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WORKING CAPITAL

MANAGEMENT

Working capital
It refers to the funds, which a company must

possess to finance its day-to-day operations


-Ramamoorthy

Working capital refers to short-term funds to meet

operating expenses.

Kinds of Working Capital


Working capital may be classified on the basis of:

A. Concept :
1. Gross Working Capital (Quantitative concept)
2. Net working capital (Qualitative Concept)
B. Time base:

1. Permanent Working capital


2. Temporary or Variable working capital

Concepts of Working Capital

Gross working capital (GWC)


Net working capital (NWC).

Gross working capital (GWC)


GWC refers to total current assets
It is a Quantitative concept
GWC focuses on
1. Optimisation of investment in Current Assets:
Investment in current assets must be adequate to the needs
of the firm-NOT inadequate or excessive
Inadequate - interruption in production, threaten solvency
(if current obligations are not met)
Excessive Reduces firms profitability
2. Financing of current assets

Net working capital (NWC)


NWC refers to the difference between current assets
and current liabilities

NWC focuses on
1. Liquidity position of the firm
NWC indicates or measures the liquidity position of the firm
To maintain liquidity position, current assets should be
sufficiently in excess of current liabilities (As buffer)
1. Judicious mix of short-term and long-term financing
NWC is the portion of current assets that should be financed by
long-term funds
This concept helps to decide the extent of long-term funds
required in finance current assets

Current Assets
Current assets are the assets which can be converted

into cash within an accounting year (or operating


cycle)
Include:
Cash
Short-term securities
Debtors (accounts receivable)
Bills receivable
Stock (inventory)
Prepaid expenses
Characteristics of current assets:

(1) short life span and


(2) swift transformation into other asset forms.

Current Liabilities
Current

liabilities (CL) are those claims of


outsiders which are expected to mature for
payment within an accounting year

Are liabilities that have to be paid within the accounting

year or within a year


Include :
Creditors (accounts payable)
Bills payable
Outstanding expenses
Bank overdraft

Permanent and Fluctuating Working


Capital
Permanent or fixed working capital

A minimum level of current assets, which is


continuously required by a firm to carry on its business
operations.
Fluctuating or variable working capital

The extra working capital needed to support the


changing production and sales activities of the firm at
different times

Permanent and Fluctuating Working


Capital (Stable Firm)
Working Capital

Temporary
Working Capital

Permanent
Working Capital
Time

Permanent and Fluctuating Working


Capital (Growing Firm)
Working Capital

Temporary WC

Permanent WC

Time

Determinants Of Working Capital


Nature and size of Business
Seasonality of Operations
Production cycle and technology
Production Policy
Market Conditions and credit policy
Conditions of Supply
Availability of Suppliers credit
Operating efficiency
Inflation (Price level changes)
Business Cycle
Growth & Expansion
Level of Taxes and Dividend Policy

Working capital management


Management of working capital refers to the

management of current assets and current


liabilities.
Major thrust is on the management of current

assets.

Significance of Working Capital


Management
Time

A lot of time spent by finance managers on managing WC

Investment

Investment in current assets represents a substantial portion


of total investment.

Criticality
o Significant for all firm but Critical for small firms

Growth
o Investment in current assets and the level of current liabilities
have to be geared quickly to change in sales.

Need For Working Capital


The need for working capital arises due to

existence of operating cycle.


The longer the operating cycle, the more the

requirement for working capital

Operating Cycle
Operating cycle is the time that elapses between the
purchase of raw materials and the collection of cash for
sales
Operating cycle is the time duration required to

convert sales, after the conversion of resources into


inventories, into cash.

Operating Cycle
The operating cycle of a manufacturing

company involves three phases:

Acquisition of resources such as raw material,


labour, power and fuel etc.

Manufacture

of

the

product

which

includes

conversion of raw material into work-in-progress


into finished goods.

