Working Capital Management

Content
• What is Working Capital Management?
• Importance of Working Capital Management
• Concept & Types
• Operating Cycle and its Relevance for
Working Capital Management
• Estimation of Working Capital Requirements
• Overview of Working Capital Financing
 What is Working Capital Management
• It is concerned with the management of current
assets, current liabilities & interaction between
them.

• The objective of Working capital mgmt. is to

maintain a satisfactory level of Working capital to
ensure sufficient liquidity in the operations of an
enterprise

• The extent of liquidity depends on:

 The time required to convert the asset into money
 The degree of certainty associated with the price
realised for the asset
 Practical Importance
• Higher profitability & return on capital
• Improved credit profile and solvency
• Higher liquidity
• Increased business value
• Favourable financing conditions
• Uninterrupted production
 Measuring liquidity
Three basic measures:
1.Current ratio
2.Acid test ratio
3.Net working capital

Current & acid test ratio used in inter-firm

comparison whereas NWC is useful for
internal control.
 Concept Of Working Capital :
Gross v/s Net Working Capital
• Gross W.C. :The amount of funds invested in
various components of current assets. It
consists of raw materials, work in progress,
finished goods, debtors

• Net W.C.: The excess of current assets over

current liabilities is known as Net working
capital. The principal objective here is to learn
the composition and magnitude of current
assets required to meet current liabilities.
 Concept of working capital:
Permanent v/s Temporary Working capital

• Permanent (fixed) working capital:

 The minimum amount of working capital which even
required during the dullest season of the year
 Permanent W.C. is locked in the business as long as it
continues to exist.
• Temporary or Variable Working Capital: It represents
the additional current assets (in addition to permanent
working capital)required at different times during the
operating year to meet additional inventory, extra cash,
etc.
 Factors affecting composition of
Working Capital
• Nature of business
• Production policy
• Credit policy
• Inventory policy
• Market conditions
• Conditions of supply
• Business cycle
• Operating efficiency
• Availability of raw material
 Working Capital-Planning
• As there is a time-lag involved between conversion of cash
back into cash,it is necessary to maintain sufficient level of
working capital to sustain sales activity.
• This continuing flow from cash to suppliers to inventory to
accounts receivable & back to cash is called the operating
cycle
• Operating cycle duration is the time between acquisition
of raw materials & final cash realisation from debtors.
• Thus it consists of three phases….
 Calculating Operating Cycle Period

• This approach is very useful in controlling & forecasting working capital.

• The duration of operating cycle = (R + W+ F + D – C)

Where: R = Avg. stock of R.M./stores Raw material storage period

Avg. R.M. consumption per day

W = Avg. W.I.P. inventory Conversion Period

Avg. COP per day

F= Avg. F.G. inventory Finished goods storage

Avg. cost of goods sold per day period

D= Avg. Debtors Average collection period

Avg. credit sales per day

C= Avg. creditors Average payment period

Avg. credit purchases per day
 Calculate Operating (Cash
Conversion Cycle)…Caselet 1
1. From the following information, extracted from the books of a trading
company, compute the operating cycle in days:
Period covered: 365 days Average period of credit allowed by suppliers,
16 days
Other data are as follows:
(Rs ’000)
Average debtors (outstanding) 480
COGS 10,000
Sales for the year (100 % credit) 16,000
Value of average stock maintained: 260
 Caselet 1 Solution
• Operating cycle period = Days in
inventory,Receivables less payables:
Component Calculation Days
Inventory holding 260/(10,000/365) 9.49
period(Average)
Debtors collection 480/(16,000/365) 10.95
period
Gross O.C. 20.44
Less : Payable 16.00
period
Net operating cycle 4.44
 Caselet 2

The following information is available for NCEP Limited engaged in trading of

goods. Calculate the Operating Cycle Period .

Data from P&L Statement: Rs.Lakhs

Sales 6000
COGS 4000

Data from Balance Sheet:

Opening Balance Closing Balance

Inventory 800 820
Accounts Receivable 500 490
Accounts Payable 290 205
 Caselet 2 Solution
Component Calculation Days
Inventory holding period 810/(4000/365) 73.91
Debtors collection period 495/(6000/365) 30.11
Gross O.C.
Less : Payable period 247.5/(4000/365) 22.58
Net operating cycle 81.44
 Working Capital-Planning
Forecasting working capital requirements
1. Sound & realistic forecast of the sales is the first step.
2. Forecast of debtors,production,raw materials,labour &
other operating expenses follow sales forecast
3. The operating cycle is then determined to decide upon the
Net working capital requirement by:
(i) Adding the amounts required to be invested in the current
assets-inventory,receivables & cash - depending on the
holding period &
(ii) Deducting current liabilities – creditors, outstanding
expenses- depending on time lag in payment.
 Caselet 1 : Calculate working capital
requirement for a dealer….
• Projected annual sales Rs. 6,50,000
• Percentage of gross profit on sales 20 % .
• Annual General & selling expenses : Rs.78,000.
• Average credit period allowed to debtors 10 Weeks Average
• Credit period allowed by creditors 4 Weeks
• Average stock holding in terms of sales requirements 8
Weeks
• Allow 20% for contingencies
 Projected Income statement
Rs.
Sales 6,50,000
COGS (80 %) 5,20,000
General & Selling 78,000
expenses
Total operating Cost 5,98,000
Operating profit 52,000
Estimation of Working Capital Requirement
• Current Assets : Rs.

