Working Capital Management

WORKING CAPITAL

MANAGEMENT

Working capital

It refers to the funds, which a company must

possess to finance its day-to-day operations

-Ramamoorthy

Working capital refers to short-term funds to meet

operating expenses.

Kinds of Working Capital

Working capital may be classified on the basis of:

A. Concept :

1. Gross Working Capital (Quantitative concept)

2. Net working capital (Qualitative Concept)

B. Time base:

1. Permanent Working capital

2. Temporary or Variable working capital

Concepts of Working Capital

Gross working capital (GWC)

Net working capital (NWC).

Gross working capital (GWC)

GWC refers to total current assets

It is a Quantitative concept

GWC focuses on

1. Optimisation of investment in Current Assets:

Investment in current assets must be adequate to the needs of the firm-NOT inadequate or excessive

Inadequate - interruption in production, threaten solvency (if current obligations are not met)

Excessive Reduces firms profitability

2. Financing of current assets

Net working capital (NWC)

NWC refers to the difference between current assets and current liabilities

NWC focuses on 1. Liquidity position of the firm

NWC indicates or measures the liquidity position of the firm

To maintain liquidity position, current assets should be

sufficiently in excess of current liabilities (As buffer)

1. Judicious mix of short-term and long-term financing

NWC is the portion of current assets that should be financed by

long-term funds

This concept helps to decide the extent of long-term funds

required in finance current assets

Current Assets

Current assets are the assets which can be converted

into cash within an accounting year (or operating

cycle)

Include:

Cash

Short-term securities

Debtors (accounts receivable)

Bills receivable

Stock (inventory)

Prepaid expenses Characteristics of current assets:

(1) short life span and

(2) swift transformation into other asset forms.

Current Liabilities

Current liabilities (CL) are those claims of outsiders which are expected to mature for payment within an accounting year

Are liabilities that have to be paid within the accounting year or within a year

Include :

Creditors (accounts payable)

Bills payable

Outstanding expenses

Bank overdraft

Permanent or fixed working capital

A minimum level of current assets, which is

continuously required by a firm to carry on its business

operations.

Fluctuating or variable working capital

The extra working capital needed to support the

changing production and sales activities of the firm at

different times

Permanent and Fluctuating Working Capital

Working Capital

Time

Permanent

Working Capital

Temporary

Working Capital

Permanent and Fluctuating Working Capital (Stable Firm)

Working Capital

Time

Permanent WC

Temporary WC

Permanent and Fluctuating Working Capital (Growing Firm)

Determinants Of Working Capital

Level of Taxes and Dividend Policy

Growth & Expansion

Business Cycle

Inflation (Price level changes)

Operating efficiency

Availability of Suppliers credit

Conditions of Supply

Market Conditions and credit policy

Production Policy

Production cycle and technology

Seasonality of Operations

Nature and size of Business

Working capital management

Management of working capital refers to the

management of current assets and current

liabilities.

Major thrust is on the management of current

assets.

Significance of Working Capital Management

Time

A lot of time spent by finance managers on managing WC

Investment

Investment in current assets represents a substantial portion of total investment.

Criticality

o Significant for all firm but Critical for small firms

Growth

o Investment in current assets and the level of current liabilities have to be geared quickly to change in sales.

Need For Working Capital

The need for working capital arises due to

existence of operating cycle.

The longer the operating cycle, the more the

requirement for working capital

Operating Cycle

Operating cycle is the time duration required to

convert sales, after the conversion of resources into

inventories, into cash.

Operating cycle is the time that elapses between the

purchase of raw materials and the collection of cash for

sales

Operating Cycle

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-progress

into finished goods.

Sale of the product either for cash or on credit

resulting in increase in accounts receivable

RAW MATERIALS

WORK-IN-PROCESS

FINISHED GOODS

CREDIT SALES DEBTORS

CASH

Operating Cycle

CASH SALE

OPERATING CYCLE AND CASH CYCLE

Order

placed Stock

arrives Goods sold Cash

received Inventory

Conversion

Period (ICP)

Accounts

receivable

(Debtors

Conversion period

(DCP)) Accounts

payable period

Firm receives invoice Cash paid for materials

Operating Cycle

Cash Cycle

(Cash Conversion Cycle)

(CCC)

Operating Cycle

The length of the operating cycle of a manufacturing

firm is the sum of:

Inventory conversion period (ICP)

Is the time from the purchase of raw materials to the

sale of finished goods

Accounts Receivable period/ Debtors

(receivable) conversion period (DCP)

is the time required to collect the outstanding

amount from the customers.

Operating Cycle

Period conversion Debtors Period ConversionInventory

cycle Operating

COGS/365 Average

inventory Average (ICP) Period ConversionInventory

sales/365Credit Annual Average

Receivable Accounts Average (DCP) Period Conversion Debtors

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)

Inventory Conversion Period

FGCP WIPCP RMCP Period ConversionInventory

n/365Consumptio Material Raw ofCost Average

inventory Material Raw Average

(RMCP) Period Conversion Material Raw

/365Production ofCost Average

inventory Process-in- WorkAverage

(WICP) Period Conversion Process-in-Work

Sold/365 Goods ofCost Average

inventory Goods Finished Average

(FGCP) Period Conversion Goods Finished

Cash Cycle

Cash cycle is the difference between operating cycle

and accounts payable period.

Accounts payable period or Creditors (payables)

deferral period (CDP) is the length of time the firm is

able to defer payments on various resource purchases.

