Working Capital

Definition of Working Capital

Current assets such as cash, marketable securities, accounts receivable and
inventory which have a life of less than one year along with the adjustment of
less than one year liabilities.
Working Capital Management
Managerial Decisions on the amount of capital to be invested in various
current assets and how this investment is to be financed.
Equals managing liquidity
Entails two aspects of operations:
Investment in current assets
Use of short-term or current liabilities

Working Capital Cycle

Cash
Inventory

Accounts
Receivable

Cash

Extra

Working Capital Cycle

The working capital cycle is one rollover of the working
capital unit. It can be of any duration depending on the
companys activity
Fixed Working Capital
Initial
Reserve

Variable Working Capital

Seasonal
Cyclical
Normal

Factors affecting Working

Capital

Nature of Business

Size of the Business

Production Policy
Seasonal Variation
Credit Policy
Business Cycle
Operating Efficiency

Generalizations of Working
Capital
Each turnover of a unit of working capital at a
mark up will result in a gross profit (GP)
From an accountants point of view the GP occurs
in the selling phase of the cycle. Whereas from a
treasurer point of view the GP is not earned until
the last phase of the cycle is completed
When profit % is calculated using cost it is known
as mark up. When profit % is calculated using
selling price it is known as gross margin.

Generalizations of Working
The amount of GPCapital
from a single turnover is
dependant upon the size of the working capital
unit in terms of mark up or margin
The sum of cash provided at the completion of
each turnover is normally used for financing a
subsequent turnover and other expenditure.
The number of times that a single unit of working
capital can be turned in a year depend on the
length of the turnover period.
High turnover period means money is tied up in
working capital longer and vice versa

Characteristics of Working
Capital

Short Life

Working capital is characterized by assets with

a life span which is generally less than a year

Nearness to Cash
Components of working capital are generally
considered to possess liquidity

Lack of Synchronization
The level of investments in working capital is
affected by the sales volume, production
policies and collection policies

Financing Current Assets

Matching Approach
A particular source of funding for an asset can be selected by
matching the length of its maturity with the life of the asset
Basically current assets are financed by current liabilities
This approach assumes perfect information on demand, sales
and collections

Hedging Approach
The portion of current assets that fluctuates is financed by
current liabilities.
The fixed portion is financed by permanent financing
This leads to a greater efficiency of funds
There is a risk involved in making this assumption.

Financing Current Assets

Conservative Approach
Only use permanent financing to finance working capital
Excess funds are put into marketable securities
Not a sound decision as permanent financing is more
expensive than short term credit

Aggressive Approach
Exclusively use short term credit
This approach increases profitability because short term
credit is cheaper than other sources of financing
But the risk increases as the firm becomes dependant on
the renew ability of short term borrowings.

Working Capital Estimate

Comprehensive Question

Problems
Q) Amtek Company currently has total assets of Rs 3.2 million, of
which current assets comprise Rs 0.2 million. Sales are Rs 10
million annually, and the before-tax net profit margin (the firm
currently has no interest-bearing debt) is 12 percent. Given
renewed fears of potential cash insolvency, an overly strict credit
policy, and imminent stock outs, the company is considering
higher levels of current assets as a buffer against adversity.
Specifically, levels of Rs 0.5 million and Rs 0.8 million are being
considered instead of the Rs 0.2 million presently held. Any
addition to currents assets would be financed with new equity
capital.
a) Determine the total asset turnover, before-tax return on
investment, and before-tax net profit margin under the three
alternative levels of current assets.
b) If the new additions to current assets were finance with longterm debt at 15 percent interest, what would be the before-tax
interest cost of the two new policies?

Problems
Q

Ace Metal Specialties, Inc. has a seasonal pattern to its business. It borrows under a line of credit
from Central Bank at 1 percent over prime. Its total asset requirements now (at year end) and estimated
requirements for the coming year are (in millions):
Now
Rs 4.5
1st Quarter
Rs 4.8
2nd Quarter
Rs 5.5
3rd Quarter
Rs 5.9
4th Quarter
Rs 5.0
Assume that these requirements are level throughout the quarter. At present the company has Rs 4.5
million in equity capital plus long-term debt plus the permanent component of current liabilities, and this
amount will remain constant throughout the year. The prime rate currently is 11 percent, and the company
expects no change in this rate for the next year. Ace Metal Specialties is also considering issuing
intermediate-term debt at an interest rate of 13.5 percent. In this regard, three alternative amounts are
under consideration: zero, Rs 500,000, and Rs 1 million. All additional funds requirements will be
borrowed under the companys bank line of credit.
Required:
Determine the total rupee borrowing costs for short-and intermediate-term debt under each of the three
alternatives for the coming year. (Assume that there are no changes in current liabilities other than
borrowings.) Which alternative is lowest in cost?