Working capital

management

Introduction
Financial management

Financial Management means planning,

organizing, directing and controlling the
financial activities such as procurement and
utilization of funds of the enterprise. It means
applying general management principles to
financial resources of the enterprise

Scope / elements
Investment decision
Financing decision
Dividend decision

Investment decision

Investment
decision

Capital
budgeting
Working
capital
management

Working capital
management
The management of working capital is

concerned with the management of assets

such as cash, marketable securities, accounts
receivables, investor prepaid expenses &
current assets ; also liabilities such as
accounts payable, wages payable, and
accruals.

Finance decisions
How should the firm manage its

cash?
To whom should the firm grant
credit?
How much inventory should the firm
keep?
What should be the firms current
debt?

Thus ..
Working Capital is a financial metric which

represents operating liquidity available to a

business.
The goal of working capital management is to
ensure that the firm is able to continue its
operations and that it has sufficient cash flow
to satisfy both maturing short-term debt and
upcoming operational expenses.

Working capital meaning

Working Capital refers to that part of the

firms capital, which is required for financing

short-term or current assets such cash,
marketable securities, debtors and
inventories.
Funds thus, invested in current assets keep
revolving fast and are constantly converted
into cash and this cash flow out again in
exchange for other current assets. Working
Capital is also known as revolving or
circulating capital or short-term capital.

 circulating capital means current

assets of a company that are
changed in the ordinary course of
business from one form to another,
as for example, from cash to
inventories,
inventories
to
receivables, receivable to cash
Genestenbreg

Resource flows for a manufacturing

firm
Used in

Used in

Production
Process
Generates

Accrued
Direct
Labour and
materials
Working
Capital
cycle

Inventory
Via Sales Generator

Accounts
receivable

Collection
process

Accrued Fixed
Operating
expenses
Used to
purchase
Cash and
Marketable
Securities

Used to
purchase

External Financing
Return on Capital
Suppliers
Of Capital

Fixed
Assets

Components of working
capital
The working capital cycle is made up of

four core components:

Cash & Cash equivalent.
Creditors/accounts payable.
Inventory/stock in hand.
Debtors/accounts receivables.

Importance of working
capital
The goal of working capital management is to

manage the firms current assets and

liabilities in such a way that a satisfactory
level of working capital is maintained.
The interaction between current assets and
current liabilities is, therefore the main theme
of the theory of the working capital
management.

Contd..
It is important we work out the right level of

working capital you will need. If the working

capital is too:
High - Business has surplus funds which are
not earning a return; and
Low - May indicate that your business is
facing financial difficulties.

1.

Disadvantages of Redundant or Excess Working Capital

Idle funds, non-profitable for business, poor ROI
Unnecessary purchasing & accumulation of inventories over required level
Excessive debtors and defective credit policy, higher incidence of B/D.
Overall inefficiency in the organization.
When there is excessive working capital, Credit worthiness suffers
Due to low rate of return on investments, the market value of shares may fall

Disadvantages or Dangers of Inadequate or Short

Working Capital
Cant pay off its short-term liabilities in time.
Economies of scale are not possible.
Difficult for the firm to exploit favourable market
situations
Day-to-day liquidity worsens
Improper utilization the fixed assets and ROI
falls sharply

Contd
To Forecast the optimum working capital

requirement the following formula may be

used:
(Estimated cost of good sold x Operating
cycle) + Desired cash balance.
Operating Cycle, O = R + W + F + D C
Where, O = Duration of operating cycle. R =
Raw Material storage period. W= Work-inprocess period. F = Finished Good Storage
period. D = Debtors collection period. C =
Creditors payment period.

MANAGEMENT OF WORKING CAPITAL ( WCM )

Management of working capital is concerned
with the problems that arise in attempting to
manage the current assets, the current
liabilities and the inter-relationship that exists
between them. In other words, it refers to all
aspects of administration of CA and CL.
Working Capital Management Policies of a firm
have a great effect on its profitability, liquidity
and structural health of the organization.

Kinds / concepts of working capital

A) Balance sheet concept
B) Operating cycle concept

Balance sheet concept

There are two interpretations of working

capital under the balance sheet concept.

Gross working capital
Net working capital

Gross working capital

Gross Working Capital' The sum of all of a

company's current assets (assets that are

convertible to cash within a year or less).
Gross working capitalincludes assets such
as cash, checking and savings account
balances, accounts receivable, short-term
investments, inventory and marketable
securities

Support for this

argument
Economists like Mead, Malott, Baker & Field

feel that
Current assets should be considered as
working capital as the whole of it helps to earn
profits &
Management is concerned with the total
current assets as they constitute the total
funds available for operational purposes.

Net working capital

It is represented by the excess of current

assets over current liabilities

Net working capital = Current Assets
Current Liabilities.

Contd..
Economists like Lincoln & Saliers argue that:
In the long run what matters is the surplus of

current assets over current liabilities

It is this concept which helps creditors and
investors to judge the financial soundness of
the enterprise
It helps to find out the correct financial
position of the company

Operating cycle concept

A companys operating cycle consists of three

primary activities:
Purchasing resources
Producing the product
Distributing the product

Contd..
If the firm is to maintain liquidity and function

properly it has to invest funds in various short

term assets .
It has to maintain a cash balance to pay the
bills as they come due.
The company must invest in inventories to fill
customer orders promptly.
The company must invest in accounts
receivables to extend credit to its customers.

