Working Capital

Management
Methods to determine working capital
amount
 Methods to determine working capital
amount
• There are many methods that are used to calculate the amount of
working capital required by a company. Three of the more popular
methods are as follows:

1. Conservative approach
2. Operating cycle approach
3. Current Assets holding period
 Conservative approach
• This approach states that a company should maintain current assets and
current liabilities at a proportion of 2:1. That means, for every Tk 1 of
current liabilities a firm should hold atleast Tk 2 worth of current assets.

• This approach will ensure that a firm always has sufficient working capital to
maintain smooth business operations. The safety, liquidity and solvency of
the firm is promoted.

• However, maintaining so much current assets will negatively affect company

profitability as current assets like cash, inventory, accounts recievable are
“idle asset” that do not earn return.
 Operating Cycle approach
• This
  approach states that the amount of working capital required by a business
depends on the length of its operating cycle and net operating cycle/cash
conversion cycle.
• Operating cycle refers to the average period of time taken by a business to make
an initial outlay of cash to purchase raw materials, use it to produce finished
goods, sell that finished goods (on cash and credit) and finally realize cash from
the customers for the credit sales.

So, Operating cycle = inventory conversion period + receivables collection period

Operating cycle =( × 360 ) + ( × 360 )
 Operating Cycle approach
• The
  cash conversion cycle or net operating cycle also influences the amount of
working capital required. Cash conversion cycle/net operating cycle is basically
the operating cycle of a company adjusted for the payable’s collection period.

• So,
Net operating cycle = Inventory conversion period + receivables collection period – payable’s deferral period
NOC = =( × 360 ) + ( × 360 ) - ( × 360 )

There exists a positive relationship between the length of operating cycle, Cash conversion cycle and working
capital requirement. The longer the length of these cycles the more is the working capital requirement of a
firm. This is because longer cycle means that the own cash of the companies are stuck for a longer time and
it will have to manage working capital from external sources.
 Current Assets holding period
• This method is basically an extension of the operating cycle approach.
It states that the amount of working capital required by a firm will
depend on the length of time taken by the firm to process its current
assets. Moreover, the deferral time of current liabilities also has an
impact.

• This method is one of the most popular ones to determine working

capital requirement. The application of this method is shown next.
 Current Assets holding period- Example
Following is the cost statement of ABC ltd. co.
Particulars Cost/profit per unit
Selling price 140 Q) Calculate the working
Raw material 50 capital required by ABC ltd.
Direct labor 20 for total production and sales
Overhead 40 of 70,000 units of goods.
Total cost 110
Profit 30

Other information given

Average raw material in stock/raw material conversion period = One month
Average raw material in process / WIP conversion period = Half month
average finished goods conversion period = 30 days
20% of sales are in cash
Expected cash balance to be maintained 100,000
Credit period allowed to debtors/average recievables collection period = 2 months
credit period received from creditors/payables deferral period = 45 days
Time lag in payment of wages/wage deferral period= 15 days
time lag in payment of overheads/overhead deferral period= 1 month
Current Assets holding period- Example
Alternative strategies for financing working
capital
Alternative strategies for financing working capital

• There are basically three alternative strategies for financing working

capital. These are:

1. Maturity matching approach

2. Aggressive approach
3. Conservative Approach
Maturity Matching approach
Under this approach, a firm tries to
match the maturity of the asset with the
maturity of the financing.

Thus, the permanent working capital is

financed using long term debt and equity
financing.

The temporary/fluctuating working

capital is financed using short term
financing.

The objective of this strategy is to

maintain a balance between firm safety
and profitability.
Conservative Approach
Under this approach, a firm focuses
more on company safety than
profitability.

In this strategy, the firm finances the

entirety of the permanent working
capital and a portion of the temporary
working capital using long term
financing. The remainder is financed
using short term financing.

This is done to increase safety of the

firm. Since long term financing does not
have to be arranged frequently, it is less
risky.
Aggressive approach
Under this approach, a firm focuses
more on company profitability than
safety.

In this strategy, the firm finances the

entirety of the temporary working
capital and a portion of the permanent
working capital using short term
financing. The remained is financed
using long term financing.

This is done to reduce cost of the firm.

