Subject Name: Financial management

Module IV
WORKING CAPITAL MANAGEMENT

Dr. Preeti Garg

1
• MEANING
Working capital is defined as the excess of current assets over
current liabilities. Current assets are those assets which will
be converted into cash within the current accounting period
or within the next year as a result of the ordinary operations
of a business.
 WORKING CAPITAL

• Working Capital is that part of the capital which is needed for meeting
day to day requirement of the business concern. For example, payment to
creditors, salary paid to workers, purchase of raw materials etc
• It can be easily converted into cash. Hence, it is also known as short-
term capital.
DEFINITION

• According to the definition of Shubin, “Working Capital is the amount

of funds necessary to cover the cost of operating the enterprises”.
• According to the definition of Genestenberg, “Circulating capital means
current assets of a company that are changed in the ordinary course of
business from one form to another, for example, from cash to
inventories, inventories to receivables, receivables to cash”.
FACTORS DETERMINING WORKING CAPITAL REQUIREMENT

 NATURE OR CHARACTER OF BUSINESS

 SIZE OF BUSINESS/SCALE OF OPERATIONS
 PRODUCTION POLICY
 MANUFACTURING PROCESS/LENGTH OF PRODUCTION CYCLE
 SEASONAL VARIATION
 WORKING CAPITAL CYCLE
 RATE OF STOCK TURNOVER
 CREDIT POLICY
 BUSINESS CYCLE
 RATE OF GROWTH OF BUSINESS
 EARNING CAPACITY AND DIVIDEND POLICY
 PRICE LEVEL CHANGES
 OTHER FACTORS
 BASICS OF WORKING CAPITAL

A. GROSS AND NET WORKING CAPITAL

B. PERMANENT AND TEMPORARY WORKING
CAPITAL
 Gross Working Capital

• It is the general concept.

• It is the capital invested in total current assets of the

business concern.
• Gross Working Capital is simply called as the total
current assets of the concern.
GWC = CA
 GROSS AND NET WORKING CAPITAL
1. The term gross working capital refers to
investment in current assets.
2. The term net working capital refers to excess
of current assets over current liabilities.
 Net Working Capital

• It is the specific concept, which, considers both current assets and current
liability of the concern.
• It is the excess of current assets over the current liability of the concern during
a particular period.
• If the current assets exceed the current liabilities it is said to be positive
working capital; when it is reverse, it is said to be Negative working capital.
NWC = C A – CL
 PERMANENT AND TEMPORARY WORKING
CAPITAL
1. Permanent working capital represents the
assets required on continuing basis over the
entire year.
2. Temporary working capital represents
additional assets required at different items
during the operations of the year.
 Permanent Working
Capital
The amount of current assets required to meet a
DOLLAR AMOUNT firm’s long-term minimum needs.

Permanent current assets

TIME
 Temporary Working
Capital
The amount of current assets that varies with
seasonal requirements.

Temporary current assets

DOLLAR AMOUNT

Permanent current assets

TIME
 Importance of Working Capital

• It is important we work out the right level of

working capital you will need. If the working
capital is too:
– High - Business has surplus funds which are
not earning a return; and
– Low - May indicate that your business is
facing financial difficulties.
The working capital cycle is made up of four core components:
• Cash & Cash equivalent.
• Creditors/accounts payable.
• Inventory/stock in hand.
• Debtors/accounts receivables
OPERATING CYCLE ANALYSIS
 WORKING CAPITAL CYCLE

• In manufacturing firm working capital cycle starts with the purchase of

raw material and ends with the realisation of cash from the sale of
finished products.

• The speed with which the working capital complete one cycle
determines the requirement of working capital.

• Longer the period of the cycle larger the requirement of working capital.
WORKING CAPITAL/OPERATING CYCLE OF A MANUFACTURING CONCERN

DEBTORS
(RECEIVABLES)

CASH
Paid to creditors or FINISHED GOODS
earned as profit

RAW MATERIALS WORK-IN-PROGRESS

 OPERATING CYCLE AND WORKING CAPITAL
NEEDS
• The operating cycle may be defined as the
time duration starting from the procurement
of goods or raw materials and ending with the
sales realisation.
 OPERATING CYCLE PERIOD
The length or time duration of the operating
cycle of any firm can be defined as the sum of
its inventory conversion period (ICP) and the
receivables conversion period (RCP).
TOTAL OPERATING CYCLE PERIOD= ICP+RCP
NOC=TOCP-DP(DEFERRED PAYMENTS)
OPERATING CYCLE
 OPERATING CYCLE

