Working Capital Mgmt.

Working capital
Introduction
• Working capital typically means the firm’s
holding of current or short-term assets
such as cash, receivables, inventory and
marketable securities.
• These items are also referred to as
circulating capital
• Corporate executives devote a
considerable amount of attention to the
management of working capital.
 Definition of Working Capital

Working Capital refers to that part of the firm’s capital,

which is required for financing short-term or current
assets such a cash marketable securities, debtors and
inventories. Funds thus, invested in current assets keep
revolving fast and are constantly converted into cash and
this cash flow out again in exchange for other current
assets. Working Capital is also known as revolving or
circulating capital or short-term capital.
 Concept of working capital
• There are two possible interpretations of
working capital concept:
1. Balance sheet concept
2. Operating cycle concept
Balance sheet concept
There are two interpretations of working
capital under the balance sheet
concept.
a. Excess of current assets over
current liabilities
b. gross or total current assets.
• Excess of current assets over current liabilities
are called the net working capital or net current
assets.
• Working capital is really what a part of long term
finance is locked in and used for supporting
current activities.
• The balance sheet definition of working capital is
meaningful only as an indication of the firm’s
current solvency in repaying its creditors.
• When firms speak of shortage of working capital
they in fact possibly imply scarcity of cash
resources.
• In fund flow analysis an increase in working
capital, as conventionally defined, represents
employment or application of funds.
• Operating cycle concept
• A company’s operating cycle typically consists of
three primary activities:
– Purchasing resources,
– Producing the product and
– Distributing (selling) the product.
These activities create funds flows that are both
unsynchronized and uncertain.
Unsynchronized because cash disbursements (for
example, payments for resource purchases) usually take
place before cash receipts (for example collection of
receivables).
They are uncertain because future sales and costs, which
generate the respective receipts and disbursements,
cannot be forecasted with complete accuracy.
• The firm has to maintain cash balance to
pay the bills as they come due.
• In addition, the company must invest in
inventories to fill customer orders
promptly.
• And finally, the company invests in
accounts receivable to extend credit to
customers.
• Operating cycle is equal to the length of
inventory and receivable conversion
periods.
 TYPES OF WORKING CAPITAL

WORKING CAPITAL

BASIS OF BASIS OF
CONCEPT TIME

Gross Net Permanent Temporary

Working Working / Fixed / Variable
Capital Capital WC WC

Seasonal Special
WC WC
Regular Reserve
WC WC
Operating cycle of a typical company

Receive
Purchase Sell
Cash
resources Product
On credit
Pay for
Resources
purchases

Receivable
Inventory conversion
Conversion period
period

Cash conversion
Payable
cycle
Deferral period

Operating
cycle
• Inventory conversion period
Avg. inventory
= _________________
Cost of sales/365
• Receivable conversion period
Accounts receivable
= ___________________
Annual credit sales/365
• Payables deferral period
Accounts payable + Salaries, etc
= ___________________________
(Cost of sales + selling, general and admn. Expenses)/365
• Cash conversion cycle = operating cycle –
payables deferral period.
• Importance of working capital
– Risk and uncertainty involved in managing the
cash flows
– Uncertainty in demand and supply of goods,
escalation in cost both operating and
financing costs.
• Strategies to overcome the problem
– Manage working capital investment or
financing such as
 – Holding additional cash balances beyond
expected needs
– Holding a reserve of short term marketable
securities
– Arrange for availability of additional short-term
borrowing capacity
– One of the ways to address the problem of
fixed set-up cost may be to hold inventory.
– One or combination of the above strategies
will target the problem
• Working capital cycle is the life-blood of
the firm
 Resource flows for a manufacturing firm

Used in

Accrued Direct
Accrued Fixed
Used in Labour and
Operating
Production materials
expenses
Process
Used to
Working purchase
Generates Capital
cycle Cash and
Inventory Marketable
Securities Used to
Collection purchase
Via Sales Generator process
Fixed
External Financing Assets
Return on Capital
Accounts
receivable
Suppliers
Of Capital
 Working capital investment

