CHAPTER -1

WORKING CAPITAL MANAGEMENT

Working capital is the term commonly used to summarize

the financial resources available for a firm’s day-to-day
operations. These must be liquid resources, available as
cash (or convertible to cash) when required. Working
capital includes cash and marketable securities—the most
liquid of resources—and also the somewhat less liquid
resources of accounts receivable, inventories, and prepaid
expenses
 Working capital defined

 Working capital is defined as a firm’s investments in

current assets. GWC = Total CA = Cash +
Marketable securities + Receivables + Inventories
 Gross Working Capital: the gross working capital is the
capital invested in total current assets of the business.
Gross Working Capital is simply called as the total
current assets of the concern.
GWC = CA
 Net Working Capital
 Net Working Capital is the excess of current assets
over the current liability of the firm during a
particular period. If the current assets exceed the
current liabilities it is said to be positive working
capital; if it is reverse, it is said to be Negative
working capital.

NWC = CA – CL
 Current Assets
 Current assets- assets which are used in the selling
activities and assets which are expected to be converted
into cash with one year or one accounting year
 Cash and cash equivalents
 Short-term investment- surplus of idle cash that is
needed after a few months.
 Receivables
 Prepaid expenses- expenses paid for goods &
services the benefits of which haven’t yet been
received
 Inventories of RM, WIP, FG, stores it will be
determined by sales and production
 Current liabilities
 Current liabilities - are obligations that are expected to
required cash payment within one year (or within the
operating period if it is longer than one year)
Accounts payable

Notes payable

Accrued expenses

Bank over draft

Proposed and declared dividend

Tax payment and others.

Importance of Adequate Working Capital
Working capital is the life blood and nerve centre of a business. No
business can run successfully without an adequate amount of working
capital. The main advantages of maintaining adequate amount of working
capital are as follows:
o Solvency of the Business

o Goodwill

o Easy Loans

o Cash Discounts

o Regular Supply of Raw Material

o Regular payment of salaries, wages and other day to day commitments

o Ability to face crisis

o Quick and regular return on investments

o Exploitation of Favorable market conditions

o High Morale
 Types of Working Capital

Working Capital may be classified into two important

types on the basis of time. Working capital is:

1. Permanent working capital

2. Temporary working capital

 1. Permanent working capital

 Permanent working capital is the base

level of working capital, the amount
required independent of daily, seasonal,
or cyclical variations in business activity. It
is made up of permanent current assets
and permanent current liabilities. The firm
needs its permanent working capital on a
continuous basis.
2. Temporary working capital
Temporary working capital is the amount above the
base level which results from variations in business
activity. It is caused by three simultaneous processes.
 First, the business cycle increases and decreases the
resource needs of all businesses over a multiyear time
period.
 Second, most firms are seasonal, having an annual
cycle of activities.
 Third, daily events impact resource needs since
revenues and expenses, and cash inflows and
outflows, rarely balance on a day-to-day basis.
NEEDS OF WORKING CAPITAL

Working Capital is needed for the following purposes.

 Purchase of raw materials and spares: The basic part
of manufacturing process is, raw materials. It should
purchase frequently according to the needs of the
business concern.
 Payment of wages and salary: Periodical payment
facilities make employees perfect in their work.
 Day-to-day expenses: A business concern has to meet
various expenditures regarding the operations at daily
basis like fuel, power, office expenses, etc.
 Provide credit obligations: A business concern
responsible to provide credit facilities to the customer
and meet the short-term obligation.
Objectives of Working Capital Management

WCM has got three dimensions

 Concerned with risk, liquidity and return policies

 Concerned with the decision about composition of

current asset

 Concerned with the level and composition of current

liabilities
Working capital Financing sources

Three types of financing may be distinguished:

 Spontaneous financing -refers to the automatic source of
short term funds arising in the normal course of business
 Account payable, Accruals (wages, taxes)
 Short term financing is obtained for a period less than a
year.
 Commercial banks, (COD, Term loans)
 Other creditors
 Long term financing
 Debt (long term loans)
 Equity (share capital, retained earnings)
Operating Cycle and cash conversion cycle

 The Operating Cycle can be said to be at the heart of

the need for working capital. The continuing flow from
cash to suppliers, to inventory, to accounts receivable
and back into cash is what is called the Operating
Cycle.
Figure - Operating Cycle
RECEIVABLE
S
CASH

INVENTORY
The three phases of Operating cycle
The Operating cycle consists of three phases.
 In the phase – 1, cash gets converted into inventory. This
includes purchase of raw materials, conversion of raw
material into WIP, finished goods and finally the transfer
of goods to stock at the end of the manufacturing process
 In phase – 2 of the cycle the inventory is converted into
receivables as credit sales are made to customers. Firms
which do not sell on credit obviously not have phase – 2 of
the operating cycle.
 The last, phase, phase – 3, represents the stage of when

receivables are collected.

