WORKING

WORKING CAPITAL
CAPITAL
MANAGEMENT
MANAGEMENT
SOUMYA V
 INTRODUCTION
• Working capital is the amount of funds
used for financing the day to day affair
of the business. It is that part of total
capital which is used for carrying out
the routine business activities.
 Types of WC

On the basis of On the basis of

concept Periodicity

Fixed or
Gross WC Net WC Variable WC
Permanent WC

Positive WC Regular WC Seasonal WC

Reserve Margin
Negative WC Special WC
Or Cushion WC
 On the basis of concept
Classified in to 2:
– Balance sheet concept
– Operating cycle concept
 Balance sheet concept of WC
Classified in to 2. They are:
a) Gross WC and
b) Net WC
Gross WC: Gross W C refers to the firm’s total
investment in current assets.

Net WC: Net W C refers to the difference between

current assets and current liabilities.
When CA is more than CL it is + WC and when CL is
more than CA it is -WC
 Gross WC
It focuses attention on 2 aspects viz,
a) Optimum investment in current assets
and
b) Financing of current assets
Net WC
• It indicates the liquidity position of the
firm and
• It suggests the extent to which WC needs
may be financed by permanent source of
funds.
Operating cycle concept of WC

(Circular Flow Concept)

Cash

Debtors Raw Material

Sales Work in progress

Finished goods
Operating cycle concept classified in to 2:
1. Gross operating cycle
2. Net operating cycle

Gross operating cycle = Raw material conversion

period + Work in progress conversion period +
Finished goods conversion period + receivable
conversion period

Net operating cycle = Gross operating cycle –

Payable deferral period
 Formulae
Raw material conversion period:
Average stock of raw material
Per day consumption of raw material
WIP conversion period:
Average stock of WIP
Cost of production per day
Finished goods conversion period:
Average stock of finished goods
Cost of sales per day
Receivable conversion period:
Average debtors (Accounts receivable)
Credit sales per day
Payable deferral period:
Average creditors
Credit purchases per day
 On the basis of periodicity

• Classified in to 2. They are:

– Fixed or Permanent WC
– Variable WC
 Fixed or Permanent WC
Minimum amount of WC required to meet the day to
day activities.

It is that part of WC which is locked up in current

assets to carry out business activities smoothly.

It is also called core current assets

Quantity of fixed WC increases proportionately to

the expansion of the business
 Diagrammatic representation
of Fixed WC

Y Y
Amount of WC

Amount of WC
Fixed WC
Fixed WC

0 0
Time X Time X
 Classification of fixed WC
a) Regular WC - minimum amount of WC needed to
keep up the circulation of capital from cash to
inventory to receivables and again to cash. (WC to
be maintained in normal conditions)

b) Reserve margin or Cushion WC- It is the excess

over the regular WC kept to meet uncertainties.
(WC maintained to meet contingencies like price
rise, strikes, etc)
 Variable WC
WC required to meet seasonal demand or
special needs is called variable or
temporary WC. It is over and above fixed
WC

It is subdivided in to
a) Seasonal WC &
b) Special WC
 Diagrammatic representation
of Variable WC

Y Y
Amount of WC

Amount of WC
Fixed WC
Fixed WC

0
Time X 0 Time X
• Seasonal WC: The WC required to
meet the seasonal demand of the
product arises from festivals,
economic conditions etc.

• Special WC: The WC required for

financing special operations such as
extensive marketing campaigns,
carrying out special job orders etc.
 Determinants of WC
or
Factors affecting WC requirements

• Nature of business or • Seasonal variations

industry • Length of operating cycle
• Size of business or • Fluctuations in the supply
of raw materials
scale of operations
• Terms of purchase &
• Growth & expansion of sales
business
• Manufacturing cycle
• Production policies
 Determinants of WC (Contd)

• Price level changes • Rapidity of turnover

• Conversion of current • Taxes
assets in to cash Dividend policy
•
• Business cycle Depreciation policy
•
• Operating efficiency Government
•
• Profit margin regulations
Procedure for estimation of WC
requirement

1. Estimation of total current assets

2. Estimation of total current
liabilities
3. Ascertainment of Net working
capital requirement
 Issues
Issues in
in Working
Working
Capital
Capital Management
Management
Importance of working capital
management

• Time
• Investment
• Criticality
• Growth
 How
How toto decide
decide the
the
levels
levels and
and financing
financing of
of
current
current assets??
assets??
 Level of current assets

• Determine the optimum level of CA

so that wealth of the shareholders is
maximised.
• The level can be measured by
relating CA to FA
 Current Assets to Fixed
Assets ratio
• Higher CA/FA ratio – conservative CA
policy – greater liquidity and lower risk-
lower return

