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WORKING CAPITAL MANAGEMENT

MEANING AND DEFINITION:
Working capital refers to the capital required to meet the day to day operations of a business firm.
Working capital is defined as “the excess of current assets over current liabilities and provisions”.
It is the minimum amount required for working of the business. It is also known as circulating
capital, Revolving Capital, Floating Capital or Liquid Capital. Funds required for as for purchasing
raw material, payment of salaries, wages, rents rates, advertising etc are examples of working capital.
CLASSIFICATION OF WORKING CAPITAL:
1. Gross Working Capital: refers to the firm’s investment in total current assets.
Merits: a) Working capital at any time.
b) Management of current assets individually.
c) Maximaise returns on current assets.
d) Increases financial responsibility.
2. Net Working Capital: refers to the excess of current assets over current liabilities. It is qualitative
in nature. Net working capital may be positive or negative.
Merits: a) Give importance to liquidity.
b) To evaluate short term solvency.
c) To determine the financial soundness.
d) To know the amount of working capital from long term funds.
3. 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. It is also
known as “Core Current Assets or Hard Core Working Capital”.
4. Variable Working Capital: Working capital which varies with volume of business is called
variable working capital. Since it is required for managing seasonal operations, it is also known as
“Seasonal Working Capital or Special Working Capital”.
4. Temporary Working Capital: The amount of such working capital keeps on fluctuating from
time to time on the basis of business activities. Generally temporary working capital is generally
financed from short-term sources of finance such as bank credit.
5. Negative Working Capital: This situation occurs when the current liabilities exceed the current
assets. It is an indication of crisis to the firm.
6. Regular Working Capital: refers to the amount required for routine operations of the business.
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7. Reserve Margin / Cushion Working Capital: is the additional reserve of working capital
maintained to meet the unforeseen situation like strike, shortage in supply of inputs, increase in price
of inputs, etc.
Operating Cycle / Cash Conversion Cycle: is the time gap between purchase of inventory and
realisation of cash from the sale of the same. It represents the number of days a firm’s cash remains
tied up in current assets. Working capital based on operating cycle is also called Cash Cycle, Asset
Conversion Cycle or Net Operating Cycle. Cash flow analysis reveals the efficient management of
working capital.
The term “Operating cycle” consists of the following six steps:
1. Conversion of cash into raw materials.
2. Conversion of raw materials into work-in-process.
3. Conversion of work-in-process into finished products
4. Time for sale of finished goods—cash sales and credit sales
5. Time for realisation from debtors and Bills receivables into cash
6. Credit period allowed by creditors for credit purchase of raw materials, inventory and
creditors for wages and overheads.
Operating Cycle Period (OCP) = Inventory Conversion Period (ICP) + Debtors Conversion
Period (DCP)
Inventory Conversion Period (ICP) = Raw material Conversion Period (RMCP) +Work-in-progress
Conversion Period (WIPCP) + Finished Goods Conversion Period (FGCP)
ICP= RMCP + WIPCP + FGCP
Gross Operating Cycle Period (GOP) = Operating Cycle Period (OCP + ………………………….
Payment Deferred Period (PDP): is the period by which a firm is able to delay payment mentioned
above.
RCP = Receivable conversion period.
DCP = debtors conversion period.
Net Operating Cycle Period (NOC) = GOC – PDP
Duration of Operating Cycle = RMCP + WIPCP + FGCP + RCP + DCP – PDP
DETERMINANTS OF WORKING CAPITAL:
Working capital requirements of a firm is influenced by various factors like :
1. Nature and Size of the Business: The working capital requirements of a firm are basically
influenced by the nature and size of the business. A firm with larger scale of operations will need
more working capital than a small firm. Similarly, the nature of the business - influence the working
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capital decisions. Manufacturing and trading firms require a large sum of money to be invested in
working capital. But firms run on cash basis require less working capital.
2. Production Cycle / Manufacturing Cycle: The production cycle starts with the purchase of raw
material and completes with the production of finished goods. If the production cycle is more the
requirement of working capital will also more and vice versa.
3. Production Policy: The firm which follows seasonal production policy require the working
capital requirement will be higher with varying production schedules in accordance with the
changing demand.
4. Credit Policy: Firms following liberal credit policy to its customers require more funds. On the
other hand, the firm adopting strict credit policy will require less amount of working capital.
5. Availability of Credit: A firm will need less working capital if liberal credit terms are available
than a firm without such credit facility.
6. Growth and Expansion of Business: A growing firm may need funds to invest in fixed assets in
order to sustain its growing production and sales. This will, in turn, increase investment in current
assets to support increased scale of operations. Thus, a growing firm needs additional funds
continuously.
7. Profit Margin: A firm with high net profit margin requires less working capital than a firm with
low profit margin.
8. Dividend Policy: Firm which follows liberal dividend policy requires more working capital than a
firm which follows conservative dividend policy.
9. Operating Efficiency: In case of high operating efficiency the volume of working capital is
comparatively lesser than an inefficient firm
10. .Business Fluctuations: When there is an upward swing in the economy, sales will increase,
correspondingly, the firm’s investment in inventories and book debts will also increase. Besides,
additional investment in fixed assets may be made by some firms to increase their capacity. This will
require additional funds. On the other hand when, there is a decline in economy, sales will come
down and consequently the conditions, the firm try to reduce their short-term borrowings. This will
lead to lower volume of funds.
11. Changes in Technology: If the firm wish to install a new machine in the place of old system, the
new system can utilise less expensive raw materials, the inventory needs may be reduced there by
working capital needs.
12. Taxation Policy: If the Government follows regressive taxation policy, the volume of retained
earnings is comparatively low. Consequently the firm has to borrow additional funds to meet their
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increased working capital needs. When there is a liberalised tax policy, the pressure on working
capital requirement is minimised.
13. Other Factors: Various other factors like import policy, infrastructural facilities, etc, also
influence the volume of working capital.
Estimating Working Capital Requirement
The following are the important methods used to estimate the working capital requirement:
1. Net Current Asset Forecast Method:
Under this method the difference between the total value of current assets and delay in payment of
current liabilities (value) is taken as Net Working Capital. Besides, contingency is added if any.
The calculation of net working capital may also be shown as follows;
Working Capital = Current Assets – Current Liabilities
= (Raw Materials + Work-in-progress + Finished Goods + Debtors + Cash
Balance) – (Creditors + Outstanding Wages + Outstanding Overheads).

