Working Capital Management

Financial Management
Working Capital

• Working Capital that part of the firm’s

capital, which is required for financing
short-term assets (cash marketable
securities, debtors and inventories)
Working Capital
• Working Capital — Revolving Capital or
Circulating Capital or
Short-Term Capital
• Net Working Capital
• Part of the current assets financed by long term
funds
WC… Significance
• Nature of business (retail or manufacturing)
• Optimum investment in CA
• Business cycle fluctuation (boom, recession etc.)
• Seasonal operation
• Maintaining liquidity position
• Credit policy
• Market competitiveness (more competition - liberal credit)
• Supply condition
Zero Working Capital
• Inventories = major constituent of CA
(+)
• Receivables = major constituent of CA
(—)
• Payables = Raw material is financed
Zero Working Capital
• Reduction in Working Capital
• One time release of cash flow
• Saving in capital cost
• Corporates produce and deliver faster
• Storage and loss due to obsolete investment is minimized
Operating Cycle

• The time taken for the conversion of

raw material into realized sales.
 Accounts Payable Value Addition

Raw WIP
Materials

THE WORKING CAPITAL

Cash CYCLE Finished
(OPERATING CYCLE) Goods

Accounts SALES
Receivable
Operating Cycle
• The time taken to convert raw material into
cash is known as operating cycle
• Conversion of cash into raw material
• Conversion of raw material into work in progress
• Conversion of Work in progress into finished
goods
• Conversion of finished good into Sales ( Debtors
and cash )
 Operating Cycle
Raw WIP
Materials
DP = Deferral Payment
Credit facility from suppliers FGCP
RMCP WPCPand
wage earners, so payment to them is Finished
Cash deferred. Goods

RCP

Debtors SALES
Operating Cycle
• Raw material Cycle Period (RMCP)
Average Raw Material
Total Raw Material Consumed
* 365
• Work – In – Progress Cycle Period (WPCP)
Average Work-In-Progress
Total Cost of Production * 365
• Finished Goods Cycle Period (FGCP)
Average Stock
Total Cost of Goods Sold
* 365
Operating Cycle
• Receivables Cycle Period (RCP)
Average Receivables or Average Debtors
* 365
Total Credit Sales
• Deferral Period (DP)
Average Creditors
* 365
Total Credit Purchases
 TIME IS MONEY
If you Then ......
Collect receivables (debtors) You release cash
faster
Collect receivables (debtors) Your receivables soak up cash
slower
Get better credit (in terms of You increase your cash resources
duration or amount) from
suppliers
Shift inventory (stocks) faster You free up cash

Move inventory (stocks) slower You consume more cash

Ratios associated with
WCM
Inventory Turnover Ratio COGS
(Times) AVERAGE STOCK

Inventory Turnover Ratio Average Stock x 365

(Days) COGS

Receivables Turnover Ratio Net Credit Sales

OR Debtors Turnover Ratio Average Accounts
(Times) Receivable
Ratios associated with
WCM
Debtor or Receivables Avg. A/C Receivable x 365
Collection Period OR Net Credit Sales
Average Receivables Period
(Days)
Payables Turnover Ratio Net Credit Purchases
(Times) Average Accounts
Receivable
Average Payables Period Avg. A/C Receivable x 365
(Days) Net Credit Sales
Ratios associated with
WCM
Current Ratio Current Assets
Current Liabilities

Quick Ratio CA – Stock

Current Liabilities

Working Capital Turnover Net Sales

Ratio Net Working Capital
Calculating Operating Cycle
• From the following information , Compute the
operating cycle
• Sales 3000 Lakhs
• Inventory Opening 610 Lakhs ; Closing
475 Lakhs
• Receivable opening 915 Lakhs; Closing
975 Lakhs
• Cost of Goods Sold 2675 Lakhs
WC, CA and Sales

• Inevitable relationship between WC / CA and

Sales
• Forecasted sales impact the amount of CA that
should be maintained
 WC, CA and Sales
Current Conservative
Assets Moderate

