Working

Capital
Manageme
nt

Definition of Working Capital

WorkingCapitalreferstothatpartofthe
firmscapital,whichisrequiredfor
financingshort-termorcurrentassetssucha
cashmarketablesecurities,debtorsand
inventories.Fundsthus,investedincurrent
assetskeeprevolvingfastandare
constantlyconvertedintocashandthiscash
flowoutagaininexchangeforothercurrent
assets.WorkingCapitalisalsoknownas
revolving or circulating capital or shortterm capital.

KINDS OF WORKING CAPITAL

WORKING CAPITAL
BASIS OF
CONCEPT
Gross
Working
Capital

BASIS OF
TIME
Permanent
/ Fixed
WC

Net
Working
Capital

Temporary
/ Variable
WC

Seasonal
WC
Regular
WC

Reserve
WC

Special
WC

Significance of Gross WC
OptimuminvestmentinCA
InvestmentinCAmustbeadequateCAinvestmentshouldnot
beinadequateorexcessiveinadequateWCcandisturb
productionandcanalsothreatenthesolvencyoffirm,ifitfails
tomeetitscurrentobligationexcessiveinvestmentinCA
shouldbeavoided,sinceitimpairsfirmsprofitability

FinancingofCA
NeedforWCarisesduetoincreasinglevelofbusinessactivity
&itistoprovidedquicklysometimesurplusfundmayarises
whichshouldbeinvestedinShorttermsecurities,theyshould
notbekeptidle

Significance of Net Working Capital

MaintainingLiquidityposition
Formaintainingliquiditypositionthereisa
needtomaintainCAsufficientlyinexcessof
CL
JudgeFinancialSoundnessofafirm
TheNetworkingcapitalhelpscreditorsand
investorstojudgefinancialsoundnessofa
firm

BALANCE SHEET OF ABC COMPANY AS ON 31-32000

Liabilities

Rs

Assets

Rs

Equity Shares

20000
0

Goodwill

20000

8% Debentures

10000
0

Land and
Building

15000
0

Reserve & Surplus 50000

Plant and
Machinery

10000
0

Sundry Creditors

15000
0

Inventories

Bills Payable

30000

Finished Goods

60000

Outstanding
Expenses

20000

Work in process

40000

Bank Overdraft

50000 Prepaid Expenses 20000

Provision for
Taxation

Marketable
Securities

60000

Sundry Debtors

90000

Bills Receivables

20000

20000

Proposed Dividend 30000

Cash & Bank

Difference between permanent &

temporary working capital

Amount
of
Working
Capital

Variable Working Capital

Permanent Working Capital

Time
Permanent and temporary working capital for Stable firm

Variable Working Capital

Amount
of
Working
Capital
Permanent Working Capital

Time
Permanent and temporary working capital for Growing firm

Operating cycle concept

Maximization of share holders wealth of a firm is
possible only when there are sufficient return from the
operations
Successful sales activity is necessary for earning profit
sales do not convert into cash immediately
There is invisible time lap between the sale of good
and receipt of cash
The time taken to convert raw material into cash is
known as operating cycle
Conversion of cash into raw material
Conversion of raw material into work in progress
Conversion of Work in progress into finished goods
Conversion of finished good into Sales ( Debtors and
cash )

Raw
Materials

Cash

WIP

Operating Cycle in
Manufacturing firm

Debtors

SALES

Finished
Goods

Operating cycle
Manufacturing

of Non
Firm

Receivables
cash

Stock of finished goods

Formula for calculating Operating

cycle for Manufacturing firm
OC = ICP+ARP
OC = Operating cycle
ICP = Inventory Conversion period
ARP = Account Receivable Period
ICP = Average Inventory
Cost of good sold /365
ARP = Average Account Receivable
Sales/365

ABC Company Provide the

following information , Compute
the operating cycle

Sales3000Lakhs
InventoryOpeningRs610Lakhs;
closingRs475Lakhs
ReceivableopeningRs915Lakhs;
ClosingRs975Lakhs
CostofGoodsSoldRs2675Lakhs