Since long term financing is more
expensive than short term financing.
Firms use more short term financing.
However, as there is mismatch of
financing and working capital type, risk is
also higher.
 Summary of the relative costs and benefits of
alternative financing strategies

Factors Maturity matching Conservative Approach Aggressive Approach

approach
Liquidity Balanced Higher Lower
Profitability Balanced Lower Higher
Cost Balanced Higher Lower
Risk Balanced Lower Higher
Sources of Working Capital
 Sources of Working Capital

Once the amount of working capital required has been determined, a firm can avail the amount
from different sources. These sources of working capital can be classified as follows:

• Long term/Permanent sources: This can be further classified into internal and external sources.
Internal sources include retained earnings, general provisions etc. External sources include share
capital, debentures, bonds, long term bank loans etc.

• Short term sources: These are financing obtained for a period of less than 1 year. The short term
financing sources can be sub-classified into spontaneous financing and negotiated financing.
Spontaneous financing includes trade credit and accrual expenses. Negotiated financing includes
short term bank loan, revolving loan, commercial paper, accounts receivables financing and
inventory financing.
 Characteristics/advantages of short term
financing
• The characteristics of short term financing are as follows:
• Time – less than 1 year
• Purpose - to meet working capital requirement
• Cost of fund – usually less than long term sources
• Renewal- short term sources of financing are usually renewed by their providers at
maturity provided that the payments were made in time.
• Security – Usually, no security/collateral is required. However, there are
exceptions.
• Speed – Short term financing are usually processed very quickly and thus firms can
get it quickly from banks and institutions with minimal processing time
• Less restrictive – Do not involve restrictive covenants/stipulations like those
involved in long term financing
 Spontaneous sources of short term financing
• Spontaneous financing refer to those financing which a company can raise in the
normal course of its business without having to engage in a lot of formal
agreement/effort. Two major types of spontaneous financing are :
• Accounts payable
• Accruals of expenses

• Spontaneous financing usually does not involve any explicit cost like
interest/dividends etc. However, they do involve some implicit cost (higher price
of inventory, opportunity cost etc.)
 Accounts payable or trade credit
• Accounts payable/trade credit arises when a company purchases goods/inventory
on credit from its suppliers but does not pay for it immediately. Rather, the
payment is made after a certain credit period. This is a form of spontaneous
financing for a company.

• A firm should always try to pay its creditors as slowly as possible without
damaging its credit rating and market reputation.
 Importance/Advantages of trade credit
• The importance/advantage of trade credit are as follows:
• Easy availability
• Possibility of more profit by increasing sales
• Less formalities to avail trade credit
• Less costly – no explicit cost. However, there are some implicit cost.
• No need for collateral securities
• Development of mutual respect and trust
• Only source of financing available to very small businesses
 Disadvantages of trade credit
• The disadvantages of trade credit are as follows:

• Shorter repayment period compared to other financing sources

• High cost of forgoing cash discount
• High price of goods charged by supplied – this is also an implied cost
• No exemption of taxes
 Analyzing credit terms- should a company
take cash discount?
•• A
  company often has the opportunity to avail cash discount. For example, ABC company
purchased goods on credit terms 2/10 net 30. This means that if ABC ltd. pays for the goods
within 10 days of purchase than it will get 2% cash discount. Here, 10 days is the Discount period.
If it doesnttake the discount, then it will have to pay for the goods within 30 days. So, 30 days is
the credit period.

• A company’s decision to take or forgo cash discount will depend on the cost of forgoing discount /
cost of trade credit. It is calculated as follows:

Cost of trade credit =

Here, CD = cash discount offered in % terms
N = credit period – discount period
 Example
•• What is the cost of trade credit for ABC ltd? What is the effective annualized cost of trade credit (EAC TC ) for
 ABC ltd? What is its interpretation?

Cost of trade credit =

=
= 36.73%
Effective annualized trade credit/ EAC TC = - 1
= -1
= 43.83%
The above result means, that if ABC ltd. consistently misses its cash discount than it will result in an implied
cost of 43.83% per annum. The company should therefore try to take its cash discounts.
 Accruals
• Accruals of expenses or delay of payment of expenses is another
source of spontaneous financing. The most common item of accruals
is wages and tax.

• Companies often delay the payment of wages of its staff. This is done
intentionally as this results in a form of interest free loan from the
staff.
 Negotiated short term financing
• Negotiated financing is the opposite of spontaneous financing. This are
the forms of financing which a company has to avail after completing
many formalities, negotiations and processing.