TIME BASED WORKING CAPITAL

1. Permanent or Fixed Working Capital
(a) Regular Working Capital
(b) Reserve Working Capital
2. Temporary or Variable Working Capital
(a) Seasonal Working Capital
(b) Special Working Capital

Permanent Working
Capital
This refers to that minimum amount of

investment in all current assets which is

required at all times to carry out minimum
level of business activities. In other words, it
represents the current assets required on a
continuing basis over the entire year. Tandon
Committee has referred to this type of
working capital as Core current assets

Temporary Working
Capital
The amount of such working capital keeps on

fluctuating from time to time on the basis of

business activities. In other words, it
represents additional current assets required
at different times during the operating year.
For example, extra inventory has to be
maintained to support sales during peak sales
period. Similarly, receivable also increase and
must be financed during period of high sales

Kinds of working capital

Kinds of
Working
capital

On the basis
of concept

Gross working
capital

On the basis
of time

Net working
capital

Permanent or
fixed working
capital

Regular
working
capital

Reserve
working
capital

Temporary or
variable
working
capital

Seasonal
working
capital

Special
working
capital

Factors determining working capital

(1)Nature of Business:
The nature of business is usually of two types: Manufacturing

Business and Trading Business. In the case of manufacturing

business it takes a lot of time in converting raw material into
finished goods. Therefore, capital remains invested for a long
time in raw material, semi-finished goods and the stocking of
the finished goods. Consequently, more working capital is
required.
On the contrary, in case of trading business the goods are sold
immediately after purchasing or sometimes the sale is
affected even before the purchase itself. Therefore, very little
working capital is required. Moreover, in case of service
businesses, the working capital is almost nil since there is
nothing in stock.

(2)Scale of
Operations
There is a direct link between the working

capital and the scale of operations. In other

words, more working capital is required in
case of big organisations while less working
capital is needed in case of small
organisations.

3)Business Cycle
The need for the working capital is affected

by various stages of the business cycle.

During the boom period, the demand of a
product increases and sales also increase.
Therefore, more working capital is needed. On
the contrary, during the period of depression,
the demand declines and it affects both the
production and sales of goods. Therefore, in
such a situation less working capital is
required.

(4)Seasonal Factors:
Some goods are demanded throughout the year while

others have seasonal demand. Goods which have

uniform demand the whole year their production and
sale are continuous. Consequently, such enterprises
need little working capital.
On the other hand, some goods have seasonal demand
but the same are produced almost the whole year so
that their supply is available readily when demanded.
Such enterprises have to maintain large stocks of raw
material and finished products and so they need large
amount of working capital for this purpose. Woolen
mills are a good example of it.

(5)Production Cycle
Production cycle means the time involved in

converting raw material into finished product.

The longer this period, the more will be the
time for which the capital remains blocked in
raw material and semi-manufactured
products.
Thus, more working capital will be needed. On
the contrary, where period of production cycle
is little, less working capital will be needed

(6)Credit Allowed:
Those enterprises which sell goods on cash

payment basis need little working capital but

those who provide credit facilities to the
customers need more working capital.
(7)Credit Availed:
If raw material and other inputs are easily
available on credit, less working capital is
needed. On the contrary, if these things are
not available on credit then to make cash
payment quickly large amount of working
capital will be needed.

8)Operating Efficiency
Operating efficiency means efficiently completing the

various business operations. Operating efficiency of every

organisation happens to be different.
Some such examples are: (i) converting raw material into
finished goods at the earliest, (ii) selling the finished
goods quickly, and (iii) quickly getting payments from the
debtors. A company which has a better operating
efficiency has to invest less in stock and the debtors.
Therefore, it requires less working capital, while the case
is different in respect of companies with less operating
efficiency.

9)Availability of Raw Material:

Availability of raw material also influences the

amount of working capital. If the enterprise makes

use of such raw material which is available easily
throughout the year, then less working capital will be
required, because there will be no need to stock it in
large quantity.
On the contrary, if the enterprise makes use of such
raw material which is available only in some
particular months of the year whereas for continuous
production it is needed all the year round, then large
quantity of it will be stocked. Under the
circumstances, more working capital will be required

10)Growth Prospects
Growth means the development of the scale

of business operations (production, sales,

etc.). The organisations which have sufficient
possibilities of growth require more working
capital, while the case is different in respect of
companies with less growth prospects.

11)Level of
Competition:
High level of competition increases the need

for more working capital. In order to face

competition, more stock is required for quick
delivery and credit facility for a long period
has to be made available.

(12)Inflation
Inflation means rise in prices. In such a

situation more capital is required than before

in order to maintain the previous scale of
production and sales. Therefore, with the
increasing rate of inflation, there is a
corresponding increase in the working capital.

