Working Capital Concepts

Working Capital Management – An Analysis
CONTENTS
1. Introduction 4
2. Concept Of Working capital 5
3. Features Of Working Capital 7
4. Need For Working Capital 9
5. Types Of Working Capital 11
6. Determinants Of Working Capital 14
7. Optimum Working Capital 17
8. Management Of Working Capital 19
9. Management OF Components OF Working Capital 27
10. Optimum Credit Policy 34
11. Conclusion 36
12. Analysis of Working Capital for Durgapur Steel plant
1
 INTRODUCTION :
Business Capital is broadly divided into two groups: Fixed Capital and
Working Capital. Fixed Capital refers to the funds invested in fixed assets
of a firm in the form of land, building, machinery etc. Working Capital
refers to the funds invested in the current assets of a firm such as raw
materials, work-in-progress, finished goods, receivables, cash etc. From
the viewpoint of manufacturing process, working capital means that part of
capital, which is required to keep the flow of production smooth and
continuous.
The main point of difference between the fixed capital and working capital
is that : Fixed assets are of long run duration and are not converted within
a period of one year, whereas the current assets are converted into cash
within a period of one year or less. Hence, the problem of fixed assets
belongs to the field of capital budgeting, while the problems of current
assets belong to the field of working capital management.
Working Capital, being lifeblood for any enterprise, its management

becomes a crutial exercise for the Financial Manager of a firm. The need
of working capital is directly linked to the growth of the firm. Working
Capital is as essential as fixed assets in the successful operation of a
production unit.
In the past, only the problems of the management of fixed capital were
given importance in the exercise of financial management. But in the
present scenario, looking to the increasing importance of the working
capital in any business unit, the exercise of management of working
capital has become as much important for a financial manager as the
management of fixed capital.
Some authors go the extent of saying that financial management means

working capital management. Even if this extreme view is regarded as
unacceptable, there is no doubt that a large part of a financial manager’s
time and energy is used up in attending to the problems of working capital
management.
The exercise of working capital management covers the following points to

be considered:
1. Estimating the working capital needs

2. Procurement of working capital
3. Optimum utilisation of working capital
Before discussing about the management of working capital, first of all,

let’s have a brief idea about the concept of Working Capital.
2
 CONCEPTS OF WORKING CAPITAL :
Working Capital, in the simple words, means the capital invested in the
current assets.
However it has been variously defined as :
“Working Capital means the current assets of a company that are

changed in the ordinary course of business from one form to another, as
for example, from cash to inventories, inventories to receivables,
receivables into cash.”
“Working Capital is descriptive of that capital which is not fixed. But the
more common use of working capital is to consider it as the difference
between the book value of the current assets and current liabilities.”
Thus, there are two different opinions about the meaning of the term
working capital.
(1) According to one school of thought, working capital represents all

current assets of the Company. They believe that working capital
represents those assets, which change their form during the process of
production.
Working Capital = Total Current Assets
(2) According to the other school of thought, working capital is the excess
of current assets over current liabilities.
Working Capital = Current Assets – Current Liabilities
Current assets include cash, accounts receivable, notes receivable,

advances on contracts, inventories etc. Current liabilities include accounts
payable, notes payable, accrued expenses, temporary loans etc. Under
this concept an attempt is made to measure net working capital of the
Company.
To avoid the confusion involved in the interpretation of working capital, the

total current assets are described as gross working capital, while the
excess of total current assets over total current liabilities are described as
net working capital.
Thus, there are two concepts of working capital:

1. Gross Working Capital i.e. Total Current assets
2. Net Working Capital i.e. Current assets – Current liabilities
Gross working capital concept focuses attention on two aspects of current

assets management:
3
a. What is the optimum level of investment in current assets?

b. How should current assets be financed?
Net working capital is a qualitative concept. It indicates the liquidity

position of the firm and suggests the extent to which the working capital
needs may be financed by permanent sources of funds. It indicates how
much current assets are covered by current liabilities. The net working
capital concept also covers the question of judicious mix of long-term and
short-term funds for financing the current assets.
Both gross and net working capital concepts are equally important for the
efficient management of working capital.
4
 FEATURES OF WORKING CAPITAL :
The features of the working capital distinguishing it from the fixed capital
are as follows:
 Short Term needs

Working capital is used to acquire current assets, which get converted
into cash in a short period. The duration of working capital depends on
the length of production process, the time that elapses in the sale and
the waiting period of the cash receipt.
 Circular Movement
Working capital is constantly converted into cash, which again turns
into working capital. This process of conversion goes on continuously.
It moves in a circular way. That is why working capital is also described
as circulating capital.
 An element of permanency
Though working capital is a short-term capital, it is required always and
forever. It is required to run the production activity of the firm smoothly
and uninterruptedly. So long as the production continues, the firm will
constantly remain in need of working capital.
 Fluctuating
Though the requirement of working capital is felt permanently, its
requirement fluctuates more widely than the fixed capital. The
requirement working capital varies directly with the level of production.
The portion of working capital that changes with production, sale, price
etc. is called variable working capital.
 Liquidity
Working capital is more liquid than fixed capital. It can be converted
into cash within a short period and without much loss. A firm in need of
cash can get it through the conversion of its working capital by insisting
on quick recovery of its bills receivable and by expediting sales of its
products. It is due to this trait of working capital that the firms with a
larger amount of working capital feel more secure.
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 Less Risky
Investment in the working capital is less risky as it is a short-term
investment. Working capital involves more of physical risk only and that
also is limited. It involves financial or economic risk to a much less
extent because variations of the product prices are less severe
generally. It is also free from technological changes as it gets
converted into cash again and again.
6
 NEED FOR WORKING CAPITAL :
The need of working capital to run the day to day business of a firm can
not be ignored. We will hardly find a business firm, which does not require
any amount of working capital.
The firm has to maintain an adequate level of current assets to generate