• It can be sub-classified into two types. Unsecured negotiated financing

do not require any collateral. Examples include single payment loan, line
of credit agreement and revolving line of credit agreement. Secured
negotiated financing includes accounts receivable financing (pledging
and factoring) and inventory financing (floating inventory lien, chattel
mortgage, trust receipt inventory loans and warehouse receipts loans).
 Unsecured bank loans
• There are mainly 3 types of unsecured bank loans.
1. Single transaction loan
2. Line of credit
3. Revolving line of credit
• In this loans, a bank will extend an amount for a certain period of time. The borrower will
have to pay interest and principal. The interest rate can be either fixed or floating.
• A fixed interest rate is one which remains fixed throughout the maturity of the loan. A
floating interest rate fluctuates/varies over the maturity of the loan due to fluctuation in the
economy and central bank stipulated rate.
• A floating rate is usually set by adding a premium with the prime rate. Prime rate is the rate
charged by a bank for a loan given to its best (most credit worthy/least risky) customer. For
example, a floating rate could be prime rate + 3%. This means if prime rate is 6% than floating
rate is 9%. If prime rate changes after 1 year to 8% than the floating rate will become 11%.
 Single payment loan
•• This
  is a one time loan made by a bank to a business for a specific purpose (working capital
financing/purchase of asset etc.). The bank usually issues a note mentioning the amount of loan,
interest rate, repayment schedule etc. The maturity is usually between 1 month – 9 month.

• A company will always try to take loan from the bank which offers the lowest Effective annual
interest rate (EAR). Thus, it is important to be able to calculate EAR. It is calculated as follows:

EAR = - 1
Here,
Actual amount received from bank = total loan amount minus any deductions for commission, advance
interest etc.
N = loan maturity/ period
 Example
Rectangle Pharmaceuticals needs to borrow Tk 100,000 for 90 days. It has two
options with the following information.

Bank A The bank charges a fixed interest rate of 10.5% per annum. Interests
are to be paid at the end of the maturity of the loan.
Bank B The bank charges a floating interest rate calculated using formula
(prime rate + 1% increment). The current prime rate of Bank B is 9%.
However, it is expected to rise to 9.5% in 30 days and then fall to
9.25% after another 30 days. Interests will be deducted in advance
while disbursing the loan.

Calculate the EAR for the two loan proposals. Which banks should the firm take
loan from?
 Solution
•  EAR Bank A - 1 Periodic interest amount = 100,000 *
10.5% * 90/360
= -1
= 10.92% = 2625

• EAR Bank B - 1
= -1 Average floating rate = (10%+10.5%
+10.25%/3) 10.25%
= 10.94%
So, periodic interest amount =
100,000 * 10.25% * 90/360
Company should take loan from Bank A since its EAR is lower.
= 2562
Actual loan received = 100,000-2562
=97438
 Line of Credit
• A line of credit is an agreement between a commercial bank and a business under
which the bank agrees to provide up to a certain amount of loan to the company
within a given period of time. This loan functions like a credit card loan as every time
the company repays some loan amount the limit is replenished.

• A line of credit is not a guaranteed loan. Rather, the bank will provide this loan only if
it has sufficient funds available. The features of a line of credit are as follows:
• Interest rate: The rate is usually floating. Calculated as (prime rate + % increment). Interest is charged even on
the compensating balance amount.
• Operating change restrictions: The bank holds the right to cancel the agreement if the borrowing company
undergo’s major changes in operating condition, ownership, profitability etc.
• Compensating balance: Banks do not disburse the entire loan amount. Rather, they force the borrowing
company to always maintain a certain % of the loan amount in a checking account. This is done as precaution.
This amount is known as compensating balance.
 Example
• Pentagon Pharma has taken a line of credit from Grindlays bank for 1
year. The loan amount is Tk. 10,00,000. The compensating balance
required by the bank is 20%. The company intends to withdraw the
maximum possible amount from this line.

i) Calculate the EAR.

ii) Suppose, the checking account of Pentagon pharma already contains Tk
100,000 balance. Calculate the EAR taking into consideration this info.
 Solution (i)
•Compensating
  balance = 10,00,000 * 20%
= 200,000
So, actual amount received from bank = 10,00,000 – 200,000
= 800,000
EAR= -1
= -1
= 12.50%
 Solution (ii)
• Banks
  compensating balance requirement is Tk 200,000. Pentagon pharma
already has 100,000 in its account. So, it needs to keep only 100,000 from its loan
aside for the compensating balance.

