Chapter 13 –

Working Capital
Management: An Overview

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 Learning Objectives
• Understand the nature of working capital in terms of basic concepts, strategies,
policies and financing strategies
• Analyse the planning of working capital requirements in terms of need,
determinants and its computation
• Outline the main elements of management of working capital in India

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 Introduction
• In practice, apart from the management of the fixed assets a firm has also to
employ short-term assets and short-run resources of financing.
• The management of such assets, described as working capital management or
current assets management, (short-term financial management) is one of the
most important aspects of the overall financial management.

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 Nature of Working Capital
• The goal of working capital management is to manage the firm’s current assets
and liabilities in such a way that a satisfactory level of working capital is
maintained.
• The interaction between current assets and current liabilities is, therefore, the
main theme of the theory of working management.

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 Concepts and Definitions of Working
Capital
• There are two concepts of working capital: gross and net.
• Gross working capital means the current assets which represent the proportion
of investment that circulates from one form to another in the ordinary conduct of
business.
• Net working capital is the difference between current assets and current
liabilities or alternatively the portion of current assets financed with long-term
funds.

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 The Common Definition of NWC and its
Implications
• NWC is commonly defined as the difference between current assets and current
liabilities.
• The goal of working capital management is to manage the current assets and
liabilities in such a way that an acceptable level of NWC is maintained.
Alternative Definition of NWC
• NWC can alternatively be defined as that part of the current assets which are
financed with long-term funds.

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 Concept of Zero Working Capital

• The zero working capital (ZWC) concept of net working capital differs from the
commonly used concept of working capital (CA – CL).
• Zero working Capital is inventory plus receivables minus payables.
ZWC = Inventories (+) Receivables (-) Payables.

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 Policies Related to Current Assets
Investment
• There are three alternative policies related to the total amount of investments
made in current assets:
 Relaxed,
 Aggressive and
 Moderate.
• These policies differ in respect of the total amount of current assets carried to
support any given level of sales.

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 Relaxed Current Assets Investment Policy

• Relaxed policy involves large amounts of cash/cash-equivalents, receivables and

inventory.
• They use liberal credit policy implying relatively longer time-span of credit period
extended to debtors, as a means of promoting sales.

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 Aggressive Current Assets Investment
Policy
• Aggressive policy implies minimum cash/cash equivalents, receivables and
inventory.
• The firm would hold minimum level of safety stocks of cash and inventories, and
would pursue a tight/strict credit policy for credit sales (though at times, it runs
the risk of losing sales).

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 Moderate Current Assets Investment
Policy
• This falls between the above two extreme policies in terms of current assets
carried as well as expected return and risk.

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 Determining Financing Mix
• What proportion of current assets should be financed by current liabilities and how
much by long-term resources?
• Decisions on such questions will determine the financing mix.
• Financing mix is the choice of sources of financing of current assets.
• There are three basic approaches to determine an appropriate financing mix:
 Hedging approach, also called the Matching approach;
 Conservative approach, and
 Trade-off between these two.

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 Hedging Approach
• This approach to the financing decision to determine an appropriate financing
mix is, also called as Matching approach.
• Matching approach to financing is the process of matching maturities of debt
with the maturities of the financial needs.
• According to the hedging approach, the permanent portion of funds required
should be financed with long-term funds and the seasonal portion with short-
term funds.
• Permanent needs implies financing needs for fixed assets plus the permanent
portion of current assets which remain unchanged over the year.
• Seasonal portion implies the financing requirements for temporary current
assets which vary over the year.

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 Conservative Approach
• This approach suggests that the estimated requirement of total funds should be
met from long-term sources.
• The use of short-term funds should be restricted to only emergency situations or
when there is an unexpected outflow of funds.

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 Comparison of Hedging Approach with
Conservative Approach
• A comparison of the two approaches can be made on the basis of
 cost considerations, and
 risk considerations.
Cost Considerations
• The conservative plan for financing is more expensive because the available funds are
not fully utilised during certain periods; moreover, interest has to be paid for funds
which are not actually needed (i.e. the period when there is NWC).

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 Risk Considerations
• The two approaches can also be contrasted on the basis of the risk involved.
• The hedging approach is a high profit (low cost)- high risk (no NWC) approach to
determine an appropriate financing-mix.
• In contrast, the conservative approach is low profit (high cost)-low risk (high NWC).
• A Trade-off between the Hedging and Conservative Approaches
• A trade-off between these two extremes would give an acceptable
financing strategy.
• Acceptable financing strategy is a trade-off between matching and
conservative financing strategies.
• The third approach–trade-off between the two approaches–strikes a
balance and provides a financing plan that lies between these two
extremes.
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 Comparison of the Trade-off Plan with the
Hedging and Conservative Approaches
• The hedging approach is the most risky while the conservative approach is the least
risky.
• The trade-off plan stands midway; less risky than the hedging approach but more risky
than the conservative approach.
• From the point of view of profitability a similar kind of relationship is found to exist,
the trade-off plan lying between the other two approaches.

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 Planning of Working Capital

• The planning of working capital consists of the need for working capital, the
determinants of working capital and its computation.

