Overview of Working Capital Management (WCM):

Definition and concept

WCM Accounts
Importance of WC
Classification of WC
Operating cycle and cash conversion cycle
Factors determining WC needs
Estimation of WC requirement
WCM Policy and Risk return trade off
 Working Capital Definition and Concepts
Working Capital refers to the firm’s investment in current assets such a
cash, marketable securities, debtors and inventories. Funds thus,
invested in current assets keep revolving fast and are constantly
converted into cash.

Net Working Capital

Current Assets - Current Liabilities.
Gross Working Capital
The firm’s investment in current assets.
Working Capital Management
The management of the firm’s current assets and the financing needed
to support current assets.
Working Capital Accounts from a Typical
Firm’s Balance Sheet
 Significance of Working Capital Management

• To deal with uncertainty

Labor and
regarding the future cash
Used in Used in
material flows.
production • To purchase of raw materials
process and Used to purchase Fixed Op.
generates Exp and spares.
WC • For payment of wages and
Inventory
Cycle Used to purchase salary
Cash & Mkt Sec •
via sales To meet day-to-day expenses
• To strike a balance between
Returns Used to
liquidity, profitability and risk
Account Collection to capitalpurchaseFixed
Receivables Asset • Excessive levels can result in a
Ext. fin
substandard Return on
Supplier of Investment (ROI).
capital
• Working capital management
affects the company’s risk,
return, and share price.
 Classifications of CA
 Components
 Cash, marketable securities,
receivables, and inventory

• Time
– Permanent Current Assets
– Temporary Short Time Investment or
Marketable Securities
Permanent CA Temporary CA

• The amount of current • The amount of current

assets required to meet a assets that varies with
firm’s long-term minimum seasonal requirements.
needs.
 Cash Conversion Cycle(CCC)/net OC/cash
operating cycle

Operating cycle (OC)/WC cycle is the summation of :

Inventory conversion period and receivables collection period.
Example: XYZ Industries has average inventory turnover period of 70 days, an
average collection period (ACP) of 45 days and average payable period of 40
days. What is the company’s OC and CCC?
 Factors Determining Working Capital
Management
• Nature of business
• Production cycle
• Business cycle
• Production policy
• Credit policy
• Growth and expansion
• Availability of raw material
• Earning capacity
 Estimation of Working Capital Requirement
Individual Component Method: Amount of these CA and CL are not directly given, these are to be calculated using
the following formula:

From the following information calculate the working capital:

Annual production 15,600 units
Costs per unit (in Tk.):
RM5
DL 4
O/H 2
*WIP and FG costs involves all these three costs i.e. Tk. 11 that is Total cost
Time:
RM3 weeks
(WIP)Processing period 4 weeks
FG 5 weeks
Credit allowed by creditors 3weeks
Credit allowed to debtors 4 weeks
Lag in payment of wages 2 weeks
Lag in payments of O/H 2 weeks

Calculate the working capital requirement

Estimation of Working Capital Requirement

Operating Cycle Method

ABC company expects its cost of good sold for 2018 is Tk. 136 crores. The operating
cycle for the planned year is expected to be 54 days. The company wants to
maintain a desired cash balance of Tk. 1.5 crores to meet the contingencies. What is
the expected working capital requirement for the year 2019 (assume 365 days in a
year)
Pro-forma Working Capital Estimates for Trading Concern

STATEMENTOF
STATEMENT OFWORKING
WORKINGCAPITAL
CAPITALREQUIREMENTS
REQUIREMENTS
Amount(Rs.)
Amount (Rs.)
CurrentAssets
Current Assets
(i)Cash
(i) Cash ----
----
(ii)Receivables
(ii) Receivables((For…..Month’s
For…..Month’sSales)----
Sales)---- ----
----
(iii)Stocks
(iii) Stocks((For……Month’s
For……Month’sSales)-----
Sales)----- ----
----
(iv)AdvancePayments
(iv)Advance Paymentsififany
any ----
----
Less::Current
Less CurrentLiabilities
Liabilities
(i)Creditors
(i) Creditors(For…..
(For…..Month’s
Month’sPurchases)-
Purchases)- ----
----
(ii)Lag
(ii) Lagininpayment
paymentofofexpenses
expenses -----_
-----_
WORKINGCAPITAL
WORKING CAPITAL((CA CA––CL
CL)) xxx
xxx
Add::Provision
Add Provision //Margin
Marginfor forContingencies
Contingencies -----
-----

NETWORKING
NET WORKINGCAPITAL
CAPITALREQUIRED
REQUIRED XXX
XXX
 Pro-forma Working Capital Estimates for Manufacturing Co
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
Example of Estimation of WC Requirement
 Working Capital Management Policy Issues and Risk Return Trade-
off and the impact of these policies on liquidity, profitability and risk

Policy issues from 2 dimensions:

A. Investment Decisions
B. Financing Decisions

A. Investment Decisions:
1. Conservative Working Capital Policy (Policy C).
2. Moderate Working Capital Policy (Policy M).
3. Aggressive Working Capital Policy (Policy A).

