Working Capital Management

• Working capital management is concerned

with the problems that arise in attempting to
manage the current assets, the current
liabilities and the interrelationship that exists
between them.
• Gross working capital refers to the firm’s
investment in current assets.
• Current assets are the assets which can be
converted into cash within an accounting year
and include cash, short-term securities,
debtors (accounts receivable or book debts),
bills receivable and stock (inventory).
• The consideration of the level of investment in
current assets should avoid two danger points
—excessive and inadequate investment in
current assets.
• Investment in current assets should be just
adequate to the needs of the business firm.
• Excessive investment in current assets should
be avoided because it impairs the firm’s
profitability, as idle investment earns nothing.
• On the other hand, inadequate amount of
working capital can threaten the solvency of
the firm because of its inability to meet its
current obligations.
• It should be realized that the working capital
needs of the firm may be fluctuating with
changing business activity.
• This may frequently cause excess or shortage
of working capital. The management should
be prompt to initiate an action and correct
imbalances.
• Another aspect of the gross working capital points
to the need of arranging funds to finance current
assets.
• Whenever a need for working capital funds arises
due to the increasing level of business activity or
for any other reason, financing arrangement
should be made quickly.
• Similarly, if suddenly, some surplus funds arise
they should not be allowed to remain idle, but
should be invested in short-term securities.
• Thus, the financial manager should have
knowledge of the sources of working capital funds
as well as investment avenues where idle funds
may be temporarily invested.
• Net working capital refers to the difference
between current assets and current liabilities.
• Current liabilities are those claims of outsiders
which are expected to mature for payment
within an accounting year and include
creditors (accounts payable), bills payable,
and outstanding expenses.
• It indicates the liquidity position of the firm
and suggests the extent to which the working
capital needs may be financed by permanent
sources of funds.

• Current assets should be sufficiently in excess

of current liabilities to constitute a margin or
buffer for maturing obligations, within the
ordinary operating cycle of a business.
 Need for Working Capital
• Given the objective of financial decision making to maximise
the shareholders’ wealth, it is necessary to generate sufficient
profits.

• The extent to which profits can be earned will naturally

depend, among other things, upon the magnitude of the sales.

• A successful sales programme is, in other words, 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.
• There is, therefore, 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.
• Therefore, sufficient working capital is
necessary to sustain sales activity.
• Technically, this is referred to as the operating
or cash cycle. The operating cycle can be said
to be at the heart of the need for working
capital.
Operating Cycle
 Gross Operating Cycle (GOC)

• The firm’s gross operating cycle (GOC) can be

determined as inventory conversion period
(ICP) plus debtors conversion period (DCP).

GOC = ICP + DCP

Inventory conversion period
The inventory conversion (ICP) is the sum of raw
material conversion period (RMCP), work-in-
process conversion period (WIPCP) and finished
goods conversion period (FGCP):

ICP = RMCP + WIPCP + FGCP

Raw material conversion period (RMCP)
The raw material conversion period (RMCP) is
the average time period taken to convert
material in to work-in-process.
RMCP depends on: (a) raw material
consumption per day, and (b) raw material
inventory.
RMCP = * 365

Cost of RM consumed = Opening Stock of RM +

Purchase of RM – Closing Stock of RM
Work-in-process conversion period (WIPCP):
Work-in-process conversion period (WIPCP) is
the average time taken to complete the semi
finished work or work-in-process.

WIPCP = * 365

Cost of Production = Cost of RM consumed +

Manufacturing Expenses + Opening Stock of WIP
– Closing Stock of WIP
Finished goods conversion period (FGCP):
Finished goods conversion period (FGCP) is the
average time taken to sell the finished goods.

FGCP = * 365

Cost of Goods Sold = Cost of Production + Office

and Administration Overheads + Opening Stock of
FG – Closing Stock of FG
Debtors (receivables) conversion period (DCP)
Debtors conversion period (DCP) is the average
time taken to convert debtors into cash. DCP
represents the average collection period.

