Working Capital

Management
Learning Outcome
• Assess the importance of working capital in the finance decisions.
• To recall the basic concept of working capital and their importance in
business
MEANING OF WORKING CAPITAL
• Working capital, alternatively referred to as current or circulating
capital, is the investment made by firms in their current assets.
• Current assets comprise all assets that the firm expects to convert
into cash within the year. This includes
• Cash and bank balance (already in cash form),
• Marketable securities,
• Accounts receivable, and
• Inventories.
Importance of Working Capital
Management
• Working capital decisions affect the firm’s profits through their impact
on sales, operating costs, and interest expense.
• They affect the firm’s risk through their impact on the variability of
the firm’s cash flows, the probability of not receiving the cash flow,
and the ability to generate cash in a crisis.
• Working capital integrates Purchasing – Production – Marketing
functions.
• The adequacy of working capital would enable smoother functioning
of the three functions.
Importance……….contd.
• The level and quality of current assets held by the firm determine its
solvency.
• The higher the level of current assets, the higher would be the
capacity to transform these current assets and generate cash.
• Quality of current assets also affects the liquidity position of the
business.
Types of Working Capital
Concept based:
• Gross Working Capital
• Net Working Capital

Time based
Permanent and Temporary Working Capital
GROSS AND NET WORKING
CAPITAL
• Gross working capital (GWC) is defined as investment in current
assets.
• Net working capital (NWC) is defined as excess of current assets over
current liabilities.
• Both concepts (GWC and NWC) are equally important in the
management of working capital, as both are related.
• One is a measure of the level of current assets while the other
measures the extent to which long‐term sources of financing have
been used to finance current assets.
GROSS WORKING CAPITAL
• Gross working capital (GWC) refers to the total investment made by a
firm in current assets.
• It denotes the liquidity position of the firm.
• Other factors remaining the same, the higher the GWC of a firm, the
better its liquidity position.
• Increasing GWC affects profitability adversely as more funds get tied
up in current assets that have low/zero yield.
NET WORKING CAPITAL
• Net Working capital (NWC) refers to the difference between current
assets and current liabilities (CA – CL).
• This differential denotes that part of current assets which is financed
by long‐term sources of financing.
• An increasing NWC indicates an improving liquidity position of the
firm.
Determinants of Working
Capital
1. Nature of business
2. Business Cycle Fluctuations: boom, recession, recovery
3. Market Competitiveness
4. Technology and manufacturing policy(Mfg. Operating Cycle)
5. Credit policy(Credit Standard & Terms)
6. Supply Conditions
7. Seasonal Operations
Profitability-Liquidity Trade Off
• There exists a trade-off between profitability and liquidity on a trade-
off between risk(liquidity) and return(profitability).
• The risk in this context is measured by probability that the firm will
become technically insolvent(illiquid) by not paying current liabilities
as they occur.
• Profitability here means the reduction of cost of maintain current
assets.
Assumptions
• Current assets are less profitable than long term assets.
• Short term funds are cheaper than long term funds.
• The firm has fixed level of funds inclusive of long term and short term
funds
• The firm has fixed level of total assets inclusive of current assets and
fixed assets.
 WORKING CAPITAL POLICY

Two important issues in working capital policy are:

• What should be the level of investment in current

assets?

• What mix of long-term and short-term financing should

the firm employ to support current assets?

Financing Policy
Matching Approach
Conservative Approach
Aggressive Approach
Working Capital Policy
 Current Assets Cycle

Finished
goods

Accounts Work-in-
receivable process
Wages, salaries,
factory overheads
Raw materials

Cash Suppliers
 Operating Cycle
• Realization of cash ( Trading firm vs Manufacturing firm)
• The operating cycle of a manufacturing company involves three
phases:
• 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-process into finished goods.
• Sale of the product either for cash or on credit. Credit sales
create account receivable for collection.

Operating cycle is the time duration required to convert sales into

cash, after the conversion of resources into inventories.

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 OPERATING CYCLE AND CASH CYCLE
Order placed Stock arrives Goods sold Cash received

Inventory period Accounts

receivable period

Accounts
payable period

Firm receives Cash paid for

invoice materials
Operating cycle

Cash cycle
Average inventory
Inventory period =
Average COGS / 360
Average accounts receivable
Accounts receivable period =
Annual sales / 360
Average accounts payable
Average payable period =
Average raw material / 360
IBM Operating Cycle-Cash
Conversion Cycle
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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• Raw material conversion period (RMCP) = Average Raw Material Stock
-------------------------------
Total Raw Material consumption/360

• Work-in-process conversion period (WIPCP) = Avg Work-in-progress

-------------------------------
Total cost of production/360

• Finished goods conversion period (FGCP) = Avg Finished Goods

-------------------------------
Total cost of goods sold/360

• Assuming 360 days in a year

Debtors (receivables) 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:

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Creditors (payables) 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:

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 CASH REQUIREMENT FOR
WORKING CAPITAL

Step 1 : Estimate the cash cost of various current assets

required by the firm.

Step 2 : Deduct the spontaneous current liabilities from

the cash cost of current assets

Example
• Find the Gross Operating Cycle and Net Operating Cycle
• Cost of Goods Sold = Rs 800,000
• Cost of Production = Rs 500,000
• Raw Material consumed during year = Rs 600,000
• Average Finished Goods = Rs 40,000
• Avg Work-in-process = Rs 30,000
• Avg Raw material = Rs 50,000
• Avg Debtors = Rs 20000
• Avg Creditors = Rs 50,000
• Annual Sales(on credit) = Rs 160,000
Example

In Rs. Cost per unit

Raw Material 60
Direct labour 25% of raw material
Overheads 40% of Direct labour

Profit 20

Additional information Avg Raw material in stock = 1 month

Avg W-I-P = 1 month,
Finished Goods remain in warehouse = 2 months
Credit allowed to debtors = 1.5 months (25% of sales on cash basis)
Credit allowed by suppliers = 2 month
Avg time lag in payment of wages = 10 days
Avg time lag in payment of overheads = 30 days
Minimum Cash balance to be maintained = Rs 80,000
Calculate Working Capital required
for 60,000 units of annual output
Example
In Rs. Cost per unit
Raw Material 50
Direct labour 20
Overheads 30
Total Cost 100
Profits 20
Selling Price 120
Additional information Avg Raw material in stock = 1 month
Avg W-I-P = 1/2 month, Credit allowed by suppliers = 1 month
Credit allowed to debtors = 1 month
Minimum Cash balance to be maintained = Rs 100,000
Finished Goods remain in warehouse = 1 month
Avg time lag in payment of wages = 10 days
Avg time lag in payment of overheads = 30 days
25% of sales on cash basis

Calculate Working Capital required

for 54000 units of annual output