WORKING CAPITAL MANAGEMENT

Ashok Thampy
Professor
Finance & Accounting Area, IIMB
WORKING CAPITAL MANAGEMENT
 Working capital management constitutes
management of short term assets and liabilities
 Gross working capital = total current assets

 Net working capital =

current assets - current liabilities
SHORT TERM ASSETS AND LIABILITIES
 Assets and liabilities:
 short term
 long term

 Short term - converted into cash within a year

CONSTITUENTS OF CURRENT ASSETS
 Inventories
 raw materials and components
 work-in-progress
 finished goods
 others
 Trade debtors/ Receivables
 Loans and advances
 Investments
 Cash and bank balances
CONSTITUENTS OF CURRENT LIABILITIES
 Sundry creditors/Accounts payable
 Trade advances

 Borrowings
 Commercial banks
 Others

 Provisions
CHARACTERISTICS OF CURRENT ASSETS
 Short life span
 Each asset is quickly transformed into some
other asset form-
 cash is transformed into raw materials
 raw materials are transformed into finished goods
and then receivables and then again into cash
CHARACTERISTICS OF CURRENT ASSETS

 The short life span of working capital assets and

their swift transformation has certain implications:
 decisions wrt working capital are repetitive and
frequent
 the difference between profit and present value is
insignificant
 each aspect of working capital is linked to the others
and therefore requires coordination and an overall
approach.
CURRENT ASSET CYCLE

Finished
goods
Work in
Accounts progress
receivable
Wages, salaries,
factory overheads Raw
materials

$Cash$ Suppliers
FACTORS INFLUENCING WORKING CAPITAL
REQUIREMENTS

 Nature of business
 manufacturing business
 services
 Seasonality of operations
 Production policy

 Market conditions and level of competition

 Conditions of supply of inputs

 Credit sales policy

CURRENT ASSETS RATIO IN DIFFERENT
SECTORS

Current assets Fixed assets Industries

10-20 80-90 Hotels and restaurants
20-30 70-80 Electricity generation and distribution
30-40 60-70 Aluminium and shipping
40-50 50-60 Iron and steel, basic chemicals
50-60 40-50 Tea plantation
60-70 30-40 Cotton textiles, sugar
70-80 20-30 Edible oils, tobacco
80-90 10-20 Trading and construction
LEVEL OF CURRENT ASSETS
 Flexible policy
 High levels of current assets
 high balance of cash and marketable securities, enough raw
materials and liberal credit terms
 No production stoppage and high sales but high investment in
current assets
 Restrictive policy
 Low levels of current assets
 minimum level of cash and marketable securities, low level of
raw materials and strict credit terms
 Frequent or occasional production stoppages and slower sales

growth but investment in current assets would be lower.

 CARRYING COSTS AND SHORTAGE COSTS
Carrying
costs
and Total cost
shortage
costs

Carrying
Flexible cost
Restrictive policy Shortage
policy costs

CA* Level of current assets

 CURRENT ASSETS FINANCING POLICY
A
Capital
reqt. B
C

Fluctuating
CA reqt.

Permanent
CA reqt.
Fixed asset
requirement
Time
CAPITAL REQUIREMENT AND
FINANCING
 Strategy A: Long-term financing is used to
meet fixed asset requirement as well as peak
working capital requirement.
 Strategy B: Long term financing used for fixed
asset requirements, permanent working capital
requirements, and a part of fluctuating
working capital requirement. During seasonal
upswings, short term financing is used.
 Strategy C: Long term financing used for fixed
and permanent working capital requirement.
Short term finance for seasonal variations.
MATCHING PRINCIPLE
 Maturity of sources of funds should match the
maturity of assets being financed.
 Implies:
 Fixed assets and permanent portion of CA should be
financed by long term sources of funds
 Fluctuating CA must be supported by short term
sources of finance.
 Strategy C reflects the matching principle.
FINANCING OF CURRENT ASSETS
 Trade credit/Accounts payable
 Bank credit
 Cash credit
 Loan

 Bill discounting
 Factoring
PROFIT CRITERION FOR WORKING
CAPITAL
 Profit criterion is profit per year of investing Rs.
P in working capital
 Return for year = Pr

 Cost of funds for the year = Pk

 Profit per year = Pr - Pk = P(r-k)

 For a multi-period investment of Rs. P in working

capital,
NPV = (Pr-Pk).(PVIFAk,n)
 OPERATING CYCLE AND CASH CYCLE

Finished
Raw material Cash
Order products
stock arrives received
placed sold
Accounts
Inventory period
receivable period

Accounts
payable period

Firm receives Cash paid for

invoice materials
Operating Cycle
Cash Cycle
 ESTIMATING WORKING CAPITAL CYCLE
FROM FINANCIAL STATEMENTS

Average inventory
Inventory period 
Annual COGS/365
Average accounts receivable
A/R period 
Annual sales/365
Average accounts payable
A/P period 
Annual COGS/365
 FINANCIAL INFORMATION FOR
ABC CO.