• (i)Stock (8 weeks) (5,20,000/52 ×8) = 80,000

• (ii)Debtors (10 weeks) (5,98,000/52 × 10) = 1,15,000
• Total investment in current Assets = 1,95,000
Less: Current Liability:
• Creditors (4 weeks) (5,20,000/52 × 4) = (40,000)
• Net Working Capital 1,55,000
Add: 20% for Contingencies 31,000
Working Capital Required 1,86,000
 Estimate Working capital requirement

Cost Structure Operating cycle period Months

Expected annual demand
( units) 2400 R.M. storage period 1 month
Selling price per unit 200 F.G. storage period 1 month
R.M. per unit 100 Credit to custmers 2 months
Direct labour per unit 20 Credit from supplier 1.5 months
Other factory & administration
cost(Total: Excluding
depreciation)) Rs.24,000 S& D expenses Quarterly in advance
Selling & distribution cost
(Total) Rs.12,000 Direct labour One month arrears
Minimum cash requirement Rs.20,000
Contingency margin 10%
 Annual cost ….
Total cost :(Annual) Rs.
RM 240000
Wages 48000
Factory /adm overheads 24000
Production cost 312000
Selling & Distribution cost 12000
Total cost of sales 324000
 Calculating Working Capital..
1 Inventory: Rs.
R.M. 240000/12*1 20000
F.G. 312000/12*1 26000

Receivables
2 324000/12*2 54000
3 Advance S& D expenses 12000/12*3 3000
4 Cash Requirement 20,000
Estimated Current Assets 123000
Less: Current Liabilities:
Payables for RM 240000/12*1.5 30000
Outstanding wages 48000/12*1 4000
Estimated Current Liabilities 34000
Net Working Capital 89000
Add 10 % contingency 8900
Working capital requirement 97900
 Financing of W.C.
Liquidity v/s Profitability
• The level of NWC has a bearing on the profitability &
risk.
 Profitability is measured by profits after deducting
expenses
 Risk is the probability that a firm will not be able to
make payments as they become due(technically
insolvent)
 Greater the amount of NWC the more liquid (less risky)
the firm is.
 The goal of WC management is trade-off between
profitability & risk(Liquidity)
 Working Capital Financing
Strategies

1.Suppose we use long-term financing to

finance some of our current assets.
This strategy would be less risky, but more
expensive!

2.Suppose we use current liabilities to finance some

of our fixed assets.
This strategy would be less expensive, but more
risky!
 Determining the financing mix
• The basic question is what proportion of
current assets should be financed by current
liabilities and how much by long term
resources?
• 3 basic approaches:
 Hedging
 Conservative
 Trade-off
 Hedging approach
Hedging approach suggests :
– Long term funds should be used to finance the
fixed(permanent) part of current asset requirements
&
– Seasonal(temporary) requirements over & above
the permanent financing needs should be financed
with short term funds i.e.current liabilities
– Thus short-term financing requirements (current
assets)= short-term financing available(current
liabilities)
 Conservative approach

• Conservative approach suggests:

 Estimated requirements of total funds
should be financed from long-term
sources
 Short term funds should be used only in
emergency situations involving
unexpected outflow of funds.
 Hedging v/s Conservative
• Conservative approach is more expensive as
the available funds may not be fully utilised
in certain periods but interest has to be paid
on it.
• Hedging is more risky as there is no NWC
& no provision for emergency short-term
needs.
 Trade-off approach
• It attempts to strike a balance between hedging &
conservative approach.
• Actual trade-off differs from case to case depending
on risk-taking ability of the decision maker.
• E.g. :
 Average of minimum & maximum monthly
requirements will be financed through long term
funds,
 Any additional requirement to be financed using
short-term funds.
 Sources of Working Capital Financing
Long Term Sources Short Term Sources
• Equity share capital  Accruals
• Retained earnings  Trade credit
 Bank finance
• Debentures  Public deposits
• Term loans  Inter-corporate deposits
• Public deposits  Short-term loans from
financial institutions
 Commercial paper
 Factoring
Any questions?

Thank you!