Sale of the product either for cash or on credit

resulting in increase in accounts receivable

Operating Cycle
RAW
MATERIALS

WORK-INPROCESS

CASH

CASH SALE

DEBTORS

CREDIT
SALES

FINISHED
GOODS

OPERATING CYCLE AND CASH CYCLE


Order
placed

Stock
arrives

Cash
Goods sold
Accounts received
Inventory
receivable
Conversion
(Debtors
Period (ICP)
Conversion period
(DCP))
Accounts
payable period
Firm receives invoice Cash paid for materials
Operating Cycle
Cash Cycle
(Cash Conversion Cycle)
(CCC)

Operating Cycle
The length of the operating cycle of a manufacturing

firm is the sum of:


Inventory

conversion period (ICP)

Is

the time from the purchase of raw materials to the


sale of finished goods

Accounts

Receivable

period/

Debtors

(receivable) conversion period (DCP)


is

the time required to collect the outstanding


amount from the customers.

Operating Cycle
Operating cycle
Inventory Conversion Period Debtors conversion Period
Average inventory
Inventory Conversion Period (ICP)
Average COGS/365
Average Accounts Receivable
Debtors Conversion Period (DCP)
Average Annual Credit sales/365

Inventory Conversion Period


Inventory conversion period is the total time

needed for producing and selling the product.

Typically, it includes:

raw material conversion period (RMCP)

work-in-process conversion period (WIPCP)

finished goods conversion period (FGCP)

Inventory Conversion Period


InventoryConversion Period RMCP WIPCP FGCP
Raw Material Conversion Period (RMCP)
Average Raw Material inventory

Average Cost of Raw Material Consumption/365


Work - in - ProcessConversion Period (WICP)
Average Work - in - Processinventory

Average Cost of Production/365


Finished Goods Conversion Period (FGCP)
Average Finished Goods inventory

Average Cost of Goods Sold/365

Cash Cycle
Cash cycle is the difference between operating cycle

and accounts payable period.

Accounts payable period or Creditors (payables)

deferral period (CDP) is the length of time the firm is


able to defer payments on various resource purchases.
WC Qs.doc

OPERATING CYCLE AND CASH CYCLE


Cash cycle Operating Cycle - Creditors DeferralPeriod
Creditors Deferral Period (CDP)

Average Accounts Payable


Average Annual Credit Purchases/365

ISSUES IN WORKING CAPITAL


POLICY
DETERMINATION

OF

LEVEL

OF

CURRENT

ASSETS

i.e. What should be the level of investment in current


assets?

CURRENT ASSETS FINANCING POLICY

i.e. What mix of long-term and short-term financing


should the firm employ to support current assets?

LEVEL OF CURRENT ASSETS

The policy for level of current assets may be:


1. Conservative Policy (Flexible Policy)
2. Aggressive Policy (Restrictive Policy)

LEVEL OF CURRENT ASSETS


1. CONSERVATIVE POLICY (FLEXIBLE POLICY):
Means more liquidity and less risk of insolvency
Implies HIGHER investment in current assets

Huge balance of cash and marketable securities


High levels of inventory
High level of debtors (due to liberal credit to customers)

Consequences:

Results in fewer production stoppages,


ensures quicker deliveries to customers,
stimulates sales

BUT
Reduces return/profitability

LEVEL OF CURRENT ASSETS

2. AGGRESSIVE POLICY (RESTRICTIVE POLICY):


Means LESS liquidity and HIGHER risk of insolvency
Implies LOWER investment in current assets

Small balance of cash and marketable securities


Less inventories
Low level of debtors (due to stiff terms of credit to customers)

Consequences:

leads to more production stoppages


delayed deliveries to customers
lost sales

BUT
Higher return/profitability

LEVEL OF CURRENT ASSETS: RISK-RETURN


TRADE-OFF
Theres a riskreturn tradeoff in holding current assets.
INVESTMENT IN CURRENT ASSETS
HIGH

