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Working Capital Management

Capital Requirements

Short Term Capital Long Term Capital

Working Capital

Short term finance involving current assets and current liabilities

Involve cash flows within one year or one operating cycle of the firm.

Relevance of Working Capital:

Investment in current assets represents substantial portion of total


Investment in current assets and the level of current liabilities have to be

geared quickly to changes in sales. Variation of fixed assets and long term
finance vis--vis sales is not as direct and close as is the working capital.

a. Raw Materials
b. WIP Current Assets Loans &
c. Finished goods
d. Others

Cash and
(Short term)
Trade Advances
Commercial Banks

Sundry Creditors Provisions

Current Asset Cycle



Finished Work-In-
Goods Progress
Concepts of Working Capital

Working Capital

Gross Working Capital = Net Working Capital =

Current Assets Current Assets Current Liabilities
(Cash, Short-term securities, Current liabilities include creditors,
debtors, bills receivable and bills payable and outstanding
stock) expenses
Factors influencing Working Capital

Nature of Business

Seasonality of operations

Production policy

Market conditions

Conditions of supply
Nature of Business

Industries Current Assets Fixed Assets

Electricity Generation and 20-30% 70-80%


Aluminium, Shipping 30-40% 60-70%

Iron and steel, Basic 40-50% 50-60%

Industrial Chemicals

Tea Plantation 50-60% 40-50%

Cotton Textiles, Sugar 60-70% 30-40%

Edible Oils, Tobacco 70-80% 20-30%

Trading, Construction 80-90% 10-20%

Level of Current Assets

Conservative or Flexible Aggressive or Restrictive policy

CA high CA investment low

Few production stoppages May lead to frequent production

Quick delivery to customers
Delayed delivery to customers
Stimulates sales
Loss of sales
Costs Involved in Current Assets

a. Carrying Costs

Costs that rise with CA

Cost of financing higher level of CA

b. Shortage Costs

Costs that fall with CA

Disruption in production schedule, loss of sales and loss of customer
Current Assets Financing Policy

Current Assets

Permanent Current Assets Temporary Current Assets

Strategies of Current Asset Financing


Long Term financing for Long-Term Financing to

Long-term Financing for
Fixed Assets & PWC & meet fixed asset and
FA & Peak WC
Portion of TWC PWC.
Operating Cycle and Cash Cycle
Payable Period
= Invoice date
Order payment for
Placed materials


sold Inventory
Receivable Period
Operating Cycle

Purchase of raw Receiving cash for

materials sale of finished goods

Inventory Period + Accounts Receivable Period

Cash Cycle

Payment of raw Cash received for sale

materials of finished goods

Operating Cycle Accounts Payable Period

Average Inventory
Inventory Period =
(Annual COGS / 365)

Average Accounts Receivable

Accounts Receivable Period =
(Annual Sales/ 365)

Average Accounts Payable

Accounts Payable Period =
(Annual COGS / 365)
Eg 1:
Calculate Inventory Period, Accounts Receivable Period, Accounts Payable
Period, Operating Cycle, Cash Cycle

Balance Sheet Data

Profit & Loss Beginning of End of 2000

Data 2000

Sales 800 Inventory 96 102

COGS 720 Accounts 86 90


Accounts 56 60
1. Inventory Period = Average Inventory / (Annual COGS/365)

= (102 + 96) / 2 = 99 = 50.18 days

(720/365) 1.97

2. Accounts Receivable Period = Average Accounts Receivable / (Sales /365)

= (86 + 90) / 2 = 88 = 40.2 days

(800/365) 2.19

3. Accounts Payable Period = Average Accounts Payable / (COGS / 365)

= (56 + 60) / 2 = 58 = 29.4 days

(720/365) 1.97
Operating Cycle = Inventory Period + Accounts Receivable Period

= 50.2 days + 40.2 days = 90.4 days

Cash Cycle = Operating Cycle Accounts Payable Period

= 90.4 days 29.4 days = 61 days

Eg. 2: Financial Information of X Ltd. For the year ended 2001 is given below:

Profit & Loss A/c data Balance Sheet data

(Rs. Mn) Beginning of End of 2001


Sales 80 Inventory 9 12

COGS 56 Accounts 12 16

Accounts 7 10

Calculate Inventory Period, Accounts Receivable Period, Accounts Payable

Period, Operating Cycle, Cash Cycle

Inventory Period = Average Inventory / (Annual COGS/365)

= (9 + 12) /2 = 68.4 days

Accounts Receivable Period= Avg. Accounts Receivable / (Annual sales /365)