sales. The current assets are required, as the sales generated by the firm
do not convert into cash immediately. There is always an operating cycle
involved in conversion of sales into cash.
♦ Operating Cycle:
Operating Cycle is the time duration required to convert sales, after the
conversion of resources into inventories, into cash. It is the time
interval between the cash collections from sale of the product and cash
payments for resources acquired by the firm. It also refers to the time
interval over which the working capital should be obtained in order to
carry out the firm’s operations. The operating cycle of a manufacturing
company involves three phases:
• Acquisition of resources such as raw materials, labour, power

and fuel etc.
• Manufacture of the product which includes conversion of raw
material into work-in-progress into finishes goods
• Sale of the product either for cash or on credit. Credit sales
create account receivable for collection
Cash
Collection of Purchase of Raw
receivables Material
Accounts Raw
Receivable Material
s
Work-in-Progress
Sales Finished
Goods
Figure 1 Operating Cycle
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These phases of operating cycle affect the firm’s cash flows : both cash
inflows and cash out flows. However these cash flows are neither
synchronised nor certain. They are not synchronised because most of
the time the cash outflows occurs before cash inflows. Cash inflows are
not certain because sale and collections, which gives rise to cash
inflows are difficult to forecast accurately. Cash outflows, on the other
hand, are relatively certain. The firm is therefore, required to invest in
current assets for a smooth, uninterrupted functioning.
The firm’s requirement for working capital, is thus, depends on its

operating cycle. For that purpose it needs to forecast the length of its
operating cycle.
 How to determine the

length of the operating
cycle?
The length of the operating cycle can be determined by addition of the
inventory conversion period and debtor’s conversion period.
The inventory conversion period is the total time needed for producing
and selling the product. The debtor’s conversion period is the time
required to collect the outstanding amount from the customers. The
total of inventory conversion period and debtor’s conversion period is
referred to as gross operating cycle.
There are certain expenses, the payment of which can be temporarily

postponed. Such types of expenses are the spontaneous sources of
working capital for a firm to finance its investment in current assets.
The period during which the firm can temporarily defer the payment of
such expenses is called as payables deferral period and the difference
between the gross operating cycle and the payables deferral period is
referred to as net operating cycle.
Based on the forecast of the operating cycle of a firm, its requirement for
working capital can be estimated.
8
 TYPES OF WORKING CAPITAL :
Basically two types of working capital are needed in the business:
1. Permanent Working Capital

2. Variable Working Capital
These two types of working capital can also be classified as under :
Working Capital
Permanent Variable
Initial Regular Seasonal Special

Working Working Working Working
Capital Capital Capital Capital
Let’s discuss each of the types in brief:
♦ Permanent Working
Capital :
This is the minimum level of current assets, which is continuously
required by the firm to carry on its business operations. It is permanent
in the same way as the firm’s fixed assets are. Depending upon the
changes in the production and sales, the need for working capital, over
and above the permanent working capital, will fluctuate.
 Initial Working Capital :

In the initial period of its operation, a firm must need enough money
to pay certain expenses before the business yields cash receipt. In
the initial years the banks may not grant loans or overdrafts, sales
may have to be made on credit and it may be necessary to pay the
9
creditors immediately. Therefor the owners themselves have to

provide necessary funds in the initial period, which may be known
as initial working capital.
 Regular Working Capital

:
The firm is always required to keep certain funds with it to continue
the regular business operations, which is called as Regular Working
Capital. It is required to maintain regular stock of raw materials and
work-in-progress and also of the finishes goods, which must be
maintained permanently at a definite level. Regular working capital
is the excess of current assets over current liabilities. It ensures
smooth operation of business.
♦ Variable Working Capital :

This is the working capital which, keeps on changing with the change in
the production and sales activities. It is the extra working capital, over
and above the permanent working capital, that is needed to support the
changing production and sales activities. This type of working capital is
also called as fluctuating or variable working capital.
 Seasonal Working
Capital :
Some business operations require additional working capital during
a particular season. For example, the groundnut oil producers may
have to purchase groundnut in a particular season and have to
employ additional labour for that purpose. These may require
additional funds for a temporary period, which may be called as
seasonal working capital.
 Special Working
Capital :
In all enterprises, some unforeseen events do occur like sudden
increase in demand, downward movement of prices of raw
materials, strike or natural calamities, when extra funds are needed
to tide over such situation. Such type of extra funds is called as
Special working capital.
10
Both the kinds of working capital – permanent and temporary – are

necessary to facilitate the production and sales through the operating
cycle. However, the temporary working capital is created by the firm to
meet the liquidity requirements that will last only temporarily.
The difference between the permanent and variable working capital

may be represented in the following two diagrams:
Amount of working capital (Rs.)
Temporary or fluctuating
Permanent
Time
Figure 2 Permanent and temporary working capital

Amount of working capital (Rs.)
Temporary or fluctuating
Permanent
Time
Figure 3 Permanent and temporary working capital
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 DETERMINANTS OF WORKING CAPITAL :
There are no set rules or formulate to determine the working capital

requirements of a firm. There are ‘n’ numbers of factors influencing the
working capital requirements of a firm, which can be briefed as under:
♦ Nature of business :
Working capital requirement of a firm is basically influenced by the
nature of its business. Trading and financial firms require large amount
of working capital. In contrast, the manufacturing firms require less
amount of working capital and large amount of fixed assets.
♦ Sales and Demand