CASHCONVERSIONCYCLE
Theamountoftimeafirmsresourcesaretiedup
calculatedbysubtractingtheaveragepayment
periodfromtheoperatingcyclethetimeperiod
betweenthedateafirmpaysitssupplierandthe
dateitreceivescashfromitscustomer
CCC=OCAPP
AAI=AverageInventory
Costofgoodsold/365
ARP=AverageAccountReceivable
AnnualSales/365
APP=AccountPayablePeriod
Costofgoodsold/365

Calculate CCC
(CASH CONVERSION CYCLE)
Average use of Inventory 80 days
Account receivable collection period 50
days
Account payable period is 40 days
CCC= OC- APP
OC = AAI+ARP
80+50=130
CCC =130-40 =90 days

PurchaseofSaleofGoods
Collectionof
RawMaterial
onCredit
AccountReceivables
Oncredit

Averageageof Accountreceivable
Inventory(AII)
period(ARP)

AccountPayable
Period(APP)

Paymentto
suppliers

ReceiptofInvoice OperatingCycle(OC)

Cash Conversion cycle

Resource flows for a

manufacturing firm
Used in

Production
Process

Used in

Generates

Accrued Direct
Labour and
materials
Working
Capital
cycle

Inventory
Via Sales Generator

Accounts
receivable

Collection
process

Accrued Fixed
Operating
expenses
Used to
purchase
Cash and
Marketable
Securities

External Financing
Return on Capital
Suppliers
Of Capital

Used to
purchase
Fixed
Assets

Calculate cash conversion cycle

Sales Rs 1587.95
Cost of Good sold Rs 1406.27
Inventory opening 195.82, closing
202.29
Account receivables opening 423.03
closing 449.46
Account payable opening 140.40,
closing 168.33
CCC = OC APP
OC = AAI + ARP

FORECASTING / ESTIMATION OF
WORKING CAPITAL REQUIREMENTS

Factorstobeconsidered
Totalcostsincurredonmaterials,wagesandoverheads
Thelengthoftimeforwhichrawmaterialsremaininstoresbeforethey
areissuedtoproduction.
The length of the production cycle or WIP, i.e., the time taken for
conversionofRMintoFG.
ThelengthoftheSalesCycleduringwhichFGaretobekeptwaiting
forsales.
Theaverageperiodofcreditallowedtocustomers.
The amount of cash required to pay day-to-day expenses of the
business.
Theamountofcashrequiredforadvancepaymentsifany.
Theaverageperiodofcredittobeallowedbysuppliers.
Timelaginthepaymentofwagesandotheroverheads

PROFORMA - WORKING CAPTIAL

ESTIMATES
1. TRADING CONCERN
STATEMENTOF
OFWORKING
WORKINGCAPITAL
CAPITALREQUIREMENTS
REQUIREMENTS
STATEMENT
Amount(Rs.)
(Rs.)
Amount

CurrentAssets
Assets
Current
(i)Cash
Cash
(i)
(ii)Receivables
Receivables((For..Months
For..MonthsSales)---Sales)---(ii)
(iii)Stocks
Stocks((ForMonths
ForMonthsSales)----Sales)----(iii)
(iv)AdvancePayments
Paymentsififany
any
(iv)Advance
Less::Current
CurrentLiabilities
Liabilities
Less
(i)Creditors
Creditors(For..
(For..Months
MonthsPurchases)Purchases)(i)
(ii)Lag
Lagin
inpayment
paymentof
ofexpenses
expenses
(ii)
WORKINGCAPITAL
CAPITAL((CA
CACL
CL))
WORKING
Add::Provision
Provision //Margin
Marginfor
forContingencies
Contingencies
Add
NETWORKING
WORKINGCAPITAL
CAPITALREQUIRED
REQUIRED
NET

