CHAPTER (2): Working Capital Analysis

1. INTRODUCTION
Capital of the business concern may be divided into two major headings: Fixed capital and
Working Capital.
 Fixed capital means that capital, which is used for long-term investment of the business.
For example: purchase of permanent assets. Normally it consists of non-recurring in
nature.
 Working Capital is another part of the capital which is needed for meeting day to day
requirement of the business concern.
For example: payment to creditors, salary paid to workers, purchase of raw materials
etc., normally it consists of recurring in nature. It can be easily converted into cash.
Hence, it is also known as short-term capital.

2. DEFINITION
Definition 1: According to Shubin “Working Capital is the amount of funds necessary to cover
the cost of operating the enterprises”.

Definition 2: According to Genestenberg “Circulating capital means current assets of a

company that are changed in the ordinary course of business from one form to another, for
example, from cash to inventories, inventories to receivables, receivables to cash”.
Source : Financial Management ; Authors : C. Paramasivan & T. Subramanian

There are two concepts of working capital: Gross and Net

 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, accounts receivable and inventory.

𝐺𝑟𝑜𝑠𝑠 𝑊𝑜𝑟𝑘𝑖𝑛𝑔 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 = 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠

 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.

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 𝑁𝑒𝑡 𝑊𝑜𝑟𝑘𝑖𝑛𝑔 𝐶𝑎𝑝𝑖𝑡𝑎𝑙
= 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠 − 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

 Net working capital is the excess of current assets over the current liability during a
particular period. It can be positive or negative:
 A positive net working capital will arise when current assets exceed current
liabilities.
 A negative net working capital occurs when current liabilities are in excess of
current assets.

Net working capital is a qualitative concept. 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.

A weak liquidity position poses a threat to the solvency of the company and makes it unsafe
and unsound. A negative working capital means a negative liquidity, and may prove to be
harmful for the company’s reputation.

3. 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 that should be purchased frequently according to the needs of the
manufacturing company. Hence, every business concern maintains certain amount as
working capital to purchase raw materials, components, spares, etc.
 Payment of wages and salary: The next part of working capital is payment of wages
and salaries to labor and employees. Periodical payment facilities make employees
perfect in their work. So a business concern maintains an adequate amount of working
capital to make timely payments of wages and salaries.
 Day-to-day expenses: A business concern has to meet various expenditures regarding
the operations at daily basis like fuel, office expenses, current bills, etc.
 Provide credit obligations: A business concern responsible to provide credit facilities
to the customer and meet the short-term obligation.

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Working capital level should avoid two danger points (excessive and inadequate), it should be
just adequate to the needs of the business firm. On the one hand, excessive net working capital
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.
A. Causes and effects of excessive working capital.
i. Excessive working capital leads to unnecessary accumulation of raw materials,
components and spares.
ii. It creates bad debts, reduces collection periods, etc.
iii. It leads to reduce the profits.

B. Causes and effects of inadequate (or insufficient) working capital

i. Inadequate working capital inhibits the business to buy its requirements in bulk
order .
ii. It becomes difficult to implement operating plans and activate the firm’s profit
target.
iii. It becomes impossible to utilize efficiently the fixed assets.
iv. The rate of return on investments also falls with the shortage of working capital.

Another aspect of the gross working capital is related 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.

4. TYPES OF WORKING CAPITAL

Working capital may be classified into three important types on the basis of time.

a) Permanent working capital

It is also known as fixed working capital. Companies must maintain certain amount of working
capital at minimum level at all times. The level of permanent capital depends upon the nature
of the business. Permanent or fixed working capital will not change irrespective of time or
volume of sales.

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 Fig 1: Permanent working Capital

b) Temporary working capital

It is also known as variable working capital. It is the amount of working capital which is
required to meet the seasonal demands (or needs) and some special purposes such as launching
of extensive marketing campaigns. It can be further classified into seasonal working capital and
special working capital.

Fig 2: Temporary working capital

c) Semi variable working capital

Certain amount of working capital is in the field level up to a certain stage and after that it will
increase depending upon the change of sales or time.

Fig 3: Semi variable working capital

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 5. FACTORS DETERMINING WORKING CAPITAL REQUIREMENTS
Working capital requirements depends upon various factors. There are no set of rules or formula
to determine the adequate working capital. The following are the major factors which are
determining the working capital requirements.

a) Nature of business: working capital of the business concerns largely depends upon the
nature of the business.
 If the business concerns follow rigid credit policy and sell goods only for cash,
they can maintain …………. amount of working capital.
 A transport company maintains ……… amount of working capital while a
construction company maintains ……….. amount of working capital.

b) Production cycle: working capital depends upon the length of the production cycle.
 If the production cycle length is small, they need to maintain ……… amount of
working capital.
 If it is not, they have to maintain ……… amount of working capital.

c) Production policy: It is also one of the factors which affects the working capital
requirement of the business concern.
 If the company maintains the continues production policy, there is a need of
………… working capital.
 If the production policy of the company depends upon the situation or conditions
(seasonal production policy), working capital requirement will depend upon the
conditions laid down by the company

d) 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 …….
 In the depression condition, requirement of working capital will ……. .

e) Growth and expansion: the working capital requirements are ……… during the
growth and expansion period because companies incur some extra expenses at the initial
stages.