Conditions :
The sales and demand conditions of a firm also affect its working
capital position. It is difficult to precisely determine the relationship
between volume of sales and working capital needs. Sales depend on
the demand conditions. Most of the firms experience seasonal and
cyclical fluctuations in the demand of their products and services.
These business variations affect the working capital requirement,
particularly the temporary working capital requirement of the firm.
When there is an upward swing in the economy, the sales will increase
and untimely the firm’s investment in inventories and debtors will also
increase. On the other hand, when there is a decline in the economy,
the sales will fall and ultimately, the level of inventories and debtors will
also fall. Under recessionary conditions firms try to reduce their short-
term borrowings.
♦ Technology and
Manufacturing Policy :
The manufacturing cycle of the firm also affects the requirement of the
working capital. The manufacturing cycle comprises the purchase and
use of raw material and production of finished goods. Longer the
manufacturing cycle, larger will be the firm’s working capital
requirements and vice versa. An extended manufacturing time span
means a larger tie-up of funds in inventories. Thus, if there are
alternative technologies for manufacturing a product, the technological
process with the shortest manufacturing cycle may be chosen.
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Further, the requirement of working capital also depends on whether

the firm has adopted steady production policy or variable production
policy.
♦ Credit Policy :
In the present day circumstances, almost all units have to sell goods on
credit. The nature of credit policy is an important consideration in
deciding the amount of working capital requirement. The larger the
volume of credit sales, the greater will be the requirement of working
capital. Also the longer the period of collection of payment, the greater
will be the requirement of working capital. Generally, the credit policy of
an individual firm depends on the norms of the industry to which the
firm belongs.
♦ Availability of Credit :
The availability of credit from banks and financial institutions also
influences the working capital requirement of a firm. The availability of
credit to a firm depends upon the creditworthiness of the firm in the
money market. If a firm has good credit standing in the market, it can
get credit easily on favorable terms and hence it will require less
working capital.
♦ Operating Efficiency :
The operating efficiency of the firm relates to the optimum utilisation of
resources at minimum costs. If the firm is efficient in controlling its
operating costs and utilizing its current assets, than it helps in keeping
the working capital at a lower level. The use of working capital is
improved and pace of cash conversion cycle is accelerated with
operating efficiency.
♦ Price Level Changes :

The price level changes also affect the level of working capital.
Generally, rising price levels will require a firm to maintain higher
amount of working capital. However, the effect of rising prices may be
different for different companies, as though the general price level
increases, the individual prices may move differently. Therefor some
firms may require more working capital, while other may require less
working capital in case of price rise.
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♦ Growth and Expansion

Plans :
The growth and expansion plans to be undertaken by a firm also affect
its requirements of working capital. Hence the planning of the working
capital requirements and its procurements must go hand in hand with
the planning of the growth and expansion of the firm. Even the
expansion of the sales also increases the requirements of working
capital.
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 OPTIMUM WORKING CAPITAL :
A firm has to maintain an adequate level of working capital to run its

operations smoothly and effectively. It should be adequate in the sense
that it shall not be more than the requirements nor it shall be less than the
requirements. Both the excessive as well as inadequate working capital
positions are dangerous from the firm’s point view.
We know that the current liabilities are met out of the current assets. So
the level of current assets shall be sufficient enough to meet the current
liabilities. Excessive working capital refers to the position where when the
level of current assets is much higher to meet current liabilities. The
excessive capital has opportunity cost for the firm, as this excessive
capital remains idle in the firm, which earns no profit for the firm. If these
funds shall be invested in some profitable project, it adds the profitability of
the Company.
On the other hand, inadequate working capital refers to the position where
the current assets are not sufficient enough to meet the current liabilities.
Such type of position may be harmful to the firm as it may interrupt the
production and sales of the Company, which ultimately affects the
profitability of the Company. Moreover if the liquidity position of the firm is
not adequate enough to meet its current liabilities, it may affect its
credibility in the market.
Therefore an enlightened management should maintain the right amount

of working capital on a continuos basis. Only then the proper functioning of
business operations can be ensured. The amount of the working capital
shall be maintained at such level, which is adequate for it to run its
business operations, neither excessive nor inadequate. This level of
working capital is called as the “Optimum Working Capital”.
♦ Risk – Return Trade-off :

Liquidity v/s Profitability:
The level of working capital affects the degree of risk and profitability
both. Hence the level of working capital should be so fixed that, on the
one hand, its financial soundness is maintained and on the other hand,
its profitability is optimised.
At this point it is necessary to be clear about the meaning of solvency

or insolvency of the firm. Solvency means a situation in which a firm
can easily repay its debts as and when they mature. On the other
hand, insolvency is a situation in which a firm is not able to repay its
debts as and when they become due for payment.
15
The term risk implies the profitability that a firm will become technically
insolvent, so that it will not be able to meet its obligations as and when
they become due for payment.
Nature of trade-off:
If profitability is to be increased, the firm must increase its risk. If the

firm wants to decrease risk, its profitability will also decrease. If a firm
wants to maintain insolvency, it must maintain a higher level of liquidity.
That is, it must hold a larger amount of current assets such as cash,
receivables, stock of goods etc., so that there would be no problem in
repaying the debts as and when they due for payment. However, if a
firm holds more amount of current assets, the prospects of profit
decline due to the fact that most of its funds are locked up in idle
current assets, which earn no profit.
On the other hand, if a firm wants s to increase its profitability, it must

be prepared to increase its risk of insolvency, as it would have to
reduce its investment in current assets. However a smaller amount of
liquidity increases risk of insolvency and, at the same time, it increases
profitability also.
The firm should maintain the its current assets at such level that on the
one hand its profitability increases and on the other hand its risk of
insolvency decreases. There should be a balance between profitability
and risk. The level, at which there is a trade-off between the risk and
return, is the optimum level of working capital for a firm.
The following figure will clear the idea about the Risk – Return Trade-
off of a firm:
Optimum Working Capital

