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Working

CapitalManagement


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Definition of Working CapitalWorking Capital refers to that part of the

firms capital, which is required for

financing short-term or current assets such a

cash marketable securities, debtors and

inventories. Funds thus, invested in current

assets keep revolving fast and are constantly

converted into cash and this cash flow out

again in exchange for other current assets.Working Capital is also known as revolving

or circulating capital or short-term

capital.


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KINDS OF WORKING CAPITAL

WORKINGCAPITAL

BASIS OF

CONCEPT

BASIS OF

TIME

Gross

Working

Capital

Net

Working

Capital

Permanent

/ Fixed

WC

Temporary

/ Variable

WC

Regular

WC

Reserve

WC

Special

WC

Seasonal

WC


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Significance of Gross WC Optimum investment in CA

Investment in CA must be adequate CA investment should notbe inadequate or excessive inadequate WC can disturbproduction and can also threaten the solvency of firm , if it fails

to meet its current obligation excessive investment in CAshould be avoided , since it impairs firms profitability

Financing of CA

Need for WC arises due to increasing level of business activity& it is to provided quickly some time surplus fund may ariseswhich should be invested in Short term securities , they shouldnot be kept idle


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Significance of Net Working Capital

Maintaining Liquidity position

For maintaining liquidity position there is a

need to maintain CA sufficiently in excess of

CL

Judge Financial Soundness of a firm

The Net working capital helps creditors andinvestors to judge financial soundness of a

firm


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BALANCE SHEET OF ABC COMPANY AS ON 31-3-2000

Liabilities Rs Assets Rs

Equity Shares 200000 Goodwill 20000

8% Debentures 100000 Land and Building 150000Reserve & Surplus 50000 Plant and Machinery 100000

Sundry Creditors 150000 Inventories

Bills Payable 30000 Finished Goods 60000

Outstanding Expenses 20000 Work in process 40000

Bank Overdraft 50000 Prepaid Expenses 20000

Provision for Taxation 20000 Marketable Securities 60000

Proposed Dividend 30000 Sundry Debtors 90000Bills Receivables 20000

Cash & Bank Balance 90000

TOTAL 650000 TOTAL 650000


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Difference between permanent & temporary workingcapital

Amount Variable Working Capitalof

Working

Capital

Permanent Working Capital

TimePermanent and temporary working capital for Stable firm


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Variable Working Capital

Amount

ofWorking

Capital

Permanent Working Capital

Time

Permanent and temporary working capital for Growing firm


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Operating cycle concept Maximization of share holders wealth of a firm is possible only

when there are sufficient return from the operations

Successful sales activity is necessary for earning profit sales do notconvert into cash immediately

There is invisible time lap between the sale of good and receipt ofcash

The time taken to convert raw material into cash is known asoperating 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 )


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Operating Cycle in

Manufacturing firmCash

Raw

MaterialsW I P

Finished

Goods

DebtorsSALES


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Operating cycle of NonManufacturing Firm

cash

Receivables

Stock of finished goods


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Formula for calculating Operatingcycle for Manufacturing firmOC = ICP+ARPOC = Operating cycleICP = Inventory Conversion period

ARP = Account Receivable Period

ICP = Average Inventory

Cost of good sold /365ARP = Average Account Receivable

Sales/365


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ABC Company Provide the

following information , Compute

the operating cycle Sales 3000 Lakhs

Inventory Opening Rs 610 Lakhs ;

closing Rs 475 Lakhs

Receivable opening Rs 915 Lakhs;

Closing Rs 975 Lakhs

Cost of Goods Sold Rs 2675 Lakhs


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CASH CONVERSION CYCLE

The amount of time a firms resources are tiedup calculated by subtracting the average

payment period from the operating cycle thetime period between the date a firm pays itssupplier and the date it receives cash from itscustomer

CCC = OCAPPAAI = Average Inventory

Cost of good sold /365

ARP = Average Account ReceivableAnnual Sales/365

APP = Account Payable Period

Cost of good sold /365


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Calculate CCC(CASH CONVERSION CYCLE)Average use of Inventory 80 days

Account receivable collection period 50 days

Account payable period is 40 days

CCC= OC- APP

OC = AAI+ARP

80+50=130

CCC =130-40 =90 days


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Purchase of Sale of Goods Collection of

Raw Material on Credit Account Receivables

On credit

Average age of Account receivable

Inventory (AII) period (ARP)

Account PayablePeriod (APP)