• So, actual amount received from bank will be (10,00,000-100,000)= 900,000

EAR= -1
= -1
= 11.1%
 Revolving line of credit
• It is a guaranteed line of credit. This means that the bank promises to provide
this loan to the borrower whenever the borrower requires it regardless of
whether the bank has sufficient funds or not. Because of this special feature, the
bank charges a commitment fee on any unused portion of the loan in addition to
the interest on the used portion.
 Example
• Hexagon Ltd. has take a revolving line of credit of 20,00,000 Tk. The
average used portion/borrowing was tk 15,00,000 for the last year.
The bank charges a commitment fee of 0.5%. The rate of interest was
10%. Calculate the EAR.
 Solution
•• The
  interest amount = used portion * rate of interest * maturity/360
= 15,00,000 * 10% * 360/360
= 150,000
• Commitment fee = unused portion * 0.5%
= 500,000 * 0.5%
= 2500
EAR= -1
= -1
= 10.17%
 Unsecured open market financing
These are mainly two types:
1. Commercial Paper: This is an short term, unsecured promissory note issued
mainly by highly credit worthy companies. They typically have a maturity
between 3-270 days. Commercial papers usually do not pay any explicit
interest. Rather, they are sold at a discount compared to the face value. The
different being the implied rate of interest of the instrument.
2. Bankers acceptance: This is a financing where the bank, on behalf of the
borrower, agrees to pay a third party a certain amount of money at a
certain date provided that some pre-determined conditions have been met.
This form of financing is done to settle transactions between two parties
who do not trust each other.
 Example of Commercial Paper
ABC ltd. has just issued a 90 day commercial paper with a face value of
tk. 10,00,000. The commercial papers have been sold for 980,000 tk.
The floatation cost of issuing the CP is 1% of the face value. Calculate
the EAR.
 Solution
• 
EAR= -1
=-1
= 12.96%
• The EAR formula of Commercial paper can be rewritten as
EAR= -1
 Secured Short Term Loans
• Secured short term loans are loans taken keeping some asset as a
collateral. The lender keeps this collateral so that the loss is reduced
in case the loan is defaulted.

• There are mainly two types of secured short terms loans:

1. Loan taken by keeping accounts receivable as collateral
2. Loan taken by keeping inventory as collateral
 Accounts Receivable financing
• A company can often borrow money from institutions by using its
accounts receivable as collateral. This is known as accounts receivable
financing. There are two types of accounts receivable financing:
1. Accounts Receivable pledge
2. Accounts Receivable Factoring
 Accounts Receivable Pledge
• The pledging process is as follows:
• Firm requests to borrow funds using accounts receivable as pledge
• Lender evaluates the desirability of the accounts receivable
• Lender selects the “acceptable” accounts receivable and calculates its amount after adjusting for
sales allowance, sales return etc.
• The percentage of loan to be given against the acceptable accounts receivable is determined. This
is typically 50%-60%
• The lender files a Lien (legal right) on the accounts receivable

• Pledges on loan are usually made on a non-notification basis. So, the firm collects the
accounts receivable as they fall due. The lender charges an interest rate as well as a
processing fee for pledge loans. The bank usually deducts the interest and processing
fee upfront and disburses the remainder amount of the loan.
 Math
ABC ltd’s total credit sale is Tk. 10,00,000 and its average A/R is Tk. 200,000.
The company is considering to take a loan from XYZ bank pledging it’s A/R.
The interest rate is 12%. The bank requires 15% margin (reserve) on the face
value of the average A/R.