Working capital
investment
The size and nature of investment in current

assets is a function of different factors such as

type of products manufactured, the length of
operating cycle, the sales level, inventory
policies, unexpected demand and
unanticipated delays in obtaining new
inventories, credit policies and current assets.

Three alternative working capital

investment policies
Policy C
Policy B
Policy A
Current
Assets
($)

Sales ($)

Working capital investment policies

Policy C represents a conservative approach

to working capital management.

Under this policy the company holds a
relatively large proportion of its total assets in
the form of current assets.
This policy results in lower expected
profitability and lower risk.

Policy A
It represents an aggressive approach.
Under this policy the company holds a

relatively small proportion of its total assets in

the form of lower yielding current assets.
As a result this policy yields a higher expected
profitability and a higher risk
Policy B represents a moderate approach,

because expected profitability and risk levels

falls between those o policy A and policy B

PROFORMA - WORKING CAPTIAL ESTIMATES

1. TRADING CONCERN
STATEMENTOF
OFWORKING
WORKINGCAPITAL
CAPITALREQUIREMENTS
REQUIREMENTS
STATEMENT
Amount(Rs.)
(Rs.)
Amount

CurrentAssets
Assets
Current
(i)Cash
Cash
(i)
(ii)Receivables
Receivables((For..Months
For..MonthsSales)---Sales)---(ii)
(iii)Stocks
Stocks((ForMonths
ForMonthsSales)----Sales)----(iii)
(iv)AdvancePayments
Paymentsififany
any
(iv)Advance
Less::Current
CurrentLiabilities
Liabilities
Less
(i)Creditors
Creditors(For..
(For..Months
MonthsPurchases)Purchases)(i)
(ii)Lag
Lagininpayment
paymentof
ofexpenses
expenses
(ii)
WORKINGCAPITAL
CAPITAL((CA
CACL
CL))
xxx
WORKING
xxx
Add::Provision
Provision //Margin
Marginfor
forContingencies
Contingencies
Add
NETWORKING
WORKINGCAPITAL
CAPITALREQUIRED
REQUIRED
NET

-----------------------------------_
-----_
---------

XXX
XXX

1. MANUFACTURING CONCERN

STATEMENT OF WORKING CAPITAL REQUIREMENTS

Amount (Rs.)
Current Assets
(i) Stock of R M( for .months consumption)
(ii)Work-in-progress (formonths)
(a) Raw Materials
(b) Direct Labour
(c) Overheads
----(iii) Stock of Finished Goods ( for months sales)
(a) Raw Materials
(b) Direct Labour
(c) Overheads
----(iv) Sundry Debtors ( for months 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.. Months 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

COMPUTATION OF WORKING
CAPITAL
A number of methods are used to determine working

capital needs of a business. The important among

them are: (1) Operating Cycle Method:- Operating
cycle is the time span the firm requires in the purchase
of raw materials, conversion of raw materials into work
in progress andfinished goods, conversion of finished
goods into sales and in collecting cash from debtors.
Larger the time span of operating cycle, larger the
investment in current assets.
Hence, time period of each stage of operating cycle is
estimated and then working capital needed in each
stage is computed on the basis of cost of each item.

The following factors should be

taken into consideration:
Cost of raw materials, wages and overheads.
Period during which raw materials remain in store

before it is issued for production purpose.

Period of Production cycle.
Period during which finished goods is stored before sale.
Period of credit allowed to debtors and period of credit
allowed by suppliers.
Minimum cash balance required to be maintained.
A certain percentage for contingencies may also be
added to the above estimates to determine the working
capital requirement.

Statement showing working capital

requirement
Current assets:
a) Stock of raw material
cost of yearly consumption * Avg holding period
52 weeks /12 months
b) Work in progress
Cost of yearly consumption * Avg holding period
52 weeks/ 12 months

Contd..
+ yearly wages *50%* Avg holding period

52 weeks /12 months

+ yearly manufacturing and administrative

overheads(excld depreciation ) *50% * Avg holding

period/ 52 weeks or 12 months
Note:
While calculating WIP it is assumed that full unit of raw

materials is required in the beginning , whereas wages

and overhead expenses accrue evenly throughout
production cycle. Hence raw materials cost is taken at
100 % and overheads at 50%

Stock of finished stock

Cost of goods produced (cost of raw

materials+ wages+M&A overheads ) * Avg

finished goods holding period
52 weeks / 12
months

Debtors
Cost of goods produced (ie RM+ Wages+

adminstraive manufacturing ) * Avg holding

period / 52 weeks or 12 months

Points to be remembered while

estimating WC
(1)

Profits should be ignored while calculating working

capital requirements for the following reasons.
(a)Profits may or may not be used as working capital
(b) Even if it is used, it may be reduced by the amount of
Income tax, Drawings, Dividend paid etc.
(2) Calculation of WIP depends on the degree of
completion as regards to materials, labour and
overheads.
However, if nothing is mentioned in the
problem, take 100% of the value as WIP. Because in such
a case, the average period of WIP must have been
calculated as equivalent period of completed units.
(3) Calculation of Stocks of Finished Goods and Debtors
should be made at cost unless otherwise asked in the
question