CHAPTER THREE

WORKING CAPITAL
MANAGEMENT
 INTRODUCTION
• Working capital management is also one of the
important parts of the financial management.
• Short-term, or current assets and liabilities are
collectively known as working capital.
• It is also known as short-term finance, current capital or
circulating capital.
• The most important difference between short-term and
long-term finance is in the timing of cash flows.
 Cont…
• Working capital, sometimes called gross working
capital, simply refers to current assets used in
operations.
• Net working capital is defined as current assets
minus current liabilities(CA-CL).
– This is one measure of the extent to which the firm is
protected from liquidity problems.
• Net operating working capital is defined as current
assets minus none interest-bearing current liabilities.
• Some examples of non-interest bearing current liabilities
include accounts payable, accrued expenses, and taxes
payable
 SIGNIFICANCE OF WORKING CAPITAL

• The current assets of a manufacturing firm account for

over half of its total assets.
• For a distribution company, they account for even
more.
• For small companies, current liabilities are the principal
source of external financing.
• Working capital decisions have effect on the
company’s risk, return, and share price.
 NEEDS OF WORKING CAPITAL

• W/Capital is needed for the following purposes;-

 Purchase of raw materials and spares.
 Payment of wages and salary.
 Day-to-day expenses.
 Provide credit obligations.
 Importance of Working Capital Management

• It helps to manage firm's current assets in best and

possible manner.
• It helps to maintain optimal levels of current assets
and liabilities.
• It increases efficiency of firms.
• It helps to maintain the liquidity of a firm.
 TYPES OF WORKING CAPITAL
Permanent Working Capital
• It is also known as Fixed Working Capital because it will not changed
irrespective of time or volume of sales.
• It is the capital the business must maintain certain amount of capital at
minimum level and all the times.
• It is continuously required by a firm to carry on its business operations.
Temporary Working Capital
• It is also known as variable working capital.
• It can be changed with increasing and decreasing of production and sales.
• It is an amount of working capital above permanent working capital.
• It can be further classified into Seasonal and Special Working Capital.
 Cont…

• Seasonal Working Capital is the capital required to meet the

seasonal needs of the business concern.
• Examples of seasonal working capital include businesses that experience a
surge in demand during certain times of the year, such as retailers during
the holiday season or agricultural businesses during harvest time.

• Special working capital is the capital required to meet

emergency and special events.
• Examples of special working capital might include unexpected
expenses such as equipment repairs, legal fees
 DETERMINANTS OF WORKING CAPITAL REQUIREMENTS

• Working Capital requirements depends upon various factors.

• The following are the major factors that determining the Working Capital requirements.
1) Nature and size of the business:-
 Manufacturing business: it takes a lot of time in converting raw material into finished
goods.
 More working capital is required
 Trading business: goods are sold immediately after purchasing
 very little working capital is required.
 Service business: Working capital is very low.
2) Production cycle: It 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.
 Cont…

3) Operating Efficiency: means efficiently completing the various business operations.

 A company which has a better operating efficiency has to invest less in stock and
the debtors.
4) Growth Prospects: The organizations which have sufficient possibilities of growth
require more working capital
5) Business cycle
 During the boom period, the demand for a product increases and sales also
increase.
 Therefore, more working capital is needed.
 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.
 STRATEGIES/POLICIES OF WORKING CAPITAL MANAGEMENT

• Working capital policy refers to the firm’s policies

regarding
(1) target levels for each category of current assets and

(2) how current assets will be financed.

• Working capital management involves both setting

working capital policy and carrying out that policy in
day-to-day operations.
 Cont…

• Because working capital management is so important, a company will need to formulate

clear strategy.
• Selecting the best working capital strategies depends on many factors including the type
of business, working capital cycle, management ability, and external economic factors.
• There are three working capital strategies;-
1. conservative working capital strategy.
2. moderate working capital strategy.
3. aggressive working capital strategy.
 A. Conservative working capital strategy

• The strategy suggests carrying of high levels of current assets in

relation to sales.
• It is associated with maintaining a larger cash balance, offering more
generous credit terms to customers and holding higher levels of
inventory.
• Surplus current assets enable the firm to absorb sudden variations
in sales and production without disrupting production plans.
• This strategy will go for more long-term finance which reduces the
risk of uncertainty associated with frequent refinancing.
• The strategy is characterized by higher liquidity, lower risk and lower
return.
 B. Aggressive working capital strategy

