Principles of WC

8/11/2019 Principles of WC

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Principles of WorkingCapital Management


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Topics

Concept of working capital

Operating and cash conversion cycle

Permanent and variable working capital

Balanced working capital

Determinants of working capital

Issues in working capital management

Estimating working capital

Policies of working capital finance

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Concepts of Working Capital

Gross working capital (GWC)

GWC refers to the firms total investment in

current assets.

Current assetsare the assets which can be

converted into cash within an accounting year

(or operating cycle) and include cash, short-

term securities, debtors, (accounts receivableor book debts) bills receivable and stock

(inventory).

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Net working capital (NWC).

NWCrefers to the difference betweencurrent assets and current liabilities.

Current liabilities (CL) are those claims ofoutsiders which are expected to mature forpayment within an accounting year andinclude 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

Optimization of investment in current assets

Financing of currentassets NWC focuses on

Liquidity position of the firm

Judicious mix of short-term and long-ternfinancing

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Operating Cycle

Operating cycle is the time durationrequired to convert sales, after the

conversion of resources into inventories,

into cash. The operating cycle of a

manufacturing company involves three

phases: Acquisition of resourcessuch 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 producteither 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).

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Operating Cycle

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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Operating Cycle

The debtors conversion period is the time

required to collect the outstanding amount

from the customers.

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Operating Cycle

Gross operating cycle (GOC)

The total of inventory conversion period and debtors

conversion period is referred to as gross operating cycle

(GOC). Net operating cycle(NOC)

NOC is the difference between GOC and CDP.

Cash conversion cycle (CCC)CCC is the difference between NOP and non-cash items like

depreciation.

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Operating Cycle


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RMCP= RMI * 360 / RMC

WIPCP= WIPI * 360 / COP

FGCP= FGI * 360 / COGS DCP= Debtors * 360 / Credit Sales

CDP= Creditors * 360 / Credit Purchases

GOC = RMCP + WIPCP + FGCP + DCP

NOC = GOC - CDP

Formulas for Gross and Net

Operating Cycle


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Permanent & Variable WC

Permanentor

fixed working capitalA minimum level of current assets, which iscontinuously required by a firm to carry onits business operations, is referred to as

permanent or fixed working capital. Fluctuatingor variable working capital

The extra working capital needed tosupport the changing production and sales

activities of the firm is referred to asfluctuating or variable working capital.

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Permanent & Variable WC

Temporary

A

mo

u

nt

of

W

C

Time

Permanent

TemporaryA

m

ou

nt

of

W

C

Time

Permanent


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Determinants of Working Capital

Nature of business

Market and demand

Technology and manufacturing policy Credit policy

Supplies credit

Operating efficiency Inflation

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Issues in Working Capital

Management

Levels of current assets

Current assets to fixed assets

Liquidity Vs. profitability

Cost trade-off

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Current assets to fixed assets

Output

L

e

v

el

o

f

C

A

Conservative policy

Average policy

Aggressive

policy

Fixed asset level

A

B

C


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Cost trade-off

Optimum Level of CA Level of CA

C

o

s

t

Minimum Cost

Total Cost

Cost of

Liquidity

Cost of

illiquidity


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Estimating Working capital Current assets holding period

To estimate working capital requirements on the basis ofaverage holding period of current assets and relating themto costs based on the companys experience in theprevious years. This method is essentially based on the

operating cycle concept. Ratio of sales

To estimate working capital requirements as a ratio ofsales on the assumption that current assets change withsales.

Ratio of fixed investment

To estimate working capital requirements as a percentageof fixed investment.

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Current Assets

RMCP * (RMC / 360) = RMI

WIPCP * (COP /360) = WIPI

FGCP * (COGS / 360) = FGI

DCP * (Credit Sales cost / 360) = Debtors Current Liabilities

CDP * (Purchase of raw Material / 360)= Creditors

(Wages /360) * Time lag in payment= Differed Wages

(Overheads / 360) * Time lag in payment = Overheads

NWC = Current assetsCurrent Liabilities

Estimating Working capital


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Working Capital Finance Policies

Long-term

Short-term

Spontaneous

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Short-term Vs.

Long-term

financing

Cost Flexibility

Risk


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Working Capital Finance Policies

Matching

Conservative

Aggressive

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"Hard Work is like a cup of milk. Luck is like a

spoon of sugar. God always gives sugar tothose who have a cup of milk."

Documents

Principles of WC