Procurement of raw materials

Conversion of raw materials into work in

progress

Conversion of work in progress into finished

goods

Sale of finished goods(cash or credit)

Conversion of receivables into cash

Duration of the Operating Cycle
The duration of the operating cycle is equal to the sum of
the duration of each of these stages less the credit period
allowed by the suppliers of the firm. In symbols,
O=R+W+F+D–C
Where,
O = duration of operating cycle.
R = raw material storage period.
W= work-in-process period.
F= finished goods storage period.
D=debtors collection period, and
C = creditors payment period.
CALCULATION OF VARIOUS CONVERSION
PERIODS
1. RMCP= average raw material stock x 365=27
total raw material consumption
2. WPCP= average work in progress x 365=13
total cost of production
3. FGCP= Average finished goods x 365=9
total cost of goods sold
4. RecCP= average receivables x 365=11
total credit sales
5.CrPP= average creditors x 365=16
total credit purchases=27+13+9+11-16=44
 Forecasting of Working Capital
• To forecast the working capital requirement for the next year
the following formula may be used :
(Estimated cost of goods sold x Operating Cycle) + Desired Cash
Balance
• Example – X Ltd. Expects its cost of goods sold
for the forthcoming year to be Rs. 2 crore. The
present operating cycle of the firm is 78 days.
The firm plans to reduce its operating cycle to
73 days and desired cash balance is Rs. 5 lakh.
• The expected working capital requirement
would be, 2,00,00,000*73+ 5,00,000
365 =45,00,000
 Control of Working Capital

• Working capital requirement depends upon the level of

operation and the length of operating cycle.
• Monitoring the duration of the operating cycle is an important
ingredient of working capital control
 Duration of raw material
• The duration of the raw material stage depends on regularity
of supply, transportation time, price fluctuations and economy
of bulk purchase. For imported materials it takes a longer time.
 Duration of work-in-process
• The duration of the work-in-process depends on the length of
manufacturing cycle, consistency in capacities at different
stages, and efficient coordination of various inputs.
 Duration of the finished goods
• The duration of the finished goods depends on
the pattern of production and sales. If
production is fairly uniform throughout the
year but sales are highly seasonal or vice
versa. The duration of finished goods tends to
be long.
 Duration at debtors
The duration at debtors stage depends on the
credit period granted, discounts offered for
prompt payment, and efficiency and rigour of
collection efforts.
The duration at Creditors stage depends on the
credit period granted by suppliers, discounts
offered by them on payment etc, regular
payment habit on the part of the company as
they instill confidence in the minds of the
suppliers.
• It is helpful to monitor the behaviour of overall operating cycle and its
individual components. For this purpose time series analysis and cross
section analysis may be done. In time series analysis the duration of the
operating cycle and its individual components is compared over a period
of time for same firm. In cross section analysis the duration of the
operating cycle and its individual components is compared with that of
other firms of a comparable nature.
 Importance of adequate WC
• Solvency of the business
• Goodwill
• Easy loans
• Cash Discount
• Regular supply of Raw Material
• Regular payment of salaries wages and other day to day
• Exploitation of favourable market conditions
• Ability to face crisis
• Quick and regular return on investments
• High Morale
 Disadvantage of excessive WC
• Idle funds: no profit for business
• Unnecessary purchasing and inventory accumulation
• Excessive debtors or defective credit policy- higher badbebts
• overall inefficiency in the organisation
• Relations with banks & other fin Inst.
• Low rate of return-fall in value of shares
• Speculative transactions.
 Disadvantage of inadequate WC
• Problem in meeting sh.term liab. in time.
• Bulk purchasing not posible
• May not exploit favorable market conditions and profitable projects
• Cannot pay day to day expense: inefficiency, increases costs reduces
profit
• Impossible to Utilising efficiently F. Aset due to non availability of liquid
assets
• Rate of return on investment also falls
Inventory Management
• How do you manage your inventory?
How much do you buy? When?
• Soda
• Milk
• Toilet paper
• Gas
• Cereal
• Cash
 What Do you Consider?
• Cost of not having it.
• Cost of going to the grocery or gas station (time, money), cost
of drawing money.
• Cost of holding and storing, lost interest.
• Price discounts.
• How much you consume.
• Some safety against uncertainty.
What is inventory?
Inventory is the raw materials, component
parts, work-in-process, or finished products
that are held at a location.
Raw material
Work in Progress
Consumables
Finished goods
Spares
Why do we care?