• Under this approach current assets are maintained just to meet the
current liabilities and operating expenses without keeping any cushion
for the variations in working capital needs.
• It is associated with maintaining lower levels of inventory, receivables
and cash for a given level of activity or sales.
• The permanent working capital in this strategy is financed by long-term
sources of capital, and seasonal variations are met through short-term
borrowings
• The strategy is characterized by lower liquidity, higher risk and higher
return.
 C. Moderate Working Capital Strategy

• Moderate working capital strategy will fall in the middle of the conservative
and aggressive strategies.
• In this model, firms maintain a moderate amount of net working capital.
• In this strategy, more liquid current assets that shown on the balance sheet
for a short time would be financed with short term financing.
• Permanent current assets and long term fixed assets that are going to be on
the balance sheet for a long time should be financed from long term debt
and equity sources.
• This strategy characterized by relatively moderate amount of risk, moderate
mount of liquidity and moderate amount of expected return.
 THE OPERATING CYCLE AND THE CASH CONVERSION
CYCLE
 The primary concern in short-term finance is the firm’s short-run
operating and financing activities.
 For a typical manufacturing firm, these activities might consist of
the following sequence of events & decisions:
Event Decision
1. Buying raw materials 1. How much inventory to order
2. Paying cash 2. Whether to borrow or draw down cash balances
3. Manufacturing the product 3. What choice of production technology to use
4. Selling the product 4. Whether credit should be extended to a particular customer
5. Collecting cash 5. How to collect

 These activities create patterns of cash inflows and cash outflows.

 Cont…
 Operating cycle is the time duration required to acquire inventory, process it,
sell it, and collect for it.
• The operating cycle of a manufacturing company involves three phases.
– Acquisition of resources such as raw materials, labor, power, fuel, etc.
– Manufacturing of the product.
– Selling of the product either for cash or on credit.
• Credit sale create account receivable for collection.
 This cycle has two distinct components.
The inventory period: the time it takes to acquire and sell the inventory.
The accounts receivable period: the time it takes to collect on the sale.
 Cont…

 Cash conversion cycle (CCC) is The length of time between the firm’s
payment for its raw materials and the collection of payment from the
customers.
 The cash cycle is the difference between the operating cycle and the
accounts payable period:
• The firm starts the cycle by purchasing raw materials, but it does not pay for them
immediately. This delay is the accounts payable period.
• The delay between the initial investment in inventories and the sale date is the
inventory period.
• The delay between the date of sale and the date at which the firm is paid is the
accounts receivable period.
 Cont…
• To summarize, OC = Inventory period + receivable period
• CCC = (inventory period + receivables period) – accounts payable period
• Inventory period
Inventory turnover ratio = Cost good sold/Average inventory
Inventory period = number of days in reporting period/ inventory
turnover ratio
• Account receivables period
– A/R turnover ratio = Credit sales/average A/R
– A/R period = number of days in reporting period/ A/R turnover ratio
• Account payable period
– A/P turnover ratio = Cost of good sold/average A/P
– A/P period = number of days in reporting period/ A/P turnover ratio
 Exercise
The following are some balance sheet and income statement information and
you are required to analyze the company’s operating cycle and cash
conversion cycle:

Item Beginning Ending Average

Inventory $2,000 $3,000 $2,500
Accounts receivable 1,600 2,000 1,800
Accounts payable 750 1,000 875

Also, from the most recent income statement, we might have the following figures (in thousands):
Net credit sales ……$11,500
Cost of goods sold…. 8,200
• To summarize, OC = Inventory period + receivable period =111.28+57=139 dys
• CCC = (inventory period + receivables period) – accounts payable perid=139-38=100dys
• Inventory period
Inventory turnover ratio = Cost good sold/Average inventory=8200/2500=3.28
Inventory period = number of days in reporting period/ inventory turnover ratio=365/3.28=111.28 d
• Account receivables period
– A/R turnover ratio = Credit sales/average A/R=11500/1800=6.388
– A/R period = number of days in reporting period/ A/R turnover ratio =365/6.388=57d
• Account payable period
– A/P turnover ratio = Cost of good sold/average A/p=8200/875=3.37
– A/P period = number of days in reporting period/ A/P turnover ratio= 365/9.37=38.95
 End of
chapter Three !!!