-----------------------------------_
-----_
xxx
xxx
--------XXX
XXX

1. MANUFACTURING CONCERN
STATEMENT OF WORKING CAPITAL REQUIREMENTS
Amount (Rs.)
Current Assets
(i) Stock of R M( for .months consumption)
(ii)Work-in-progress (formonths)
(a) Raw Materials
(b) Direct Labour
(c) Overheads
(iii) Stock of Finished Goods ( for months sales)
(a) Raw Materials
(b) Direct Labour
(c) Overheads
(iv) Sundry Debtors ( for months sales)
(a) Raw Materials
(b) Direct Labour
(c) Overheads
(v) Payments in Advance (if any)
(iv) Balance of Cash for daily expenses
(vii)Any other item
Less : Current Liabilities
(i) Creditors (For.. Months Purchases)
(ii) Lag in payment of expenses
(iii) Any other
WORKING CAPITAL ( CA CL )xxxx
Add : Provision / Margin for Contingencies
NET WORKING CAPITAL REQUIRED

--------------------------------------------------------------------XXX

Prepare an estimate of Working capital requirement

from the following information of a trading concern:
Projectedannualsales

100000units

Sellingprice

Rs8perunit

%ageofNetprofitonsales

25%

AverageCreditPeriodallowedto
customer

8weeks

AverageCreditPeriodallowedby
supplier

4weeks

Averagestockholdingintermaofsales
requirement
12weeks
contingencies

10%

Points to be remembered while

estimating WC

(1) Profits should be ignored while calculating working

capital requirements for the following reasons.
(a)Profits may or may not be used as working capital
(b) Even if it is used, it may be reduced by the amount of
Income tax, Drawings, Dividend paid etc.
(2) Calculation of WIP depends on the degree of completion
as regards to materials, labour and overheads. However, if
nothing is mentioned in the problem, take 100% of the value
as WIP. Because in such a case, the average period of WIP
must have been calculated as equivalent period of completed
units.
(3)
Calculation of Stocks of Finished Goods and Debtors
should be made at cost unless otherwise asked in the
question.

Prepare statement of working

capital requirement, Profit
&Loss A/C, Balance Sheet
Assuming

Share Capital
8% Debentures
Fixed asset
Material
Direct lab our
Overheads

150000
200000
130000
40%
20%
20%

The following further particular are available

It is proposed to maintain a level of activity of
2,00,000 units
Selling price is Rs 12/- per unit
Raw Material are expected to remain in stores for
an average period of one month
Material will be in process , on average half a month
Finished goods are required to be in stock for an
average period of one month
Credit allow to debtors is two month
Credit allow by supplier is one month

Working Capital Financing Mix

Approaches to Financing
Mix

The Hedging or
Matching Approach

The Conservative
Approach

The Aggressive
Approach

Hedging approach to asset

financing
Total Assets
Short-term
Debt
Fluctuating Current Assets

Permanent Current Assets

Fixed Assets

Time

Long-term
Debt +
Equity
Capital

The Hedging approach

Hedging approach refers to a process of

matching maturities of debt with the
maturities of financial need . In this
approach maturity of source of fund should
match the nature of asset to be financed
This approach is also known as matching
approach.
The hedging approach suggests that the
permanent working capital requirement
should be financed with fund from long
term sources while the temporary working
capital requirement should be financed
with short term funds.

Estimated Total Investment in Current Asset of company X for

the year 2000
Permanent or
Investment Fixed
Temporary
in Current Asset Investments or seasonal Invest
Month
(R's )
(R's)
(R's)
January
50400
45000
5400
February
50000
45000
5000
March
48700
45000
3700
April
48000
45000
3000
May
46000
45000
1000
June
45000
45000
July
47500
45000
2500
August
48000
45000
3000
September
49500
45000
4500
October
50700
45000
5700
November
52000
45000
7000
December
48500
45000
3500
TOTAL
44300

Conservative Approach
This approach suggested that the entire
estimated investments in current asset
should be finance from long term source
and short term should be use only for
emergency requirement
Distinct features of this approach
Liquidity is greater
Risk is minimized
The cost of financing is relatively more as
interest has to be paid even on seasonal
requirement for the entire period