Risk proxy ratio measured by CA/TA (relative asset liquidity)

 Optimal Amount (Level) of Current Assets

Assumptions
• 50,000 maximum units Policy C
of production

ASSET LEVEL ($)

Policy M
• Continuous production
Policy A
• Three different
policies for current
Current Assets
asset levels are
possible

0 25,000 50,000
OUTPUT (units)
 Impact on Liquidity
Optimal Amount (Level) of Current Assets

Liquidity Analysis
Policy Liquidity Policy C

ASSET LEVEL ($)

C High Policy M

M Moderate Policy A
A Low
Greater current asset Current Assets
levels generate more
liquidity; all other factors
held constant. 0 25,000 50,000
OUTPUT (units)
 Impact on
Expected Profitability
Optimal Amount (Level) of Current Assets
Return on Investment =
Net Profit Policy C

ASSET LEVEL ($)

Total Assets Policy M
Let Current Assets = (Cash + Policy A
Rec. + Inv.)

Return on Investment = Current Assets

Net Profit
Current + Fixed Assets
0 25,000 50,000
OUTPUT (units)
 Impact on
Expected Profitability
Optimal Amount (Level) of Current Assets

Profitability Analysis
Policy Profitability Policy C

ASSET LEVEL ($)

A High Policy M

M Moderate Policy A
C Low
As current asset levels Current Assets
decline, total assets will
decline and the ROI will rise.
0 25,000 50,000
OUTPUT (units)
 Impact on Risk
Optimal Amount (Level) of Current Assets
• Decreasing cash reduces the
firm’s ability to meet its Policy C
financial obligations. More

ASSET LEVEL ($)

risk! Policy M
• Stricter credit policies reduce Policy A
receivables and possibly lose
sales and customers. More
risk! Current Assets
• Lower inventory levels
increase stockouts and lost
sales. More risk!
0 25,000 50,000
OUTPUT (units)
 Impact on Risk
Optimal Amount (Level) of Current Assets

Risk Analysis
Policy Risk Policy C

ASSET LEVEL ($)

A High Policy M

M Moderate Policy A
C Low
Current Assets
Risk increases as the level of
current assets are reduced.

0 25,000 50,000
OUTPUT (units)
 Summary of the Optimal
Amount of Current Assets
SUMMARY OF OPTIMAL CURRENT ASSET ANALYSIS
Policy Liquidity Profitability Risk
C High Low Low
M Moderate Moderate Moderate
A Low High High

1. Profitability varies inversely with liquidity.

2. Profitability moves together with risk.
(risk and return go hand in hand!)
 B. Financing Decisions of
Current Assets and risk return trade
off

Hedging approach
Conservative approach
Aggressive approach
Risk proxy ratio measured by CL/TF
(relative financing liquidity)
 Hedging (or Maturity Matching) Approach

long-term finance shall be used to finance fixed assets and permanent current
assets and short-term financing to finance temporary or variable assets.

Short-term financing**
DOLLAR AMOUNT

Current assets*

Long-term financing
Fixed assets

TIME
 Conservative Approach
Under this approach, the entire estimated finance in current assets should be financed from long-term sources and the short-term sources should be used only for
emergency requirements. This approach is called as “Low Profit – Low Risk” concept.

Firm can reduce risks associated with short-term borrowing by using a

larger proportion of long-term financing.
Short-term Investment
DOLLAR AMOUNT

Short Term Financing

Current assets

Long-term financing
Fixed assets

TIME
 Aggressive Approach
Under this approach, the entire estimated requirement of current assets should be
financed from short-term sources and even a part of fixed assets financing be financed
from short- term sources. This approach makes the finance mix more risky, less costly and
more profitable.

Firm increases risks associated with short-term borrowing by using a larger

proportion of short-term financing.

Short-term financing
DOLLAR AMOUNT

Current assets

Long-term financing
Fixed assets

TIME
 Interaction of Investment (CA/TA)
and Financing Decisions (CL/TF)

Financing
Maturity
SHORT-TERM LONG-TERM
Asset
Maturity

SHORT-TERM Moderate Low

(Temporary) Risk-Profitability Risk-Profitability
(Conservative)

High
LONG-TERM Moderate
Risk-Profitability
(Permanent) Risk-Profitability
(Aggressive)
(Moderate)
 Disadvantages of Redundant or Excess Working Capital

Idle funds, non-profitable for business, poor ROI.

Unnecessary purchasing & accumulation of inventories over required.
Excessive debtors and defective credit policy, higher incidence of bad debt.
Credit worthiness suffers.
Due to low rate of return on investments, the market value of shares may fall.
Disadvantages or Dangers of Inadequate or Shortage of Working Capital

Inability to pay off its short-term liabilities on time.

 Difficult for the firm to exploit favorable market situations.
Day-to-day liquidity worsens.
Improper utilization the fixed assets and ROA/ROI falls sharply.
 Ratios associated with WCM
Stock Turnover Ratio COGS
(Times) AVERAGE STOCK
Stock Turnover Ratio (Days) Average Stock x 365
COGS
Receivables Turnover Ratio Net Credit Sales
(Times) Average Accounts
Receivable
Average Receivables Period Avg A/C Receivable x 365
(Days) Net Credit Sales
Payables Turnover Ratio Net Credit Purchases
(Times) Average Accounts payables

Average Payables Period Avg A/C payable x 365

(Days) Net Credit purchase
Current Ratio Current Assets
Current Liabilities
Quick Ratio CA – Stock of inventory
Current Liabilities
Working Capital Turnover Net Sales
Ratio Net Working Capital