Risk / Liquidity
Return / Profitability
Figure 4 Risk – Return Trade-off
16
17
 MANAGEMENT OF WORKING CAPITAL :
Working Capital management refers to the administration of all aspects of

current assets namely cash, marketable securities, debtors and stock
(inventories) and current liabilities. The financial manager should
determine levels and composition of current assets. He must see that right
sources are tapped to finance current assets and that current liabilities are
paid in time.
Working capital management is critical for all firms, but particularly for
small firms. A small firm may not have much investment in fixed assets,
but it has to invest in current assets. Further, the role of current liabilities in
financing the current assets is far more significant in case of small firms,
as, unlike large firms they, face difficulties in raising long-term finances.
The main problems of the management of working capital are as stated

below:
a. to determine a proper amount of working capital to be held in the

business i.e. estimating the working capital needs
b. to take decision on the sources of working capital i.e. procurement of
working capital
c. to ensure that the working capital is efficiently utilised i.e. optimum of
utilisation of working capital
Before we consider these problems lets first understand some of the

principles of working capital management:
 Principles of Working Capital Management :
The financial manager must keep in mind the following principles of

working capital management:
→Principle of Optimisation :
The level of working capital must be so kept that the rate of return
on investment is optimised. In other words, the working capital
should be maintained at an optimum level. This is the point at which
the increase in cost due to decline in working capital is equal to the
increase in the gain associated with it.
According to the principle of optimisation, the magnitude of working

capital should be such that each rupee invested adds to its net
value. In other words Capital should be invested in each component
of working capital as long as the equity position of firm increases.”
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→Principle of Risk Variation :

This principle is based on the assumption that the rate of return on
investment is linked with degree of risk in the business. The greater
on investment is linked with the degree of risk in the business
assumes, the greater is the opportunity for gain or loss.
→Principle of Cost of
Capital :
Each source of working capital has different cost of capital. The
degree of risk also differs from one source to another. The type of
capital used to finance working capital directly affects the amount of
risk that a firm assumes as well as the opportunity for gain or loss
and cost of capital. A firm should raise capital in such a manner that
a balance is maintained between risk and profit.
→Principle of Maturity of
Payment :
This principle states that the working capital should be so raised
from different sources that the firm is able to repay them on maturity
out of its inflows of funds. Otherwise the firm would fail to repay on
maturity and ultimately, it would find itself into liquidation though it is
earning huge profits. This implies that the firm’s ability to repay its
short-term debts depends not on its earnings but on the flow of
cash into it.
These are some of the principles of working capital, which a financial

manager should keep in mind while managing working capital. Now
let’s discuss how to manage working capital.
⇒ Estimating Working Capital needs :
The first step in managing working capital is to estimate about the

working capital needs. The most appropriate method for calculating
working capital needs of a firm is the concept of operating cycle.
In estimating working capital needs, different people adopt different

approaches. Some authors suggest that the working capital should
be greater than the minimum requirements of the firm. The
management should feel safety. It would be able to meet its
obligations even in adverse circumstances. However, the excessive
capital may lead to waste and inefficiency.
19
On the other hand, many authors suggest that the working capital
should be lower than the requirement so that no idle funds shall be
invested in the current assets and it ultimately leads to increase in
profitability of the Company. However, in such case the firm always
have risk of technical insolvency as it may not meet its obligations
as and when they falls due for payment.
So the question is what the proper amount of working capital is. It is

not an absolute amount. It depends upon the needs and
circumstances available in the firm.
There are various approaches which have been applied in practice

for estimating the working capital needs of a firm. Let’s discuss
some of them in brief.
• Conservative Approach:
The conservative approach states that the proportion of
current assets to current liabilities should be kept at 2:1. Is
this proportion is to be kept the firm would be able to meet its
obligations on time and hence its financial solvency would
not be in trouble. However, the limitation of this approach is
that it suggests only quantitative measure. It does not
suggest as to what type of assets are to be included in
current assets. If the current assets contain stock, which is
outdated or receivable which are not collectable, than the
amount of current assets has no meaning. Further, in the
present scenario no firm maintains this ratio, as it’s too
difficult for them to maintain such a high level of current
assets.
• Objective Test:
Some objective tests are suggested for determining the level
of working capital of a firm. On the basis of answer to the
following questions, it can be determined whether the level of
working capital is adequate or not:
1. Whether the Company is able to make cash purchases

and can avail of cash discounts.
2. Whether the Company has enough credit worthiness to

get finance from Banks easily as and when needed?
3. Whether the creditors allow enough credit on purchases?
4. Whether the Company experiences any difficulty in

paying dividend?
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• Modern Approach :
Apart from the conventional methods for estimating the need
for working capital, the following two methods are used in the
modern enterprises for the purpose:
1. Ratio of Current Assets to Fixed Assets

2. Current Asset holding period
Let’s have a brief idea about each of them.
1. Ratio of Current Assets to Fixed Assets
The financial manager should determine the optimum

level of current assets so that the wealth of shareholders
is maximised. In a business enterprise both fixed and
current assets are needed to support a particular level of
output. However, to support the same level of output, the
firm can have different levels of working capital. The level
of current assets can be measuring the current assets to
fixed assets i.e. by measuring the ratio of current assets
to fixed assets.
Dividing current assets by fixed assets gives the ratio of

Current Assets to Fixed Assets.
From the viewpoint of this ratio, there are three types of

approaches:
A. Conservative approach
Many firms maintain a high ratio of current assets to

fixed assets so that they may not have any difficulty
even in crisis. It suggests greater liquidity and lower
risk. Risk adverse firms mainly adopt this approach.
B. Aggressive approach
Many firms maintain low ratio of current assets to

fixed assets, so that their funds may not block idle and
they can be used for some profitable purpose. It
involves higher risks and smaller liquidity.
C. Average Capital approach
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Most of the firms maintain their current level between

these two extreme levels. This is an average capital
approach. This involves moderate liquidity and
moderate risk.
A. Conservative Approach
Level of Current Assets

