Working Capital Management

RT
 Introduction
• The capital of a business which is used in its day-to-day
trading operations.
• Working capital is a measure of both a company's efficiency
and its short-term financial health.
• If a company's current assets do not exceed its current
liabilities, then it may run into trouble paying
back creditors in the short term. The worst-case scenario
is bankruptcy. A declining working capital ratio (Current
Assets/Current Liabilities) over a longer time period could
also be a red flag that warrants further analysis.
• Working capital management- the administration of the
firm’s current assets and the financing needed to support
current assets.
Indian Manufacturing Current Assets
and Liabilities, March 31, 2013 (Rs.
Million)
Break-up of Current Assets, India, 2013
Gross and Net Working Capital
• Gross Working Capital-
– Total of investments in all current assets
– Focus on optimization of investment in current assets and the means of
financing current assets
• Net Working Capital-
– Excess of total current assets over total current liabilities.
– Indicates the extent to which working capital needs may be financed
by permanent sources of funds.
– Can be positive or negative
• Current Assets are cash and other assets that are expected to
be converted to cash within the year or the operating cycle of
the firm.
– Cash and bank balances
– Marketable securities
– Accounts receivable
– Inventory

• Current Liabilities are obligations that are expected to

require cash payment within the year.
– Accounts payable
– Accrued wages
– Taxes
Permanent And Variable Working Capital
• The magnitude of current assets keeps on changing from time
to time.

• Permanent or fixed working capital:

– A minimum level of current assets continuously required by a firm to
carry on its business operations, is referred to as permanent or fixed
working capital.

• Fluctuating or variable working capital:

– The extra working capital needed to support the changing production
and sales activities of the firm is referred to as fluctuating or variable
working capital.
Permanent and Variable Working Capital

Permanent Working Capital

Simple Cycle of Operations
Cash Conversion Cycle
 ACCOUNTS RECEIVABLE, PAYABLE &
INVENTORY PERIOD
• Debtors period / Receivable period
– (Average Debtors/Total Sales) x 360

• Creditors period / Payable period

– (Average Creditor/Total Purchase) x 360

• Inventory days outstanding

– (Average Inventory/Cost of Goods Sold) x 360
 Cash Conversion Cycle, Indian
Manufacturing, 2013 (Rs. Millions)
 Working Capital and the Cash
Conversion Cycle
• Cash Conversion Cycle
= operating cycle – accounts payable period
= (inventory period + receivables period) – accounts payable
period
• Cash Conversion Cycle

Cash Conversion
Cycle:
 HOW MUCH WORKING CAPITAL DO WE
NEED?
• To answer this question, you need to understand how money
will flow through your business – in other words, you need to
understand your “working capital cycle.”
– The cycle consists of:
• (i) how quickly accounts receivables & inventory are turned
into cash and
• (ii) how quickly that cash is used to pay accounts payable.

• When starting a business, you will have projections for key

items such as sales, cost of goods sold and other expenses.
 Contd…
• You also need assumptions on the following:
– How many days of inventory do you need to keep
in hand (“inventory turnover”)?
– How many days will you give customers to pay you
(accounts receivable terms)?
– How many days will your vendors give you to pay
them (accounts payable terms)?

• Armed with this information, you can calculate how

much working capital is needed to start your business.
WORKING CAPITAL REQUIREMENT
ANALYSIS: FRAMEWORK
 Cash Conversion Cycle,
Selected Companies, 2013
Working Capital Financing Policies

Financing Policies Sources

Long-term Equity, Debentures, Reserves and

Surplus, and Long term borrowings

Short-term Commercial Papers, working capital

funds from banks, factoring of
receivables
Spontaneous Trade (suppliers) credits and
outstanding expenses.
Working Capital Financing Policies
Approach Features

Matching / Long term financing for fixed assets and permanent current
Hedging assets.
Short term financing for variable / temporary current assets.

Conservative More focus on Long term financing and used for fixed assets,
permanent current assets and partially also variable / temporary
current assets.
Short term financing for remaining variable / temporary current
assets.

