Working Capital

Management

-Introduction
 Meaning of Working Capital
Management
• Working Capital Management refers to management of working
capital, or to be more precise, management of current assets.
• Current Assets are short term assets such as cash, cash at bank ,
inventories (stock), receivables and marketable securities.
• WCM refers to the management of the level of the individual current
assets as well as total working capital.
• WCM is imperative for any firm, the need of WCM arises because of
two considerations:
1. Fixed Assets usually requires huge investment, it can be optimally
managed, if supported by sufficient working capital.
Contd.
2. If Working Capital is not sufficiently maintained the it will lead to
hindrance in the smooth functioning of the firm.
Nature and Types of Working Capital
A Financial Manager is faced with a decision involving some of
the considerations as follows:
1. What should be the total investment in the working capital
of the firm?
2. What should be the level of individual current assets?
3. What should be the relative proportion of different sources
to finance the working capital requirements?
• The term Working Capital is used in two different ways:
• 1.Gross Working Capital( or total working capital): it refers to the
firm’s investment in all the current assets taken together. For
example, a firm has a stock of ₹. 50,000, debtors of ₹ . 1,00,000 and
cash balance of ₹ 80,000, the gross working capital is ₹ 2,30,000( i.e.
₹. 50,000 + ₹ . 1,00,000 + ₹ 80,000).
• 2. Net Working Capital: may be defined as excess of total working
capital over total current liabilities. The greater the margin between
the firm’s current assets and liabilities the better it will be for the
firm.
A firm should have an optimum level of gross working capital. This
helps in avoiding (i) the unnecessarily stoppage of work or chance of
liquidation due to insufficient working capital. (ii) effect on profitability.
• The Operating Cycle
• The operating cycle refers to the time gap between the completion of
the chronological sequence of some or all of the following:
i. Procurement of raw material and services.
ii. Conversion of raw materials into work in progress(WIP).
iii. Conversion of WIP into finished goods.
iv. Sale of finished goods(either on cash or credit)
v. Conversion of receivables into cash.
These activities create and necessitate cash flows which are neither
synchronized nor certain.
• Operating Cycle Period
• The length and the time duration of the operating cycle is a sum of
inventory conversion period and the receivable conversion period.
• Inventory conversion Period: The inventory conversion period is the
time required to obtain materials for a product, manufacture it, and
sell it. The inventory conversion period is essentially the time period
during which a company must invest cash while it converts materials
into a sale. In a manufacturing firm it consists of Raw Material
Conversion Period(RMCP), WIP Conversion Period(WPCP), and
Finished Goods Conversion Period(FGCP).
• Receivables Conversion Period: Receivable conversion period is the
time between the sale of the final product on credit and cash receipts
for the accounts payable. Receivables conversion period is also known
as Average Collection Period.
• Deferral Period: the firm might be getting some credit facilities from
the suppliers of the raw materials, wage earners, the period for which
it is delayed is known as Deferral period.

• Inventory Conversion Period + Receivable conversion Period

= Total Operating Cycle Period
Net Operating Cycle = Total Operating Cycle period – Deferral Period.
• Various conversion periods are calculated as:
• RMCP = Average raw materials consumed * 365
Total Raw Materials Consumed
• WPCP = Average Work-in -Progress * 365
Total Cost of Production
• FGCP = Average Finished Goods * 365
Total Costs of Goods sold
• RCP = Average Receivables * 365
Total Credit Sales
• DP= Average Creditors * 365
Total Credit Purchases
Let’s take up an example.
From the following information, compute the operating cycle in days:
Period covered 365 days, average period of credit allowed suppliers 16 days.
Particulars Amount ( ₹.)
Average Debtors 480
outstanding
Raw Material 4,400
Consumption
Total Production Cost 10,000
Total cost of goods sold 10,500

