Corporate Finance

Working Capital Management

Topics Covered

• Overview and Characteristics of Current Assets

• Factors influencing Working Capital Requirements

• Current Asset Policy

• Current Assets Financing Policy

• Profit Criterion for Current Assets

• Operating Cycle Analysis

• Duration of the Operating Cycle

Working Capital Management_10
Working Capital
There are two concepts of working capital:
Gross Working Capital
Net Working Capital
Gross WC = Current Assets
Net WC = Current Assets – Current Liabilities
Current Assets Current Liabilities
Inventories Sundry creditors
* Raw material Trade advances
* Work-in-progress Borrowings
* Finished goods * Commercial banks
Trade debtors Provisions
Loans & advances
Cash & bank balance

Working Capital Management_10

Characteristics of Working Capital

1) Management of working capital refers to the

management of current assets as well as current
liabilities.

2) While management of working capital, the

characteristics of current assets must be taken
into consideration. These are:
i) Short life span, and
ii) Swift transformation into other asset forms

Working Capital Management_10

--Working Capital
3) The life span of current assets depends upon the
time required in the activities of procurement,
production, sales, collection and the degree of
synchronisation among them.
Cash → Raw Materials → Work-in-process
↑ ↓
A/R ← Sales ← Finished goods
4) Efficient management of one component depends
upon the consideration of other components.
e.g.: i) If more finished goods inventory, more liberal credit
term is required.
ii) If the firm has a cash crunch, it may have to offer
generous discounts.
Working Capital Management_10
Factors affecting Working Capital Requirements

1) Nature of business
2) Seasonality of operations
3) Production policy
4) Market conditions
5) Conditions of supply

Working Capital Management_10

Working Capital Policy
For formulating the Working Capital Policy, the
important issues are as follows:

i) Ratio of Current Assets to Sales

ii) Ratio of ST-financing to LT-Financing

Working Capital Management_10

Current Assets in relation to Sales--

C Conservative
u
r
r Moderate
e
n
t
Aggressive
A
s
s
e
t
s Working Capital Management_10
Sales à
--Current Assets in relation to Sales--

1) If the firm pursues a very conservative current

asset policy, it would carry a high level of current
assets in relation to sales.
It tends to reduce risk. The surplus current
assets under this policy enable the firm to cope-
up with variations in sales, production plans and
procurement time comfortably.

2) If the firm adopts a moderate current asset policy,

it would carry a moderate level of current assets
in relation to sales.
Working Capital Management_10
--Current Assets in relation to Sales--
3) If the firm follows a highly aggressive current
asset policy, it would carry a low level of current
assets in relation to sales. It minimises the
investment in current assets which exposes the
firm to greater risk.
e.g.:
Conservative Policy Aggressive Policy

Sales Rs. 10,00,000 Rs. 10,00,000

EBIT Rs. 2,00,000 Rs. 2,00,000
Current Assets Rs. 6,00,000 Rs. 4,00,000
Fixed Assets Rs. 5,00,000 Rs. 5,00,000
Total Assets Rs. 11,00,000 Rs. 9,00,000
ROI (=EBIT/TA) 18.18% 22.22%
Working Capital Management_10
Ratio of ST-Financing to LT-Financing
Current Assets of a firm are supported by short-term
as well as long-term sources of Finance. Thus, we
have various types of Current Asset Financing Policy.

Conservative Current Asset Financing Policy

It depends less on short-term financing and more on
Long-term sources of Finance.
If it is highly conservative, it would rather replace
long-term debt by equity.
Aggressive Current Asset Financing Policy
It depends highly on short-term bank finance and
less on the long-term sources of finance.
It exposes the firm to a higher degree of risk.
Working Capital Management_10
Choosing the Working Capital Policy
Current Asset Financing Policy
A
g
Moderate Aggressive
g Overall Working Overall Working
r
e Capital Policy Capital Policy
s
s
i
v
e

c
o
n
s
e
r Conservative Moderate
v
a Overall Working Overall Working
t
i
Capital Policy Capital Policy
v
e

Conservative Aggressive
Working Capital Management_10
Current Asset Policy
Note:
1) A Conservative Overall Working Capital Policy means that
the firm has a Conservative Current Asset Policy along with
a Conservative Current Asset Financing Policy. It reduces
risk and offers low return.

2) A Moderate Overall Working Capital Policy means a

combination of Aggressive Current Asset Policy and
Conservative Current Asset Financing Policy OR,
Conservative Current Asset Policy along with Aggressive
Current Asset Financing Policy. It offers moderate return
and moderate risk.

3) An Aggressive Overall Working Capital Policy means that the

firm has an Aggressive Current Asset Policy along with
Aggressive Current Asset Financing Policy. It provides high
Working Capital Management_10
return accompanied with high risk.
Profit Criterion for Working Capital--
Current assets can be easily liquidated and the value realised
on liquidation would be more or less equal to the amount
invested initially.
i.e. investment in current assets is easily reversible.
For reversible investments, the criterion of net profit per
period (which here means residual income) is equivalent
to the criterion of net present value.
Let P be the initial investments in current asset, r the rate of
interest earned on it and k the cost of capital.
∴Profit per year = Pr – Pk
where,
Pr = return for the year
Pk = cost of funds for the year
Let us assume that the investment in current assets continue
for n years.
Working Capital Management_10
--Profit Criterion for Working Capital
Now,
NPV = - P + Pr × PVIFA(k,n) + P × PVIF(k,n)
Where,
P = Initial investments in the current assets
Pr × PVIFA(k,n) = PV of the annual return of Pr for a period of n
years
P × PVIF(k,n) = PV of the liquidation value of P realised at the end of
n years
Simplifying it, we get
NPV = (Pr – Pk) × PVIFA(k,n)

It is quite obvious from the above simplification that the

criterion of profit per period is equivalent to the criterion of net
present value.
Hence, the criterion of net profit per period may be substituted
for the criterion of net present value in analysing working
capital decisions. Working Capital Management_10
Operating Cycle Analysis
The operating cycle of a firm begins with the
acquisition of raw materials and ends with the
collection of receivables.

It is divided into four stages:

i) Raw Materials and Stores Storage Stage

ii) Work-in-Process Stage

iii) Finished Goods Inventory Stage

iv) Debtor Collection Stage

Working Capital Management_10
Duration of the Operating Cycle--
It is equal to the sum of the durations of each of the
above stages less the credit period allowed by the
suppliers of the firm.
We have,
O=R+W+F+D–C
Where,
O = Duration of the operating cycle
R = Raw Materials and Stores Storage Period
W = Work-in-Process Period
F = Finished Goods Storage Period
D = Debtor Collection Period
C = Creditors Payment Period
Working Capital Management_10
Now,
Average stock of raw materials and stores
R=
Average raw materials and stores consumed per day
It depends upon the regularity of supply, transportation time,
degree of perishability, price fluctuations and economies of
bulk purchases.
Average work-in-process inventory
W=
Average cost of production per day
It depends upon the length of manufacturing cycle,
consistency in capacities at different stages and efficient co-
ordination of various inputs.

Working Capital Management_10

 Average finished goods inventory
F=
Average cost of goods sold
It depends upon the pattern of production and sales.
Average book-debts
D=
Average credit sales per day
It depends upon the credit period, discount offered for prompt
payments and efficiency of collection effort.
Average trade creditors
C=
Average credit purchase per day

Working Capital Management_10

XXXXXXXXXXXXXXXXXXXXXX

Working Capital Management_10