WORKING CAPITAL

MANAGEMENT

1
 Concept of Working Capital

Working Capital is a capital which is consumed during

a fiscal period in creating current income. It is
investment in current assets and there is cost involved
 Concept of Working Capital
Gross working capital:
Total current assets.
Net working capital:
Current assets - Current liabilities.
Net operating working capital (NOWC):
Operating CA – Operating CL =
(Cash + Inv. + A/R) – (Accruals + A/P)
 Types of Working Capital
1. Net Working Capital
2. Gross Working Capital
3. Permanent Working Capital
4. Variable Working Capital
5. Negative Working Capital
 Net Working Capital
The net working capital is the difference
between current assets and current liabilities.
 Gross Working Capital
Gross Working capital is the amount of funds
invested in the various components of current assets.

This concept has the following advantages:

(a) It enables a firm to realize the greatest return on its
investment
(d) It helps in the fixation of various areas of financial
responsibility
(e) It enables a firm to plan and control funds and to
maximize the return on investment.
 Permanent Working Capital
Permanent working capital is the minimum amount of
current assets which is needed to conduct a business even
during the dullest season of the year.

• This amount varies from year to year, depending upon the

growth of a company and the stage of the business cycle in
which it operates.

Permanent working capital has the following characteristics:

(a) It is classified on the basis of the time factor
(b) Its size increases with the growth of business operations.
Temporary or Variable Working Capital

It represents the additional assets which are

required at different times during the
operating year -additional inventory, extra
cash etc.
• It is not always gainfully employed. It is
particularly suited to business of a seasonal or
cyclical nature
 Negative Working Capital
Negative working capital emerges when
current liabilities exceed current assets. Such a
situation is not absolutely theoretical, and
occurs when a firm is nearing a crisis of some
magnitude.
•
Characteristics of Working Capital
• Short life span
• Swift transformation into other asset forms

Current Assets Cycle

Finished
goods

Accounts Work-in-
receivable process
Wages, salaries,
factory overheads
Raw materials

Cash Suppliers
The Operating Cycle and the Cash Cycle
Raw material
Cash
purchased Finished goods sold
received
Order Stock
Placed Arrives

Inventory period Accounts receivable period

Time
Accounts payable period

Firm receives invoice Cash paid for materials

Operating cycle

Cash cycle
The Operating Cycle and the Cash Cycle
Accounts
Cash cycle = Operating cycle – payable
period
 FACTORS INFLUENCING WORKING CAPITAL
REQUIREMENTS
• Nature of Business

• Seasonality of Operations

• Production Policy

• Market Conditions

• Conditions of Supply
 WC Policy

Flexible/Relaxed Restrictive
(Conservative) (Aggressive)
Policy Policy
Liquidity High Low
Inventories Large Small
Debtors High Low
 CURRENT ASSETS FINANCING POLICY

According to the matching principle, fixed assets and

permanent current assets should be supported by long-term

sources of finance whereas fluctuating current assets must

be supported by short-term sources of finance.

 METHODS OF ESTIMATING WORKING CAPITAL

1. Conventional Method: According to the

conventional method, cash inflows and
outflows are matched with each other.
 2. Operating Cycle Method
• Operating cycle of an enterprise is the length of
time which is required to convert cash into
resources, resources into final product, the final
product into receivables and receivables back into
cash.
 Operating Cycle Method
O =R+W+F+A-P
R= Av Stock of RM/ Per day Consumption
of RM
W= Av Stock of WIP/ Per day Production
F = Av Stock of FG / Per day Sales
A= Av book debts / Av. credit sales per day
P = Av trade creditors / credit sales per day
 ADEQUACY OF WORKING CAPITAL

• It protects a business from the adverse effects of shrinkage in the

values of current assets.
• It is possible to pay all the current obligations promptly and to take
advantage of cash discounts.
• It ensures to a greater extent the maintenance of a company's credit
standing and provides for such emergencies as strikes, floods etc.
• It permits the carrying of inventories at a level that would enable a
business to serve satisfactorily the needs of its customers.
• It enables a company to extend favourable credit terms to customers.
• It enables a company to operate its business more efficiently because
there is no delay in obtaining materials.
• It enables a business to withstand periods of depression smoothly.
 Contd..
• There may be operating losses or decreased retained earnings.
• There may be excessive non-operating or extraordinary losses.
• The management may fail to obtain funds from other sources
for purposes of expansion.
• There may be an unwise dividend policy.
• Current funds may be invested in non-current assets.
• The management may fail to accumulate funds necessary for
meeting debentures on maturity.
• There may be increasing price necessitating bigger
investments in inventories and fixed assets.
 When working capital is inadequate, a
company faces the following problems

• It is not possible for it to utilise production facilities fully for want of working
capital.
• A company may not be able to take advantage of cash discount facilities.
• The credit-worthiness of the company is likely to be jeopardised because of
lack of liquidity,
• A company may not be able take advantage of profitable business
opportunities.
• The modernisation of equipment and even routine repairs and maintenance
facilities may be difficult to administer.
• A company will not be able to pay its dividends because of the non­availability
of funds.
• A company may have to borrow funds at exorbitant rates of interest.
• Its low liquidity may lead to low profitability in the same way as low
profitability results in low liquidity.
DANGERS OF EXCESSIVE WORKING CAPITAL

• A company may keep very big inventories and tie up its

funds unnecessarily.
• There may be an imbalance between liquidity and
profitability . A company may enjoy high liquidity and, at
the same time, suffer from low profitability.
• High liquidity may induce a company to undertake greater
production which may not have a matching demand.
• A company may invest heavily in its fixed equipment which
may not be justified by actual sales or production. This
may provide a fertile ground for later over-capitalisation.
Four test of working capital policy:
There are four test of working capital policy:
• Level of Working Capital: This should be maintained by a careful study of the
movements of working capital in successive periods. If a management can develop a
pattern in these movements, this pattern would serve as guide to its changing
requirements in relation to certain decisions which are made from time to time.
• Structural Health: The relative health of the various components of the working
capital should be considered from the point of view of liquidity. It is necessary to draw
structural relationships in respect of each component constituting the current assets.
• Circulation: This is an important feature of the liquid position and involves the natural
activity cycle of an enterprise. Ratios may be calculated to show the average period
required for the conversion of raw materials into finished goods, finished goods into
sales, and sales into cash.
• Liquidity: A more comprehensive test to measure liquidity may be adopted by using
following three ratios, each expressed as a percentage of:
(a) Working capital to current assets;
(b) Stocks to current assets;
(c) Liquid resources to current assets