Working Capital Management

Constituents of CL Constituents of CA
Creditors, B/P Cash, Bank
Trade advances Debtors, Inventory [RM,WIP,FG]
Short term borrowings Loans & advances
Provisions Gross WC = CA
Net WC = CA - CL
Features: (a) Short life span (b) Swift transformation to other form
Hence, implications: WC decisions are repetitive & frequent
No difference between profit or PV concept
Close interaction among components
Factors influencing WC requirements: Nature of business, Seasonality
Production policy, market conditions, conditions of supply, operating
efficiency, inflation

Permanent or fixed working capital:A minimum level of current assets required at

any point of time so that business operations are not interrupted.

Fluctuating or variable working capital: Additional WC to take care of additional or

increased production and sales activities of the firm.
 What is WC management?
It means: decisions relating to:
(a) The level of each current asset.
(b) How current assets are financed.

Operating Cycle [OC] & Cash Cycle [CC]

OC = Inventory Period1 + A/c Receivable Period
CC = Inventory Period + A/c Receivable Period – A/c Payable Period
NOTE: 1 = (a + b + c), OC is also known as Gross OC, CC is Net OC

RMa + WIPb + FGc + A/c Receivabled – A/c Payablef

a = RM Conversion Period = [Average RM Inventory x 365] ÷ RM Consumed

b = WIP Conversion Period = [Average WIP Inventory x 365] ÷ Cost of Production
c = FG Conversion Period = [Average FG Inventory x 365] ÷ COGS
d = A/c Receivable Conversion Period = [Average A/c Receivable x 365] ÷ Cr.Sales
f = A/c Payable Deferral Period = [Average A/c Payable x 365] ÷ Credit Purchases
 Level of CA
C
O
S
T Total Cost

Carrying Cost

Shortage Cost

Level of CA
Financing of CA
Matching Concept
 WC Finance: MPBF-Tandon committee
Method I: MPBF = 0.75 (CA – CL)
Method II: MPBF = (0.75 CA) – CL
Method III: MPBF = 0.75 (CA – CCA) – CL [This was not accepted &
by pure academic interest, one may consider]
CCA = ‘Core Current Assets’, i.e., permanent current assets.

Cash Management:
Short term Forecasting: Use Cash Budget
Long term Forecasting: Use Cash flow statement
Cash Collection & Disbursement: Float = Float is the
difference between the actual bank [pass book] balance and
the bank balance as per cash book
Playing on Net Float [NF]
= Disbursement Float + Collection Float
Positive NF = If DF > CF, Negative NF = If DF < CF
Lesson: Maximize DF relative to CF
Cash Management Models:
Baumol Model: Similar to EOQ concept & assumes stable conditions
in terms of cash requirement, return on investing in marketable
securities,
cost
b= ofCost
converting securities
per sale to cash etc.
of securities
T = Cash needed, Ascertain Optimum
I = Interest rate on securities for the cash Conversion = C
planning period Use it for expenses till it is
C exhausted
C C C
A Once exhausted, sell securities
S & replenish cash balance
H C = √(2bT/ I)
B
Average Cash = C/2 Total Cost = TC
L TC = I (C/2) + b (T/C)
A i.e., = (Interest foregone +
N Conversion cost)
Sell Sell Sell
C C is an increasing function
E of T & b and decreasing
Time function of I
Miller-Orr Model: Stochastic model & applies when cash flows are uncertain.
This model deals with cash inflows/outflows that change on a daily basis. It
assumes a normal distribution of cash in/outflows. It answers as to when and by
how much transfers between cash & securities be made. Cash balance up to UL
is allowed. Once cash reaches UL, cash is reduced to RP by investing cash of the
size of (UL – RP) in marketable securities. Then, cash go down to LL limit. If it
reaches LL, then securities are sold & hence cash is replenished to RP level.