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 f) Availability of raw materials: major part of the working capital requirements are
largely depend on the availability of raw materials. Raw materials are the basic
components of the production process. If the raw material is not readily available, it
leads to production stoppage. So, the concern must maintain adequate raw material.

6. ESTIMATION OF WORKING CAPITAL REQUIREMENT

Working capital requirement depends on various factors which are already discussed in the
previous parts. Now the discussion is on how to calculate the working capital needs of the
business concern.

As it is mentioned earlier, working capital requirements depend on the operating cycle of the
business which begins with the acquisition of raw material and ends with the collection of
receivables.

Operating cycle consists of the following important stages:

1. Raw Material and Storage Stage, (R)
2. Work in Process Stage, (W)
3. Finished Goods Stage, (F)
4. Debtors Collection Stage, (D)
5. Creditors Payment Period Stage. (C)

Fig 4: Working capital cycle for manufacturing companies

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A manufacturer's operating cycle is the amount of time required for the manufacturer's cash
to be used to:

 pay for the raw materials needed in its products

 pay for the labor and overhead costs needed to convert the raw materials into products
 hold the finished products in inventory until they are sold
 wait for the customers' cash payments to be collected

Operating cycle
Definitions Formulas
ratios
Raw Material and Storage Stage
= (Average Inventory of RM x 365)
/ RM consumption

It is the average number The Average inventory of RM =

Holding period for Raw (opening inventory of RM +
of days that RM is hold
Material (RM) Closing inventory of RM) / 2
before its uses
RM consumption = opening
inventory of RM + Purchase of RM
- closing inventory of RM
Work in Process Stage
= (Average inventory of WIP x 365)
/ cost of production (COP)
It is the average number
Holding period for of days that WIP is hold
COP = Raw materials consumed +
Work in Process (WIP) before being a finished
manufacturing expenses +
good
depreciation + opening inventory of
WIP – closing inventory of WIP
Finished Goods Stage
= (Average inventory of FG x 365) /
It is the average number cost of sales (COS)
Holding period for
of days that FG is hold
Finished Goods (FG)
before being sold COS = COP + Opening inventory of
FG - Closing inventory of FG
Finished Goods Stage (for commercial companies)
= Cost of Goods Sold (COGS) /
Average Inventory
It indicates the
Inventory Turnover company's past ability to
COGS = cost of purchasing goods
sell its goods.
+ Opening inventory of goods -
Closing inventory of goods
It is the amount of time
Inventory Period inventory sits in storage = 365 / Inventory Turnover
until sold

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 Debtors Collection Stage
It indicates the
company's ability to = Credit Sales / Average Accounts
Receivables Turnover
collect its accounts Receivable
receivable
It is the average number
of days between the
dates that credit sales
Accounts Receivable = 365 / Receivables Turnover
were made, and the
Period
dates that the money
was collected from the
customers
Creditors Payment Period Stage
It indicates the
= credit purchases /Average
Payables Turnover company's ability to pay
Payables
back its suppliers
The average number of
Accounts Payable days in which a
= 365 / Payables Turnover
Period company pay back its
suppliers
It is important to realize that operating cycle ratios will likely vary between industries. Hence,
a company's ratios should be compared to its own past ratios and to the ratios of companies
within its industry

 THE OPERATING CYCLE

The operating cycle is the length of time between the purchase of inventory and the cash
collected from the sale of inventory.
Operating Cycle = Inventory Period + Accounts Receivable Period

 THE NET OPERATING CYCLE

The net operating cycle (or cash conversion cycle or working capital cycle) focuses on the
time between payments made for materials and labor and payments received from sales. It is
the length of time between paying for inventory and the cash collected from the sale of
inventory.

Working Capital Cycle = Inventory Period + Accounts Receivable Period – Accounts

Payable Period

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Interpretations:
A shorter cycle is preferred and indicates a more efficient and successful business. A shorter
cycle indicates that a company is able to recover its inventory investment quickly and possesses
enough cash to meet obligations. If a company’s operating cycle is long, it can create cash
flow problems.

Hence, a company can reduce its net operating cycle in three ways:

1. Speed up the sale of its inventory: If a company is able to quickly sell its inventory,
the operating cycle should decrease.
2. Reduce the time needed to collect receivables: If a company is able to quickly collect
credit sales more quickly, the operating cycle would decrease. Managers should
encourage the customer to pay promptly with the help of offering discounts, special
offer…
3. Slowing Disbursement: If a company is able to slow disbursement of cash or increase
the suppliers’ terms, the operating cycle would decrease. Managers should avoid the
early payment of cash in order to be retained and used for other purposes. Firms pay
their payable only on the last day of the payment.

Illustrations

1) Selected financial information from company A at the end of the year N is reproduced
below. Compute the inventory days
 Cost of goods sold: $ 1 200 000
 Beginning inventory: $ 200 000
 Ending inventory: $ 400 000
2) Compute the cash conversion cycle
 Credit sales: $ 500 000
 Credit purchases: $ 250 000
 Average inventory: $ 50 000
 Average accounts receivable: $ 120 000
 Average accounts payable: $ 20 000
 The selling price is normally based on cost of goods sold plus 25%

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