• The size and nature of investment in

current assets is a function of different
factors such as type of products
manufactured, the length of operating
cycle, the sales level, inventory policies,
unexpected demand and unanticipated
delays in obtaining new inventories, credit
policies and current assets.
 Three alternative working capital
investment policies
Policy C

Policy B
Current Assets ($)

Policy A

Sales ($)
• Policy C represents conservative approach
• Policy A represents aggressive approach
• Policy B represents a moderate approach

• Optimal level of working capital investment

• Risk of long-term versus short-term debt

 Difference between permanent & temporary working
capital

Amount Variable Working Capital

of
Working
Capital

Permanent Working Capital

Time
 Variable Working Capital
Amount
of
Working
Capital
Permanent Working Capital

Time
Financing needs over time
Total Assets

$
Fluctuating Current Assets

Permanent Current Assets

Fixed Assets

Time
Matching approach to asset financing
Total Assets
Short-term
Debt
$
Fluctuating Current Assets

Long-term
Permanent Current Assets Debt +
Equity
Capital

Fixed Assets

Time
Conservative approach to asset financing

Total Assets
Short-term
Debt
$
Fluctuating Current Assets

Long-term
Permanent Current Assets Debt +
Equity
capital

Fixed Assets

Time
Aggressive approach to asset financing

Total Assets
Short-term
Debt
$
Fluctuating Current Assets

Long-term
Permanent Current Assets Debt +
Equity
capital

Fixed Assets

Time
FACTORS DETERMINING WORKING CAPITAL

1. Nature of the Industry

2. Demand of Industry
3. Cash requirements
4. Nature of the Business
5. Manufacturing time
6. Volume of Sales
7. Terms of Purchase and Sales
8. Inventory Turnover
9. Business Turnover
10. Business Cycle
11. Current Assets requirements
12. Production Cycle

contd…
Working Capital Determinants (Contd…)

13. Credit control

14. Inflation or Price level changes
15. Profit planning and control
16. Repayment ability
17. Cash reserves
18. Operation efficiency
19. Change in Technology
20. Firm’s finance and dividend policy
21. Attitude towards Risk
 EXCESS OR INADEQUATE WORKING CAPITAL

Every business concern should have adequate working

capital to run its business operations. It should have
neither redundant or excess working capital nor
inadequate or shortage of working capital.

Both excess as well as shortage of working capital

situations are bad for any business. However, out of the
two, inadequacy or shortage of working capital is more
dangerous from the point of view of the firm.
Disadvantages of Redundant or Excess Working Capital

Idle funds, non-profitable for business, poor ROI

Unnecessary purchasing & accumulation of inventories over required level
Excessive debtors and defective credit policy, higher incidence of B/D
Overall inefficiency in the organization
When there is excessive working capital, Credit worthiness suffers
Due to low rate of return on investments, the market value of shares may fall
Disadvantages or Dangers of Inadequate Working Capital

Can’t pay off its short-term liabilities in time

Economies of scale are not possible
Difficult for the firm to exploit favourable market situations
Day-to-day liquidity worsens
Improper utilization the fixed assets and ROA/ROI falls sharply
MANAGEMENT OF WORKING CAPITAL ( WCM )

Management of working capital is concerned

with the problems that arise in attempting to
manage the current assets, the current liabilities
and the inter-relationship that exists between
them. In other words, it refers to all aspects of
administration of CA and CL.

Working Capital Management Policies of a firm

have a great effect on its profitability, liquidity
and structural health of the organization.
3D Nature of Working Capital Management

DimensionII
Dimension
Profitability,
Profitability,
Risk,&
Risk, &Liquidity
Liquidity

nIIII el C DDiimmen
si o
ion Leevvel Coom
mpo enssiioon
e n
men n&s possiiti n IIII
Diim o &L tioonn & II
D sittiion
m ppoosi CAA ooffCCL& LLeevvel
Coom oof fC L el
C
 PRINCIPLES OF WORKING CAPITAL
MANAGEMENT / POLICY