AAAAAA
B. Average Approach
C. Aggressive Approach
Output
Figure 5 Alternative Current Asset Approaches
2. Current Assets holding period
In this method the working capital requirements are to be

estimated on the basis of average holding period of
current assets and relating them to costs based on the
firm’s experience in the previous years. This method is
essentially based on the operating cycle concept.
A modified version of this method is also used by various

firms, in which the current assets are carefully estimated
and at the same time the current liabilities are also to be
estimated. The difference between two gives a rough
idea about the net working capital requirements of the
firm.
Let’s have a brief idea about how various components of

current assets and current liabilities are to be estimated
for estimating the working capital requirements:
1. Stock of Raw Materials =
No. of Units Produced * Per Unit Cost of raw

materials * Average holding period of raw
materials
2. Work in Progress =
i. Materials : No. of Units Produced * Per Unit
Cost of raw materials * Average
period of raw materials in
process
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ii. Labour : No. of Produced * Per Unit Cost

of Labour * Average of period of
labour in process
iii. Overhead: No. of Produced * Per Unit Cost
of Overheads* Average of period
of Overheads in process
Generally, the WIP is to be taken as half a month’s

raw material cost and one month’s labour and
variable cost.
3. Finished Goods =
No. of Units Produced * Per Unit Total Cost
4. Sundry Debtors =
No. of Units Sold * Period of credit given to debtors

* Total Cost of Production
Profit is not to be considered for calculating the

outstanding debtors. On the same way only the sales
which are made on credit are to be considered. Thus the
cash sales are to be deducted before estimating the
debtors.
5. Sundry Creditors =
No. of Units Produced * Per unit cost of raw

materials * Credit period allowed by the suppliers
6. Outstanding Wages and Overheads =
No. of Units Produced * Per unit cost of Wages

and Overheads * Time leg in payment of Wages
and Overheads
After estimating the components of current assets and

current liabilities a Statement Showing the Working
Capital Requirement is to be prepared as under:
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Statement Showing Requirement of Working Capital
Particulars Rs. Rs.

Current Assets :
1. Stock of Raw Materials ----------
2. Stock of Work in progress :
Material Cost ----------
Wages ----------
Overheads ---------- ----------
3. Stock of Finished Goods (at cost of ----------
production)
4. Debtors ----------
5. Minimum Cash required ----------
6. Advance Payments ----------
Total Current Assets (A) -------------
Current Liabilities :
1. Creditors for purchases ----------
2. Outstanding wages and overheads ---------
3. Advance received from customers ---------
Total Current Liabilities (B) -----------
Total Working Capital Requirement

(A – B) -----------
These are some of the methods that are used in estimating the
working capital requirements. After estimating the working capital
requirements, the second step for financial manager is to think
about the procurement of working capital.
Let’s see how a financial manager decides about the procurement

of working capital.
⇒ Procurement (financing) of Working Capital:
The second step in managing the Working Capital is to take into

consideration the various sources from which a working capital can
be procured and to decide about the best suitable source for
procurement of Working Capital.
Generally, it is believed that funds for acquiring the Fixed Assets

should be raised from long term sources and short-term sources
should be utilised for raising working capital. But in the recent
modern enterprises, both the types of sources are utilised for
financing both fixed and current assets.
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There are different approaches for determining the proportion in

which the short term and long term sources shall be used to finance
fixed assets and current assets. There are three approaches:
1. Hedging Approach:
Under this approach, the funds for acquiring fixed assets and
permanent current should be acquired with long term funds and
for temporary working capital short term funds should be used.
2. Conservative Approach:
This approach suggests that in addition to fixed assets and

permanent current assets, even a part of variable current assets
should be financed from long-term sources. The short-term
sources are used only to meet the peak seasonal requirements.
During the off season, the surplus fund is kept invested in
marketable securities. This approach depends upon the long-
term sources to a great extent.
3. Aggressive Approach:
This approach depends more on short-term funds. More short-

term funds are used particularly for variable current assets and a
part of even permanent current assets, the funds are raised from
short term sources.
The main sources from which the working capital can procured are as
under:
1. Shares and Debentures

2. Retained Profits
3. Commercial Banks by way of loan, cash credit etc.
4. Trade Creditors
5. Public Deposits
6. Indigenous Bankers and Money-lenders
7. Urban Co-operative Banks
The financial manager should decide about the best suitable

source for procuring the working capital, as each source has its
own pros and cons.
25
MANAGEMENT OF COMPENENTS OF WORKING CAPITAL :
The financial manager of a firm shall, while thinking about the

management of working capital, consider the management of the following
components of working capital individually:
1. Cash Management
2. Inventory Management
3. Receivable Management
The exercise of management of each component of Working Capital leads

to effective management of Working Capital of a firm.
Let’s have a brief idea about the management of each component of

working capital.
1. Cash Management :
Cash is the medium of exchange which allows management to carry on

the various activities of the business on day to day basis. It includes
coins, currency, cheques held by the firm and the balance in its bank
accounts. In a broader sense, it also includes “Near Cash Assets” such
as marketable securities and time deposits with the bank.
A firm should have a sufficient balance of cash neither more nor less
than the requirements. A firm holds cash for the following motives :
a) Transaction Motive,
b) Precautionary Motive,
c) Speculative Motive and
d) Compensating Motive.
The cash management of a firm involves the consideration of the

following four factors :
→ Ascertainment of the minimum cash balance and controlling the

levels of cash
→ Controlling cash inflows
→ Controlling cash outflows
→ Optimum investment of surplus cash
• Controlling the levels of

cash :
The financial manager of a firm shall have the following tools
available with him for controlling the levels of cash.
26
 Preparing Cash Budget:
Cash budget is a statement showing the estimated cash

inflows and cash outflows over the next planning period. The
surplus or shortfall of cash is highlighted by the cash budget.
 Providing for contingencies:
In addition to the level of cash determined by the cash

budget, a suitable minimum amount of cash must be kept for
meeting the unforeseen contingencies such as strikes,
floods, fire etc.
 Consideration of cost of shortage of cash:
The cost arises in terms of loss of firm’s reputation or

additional cost of borrowing at higher rate of interest shall be
considered.
 Availability of other sources of funds:
In case of shortage of cash, which are the sources that can

