Working Capital

Management

Introduction

Concept:

Gross Working Capital-Total Current Assets

Net Working Capital-Excess of CA over CL

Operating Cycle
Types of WC:

Permanent WC
Temporary WC

Permanent Working
Capital

AMOUNT of WC

The amount of current assets required to

meet a firms long-term minimum needs.

Permanent current assets

TIME

Temporary Working
Capital

AMOUNT of WC

The amount of current assets that varies

with seasonal requirements.

Temporary current assets

Permanent current assets

TIME

Managing WC

Estimating the amount of WC

Sources from which these funds
have to raised

Management of WC

Estimating the amount of WC

Factors

Production policies
Nature of the business
Length of the manufacturing process
Credit policy
Seasonal fluctuations
Fluctuations of supply

Calculation of amount of WC

By determining the amount of current assets and

current liabilities

Management of WC

Example: X & Co. is desirous to purchase a business and has consulted

you, an one point on which you are asked to advise them is the average
amount of working capital which will be required in the first years
working. With the following estimates add 10% contingencies from the
computed figure.
Figures for the year is given.
(I) Average amount locked up for the stocks:
Rs.
Stock of finished products
5,000
Stock of stores, materials, etc.
8,000
(ii) Average credit given
Inland sales: 6 weeks credit
3,12,000
Export sales: 1.5 weeks credit
78,000
(iii) Lag in payment of wages and other outgoings:
Wages: 1.5weeks
2,60,000
Stores, materials, etc.,:1.5 months
48,000
Rent, Royalties, etc.,:6 months
10,000

Example
Clerical Staff:1/2 month
62,400
Manager:1/2 months
4,800
Miscellaneous expenses:1/2months
48,000
(iv) Payment in advance:
Sundry expenses (paid quarterly in advance)
8,000
(v) Undrawn profits on the average throughout the year 11,000

Set up your calculations for the average amount of working

capital required.

Management of Cash

Introduction

Zero Working Capital:

Increasing speed of production process

Demand flow
Just-in-time

Meaning of cash: Nonearning asset

Goal or objective of cash management

To minimize the amount of cash the firm

must hold for use
To meet the cash disbursements

Cash Management

Reasons for Holding cash

Transaction Motive:

Compensation Motive:

Compensation to banks for providing loans and

services

Precautionary Motive:

Cash balances associated with routine payments and

collections are known as transactions balances.

For unpredictable situation

Speculative motive:

To take advantage of opportunities

Cash Management cont

Cash Management : Basic Strategies

Controlling level of cash

Preparing cash budget

Providing for unpredictable discrepancies

Consideration of short costs

Availability of other sources of funds

Controlling inflows of cash

Concentration Banking

Lock-Box system

Controlling outflows of cash

Single control system

Payment on due dates

Playing float

Optimum investment of surplus cash

Determination of the amount of surplus cash

Determination of the channels of investment

Cash Management cont

Safety level of cash = Desired days

of cash * Average daily cash
outflow

Inventory Management

Inventories are goods held for eventual sale

by a firm.
Kinds of Inventories:

Raw materials
Work in process
Finished goods

Benefits of holding inventories

- Avoiding losses of sales
- Reducing ordering cost
- Achieving efficient production runs

Inventory Management
cont

Costs Involved

Materials Cost
Ordering Cost
Carrying cost

Basic Strategies

Maintaining a sufficiently large size of

inventory
Maintaining a minimum investment in
inventories

Inventory Management
cont

Techniques of IM
1. Determination of Economic Order Quantity (EOQ)

Formula Q = (2U * P)/S

U Quantity purchased in a year
P cost of placing an order
S - Annual cost of storage of one unit

-Illustration: A refrigerator manufacturer, purchases

1,600 units of a certain component from B. His
annual usage is 1,600 units. The order placing cost
is Rs.100 per order and the cost of carrying one
until for a year is Rs.8. Calculate the Economic
Ordering Quantity.
- Answer: EOQ = 200 units

Inventory Management
cont

Techniques:
2. Determination of Re-order level
- The level of inventory at which the firm should
place an order to replenish the inventory.
- Required for calculation: lead time and usage
rate
- Formula: Reorder level = Lead Time * Average
Usage
- Example: If the lead time is 3 weeks and the
average usage 50 units per week, then reorder
level = 150 units.

