Working Capital

Management

BY
Punit K Dwivedi
Introduction:
 Any business firm requires two types of
assets- long term and short assets.
 In investment decision we studied that
how a firm should select the most
profitable project to acquire some capital
assets or long term asset.
Meaning and Concept of WC
 Funds invested in Current Assets.
 Means investment in Stocks,sundry
debtors,cash and other Current Assets.
 The requirement of current assets are usually
greater than the amount of funds payable
through current liabilities. In other words,the
Current assets are to be kept at a higher
level than the Current Liabilities.
Contd.
 In financing decision making we discussed
the concepts of leverages, capital
structure theories and EBIT & EPS
analysis through which we can how the
shareholders wealth can be increased.
Contd.
 In Dividend decision we acquired little bit
knowledge about the dividend policies;
payout and retention ratio and how a firm
can increase it market value of share at
given EPS by making change in payout
ratio.
Contd.
 Now, all this may happen in any
business if it can run smoothly. The
question is what is essential to run a
business or to make fixed assts
operative ?
 The answer is Working Capital.
Theory of Working Capital
Management:

 Working capital represents the value of current assets in

the firm.
 The management of short term assets is so important for
a firm that it can survive only after keeping adequate
level of short term assets.
 The working capital plays a role in business firm like a
lubricants and fuel in automobile. It converts an asset
from non productive to productive one and vice-versa.
 It applies for all the factors of production. In every
business the receipts are uncertain where as the
payments are certain.
Contd.
 So, to fill this gap,a firm needs optimum quantity of
working capital.
 The working capital management refers the matching
of current assets and current liabilities to maintain long
term assets and to pay respectable compensation to
the long term funds.
 It establishes the relationship between current assets
and current liabilities. It should be adequately supplied
to increase the wealth of the organization.
Contd.
Working capital management involves two
main processes.
 Determining the size of the working capital

 Arranging the sources of working capital

Determining the size of the
working capital:
It is determined on the basis of certain
factors, like –
 Nature of Industry
 Size of Business
 Manufacturing Cycle
 Production Policy
 Volume of Sales
 Terms of purchase & Sales
Contd.
 Business Cycle
 Growth and Expansion
 Supply of Raw Materials
 Price Level changes
 Operating Efficiency
 Profit Margin
 Profit Appropriation
 Capital Structure
 Monetary Policy
Arranging the sources of working
capital:
It depends mainly upon the availability of funds and
different application of this working capital. Current
assets or working capital includes mainly three
components
 Inventories
 Cash
 Receivables

So, in short we can also say that the working capital

management means to manage all these three
components in the firm.
Contd.
 Types of Working Capital: There two broad
classifications of the working capital.
 Gross Working Capital
 Net Working Capital
There are two more classifications which are also
very important.
 Permanent Working Capital
 Temporary Working Capital
Gross Working Capital:
 It refers to the firm’s investment in current
assets which include mainly cash, short
term securities, and debtors, bills
receivable and stock.
 The concept of the current assets is the
assets which can be converted in to cash
within one accounting year.
Net Working Capital:
 It refers to the difference between current
assets and current liabilities.
 Current liabilities are those which are
expected to mature for claim within one
accounting year and which include trade
creditors, bills payables and outstanding
expenses.
Permanent Working Capital:
 It refers to the amount of working capital
which is required by the firm every time.
 It shows the minimum level of working
capital which required maintaining day to
day operations of the firm.
Temporary Working Capital:
 It is required by the when while some
changes in production or sales volume or
change in the price level of any factors of
production.
Contd.
 The net working capital may be positive or
negative.
 Positive working capital shows the surplus of
current assets over current liabilities and
 Negative shows deficiencies
Determining the Financing mix
In working capital finance we will discuss
two things-
 Sources of Working Capital

 Approaches for determining the Financing

Mix
Sources of Working Capital:
 On the basis of sources, we can classify it
in to three broad categories-
 Long Term Financing
 Short Term Financing
 Spontaneous Financing
Long Term Financing:
It includes the following
 Term loans from financial institutions

 Issue of Debentures

 Issue of Shares

 Accepting Public Deposit

 Internal Financing (Retained Earnings)