PRINCIPLES OF
WORKING CAPITAL
MANAGEMENT

Principle of Principle Principle of Principle of

Risk of Cost of Equity Maturity of
Variation Capital Position Payment
 FORECASTING / ESTIMATION OF WORKING CAPITAL
REQUIREMENTS

Factors to be considered
• Total costs incurred on materials, wages and overheads
• The length of time for which raw materials remain in stores
before they are issued to production.
• The length of the production cycle or WIP, i.e., the time taken for
conversion of RM into FG.
• The length of the Sales Cycle during which FG are to be kept
waiting for sales.
• The average period of credit allowed to customers.
• The amount of cash required to pay day-to-day expenses of the
business.
• The amount of cash required for advance payments if any.
• The average period of credit to be allowed by suppliers.
• Time – lag in the payment of wages and other overheads
 PROFORMA - WORKING CAPTIAL ESTIMATES

1. TRADING CONCERN
STATEMENTOF
STATEMENT OFWORKING
WORKINGCAPITAL
CAPITALREQUIREMENTS
REQUIREMENTS
Amount(Rs.)
Amount (Rs.)
CurrentAssets
Current Assets
(i)Cash
(i) Cash ----
----
(ii)Receivables
(ii) Receivables((For…..Month’s
For…..Month’sSales)----
Sales)---- ----
----
(iii)Stocks
(iii) Stocks((For……Month’s
For……Month’sSales)-----
Sales)----- ----
----
(iv)AdvancePayments
(iv)Advance Paymentsififany
any ----
----
Less::Current
Less CurrentLiabilities
Liabilities
(i)Creditors
(i) Creditors(For…..
(For…..Month’s
Month’sPurchases)-
Purchases)- ----
----
(ii)Lag
(ii) Lagininpayment
paymentofofexpenses
expenses -----_
-----_
WORKINGCAPITAL
WORKING CAPITAL((CA CA––CLCL)) xxx
xxx
Add::Provision
Add Provision //Margin
MarginforforContingencies
Contingencies -----
-----

NETWORKING
NET WORKINGCAPITAL
CAPITALREQUIRED
REQUIRED XXX
XXX
 1. MANUFACTURING CONCERN
STATEMENT OF WORKING CAPITAL REQUIREMENTS
Amount (Rs.)
Current Assets
(i) Stock of R M( for ….month’s consumption) -----
(ii)Work-in-progress (for…months)
(a) Raw Materials -----
(b) Direct Labour -----
(c) Overheads -----
(iii) Stock of Finished Goods ( for …month’s sales)
(a) Raw Materials -----
(b) Direct Labour -----
(c) Overheads -----
(iv) Sundry Debtors ( for …month’s sales)
(a) Raw Materials -----
(b) Direct Labour -----
(c) Overheads -----
(v) Payments in Advance (if any) -----
(iv) Balance of Cash for daily expenses -----
(vii)Any other item -----

Less : Current Liabilities

(i) Creditors (For….. Month’s Purchases) -----
(ii) Lag in payment of expenses -----
(iii) Any other -----
WORKING CAPITAL ( CA – CL )xxxx
Add : Provision / Margin for Contingencies -----

NET WORKING CAPITAL REQUIRED XXX

 Points to be remembered while estimating WC

(1) Profits should be ignored while calculating working capital

requirements for the following reasons.
(a) Profits may or may not be used as working capital
(b) Even if it is used, it may be reduced by the amount of Income
tax, Drawings, Dividend paid etc.
(2) Calculation of WIP depends on the degree of completion as
regards to materials, labour and overheads. However, if
nothing is mentioned in the problem, take 100% of the value as
WIP. Because in such a case, the average period of WIP must
have been calculated as equivalent period of completed units.
(3) Calculation of Stocks of Finished Goods and Debtors should
be made at cost unless otherwise asked in the question.
 Accounts Payable Value Addition

Raw WIP
Materials

THE WORKING CAPITAL

Cash CYCLE Finished
(OPERATING CYCLE) Goods

Accounts SALES
Receivable
 Time & Money Concepts in
Working Capital Cycle

Each component of working capital

(namely inventory, receivables and
payables) has two
dimensions ........TIME ......... and MONEY,
when it comes to managing working
capital
 TIME IS MONEY
 You can get money to move faster around the
cycle or reduce the amount of money tied up.
Then, business will generate more cash or it will
need to borrow less money to fund working capital.
 As a consequence, you could reduce the cost
of bank interest or you'll have additional free
money available to support additional sales growth
or investment.
 Similarly, if you can negotiate improved terms
with suppliers e.g. get longer credit or an
increased credit limit, you effectively create free
finance to help fund future sales.
 If you Then ......