WC Qs.doc

OPERATING CYCLE AND CASH CYCLE

Period Deferral Creditors - Cycle Operating cycleCash

365Purchases/Credit Annual Average

Payable Accounts Average (CDP) Period Deferral Creditors

ISSUES IN WORKING CAPITAL POLICY

DETERMINATION OF LEVEL OF CURRENT ASSETS

i.e. What should be the level of investment in current assets?

CURRENT ASSETS FINANCING POLICY

i.e. What mix of long-term and short-term financing should the firm employ to support current assets?

LEVEL OF CURRENT ASSETS

The policy for level of current assets may be:

1. Conservative Policy (Flexible Policy)

2. Aggressive Policy (Restrictive Policy)


1. CONSERVATIVE POLICY (FLEXIBLE POLICY):

Means more liquidity and less risk of insolvency

Implies HIGHER investment in current assets- Huge balance of cash and marketable securities

High levels of inventory

High level of debtors (due to liberal credit to customers)

Consequences:

Results in fewer production stoppages,

ensures quicker deliveries to customers,

stimulates sales

BUT

Reduces return/profitability


2. AGGRESSIVE POLICY (RESTRICTIVE POLICY):

Means LESS liquidity and HIGHER risk of insolvency

Implies LOWER investment in current assets- Small balance of cash and marketable securities

Less inventories

Low level of debtors (due to stiff terms of credit to customers)

Consequences:

leads to more production stoppages

delayed deliveries to customers

lost sales

BUT

Higher return/profitability

LEVEL OF CURRENT ASSETS: RISK-RETURN TRADE-OFF

Theres a riskreturn tradeoff in holding current assets. INVESTMENT IN CURRENT ASSETS

LIQUIDITY

HIGH LOW

RISK OF

INSOLVENCY

RETURN/

PROFITABILITY

Conservative policy Aggressive policy

HIGH LOW

Conservative policy Aggressive policy HIGH LOW

Conservative policy Aggressive policy

WC Qs.doc

Cost trade-off

Determination of optimal level of current assets involves a

trade-off between Carrying Costs (cost of liquidity) and

Shortage Costs (cost of illiquidity).

Carrying costs include:

Cost of financing a higher level of current assets

Any losses from obsolescence of inventory or bad debts

Shortage costs include:

Losses due to stoppages in production

Loss of sales

Loss of customer goodwill

Cost Trade-off

Level of current assets

C

o

s

t

Optimum level of current assets

Minimum

cost

Total cost

Carrying

cost

Shortage cost

Working Capital Finance

Sources of financing working capital are:

1. Long-term

2. Short-term

3. Spontaneous

1. Long- Term Financing

Are funds available for more than 1 year

Examples:

Ordinary share capital

Preference share capital

Debentures

Long-term borrowings from financial institutions and

banks

Reserves and surplus (Retained Earnings)

2. Short- term Financing

Are funds available for short period of time usually less

than one year. It has to be arranged from banks and other

suppliers of short- term finance in the money market.

2. Short- term Financing

Short- Term Finances include:

Public Deposits

Intercorporate deposits

Commercial Paper

Factoring of Receivables

Working Capital funds from Banks includes:

Overdraft

Cash Credit

Purchase or Discounting of Bills

Letter of Credit

Working Capital Loan

3. Spontaneous Financing

It is finance obtained in normal course of business, without any formal negotiation.

It is an automatic sources of short- term funds which arises in the normal course of a business.

Examples:

Trade (suppliers) credit (including bills payable)

Outstanding expenses

No explicit cost of this financing

Short-term Vs. Long-term financing

1. Cost

2. Flexibility

3. Risk

Short-term funds less costly (less return)

more flexible

more risky.

Hence, a Risk-Return trade-off has to be achieved while deciding the financing mix.

Working Capital Finance Policies

These are the approaches to working capital

financing

There are three Working Capital Financing policies

(approaches) based on the mix of short term and

long term sources of financing Working Capital:

1. Conservative Policy

2. Aggressive Policy

3. Matching/Hedging Policy

1. Conservative Policy

This policy places more emphasis on the use of long-term sources to finance current assets as well as fixed assets.

Long term sources are used to finance

I. Fixed Assets

II. Permanent current assets

III.Part of the Variable current assets

This policy involves lower level of risk of shortage of funds as only a part of the variable current assets are financed through short-term sources

Financing Under Conservative Policy

Fixed Assets

Le

ve

l o

f A

ss

ets

Time

Short Term Financing

Long Term Financing

2. Aggressive Policy

This policy involves using more Short-term

sources of funds to finance assets.

Short term sources are used to finance:

I. Part of Permanent current assets

II. Temporary Current Assets

Long-term sources are used to finance:

I. Part of Permanent current assets

II. Fixed Assets

Fixed Assets

Le

ve

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ss

ets

Time


Long Term Financing

Financing Under Aggressive Policy

3. Matching Policy

This policy involves matching the life of the assets with

the maturity period of the source of finance i.e.

Fixed assets are financed by long term sources of finance

Current assets are financed by short term sources of finance.

Therefore Matching approach to financing working capital

involves:

Financing of Fixed assets and Permanent Current

Assets by long-term sources

Financing Variable Current Assets by short-term

sources.

Financing Under Matching Policy

Time

Le

ve

l o

f A

ss

ets

Fixed Assets

Long Term Financing


Estimation Of Working Capital Requirements

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

Documents

Working Capital Management