Conservative approach to asset

financing
Total Assets
Short-term
Debt
Fluctuating Current Assets

Permanent Current Assets

Fixed Assets

Time

Long-term
Debt +
Equity
capital

Trade off between

Hedging and
approaches
conservative
The hedging approaches
implies low cost ,

high profit and high risk while the

conservative approach leads to high cost ,
low profit , low risk Both the approaches
are the two extreme and neither of them
serve the purpose of efficient working
capital management
A trade off between the two will then be an
acceptable approach , One way of
determining the trade off is by finding the
AVG of maximum and minimum
requirement of current asset or working
capital

Aggressive approach to asset

financing
Total Assets
Short-term
Debt
Fluctuating Current Assets

Permanent Current Assets

Fixed Assets

Time

Long-term
Debt +
Equity
capital

Aggressive approach

The aggressive approach suggests that

the entire estimated requirement of
current asset should be financed from
short-term sources and even a part of
fixed asset investment be financed from
short - term sources

This approach make the finance mix :

More Risky
Less costly
More Profitable

Prepare a projected balance

sheet , profit and loss a/c and
then an estimation of working
capital .
Issued Share Capital
300000
6% Debentures
200000
Fixed asset
200000
Raw Material
50%
Lab our
20%
Overheads
20%
Profit
10%
There is a regular production and
sales cycle

Raw Material are kept in stores for an

average period of two month
Finished goods remain in stock for an
average period of three month
Production during the previous year was
180000 units and it is planned to maintain
the same in the current year also
Each unit of production is expected to be in
process for half a month
Credit allow to customer is three month and
given by supplier is two month
Selling price is Rs 4 per unit
Calculation of debtors may be made at
selling price

Management of Working
Capital

Working capital in general practice refer to

the excess of CA over CL.
Management of working capital therefore is
concerned with the problems that arise in
attempting to manage the CA, the CL and
the inter-relationship that exists between
them.
The basic goal of WCM is to manage the CA
& CL of a firm in such a way that a
satisfactory level of WC is maintained.
Working Capital Management Policies of a
firm have a great effect on its profitability,
liquidity and structural health of the
organization

Working capital management is 3

dimensional in Nature
DimensionII
Dimension
Profitability,
Profitability,
Risk,&
&Liquidity
Liquidity
Risk,
I
I
I
I
n
on
ell
i
v
s
o
e
e
i
v
n
ens &LLe
e
m
i
DDim sittiioonn&
osi CAA
p
o
p
m
fC
om
o
f
o
C
o
C

DDiim
men
C
Coom
mpo enssiion
possiti on IIII
itioonn
II
&
ooffCCL& LLeevvel
el
L

Working Capital Issues

Optimal Amount (Level) of Current Assets

Policy A

ASSET LEVEL

Assumptions
50,000 maximum
units of production
Continuous
production
Three different
policies for
current asset
levels are possible

Policy B
Policy C
Current Assets

25,000
OUTPUT (units)

50,0

Impact on Liquidity
Optimal Amount (Level) of Current Assets

Greater current asset

levels generate more
liquidity; all other
factors held constant.

Policy A

ASSET LEVEL

Liquidity Analysis
Policy
Liquidity
A High
B Average
C Low

Policy B
Policy C
Current Assets

25,000
OUTPUT (units)

50,0

Impact on
Expected
Profitability
Optimal Amount (Level) of Current Assets
Return on Investment =

Let Current Assets =

(Cash + Rec. + Inv.)
Return on Investment =

Policy A

ASSET LEVEL

Net Profit
Total Assets

Policy B
Policy C
Current Assets

Net Profit
Current + Fixed Assets
0

25,000
OUTPUT (units)

50,0

Impact on
Expected
Profitability
Optimal Amount (Level) of Current Assets

As current asset levels

decline, total assets will
decline and the ROI will
rise.