Payment to

suppliers

Receipt of Invoice Operating Cycle (OC)

Cash Conversion cycle


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Resource flows for a manufacturing firm

FixedAssets

Production

Process

Generates

Inventory

Via Sales Generator

Accounts

receivable

Used in

Accrued Direct

Labour and

materials

Accrued Fixed

Operating

expenses

Cash and

Marketable

Securities

Suppliers

Of Capital

External Financing

Return on Capital

Collection

process

Used to

purchase

Used to

purchase

Used in

Working

Capital

cycle


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Calculate cash conversion cycle Sales Rs 1587.95

Cost of Good sold Rs 1406.27

Inventory opening 195.82, closing 202.29

Account receivables opening 423.03 closing449.46

Account payable opening 140.40, closing168.33

CCC = OCAPP

OC = AAI + ARP


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FORECASTING / ESTIMATION OFWORKING CAPITAL REQUIREMENTSFactors to be considered

Total costs incurred on materials, wages and overheads

The length of time for which raw materials remain in stores

before they are issued to production.

The length of the production cycle or WIP, i.e., the time taken

for conversion of RM into FG.

The length of the Sales Cycle during which FG are to be kept

waiting for sales.

The average period of credit allowed to customers.

The amount of cash required to pay day-to-day expenses of the

business.

The amount of cash required for advance payments if any.

The average period of credit to be allowed by suppliers.

Timelag in the payment of wages and other overheads


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PROFORMA - WORKING CAPTIAL ESTIMATES

1.TRADING CONCERN

STATEMENT OF WORKING CAPITAL REQUIREMENTS

Amount (Rs.)

Current Assets(i) Cash ----

(ii) Receivables ( For..Months Sales)---- ----

(iii) Stocks ( ForMonths Sales)----- ----(iv)Advance Payments if any ----

Less : Current Liabilities(i) Creditors (For.. Months Purchases)- ----

(ii) Lag in payment of expenses -----_

WORKING CAPITAL ( CACL ) xxxAdd : Provision / Margin for Contingencies -----

NET WORKING CAPITAL REQUIRED XXX

1 MANUFACTURING CONCERN


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1. MANUFACTURING CONCERN

STATEMENT OF WORKING CAPITAL REQUIREMENTS

Amount (Rs.)

Current Assets

(i) Stock of R M( for .months consumption) -----

(ii)Work-in-progress (formonths)(a) Raw Materials -----

(b) Direct Labour -----

(c) Overheads -----

(iii) Stock of Finished Goods ( for months sales)

(a) Raw Materials -----


(c) Overheads -----

(iv) Sundry Debtors ( for months sales)(a) Raw Materials -----


(c) Overheads -----

(v) Payments in Advance (if any) -----

(iv) Balance of Cash for daily expenses -----

(vii)Any other item -----

Less : Current Liabilities(i) Creditors (For.. Months Purchases) -----

(ii) Lag in payment of expenses -----

(iii) Any other -----

WORKING CAPITAL ( CACL )xxxx

Add : Provision / Margin for Contingencies -----

NET WORKING CAPITAL REQUIRED XXX


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Prepare an estimate of Working capital requirement

from the following information of a trading concern:

Projected annual sales 100000 units

Selling price Rs 8 per unit

% age of Net profit on sales 25%

Average Credit Period allowed to

customer 8 weeks

Average Credit Period allowed by

supplier 4 weeksAverage stock holding in terma of sales

requirement 12 weeks

contingencies 10%


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Points to be remembered whileestimating WC (1) Profits should be ignored while calculating working capital

requirements for the following reasons.

(a) Profits may or may not be used as working capital

(b) Even if it is used, it may be reduced by the amount of Income tax,

Drawings, Dividend paid etc.

(2) Calculation of WIP depends on the degree of completion as regards

to materials, labour and overheads. However, if nothing is mentioned

in the problem, take 100% of the value as WIP. Because in such a case,

the average period of WIP must have been calculated as equivalent

period of completed units.

(3) Calculation of Stocks of Finished Goods and Debtors should bemade at cost unless otherwise asked in the question.