Where,
Raw Materials = Cost (Average cost) of Raw Materials.
Work-in-progress = Cost of Materials + Wages + Overhead
Finished Goods = Cost of Materials + Wages +Overhead ( Total Cost of Production).
Creditors for Material = Average Outstanding Creditors.
Creditors for Wages = Averages Wages Outstanding.
Creditors for Overhead = Average Overheads Outstanding.
Thus, Working Capital = Cost Raw Materials + in Work-in-progress + in Finished Goods and
+ in Debtors.
Less: Creditors for Materials
Plus: Wages in Work-in-progress + in Finished Goods and + in Debtors.
Less: Creditors for Wages.
Plus: Overheads in Work-in-progress + in Finished Goods and in Debtors.
Less: Creditors for Overheads.
Assumptions: 1.If only closing stock is given it is taken as average stock.
2. Sales is treated as credit sales.( if nothing is mentioned about cash sales)
3. Value of Work-in –Progress: It is estimated on the basis of degree of completion. If
nothing is mentioned, Material Cost (100%), Labour (50%) and Overhead (50%).
The work sheet for estimation of working capital requirements under the net current asset method is
presented as follows :
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Estimation of Working Capital Requirements

I Current Assets: Amount Amount Amount
Minimum Cash Balance ****
Inventories:
Raw Materials ****
Work-in-progress ****
Finished Goods **** ****
Receivables:
Debtors ****
Bills **** ****
Gross Current Assets (CA) **** ****
II Current Liabilities:
Creditors for Purchases ****
Creditors for Wages ****
Creditors for Overheads **** ****
Total Current Liabilities (CL) **** ****
Excess of CA over CL ****
+ Safety Margin ****
Net Working Capital ****
The following points are also worth noting while estimating the working capital requirement :
Cash basis Working Capital and Total basis Working Capital: The working capital calculated
by ignoring depreciation is known as cash basis working capital. In case, depreciation is included in
working capital calculations, such estimate is known as total basis Woking capital.
Contingency / Safety Margin: Sometimes, a firm may also like to have a safety margin of working
capital in order to meet any contingency. The safety margin may be expressed as a % of total current
assets or total current liabilities or net working capital. The safety margin, if required, is incorporated
in the working capital estimates to find out the net working capital required for the firm.
2. Operating Cycle Method: Under this method the working capital is estimated as follows:
FIRSTLY: Determine the Period of operating cycle i.e.; the duration required to complete one
operating cycle.
SECONDLY: Determine the Number of Operating Cycle in a year i.e.; Annual operating days
/
(360/365 days) Period of operating cycle.
THIRDLY: Determine the Working Capital Requirement i.e; Total expected Annual Operating
expenses / Number of Operating Cycles.
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3.Projected Balance Sheet : Under this method estimation of assets and liabilities were made in the
beginning of a financial year and prepare a projected balance sheet of the business at the end of the
financial year. The difference between the assets and liabilities in the projected balance sheet denotes
either shortage or surplus of cash. If the liability side is more than assets side, the management must
take necessary decision to investment of such excess funds. On the other hand if the assets side is
more than liability side, the management must take necessary decision to find new sources of
working capital.
4.Adjusted Profit and Loss Method:
Under this method profit or loss is estimated on the basis of projected profit and loss account.
Increase or decrease of working capital is computed adjusting the estimated profit by cash inflows
and cash out flows.
5. Cash Forecasting Method:
This method of estimating working capital requirements involves forecasting of cash receipts and
disbursements during a future period of time. Cash forecast will include all possible sources from
which cash will be received and the channels in which payments are to be made so that a
consolidated cash position is determined. This method is similar to the preparation of a cash budget.
The excess of receipts over payments represents surplus of cash and the excess of payments over
receipts causes deficit of cash or the amount of working capital required.
Importance or Advantages of Working Capital
Working capital is the life blood and nerve centre of a business. No business can run successfully
without working capital. The main advantages of maintaining adequate amount of working capital
are as follows:
1. Solvency of the Business: Adequate working capital helps in maintaining solvency of the
business by making prompt payment to suppliers.
2. Goodwill: Sufficient working capital enables a business concern to make prompt payments and
hence helps in creating and maintaining goodwill.
3. Easy Loans: A concern having adequate working capital enable the firm to avail loans from
banks and other on better terms..
4. Cash Discounts: Adequate working capital also enables a concern to avail cash discounts and
trade discount.
5. Regular Supply of Raw Materials: Sufficient working capital ensures regular supply of raw
materials and continuous production.
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6. Regular Payment of Salaries: Adequate working capital enables a concern to ensure payment of
salaries and other financial benefits in time.
7. Exploitation of Favourable Market Conditions: Only concerns with adequate working capital
can exploit favourable market conditions such as large scale purchases.
8. Ability to Face Crisis: Adequate working capital enables a concern to face business crisis in
emergencies such as depression
9. Quick and Regular Return on Investments: Sufficient working capital enables a concern to pay
quick and regular dividends to its investors.
10. Regular Maintenance: Adequacy of working capital ensure regular maintenance of fixed assets.
Excess or Inadequate Working Capital
Every business concern should have adequate working capital to run its business operations. Both
Redundant and excess as well as inadequate working capital positions are bad for any business.
Disadvantages of Redundant or Excessive Working Capital
1. Excessive Working Capital leads to low rate of return on its investments.
2. Excessive Working Capital leads to theft, wastages and losses
3. Excessive working capital may cause higher incidence of bad debts.
4. It may result into overall inefficiency in the organization.
5. Low rate of return adversely affect the market value of shares.
6. The redundant working capital gives rise to speculative transactions
Disadvantages or Dangers of Inadequate Working Capital
1. Inadequate working capital may adversely affect the reputation of the business.
2. It cannot buy its requirements in bulk and cannot avail of discounts, etc.
3. It becomes difficult for the firm to exploit favourable market conditions.
4. Irregularity in payment of day-to-day expenses creates inefficiencies and thereby reduces profits.
5. It adversely affects efficient utilization of the fixed assets.
6. The rate of return on investments also falls with the shortage of working capital.
7. Shortage of working capital may adversely affect credit worthiness.
8. The firm can not ensure proper maintenance of fixed assets.
9. Inadequate working capital also affects regularity in dividend payment.
10. Shortage of working capital prevents the firm to avail trade discounts and cash discounts.