Collect receivables (debtors) You release cash from the

faster cycle
Collect receivables (debtors) Your receivables soak up
slower cash
Get better credit (in terms You increase your cash
of duration or amount) from resources
suppliers
Shift inventory (stocks) You free up cash
faster
Move inventory (stocks) You consume more cash
slower
 MANAGEMENT OF CASH

1. Importance of Cash
When planning the short or long-term
funding requirements of a business, it is
more important to forecast the likely cash
requirements than to project profitability
etc.

Bear in mind that more businesses fail

for lack of cash than for want of profit.
2. Cash vs Profit
Sales and costs and, therefore, profits do not
necessarily coincide with their associated cash
inflows and outflows.

The net result is that cash receipts often lag cash

payments and, whilst profits may be reported, the
business may experience a short-term cash
shortfall.

 For this reason it is essential to forecast cash

flows as well as project likely profits.
 Income Statement: Month 1

Sales ($000) 75

Costs ($000) 65

Profit ($000) 10

CFs relating to Month 1: Month 1 Month 2 Month 3 Total

Amount in ($000)

Receipts from sales 20 35 20 75

Payments to suppliers etc. 40 20 5 65

Net cash flow (20) 15 15 10

(20) (5) 10 10
Cumulative net cash flow
 Calculating Cash Flows
 Project cumulative positive net cash flow
over several periods and, conversely, a
cumulative negative cash flow

 Cash flow planning entails forecasting

and tabulating all significant cash inflows
relating to sales, new loans, interest received
etc., and then analyzing in detail the timing of
expected payments relating to suppliers,
wages, other expenses, capital expenditure,
loan repayments, dividends, tax, interest
payments etc.
CASH MANAGEMENT STRATEGIES

Cash Planning

Cash Forecasts and Budgeting

Receipts and Disbursements Method
Adjusted Net Income Method (Sources and
Uses of Cash)
MANAGING CASH FLOWS

After estimating cash flows, efforts should be

made to adhere to the estimates of receipts and
payments of cash.

Cash Management will be successful only if

cash collections are accelerated and cash
payments (disbursements), as far as possible,
are delayed.
Methods of ACCELERATING CASH INFLOWS
 Prompt payment from customers (Debtors)
 Quick conversion of payment into cash
 Decentralized collections
 Lock Box System (collecting centers at different locations)

Methods of DECELERATING CASH OUTFLOWS

 Paying on the last date
 Payment through Cheques and Drafts
 Adjusting Payroll Funds (Reducing frequency of payments)
 Centralization of Payments
 Inter-bank transfers
 Making use of Float (Difference between balance in Bank Pass
Book and Bank Column of Cash Book)
 MANAGEMENT OF RECEVABLES
Receivables ( Sundry Debtors ) result from
CREDIT SALES.
A concern is required to allow credit in order to
expand its sales volume.
Receivables contribute a significant portion of
current assets.
But for investment in receivables the firm has to
incur certain costs (opportunity cost and time
value )
Further, there is a risk of BAD DEBTS also.
It is, therefore very necessary to have a proper
control and management of receivables.
OBJECTIVES

The objective of Receivables

Management is to take sound decision as
regards to investment in Debtors. In the
words of BOLTON S E., the objective of
receivables management is

“ to promote sales and profits until that

point is reached where the return on
investment in further funding of
receivables is less than the cost of funds
raised to finance that additional credit”
DIMENSIONS OF RECEIVABLES MANAGEMENT