= (12 + 16) /2 = 63.9 days


Accounts Payable Period = Avg. Accounts Payable / (Annual COGS/365)

= (7 + 10) / 2 = 55.4
Operating Cycle = Inventory Period + Accounts Receivable Period
= 68.4 + 63.9
= 132.3 days

Cash Operating Cycle = Operating Cycle Accounts Payable Period

= 132.3 55.4
= 76.9 days
Cash Requirement for Working Capital
Estimate the cash requirements using the following two steps:

1. Estimate the cash cost of various current assets required by the firm. The
cash cost of a current assets is:

Value of the current asset

- Profit element, if any, included in the value
- Non-cash charges like depreciation, if any, included in the value

2. Deduct the spontaneous current liabilities from the cash cost of current
(Portion of current asset supported by trade credit and accruals of wages
and expenses are referred to as spontaneous current liabilities)
Working Capital Financing

Sources of Finance that are used to support Current Assets are as under:

1. Accruals
2. Trade Credit
3. Working Capital Advance by Commercial Banks
4. Regulation of Bank Finance
5. Public Deposits
6. Inter-Corporate Deposits
7. Short-term loans from Financial Institutions
8. Rights Debentures for Working Capital
9. Commercial Paper
10. Factoring


Employees Government

Wages Taxes
Level of

Trade Credit

Obtaining Trade Cost of Trade

Credit Credit

With discount
Track Record

position of the

Record of
Cost of Trade

30 days Net Net 30 days

Discount given
if paid promptly
Net 30 i.e. cost associated beyond the discount period

30 days period

10 days 20 days
Discount Period Non-Discount Period

Cost = Dis X 360

(1-Dis) (Credit Period Dis Period)
Problems on Trade Credit

1. What is annual percentage interest cost associated with the following credit

a. 2/20 net 50

(0.02 / 0.98) X (360 / 50 - 20) = 24.5%

b. 2/15 net 40

(0.02 / 0.98) X (360 / 40 15) = 29.4%

c. 1/15 net 30

(0.01 / 0.99) X (360 / 30 - 15) = 24.2%

d. 1/10 net 30

(0.01 / 0.99) X (360 / 30 10) = 18.2%

e. 1/10, net 20

(0.01 / 0.99) X (360 / 20 - 10) = 36.4%

f. 2/10, net 45

(0.02 / 0.98) X (360 / 45 - 10) = 20.99%

g. 3/10, net 60

(0.03 / 0.97) X (360 / 60 - 10) = 22.26%

h. 2/15, net45

(0.02 / 0.98) X (360 / 45 - 15) = 24.48%

Working Capital Advance by Commercial Banks

Application and Processing

Sanction and Terms and Conditions

Forms of Bank Finance

Cash Credits/ Overdrafts
Purchase/ Discount of Bills
Letter of Credit

Margin Amount
Purchase or Discount of
Bills Seller Draws
Bill on

On due date,
bank collects Purchaser
from Accepts

Bank Pays
Presents bill
to bank
Maximum Permissible Bank Finance


0.75 (CA CCA) -

0.75(CA - CL) 0.75 (CA) - CL
Public Deposits


Term Interest Rate

1Yr 6-7%
2Yr 7-8%
3Yr 9-10%


1. Procedure is simple
2. No Restrictive Covenants
3. No security is offered
4. Reasonable Cost


1. Limited quantum of funds

2. Maturity period is relatively short
Advantages from the view point of investors

1. Rate of interest is higher

2. Maturity period is short


1. No security offered by the company

2. Interest is not exempt from taxation
Inter-Corporate Deposits

Call Deposits Three-Months Deposits Six-Months Deposits

Characteristics of Inter-Corporate Deposit Market



Personal Contacts
Short-Term Loans from Financial Institutions

Insurance companies offer to manufacturing companies with good track record


1. Totally Unsecured. Given on the strength of a demand Promisory Note

2. Given for 1Yr Period and renewed for two consecutive years later

3. After loan is repaid, company has to wait for atleast 6 months before availing
of fresh loan

4. Interest is payable at quarterly rests

Commercial Paper

Promisory Notes
Issued by firms with good credit rating

Features of Commercial Paper

1. Maturity Period 90-180 Days

2. Sold at discount and redeemed at Face Value
3. No Secondary Market

Factor is Financial Institution that manages debts arising from credit sales
In India only 4 Public Sector Banks allowed to do factoring
SBI (SBI Factoring and Commercial Services Limited)
Canara Bank (Canara Bank Factoring Limited)
Allahabad Bank