Policy A

ASSET LEVEL

Profitability Analysis
Policy
Profitability
A Low
B Average
C High

Policy B
Policy C
Current Assets

25,000
OUTPUT (units)

50,0

Impact on Risk
Optimal Amount (Level) of Current Assets

Decreasing cash
reduces the firms
ability to meet its
financial obligations.
More risk!
Stricter credit policies
reduce receivables and
possibly lose sales and
customers. More risk!
Lower inventory levels
increase stockouts and
lost sales. More risk!

Policy A

ASSET LEVEL

Policy B
Policy C
Current Assets

25,000
OUTPUT (units)

50,0

Impact on Risk
Optimal Amount (Level) of Current Assets

Risk increases as the

level of current assets
are reduced.

Policy A

ASSET LEVEL

Risk Analysis
Policy
Risk
A
Low
B
Average
C
High

Policy B
Policy C
Current Assets

25,000
OUTPUT (units)

50,0

Summary of the
Optimal Amount of
Current Assets
SUMMARY OF OPTIMAL CURRENT ASSET ANALYSIS
Policy
Liquidity Profitability
A
High
Low
Low
B Average
Average
Average
C
Low
High
High

Risk

1. Profitability varies inversely with

liquidity.
2. Profitability moves together with risk.
(risk and return go hand in hand!)

Techniques of analysis of
working capital

The analysis of working capital can be

conducted through a number of devices
such as
Ratio analysis
Fund flow analysis
Working capital Budgeting
Ratio analysis : A ratio is a simple
arithmetical expression of the relationship
of one number to another , this technique
can be employed for measuring short term
liquidity or working capital position of a
firm.

The following ratios may be

calculated for this purpose
Liquidity Ratio
a) Current Ratio
b) Acid test ratio/quick ratio/liquid ratio
c) Cash Position ratio/absolute liquid ratio
Inventory turnover ratio
Receivable turnover ratio
Payable turnover ratio
Working capital turnover ratio

 Current

ratio may be define as

the relationship between CA
and CL
This ratio is also known as
WCR. (Working capital ration).
It is helpful to measure short
term financial position or
liquidity of a firm
Current ratio: Current asset
Current liabilities

CURRENT ASSETS

CURRENT LIABILITIES

Cash in hand
Bills Payable
Cash at bank

Sundry Creditors

Sundry Debtors

Accrued or Outstanding
Expenses

Marketable securities
(Short term)

Short term loan and

advances

Bills Receivable

Dividend payable

Inventories of Stock

Bank Overdraft

Work in progress

Finished goods

Prepaid Expenses

Quick or Acid test or

Liquid Ratio
An asset is said to be liquid if it can
be convert into cash with in a short
period with out loss of value
Inventory cannot be termed to be
liquid asset because they cannot be
convert into cash immediately
The quick ratio can be calculated
Quick ratio: liquid asset
Current liabilities

Quick or liquid

Current Liabilities

Cash in hand

Bills Payable

Cash at bank

Sundry Creditors

Sundry Debtors

Accrued or Outstanding
Expenses

Marketable securities
Temporary
Investments

Short term advances

Dividend payable
Bank Overdraft
Income tax payable

Convection quick ratio of 1:1 is consider

satisfactory

Cash Position ratio/absolute liquid

ratio
Absolute Liquid assets include cash in
hand and cash at bank and marketable
securities or temporary investments
The acceptable norms for this ratio is
50% or .05%
Cash ratio: Cash & bank + Short term
securities
Current liabilities

Calculate all the three

ratio
Liabilities
Rs
Assets
Rs
9%
preference
share
Equity share
capital
8%
debentures
Long term
loan

Bills payable
Sundry
creditors
Bank over
draft
Outstanding
expenses

500000 Goodwill
Land and
1000000 building
200000 Plant
Furniture
100000 and fixtures
Bills
60000 receivable
Sundry
70000 debtors
Bank
30000 balance
short term
5000 investments

100000
650000
800000
150000
70000
90000
45000
25000

CONCLUSION:
Current

ratio of the company is not

satisfactory because the ratio 1:6 is
much below then the expected
Standards .
Acid test ratio on the other hand is
more than the normal standard of 1:1
Absolute ratio is slightly low because
it is 0.42 where as the accepted
standard is 0.5
In this company need to improve its
short term financial position