Aggressive Short term financing partially for permanent current assets as

well as for variable / temporary current assets.
Matching Approach
Conservative Approach
Aggressive Approach
 Inventory management
• Components of Inventory
– Raw materials
– Work in progress
– Finished goods
• Goal: Minimize amount of cash tied up in
inventory
– Tools used to minimize inventory
• Just-in-time
• EOQ
Inventory Conversion Period
• Inventory conversion period (ICP) = RMPC + WIPCP + FGCP

Average inventory
• Raw Material Conversion Period (RMCP) = 𝑅𝑎𝑤 𝑚𝑎𝑡𝑒𝑟𝑖𝑎𝑙 𝑐𝑜𝑛𝑠𝑢𝑚𝑝𝑡𝑖𝑜𝑛 / 365

Average inventory
• Work-In-Process Conversion Period (WIPCP) = 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑝𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑜𝑛 / 365

Average inventory
• Finished Goods Conversion Period (FGCP) =
𝐶𝑜𝑠𝑡 𝑜𝑓 𝑔𝑜𝑜𝑑𝑠 𝑠𝑜𝑙𝑑 / 365

• However, assuming 30 Days = 1 Month is normal practice in

some books. Thus 1 year = 360 Days.
Managing Inventories
Determining Optimal
Order Size
 Inventories
• Economic Order Quantity
– Order size that minimizes total inventory costs

2  annual sales  cost per order

Economic order quantity =
carrying cost
• As Order Size Increases
– Number of orders decreases
– Order cost decreases
– Average amount in inventory increases
– Carrying cost of inventory increases
 Credit Management
• Terms of Sale
– Credit, discount, and payment terms offered on
sale

– Example: 5/10 net 30

• 5: Percent discount for early payment
• 10: Number of days discount is available
• Net 30: Number of days before payment due
 Credit Management
• Terms of Sale
– Firm that buys on credit borrows from supplier
• Save cash today, pay later (implicit loan)
• Cost of implicit loan:

Effective annual rate


 1+ discount
discountedprice

365/extra days credit
1
 Credit Management
• Example
– Calculate implied interest rate on Rs.100 sale with
terms 5/10 net 60

Effective annual rate


 1+ discount
discountedprice

365/extra days credit
1
 1 + 
5 365/50
95  1 = .454, or 45.4%
 Credit Management
• Credit Analysis
– Procedure to determine likelihood that customer
will pay bills
• Credit agencies provide reports on credit
worthiness of potential customers
• Financial ratios can help determine a
customer’s ability to pay bills
• Set your credit policy to determine amount and
nature of credit extended to customers
 Credit Management
• Credit Decision
– Based of probability of payoffs, expected profit
can be expressed as:
p  PV(rev  cost)  (1  p)  (PV(cost))
Credit Decision and Probable Payoffs
 Credit Management
• Collection Policy
– Procedure to collect and monitor receivables
(factoring services)

• Aging Schedule
– Classification of accounts receivable by time
outstanding
 Credit Management
• Sample Aging Schedule, Accounts Receivable
Customer' s Less than More than
1 - 2 Months 2 - 3 Months Total Owed
Name 1 Month 3 Months
A 10,000 0 0 0 10,000
B 8,000 3,000 0 0 11,000
* * * * * *
* * * * * *
* * * * * *
Z 5,000 4,000 6,000 15,000 30,000
Total $200,000 $40,000 $15,000 $43,000 $298,000
 Cash Management
• Cash Does Not Pay Interest
– Move money from cash accounts to short-
term securities
– Sweep programs
– Concentration banking
– Lock-box system
 Cash Management
• Electronic Funds Transfer (EFT)
– Allows instantaneous payment
• Automated Clearinghouse (ACH)
– Allows direct payment of recurring expenditures
Money-market Investments in India
Cash Management Models
• Cash management models address the issue
of split between marketable securities and
cash holdings. Two such models are :
• Baumol model
• Miller and Orr model
 Baumol Model
• Baumol’s EOQ Model of Cash Management
• William J. Baumol (1952) suggested that cash
should be managed in the same way as any other
inventory
• And that the inventory model could reasonably
reflect the cost- volume relationships as well as
the cash flows.
• In this way, the economic order quantity (EOQ)
model of inventory management could be
applied to cash management.
• The Baumol’s model assumes that the firm
uses cash at a constant rate per period.
• In the model, the carrying cost of holding
cash-namely the interest forgone on
marketable securities is balanced against the
fixed cost of transferring marketable securities
to cash, or vice-versa.
According to this model, the optimal conversion amount
of marketable securities into cash, C, is given by the
following formula:
2𝑏 𝑇
C=
𝑖
b is the cost of conversion into cash per transaction.
T is the projected cash requirement during the
period.
i is interest rate earned per planning period on
investments in marketable securities.
Question 1: Find out the optimum cash balance using Baumol's Model
Annual cash needed Rs.48,00,000
Transaction cost Rs.90 per conversion
Interest rate 9%