Features of Factoring Arrangement

Factor selects
accounts of
clients to

Collects from Fixes the

buyers and credit limit in
pays balance consultation
amount with client

He advances
to the client Factor
70-80%. assumes the
Charges collection
interest & responsibility
Cash and Liquidity Management
Reasons for holding Cash

Cash collected is not exactly same as cash

Transaction Motive disbursed
Cash is required as buffer

Uncertainty about magnitude and timing of

cash inflows and outflows.
Precautionary Motive
Cash required to protect against

Fluctuations in commodity prices, security

Speculative Motive
prices, interest rates and forex rates
Establish reliable forecasting and reporting systems

Improve cash collections and disbursements

Achieve optimal conservation and utilisation of funds

Contents of the Chapter

Cash Budgeting

Long-term Cash Forecasting

Reports for Control

Monitoring Collections and Receivables

Optimal Cash Balance

Investment of Surplus Funds

Cash Management Models

Cash Budgeting

Estimating Cash Requirements

Short-term Financing

Scheduling payments w.r.t Capital Expenditure Projects

Planning Purchases of Materials

Developing Credit Policies

Checking accuracy of long-term forecasts

Designs of Short-Term Forecast

One year divided into Quarters or Months

One Quarter divided into Months

One Month divided into Weeks

One Week divided into days

Receipts and Payments Method

Expected receipts and payments

Needs information
o Estimated Sales
o Production Plan
o Purchasing Plan
o Financing Plan
o Capital Expenditure budget
Sl.No. Items of Cash Receipts Basis of Estimation
and Payments
1. Cash Sales Estimated Sales and its division between Cash
and Credit Sales
2. Collection of Accounts Estimated Sales, its division between Cash and
Receivable Credit Sales and Collection pattern
3. Interest and Dividend Firms Portfolio of Securities and Return expected
Receipts from the portfolio
4. Increase in Financing Plan
Loans/Deposits and
Issue of Securities
5. Sale of Assets Proposed disposal of Assets
6. Cash Purchases Estimated Purchases and its division between
Cash and Credit Purchases
7. Payment of Purchases Estimated Purchases, its division between Cash
and Credit Purchases and Terms of Credit
Sl.No. Items of Cash Receipts & Basis of Estimation
8. Wages & Salaries Manpower employed and wages and
salaries structure
9. Manufacturing expenses Production Plan
10. General, Administration and Administration and Sales Personnel and
Selling Expenses Proposed Sales Promotion and
distribution expenditure
11. Capital Equipment Purchases Capital expenditure budget and payment
pattern associated with Capital
Equipment Purchases
12. Repayment of Loans and Financing Plan
Retirement of Securities
Deviations from Expected Cash Flows

Deviation from the actual cash flows and the expected cash flows.

Result of assumptions made to arrive at the cash flows.

It would be appropriate to make different sets of assumptions under three

different scenarios

Pessimistic scenario, Normal Scenario and Optimistic Scenario

Make Contingency plans accordingly.

Evaluation of Receipts and Payments Method


1. Complete Picture
2. Appropriate tool for day-to-day predictions


1. Results vary according to collection delays or unforeseen expenses

2. Does not clearly depict important changes in companys WC movements
relating to inventories and receivables
Long-Term Cash Forecasting
Adjusted Net Income Method
2009 2010 2011
Net Income After Taxes
Non-Cash Charges
Increase in Borrowings
Sale of Equity Shares
Capital Expenditure
Increase in Current Assets
Repayment of borrowings
Dividend Payments
Opening Cash Balance
Closing Cash Balance
Reports for Control

Daily Cash Report

Daily Treasury Report

Monthly Cash Report

Cash Collection and Disbursement


Difference between the Cash Balance and the Bank Balance of Cash

Disbursement Float Cheques issued by company

Firms Available Balance > Firms Book Balance

Collection Float Cheques received by company

Firms Available Balance < Firms Book Balance
Speeding Up Collections

Customer Company Company deposits Cash

Mails Cheque Receives Chq Cheque Available

Mailing Time Processing Availability Delay

Techniques Used by Companies to Speed up Collections

Lock Boxes Concentration Banking Delaying Payments

Lock Boxes

Company takes drop box with

local post office

Customer asked to drop

cheques in this drop box Reduces
the Mailing

Collecting bank collects

cheques directly and deposits in
local bank account of customer
Bank account of customer is
Evaluation of Lock Boxes

Average Number of Daily Payments - 50

Average Size of Payment - Rs. 8000

Savings in mailing and processing time - 2days

Annual Rental for the Lock Box - Rs. 3000

Bank Charges for operating the Lock Box - Rs. 72000

Interest Rate - 15%

Increase in companys collected balance because of lock box
= 50 Items a day X Rs. 8000 Per item X 2 days saved
= Rs. 800000/-

Return on Rs. 800000 @ 15% = Rs. 120000/-

Annual Cost of Lock Box

= Rs. 3000/- (Rental) + Rs. 72000/- (Bank Charges)
= Rs. 75000/-

Total Savings = Rs. 120000 75000 = Rs.45000/-

Concentration Banking

Customers in a particular area send cheques to the local bank office and
not the Corporate Office.