C
A h UL UL = Upper Control Limit
S LL = Lower Control Limit
H RP = Return Point
b = Cost per sale of securities
B Z RP I = daily interest rate on
L marketable securities
A
LL σ = variance of daily changes
2
N O in the expected cash balance
C
E
Time
LL = Policy of firm UL = [3RP – 2LL] RP = { [3 b σ 2 / 4 I ] 1/3 + LL}
 Receivables management
1. Terms of Payment: Cash in advance or Cash on delivery, net 30, 2/10, net 30,
Bills of exchange, Letter of credit [L/C].
2. Credit Policy variables:
(a) Credit Standards: Liberal versus stringent, depends on impact on
Residual income [RI]. This is evaluated using:

∆RI = [∆S (1 – V) – ∆S bn](1 – t) – k ∆I ………(1)

(b) Credit Period: Credit period be extended or contracted. To examine the

efficacy of the decision, we may use …..(1)
(c) Cash Discount: Examine the impact on RI using the formula:
∆RI = [∆S (1 – V) – ∆DIS](1 – t) – k ∆I ………(2)

∆RI = Change in residual income, ∆S = Change in sales, V = Ratio of Variable cost

to sales, bn = bad debt loss ratio on new sales, t = tax rate, k = cost of capital,
∆I = Change in debtors = V x ACP x (∆S / 360)……Common expression
∆I = [(ACPn – ACPo)(So/360) + V x ACPn (∆S / 360)]……for (1) & (3)
∆I = [(ACPo – ACPn)(So/360) – V x ACPn (∆S / 360)]……for (2)
ACP = Average Collection period, n = new or after, o = old or before
∆DIS = Increase in discount charges = Pn (So + ∆S) dn – PoSodo
P = Proportion of discount sales, d = discount rate
(d) Collection Effort: Lax versus rigorous collection programme.
Attributes Lax Rigorous
Sales Increases Decreases
Bad debts incidence More Less
ACP Lengthens Shortens
Expenses Less More
This is examined by:
∆RI = [∆S (1 – V) – ∆BD](1 – t) – k ∆I …..(3)

Where, ∆BD = increase in bad debts = bn (So+ ∆S) – boSo

3. Credit Evaluation:
Type I Error: A good customer is misclassified as a poor credit risk: Loss of profit
Type II Error: A bad customer is misclassified as a good credit risk: bad debts up
How to minimise these errors?
Answers: (a) Traditional Credit Analysis [five C’s, Character, Capacity, Capital,
Collateral, Conditions]
(b) Credit rating Index: = Sum of FW, Where, Factors like past payment
record, N/P ratio, Current ratio, D/E ratio, ROE etc and W is respective weights
Y + (c) Discriminant Analysis: Take ROE on X-axis & current ratio on Y-axis
+ GOOD Customers
*
+ +
BAD*
+
*
X
4. Credit Granting Decision: Apply decision tree approach
Pays Yes Credit Pays
es Credit De
Y fau No De
No lts Cr fau
ed lts
Cr it
ed
it

5. Control of A/C Rec: (a) Days’ Sales O/S = DSO

DSO= Debtors /Average Daily Sales
Calculate DSO: monthly, quarterly etc, then, compare DSO over a period of time.
Increasing trend of DSO means, collections not improved
Decreasing trend of DSO means, collections improved
(b) Ageing Schedule: Age Group [days] % of Debtors
0-30 39
31-45 45
46-90 12
>90 04
 Inventory Management
Costs: Carrying cost, Ordering cost, Shortage [stock out] cost
EOQ: Considers carrying & ordering costs only and shortage cost is
ignored on the plea that inventory can be procured without much delay.
Formula: EOQ = √2 SU / PC Where, S = Ordering cost per order, U = annual
usage, P = Purchase price per unit, C = Carrying cost in percentage
Total cost = Total S + Total C = {(U/EOQ) x S} + {(EOQ/2) x P x C}
Quantity Discounts and EOQ: To avail quantity discounts one may have to order
at a quantity which is higher than EOQ. Then, the call depends on impact on N/P.
∆NP = UD + [U/EOQ – U/Q]S – [Q(P – D)C – (EOQ x PC)] / 2
D = Discount per unit, Q = quantity eligible get discount, NP = Net profit
Reorder level = Normal consumption during lead time + safety stock