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Prepare statement of workingcapital requirement, Profit &LossA/C, Balance Sheet Assuming Share Capital 150000

8% Debentures 200000 Fixed asset 130000

Material 40%

Direct lab our 20% Overheads 20%


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The following further particular are available

It is proposed to maintain a level of activity

of 2,00,000 units Selling price is Rs 12/- per unit

Raw Material are expected to remain instores for an average period of one month

Material will be in process , on averagehalf a month

Finished goods are required to be in stockfor an average period of one month

Credit allow to debtors is two month

Credit allow by supplier is one month


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Working Capital Financing Mix

Approaches to Financing

Mix

The Hedging orMatching Approach

The ConservativeApproach

The AggressiveApproach


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Hedging approach to asset financing

Fixed Assets

Permanent Current Assets

Total Assets

Fluctuating Current Assets

Time

Short-term

Debt

Long-term

Debt +

Equity

Capital


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The Hedging approach Hedging approach refers to a process of

matching maturities of debt with the maturities offinancial need . In this approach maturity ofsource of fund should match the nature of assetto be financed

This approach is also known as matchingapproach.

The hedging approach suggests that thepermanent working capital requirement should befinanced with fund from long term sources whilethe temporary working capital requirement

should be financed with short term funds.


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Estimated Total Investment in Current Asset of company X for

the year 2000

Month

Investmentin Current Asset

(R's )

Permanent or

FixedInvestments

(R's)

Temporaryor seasonal Invest

(R's)

January 50400 45000 5400

February 50000 45000 5000

March 48700 45000 3700April 48000 45000 3000

May 46000 45000 1000

June 45000 45000 -

July 47500 45000 2500

August 48000 45000 3000September 49500 45000 4500

October 50700 45000 5700

November 52000 45000 7000

December 48500 45000 3500

TOTAL 44300


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Conservative ApproachThis approach suggested that the entire

estimated investments in current asset should befinance from long term source and short termshould be use only for emergency requirement

Distinct features of this approach

Liquidity is greater

Risk is minimized

The cost of financing is relatively more asinterest has to be paid even on seasonalrequirement for the entire period


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Conservative approach to asset financing

Fixed Assets


Total Assets


Time

Short-term

Debt

Long-term

Debt +

Equity

capital

Trade off between Hedging and


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Trade off between Hedging and

conservative approaches

The hedging approaches implies low cost , highprofit and high risk while the conservativeapproach leads to high cost , low profit , low

risk Both the approaches are the two extremeand neither of them serve the purpose ofefficient working capital management

A trade off between the two will then be anacceptable approach , One way of determiningthe trade off is by finding the AVG of maximumand minimum requirement of current asset or

working capital


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Aggressive approach to asset financing

Fixed Assets


Total Assets


Time

Short-term

Debt

Long-term

Debt +

Equity

capital


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Aggressive approach

The aggressive approach suggests that the entireestimated requirement of current asset should befinanced from short-term sources and even a

part of fixed asset investment be financed fromshort - term sources

This approach make the finance mix :

More Risky

Less costly

More Profitable


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Prepare a projected balancesheet , profit and loss a/c andthen an estimation of workingcapital .

Issued Share Capital 300000

6% Debentures 200000

Fixed asset 200000 Raw Material 50%

Lab our 20%

Overheads 20%

Profit 10%

There is a regular production andsales cycle


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Raw Material are kept in stores for an

average period of two month

Finished goods remain in stock for anaverage period of three month

Production during the previous year was180000 units and it is planned to maintain

the same in the current year also Each unit of production is expected to be

in process for half a month

Credit allow to customer is three monthand given by supplier is two month

Selling price is Rs 4 per unit

Calculation of debtors may be made at

selling price


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Management of Working Capital

Working capital in general practice refer to theexcess of CA over CL.

Management of working capital therefore isconcerned with the problems that arise in

attempting to manage the CA, the CL and theinter-relationship that exists between them.

The basic goal of WCM is to manage the CA & CLof a firm in such a way that a satisfactory level of

WC is maintained. Working Capital Management Policies of a firm

have a great effect on its profitability, liquidity andstructural health of the organization


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Working capital management is 3 dimensional inNature

Dimension I

Profitability,

Risk, & Liquidity


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Working Capital Issues

Assumptions

50,000 maximum unitsof production

Continuous production

Three different policies

for current asset levelsare possible

Optimal Amount (Level) of Current Assets

0 25,000 50,000OUTPUT (units)

A

SSETLEVEL

Current Assets

Policy C

Policy A

Policy B


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Impact on Liquidity

Liquidity Analysis

Policy LiquidityA High

B Average

C Low

Greater current asset levelsgenerate more liquidity; allother factors held constant.


