Working

Capital
Management
MODULE 3
FINANCIAL MANAGEMENT
Concept of Working Capital
Types of working capital investment
policies
Factors affecting working capital
Learning
Objectives
Concept of Operating cycle

Working capital sources

Working Capital
Involves the administration, control, procurement and financing of current
assets
Current assets include cash, marketable securities, short-term investments,
accounts receivables, inventory and other current assets
Financing of current assets includes management of current liabilities and bank
borrowings. Thus, working capital management deals with funds involved in the
day-to-day operations of the firm
Working Capital Management
Concepts
(1) What is the appropriate amount and mix of short-term assets for the firm to
hold?
(2) How should these short-term assets be financed? Firms must carry a certain
amount of short-term assets to be able to operate smoothly.
Working Capital Accounts and Trade-Offs
Generally Current Assets are the least profitable assets of the Company
Investment in lower capital involves lower return
The lower the return the lower the risk
Lower Default Risk
Investment in working capital more has given the company a greater liquidity
Profitability is inversely related to liquidity
Working Capital Terms and
Concepts
1.Current assets are cash and other assets that the firm expects to convert into cash in a year or less. These assets are
usually listed on the balance sheet in order of their liquidity. Typical current assets include cash, short-term investments
(sometimes also called marketable securities or cash equivalents because of their liquidity), accounts receivable,
inventory, and others, such as prepaid expenses.

2.Current liabilities (or short-term liabilities) are obligations that the firm expects to repay in a year or less. They may be
interest bearing, such as short-term notes and current maturities of long-term debt, or noninterest bearing on such as
accounts payable, deferred revenue, or accrued expenses.

3.Working capital (also called gross working capital) includes the funds invested in a company's cash and short-term
investment accounts, accounts receivable, inventory, and other current assets. All firms require a certain amount of current
assets to operate smoothly and to carry out day-to-day operations. Note that working capital is defined in terms of current
assets, so the two terms are one and the same .
Working Capital Terms and
Concepts
4.Net working capital (NWC) refers to the difference between current assets and current liabilities. NWC is important because it is a
measure of a firm's liquidity. It is a measure of liquidity because it is the amount of working capital a firm would have left over after it
paid off all of its short-term liabilities. The larger the firm's net working capital, the greater its liquidity. Most firms have more current
assets than current liabilities and therefore their net working capital is positive.

5.Working capital management involves management of current assets and their financing. The financial manager's responsibilities include
determining the optimum balance for each of the current asset accounts and deciding what mix of short-term debt, long-term debt, and
equity to use in financing working capital. Working capital management decisions are usually fast paced as they reflect the pace of the
firm's day-to-day operations.

6.Working capital efficiency is a term that refers to how efficiently working capital is used. It is most commonly measured by a firm's cash
conversion cycle, which reflects the time between the point at which raw materials are paid for and the point at which finished goods made
from those materials are converted into cash. The shorter a firm's cash conversion cycle, the more efficient is its use of working capital.

7.Liquidity is the ability of a company to convert assets—real or financial—into cash quickly without suffering a financial loss.
Working Capital Investment Policy
Conservative Investment Policy
- A policy under which relatively large amount of cash, marketable securities,
and inventories are carried

Aggressive Investment Policy

- A policy under which holdings of cash, securities, inventories and receivables
are minimized.
 Conservativ
e Aggressive
Description Relaxed Restricted
Working
Profitability Capital
Low Investment
High Policy
Default Risk Low High
Liquidity High Low
Investments High CA Low CA
Financing Low ST Debt High ST Debt
Operating and Cash Conversion
Cycle
Operating and Cash Conversion Cycle
The operating cycle starts with the receipt of raw materials and ends with the
collection of cash from customers for the sale of finished goods made from those
materials. The operating cycle can be described in terms of two components:
days' sales in inventory and days' sales outstanding.
Day’s sales Inventory (DSI) + Day’s sales Outstanding (DSO)
 Operating and Cash Conversion
Cycle
Days' sales in inventory (DSI) shows, on average, how long a firm holds
inventory before selling it, that it is calculated by dividing 365 days by the firm's
inventory turnover and that inventory turnover equals cost of goods sold (COGS)
divided by inventory.
 Operating and Cash Conversion
Cycle
Days' sales outstanding (DSO) indicates how long it takes, on average, for the firm to collect its
outstanding accounts receivable. DSO is calculated by dividing 365 days by accounts receivable turnover and that
accounts receivable turnover equals net sales divided by accounts receivable. Sometimes this ratio is called the average
collection period. An efficient firm with good working capital management should have a low average collection period
compared with that of its industry.
Operating and Cash Conversion Cycle
Cash Conversion Cycle is the length of time from the point at which a company
actually pays for raw materials until the point at which it receives cash from the
sale of finished goods made from those materials. This is an important concept
because the length of the cash conversion cycle is directly related to the amount
of money that a firm needs to finance its working capital.

Cash Conversion Cycle = DSI + DSO – Days Payable Outstanding (DPO) or

Operating Cycle - DPO
Illustration
ABC Company sells 3000 product A a day at a cost of P250 per product for prime
cost. It takes the company 20 days to convert raw materials of product A. ABC
Company allows its customers 25 days in which to pay for the product and it pays
suppliers on a 15-day basis
Requirement:
1. How long is ABC Company’s operating cycle and cash conversion cycle
respectively?
2. Assuming that the production of Product A is steady, what amount of working
capital must ABC Company finance?
Solution
Operating cycle : 20 days + 25 days = 45 days
Cash Conversion cycle: 45 days – 15 days = 30 days
Investment in Working Capital = 3,000 x P250 x 30 days = 22,500,000