–Sales
– Sales
–Sales growth:
growth: growth:
right right
right
inventory inventory
at the inventory
right place atat at
the
the the
rightrightright
place
place
time
Sales growth: right inventory at the right place
atreduction:
Costat
at
the
the
the right
right
right timetime
time
less money tied up in inventory, inventory
–management,
–
CostCostreduction:
reduction:
obsolescenceless
– Cost reduction:Atless lessmoney
money tiedtiedup upininin
inventory,
inventory,
money
the firm level: tied up inventory,
inventory
inventory
inventory management,
management,
management, obsolescence
obsolescence
obsolescence
– Higher profit
• Benefits of Holding Inventories
i. The Transaction Motive
ii. The Precautionary motive
iii. The Speculative Motive
Risk & Cost of Holding Inventories:
Capital Costs, Storage and Handling Costs
Risk of Price Decline/ Obsolescence
Risk of Deterioration in quality.
 Transaction needs

The transaction need of holding nventories is dependent upon the

manufacturing cycle & normal production level of the firm and policy
of the management. The manufacturing cycle of the firm will vary
from industry to industry. It will be very large (months) in case
engineering, procurement, & construction contractor and will be
small in case of food processing, and detergent & soap manufacturer.
The policy of the management such as aggressive, moderate, and
conservative will also guide the inventory-holding period of the firm.
An aggressive management will hold minimal inventories and
conservative firm will hold high level of inventories.
 Precautionary needs
The firm will like to hold some level of inventory
for precautionary needs.The actual level of
production may exceed the planned level and
thus there is need for higher level of inventories.
It may be in case of firm, which is in a seasonal
industry or has just come out of a recession. The
objective is not to have stock out but at the
same time not to erode the profitability of the
firm by maintaining excessive inventories.
 Speculative needs
The management of the firm depending on its attitude may like to benefit
from speculative activities by maintaining the higher level of inventories to
benefit
from the price fluctuations.
Maintaining inventories entails cost. Lack of inventories causes disruption
in production, unsatisfied demand, and customer switching to the
competitors. Thus, there is a need that firm should be able to quantify
optimum level of inventories and hold it
Costs of Inventory
Physical holding costs:
out of pocket expenses for storing inventory
(insurance, security, warehouse rental, cooling)
All costs that may be entailed before you sell it
(obsolescence, spoilage, rework...)
Opportunity cost of inventory: foregone
return on the funds invested.
Operational costs:
Delay in detection of quality problems.
Delay the introduction of new products.
Increase throughput times.
 Benefits of Inventory
•Hedge against uncertain demand
•Hedge against uncertain supply
•Economize on ordering costs
•Smoothing
To summarize, we build and keep inventory in
order to match supply and demand in the
most cost effective way.
Total Cost = Purchasing Cost + Ordering Cost + Inventory Cost
Purchasing Cost = (total units) x (cost per unit)
Ordering Cost = (number of orders) x (cost per order
Inventory Cost = (average inventory) x (holding cost)
 Finding the optimal quantity to order…
Let’s say we decide to order in batches of Q…

Inventory position D
Number of periods will
be
Q

The average
inventory for each
period is…
Time
Period over which demand for Q has occurred Q

2
Total Time
Finding the optimal quantity to order…
Purchasing cost = D x C

D
Ordering cost = x S
Q

Q
Inventory cost = x H
2
So what is the total cost?

D Q
TC = D C + S + H
Q 2

In order now to find the optimal quantity we need to optimize the total cost
with respect to the decision variable (the variable we control)
Economic Order Quanity
 economic order quantity
• The firm has to decide the inventory order quantity. If the order quantity is large, the firm
economizes on the ordering cost, as the number of the orders will be less during the year. The
ordering cost is the administrative cost associated with the placing of an order.
• For example, if the annual production level of a motorbike manufacturer is 100,000 units, the tyres
and tubes required will be 200,000. If the firm places an order for 50000 tyres and tubes at one time,
it has to place just four orders during the year. However, the inventory carrying cost of 50,000 tyres
and tubes will be very high. The inventory carrying cost includes the insurance, rental of stores,
spoilage, obsolescence, and interest on investment in the inventories. Thus, the trade-off is between
the ordering cost and the carrying cost.
What is the main insight from EOQ?
There is a tradeoff between holding costs and ordering costs

Total cost

Cost
Holding costs

Ordering costs

Order Quantity (Q*)

 Economic order quantity

economic order quantity makes the

following assumptions:
1. · The ordering cost per order and carrying cost per
unit per annum are know a priori and are fixed.
2. · The material cost per unit is known a priori and is
constant.
3. · The material consumption level during the year are
known in advance
4. · No stock out occurs.
Economic Order Quantity - EOQ
2SD
Q =
*