0 25,000 50,000OUTPUT (units)

A

SSETLEVEL

Current Assets

Policy C

Policy A

Policy B


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Impact on

Expected Profitability

Return on Investment=

Net ProfitTotal Assets

Let Current Assets = (Cash +

Rec. + Inv.)

Return on Investment=

Net Profit

Current + Fixed Assets


0 25,000 50,000OUTPUT (units)

A

SSET

LEVEL

Current Assets

Policy C

Policy A

Policy B


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Impact on

Expected Profitability

Profitability Analysis

Policy ProfitabilityA Low

B Average

C High

As current asset levels decline,

total assets will decline and

the ROI will rise.


0 25,000 50,000OUTPUT (units)

A

SSETLEVEL

Current Assets

Policy C

Policy A

Policy B


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Impact on Risk

Decreasing cash reduces thefirms ability to meet its

financial obligations. Morerisk!

Stricter credit policies reducereceivables and possibly losesales and customers. Morerisk!

Lower inventory levelsincrease stockouts and lostsales. More risk!


0 25,000 50,000OUTPUT (units)

A

SSETLEVEL

Current Assets

Policy C

Policy A

Policy B


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Impact on Risk

Risk Analysis

Policy RiskA Low

B Average

C High

Risk increases as the level of

current assets are reduced.


0 25,000 50,000OUTPUT (units)

A

SSETLEVEL

Current Assets

Policy C

Policy A

Policy B


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Summary of the Optimal

Amount of Current Assets

SUMMARYOFOPTIMALCURRENTASSETANALYSIS

Policy Liquidity Profitability Risk

A High Low LowB Average Average Average

C Low High High

1. Profitability varies inversely with liquidity.

2. Profitability moves together with risk.(risk and return go hand in hand!)

Techniques of analysis of working


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Techniques of analysis of working

capital

The analysis of working capital can be conductedthrough a number of devices such as

Ratio analysis

Fund flow analysisWorking capital Budgeting

Ratio analysis : A ratio is a simple arithmetical

expression of the relationship of one number toanother , this technique can be employed formeasuring short term liquidity or working capital

position of a firm.

Th f ll i i b


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The following ratios may be

calculated for this purpose Liquidity Ratioa) Current Ratio

b) Acid test ratio/quick ratio/liquid ratio

c) Cash Position ratio/absolute liquid ratio

Inventory turnover ratio

Receivable turnover ratio

Payable turnover ratio

Working capital turnover ratio


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Current ratio may be define as therelationship between CA and CL

This ratio is also known as WCR.

(Working capital ration).

It is helpful to measure shorttermfinancial position or liquidity of a firm

Current ratio: Current assetCurrent liabilities


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CURRENT ASSETS CURRENT LIABILITIESCash in hand

Bills Payable

Cash at bank Sundry Creditors

Sundry DebtorsAccrued or Outstanding

Expenses

Marketable securities(Short term)

Short term loan andadvancesBills Receivable Dividend payable

Inventories of Stock Bank OverdraftWork in progress

Finished goods

Prepaid Expenses

Q i k A id Li id


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Quick or Acid test or Liquid

RatioAn asset is said to be liquid if it can be convert

into cash with in a short period with out loss ofvalue

Inventory cannot be termed to be liquid assetbecause they cannot be convert into cashimmediately

The quick ratio can be calculated

Quick ratio: liquid asset

Current liabilities


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Quick or liquid Current LiabilitiesCash in hand Bills Payable

Cash at bank Sundry Creditors

Sundry DebtorsAccrued or Outstanding

Expenses

Marketable securitiesShort term advances

Temporary Investments Dividend payable

Bank OverdraftIncome tax payable

Convection quick ratio of 1:1 is consider satisfactory


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Cash Position ratio/absolute liquid ratio

Absolute Liquid assets include cash in hand andcash at bank and marketable securities ortemporary investments

The acceptable norms for this ratio is 50% or.05%

Cash ratio: Cash & bank + Shortterm securities

Current liabilities

C l l ll h h i


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Calculate all the three ratioLiabilities Rs Assets Rs

9% preference

share 500000 Goodwill 100000

Equity share

capital 1000000 Land and building 650000

8% debentures 200000 Plant 800000

Long term loan 100000Furniture andfixtures 150000

Bills payable 60000 Bills receivable 70000

Sundry creditors 70000 Sundry debtors 90000

Bank over draft 30000 Bank balance 45000

Outstanding

expenses 5000

short term

investments 25000

Prepaid expenses 5000

Stock 30000

1965000 1965000


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CONCLUSION:

Current ratio of the company is not

satisfactory because the ratio 1:6 is muchbelow then the expected Standards .