Aggressive

Sales Level
KINDS OF WORKING CAPITAL

WORKING CAPITAL

BASIS OF BASIS OF
CONCEPT TIME

Gross Net Permanent Temporary

Working Working / Fixed / Variable
Capital Capital WC WC

Seasonal Special
WC WC
Regular Reserve
WC WC
Types of Working Capital

• Permanent Working Capital

• Temporary Working Capital

Permanent & Temporary
working capital

Amount Temporary Working Capital

of
Working
Capital

Permanent Working Capital

Time
Permanent and temporary working capital for Stable firm
Permanent & Temporary
working capital
Temporary Working Capital
Amount
of
Working
Capital
Permanent Working Capital

Time
Permanent and temporary working capital for Growing firm
Working Capital
• EXCESS OR INADEQUATE WORKING CAPITAL

• Both excess as well as shortage of working capital

situations are bad for any business. However, out of the
two, inadequacy or shortage of working capital is more
dangerous from the point of view of the firm.
Inadequacy of WC
• Can’t pay off its short-term liabilities in time
• Economies of scale are not possible
• Difficult for the firm to exploit favorable market
situations
• Day-to-day liquidity worsens
Excess of WC
• Idle funds — non-profitable, poor ROI
• Unnecessary accumulation of inventories over
required level
• Excessive debtors and Defective credit policy, Higher
B/D
• Credit worthiness suffers
• Low rate of Return on Investments — Market Value
of shares fall
Liquidity versus
Profitability Trade-off
• Large investments in working capital means that
more stock, more current assets as a result…
• Loss on return on investments
• Loss of Production, Loss of Sales, Inability to pay
creditors on time
• Less investments in working capital means…
• Risk of liquidity
• There is a TRADEOFF between RISK (liquidity)
and RETURN (profitability)
Working Capital
Financing Mix
Approaches to Financing
Mix

The Hedging or The Conservative The Aggressive

Matching Approach Approach Approach
Hedging Approach
• Matching maturities of debt with the maturities of
financial need
• Maturity of source of fund should match the nature of
asset to be financed
• Permanent Working Capital requirement should be
financed with fund from Long Term Sources
• Temporary Working Capital requirement should be
financed with fund from Short Term Sources.
Hedging Approach
Total Assets
Short-term
Debt
Fluctuating Current Assets

Long-term
Permanent Current Assets Debt +
Equity
Capital

Fixed Assets

Time
Conservative Approach
• Entire estimated investments in current asset
should be financed from long term source and
short term should be use only for emergency
requirement
• Liquidity is greater
• Risk is minimized
• More cost of financing
Conservative Approach
Total Assets
Short-term
Debt
Fluctuating Current Assets

Long-term
Permanent Current Assets Debt +
Equity
capital

Fixed Assets

Time
Aggressive Approach
• The entire estimated requirement of current asset
should be financed from short-term sources and
even a part of fixed asset investment be financed
from short - term sources
• More Risky
• Less Costly
• More Profitable
Aggressive Approach
Total Assets
Short-term
Debt
Fluctuating Current Assets

Long-term
Permanent Current Assets Debt +
Equity
capital

Fixed Assets

Time
Trade Off…
• Hedging Approach: • Conservative Approach:
• Low Cost • High Cost
• High Profit • Low Profit
• High Risk • Low Risk
 Trade off
Profit
Low

Conservative

Trade Off
Cost
Of Hedging
Funds
Profit
High

High Risk Low Risk

NWC
 Working Capital Management

Cash Receivables Inventory

Management Management Management
Cash Management
• Identify the cash balance which allows for the business to
meet day to day expenses
• reduces cash holding costs

Receivables Management
• Money which is owed to a company by a customer for
products and services provided on credit
• Identify the appropriate credit policy

Inventory Management
• Identify the level of inventory which allows for uninterrupted
production
• Reduces the investment in raw materials, minimizes
reordering costs and hence increases cash flow