Sales for the year ₹ 16,000

Value of the average stock maintained:
Raw Materials 320
Work in Progress 350
Finished Goods 260
• Operating Cycle is computed as:
• RMCP = Average raw materials consumed * 365 = 320 * 365= 27 days
Total Raw Materials Consumed 4400
• WPCP = Average Work-in -Progress * 365 = 350 * 365 = 13 days
Total Cost of Production 10,000
• FGCP = Average Finished Goods * 365 = 260 * 365 = 9 days
Total Costs of Goods sold 10,500
• RCP = Average Receivables * 365 = 480 * 365 = 11 days
Total Credit Sales 16,000
TOCP = RMCP + WPCP +FGCP + RCP
= 27 + 13 + 9 + 11 = 60 days
NOC = TOCP – DP = 60-16 = 44 days
• Factors Determining Working Capital Requirement
• Nature of Business:
• The requirement of working capital depends on the nature of business.
The nature of business is usually of two types: Manufacturing Business
and Trading Business. In the case of manufacturing business it takes a
lot of time in converting raw material into finished goods. Therefore,
capital remains invested for a long time in raw material, semi-finished
goods and the stocking of the finished goods. Consequently, more
working capital is required. On the contrary, in case of trading business
the goods are sold immediately after purchasing or sometimes the sale
is affected even before the purchase itself. Therefore, very little working
capital is required. Moreover, in case of service businesses, the working
capital is almost nil since there is nothing in stock.
• (2) Scale of Operations:
• There is a direct link between the working capital and the scale of
operations. In other words, more working capital is required in case of
big organisations while less working capital is needed in case of small
organisations.
• (3) Business Cycle:
• The need for the working capital is affected by various stages of the
business cycle. During the boom period, the demand of a product
increases and sales also increase. Therefore, more working capital is
needed. On the contrary, during the period of depression, the
demand declines and it affects both the production and sales of
goods. Therefore, in such a situation less working capital is required.
(4) Seasonal Factors:
• Some goods are demanded throughout the year while others have seasonal demand. Goods
which have uniform demand the whole year their production and sale are continuous.
Consequently, such enterprises need little working capital.
• On the other hand, some goods have seasonal demand but the same are produced almost the
whole year so that their supply is available readily when demanded.
• Such enterprises have to maintain large stocks of raw material and finished products and so they
need large amount of working capital for this purpose. Woolen mills are a good example of it.
(5) Production Cycle:
• Production cycle means the time involved in converting raw material into finished product. The
longer this period, the more will be the time for which the capital remains blocked in raw
material and semi-manufactured products.
• Thus, more working capital will be needed. On the contrary, where period of production cycle is
little, less working capital will be needed.
(6) Credit Allowed:
• Those enterprises which sell goods on cash payment basis need little working capital but those
who provide credit facilities to the customers need more working capital.
(7) Credit Availed:
• If raw material and other inputs are easily available on credit, less working capital is needed. On the
contrary, if these things are not available on credit then to make cash payment quickly large amount
of working capital will be needed.
(8) Operating Efficiency:
• Operating efficiency means efficiently completing the various business operations. Operating
efficiency of every organisation happens to be different.
• Some such examples are: (i) converting raw material into finished goods at the earliest, (ii) selling the
finished goods quickly, and (iii) quickly getting payments from the debtors. A company which has a
better operating efficiency has to invest less in stock and the debtors.
• Therefore, it requires less working capital, while the case is different in respect of companies with less
operating efficiency.
(9) Availability of Raw Material:
• Availability of raw material also influences the amount of working capital. If the enterprise makes use
of such raw material which is available easily throughout the year, then less working capital will be
required, because there will be no need to stock it in large quantity.
• On the contrary, if the enterprise makes use of such raw material which is available only in some
particular months of the year whereas for continuous production it is needed all the year round, then
large quantity of it will be stocked. Under the circumstances, more working capital will be required.
(9) Availability of Raw Material:
• Availability of raw material also influences the amount of working capital. If the enterprise makes use of
such raw material which is available easily throughout the year, then less working capital will be
required, because there will be no need to stock it in large quantity.
• On the contrary, if the enterprise makes use of such raw material which is available only in some
particular months of the year whereas for continuous production it is needed all the year round, then
large quantity of it will be stocked. Under the circumstances, more working capital will be required.
(10) Growth Prospects:
• Growth means the development of the scale of business operations (production, sales, etc.). The
organisations which have sufficient possibilities of growth require more working capital, while the case
is different in respect of companies with less growth prospects.
(11) Level of Competition:
• High level of competition increases the need for more working capital. In order to face competition,
more stock is required for quick delivery and credit facility for a long period has to be made available.
(12) Inflation:
• Inflation means rise in prices. In such a situation more capital is required than before in order to
maintain the previous scale of production and sales. Therefore, with the increasing rate of inflation,
there is a corresponding increase in the working capital.
• Liquidity Vs Profitability
• Profitability refers to the company improvement in margins, margins refer to
revenue – cost the more the margins are increasing it reflects enhanced
profitability in the company for that financial year. Profitability enhances the
equity reserves and growth prospects of the company. On the other hand,
liquidity refers to the ability of the firm to meet short-term and long-term