Requirements:
i) What is the amount of loan that XYZ Bank will approve?
ii) What is the interest expense?
iii) What is the net borrowing amount?
iv) What is the EAR?
 Solution
•   maturity of the loan is equal to the accounts receivable collection period.
The

A/R collection period = × 360

= × 360
= 72 days
i) Loan amount= Average A/R – Margin/Reserve
= 200,000 – (200,000× 0.15)
= 170,000
 Solution
•ii) Interest amount = Loan amount × Interest rate × maturity
= 170,000 × 0.12 ×
= 4080
iii) Net borrowing amount = Loan amount – interest and other expenses deducted upfront
= 170,000 – 4080
= 165,920
iv) EAR= - 1
= -1
= 12.90%
 Factoring Accounts Receivable
• Factoring is, in fact, NOT a loan. Rather, it involves the outright selling of a
company’s accounts receivable to a bank at a discount to the face value.
• The factoring process is similar to the pledging process. However, factoring is
usually done a “notification basis” meaning the bank is liable to collect the A/R
from the customers. Moreover, Factoring is done on a “non-recourse basis”. This
means that the credit risk is completely borne by the bank/factor.
• The factor/bank doesn’t pay the firm immediately as it purchases the A/R. Rather,
the bank makes payment once it is able to collect the A/R from the customers or
once the credit period ends, whichever occurs first.
• However, sometimes a firm might need money urgently and cant wait for long. In
such cases, it can take a loan/advance from the factor for an interest.
 Factoring Costs
• The bank usually advances only a certain percentage (80%-90%) of the Average A/R
when it purchases it under factoring.

• The bank charges a factoring commission. Moreover, if it provides loans/advances

then it charges interest as well. These are the costs of factoring.

• However, a firm receives certain advantages as well when it raises money through
factoring. Firstly, since the bank becomes responsible for collecting the A/R, the
company no longer has to worry about bad debt loss. Moreover, the administrative
cost of collecting A/R is also saved by the company. Finally, the company can
actually earn some interest from the bank if it does not withdraw the factoring
money from its account maintained with the bank.
 Math
• DEF Ltd. total annual credit sales is Tk 80,000,000 and its accounts
receivable collection period is 90 days. The company is considering to factor
it’s A/R to a bank. In that case, it will save the average A/R bad debt loss of
2% and annual administrative cost of 800,000. The bank/factor charges a
commission of 3%. DEF ltd. is in a rush and will take an advance of 90% on
the face value of the A/R at 15% annual interest rate from the factor.

i) How much will DEF ltd. get as advance from the factor/bank?
ii) What is the net borrowing amount?
iii) Calculate the EAR of factoring.
 Solution
•First,
  we will calculate the Average A/R.

A/R collection period = × 360

90 = × 360

× 80,000,000 = Average A/R

20,000,000 = Average A/R

i) Advance amount = Average A/R × advance ratio

= 20,000,000 ×0.90
= 18,000,000
 Solution
i) Net borrowing amount =

Details Tk Tk
Advance Amount 18,000,000
Less, Factoring Commission (20,000,000 * 0.03) 600,000
Interest (18,000,000 – 600,000)* 0.15 * 90/360 652,500
12,52,500
Net Borrowing Amount 16,747,500
 Solution
•   = -1
EAR
-1
EAR = 16.52%

Details Tk
Interest cost 652500
Factoring cost 600,000
Total periodic cost 12,52,500
Less, Administrative cost (800,000 * 90/360) (200,000)
Less, Bad debt cost (average A/R * bad debt %) or (20,000,000 * (400,000)
0.02)
Net periodic factoring cost 652,500
 Pledging Vs Factoring
• Refer to table in page 431 and 432
 Inventory financing
• A company can take loan from a bank by using its inventory as collateral. There are four types
of inventory financing:

1. Floating inventory liens: This is a loan provided by a bank whereby it places a lien/claim on the inventory of
the borrower in general (meaning no specific inventory is held as collateral). Banks usually provide only
50%-60% loan to inventory value Since it annot determine the exact amount of inventory held by the
borrower
2. Chattel Mortgage: Here bank provides loan by taking personal, moveable property as collateral. This
includes cars, boats, aircrafts, electronics etc.
3. Trust Receipt Inventory loans: Here, the bank provides a loan against the inventory of the borrower.
However, the borrower is free to sell the inventory as it wishes. But once sold, the borrower must
immediately repay the loan of the bank along with any due interests.
4. Warehouse Receipt loans: Here, the bank provides a loan against the inventory of the borrower and
prevents the borrower from selling the inventory until it has repaid the loan. In fact, the bank takes the
possession of the inventory under its own control and transfers the inventory from the borrowers
warehouse to a warehouse controlled by the bank.