Solution:
As per Baumol's Model
C = Cash required each time to restore balance to minimum cash
F= Total cash required during the year = Rs.48,00,000
T= Cost of each transaction between cash and marketable securities
=Rs.90
r = Rate of interest on marketable securities = 9%
 Implication
• As per Baumol’s Model, the firm should start
each period with the cash balance equalling
‘C’ and spend gradually until its balance
comes to zero.
• At this time, the firm should replenish the
equalling ‘C’ from the sale of marketable
securities.
 Miller-Orr Model
• Baumol’s model is based on the basic
assumption that the size and timing of cash
flows are known with certainty.
• This usually does not happen in practice.
• The cash flows of a firm are neither uniform
nor certain.
• The Miller and Orr model overcomes the
shortcomings of Baumol model.
• Miller and Orr (A Model of the Demand for
Money) expanded on the Baumol model and
developed Stochastic Model for firms with
uncertain cash inflows and cash outflows.

• The Miller and Orr model provides two control

limits-the upper control limit and the lower
control limit along-with a return point as
shown in the figure below:
• When the cash balance touches the upper control
limit (h), marketable securities are purchased to
the extent of hz to return back to the normal cash
balance of z.
• In the same manner when the cash balance
touches lower control limit (o), the firm will sell
the marketable securities to the extent of oz to
again return to the normal cash balance.
• The spread between the upper and lower cash
balance limits (called z) can be computed using
Miller-Orr model as below:
Miller-Orr Model

The formula for determining the distance between the return level
and lower control limits (called Z) is as follows:

3 3𝑏𝑟 2
Z=
4𝑖
where:
𝑟 2 is the variance of daily changes in cash balances
b is the cost of conversion into cash per transaction.
i is interest rate earned on investments in marketable
securities
Miller-Orr Model
The distance between lower limit and the upper limit should be three
times the distance between the lower limit and the return level.

Upper Limit = Lower Limit + 3 Z

Return Point ( Optimal Balance) = Lower Limit + Z

The net effect is that the firms hold the average the cash balance equal
to:

Average Cash Balance = Lower Limit + 4/3Z

Example
Given conversion cost= Rs. 150, interest rate 14 percent per annum , minimum cash balance
of Rs.5,00,000and the standard deviation of daily net cash flows Rs. 2,00,000, find the
optimum cash balance and average cash balance using Miller-Orr Model.
3 3𝑏𝑟 2
• Z=
4𝑖

3 3 𝑥 150 𝑥 2000002
Z= = Rs. 2,27,227/=
4 𝑥 .14/365

Upper Limit = Lower Limit + 3 Z = Rs. 5,00,000 + 3 x 2,27,227 =

Rs.11,81,681

Return Point = Lower Limit + Z = Rs. 5,00,000 + Rs. 2,27,227 =Rs.7,27,227

4
Average cash balance = Lower Limit + 4 / 3 Z = Rs. 5,00,00 +( x 2,27,227)
3
= Rs. 8,02,969
Thank you