PAN African e-Network Project

MFC
Working Capital Management
Semester - 3
Session - 1

Ms. Kanika Arora

 Topics Covered
Working Capital Management

•Concepts of working capital

•Classification
•Importance
•Need or Objects
•Factors of Working Capital
•Nature of Working Capital Management
 Topics Covered
Working Capital Management

•Need for effective Working Capital

Management
•Principles of Working Capital Management
•Dangers of short or excess working capital
•Sources of Financing
•Operating Cycle
 Introduction

•Finance is the life blood of a business and

every business requires certain amount of
working capital in it to perform day to day
activities of the business.

•Sufficient amount of working capital is the

indicator of the efficiency and success of its
business.
 Working Capital
• "Cash is the lifeblood of business" is an
often repeated maxim amongst financial
managers.

•Working capital typically means the firm’s

holding of current or short-term assets such
as cash, receivables, inventory and
marketable securities.
 Working capital
•These items are also referred to as
circulating capital.

•Corporate executives devote a

considerable amount of attention to the
management of working capital.
What is Working Capital (WC)?

• 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.
What is Working Capital (WC)?
• 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.
“Circulating capital means current assets
of a company that are changed in the
ordinary course of business from one form
to another, as for example, from cash to
inventories, inventories to receivables,
receivable to cash”

……Genestenbreg
 Working Capital
• Working Capital is the amount of Capital
that a Business has available to meet the
day-to-day cash requirements of its
operations.

• Working Capital is a financial metric

which represents operating liquidity
available to a business.
 Working Capital Management
• Working capital management refers to the
management of current or short-term
assets and short-term liabilities.
• Components of short-term assets include
inventories, loans and advances, debtors,
investments and cash and bank balances.
• Short-term liabilities include creditors, trade
advances, borrowings and provisions.
Working Capital Management
• Working capital is one of the most
important measure of a company’s
financial strength.
• If the company has sufficient amount of
working capital, it can easily complete or
meet out its day to day activities.
Working Capital Management

• The working capital management refers to

the management of the working capital, or
to be more precise, the management of
current assets.
 Working Capital Management
• Working capital refers to current assets
which may be defined as

(i) Those which are convertible into cash

or equivalents within a period of one year,
(ii) Those which are required to meet day
to day operations.
Considerations in working capital
management
1. What should be the total investment in
working capital of the firm?
2. What should be the level of individual
current asset?
3. What should be the relative proportion of
different sources to finance the working
capital requirements?
 Concept of Working Capital

• There are two possible interpretations of

working capital concept:

1. Balance sheet concept

2. Operating cycle concept
Concept of Working Capital
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.
 Balance Sheet Concept
• 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.
 Balance Sheet Concept
• 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.
 Balance Sheet Concept

• In fund flow analysis an increase in

working capital, as conventionally
defined, represents employment or
application of funds.
 Balance Sheet Concept
• Working Capital is the sum of all Gross
Current Assets

• Net working capital is the difference

between

Current Assets – Current Liabilities

 Operating Cycle Concept

• A company’s operating cycle typically

consists of three primary activities:

– Purchasing resources,
– Producing the product and
– Distributing (selling) the product.
 Operating Cycle Concept
• 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).
 Operating Cycle Concept

• They are uncertain because future sales

and costs, which generate the respective
receipts and disbursements, cannot be
forecasted with complete accuracy.
 Operating Cycle Concept
• 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 Concept

• Operating cycle is equal to the length of

inventory and receivable conversion
periods.
Types of Working Capital
Gross working capital and Net
working capital

• Gross working capital

The gross working capital refers to the

firm’s investment in all the current assets
taken together.
Gross working capital and Net
working capital
• Net working Capital

The term net working capital may be

defined as the excess of total current assets
over total current liability. (it may be noted
that the current liabilities are those liabilities
which are payable within a period of one
year.)
Operating cycle of a typical company
Sell Receive
Purchase Product Cash
resources On credit
Pay for
Resources
purchases

Inventory Receivable
conversion Conversion period
period
Cash conversion
Payable
cycle
Deferral period

Operating
cycle
Operating Cycle and working capital

• Operating Cycle: The time duration

starting from the procurement of goods or
raw materials and ending with the sales
realization is called Operating cycle.
 OPERATING CYCLE

• The Operating cycle definition, also known as

cash operating cycle or cash conversion cycle or
asset conversion cycle, establishes how many
days it takes for a company to turn purchases of
inventory into cash receipts from its eventual sale.
OPERATING CYCLE
Operating Cycle and working capital
• The operating cycle consists of following
phases:
• Procurement of raw material and services
• Conversion of raw materials into work-in-
progress
• Conversion of work-in-progress into
finished goods
• Sale of finished goods (Cash or credit)
• Conversion of receivables into cash
 Operating cycle period
• Inventory conversion period: it is the
time required for the conversion of raw
material into finished goods.