be trapped for meeting the urgent cash requirements.
• Controlling of cash
inflows:
After having prepared the cash budget, a finance manager
must ensure that there is no significant deviation between
the projected cash inflows and the actual cash inflows.
Effective cash collection shall be made by adopting the
following techniques.
 Concentration Banking :
The Concentration Banking is a system of decentralised

collection of accounts receivable in case of large firms
having their business spread over a large area, by opening a
number of collection centers at selected strategically located
areas and making collections from that centers from the
customers residing in that area.
 Local Box System :
In this system, the firm hires a post-office box and asks its
customers to send the cheques to the box. The firm’s local
bank is given authority to open the box and credit the
payment in the firm’s bank account.
27
• Controlling of cash
outflows:
The operating cash requirement can be reduced by
controlling the cash outflows. The financial manager can use
the following techniques for the purpose.
 Centralised Disbursements :
All the payment can be made from only one account at the
Head Office. This will result in delay in presentation of
cheques for payment by parties who are working from distant
places.
 Playing ‘Float’ :
‘Float’ means the amount tied up in cheques that have been

drawn but have not yet been presented for payment. There is
always a time lag between the issue of a cheque by the firm
and its actual presentment for payment. As a result the firm’s
actual balance at bank may be more than the balance as
shown by its books. This different is called “Payment in
Float”.
• Optimum Investment of
Surplus Cash :
The financial manager shall use it’s the cash efficiently and
for that purpose, the following points shall be kept in mind.
 Determining Surplus Cash :
Surplus cash is the cash in excess of the firm’s normal cash

requirements. This requirement can be computed by the
multiplication of desired days of cash and average daily
outflows. If the cash balance is more than this normal
requirement, then the surplus cash can be invested
somewhere to earn returns.
 Determining Channels of Investment :
Surplus funds can be invested in marketable securities or

somewhere else. While exercising such discretion, a finance
manager must take care of security, liquidity, yield and
maturity associated with marketable securities.
28
29
2. Inventory Management :
Inventory is composed off the assets that will be sold in future in the
normal course of business operations. To the finance manager, the
inventory connotes the value of raw materials, consumables, spares,
work-in-progress, finished goods and scrap in which the firm’s funds
have been invested.
A firm holds inventory mainly for the following motives:
a. Transaction Motive
b. Precautionary Motive
c. Speculative Motive
As the inventory involves the investment of the funds, it should be

managed properly or rather controlled properly. Inventory management
is a planned method to determine which items is to be purchased and
how much to be kept in stock, so that the costs of purchase and
storage both are minimised without adversely affecting either
production or sales. It involves the decision of the firm as to the extent
to which inventories can be economically stored.
The inventory hold by the firm involves the following cost to the firm:
a. Ordering Costs:
Every time an order is placed for stock replenishment; certain

costs are incurred called as ordering cost. It includes paper work
costs, follow up costs, staff costs etc.
b. Carrying Costs:
Carrying costs are the costs of holding inventory for a given

period of time. It includes storage cost, handling cost, insurance
cost, obsolesce cost etc.
 Objectives of Inventory Management:
A fundamental objective of a good system of inventory

management is to be able to place an order at the right time
from the right source to acquire the right quantity at a right price
and of right quantity.
Mainly there are the following objectives of the Inventory

Management:
1. to ensure adequate stock

2. to minimise inventories on hand
3. to maintain continuity in production
4. to minimise the cost of purchasing and storage
30
5. to minimise the wastage and loss

6. to reduce the risk of deterioration
7. to use the available capital effectively
8. to be helpful in efficient purchasing
9. to give maximum satisfaction to customers
10. to minimise loss due to price decline
11. maximum use of storage capacity
12. proper storage of materials
 Techniques for Inventory Management:
Usually the following techniques are being used by the financial

manager for inventory control.
a. Determining the Economic Order

Quantity(EOQ):
Economic Order Quantity is that quantity at which the

total ordering costs and inventory carrying costs will be
the minimum. A firm is required to consider a number of
factors before fixing an economic ordering quantity. Of
these factors, important ones are inventory carrying costs
and ordering costs.
When the inventory carrying cost and ordering cost are in

balance, the total cost of ordered quantity is lowest and
therefore it is called as economic order quantity. The firm
should maintain its inventory at such a level so that its
inventory carrying cost and ordering cost are at balance.
There are three methods for determining the EOQ:

1. Graphic Method
2. Formula Method
3. Trial and Error Method
The results of all three methods are more and less same.
b. Determining other inventory levels:
In order that the inventory costs are reduced to the

minimum and yet the process of production and sales
goes on uninterrupted, it is necessary to determine the
following inventory levels:
1. Re-order Point or Ordering Level
It represents the quantity level at which an order

for fresh supplies must be placed with the supplier
to replenish the present stock.
31
Generally the following formula is to be used for

the purpose:
Ordering Level = Maximum Consumption *

Maximum Delivery Time
2. Minimum Level
The minimum level indicates the lower level of

stocks of inventory.
Min. Level = Re-ordering level – Average

Consumption of Average Delivery Period
3. Maximum Level
The maximum level of inventory indicates the

upper limit of level of stocks. It represents the
largest quantity of material to be kept in stock.
Max. Level = Re-ordering level – Minimum