On a daily basis, funds from this account are transferred to the Principal
Bank Account.

Concentration banking when combined with Lock Box will give further better
Delaying Payments

Delay payments to Suppliers

Payments to be done only when they fall due and not before that

Centralize Disbursements

Synchronise payments in such a way that payment to be made on receipt

from our company debtors.
Electronic Data Interchange

Electronic exchange of information between various parties

Elimination of Paper Invoices, Paper Cheques, Mailing, Handling and so on.

Seller sends electronic bill to buyer and latter authorises his bank to make
payment and the bank transfers funds electronically.

Float management will improve.

Optimal Cash Balance


Total Cost

Investment of Surplus Funds


Ready Cash Controllable Free Cash

Segment Cash Segment Segment

Taxes, dividend,
High liquidity Earning Interest
Criteria for Evaluating Investment Instruments




Investment Options

1. Fixed Deposit with Banks

2. Treasury Bills
91days, 182 days, 364days
No explicit interest rate
Sold at discount and redeemed at par
3. Mutual Fund Schemes
Equity Schemes
Balanced Schemes
Debt Schemes
4. Commercial Paper
Firms issue
Maturity date of 90-180 days
Sold at discount and redeemed at par
5. Certificate of Deposit

Negotiable receipt of funds deposited with bank

Come with explicit rate of interest


High rate of interest

Good secondary market
Tailor-made denominations and maturities
6. Inter-corporate Deposits
Call deposits
Three-month deposits
Six-month Deposits

7. Ready Forwards

8. Bill Discounting
Cash Management Models

Cash Budget

Surplus Deficit

Cash Holdings
Baumol Model
Proposed by William J.Baumol
Applies Economic Order Quantity (EOQ) concept to determine cash conversion size
which in turn influences

Model is explained with the following equation:

C = (2 bT /I)

C = Amount of Marketable Securities converted into cash per order

I = Interest Rate earned per planning period on investment in Marketable Securities
T = Projected Cash Requirements during the planning period
TC = Sum of Conversion and holding costs.

TC = I (C/2) + b (T/C)
Interest Income Conversion
Foregone Costs
1. Zeta requires Rs. 1.5 Mn cash for meeting its transaction needs over the
next 3months

2. To meet the projected cash needs, Zeta can sell its marketable securities in
any of the five lot sizes: 100000/-, 200000/-, 300000/-, 400000/- and

3. Zeta can earn 16% annual yield on its marketable securities i.e. for 3
months, interest is 4%.

4. Conversion costs are Rs. 500/- per transaction.

5. Cash payments are made evenly over the 3months planning period.

6. What is total Cost of Ordering and Holding?

T = 1.5Mn
b = 500
I = 4%

C = (2 bT/I)

C = 2 X 500 X 1500000 / 0.04

= 193649/-

This means that if the marketable securities are sold in lots of Rs. 200000/-, it
would minimise the Total Cost.
Miller & Orr Model

Extension of Baumal Model

Assumes that changes in cash balance over a given period are random in
size and direction.
As the number of periods increases, the cash balance changes from a
normal distribution

Answers the following two question:

When should the transfers be effected between marketable securities and

What should be the magnitude of these transfers?
Upward changes in cash balance are allowed till the cash balance reaches
an Upper Control Limit.

On reaching this point, the cash balance is reduced to Return Point

On the other hand, once the balance touches Lower Control Limit, enough
Marketable Securities are disposed to restore the cash balance to its
Return Point

Lower Control Point is fixed by the Management, RP and UL have been

derived by Miller and Orr with a view to minimising the total ordering and
holding costs.
RP = [(3b / 4I ) ] + LL

UL = 3 RP 2LL

RP = Return Point
B = Fixed Cost Per Order for converting Marketable securities into cash
I = Daily interest rate earned on Marketable Securities
= Variance of daily changes in the expected cash balance
LL = Lower Control Limit
UL = Upper control Limit