• ICP = Raw material conversion period

(RMCP) + work-in-progress conversion
period (WPCP) + the finished goods
conversion period (FGCP)
 Operating cycle period
• Receivables conversion period (RCP):
it is the time required to convert the credit
sales into cash sales. If refers to the
period between the occurrence of credit
sales and collection of debtors.

• ICP + RCP = Total Operating Cycle

Period (TOCP)
 Operating cycle period
• Deferral Period (DP): The firm gets some
credit facilities from the supplier of raw
materials, wage earners etc. this period
for which the payment to these parties are
deferred or delayed is known as Deferral
Period.

• Net Operating Cycle = TOCP - DP

 Calculation of various conversion
Periods
RMCP = Average Raw Material Stock X 365
Total Raw Material consumption

WPCP = Average work in progress X 365

Total cost of Production

FGCP = Average finished goods X 365

Total cost of Goods sold
Calculation of various conversion
Periods
RCP= Average receivables X 365
Total credit sales

DP = Average creditors X 365

Total credit purchase
 Numerical Example
• From the following information taken from the books of a
manufacturing concern compute the operating cycle in
days:
Period covered 365 Days
Average period of credit allowed by suppliers 16 Days
(Rs. In ‘000)
Average debtors outstanding 480
Raw materials consumption 4,400
Total Production cost 10,000
Total cost of goods sold 10,500
Sales for the year 16,000
Value of average stock Maintained:
Raw Materials 320
Work-in-progress 350
Finished goods 260
 Solution
1. RMCP = Average raw material X 365
Raw Material consumed
320 X 365 = 27 Days
4400

2. WPCP = Average work in progress X 365

Total cost of production
350 X 365 = 13 Days
10,000
 Solution
• FGCP = Average stock X 365
Total cost of goods sold

260X365 = 9 Days
10,500
DP = Average debtors X 365
Credit Sales
480 X 365 = 11 Days
16,000
 Solution
• The credit allowed by the creditors= 16
Days
• TOCP= RMCP+ WPCP + FGCP + RCP
• = 27 + 13 + 9 + 11 = 60 Days
• NOC= TOCP- DP
• = 60-16= 44 Days
 OPERATING CYCLE
• Operating cycleANALYSIS
analysis are completed simply
with this formula:

Operating cycle = DIO + DSO – DPO

Where,
DIO represents Days Inventory Outstanding
DSO represents Days Sales Outstanding
DPO represents Days Payable Outstanding
 OPERATING CYCLE
Calculation
• Calculating operating cycle may seem daunting
but results in extremely valuable information.

DIO = (Average inventories / cost of sales) * 365

DSO = (Average accounts receivables / net sales) *
365
DPO = (Average accounts payables / cost sales) *
365
 EXAMPLE

• Example: What is the operating cycle of a

business?
A company has 90 days in days inventory
outstanding, 60 days in days sales
outstanding and 70 in days payable
outstanding.
 EXAMPLE
Operating cycle = 90 + 60 – 70 = 80

This means that on average it takes 80 days for

a company to turn purchasing inventories into
cash sales. In regards to accounting, operating
cycles are essential to maintaining levels of
cash necessary to survive. Maintaining a
beneficial net operating cycle ratio is a life or
death matter.
 STRATEGIES FOR MANAGING
OPERATING CYCLE
•The goal is to minimize the length of the
operating cycle, which minimizes negotiated
liabilities. This goal can be realized through use
of the following strategies:

1. Turn over inventory as quickly as possible

without stock outs that result in lost sales.
 STRATEGIES FOR MANAGING
OPERATING CYCLE
2. Collect accounts receivable as quickly as
possible without losing sales from high-
pressure collection techniques.
3. Manage mail, processing, and clearing time
to reduce them when collecting from
customers and to increase them when paying
suppliers.
4. Pay accounts payable as slowly as possible
without damaging the firm’s credit rating.
• 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 ($)
 FUNDING REQUIREMENTS OF
OPERATING CYCLE

• An aggressive funding strategy is a

funding strategy under which the firm funds
its seasonal requirements with short-term
debt and its permanent requirements with
long-term debt.
 FUNDING REQUIREMENTS OF
OPERATING CYCLE

•A conservative funding strategy is a

funding strategy under which the firm funds
both its seasonal and its permanent
requirements with long-term debt.
• 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
 Difference between permanent &
temporary working capital

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
Management
A firm should plan its operations in such a way
that it should have neither too much nor too
little working capital. Factors are:

• Basic / General nature of the business

• Technology and Production Cycle
• Production Policy
Factors determining Working Capital
Management
• Business cycle fluctuations
• Credit Policy - Credit allowed and Credit
availed
• Growth and Expansion prospects
• Profit Level
• Price Level Changes or Inflation
• Seasonal Operations
Factors determining Working Capital
Management