Example:
Assume a car dealer that faces demand for 5,000 cars per year, and that it costs $15,000
to have the cars shipped to the dealership. Holding cost is estimated at $500 per car per
year. How many times should the dealer order, and what should be the order size?
Receivable Management
 Introduction
• Receivables result from credit sales.
• Receivables constitute a significant portion of current assets of
a firm. In investment receivables incur certain cost, also a risk
of bad debts arises. Thus , it is important to have proper
control and management of receivables.
 Meaning
• Receivables, represent the amount owed to the firm as a result
of goods or services sold during the course of business.
• The are also called accounts receivables, trade
receivables ,customer receivables
• The extent of receivables depend on the policy followed by the
firm.
 Accounts Receivable

• Receivables management is the Process of making decisions

relating to investment in trade debtors.
• Certain investment in receivables is necessary to increase the
sales and the profits of a firm.
 Costs of maintaining receivables
• Cost of financing receivables
• Cost of collection
• Bad debts
 Factors influencing the size of receivables
• Size of credit sales
• Credit policies
• Terms of trade
• Expansion plans
• Relation with profits
• Credit collection efforts
• Habits of customers
 Forecasting the receivables
• Credit period allowed
• Effect of cost of goods sold
• Forecasting expenses
• Forecasting average collection period and discounts
• Average size of receivables
 Meaning of receivable management
• Receivable management is the process of making decision
relating to investment in trade debtors.
 Purpose of receivable management

The specific purposes of receivable management are as follows:

1. To evaluate the creditworthiness of customers before granting or
extending the credit.
2. To minimize the cost of investment in receivables.
3. To minimize the possible bad debt losses.
4. To formulate the credit terms in such a way that results into
maximization of sales revenue and still maintaining minimum
investment in receivables.
5. To minimize the cost of running credit and collection department.
6. To maintain a trade off between costs and benefits associated to credit
policy process of making decisions relating to investment in trade
debtors.
 Dimensions of receivable management
• Forming of credit policy :
1. Quality of trade accounts or credit standards
2. Length of credit period
3. Cash discount
4. Discount period
• Executing credit policy
1. Collecting credit information
2. Credit analysis
3. Credit decision
4. Financing investment in receivables and
factoring
• Formulating and executing the collection
policy
 Test your knowledge
State whether each of the following statement is true or false:
i. Receivables constitute a significant portion of fixed assets.
ii. The volume of sales is influenced by credit policy of a firm.
iii. Average size of receivables= Estimated Annual sales* average
Collection Period.
Ans.i) False ii) True iii) True
 Working Capital Financing
• Fund Based:
– Cash Credit
– Overdraft
– Bills Discounting
– Working Capital Demand Loan
• Non Fund Based:
– Letter of Credit
– Bank Guarantee
• Structured Product:
– Factoring
– Commercial Paper
– Securitization of receivables
– Buyers/Supplier credit.
 Working Capital Financing Mix
Approaches to Financing
Mix

The Hedging or The Conservative The Aggressive

Matching Approach Approach Approach
Hedging approach to asset financing
Total Assets
Short-term
Debt
Fluctuating Current Assets

Long-term
Permanent Current Assets Debt +
Equity
Capital

Fixed Assets

Time
 The Hedging approach
 Hedging approach refers to a process of matching
maturities of debt with the maturities of financial
need . In this approach maturity of source of fund
should match the nature of asset to be financed
 This approach is also known as matching approach.
 The hedging approach suggests that the permanent
working capital requirement should be financed with
fund from long term sources while the temporary
working capital requirement should be financed with
short term funds.
Conservative approach to asset financing
Total Assets
Short-term
Debt
Fluctuating Current Assets

Long-term
Permanent Current Assets Debt +
Equity
capital

Fixed Assets

Time
 Conservative Approach
 This approach suggested that the entire estimated
investments in current asset should be finance from
long term source and short term should be use only
for emergency requirement
 Distinct features of this approach
• Liquidity is greater
• Risk is minimized
• The cost of financing is relatively more as interest has
to be paid even on seasonal requirement for the
entire period
Aggressive approach to asset financing
Total Assets
Short-term
Debt
Fluctuating Current Assets

Long-term
Permanent Current Assets Debt +
Equity
capital

Fixed Assets

Time
 Aggressive approach
• The aggressive approach suggests that the entire
estimated requirement of current asset should be
financed from short-term sources and even a part of
fixed asset investment be financed from short - term
sources
This approach make the finance mix :
• More Risky
• Less costly
• More Profitable
 Thank You
Please forward your query

To: pgarg53@amity.edu
CC: manoj.amity@panafnet.com