OPTIMUM LEVEL OF INVESTMENT IN TRADE RECEIVABLES

Profitability

Costs &
Profitability Optimum Level

Liquidity

Stringent Liberal
 AVERAGE COLLECTION PERIOD AND AGEING
SCHEDULE

The collection of BOOK DEBTS can be

monitored with the use of average
collection period and ageing schedule.
The ACTUAL AVERAGE COLLECTION
PERIOD IS COMPARED WITH THE
STANDARD COLLECTION PERIOD to
evaluate the efficiency of collection so that
necessary corrective action can be initiated
and taken.
THE AGEING SCHEDULE HIGHLIGHTS THE
DEBTORS ACCORDING TO THE AGE OR LENGTH
OF TIME OF THE OUTSTANDING DEBTORS.

The following table presents the ageing schedule

AGEING SCHEDULE

Outstanding Period O/s Amount of Debtors % of

Debtors

0 – 30 Days 5,00,000 50
31 – 40 Days 1,00,000 10
41 – 60 Days 2,00,000 20
61 – 90 Days 1,00,000 10
Over 60 Days 1,00,000 10

Total 10,00,000 100

 Guidelines for Effective Receivables Management

1. Have the right mental attitude to the control of

credit and make sure that it gets the priority it
deserves.
2. Establish clear credit practices as a matter of
company policy.
3. Make sure that these practices are clearly
understood by staff, suppliers and customers.
4. Be professional when accepting new accounts,
and especially larger ones.
5. Check out each customer thoroughly before you
offer credit. Use credit agencies, bank
references, industry sources etc.
6. Establish credit limits for each customer... and
stick to them.
7. Continuously review these limits when you
suspect tough times are coming or if
operating in a volatile sector.
8. Keep very close to your larger customers.
9. Invoice promptly and clearly.
10. Consider charging penalties on overdue
accounts.
11. Consider accepting credit /debit cards as a
payment option.
12. Monitor your debtor balances and ageing
schedules, and don't let any
debts get too large or too old.
MANAGEMENT OF INVENTORIES
Managing inventory is a juggling act.

Excessive stocks can place a heavy burden on

the cash resources of a business.

Insufficient stocks can result in lost sales, delays

for customers etc.

INVENTORIES INCLUDE
RAW MATERIALS, WIP & FINISHED
GOODS
FACTORS INFLUENCING INVENTORY MANAGEMENT

 Lead Time
 Cost of Holding Inventory
Material Costs
Ordering Costs
Carrying Costs
Cost of tying-up of Funds
Cost of Under stocking
Cost of Overstocking

Contd…
 Stock Levels
Reorder Level
Maximum Level
Minimum Level
Safety Level / Danger Level
Variety Reduction
 Materials Planning
 Service Levels
 Obsolete Inventory and Scrap
 Quantity Discounts
INVENTORY MANAGEMENT TECHNIQUES

MANAGING INVENTORIES EFFICIENTLY

DEPENDS ON TWO QUESTIONS

1. How much should be ordered?

2. When it should be ordered?

The first question “how much to order”

relates to ECONOMIC ORDER QUANTITY and
The second question “when to order”arises
because of uncertainty and relates to
determining the RE-ORDER POINT
 ECONOMIC ORDER QUANTITY [ EOQ ]

The ordering quantity problems are solved by

the firm by determining the EOQ ( or the
Economic Lot Size ) that is the optimum level
of inventory.
There are two types of costs involved in this
model.
ordering costs
carrying costs

The EOQ is that level of inventory which

MINIMIZES the total of ordering and carrying
costs.
 ORDERING COSTS CARRYING COSTS

 Requisitioning  Warehousing

 Order Placing  Handling

 Transportation Clerical Staff

 Receiving,  Insurance
Inspecting & Storing
 Clerical & Staff  Deterioration &
Obsolescence
 EOQ FORMULA
For determining EOQ the following
symbols are used
C = Consumption /Annual Usage / Demand
Q = Quantity Ordered
O = Ordering Cost per Order
I = Inventory Carrying Cost (as a % on P )
P = Price per Unit
TC = Total Cost of Ordering & Carrying