• Size of Business/Scale of operations

• Vagaries in the availability of Raw Material
• Length of operating cycle
• Supply Conditions
• Operating Efficiency
• Market Competitiveness
• Government Policies, Regulations
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.
EXCESS OR INADEQUATE
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.
Disadvantages of Redundant or
Excess Working Capital

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 or Short 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
 DETERMINING FINANCING-MIX
There are two sources from which funds can
be raised for current assets financing-

• Short term sources, like current liabilities

and,
• Long term sources such as share capital,
long term borrowings, internally generated
resources like retained earnings, etc.
 Working Capital Financing

• Fund Based:

– Cash Credit
– Overdraft
– Bills Discounting
– Working Capital Demand Loan
 Working Capital Financing

• Non Fund Based

– Letter of Credit
– Bank Guarantee
 Working Capital Financing

• Structured Product

– Factoring
– Commercial Paper
– Securitization of receivables
– Buyers/Supplier credit.
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.
MANAGEMENT OF WORKING
CAPITAL ( WCM )

Working Capital Management Policies of a firm

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

• Objectives

– Business should have adequate working

capital to run its day to day business
operations.
– Harmonize Profitability, Risk and Liquidity
factors
Working Capital Management

• Impact

– Working Capital Management Policies of a

business have a great impact on Internal,
External and Environmental health of the
organization.
3D Nature of Working Capital
Management

Dimension I
Profitability,
Risk, & Liquidity
 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
PRINCIPLES OF WORKING CAPITAL
MANAGEMENT / POLICY

• Principle of Risk Variation:

Larger investment in current assets will
lead to dependence. Short term
borrowings increases liquidity, reduces
risk and thereby decreases the opportunity
for gain or loss.
PRINCIPLES OF WORKING CAPITAL
MANAGEMENT / POLICY

• Principle of Equity Position:

The various sources of raising WC finance
have different cost of capital and the
degree of risk involved.
PRINCIPLES OF WORKING CAPITAL
MANAGEMENT / POLICY

• Principle of Cost Capital:

This principle is considered with planning
the total investment in current assets.
PRINCIPLES OF WORKING CAPITAL
MANAGEMENT / POLICY

• Principle of Maturity Payment:

As per this principle a firm should make
every effort to relate maturities of its flow of
internally generated funds in other words it
should plan its cash inflow in such a way that
it could easily cover its cash out flows or else
it will fail to meet its obligation in time.
 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.
 FORECASTING / ESTIMATION OF
WORKING CAPITAL REQUIREMENTS

• 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.
 FORECASTING / ESTIMATION OF
WORKING CAPITAL REQUIREMENTS

• 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
STATEMENT OF WORKING CAPITAL REQUIREMENTS
Amount (Rs.)
Current Assets
(i) Cash ----
(ii) Receivables ( For…..Month’s Sales)---- ----
(iii) Stocks ( For……Month’s Sales)----- ----
(iv)Advance Payments if any ----
Less : Current Liabilities
(i) Creditors (For….. Month’s Purchases)- ----
(ii) Lag in payment of expenses -----_
WORKING CAPITAL ( CA – CL ) xxx
Add : Provision / Margin for Contingencies -----

NET WORKING CAPITAL REQUIRED XXX

 2. 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.
 Points to be remembered while
estimating WC

(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.
 Points to be remembered while
estimating WC

(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
 Operating & Cash Cycle

• Operating Cycle of WC

– Average elapsed time between Purchase of

RM & Collection of Cash for Sales
– Formula to get Operating Cycle

DIO + DSO
 Operating & Cash Cycle

• Cash Cycle of WC

– Average elapsed time between Payment of

RM Purchase & collection of Cash for Sales
– Formula to get Cash Cycle (CCC)

DIO + DSO - DPO

 Exercise
From the following Information, you are required to
calculate the length of Operating Cycle of XYZ Ltd. for
the year ended 31st March 2013. Assume 365 days in a
year.
Balances as at 31st March
P/L Data 2013 Balance Sheet Data 2012 2013

Sales 80,000 Inventory 9,000 12,000

Cost of Goods Sold 56,000 Debtors 12,000 16,000
Creditors 7,000 10,000
 Exercise - Solution
Operating Cycle : Av Inventory Period + Av Accounts Receivable Period

Inventory Period Receivable Period

Average Inventory Average Receivables
-------------------------- x 365 -------------------------- x 365
Cost of Goods Sold Annual Sales

(9000+12000) / 2 (12000 + 16000) / 2

-------------------------- X 365 ---------------------------- X 365
56000 80000
Inv Period = 68.4 days Receivable Period = 63.9
days

Operating Cycle : 68.4 + 63.9 = 132.3 days

Please forward your query

To: karora1@amity.edu