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Working Capital Management:


An Overview
Overview of Working Capital Management
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After Plant & Machinery has been installed and the manufacturing
facility is put in place, the firm would require investment in Short-term
assets.
Firms would be required to maintain stocks of raw material/finished
goods leading to Inventories and /or sell finished products on credit
leading to Receivables (or Debtors).
Investments in such short-term assets is called Working Capital.
Working Capital Management: An Overview
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Overview of Working Capital Management
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Those assets that are either in the form of cash or are expected to be
converted into cash in the short term (usually defined as less than one
year).
Cash: most liquid asset
Short Term Investments (Marketable securities) such as
Government bonds, generally can be converted into cash quickly, at
low cost and with minimum loss of value
Inventory of Raw Materials, work-in-progress or Finished goods
Receivables (Debtors): When a firm sells goods on credit, it creates
receivables. On realization , they are converted into cash
Current Assets
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Those liabilities that are expected to be paid within a year.
Non-interest bearing Current Liabilities
Payables ( Creditors): when a firm buys goods on credit, it
creates accounts payables
Accrued expenses: Firms accrue wages & salaries to their
employees or taxes to government
Provisions for Dividends/Taxes etc.
Interest bearing Current Liabilities
Current portion of long-term debt (Interest & Principal)
Short-term debt
Current Liabilities
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Overview of Working Capital Management
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Current Liabilities
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Gross Working Capital is the aggregate investment in Current Assets.
Trade-off between excessive and inadequate Current Assets;
Financing of Current Assets.
Net Working Capital is the difference between the Current Assets and
Current Liabilities of a firm.
Indicates the liquidity position of a firm and indicates the extent to
which working capital requirements may be financed by long-term
sources.
Current Assets should be sufficiently in excess of the current
liabilities and form a buffer for maturing obligations within a
operating cycle.
Negative NWC (CL > CA) indicates negative liquidity, may prove
harmful to the firm.
Excessive liquidity (high +ve NWC) is also not good.
Gross & Net Working Capital
Raw
Material
Work-in-
Progress
Finished
Goods
Debtors
Cash
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Purchase Convert
Sale of
Goods
Realise
Operating Cycle
Why do we need Working Capital?
Convert
Current Assets are required as Sales do not convert into cash instantaneously.
Operating Cycle time duration required to convert cash into R/M, then into
finished goods and finally into cash.
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Overview of Working Capital Management
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Operating Cycle
Purchase of Raw
Material on Credit
Collection of
Receivables
Payment for
Credit Purchases
Credit Sales
Gross Operating Cycle
Inventory Conversion Period
Receivables Conversion Period
Payable Deferral Period Net Operating Cycle
D A C B
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Operating Cycle
Gross
Operating
Cycle
Inventory
Conversion
Period
Receivables
Conversion
Period
=
+
Inventory
Conversion
Period
Raw Material
Conversion
Period
WIP
Conversion
Period
Finished
Goods
Conversion
Period
=
+
+
Net
Operating
Cycle
(Cash Conversion
Cycle)
Gross
Operating
Cycle
Payable
Deferral
Period
=
-
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Overview of Working Capital Management
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Operating Cycle
Raw Material
Conversion
Period
=
Average time taken to convert
Raw Material into Work-in-
Progress
RMCP depends upon:
Average Raw Material Inventory , and
Raw Material consumed per day
=
Average Raw Material Inventory (Op.RM + Cl. RM)/2
RMCP=
Raw Material consumed per day Raw Material consumed /360
Rs. 200/-
RMCP= = 10 days
Rs. 20/- per day
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Operating Cycle
(Op.WIP + Cl. WIP)/2
WIPCP =
Cost of Production /360
(Op.FG + Cl. FG)/2
FGCP =
Cost of Goods Sold /360
(Op.Rec. + Cl. Rec)/2
RCP =
Credit Sales /360
(Op.Payables + Cl. Payables)/2
PDP =
Credit Purchases /360
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Overview of Working Capital Management
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Working Capital Cycle estimation
1 Raw Material Purchased 5,000
2 Opening Inventory of R/M 500
3 Closing Inventory of R/M 900
4 Raw Material Consumed (1+2-3) 4,600
5 Direct Labour 450
6 Depreciation 100
7 Other Manufacturing Expenses 600
8 Total Cost (4+5+6+7) 5,750
9 Opening Inventory of WIP 185
10 Closing Inventory of WIP 325
11 Cost of Production (8+9-10) 5,610
12 Opening Inventory of FG 320
13 Closing Inventory of FG 525
14 Cost of Goods Sold (11+12-13) 5,405
15 Selling, Administrative & General Expenses 300
16 Cost of Sales (14+15) 5,705
17 Credit Sales 6,100
18 Receivables (Average) 750
19 Payables (Average) 450
Overview of Working Capital Management
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Working Capital Cycle estimation
A Raw Material Conversion Period (RWCP)
1 Raw Material Consumption 4,600
2 Raw Material Consumed per day 12.78
3 Average Inventory of RM 700
4 RMCP (Days) A3/A2 55
B WIP Conversion Period (WIPCP)
1 Cost of Production 5,610
2 COP per day 15.58
3 Average Inventory of WIP 255
4 WIPCP (Days) B3/B2 16
C FG Conversion Period (FGCP)
1 Cost of Goods Sold 5,405
2 COGS per day 15.01
3 Average Inventory of FGs 423
4 FGCP (Days) C3/C2 28
D Receivables Conversion Period (RCP)
1 Credit Sales 6,100
2 Credit Sales per day 16.94
3 Average Receivables 750
4 RCP (Days) D3/D2 44
E Payables Deferral Period (PDP)
1 Credit Purchases 5,000
2 Credit Purchases per day 13.89
3 Average Payables 450
4 PDP (Days) E3/E2 32
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Overview of Working Capital Management
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Working Capital Cycle estimation
Working Capital Cycle
1 Inventory Conversion Period:
- RMCP 55
- WIPCP 16
- FGCP 28
2 Receivables Conversion Period 44
3 Gross Working Capital Cycle 144
4 Less: Payables Deferral Period 32
5 Net Working Capital Cycle 111
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Excess Working Capital:
Accumulation of Inventory
Issues with Credit Policy & Slack collection efforts
Idle cash
Complacent management
Inadequate Working Capital:
Hampered Sales & hence loss of profit
Operating difficulties due to inability to meet day-to-day expenses
Inefficient utilization of Fixed assets
Loss of reputation
Excessive vs. Inadequate Working Capital
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Overview of Working Capital Management
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As Operating Cycle is a continuous process, hence Current Assets are
required continuously but the quantum of Current Assets required may
not remain constant throughout and may vary over time.
Some part of the Working Capital is required continuously, which is
called FIXED Working Capitalrepresents the MINIMUM level of
Current Assets.
Depending upon changes in production & sales, the need for Working
Capital over and above the Fixed Working Capital may fluctuate.
Additional working capital required to support the changing production
& sales level is called VARIABLE or TEMPORARY Woking Capital.
Fixed & Variable Working Capital
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Fixed & Variable Working Capital (Contd.)
Time
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o
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W
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C
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Variable Working Capital
Fixed Working Capital
A
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Time
Fixed Working Capital
Variable Working Capital
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Short term vs. Long term funds
Short-term funds are less costly and more flexible but at the
same time more Risky.
Hence, a Risk-Return trade-off has to be achieved while
deciding the financing mix.
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Approaches to Working Capital Financing
Based on the mix of Short Term(Spontaneous Sources/Current
Liabilities) and Long term sources of financing working Capital, and
the Fixed & Variable Current Assets, there are three approaches to
Working Capital Financing.
Matching Approach
Conservative Approach
Aggressive Approach
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Overview of Working Capital Management
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Matching Approach
Expected life of an asset should
match the tenure of the financing
source.
Fixed Current Assets should be
financed by long-term sources
while the Variable Current Assets
should be financed by short-term
sources.
Variable Working Capital
Fixed Working Capital
A
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f