2 CO / PI
Total Cost of ordering & carrying inventory
are equal to ( TC ) =

C Q
xO+ x P x I
Q 2

TC is minimized at EOQ
 EOQ – GRAPHICAL APPROACH

Minimum Total Costs

s t s
Co
g
Costs

y i n
arr
C

Ordering Cost

EOQ Order Size Q

 QUANTITY DISCOUNTS & EOQ
The standard EOQ analysis is based on the
assumption that the price per unit remains constant
irrespective of the order size. When quantity
discounts are available (very usual) then price per
unit is influenced by the order quantity. To
determine the optimum lot size with price discounts,
the following procedure is adopted
1. Determine the normal EOQ assuming no discount.
Call it Q*
2. If Q* enables the firm to get the quantity discount
then it represents the optimum lot size.
3. If Q* is less than the minimum order size ( Q’ )
required for quantity discount compute the change
in profit as a result of increasing Q* to Q’
 The formula for change in profit is given as

C C Q’( P-D ) I Q* PI
Dl = CD + - O - -

Q* Q’ 2 2

where
Dl = change in profit
C = Annual Consumption / Usage /
Demand
D = Discount per unit when available
Q* = EOQ without Quantity Discount
Q’ = Min order size required for Discount
O = Fixed Ordering Cost
 SELECTIVE CONTROL OF INVENTORY
Different classification methods
Classification Basis
ABC Value of items consumed
[Always Better Control ]
VED The importance or
[ Vital, Essential, criticality
Desirable ]
FSN The pace at which the
[ Fast-moving, Slow- material moves
moving, Non-moving ]
HML Unit price of materials
[ High, Medium, Low ]
SDE Procurement Difficulties
[ Scarce, Difficult, Easy ]
XYZ Value of items in storage
 An eye-opener to Inventory Management

For better stock/inventory control, try the following:

• Review the effectiveness of existing purchasing and
inventory systems.
• Know the stock turn for all major items of inventory.
• Apply tight controls to the significant few items and
simplify controls for the trivial many.
• Sell off outdated or slow moving merchandise - it gets
more difficult to sell the longer you keep it.
• Consider having part of your product outsourced to
another manufacturer rather than make it yourself.
• Review your security procedures to ensure that no
stock "is going out the back door !"
MANAGEMENT OF ACCOUNTS PAYABLE

Creditors are a vital part of effective

cash management and should be
managed carefully to enhance the
cash position.
Purchasing initiates cash outflows
and an over-zealous purchasing
function can create liquidity problems.

Guidelines for effective management

of Accounts Payable……
•Who authorizes purchasing in your company - is it
tightly managed or spread among a number of (junior)
people?
•Are purchase quantities geared to demand forecasts?
•Do you use order quantities which take account of stock-
holding and purchasing costs?
•Do you know the cost to the company of carrying stock ?
•Do you have alternative sources of supply ? If not, get
quotes from major suppliers and shop around for the best
discounts, credit terms, and reduce dependence on a
single supplier.
•How many of your suppliers have a returns policy ?
•Are you in a position to pass on cost increases quickly
through price increases to your customers ?
•If a supplier of goods or services lets you down can you
charge back the cost of the delay ?
•Can you arrange (with confidence !) to have delivery of
 Ratios associated with WCM
Stock Turnover Ratio COGS
(Times) AVERAGE STOCK
Stock Turnover Ratio (Days) Average Stock x 365
COGS
Receivables Turnover Ratio Net Credit Sales
(Times) Average Accounts
Receivable
Average Receivables Period Avg A/C Receivable x 365
(Days) Net Credit Sales
Payables Turnover Ratio Net Credit Purchases
(Times) Average Accounts
Receivable
Average Payables Period Avg A/C Receivable x 365
(Days) Net Credit Sales
Current Ratio Current Assets
Current Liabilities
Quick Ratio CA – Stock
Current Liabilities
Working Capital Turnover Net Sales
Ratio Net Working Capital