LIQUIDITY

Conservative policy
LOW

RISK OF
INSOLVENCY Conservative policy
LOW

RETURN/
PROFITABILITY
Conservative policy

LOW

Aggressive policy
HIGH

Aggressive policy
HIGH

Aggressive policy
WC Qs.doc

Cost trade-off
Determination of optimal level of current assets involves a

trade-off between Carrying Costs (cost of liquidity) and


Shortage Costs (cost of illiquidity).
Carrying costs include:

Cost of financing a higher level of current assets

Any losses from obsolescence of inventory or bad debts

Shortage costs include:

Losses due to stoppages in production

Loss of sales

Loss of customer goodwill

Cost Trade-off
Minimum
cost
C
o
s
t

Total cost
Carrying
cost

Shortage cost

Optimum level of current assets

Level of current assets

Working Capital Finance


Sources of financing working capital are:
1. Long-term

2. Short-term
3. Spontaneous

1. Long- Term Financing


Are funds available for more than 1 year

Examples:

Ordinary share capital

Preference share capital


Debentures

Long-term borrowings from financial institutions and


banks

Reserves and surplus (Retained Earnings)

2. Short- term Financing

Are funds available for short period of time usually less

than one year. It has to be arranged from banks and other


suppliers of short- term finance in the money market.

2. Short- term Financing


Short- Term Finances include:
Public Deposits
Intercorporate deposits
Commercial Paper
Factoring of Receivables
Working Capital funds from Banks includes:
Overdraft
Cash Credit
Purchase or Discounting of Bills
Letter of Credit
Working Capital Loan

3. Spontaneous Financing
It is finance obtained in normal course of business,

without any formal negotiation.


It is an automatic sources of short- term funds which
arises in the normal course of a business.
Examples:
Trade (suppliers) credit (including bills payable)
Outstanding expenses
No explicit cost of this financing

Short-term Vs. Long-term financing


1. Cost
2. Flexibility
3. Risk

Short-term funds
less costly (less return)
more flexible
more risky.

Hence, a Risk-Return trade-off has to be


achieved while deciding the financing mix.

Working Capital Finance Policies


These are the approaches to working capital

financing
There are three Working Capital Financing policies

(approaches) based on the mix of short term and


long term sources of financing Working Capital:

1. Conservative Policy
2. Aggressive Policy
3. Matching/Hedging Policy

1. Conservative Policy
This policy places more emphasis on the use of long-

term sources to finance current assets as well as


fixed assets.
Long term sources are used to finance
I. Fixed Assets
II. Permanent current assets
III.Part of the Variable current assets
This policy involves lower level of risk of shortage
of funds as only a part of the variable current assets
are financed through short-term sources

Financing Under Conservative Policy

Level of Assets

Short Term
Financing

Long Term
Financing
Fixed Assets
Time

2. Aggressive Policy
This policy involves using more Short-term
sources of funds to finance assets.

Short term sources are used to finance:


I. Part of Permanent current assets
II. Temporary Current Assets

Long-term sources are used to finance:

I. Part of Permanent current assets


II. Fixed Assets

Financing Under Aggressive Policy

Level of Assets

Short Term
Financing

Long Term
Financing
Fixed Assets
Time

3. Matching Policy
This policy involves matching the life of the assets with
the maturity period of the source of finance i.e.
Fixed assets are financed by long term sources of finance
Current assets are financed by short term sources of finance.

Therefore Matching approach to financing working capital


involves:
Financing of Fixed assets and Permanent Current
Assets by long-term sources
Financing Variable Current Assets by short-term
sources.

Financing Under Matching Policy

Level of Assets

Short Term
Financing

Long Term
Financing
Fixed Assets
Time

Estimation Of Working Capital


Requirements
Step 1 : Estimate the cash cost of various current
assets required by the firm.
Step 2 : Deduct the spontaneous current liabilities
from the cash cost of current assets

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