W
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C
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Time
Long Term
Sources
Short Term
Sources
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Under this approach, more
reliance is on long-term
sources
Long term sources are used
to finance Fixed Assets +
Fixed Current Assets + Part of
the Variable Current Assets.
Lower level of risk of
shortage of funds.
Conservative Approach
Long Term
Sources
Variable Current
Assets
Fixed Assets
A
m
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o
f

W
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C
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Time
Short Term
Sources
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Overview of Working Capital Management
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Aggressive Approach
Under this approach, more
reliance is on Short-term sources
of funds to finance assets.
Part of Fixed Current Assets +
Temporary Current Assets are
financed by short-term sources.
Variable
Current Assets
Fixed Assets
A
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W
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C
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Time
Short Term
Sources
Long Term
Sources
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Impact of Short term vs. Long term Financing
Conservative Moderate Aggressive
Fixed Assets 60.00 60.00 60.00
Current Assets 40.00 40.00 40.00
Equity 40.00 40.00 40.00
Long Term Debt 48.00 30.00 0.00
Short Term Debt 12.00 30.00 60.00
EBIT 20.00 20.00 20.00
Interest - LT Debt @ 15% 7.20 4.50 0.00
Interest - ST Debt @ 10% 1.20 3.00 6.00
EBT 11.60 12.50 14.00
Taxes @ 35% 4.06 4.38 4.90
PAT 7.54 8.13 9.10
PAT/Equity 18.9% 20.3% 22.8%
STF/TF 12% 30% 60%
Higher
returns, but
Higher risk as
well
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Determinants of Working Capital
Large number of factors influence the working capital requirements. Each
factor has different importance which varies over time as well.
1. Nature & Size of Business: As compared with Total assets, Trading
companies require large investment in working capital (than
investment in Fixed Assets), while Utility companies such as Power
Generation Company, require low levels of working capital and huge
investments in Fixed Assets.
Size (Scale of operations) - Large company would require more
working capital.
2. Manufacturing Cycle: Longer the Manufacturing cycle, larger will be
requirement of working capital.
3. Sales Growth: As sales grow, more working capital would be
required, though a definite relationship is difficult to determine.
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4. Demand Conditions:
For seasonal products, as demand varies, so does the working
capital varies.
During Boom periods, as demand picks up, not only the variable,
but the fixed working capital requirements also goes up.
5. Production Policy: Constant Production Policy would lead to
accumulation of inventory in off-season.
Cost of maintaining inventory
Risks- damage; no- off take.
To minimize - firm may choose to vary its production schedules.
6. Price Level Changes: Increase in prices, calls for higher investment in
working capital. Though, the impact of increase in general prices may
be different on different companies.
Determinants of Working Capital
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Overview of Working Capital Management
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7. Operating Efficiency: A firm should make optimum utilisation of its
resources at minimum costs. Efficient utilisations of various factors of
production, helps in reducing the overall quantumof working capital.
8. Credit Policy: Liberal Credit Policy means high debtors, high
collection period, and high bad debts - hence more working capital
would be required. Therefore, company should follow a rational credit
policy evaluate the credit worthiness of customers and review them.
9. Availability of Credit fromSuppliers: If a firm gets liberal credit from
its suppliers, the requirements of working capital would be less.
Suppliers credit finances the firms inventory and reduces the WC
finance.
Determinants of Working Capital