Consumption of Minimum Period + Re-ordering
Quantity
c. ABC System of Inventory Control :
A modern system of inventory control, which is

economical, too is ABC System of inventory control. It is
Always Better Control (ABC).
Some items included in the inventory are of very low

value and its detailed accounting is not economical.
Hence, such items must be stored in sufficient quantity
and its use is not restricted. On the other hand, there are
certain items of inventory that represent a large
proportion of the total value of inventory.
In ABC Analysis all items are divided into three

categories A, B and C.
In category A, are included those items which are very

important and of high value but forms only a small
proportion of total quantity of inventory. Strict control over
receipts, storage and issue should be exercised over
such items. Its requirements must be estimated in
advance and its purchases must be planned, so that it is
available as and when needed.
In category B, those items are included, which are not as

important as those are in A group, but are important
32
enough for its proper records to be maintained. Maximum

and Minimum levels must be fixed for such items and
they must be issued against proper material requisition
only.
The remaining items must be places in Category C. They

are not important from the view point of maintaining
control over their receipts and consumption. Little control
is to be put on such items.
The ABC System of inventory control is very useful for

the modern management as it helps in saving their time
from the unnecessary work and leads to efficient
inventory control.
d. Perpetual Inventory System :
For efficient inventory control, it is necessary that the

various items of inventory must be continuously checked
and compared with records maintained. This is done by
Perpetual Inventory System.
Perpetual Inventory means a system of maintaining

continuous stock records through bin cards and stores
ledger. This implies continuous stock taking in which a
certain number of inventory items are checked and
verified everyday or at frequent intervals.
3. Receivables Management :
When the goods are sold on credit in business, the price of the goods
becomes receivable. In the present economic system, credit sales are
essentials, unless the goods sold are in short supply. The money
involved in inventories are blocked till future and therefore there is an
opportunity cost of receivables. However, the credit sales are also
essential in order to meet the sever competition. Thus, the
management of receivable requires great care. It must be so managed
that the benefit available from additional sales and the cost of funds
raised to finance the additional credit coincide.
The management of receivables is important in the sense that in India

it forms about one-third of current assets. The management of
receivable is needed as; a firm has to incur the following cost
associated with receivables.
1. Collection Cost i.e. the costs incurred in collecting the payments

2. Default Cost i.e. the bad debt losses arise when a firm is unable
to collect some receivable
3. Opportunity Cost
4. Administrative Cost
33
 Optimum Credit Policy :

If a firm sells goods on credit, it has to decide the optimum credit
policy. It has neither to be too rigid nor too liberal. The sales must
go on rising and yet the bad debts and collection costs are kept to
the minimum.
Thus two types of credit policies are to be considered:
1. Liberal or Lenient Credit Policy

2. Strict or stringent credit policy
In Liberal Credit Policy, the customers are allowed liberal terms for
credit sales and credit is granted for a longer period even to those
customers whose financial position is doubtful. A liberal policy
results into increase of sales and increase of profits. However, the
risk of bad debts and the opportunity cost of receivables are also
increased. The collection costs are also increased.
On the other hand, a strict or stringent policy implies that the firm
sells in credit on a highly selective basis and only to those
customers whose financial position is sound. It results into reduction
in sales and reduction in profit also. However, the cost involved with
the high volume of receivables and risk of bad debts are also
reduced.
The firm should determine its credit policy in such a manner that on
one hand its profitability is to be increased and on the other hand its
liquidity position is not hampered. That means the point at which the
profitability and liquidity is balanced is the optimum credit policy for
the firm.
 Credit Policy Variables :

While framing optimum credit policy, the financial manager shall
consider carefully the following variables of the credit policy:
a. Credit Standards
Credit Standards means the criteria on the basis of which, credit

is granted to a particular customer or particular group of
customers. If the standards are very strict in would reduce the
volume of receivables and vice versa.
Credit Standards of most of the firms include the

creditworthiness of the customer. That means the credit should
be granted to a customer after accessing his credit worthiness.
34
For accessing the creditworthiness of a customer two factors are

important :
i. average collection period of a particular customer

ii. his default rate
While determining the creditworthiness of a customer five C’s

are taken into account:
i. Character
ii. Capacity
iii. Collateral
iv. Condition and
v. Capital
b. Credit Terms
Credit terms means both the credit period and the cash discount
offered, the credit period is the length of time for which credit is
extended to customers. It is stated by such terms as “3/15 Net
45” meaning that if payment is made within 15 days, 3% cash
discount will be given. Even without discount, payment will be
made within 45 days. Generally, the customers of the industry
determine the credit terms.
c. Collection Policy
The collection policy must be such as would help in collecting

book-debts in time and reduce the bad debts. A collection policy
should ensure prompt and regular collection. This would reduce
the need for more working capital and loss of bad debts. The
firm must frame a procedure to expedite collection from the
customers.
e.g. First, a letter must be written to the customer to pay his

dues. If he does not respond, then a strong letter must be
written. As a last step, a letter must be sent informing the
customer that legal action would be taken is dues are not paid
within certain days.
Thus, a financial manager of a firm shall, while managing its working

capital, consider carefully the management of the components of the
working capital, in the manner as stated above.
35
 CONCLUSION:
Working Capital occupies a peculiar position in the Capital Structure of a

firm. It is the life-blood of all types of enterprises, manufacturing and
trading both. If the business has enough Working Capital, it can maintain
its operating efficiency. Not only that, but adequate working capital
provides psychological satisfaction and relief to the management. Only
those enterprises, which have adequate working capital, can survive in
times of depression. It has been observed that number of business
enterprises have failed due to inefficient management of working capital.
That is the reason why the management of working capital becomes a

tedious exercise for a financial manager of a firm. For any enterprise the
question of adequacy of working capital and its efficient management is a
test of efficiency of a financial manager. The experience shows that much
of the financial manager’s time is used in the management of working
capital.
Working Capital constitutes a large portion of total investment in assets. It

is estimated that about 60% of the total net assets of the public sector
companies in India is in the form of current assets. This underlines the
importance of the working capital management.
Working Capital management is more important for small firms also.