Net Operating Income Theory (NOI)

According to NOI approach the value of the firm is determined by the operating profit of the firm. In
other words the value of the firm is determined by the business risk. The capital structure has no
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relevance in determining the value of the firm. So overall cost of capital (ko) remaining constant at
any degree of leverage
Assumptions:-
(1) ko remaining constant at any degree of leverage
(2) No tax
(3) Cost of debt (kd) is lower than cost of equity (ke):-kd<ke
(4) Kd remains constant
(5) More application of debt increases ke and the benefits of derided from the debt is equated
with the increase in cost of equity. So value of the firm reaming the same.
Calculation of value of the firm
V=NOI/ko
NOI= Net operating income or EBIT
Ko= over all cost of capital .
Value of equity(E) and cost of equity (ke) can also be derived from this equation
Since V=E+D
E=V-D
Ke=NI/E
Limitations
(1) value of the firm is influenced by many factors
(2) No tax
Traditional theory:
Traditional theory was propounded by Soloman Ezra in 1963.It is a combination of net income
theory and net operation income theory . According to this theory, the concept of leverage on the
value of the firm is explained in3 different stages
First stage : (Increase the value of the firm)
In the first stage, increased application of debt capital help to reduce the overall cost of capital and
thereby increase the value of the firm. This is due to the fact that marginal cost debt is less than the
marginal cost of equity . So the first stage of leverage is just similar to not income approach.
Second stage: (Reaches the optimum value)

In the second stage, the overall cost of capital will remain the same i,e. by
off setting in the advantages of debt capital by the increases in cost of equity as a result of increase
in financial risk . Therefore the value of the firm will reach its maximum .i,e. at optimum capital
structure at this second phase. The marginal cost of debt cannot be equal to marginal cost of equity

Third stage :(Decrease the value of the firm)In the third stage, increased application of debt will lead
to decrease in value of the firm. This is due to increase in the overall cost of capital of the firm.
Modigliani Miller Theory ( M.M Theory)
M.M Theory, two similar firms have similar market value even if their capital structure is different.
According to this theory the degree of leverage is irrelevant in determining the value of the firm.
M.M Theory without Taxes (Two Propositions)
Proposition I; The market value of levered firm (VL) and the market value of unlevered firm (Vu)
will be the same, irrespective of differences in capital structure. The overall cost of capital (Ko) will
remain the same regardless of degree of leverage.
VL= Vu
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VL = Market value of levered firm

Vu = Market value of unlevered firm
Arbitrage: is the process of buying shares at a low priced market and selling the shares at a high
priced market. According to M.M Theory , the value of shares of firm using debt capital ( levered
firm ) is high and the value of shares of firm not using debt capital (un levered firm ) is low. Since
the investors are rational they will sell the shares of levered firm and switch their investment to
unlevered firm. The high demand for low priced shares leads to increase in the market value and
increased selling of high priced shares leads decrease in the market value. Thus due to the frequent
switching from high priced to low priced and vice versa leads to market equilibrium by which the
prices of both the levered firm and unlevered firm get equalized.
Proposition II:
According to Proposition2 of M M theory determines the cost of equity (Ke).
Ke = Ko + (Ko – Kd) D / E
Where:
Ke = Cost of Equity
Ko = Overall Cost of Equity ( Without debt)
Kd = Cost of Debt
D/E = Debt Equity Ratio
MM Theory states that the

