Working Capital Management

Working Capital Management
LEARNING OBJECTIVES
Explain the gross and net Discuss permanent and

Calculate working
concepts of working variable working capital
capital operating cycle of
capital and their and need for balanced
a firm with an example.
importance. working capital.
Describe the issues of

Explain the factors that a
liquidity versus Suggest a plan for
finance manager should
profitability and cost financing the working
consider as determinants
trade-off in managing capital of a firm.
of working capital.
working capital.
2
MANAGEMENT OF FIXED ASSETS AND
CURRENT ASSETS: DIFFERENCES
First, in managing fixed assets, time is a very important factor; consequently, discounting
and compounding techniques play a significant role in capital budgeting and a minor one
in the management of current assets.
Second, the large holding of current assets, reduces the overall profitability. Thus, a risk-
return trade-off is involved in holding current assets.
Third, levels of fixed as well as current assets depend upon expected sales, but it is only
the current assets which can be adjusted with sales fluctuations in the short run. Thus, the
firm has a greater degree of flexibility in managing current assets.
3
CONCEPTS OF WORKING CAPITAL
• Gross working capital (GWC)

GWC refers to the firm’s total investment in current assets.
Current assets are the assets which can be converted into cash within an
accounting year (or operating cycle) and include
cash,
short-term securities,
debtors, (accounts receivable or book debts)
bills receivable and stock (inventory).
4
Net working capital (NWC)

• NWC refers to the difference between current assets and current
liabilities.
• Current liabilities (CL) 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.
• NWC can be positive or negative.
• Positive NWC = CA > CL
• Negative NWC = CA < CL
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GWC focuses on
• Optimisation of investment in current

• Financing of current assets
NWC focuses on
• Liquidity position of the firm

• Judicious mix of short-term and long-tern financing
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OPERATING CYCLE
• Operating cycle is the time duration required to convert
sales, after the conversion of resources into inventories,
into cash. It has three phases in a manufacturing company:
• Acquisition of resources such as raw material, labour, power and
fuel etc.
• Manufacture of the product which includes conversion of raw
material into work-in-progress into finished goods.
• Sale of the product either for cash or on credit. Credit sales create
account receivable for collection.
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OPERATING CYCLE
• The length of the operating cycle of a manufacturing firm is the sum of:
• Inventory conversion period (ICP).

• Debtors (receivable) conversion period (DCP).
Operating cycle of a manufacturing firm

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GROSS OPERATING CYCLE (GOC)
• The firm’s gross operating cycle (GOC) can be determined as inventory

conversion period (ICP) plus debtors' conversion period (DCP). Thus,
GOC is given as follows:
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INVENTORY CONVERSION PERIOD
• Inventory conversion period is the total time needed for producing and
selling the product. Typically, it includes:
• raw material conversion period (RMCP)

• work-in-process conversion period (WIPCP)
• finished goods conversion period (FGCP)
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RECEIVABLES (DEBTORS) CONVERSION PERIOD
(DCP)
• Debtors’ conversion period (DCP) is the average time taken to convert
debtors into cash.
• DCP represents the average collection period. It is calculated as follows:
11
PAYABLES (CREDITORS) DEFERRAL PERIOD (CDP)
• Creditors(payables) deferral period (CDP) is the average time taken by the firm in
paying its suppliers (creditors).
• CDP is given as follows:
12
CASH CONVERSION OR NET OPERATING CYCLE
• Net operating cycle (NOC) is the difference between gross

operating cycle and payables deferral period.
• Net operating cycle is also referred to as cash conversion

cycle.
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Permanent A minimum level of current assets, which is
or fixed continuously required by a firm to carry on
working its business operations, is referred to as
capital permanent or fixed working capital.
PERMANENT
AND
VARIABLE
WORKING
CAPITAL Fluctuating The extra working capital needed to support
or variable the changing production and sales activities
working of the firm is referred to as fluctuating or
capital variable working capital.
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Permanent and temporary working capital
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Nature of business
Market and demand
DETERMINAN Technology and manufacturing policy
TS OF Credit policy
WORKING
CAPITAL Supplies’ credit
Operating efficiency
Inflation
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ISSUES IN WORKING CAPITAL
MANAGEMENT
• Current Assets to Fixed Assets Ratio
• Liquidity vs. Profitability: Risk–Return Trade-off
Alternative current asset policies

17
Liquidity vs.
Profitability:
Risk–Return
Trade-off
WORKING CAPITAL FINANCE
Long-term: The sources of long-term financing include ordinary share capital, preference share
capital, debentures, long-term borrowings from financial institutions and reserves and surplus
(retained earnings).
Short-term: The short-term financing is obtained for a period less than one year. It is arranged in
advance from banks and other suppliers of short-term finance in the money market. Short-term
finances include working capital funds from banks, public deposits, commercial paper, factoring of
receivables, etc.
Spontaneous: Spontaneous financing refers to the automatic sources of short-term funds arising in
the normal course of a business. Trade (suppliers’) credit and outstanding expenses are examples of
spontaneous financing. There is no explicit cost of spontaneous financing.
19
WORKING CAPITAL FINANCE POLICIES
Matching Conservative Aggressive
20

Working Capital Management

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Working Capital Management

Explain the gross and net Discuss permanent and

Describe the issues of

• Gross working capital (GWC)

Net working capital (NWC)

• Optimisation of investment in current

• Liquidity position of the firm

• Inventory conversion period (ICP).

Operating cycle of a manufacturing firm

• The firm’s gross operating cycle (GOC) can be determined as inventory

• raw material conversion period (RMCP)

• DCP represents the average collection period. It is calculated as follows:

• CDP is given as follows:

• Net operating cycle (NOC) is the difference between gross

• Net operating cycle is also referred to as cash conversion

Market and demand

DETERMINAN Technology and manufacturing policy

Alternative current asset policies

Matching Conservative Aggressive

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