Short Term Financing:
 It includes following-
 Short term bank loan (Bank Overdraft)
 Commercial Papers (like bills hundies
etc.)
Spontaneous Financing:
 This source of finance is cost free
sources. It includes following-
 Trade Creditors
 Outstanding Expenses etc.
Approaches for determining the
Financing Mix:
 There are following three types of
approaches to finance the working capital
 Matching Approach or Hedge Approach
 Conservative Approach
 Aggressive Approach
Matching Approach or Hedge
Approach:
 In this approach of financing the working
capital the firm tries to finance the
permanent working capital through the
long term funds and temporary working
capital through short term funds.
 The concept behind this is that the
maturity of source of funds should match
the nature of assets to be financed.
Conservative Approach:
 According this approach the whole amount
of working capital should be financed
through the long term funds. In this approach
the firm does not want to take any risk.
 It is a costly approach in comparison to
matching approach.
Aggressive Approach:
 Under this approach the firm uses the
short term funds to finance some part of
permanent working capital and the whole
of part of temporary working capital.
 But this approach is more risky for the
firm, however this the cheapest approach.
Planning of working capital
 Every firm must maintain a sound working capital otherwise;
its business activities may be adversely affected.
 The objective of financial management i.e. to maximize the
wealth of the shareholder cannot be attained if operations
the firm are not optimized.
 Thus, every firm has to maintain adequate working capital.
It should have neither the excessive working capital nor
inadequate working capital.
Need
 To increase operating profit, the firm should
increase its sales.
 In practical life it has been seen that when
firm increases its sales the profit may
increase but it is not necessary that the cash
profit may increase, because sales include
the cash and credit sales.
 Cash sales increase the cash position
whereas credit sales increase the
receivables.
….Need
 The collection of cash from receivables require
some times span. So, to meet out day to day
expenses the firm needs some sort of funds to
run uninterrupted business operations, the
amount will be locked up in the current assets.
 It happens due to operating cycles. The need of
working capital is based on the length of
operating cycles. The length of operating cycle
depends mainly on the nature of business it self.
 Operating Cycle
Cash Raw material
Work in progress Finished

Goods Sales
Debtors Bills receivables
Cash
Concept and Computation of
Operating Cycle:

 The operating cycle concept refers to the

time lag, which is required to convert the
raw material in to finished products and
finished product to cash again.
Computation of Operating Cycle
 The Total Operating Cycle Period
(TOCP) will be equal to Inventory
Conversion Period (ICP) + Receivable
Conversion Period (RCP).
 The firm might get some credit form
supplier of raw material, wages
earners etc.
…Cont.
 The period for which the payments to these
parties are delayed or deferred is known as
Deferred Period (DP).
 The Net Operating Cycle (NOC) of the firm
may be calculated by deducting Deferred
Period (DP) from the Total Operating Cycle
Period (TOCP).
NOC = TOCP – DP
or
NOC = ICP + RCP – DP
For calculation of TOCP and NOC, various
conversion periods may be calculated as
follows:
 Average Raw Material Stock
RMCP = X 365
Total Raw Material Consumption

Average Work in Progress

WPCP = X 365
Total Cost of Production
 Average Finished Goods
FGCP = X 365
Total Cost of Goods Sold
Average Receivables
RCP = X 365
Total Credit Sales
Average Creditors
DP = X 365
Total Credit Purchase
 Particulars Numbers of
 On the basis of above
conversion periods,
Days
TOCP and NOC may RMCP ……..Days
be ascertained as
follows. + WMCP ……..Days
+ FGCP ……..Days
+ RCP ……..Days
TOCP ……..Days
-DP ……..Days
NOC ……..Days
RMCP Raw Material Conversion Period

+ WMCP Work in Progress Conversion Period

+ FGCP Finished Goods Conversion Period

+ RCP Receivables Conversion Period

TOCP Total Operating Cycle Period

-DP Deferred Period

NOC Net Operating Cycle

Example
Rs, In 000

Sales 3,000

Cost of Production 2,100

Purchase 600

Average Raw Material 80

Average Work in Progress 85

Average Finished Goods 180

Average Creditor 90

Average Debtors 350

Solution:
Particulars Numbers of Days

RMCP 49 Days
+ WMCP 15 Days
+ FGCP 31 Days
+ RCP 43 Days
TOCP 138 Days
-DP 55 Days
NOC 83 Days
Problems Associated with Excess
and Inadequate Working Capital:
 This is very important aspect of working capital
management that excessive as well as
inadequate working capital both are harmful to
the organization. Excess working capital creates
idle funds, which cannot earn any return,
whereas shortages of working capital will
hamper the production process and other
business operations. In both the situations firm
has to suffer loss.
Demerits of Excessive Working
Capital
There may be following problems
 It can accumulate unnecessary inventories. Thus chance
of mishandling, theft, wastage of inventories may occur.
 It also indicates poor collection of receivable and very
liberal credit policy regarding sales. The bad debts will
increase it such situation continues for long time.
 It allows to the management to inefficiently
 Accumulation of excessive inventories also leads to
speculative profit. This may tend to make dividend policy
liberal, which may create serious problems in future.
 Excessive availability of cash tempts the executive to
spend more.
Demerits of Inadequate Working
Capital:
 There may be following problems-
 It becomes difficult for the firms to undertake profitable projects due
to shortage of working capital.
 The firm may face problems in implementing the operating plans
and achieve the firm’s profit target.
 It also creates problem in meeting out day-to-day or routine
expenses.
 Fixed assets can be utilized more effectively, thus the overall return
may go down.
 Due to inadequate working capital firm may loose some good credit
opportunities
 The firm may spoil its fame and reputation if it fails to honour short-
term obligations. As a result, the firm faces tight credit terms.
 It directly affects the liquidity positions of the business firms.