The financial risk increases with more debt content in the capital structure. As a result cost of
equity (Ke) increases in a manner to offset exactly the low – cost advantage of debt. Hence,
overall cost of capital remains the same.
Besides the excessive application of debt funds leads to shifting of firm’s asset to debt holders. Thus
the risk of equity share holders is shifted to debt holders ,the Ke declines and thereby Ko overall cost
of capital remain the same.
Criticisms:
1. Perfect capital market conditions.
2. No transaction cost.
3. All investors are rational.
4. All investors have same perception level.
5. Business group having homogeneous risk class.
6. 100% dividend pay out ratio.
7. No corporate tax.
M.M Theory with Taxes (Three Propositions)
Proposition 1: The value of levered firm (VL) will be higher than the value of unlevered firm (Vu)
to the extent of interest tax shield.VL >Vu + INTS
Debt financing is beneficial as interest is a deductable expense for tax purpose, but dividend is not
deductable.
So interest tax shield is the tax savings accrue to the firm due to interest on debt. The interest tax
shield is the main reason for the higher valuation of levered firm (VL).
Value of Levered Firm Vu = EBIT (1—t) where Ko = Ke – full of equity capital
KO
Value Levered Firm VL = Vu + DT
Interest Tax Shield (INTS) = Debt * Tax Rate * Kd. OR D * T *Kd.
Capitalised value of INTS = INTS = D * T *Kd. = DT
Kd Kd
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Proposition 2: According to this proposition the cost of equity will increase with increase in cost of
debt but at a lesser rate than it would be in the absence of taxes.
Ke = Ko + ( Ko – Kd) D / E ( 1—t)
Where:
Ke = Cost of Equity
Ko = Over all cost of capital (without debt0
Kd = Cost of debt
D/E = Debt Equity Ratio
t = Tax Rate.
Proposition 3: The overall cost of capital (Ko) declines for the levered firm despite increased
capitalization rate.
Ko = Ke(E) + Kd(1—t) where D= Value of Debt, E = Value of Equity.
(E+D) ( E+D)
Problems:
1) Hi-tech Ltd. plans to sell 30,000 units next year. The expected cost of good s sold is as follows:
(Per Unit)
Raw material 100
Manufacturing expenses 30
Selling, administration and financial expenses 20
Selling price 200
The duration at various stages of the operating cycle is expected to be as follows :
Raw material stage 2 months
Work-in-progress stage 1 month
Finished stage 1/2 month
Debtors stage 1 month
Assuming the monthly sales level of 2,500 units, estimate the gross working capital requirement.
Desired cash balance is 5% of the gross working capital requirement, and working-progress in 25%
complete with respect to manufacturing expenses.( ANs: 13, 75,000)
2) Calculate the amount of working capital requirement for SRCC Lt d. from the following
information. (Per Unit)
Raw materials 160
Direct labour 60
Overheads 120
Total cost 340
Profit 60
Selling price 400
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Raw materials are held in stock on an average for one month. Materials are in process on an average
for half-a -month. Finished goods are in stock on an average for one month. Credit allowed by
suppliers is one month and credit allowed to debtors is two months. Time lag in payment of wages is
1½ weeks. Time lag in payment of overhead expenses is one month. One fourth of the sales are
made o n cash basis.
Cash in hand and at the bank is expected to be Cash in hand and at the ban k is expected to be
amounts to 1,04,000 units for a year of 52 weeks.50,000; and expected level of production 50,000;
and expected level of production
You may assume that production is carried on evenly throughout th e year and a time period of four
weeks is equivalent to a month.( Ans: 67,10,000)
3) JBC Ltd. sells goods on a gross profit of 25%. Depreciation is considered as a part of cost of
production. The following are the annual figures given to you:
Sales (2 months credit) 18, 00,000
Materials consumed (1 months credit) 4, 50,000
Wages paid (1 month lag in payment) 3, 60,000
Cash manufacturing expenses (1 month lag in payment) 4, 80,000
Administrative expenses (1 month lag in payment) 1, 20,000
Sales promotion expenses (paid quarterly in advance) 60,000
The company keeps o ne month’s stock each of raw materials an d finished goods. It also keeps 1,
00,000 in cash. You are required to estimate the working cap ital requirements of the company on
cash cost basis, assuming 15% safety margin. (Ans: 4, 45,625)
Solution 1
Statement of Working Capital Requirement
1. Current Assets: Amt. ( ) Amt. ( .)
Stock of Raw Material (2,500×2×100) 5, 00,000
Work-in-progress:
Raw Materials (2,500×100) 2, 50,000
Manufacturing Expenses 25% of (2,500×30) 18,750 2, 68,750
Finished Goods :
Raw Materials (2,500×½×100) 1, 25,000
Manufacturing Expenses (2,5 00×½×30) 37,500 1,62,50 0
Debtors (2,500×150) 3, 75,000 13, 06,250
Cash Balance (13, 06,250×5/95) 68,750
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Working Capital Requirement 13, 75,000

Note: Selling, administration and financial expenses have not been included in valuation of closing
stock.
Solution:
Statement of Working Capital Requirement
1. Current Assets : Amt. ( ) Amt. ( )
Cash Balance 50,000
Stock of Raw Materials (2,00 0×160×4) 12 ,80,000
Work-in-progress :
Raw Materials (2,000×160×2 ) 6,40,000
Labour and Overheads (2,000×180×2) ×50% 3,60,000 10,00,000
Finished Goods (2,000×340× 4) 27, 20,000
Debtors (2,000×75%×340×8) 40,80,000
Total Current Assets 91, 30,000
2. Current Liabilities:
Creditors (2,000×Rs. 160×4) 12,80,000

Creditors for Wages (2,000×R s. 60×1½) 1, 80,000

Creditors for Overheads (2,000×Rs. 120×4) 9, 60,000
Total Current Liabilities 24, 20,000
Net Working Capital (CA–CL ) 67,10,000