Acid test ratio on the other hand is morethan the normal standard of 1:1

Absolute ratio is slightly low because it is

0.42 where as the accepted standard is 0.5 In this company need to improve its short

term financial position


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Inventory turnover ratio

Inventory turn over ratio = Cost of good soldAverage Inventory at cost

Generally , the cost of good sold may not be known

from the published financials , in suchcircumstances

Inventory turn over ratio = Net Sales

Average Inventory at costInventory turn over ratio = Cost of good sold

Average Inventory at selling price


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Inventory conversion period

Inventory conversion period = Days in a yearInventory Turnover Ratio

M/s Rakesh & Co supplies you the following

information for the year ending 31st Dec 1999

Credit Sales Rs 150000

Cash Sales Rs 250000

Return Inward Rs 25000

Opening Stock Rs 25000

Closing Stock Rs 35000


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Debtor/Receivable turnover ratio/Debtor velocityDebtor(Receivable) = Net credit Annual sales

Average Trade debtorsTrade debtors = Sundry debtor + Bill Receivable and

account receivable s

Average Trade Debtors = Opening Trade debtor +

Closing Trade Debtor /2Note : Debtor should always be taken at gross value , Noprovision for doubtful debt be deducted from them but whenthe information about opening and closing balance of trade

debtor and credit sales is not available , then the debtorsturnover ratio calculated by dividing the total sales by thebalance of debtors(inclusive of Bills receivables) given

Debtors turn over Ratio = Total sales

Debtors


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Average Collection Period

The average collection period represent theaverage number of days for which a firm has towait before its receivable are converted into cash

Average Collection period =

Average Trade Debtors (Drs + B/R)

Sales per day

Sales Per day = Net Sales

No of working days

O


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Or

Average collection period =Average trade debtors

Net SalesNo of working days

If the period is in months:

Average collection period =No of working daysDebtors turnover ratio

The two basis component of the ratio are debtors

and sales per day

Creditor/Payable turnover ratio


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Creditor/Payable turnover ratio

The analysis for credit turnover is basically the same

as of debtors turnover ratio except that in place oftrade debtor, the trade creditor are taken and inplace of sales , average daily purchase are taken as

the other component of the ratio.Creditors turnover ratio

= Net credit annual purchase

Average Trade creditors


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Average Payment period Ratio

= Average Trade Creditors( Creditors+ Billspayable)/Average Daily purchases.

Average daily purchase = Annual Purchase /No of

working days in a year.Average Payment Period = Trade creditor * No of

working days / Net annual purchase.

Average Payment Period = No of working days /Credit turnover Ratio.

W rkin pit l t rn r r ti


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Working capital turnover ratioWorking capital of a concern is directly related to

sales and current asset like debtors , billsreceivable , cash , stock etc .

Working capital turnover ratio = Cost of Sales /

Average working capitalAverage working capital = Opening working

capital + Closing Working capital/2

** If cost of sales is not given , then the figure ofsale can be used . O n the other hand if openingworking capital is not disclosed then working

capital at the end of the year will be used.

The following information is given about M/s S.P


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g gLtd for the year ending Dec 31 2000

Stock turnover ratio = 6times

Gross Profit ratio = 20% on sales

Sales for 2000 = Rs 300000

Closing stock is Rs 10000 more than theopening stock

Opening Creditors = Rs 20000

Closing Creditors = Rs 30000Trade debtor at the end = Rs 60000

Net Working Capital = Rs 50000

FIND OUT


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FIND OUT

Average Stock

Purchases

Credit turnover ratio

Average Payment PeriodAverage Collection Period

Working Capital turnover ratio

F nd flo n l sis F d fl l i i


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Fund flow analysis : Fund flow analysis is atechnical device designated to study the sources

from which additional fund were derived andthe use to which these sources were put . It is aneffective management tool to study change inthe financial position of business

The fund flow analysis consists of

Preparing schedule of change in working capital

Statement of sources and application of funds

Working capital Budgeting : Working


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Working capital Budgeting : Working

capital budget as a part of total

budgeting process of a business , isprepared estimating future long term

and short term working capital need

and the sources of finance them .

The objective of a working capital

budget is to ensure availability of fundas and when needed and to ensure

effective utilization of these resources .

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