 Dangers of excessive working capital
a. Excessive Working Capital leads to unnecessary
accumulation of raw materials, components and spares.
Thus, chances of inventory mishandling, waste theft and
losses increases.
b. Excessive Working Capital results in increase opportunity
cost.
c. It creates bad debts,.. etc.
d. It results in unnecessary accumulation of inventories. It is
an indication of defective credit policy and slack
collection period. Consequently, higher incidence of bad
debts results, which adversely affects profits.
e. It leads to reduce the profits.
Characteristics of Working Capital

 A) Circulating Capital
 Working capital, once invested, is constantly circulating
from one component to other component of working
capital.
 Working Capital as a Circulating Capital
WIP

Finished goods (or service)

Input (Raw Material)

Cash sales

Sales on account

Cash A/R
 b) Liquidity
 Each component of working capital has different degrees of
liquidity. Cash is the most liquid asset. Next is the marketable
security (it is sometimes called near cash asset). A/R is more
liquid than inventories in the sense that inventories may first be
converted to receivables before it is converted to cash.
 c) Risk
 Each component of working capital has its own risk. For
example, accounts receivable may be uncollectible or becomes
bad debt. The raw materials may be damaged, finished
goods may be unsalable.
Cont’d…
 d) Profitability
 Generally, excess working capital may reduce profit as the money is tied
up in current assets, entailing high cost (interest or opportunity cost).

 Policy A Policy B
Current Assets 2000 1200
Fixed Assets 5000 5000
Total Assets 7000 6200

 Current Liabilities 1000 1000

EBIT 2000 2000

 Indicators:
Risk (Current ratio) 2.00 1.20
Profitability (EBIT/TA) 0.29 0.32

 Policy A with high volume of current asset is less profitable and less risky,
while
policy B with low investment in current asset is more profitable but also
more risky
Determinants of Working Capital)

There are a number of factors, each having a different

importance, influence working capital needs of firms. Also,
the importance of factors changes for a firm over time.
Therefore, an analysis of relevant factors should be made
in order to determine total investment in working capital.
These factors affect different firm differently. They affect
the same firm differently for different period of time.
Determinants of WC
A. Nature of Business
 Working capital requirements of a firm are basically

influenced by the nature of its business.

 service firms or Public utilities have a very limited need for
working capital and have to invest abundantly in fixed assets.
Their working capital requirements are nominal because they
may have only cash sales and supply services, not products. Thus,
no funds will be tied up in debtors and stock (inventories)
 Trading and financial firms have a very small investment in fixed
assets, but require a large sum of money to be invested in
working capital.
 Manufacturing -WC requirement fall between the two
extreme requirements of trading firms and public utilities
Determinants of WC
B) Seasonality of Operations
 Firms which have marked seasonality in their operations
usually have highly fluctuating working capital
requirements.
 To illustrate, consider a firm manufacturing rain coats.
The sale of rain coats reaches a peak during the rainy
season and drops sharply during the winter period, and
almost no sales in summer season.
 The working capital need of such a firm is likely to
increase considerably in rainy months and decrease
significantly during winter period.
 Determinants of WC
C. Production (manufacturing) cycle (and technology)
 The manufacturing cycle (or the inventory conversion cycle)
comprises of the purchase and use of raw materials and the
production of finished goods. It is the time which involve in the
manufacturing of goods. It covers the time span from
procurement till the time it becomes finished goods. Longer the
manufacturing cycles, larger will be the firm’s working capital
requirements.
 If the production cycle length is small, they need to maintain
lesser amount of Working Capital. If it is not, they have to
maintain large amount of Working Capital.
 An extended manufacturing time span means a larger tie-up
of funds in inventories. Thus, if there are alternative
technologies of manufacturing a product, the technological
process with the shortest manufacturing cycle may be chosen.
Determinants of WC
 D) Market Conditions
 The degree of competition prevailing in the market
place has an important bearing on working capital
needs.
 When competition is keen, a large inventory of finished
goods is required to promptly serve customers who may
not inclined to wait because other manufacturer are
ready to meet their needs.
 working capital needs tend to be high because of
greater investment in finished goods inventory and A/R.
Determinants of WC
 f) Conditions of Supply
 The inventory of raw material, spare parts, and
stores depends on the conditions of supply.
 If the supply is prompt and adequate, the firm can
manage with small inventory.
 However, the supply is unpredictable and scant then
the firm, to ensure continuity of production, would
have to acquire stocks as and when they are
available and carry larger inventory on an
average.
Determinants of WC