Inventory turnover ratio

Inventory turn over ratio =
Cost of good sold
Average Inventory at cost
Generally , the cost of good sold may not be known
from the published financials , in such
circumstances
Inventory turn over ratio =
Net Sales
Average Inventory at cost
Inventory turn over ratio =
Cost of good sold
Average Inventory at selling price

Inventory conversion
period
Inventory conversion period = Days in a
year
Inventory Turnover Ratio
M/s Rakesh & Co supplies you the
following information for the year ending
31st Dec 1999
Credit Sales
Rs 150000
Cash Sales Rs 250000
Return Inward Rs 25000
Opening Stock Rs 25000
Closing Stock
Rs 35000

Debtor/Receivable turnover ratio

/Debtor velocity

Debtor(Receivable) = Net credit Annual sales

Average Trade debtors
Trade debtors = Sundry debtor + Bill Receivable and
account receivable s
Average Trade Debtors = Opening Trade debtor +
Closing Trade Debtor /2
Note : Debtor should always be taken at gross value
, No provision for doubtful debt be deducted from
them but when the information about opening and
closing balance of trade debtor and credit sales is
not available , then the debtors turnover ratio
calculated by dividing the total sales by the balance
of debtors(inclusive of Bills receivables) given
Debtors turn over Ratio = Total sales
Debtors

Average Collection
Period
The average collection period
represent the average number of days
for which a firm has to wait before its
receivable are converted into cash
Average Collection period =
Average Trade Debtors (Drs + B/R)
Sales per day
Sales Per day = Net Sales
No of working days

Or
Average collection period =Average
trade debtors Net Sales
No of working days
If the period is in months:
Average collection period =No of
working days Debtors turnover ratio
The two basis component of the ratio are
debtors and sales per day

Creditor/Payable
turnover ratio

The analysis for credit turnover is basically the

same as of debtors turnover ratio except that
in place of trade debtor, the trade creditor are
taken and in place of sales , average daily
purchase are taken as the other component of
the ratio.
Creditors turnover ratio
= Net credit annual purchase
Average Trade creditors

Average Payment period Ratio

= Average Trade Creditors( Creditors+
Bills payable)/Average Daily purchases.
Average daily purchase = Annual
Purchase /No of working days in a year.
Average Payment Period = Trade
creditor * No of working days / Net
annual purchase.
Average Payment Period = No of
working days / Credit turnover Ratio.

Working capital turnover

ratio
Working capital of a concern is directly

related to sales and current asset like

debtors , bills receivable , cash , stock etc .
Working capital turnover ratio = Cost of
Sales / Average working capital
Average working capital = Opening working
capital + Closing Working capital/2
** If cost of sales is not given , then the
figure of sale can be used . O n the other
hand if opening working capital is not
disclosed then working capital at the end of
the year will be used.
Cost of sale /Net working capital

The following information is given

about M/s S.P Ltd for the year ending
Dec 31 2000
Stock turnover ratio = 6times
Gross Profit ratio = 20% on sales
Sales for 2000 = Rs 300000
Closing stock is Rs 10000 more than
the opening stock
Opening Creditors = Rs 20000
Closing Creditors = Rs 30000
Trade debtor at the end = Rs 60000
Net Working Capital = Rs 50000

 FIND

OUT
Average Stock
Purchases
Credit turnover ratio
Average Payment Period
Average Collection Period
Working Capital turnover ratio

Fund flow analysis : Fund flow analysis

is a technical device designated to study
the sources from which additional fund
were derived and the use to which these
sources were put . It is an effective
management tool to study change in the
financial position of business

The fund flow analysis consists

of
Preparing schedule of change in working
capital
Statement of sources and application of
funds

 Working

capital Budgeting :
Working capital budget as a part
of total budgeting process of a
business , is prepared estimating
future long term and short term
working capital need and the
sources of finance them .
The objective of a working capital
budget is to ensure availability of
fund as and when needed and to
ensure effective utilization of these
resources .