan

 Working Capital Decisions

Working capital decisions

 Affects the cash flow of a firm for a shorter time frame, up

to max one year

 Risk Involvement is less as compared to capital budgeting

decisions

 No relevancy of Time value of money

 More flexibility in decisions

 Working Capital Perspective
Accountant Finance Manager Production
Perspective Perspective Manager
Perspective
• CA – CL
• Net WC Total investments made
by firm in CA Total funds
• Denotes that part of CA, which is that a firm
financed by long term source of financing GWC need to carry
out its day to
• Higher NWC indicate better liquidity Broader concept of WC day
position as it reflects an increasing usage operations
of long term financing sources to partly Denotes liquidity
finance the short term assets position of a firm

• But increased use of long term sources of Higher the GWC, better
financing increases the firm’s cost of the liquidity position of
financing as long term funds are normally the firm but lesser
costlier than short term financing profitability
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 What is Working Capital Management?

WCM involves two key issues:

1. What is the appropriate amount and mix of

current assets for the firm to hold?
2. How should these current assets be
financed?

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 Basic Definitions of Working Capital Terminology
CA are cash and other assets that the firm expects to convert into
cash in a year or less.

CL (or short-term liabilities) are obligations that the firm expects to

pay off in a year or less.

Working capital is the funds invested in a company’s cash account,

account receivables, inventory, and other current assets (also called
gross working capital).

NWC refers to the difference between CA & CL. NWC is imp

because it is a measure of liquidity and represents the net short-term
investment the firm keeps in the business.

WCM involves making decisions regarding the use and sources of

current assets.
Working capital efficiency refers to the length of
time between when a working capital asset is
acquired and when it is converted into cash.

 Liquidity is the ability of a company to convert

assets—real or financial—into cash quickly
without suffering a financial loss.
 Working Capital Accounts and Tradeoffs
The various working capital accounts are:

Cash: This account includes cash and marketable securities like

treasury securities. The higher the cash balance the better the ability of
the firm to meet its short-term financial obligations.

Receivables: These represent the amount owed by customers who

have taken advantage of the firm’s trade credit policy.

Inventory: Firms maintain inventory of raw materials, work in

process, and finished goods.

Payables: The payables balance represents the amount owed to the

firm’s vendors and suppliers on materials purchased on credit.
Operating Cycle

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 Operating Cycle
 OC is managed by different departments such as
Finance, Marketing and Production

 Amount of C depends upon nature of business

 OC may ranges from one day to many years

 Ratio of CA/TA is also different for different

industries

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 Operating Cycle

= Inventory Conversion Period

+
Receivables Conversion Period
+
Payables Deferral Period

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Inventory RM Conversion Period +
Conversion = WIP Conversion Period +
Period FG Conversion Period

Receivables
Conversion = Credit Sales  Cash
Period

RCP depends upon credit period and collection efforts

Payables Deferral Period = Period for which the firm

can delay its payments

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 OC can be subdivided into
Gross OC = ICP + RCP

Net OC = GOC – PDP

Cash Conversion Cycle

Normally the term OC is used to refer GOC while the
term CCC means NOC. It is the period for which the
firm is required to arrange for finance for its WC
needs.
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Purchase Payment Credit Recovery
of for Sales of Cash
Inventory Credit
on Credit Purchase

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 Methods of cutting down the OC
 Outsourcing (production, distribution or collection etc)

 Inventory Management Practices

 Reducing Collection Time

 Technology Upgradation

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 Operating and Cash Conversion
Cycles
Cash conversion cycle
The cash conversion cycle begins when the firm
invests cash to purchase the raw materials that
would be used to produce the goods that the firm
manufactures. It ends not with the finished goods
being sold to customers and the cash collected on
the sales; but when you take into account the time
taken by the firm to pay for its purchases.
 Exhibit 14.2 shows the graphical representation
of the cash conversion cycle.
Exhibit: The Cash Conversion Cycle
When managing working capital accounts, financial
managers want to do the following:

• Delay paying accounts payable as long as possible without suffering

any penalties.
• Maintain minimal raw material inventories without causing
manufacturing delays.
• Use as little labor as possible to manufacture the product while
producing a quality product.
• Maintain minimal finished goods inventories without losing sales.
• Offer customers the most attractive credit terms possible on trade credit
to maximize sales while minimizing the risk of non-payment
• Collect cash payments on accounts receivable as fast as possible to
close the loop.
• With the financial manager’s goal is to maximize the value of the firm,
each of the decisions above is intended to shorten the cash conversion
cycle and improve the firm’s liquidity.
Cost of Liquidity vs Cost of Illiquidity

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 Working capital financing Policies

Matching Approach

Conservative Approach

Aggressive Approach

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 Computation of Operating Cycle
Example: Following information has been extracted from
the financial statement of a manufacturing firm:
In Rs Crore
Average credit period allowed by suppliers (in days) 60
Average debtors outstanding 6
Raw material consumed 60
Cost of Production 145
Cost of Goods Sold 157.5
Sales 200
Inventory of RM 5.75
WIP 6.75
Finished Goods 4.80

Compute the OC for the firm assuming that the info

given above is for a full one year period
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Solution: Duration of an OC depends upon the duration
of its components

GOC = DRM + DWIP + DFG + DAR

NOC = GOC – DAP

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