DCP = * 365

Credit Sales = Total Sales - Cash Sales

Creditors (payables) deferral period (CDP)
Creditors (payables) deferral period (CDP) is the
average time taken by the firm in paying its
suppliers (creditors).

CDP = * 365

Credit Purchases = Total Purchases – Cash

purchases
 Net Operating Cycle or Cash Conversion
Cycle
Net operating cycle (NOC) is the difference
between gross operating cycle and payables
deferral period.
Net operating cycle = Gross operating cycle –
Creditors deferral period
NOC = GOC – CDP
 Determinants of Working Capital
A firm should plan its operations in such a way
that it should have neither too much nor too little
working capital. The total working capital
requirement is determined by a wide variety of
factors.

.
1. General Nature of Business
• Enterprises fall into some broad categories
depending on the nature of their business.
• Public Utilities: Least Requirement of WC
• Trading and Financial Enterprises: Large
Requirement
• Manufacturing Enterprises: Intermediate
2. Production Cycle
• The term ‘production or manufacturing cycle’ refers to the time
involved in the manufacture of goods.

• It covers the time-span between the procurement of raw

materials and the completion of the manufacturing process
leading to the production of finished goods.

• Funds have to be necessarily tied up during the process of

manufacture, necessitating enhanced working capital.

• The longer the time-span (i.e. the production cycle), the larger
will be the tied-up funds and, therefore, the larger is the working
capital needed and vice versa.
3. Business Cycle
• Business fluctuations lead to cyclical and
seasonal changes which, in turn, cause a shift
in the working capital position, particularly for
temporary working capital requirements.
• The variations in business conditions may be
in two directions: (i) upward phase when
boom conditions prevail, and (ii) downswing
phase when economic activity is marked by a
decline.
• During the upswing of business activity, the
need for working capital is likely to grow.
• The downswing phase of the business cycle
has exactly an opposite effect on the level of
working capital requirement.
4. Credit Policy

• The credit policy influences the requirement of

working capital in two ways: (i) through credit terms
granted by the firm to its customers/ buyers of goods;
(ii) credit terms available to the firm from its creditors.
• The credit terms granted to customers have a bearing
on the magnitude of working capital by determining
the level of book debts. The credit sales result in
higher book debts (receivables).
• Higher book debts mean more working capital. On the
other hand, if liberal credit terms are available from
the suppliers of goods (trade creditors), the need for
working capital is less.
5. Production Policy
• In the case of certain lines of business, the
demand for products is seasonal, that is, they
are purchased during certain months of the
year.
• There are two options open to such
enterprises: either they confine their
production only to periods when goods are
purchased or they follow a steady production
policy throughout the year and produce goods
at a level to meet the peak demand.
6. Growth and Expansion
• As a company grows, it is logical to expect that a
larger amount of working capital is required.
• It is difficult to determine precisely the
relationship between the growth in the volume
of business of a company and the increase in its
working capital.
• The composition of working capital in a growing
company also shifts with economic
circumstances and corporate practices.
• Other things being equal, growth industries
require more working capital than those that
are static.
7. Vagaries in the availability of raw material
• There may be some materials which cannot be
procured easily either because of their sources
are few or they are irregular.
• To sustain smooth production, therefore, the
firm might be compelled to purchase and
stock them far in excess of genuine production
needs.
• This will result in an excessive inventory of
such materials.
8. Profit Level
Higher profit margin would improve the
prospects of generating more internal funds
thereby contributing to the working capital pool.
The net profit is a source of working capital to
the extent that it has been earned in cash.
9. Price Level Changes
Changes in the price level also affect the
requirements of working capital.
Rising prices necessitate the use of more funds
for maintaining an existing level of activity.
For the same level of current assets, higher cash
outlays are required. The effect of rising prices is
that a higher amount of working capital is
needed.
10. Operating Efficiency
• The management can contribute to a sound
working capital position through operating
efficiency.
• Although the management cannot control the
rise in prices, it can ensure the efficient
utilisation of resources by eliminating waste,
improving coordination, and a fuller utilisation
of existing resources, and so on.
• Efficiency of operations accelerates the pace
of cash cycle and improves the working capital
turnover.