AN INTRODUCTION TO WORKING CAPITAL MANAGEMENT

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LEARNING OBJECTIVES

Know meaning of working capital State and explain the concepts of working capital Classify and explain the kinds of working capital List out the components of working capital Bring out the aspects and objectives of working capital management. Give the need for working capital Narrate the consequences of excess and inadequate working capital State and explain the factors affecting working capital Know estimation of working capital Say ways of financing current assets Explain the approaches available for financing current assets

Meaning of working capital

Working capital is that capital which is

involved in the current assets of the business. Basically, it is the capital which is required to meet the day to day expenses of the business.

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Types/Kinds of working capital

On the basis of On the basis of

concept
Gross working

need
Permanent working

capital Net working capital

capital Temporary working capital

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On the basis of concepts

1.

Gross working capital: It is the sum of all current assets appear in balance sheet

2. Net working capital: Excess of current assets over current liabilities. It can be positive or negative
Gross working capital = Total current assets Net working capital = current assets current

liabilities
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On the basis of Need

Permanent working capital

The sum up of the funds required to finance the minimum level of current assets of the business is known as the permanent working capital. This capital is required every time to put the business into working condition.

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Temporary working capital

It is required to explore the short term opportunities of the market. The requirement of temporary working capital varies with time period. Seasonal working capital Special working capital

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Working Capital Needs of Different Firms

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Concepts of working capital

1. Balance Sheet concept Gross working capital Net working capital 2. Operating cycle concept

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OPERATING CYCLE CONCEPT

Operating cycle may be defined as the time duration starting from the procurement of raw materials or goods and ending with sales realisation. Operating cycle of a firm consists of the time required for the completition of the following activities. Procurement of raw materials Conversion of raw into W-I-P

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Conversion of W-I-P into finished goods

Sale of goods(cash or credit) Conversion of recievables into cash.

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Calculation of duration of Op.cycle

Duration of raw materials storage stage + Duration of Work in Process stage + Duration of finished goods stage + Duration of receivables collection stage Duration of the credit period allowed by suppliers

O=R+W+F+D-C
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Estimation of working capital requirements

1. Calculate no. of operating cycles in a year i.e. 365 no. of days in a op. cycle 2. Total operating exp. of the year No. of the op.cycle in the year The resulted amount plus additional amount for contingencies will be the avg. requirement of working capital.
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Operating Cycle
The time that elapses in conversion of raw materials into cash

Debtor Sales Cash

Finished goods Raw Materials

Work-inProcess

Cash Conversion Cycle

Cash cycle = Operating Cycle - Time take to pay Suppliers

Objectives of Working Capital

To ensure optimum investment in current assets To strike a balance between the twin objectives of liquidity and

profitability in the use of funds

To ensure adequate flow of funds for current operations To speed up the flow of funds or to minimize the stagnation of

funds.

Importance of working capital

Working Capital Management: Determination of relevant levels of current assets and their efficient use as well as the choice of the finance mix Maximising shareholders wealth Profit maximisation Agency problem Ethical issues Social responsibilities Behavioral objectives Diversent objectives
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Need to Maintain Balanced WC

Problems with Excess WC: Unnecessary accumulation of inventory Defective credit policy Stock collection period Increases managements inefficiency Problems with inadequate WC: Stagnates growth Difficult to implement operating plans Difficult to meet day-to-day commitments Inefficient utilisation of fixed assets Unable to avail attractive cash and trade discounts Loss of reputation

Statement of Working Capital Estimation

Particulars A. Estimation of Current Assets: i) Raw materials ii) Work-in-process Raw materials (full cost) XX Direct labour (to the extent of completed stage) XX Overheads (to the extent of completed stage) XX iii) Finished goods inventory iv) Debtors v). Cash balance required Total Current Assets B. Estimation of Current Liabilities: i) Creditors ii) Expenses Overheads Labour Total Current Liabilities C. Working Capital (A-B) Add: Contingency (Percentage on working capital i.e. C) D. Working Capital Required XXX XXX XX XX XXX XXX XXX XXXX Amount (Rs.) XXX XXX XXX XXX XXX Amount (Rs.)

XXX

Estimating Working capital

Current assets holding period To estimate working capital requirements on the basis of average holding period of current assets and relating them to costs based on the companys experience in the previous years. This method is essentially based on the operating cycle concept.

Ratio of sales To estimate working capital requirements as a ratio of sales on the assumption that current assets change with sales.
Ratio of fixed investment To estimate working capital requirements as a percentage of fixed investment

Financing of working capital

Long Term financing Short Term financing Spontaneous financing

Approaches regarding financing

Hedging Approach Conservative Approach Aggressive Approach

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Approaches for Financing Current Assets

Approached for Financing Working Capital

Matching or Hedging Approach

Conservative Approach

Aggressive Approach

Matching Approach
Matching or Hedging Approach: Here funds raised for a

period which is matching with the life of an asset

Temporary Current Assets

Short-term financing

Assets

Permanent current assets Long term financing

Fixed assets Time

Conservative approach
Conservative Approach: Use of long-term funds for

financing short-term funds to finance a part of temporary current assets

Short-term financing

Assets

Temporary Current Assets (b) (a) Permanent Current Assets

Long term financing

Fixed Assets Time

Aggressive approach
Aggressive Approach: A firm is aggressive in financing

working capital when it uses short-term funds to finance a part of permanent current assets
Temporary Current Assets (b) (a) Assets Permanent Current Assets Long term financing
Short term financing

Fixed Assets Time

Working Capital Financing Policies

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Working Capital Financing Policies

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Short-Term vs. Long-Term Financing

Short-term financing

Cheap but risky

Cheapshort-term

rates generally lower than long-term rates you are continually entering marketplace to borrow

Riskybecause

Borrower will face changing conditions (ex; higher interest rates and tight money)

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Short-Term vs. Long-Term Financing

Long-term financing

Safe but expensive

Safeyou

can secure the required

capital
Expensivelong-term

rates generally higher than short-term rates

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Determinants of working capital

Nature of Business Size of Business Growth and expansion

Production cycle
Business fluctuations Production policy Sale policy

Availability of raw material

Availability of credit Volume of profit Dividend policy

Efficiency of management
Price level changes

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Working capital management

WCM is the process of planning and controlling the level and mix of the current assets of the firm as well as financing these assets. Specially wcm requires financial manager to decide that what quantities of cash, accounts receivables and inventories etc. the firm must hold at any point of time. The goal of wcm is to manage the current assets and current liabilities of the firm in such a way that satisfactory level of working capital is maintained.
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