Generally, in the small units, investment in such current assets as cash,
receivables and inventories tends to be larger than investment in fixed
assets. Also it is more difficult for small units to raise enough long term
capital for the current assets.
Therefore, the exercise of the management of working capital must be

taken with great care and attention. The financial manager must be
constantly alert to ensure that there is no over investment in working
capital. On the other hand, he also has to ensure that the firm does not
face the problem of shortage of working capital. The financial manager has
to constantly make efforts to ensure that whatever working capital the firm
possess, is managed properly so as to increase the operating efficiency of
the firm.
36
37
CALCULATION OF WORKING CAPITAL FOR BHILAI STEEL

PLANT
(In crores)
YEAR 2004-05 2005-06 2006-07 2007-08
CURRENT ASSETS:
INVENTORIES 1041.68 1505.76 1556.66 1712.9
SUNDRY DEBTORS 19.48 20.53 18.82 13.7
CASH & BANK 22.35 33.81 36.8 39.86
INTEREST RECEVIABLE 18.89 16.55 13.86 12.6
LOANS & ADVANCES 194.82 218.44 325.12 480.72
TOTAL CURRENT ASSETS 1297.22 1795.09 1951.26 2259.78
38
CURRENT LIABILITIES:
CURRENT LIABILITIES 894.57 850.16 910.08 1190.59
PROVISIONS 93.98 103.46 79.37 82.42
TOTAL CURRENT
LIABILITIES 988.55 953.62 989.45 1273.01
NET WORKING CAPITAL 308.67 841.47 961.81 986.77
CHART SHOWING WC OF BSP:
1000 961.81 986.77

841.47
800
600
400 308.67
200
0
2004-05 2005-06 2006-07 2007-08
NETWORKINGCAPITALOFBHILAI STEELPLANT
CALCULATION OF WORKING CAPITAL FOR ROURKELA STEEL

PLANT
(In crores)
YEAR 2004-05 2005-06 2006-07 2007-08
CURRENT ASSETS:
INVENTORIES 500.44 718.11 877.56 870.13
SUNDRY DEBTORS 12.44 14.6 12.96 11.66
CASH & BANK 15.75 17.22 18.79 20.66
LOANS & ADVANCES 195.93 212.72 230.94 243.15
39
PROVISIONS 50.52 49.57 50.78 48.35
TOTAL CURRENT
LIABILITIES 451.34 472.53 536.87 588.14
CHART SHOWING WC OF RSP:
700
600 605.21
559.04
500 492.59
400
300 275.76
200
100
0
2004-05 2005-06 2006-07 2007-08
NETWORKINGCAPITALOFROURKELA STEELPLANT
CALCULATION OF WORKING CAPITAL FOR BOKARO STEEL

(In crores)
YEAR 2004-05 2005-06 2006-07 2007-08
CURRENT ASSETS:
INVENTORIES 953.87 1365.56 1407.49 1185.74
SUNDRY DEBTORS 11.13 12.51 8.95 7.74
CASH & BANK 35.77 37.9 41.08 44
LOANS & ADVANCES 255.87 391.18 390.9 587.45
40

PROVISIONS 99.22 94.82 53.99 48.27
TOTAL CURRENT
LIABILITIES 755.29 855.96 854.46 965.74
CHART SHOWING WC OF BSL:
1200
1000 970.15 1007.98
870.14
800
600 524.49
400
200
0
2004-05 2005-06 2006-07 2007-08
NETWORKINGCAPITALOFBOKARO STEELPLANT
41
42

Working Capital Concepts

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Working Capital Management – An Analysis

Working Capital, being lifeblood for any enterprise, its management

Some authors go the extent of saying that financial management means

The exercise of working capital management covers the following points to

1. Estimating the working capital needs

Before discussing about the management of working capital, first of all,

 CONCEPTS OF WORKING CAPITAL :

However it has been variously defined as :

“Working Capital means the current assets of a company that are

(1) According to one school of thought, working capital represents all

Working Capital = Total Current Assets

Working Capital = Current Assets – Current Liabilities

Current assets include cash, accounts receivable, notes receivable,

To avoid the confusion involved in the interpretation of working capital, the

Thus, there are two concepts of working capital:

Gross working capital concept focuses attention on two aspects of current

a. What is the optimum level of investment in current assets?

Net working capital is a qualitative concept. It indicates the liquidity

 FEATURES OF WORKING CAPITAL :

 Short Term needs

 NEED FOR WORKING CAPITAL :

The firm has to maintain an adequate level of current assets to generate

• Acquisition of resources such as raw materials, labour, power

Figure 1 Operating Cycle

The firm’s requirement for working capital, is thus, depends on its

 How to determine the

There are certain expenses, the payment of which can be temporarily

 TYPES OF WORKING CAPITAL :

Basically two types of working capital are needed in the business:

1. Permanent Working Capital

These two types of working capital can also be classified as under :

Initial Regular Seasonal Special

Let’s discuss each of the types in brief:

 Initial Working Capital :

creditors immediately. Therefor the owners themselves have to

 Regular Working Capital

♦ Variable Working Capital :

Both the kinds of working capital – permanent and temporary – are

The difference between the permanent and variable working capital

Figure 2 Permanent and temporary working capital

Figure 3 Permanent and temporary working capital

 DETERMINANTS OF WORKING CAPITAL :

There are no set rules or formulate to determine the working capital

♦ Sales and Demand

Further, the requirement of working capital also depends on whether

♦ Price Level Changes :

♦ Growth and Expansion

 OPTIMUM WORKING CAPITAL :

A firm has to maintain an adequate level of working capital to run its

Therefore an enlightened management should maintain the right amount

♦ Risk – Return Trade-off :

At this point it is necessary to be clear about the meaning of solvency

If profitability is to be increased, the firm must increase its risk. If the

On the other hand, if a firm wants s to increase its profitability, it must

Optimum Working Capital

Figure 4 Risk – Return Trade-off

 MANAGEMENT OF WORKING CAPITAL :

Working Capital management refers to the administration of all aspects of

The main problems of the management of working capital are as stated

a. to determine a proper amount of working capital to be held in the

Before we consider these problems lets first understand some of the

 Principles of Working Capital Management :

The financial manager must keep in mind the following principles of