obligations which the business needs to pay in the long-run and in the short-
run the current portion of liabilities
• One of the key differences is that it is not necessary always that the company
who is profitable is also liquid in nature that is because the company has
invested heavily In the future projects of the company from which the
receivables are due after a considerable period of time. This is a major
difference which needs to be understood when doing financial projections for
any company. A company who is not liquid in nature can also go bankrupt in
the short-run because it does not have enough liquidity in its hands that is why
the company needs working capital in order to meet short-term obligations
• Profitability is a measure of business success that is how well the
company is performing over a period of time it is not an indication of how
cash-rich the company is and it cannot tell the analyst the cash position of
the company. Liquidity, on the other hand, tells us the cash position of the
company, too much cash on the balance sheet also indicates
poor working capital management of the company as the company is
bearing the opportunity cost of cash which is lying idle on the balance
sheet.
• Profitability is the financial performance measure of the company which
is indicated in the income statement and is reported as Net profit in the
profit and loss account. If the number of net profit is negative it indicates
that the company is bearing losses in that period. Liquidity is present in
the balance sheet on the current assets section of any balance sheet of
the company which includes marketable securities, prepaid expenses, and
inventories apart from cash
• Types of Working Capital
1. Permanent Working Capital
• It is otherwise called as Fixed Working Capital. Tandon committee has referred to this type of working
capital as Hard Core Working Capital. Permanent working capital implies the base investment amount in
all types of current resources which is respected at all times to carry on business activities. The value of
current assets have been increased or decreased over a period of time. Even though, there is a need of
having minimum level of current assets at all times in order to carry on the business activities effectively.
• Features of Permanent Working Capital
a) The gross value of permanent working capital remain constant but the value of components of current
assets is differing from each other.
b) There is a positive correlation between the size of business and the amount of permanent working
capital.
c) Only long term sources of funds are used for permanent working capital.
2. Temporary Working Capital
• It is otherwise called as Fluctuating or Variable Working Capital. There is a close relationship prevailing
between temporary working capital and the level of production and sales. There is no uniform production
and sales throughout the year. If heavy order is received for production and there is a large amount of
credit sales, there is a need of more amount of temporary working capital. At the same time, if
production is carried on in anticipation of demand in near future, temporary working capital is required.
• Aggressive approach
• An aggressive approach is most risky among working capital financing strategies. It doesn’t
assume to hold any reserves to cover spontaneous needs in working capital. It means that only
some portion of permanent working capital is financed by long-term financing. The rest and the
temporary working capital, including seasonal fluctuations, are met by short-term borrowing.
Adopting this approach makes it possible to reduce interest expense and increase profitability of
a business, but it also carries the greatest risk.
• Advantages and disadvantages
• The main drawback of an aggressive approach is that businesses need
to access short-term borrowing frequently to recover both the
portion of permanent working capital and temporary working capital.
As a result, the exposure to refinancing risk increases sharply, and
businesses become vulnerable to any interruption in accessing short-
term borrowing.
• The advantage of this working capital financing strategy is that short-
term financing is mostly cheaper compared with long-term financing,
which allows a reduction in interest expense. Such an approach,
however, violates the matching principle, which states that
noncurrent assets and permanent working capital should be financed
by long-term financing.
Moderate approach
A moderate approach, which is also called hedging strategy, follows the matching
principle. According to this approach, noncurrent assets should be financed by long-
term financing and current assets by short-term financing. Therefore, under a moderate
approach, businesses should use long-term financing to finance noncurrent assets and
permanent working capital. The need for temporary working capital should be met by
short-term financing.
• Advantages and disadvantages
• A moderate approach is a trade-off between an aggressive and a
conservative approach. It has lower reinvestment and interest rate
risk compared with an aggressive approach because short-term
financing is only used to fund temporary working capital. It also has
lower profitability, however, because of higher interest expense due
to a higher proportion of long-term financing used to fund permanent
working capital.
Conservative approach
A conservative approach has the lowest risk and lowest profitability among
other working capital financing strategies. Businesses use long-term
financing to fund not only noncurrent assets and permanent working capital
but also some portion of temporary working capital. This approach is also
inherent in low liquidity risk because of excessive cash.
 Advantages and Disadvantages of Conservative approach
• Under a conservative approach, even a portion of temporary working
capital is covered by long-term financing, and only an emerging need
for funds is met by short-term financing. It also happens that
businesses have an excessive cash balance, which should be invested
in marketable securities. Such investments are able to be sold at any
time to cover the emerging need for working capital.
• Questions for Practice:
Q1. From the following data , calculate the current working capital cycle
for XYZ ltd.
Particulars Amount(₹.)
Sales 6,000
Cost of Production 4,200
Purchases 1,200
Average raw material stock 160
Average work in progress 170
Average finished goods stock 360
Average Creditors 180
Average Debtors 700
• Q2. From the following data compute the operating cycle for each of
the two years:

Particulars Year 1”(₹.) Year 2(₹.)

Raw Materials 40,000 50,000
Work in progress 28,000 36,000
Finished Goods 42,000 48,000
Purchases 1,92,000 2,70,000
Cost of goods sold 2,80,000 3,60,000
Sales 3,20,000 4,00,000
Debtors 64,000 1,00,000
Crditors 32,000 36,000
From the following Profit and Loss Account and Balance Sheet presented by Suparna Ltd., you are requested to
compute the amount of working capital requirement under Operating Cycle Approach: 

D
Estimation and Calculation
of
Working Capital
• Methods for Estimating Working Capital Requirement
• There are broadly three methods of estimating or analysing the
requirement of working capital of a company viz. percentage of
revenue or sales, regression analysis, and operating cycle method.
Estimating working capital means calculating future working capital. It
should be as accurate as possible because the planning of working
capital would be based on these estimates and bank and other
financial institutes finance the working capital needs to be based on
such estimates only.
• Percentage of Sales Method
• Percentage of sales method is a working capital forecasting method
which is based on past relationship between sales and working
capital. Just like technical analysis in the stock market, it assumes that
the history will repeat itself and thus the ratio of working capital to
sales will remain constant. In other words, it assumes that the whole
business will move in tandem with sales.
• The following three steps are required for estimation of working
capital:
• 1. To estimate the total current assets as a % of estimated net sales.
• 2. To estimate current liabilities as a % of estimated net sales, and
• 3. The difference between the above two is net working capital as a %
of net sales.
• For example, net sales are ₹. 10,00,000, total current assets are ₹.
2,00,000 and current liabilities are ₹. 50,000.
• Now the total current assets as a % of estimated net sales = 20%.
current liabilities as a % of estimated net sales = 5%
The difference between the above two is net working capital as a % of
net sales = 15% of ₹. 10,00,000 i.e. ₹. 1,50,000
Thus, working Capital is ₹. 1,50,000
Working Capital based on Operating Cycle:
The Working Capital to Total Assets ratio measures a company’s ability
to cover its short term financial obligations (Total Current Liabilities) by
comparing its Total Current Assets to its Total Assets. This ratio can
provide some insight as to the liquidity of the company, since this ratio
can uncover the percentage of remaining liquid assets (with Total
Current Liabilities subtracted out) compared to the company’s Total
Assets.
Importance of Working Capital to Total Assets
• An increasing Working Capital to Total Assets ratio is usually a positive
sign, showing the company’s liquidity is improving over time. A low or
decreasing ratio indicates the company may have too many Total
Current Liabilities, reducing the amount of Working Capital available.
• Working Capital based on operating cycle( v.impt)
• Operating cycle has already been discussed in detail in previous slides.
The different components of working capital may be enumerated as
follows:

CURRENT ASSETS CURRENT LIABILITIES

Cash and bank balance Creditors for Purchases
Inventory of Raw materials Creditors for Expenses
Inventory of Work in progress
Inventory of Finished Goods
Receivables
• Estimation of Working Capital requirement can be as follows:
• Need for cash and bank balance: every firm must maintain some
minimum cash and bank balance to meet day to day requirement foe
petty expenses, general expenses, and even for cash purchases. The
minimum cash balance is estimated on the basis of past experience.
• Need for Raw Materials: every manufacturing firm has to maintain
some stock of raw material in stores in order to meet the
requirements of the production process. For example, it take s 5 days
to procure fresh stock and daily requirement is 50 units, then
minimum stock balance should 250 units.
• Need for Work in progress: the production process is continuous and
generally consists of various stages, it intakes full raw material, units
of labor expenses and overheads are 50% complete.
• Need for Finished Goods: the term receivables include the debtors
and bills. When the goods are sold by a firm on cash basis, the sale
revenue is realized immediately. However, in case of credit sales,
there is time lag between sales and collection of sales revenue. For
example, a firm makes a credit sales of ₹. 1,50,000 per month and
credit period allowed is 15 days, then working capital locked up is ₹
75,000 i.e. (₹. 1,50,000 * ½ month)
• Creditors for purchases: likewise a firm sells goods and services on
credit it may procure raw material and finished goods on credit basis.
The payment for these purchases may be postponed for the period of
credit allowed by suppliers. For example, a firm makes a credit
purchases of ₹. 60,000 per month and credit period given by the
suppliers is 2 months, the working capital supplied by the creditors is
₹. 1,20,000 (i.e. 2 months* ₹.60,000)
• Creditors for expenses and wages: usually, the expenses and wages
are paid are paid at the end of a month.
Estimation of Working capital Requirement
I. Current Assets Amount
Minimum Cash Balance XXX
Inventories: XXX
Raw Materials XXX
Work-in-progress XXX
Finished Goods XXX
Receivables: XXX
Debtors XXX
Bills XXX
Gross Working Capital (CA) XXX
 II. Current Liabilities Amount (₹.)
Creditors for Purchases XXX
Creditors for Wages XXX
Creditors for Overheads XXX
Total Current Liabilities(CL) XXX
Excess of CA over CL XXX
+ Safety Margin XXX
Net Working Capital XXX

• Kindly note the following points:

• 1. Depreciation: is a non- cash expense and there is funds locked up in the depreciation as such,
therefore, it is ignored.
• 2. Safety Margin: sometimes, a firm may also like to have a safety margin of working capital in
order to meet the contingencies, it is expressed as a percentage of total current assets or total
current liabilities or net working capital.
• From the following details, prepare an estimate of the requirement of
working Capital
• Production during the year 60,000 units
• Selling Price ₹. 5 per unit
• Raw material 60%
• Wages 10%
• Overheads 20%
• Raw material storage period 2 months, Work in progress storage
period 1 months, Finished goods storage period 3 months, credit
allowed by suppliers 2 months, credit allowed to customers 3 months,
minimum cash declared ₹.20,000, wages and overheads payment 1
month.
• Solution:
• Production per month (60,000 units/ 12 months) =5,000 units
• Selling price = ₹. 5 per unit
• Raw material = 60% of ₹. 5 = ₹.3 p.u
• Wages = 10% of ₹.5 = ₹. 0.5 p.u
• Overheads = 20% of ₹. % = ₹. 1 p.u
Current Assets Amount(₹.) Amount(₹.)
Cash Balance 20,000
Raw Material (5,000X ₹. 3X 2 months) 30,000
Work in process
Raw Material (5,000X ₹. 3X 1 month) 15,000
Wages (5,000X ₹. 0.5X 1 month)50% 1,250
Overheads (5,000X ₹. 1X 1 month) 50% 2,500
Finished Goods (5,000X ₹. 4.5X 3months) 67,500
Debtors (5,000X ₹. 4.5X 3months) 67,500
Gross Working Capital 2,03,750
Current Liabilities Amount(₹.) Amount(₹.)
Creditors (5,000X ₹. 3X 2months) 30,000
Wages (5,000X ₹. 0.5X 1month) 2,500
Overheads (5,000X ₹. 1X 1 month) 5,000
Total Current Liabilities 37,500
Net Working Capital (CA – CL) 1,66,250.
Thank You