• Lower CA/FA ratio –aggressive CA policy –

poor liquidity-higher risk and higher return

• Moderate CA policy fall in the middle of

the two extreme policies
Alternative Current Asset
Policies

A Conservative Policy
Level of Current Assets

B Moderate Policy

C Aggressive policy

Fixed Assets Level

Output
 Liquidity Vs Profitability:
Risk – Return trade Off
• Profitability – measured by profits after
expenses
• Solvency- firm’s continuous ability to meet
maturing obligations
• Risk – probability of suffering a loss or
becoming insolvent
• Greater NWC, greater liquidity – more solvency-
less risk
• Lower NWC, lower liquidity – lower solvency -
more risk
 Effect of alternative WC
policies
WC Policy Conservative Moderate Aggressive
B Rs C Rs
A Rs
Sales 1500000 1500000 1500000
EBIT 150000 150000 150000
Current assets 500000 400000 300000
Fixed assets 500000 500000 500000
Total Assets 1000000 900000 800000
Return on total assets 15% 16.67% 18.75%
(EBIT/Total assets)
Current assets/Fixed assets 1 0.80 0.60
 The cost trade off
Cost of maintaining a particular level of
current assets
Two types of cost:
a) Cost of liquidity &
b) Cost of illiquidity
Cost of liquidity
More CA, excessive liquidity, less return
Thus cost of liquidity increases with the
level of current assets
Cost of illiquidity
Insufficient CA, too little cash, more
borrowings at higher rates of interest,
affect credit worthiness, loss of sales may
lead to insolvency
Thus cost of illiquidity increases with the
fall in level of current assets
 Cost trade off
Total Cost

Cost of liquidity
Cost

Cost of illiquidity

Level of current assets

Optimum level of
current assets
 Policies for financing
Current Assets
• Long Term Financing
• Short Term Financing
• Spontaneous Financing
Approaches for financing
current assets
• Matching or hedging approach
• Conservative approach
• Aggressive approach
Matching or hedging approach
• Match the maturity of the assets with the
maturity of the financing.
• Here, long term financing is used to finance fixed
assets and permanent current assets and short
term financing to finance variable current assets
• Exact matching may not be possible because of
the uncertainty in the life of the assets
 Financing Under Matching
Approach
Temporary Current Assets
Short term financing

Long term financing

A
s
Assets

s r r ent as sets
nt cu
e Permane
t
s
Fixed assets

Time
 Conservative Approach
• Depends more on long term funds
• A firm finances its current assets and a
part of temporary assets with long term
funds
• When temporary current assets are not
needed, the idle funds can be invested in
tradable securities
• Less risky as relies more on long term
funds
 Conservative approach
Investment in Marketable securities

ra ry C urrent Assets
Tempo
Short term financing

Long term financing

Assets

r r ent as sets
nt cu
Permane

Fixed assets

Time
 Aggressive approach

• More short tem funds

• Firm finances part of its permanent
current assets also with short term funds
• Some extremely aggressive firms may even
finance a part of their fixed assets also
with short term financing
• More risky
 Aggressive approach

Short term financing

Long term financing

Assets

r r ent as sets
nt cu
Permane

Fixed assets

Time
Short term Vs. Long term financing:
A Risk-return trade off

a) Cost : short term less costly

compared to long term (But in India
short term is costly)
b) Flexibility : short term – easy to
refund
c) Risk: short term – high risk
 Summary of
Short - VS. Long-Term Financing

Financing
Maturity
SHORT-TERM LONG-TERM
Asset
Maturity

SHORT-TERM Moderate Low

(Temporary)
Temporary Risk-Profitability Risk-Profitability

LONG-TERM High Moderate

(Permanent) Risk-Profitability Risk-Profitability
Permanent
 The following points should be noted while
framing a working capital policy

1. Individual current assets and current liabilities

policies should be framed so as to reduce or avoid
larger degree of risk in any such policy
2. One aggressive policy may be set off by an other
conservative policy. For e.g.: a firm may have a
conservative policy for current assets but
aggressive policy for current liabilities. The overall
result will tend to be moderate working capital
policy for the firm. Such a moderate WC policy will
be optimal for the firm.
 Dangers of excess WC

• Idle funds, lesser ROI

• Unnecessary purchase and accumulation of
inventories
• Excessive debtors and defective credit policies –
higher incidence of bad debts
• Lower return – fall in market value of shares
• Overall inefficiency
 Dangers of inadequate WC

• Cant pay off short term liabilities in time

• Unable to avail attractive credit opportunities
• Economies of scale not possible
• Day to day liquidity worsens
• Stagnates growth as it is difficult to take
profitable projects for non availability of WC