Inventory Management
cont

3. Calculation of safety stock:

Minimum stock required at any time

Formula: Safety Stock = Average Usage *
Period of Safety Stock
Example: If the usage rate is 50 units per week
and the firm want to hold sufficient inventory
for at least one week of production, then the
amount of safety stock will be 50 units
Hence, ROL with SS = Lead Time * Average
Usage + Safety Stock

Inventory Management
cont

Illustration: From the following data

calculate
Safety Stock

Re-order level

EOQ
Lead Time 3 Weeks
Weekly Usage 50 units
Weeks of safety stock desired by the firm 2
Quantity purchased in a year2,500units
Cost of placing an order Rs.100
Storage cost Rs.200 per year

Inventory Management
cont

Techniques:

4. ABC Analysis or control by importance and

exception(CIE)/Proportional Value analysis (PAV):

A technique of exercising selective control over inventory

items.
Three categories: A-more costly items; B-less costly items; and
C-least costly items.
Trends regarding the components of inventories

Category
% of total value
% of total quantity
A
70
10
B
25
35
C
5
55

Inventory Management
cont

ABC analysis:

Advantages:

It ensures closer control on costly items in which a

large amount of capital has been invested
It helps in developing a scientific method of controlling
inventories clerical costs are reduced and stock is
maintained at optimum level
It helps in achieving the main objectives of inventory
control at minimum cost. The stock turnover rate can
be maintained at comparatively higher level through
scientific control of inventories.

Inventory Management
cont

Limitations:

Analyses the items according to their value and not according

to their importance
5. Inventory Turnover Ratios:to minimize the investment in
inventories.
6. Aging schedule of Inventory: Classification of the inventories
according to age also helps in identifying inventories which are
moving slowly into production or sales.
7. Just in time: all materials are received in time.
-The company must have only a few suppliers
-Suppliers must be bound under long-term contracts and willing
to
make frequent deliveries in small lots.
-The company must develop a system of total quality control
-Poor quality of goods or parts cannot be accepted
-Workers must be multiskilled.

Inventory Management
cont

8. Flexible Manufacturing system: Automated

flow of materials to the cell and automated
removal of finished item from the cell.

Management of Accounts
Receivables

Receivables are asset accounts representing

amount owed to the firm as a result of sale of
goods/services in the ordinary course of business.
Objective: to promote sales and profits until that
point is reached where the return on investment
in further funding of receivables is less than the
cost of funds raised to finance that additional
credit.
Purpose of receivables:

Achieving growth in sales

Increasing profits
Meeting competition

Management of Accounts
Receivables

Costs involved in maintaining receivables:

Capital costs
Administrative costs
Collection Costs
Defaulting costs

Factors affecting the size of receivables:

Level of sales
Credit policies
Terms of trade

Credit period
Cash discount

Management of Accounts
Receivables

Techniques

Computation of average age of

receivables:
Aging schedule of receivables.

Management of Accounts
Payable

Objective: to slow down the payments process as much as

possible.
Overtrading and Undertrading
Overtrading: an attempt to maintain or expand scale of
operations of the business with insufficient cash
resources.
Causes:
Depletion of WC
Faulty financial policy
Over-expansion
Excessive taxation
Inflation and rising prices

Management of Accounts
Payable

Consequences

Difficulty in paying wages and taxes

Costly purchases

Reduction in sales

Difficulties in making payments

Undertrading: improper and underutilization of funds lying at the
disposal of the undertaking

Causes:

Non-availability of facilities

Fall in the demand

Consequences:
Profit-slow down
Shares slow down
Loss of investors

Financing

Short term Financing

Trade Credit

Open Account Credit

Acceptance Credit
Factors:

Terms of Credit

Reputation of purchasing firm

Financial position of the seller

Volume of purchases to be made by the buyer

Commercial Banks
Public Deposits