Balance sheet data

Beginning Ending
P&L accounts data 201X 201X
Sales 800 Inventory 96 102
COGS 720 Ac. Receivable 86 90
Ac. Payable 56 60
 WORKING CAPITAL CYCLE CALCULATION
Balance sheet data
Beginning Ending
P&L accounts data 201X 201X
Sales 800 Inventory 96 102
COGS 720 Ac. Receivable 86 90
Ac. Payable 56 60

(96  102)/2
Inventory period   50 .1 days
720/365
(86  90)/2
A/R period   40 .2 days
800/365
(56  60)/2
A/P period   29 .4 days
720/365
Op. cycle  inv. period  ac. rec. pd.
Op. cycle  90.3 days; Cash cycle  60.9 days
TATA MOTORS
Mar 07(12) Mar 06(12) Mar 05(12) Mar 99(12)
Average Inventory 2256.60 1806.8 1374.4 911.03
Average accounts receivable 749.39 757.59 706.79 1704.74
Average accounts payable 5860.14 5570.72 4821.37 2174.37
Annual sales 27,061.53 20,293.30 17,088.59 5,473.20
Annual COGS 25,158.63 18,685.17 15,691.14 5,486.89
PAT 1,913.46 1,528.88 1,236.95 97.46

Inventory period (days) 32.74 35.29 31.97 60.60

Accounts receivable period (days) 10.11 13.63 15.10 113.69
Accounts payable period (days) 85.02 108.82 112.15 144.64

Operating cycle (days) 42.85 48.92 47.07 174.29

Cash cycle (days) -42.17 -59.90 -65.09 29.65

(CA excluding cash, loans and

advances)/CL 0.45 0.39 0.37 0.80
WORKING CAPITAL: DAYS
OUTSTANDING
NSE Ticker Receivable Inventory Payable
Company Symbol Industry Days Days Days CCC
Ambuja
Cement(Dec'07) AMBUJACEM Cement 9.50 61.63 93.25 -22.12
ACC(Dec'07) ACC Cement 15.35 50.66 99.39 -33.39
NTPC(Mar'08) NTPC Power 29.19 38.01 45.58 21.61
Tata Motors(Mar'08) TATAMOTORS Automobiles 14.47 36.77 70.36 -19.13
Ashok Leyland(Mar'08) ASHOKLEY Automobiles 17.32 61.93 65.41 13.84
Wipro(Mar'08) WIPRO Software 75.38 12.14 0.00 87.51
TCS(Mar'08) TCS Software 73.78 0.47 34.16 40.10
Infosys(Mar'08) INFOSYSTCH Software 72.15 0.00 13.97 58.18
Cadila(Mar'08) CADILAHC Pharmaceuticals 62.77 89.70 109.48 42.99
Cipla(Mar'08) CIPLA Pharmaceuticals 127.26 123.54 58.82 191.98
Sun(Mar'08) SUNPHARMA Pharmaceuticals 122.22 65.42 108.54 79.10
Ranbaxy(Dec'07) RANBAXY Pharmaceuticals 72.77 91.45 47.36 116.87
SAIL(Mar'08) SAIL Steel 27.98 87.80 37.23 78.55
Tata Steel(Mar'08) TATASTEEL Steel 10.09 87.98 109.55 -11.47
HUL(Dec'07) HINDUNLVR Personal Care 11.83 79.29 116.82 -25.71
Colgate (Mar'08) COLPAL Personal Care 2.27 23.91 88.81 -62.63
Dabur(Mar'08) DABUR Personal Care 17.60 45.04 58.16 4.48
POOR WCM – POOR CASH FLOW
 A firm might make accounting profits, but the
investment in working capital is very high, then
the firm may not be generating cash.
 Why?
CREDIT PERIODS AND CASH DISCOUNTS
 Increase in credit period ------> higher
sales
 Increase in credit period -------> higher
default
CREDIT EVALUATIONS
 5 C’s –
 Character

 Capital

 Capacity

 Collateral

 Conditions-(credit terms, sensitivity to business

cycles)
CREDIT EVALUATIONS
 Sources of information
 bank, suppliers
 trade credit rating agencies (Dunn & Bradstreet)
 Financial ratios
 current ratio (current assets/current liabilities)
 Quick ratio or acid test ratio =
(current assets-inventory)/CL
 debt equity ratio(Debt/BV of equity, Debt/MV of
equity)
 PBDIT to asset ratio(PBDIT/Total assets)
 ROE (PAT/Net worth)
 Times Interest Earned ratio (PBDIT/Interest)
COST OF TRADE CREDIT

Trade credit terms are, say, 1/10, net 20. What does it cost
to stretch payables upto 20 days?

Discount% 360
X
1  Discount% Credit Period - Discount Period
In this example,
0.01 360
X  36 .4%
1  0.01 20 - 10
TEN COMMANDMENTS OF WCM
 Shorten Op. Cycle and cash cycle.
 Match maturity of asset to liability
 Invest surplus funds
 Sensible credit policy
 Monitoring
 Vigil over inventories
 ERP - useful for planning
 Good liquidity? Avail cash discounts
 Stretch payables upto a limit, but beyond
that it could be counter-productive
 Relationship with banker is very important