E. Business Cycle

 Business fluctuations lead to cyclical and seasonal

changes in the business condition and it will affect the
requirements of the Working Capital. In the booming
conditions, the Working Capital requirement is larger
and in the depression condition, requirement of
Working Capital will reduce.
 Determinants of WC
F. Credit policy
 The credit policy of the firm affects the working
capital by influencing the level of receivable. The
credit terms to be granted to customers may depend
up on the norms of the industry to which the firm
belongs. But a firm has the flexibility of shaping its
credit policy with in the constraint of industry norms
and practices.
* Liberal credit policy demands more working capital
while tight credit policy demands less working capital.
Determinants of WC

F. Growth and expansion

During the growth and expansion of the business
concern, Working Capital requirements are higher,
because it needs some additional Working Capital and
incurs some extra expenses at the initial stages.
 More fixed assets and more working capital

 Product diversification

 Expanding existing product line

 New business line.

Determinants of WC
G. Availability of Credit from suppliers
The working capital requirements of a firm are also
affected by credit terms granted by it suppliers. A firm
will needless working capital if liberal credit terms are
available to it from suppliers. Suppliers’ credit finances
the firm’s inventories and reduces the cash conversion
cycle. In the absence of suppliers credit, the firm either
has to hold cash or borrow from bank (which is interest
bearing).
Determinants of WC

H. Profit level
The level of profit earned defer from firm to firm
depending on the market hall, the nature of the product
and the degree of monopoly power. The net profit is the
source of working capital to the extent that it has been
earned in cash. Higher profit margins would improve the
prospects of generating more internal funds there by
contributing to the working capital needs
Determinants of WC
I. Level of taxes
The first appropriation of profit is tax. Taxes may be
payable in advance depending on previous profit. If tax
liability is increased, working capital requirement will be
high.
J. Dividend policy
 Cash dividend
 Stock dividend
 No dividend
K. Price level changes
During period of inflation to maintain the same level of
requirement additional investment is needed. The situation
has an effect only at initial position because the company
also sells the product at high amount. In this case WC
increase drastically
Determinants of WC
L. Operating Efficiency
The operating efficiency of the firm related to the
optimum utilization of resources at minimum costs. The firm
will be effectively contributing in keeping the working
capital investment at a lower level if it is efficient in
controlling operation costs and utilizing current assets.
Efficiency in operations accelerates the phase of the cash
cycle and improves in the working capital turnover ratio. It
releases the pressure on working capital by improving the
internal generation of funds.
Determinants of WC

M. Availability of raw materials:

Major part of the Working Capital requirements are
largely depend on the availability of raw materials. If
the raw material is not readily available, it leads to
production stoppage. So, the concern must maintain
adequate raw material; for that purpose, they have to
spend some amount of Working Capital.
Disadvantages of excessive working capital

 1. Excessive working capital means idle funds which earn no

profits for business
 2. it may lead to unnecessary purchasing and accumulation
of inventories causing more chances of theft, waste and losses.
 3. It may result into overall inefficiency in organization.
 4. Due to low rate of return on investments, the value of
shares may also fall
 5. It gives rise to speculative transaction.
 6. having excessive reduce the relation with financial institution
Disadvantages of Inadequate working capital

a. It cannot buy its requirements in bulk order.

b. The rate of return on investments also falls with the shortage of
Working Capital.
c. cannot pay its short-term liabilities in time. Thus, it will lose its
reputation and shall not be able to get good credit facilities
d. It stagnates growth.
e. It becomes difficult to implement operating plans and achieve
the firms profit target.
f. Fixed assets are not efficiently utilized for the lack of working
capital funds.
g. lack of working capital funds render the firm unable to avail
attractive credit opportunities etc. The firm loses its reputation
when it is not in a position to honor its shorter obligations. As a
result, the firm faces tight credit terms. (Insolvency)
 Principles of Working Capital Management

 a) Principle of Risk Variation

 b) Principle of Cost of Capital
 c) Principle of Equity position
 d) Principle of Maturity of Payment
 1. Principle of Risk Variation: Risk refers to
inability of firm to meet its obligation as and
when they become due for payment.