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 Need for Working Capital
• A successful sales programme is necessary for earning profits by any business
enterprise.
• However, sales do not convert into cash instantly.
• There is invariably a time-lag between the sale of goods and the receipt of cash.
• Therefore, there is, a need for working capital in the form of current assets to
deal with the problem arising out of the lack of immediate realisation of cash
against goods sold.

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 Operating cycle
• A sufficient working capital is necessary to sustain sales activity.
• Technically, this is referred to as the operating or cash cycle.
• Operating cycle implies the continuing flow from cash to suppliers, to inventory
to accounts receivable and back into cash.
• The operating cycle can be said to be at the heart of the need for working capital.
• ‘The continuing flow from cash to suppliers, to inventory, to accounts receivable
and back into cash is what is called the operating cycle’.
• In other words, the term cash cycle refers to the length of time necessary to
complete the following cycle of events:
 Conversion of cash into inventory;
 Conversion of inventory into receivables;
 Conversion of receivables into cash.
• The operating cycle, which is a continuous process, is shown in Fig. 13.1.
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Operating Cycle

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 Permanent and Temporary Working
Capital
• Working capital can be
 permanent and
 temporary.
• Permanent (fixed) working capital is a certain minimum level of working capital on a
continuous and uninterrupted basis.
• Temporary (fluctuating/variable) working capital is the working capital needed to
meet seasonal as well as unforeseen requirements.

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Permanent and Temporary Working Capital

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Permanent and Temporary Working Capital

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Changes in Working Capital
• The changes in the level of working capital occur for the following three basic
reasons:
 changes in the level of sales and/or operating expenses,
 policy changes, and
 changes in technology.

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 Determinants of Working Capital
•The total working capital requirement is determined by a wide variety of factors.
•These factors, however, affect different enterprises differently.
•They also vary from time to time.
•The following factors are involved in a proper assessment of the quantum of
working capital required:
 General Nature of Business
 Production Cycle
 Business Cycle
 Production Policy
 Credit Policy
 Growth and Expansion
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 Vagaries in the Availability of Raw Material
 Profit Level
 Level of Taxes
 Dividend Policy
 Depreciation Policy
 Price Level Changes
 Operating Efficiency

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 General Nature of Business
• Manufacturing and trading enterprises require fairly large amounts of working
capital to maintain a sufficient amount of cash, inventories and book debts to
support their production (purchases) and sales activity.
• Service enterprises (like public utilities) and hotels, restaurants and eating houses
need
to carry less WC.

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 Production Cycle
• The longer is the production cycle, the larger is the WC needed or vice-versa.

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 Business Cycle

• While during boom conditions, reflecting upswing in business activity, the need
for WC is likely to
grow to cater to the increased level of activity.
• The need for working capital in the downswing phase/ recessionary conditions
tend to be low due to fall in the volume of sales and production.

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 Production Policy
• The quantum of working capital is also determined by production policy.
• The production policies have to be formulated on the basis of the individual
setting of each enterprise and the magnitude and dimension of the working
capital problems will accordingly vary.

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 Credit Policy
• While the liberal credit policy offered to customers would necessitate more
working capital, tight credit terms would reduce its requirement.
• The liberal credit terms available from creditors/suppliers of materials would be
an offsetting factor.

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 Growth and Expansion

• Growth industries and firms require more working capital.

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 Vagaries in the Availability of Raw
Material
• To meet vagaries in the unavailability, a firm should have excess inventory of raw
materials to sustain smooth production.
• Such a firm would tend to have high level of WC.

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 Profit Level
• Cash profit, per-se, should not be viewed as a source of financing WC.
• The actual availability of such funds would depend upon the firm’s requirement for
payment of dividend, payment of loan instalment, creation of sinking fund, purchase
of fixed assets, and so on.
• In case these requirements are substantial, cash profit is not likely to be available to
meet the needs of a firm.
• Alternatively, only adjusted cash profits after provisioning for these requirements
should be reckoned for WC financing.

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 Level of Taxes

• If tax liability increases, it leads to an increase in the requirement of working

capital and vice versa.

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 Dividend Policy
• The payment of dividend consumes cash resources and, therefore, decreases WC
of a firm.
• Conversely, the non-payment of dividend increases WC.

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 Depreciation Policy
• Higher depreciation (enhanced rates of depreciations) has a positive impact on
WC for two reasons:
 lower tax liability and, hence, more cash profits and
 lower disposable profits and, therefore, a smaller dividend payment.
• They imply more cash with a corporate.

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 Price Level Changes

• Rising prices in input costs (without corresponding increase or less than a

proportionate increase in selling prices of products) necessitates more WC to
sustain an existing level of activity.

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 Operating Efficiency

• Efficiency of operations accelerates the pace of cash cycle and improves the WC
turnover resulting in reduced requirement of WC.

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 Computation of Working Capital
• A firm should have neither more nor less WC than required.
• While the excessive WC adversely affects its profits, the inadequate WC interrupts its
smooth operations.
• Therefore, its correct computation is an important constituent of efficient WC
management.
• There are two components of WC, namely, CA and CL.
• Each component is to be separately estimated to determine the correct amount of
WC.

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Determination of Working Capital

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