Working capital

Working capital
• Refers to current assets
• Which can be convertible into cash or equivalents
within a period of 1 year
• Which are required to meet day to day operations.
 Concepts of working capital
• Balance sheet concept
– Net working capital
– Gross working capital
• Operating cycle concept
 Working
capital

Gross working Net working

capital capital
 Gross working capital
• Refers to total investment in all current assets taken
together.
• A firm has following balances:
– Cash = Rs. 50000
– Debtors = Rs. 70000
– Inventory of raw material and finished goods = Rs. 100000
• Then, gross working capital = Rs. 220,000
 Net working capital
• Excess of total current assets over total
current liabilities.
• Measures firm’s liquidity.
• Gives an idea of buffer available to the current
liabilities.
• Positive net working capital (if CA is more than
CL)
• Negative net working capital (if CL is more
than CA)
 News Analysis
• Exporters reel under cash crunch with pending
GST refund
• Liquor companies raise a toast as the sales
pick up
 Operating Cycle
• Working capital requirement depends upon
operating cycle of the firm.
• Defined as “time duration starting from
procurement of raw materials and ends with
sales realization”.
• Length of operating cycle depends upon size
and nature of firm.
 Operating cycle
Procurement of raw materials & services

Conversion of raw materials into work – in - progress

Conversion of work – in – progress into finished goods

Sale of finished goods (cash or credit)

Conversion of receivables into cash

Operating cycle period

Operating
cycle period

Inventory Receivables
conversion conversion
period(ICP) period (RCP)
Inventory conversion period

Raw material conversion

period (RMCP)

Work – in –progress
conversion period (WPCP)

Finished goods conversion

period (FGCP)
• Raw material conversion period (RMCP)
– Period for which raw material is kept in stores before it is
issued to production department.
• Work – in – progress conversion period (WPCP)
– Period for which raw material remains in production
process before it is taken out as finished unit.
• Finished goods conversion period (FGCP)
– Period for which finished goods is kept in stores before
being sold to customers.
 Receivables conversion period (RCP)
• Time required to convert credit sales into cash.
• Refers to period b/w occurrence of credit sales and
collection of debtors.
 TOCP

Inventory
conversion
Total operating period (ICP)
cycle period
(TOCP) Receivables
conversion
period(RCP)
 Deferral period (DP)
• Credit facilities from the supplier of raw materials.
• The period for which the payments to these parties is
delayed or deferred is known as DP.

• NOC = TOCP - DP
MCQ 1
• XYZ is an oil based business company, which does not have
adequate working capital. It fails to meet its current
obligation, which leads to bankruptcy. Identify the type of
decision involved to prevent risk of bankruptcy.

a) Investment decision
b) Dividend decision
c) Liquidity decision
d) Finance decision
MCQ 2
• Kanji Company had sales last year of Rs. 265 million, including
cash sales of Rs. 25 million. If its average collection period was
36 days, its ending accounts receivable balance is closest to.
(Assume a 365-day year.)

a) Rs. 26.1 million

b) Rs. 23.7 million
c) Rs. 7.4 million
d) Rs. 18.7 million
MCQ 3
• In deciding the appropriate level of current assets for the firm,
management is confronted with

a) a trade-off between profitability and risk.

b) a trade-off between liquidity and marketability.
c) a trade-off between equity and debt.
d) a trade-off between short-term versus long-term borrowing.
MCQ 4
• Increasing the credit period from 30 to 60 days, in response to
a similar action taken by all of our competitors, would likely
result in:

a) an increase in the average collection period.

b) a decrease in bad debt losses.
c) an increase in sales.
d) higher profits.
 Problem Solving - I
• From the following information taken from the books of
manufacturing concern, compute the operating cycle in days:
• Period covered = 365 days
• Average period of credit allowed by suppliers = 16 days
• Average debtors outstanding = Rs. 480
• Raw material consumption = Rs. 4400
• Total production cost = Rs. 10000
• Total cost of goods sold = Rs. 10500
• Sales for the year = Rs. 16000
• Value of average stock maintained :
– Raw materials = 320
– Work – in – progress = 350
– Finished goods = 260
 Problem Solving - II
• From the following data, calculate the length of operating
cycle for each of the two years and comment on
increase/decrease:
Particulars Year 2017 Year 2018
Stock of Raw materials 20,000 27,000
Stock of Work-in-progress 14,000 18,000
Stock of Finished goods 21,000 24,000
Purchases 96,000 135,000
Cost of goods sold 140,000 180,000
Sales 160,000 200,000
Debtors 32,000 50,000
Creditors 16,000 18,000
Cost of production 150,000 190,000
 Problem Solving - III
• Using the following data, calculate the current
working capital cycle for XYZ Ltd. And briefly
comment on it.
Particulars (Rs. in '000)
Sales 3000
Cost of Production 2100
Purchase 600
Average raw material stock 80
Average work-in-progress 85
Average finished goods stock 180
Average creditors 90
Average debtors 350
Cost of sales 2100
 Problem solving - I
• From the following details, you are required to make an
assessment of the working capital required by the company:

Items Average period of credit Estimate for the year

Purchases of raw material 6 weeks 26,00,000
Wages 1.5 weeks 19,50,000
Rent, rates 6 months 100,000
Salaries 1 month 800,000
Other overheads 2 months 750,000
Sales (cash) - 200,000
Sales (credit) 2 months 60,00,000
Average amount of WIP - 400,000
 Problem solving - II
• Following is the information given for a trading firm. You are
required to calculate the working capital requirement of the
firm.
• The firm adds 15% amount as contingencies.
Particulars Per Annum (in Rs.)
Average amount of finished goods 30000
Average amount of raw material 60000
Average credit given for inland sales = 4 weeks 260,000
Average credit given for export sales = 2 weeks 650,000
Lag in payment of wages = 1.5 weeks 260,000
Lag in payment of overheads = 4 weeks 390,000
 Problem solving - III
• Following is the information given for a trading firm. You are required to calculate
the working capital requirement of the firm.
• The firm adds 10% amount as contingencies.
Particulars Per Annum (in Rs.)
Average amount blocked up in finished goods 5000
Average amount blocked up in raw material 8000
Average credit given for inland sales = 6 weeks 312,000
Average credit given for export sales = 1.5 weeks 78,000
Lag in payment of wages = 1.5 weeks 260,000
Stock of materials = 1.5 weeks 48,000
Rent, royalties = 6 months 10,000
Clerical staff salaries = ½ month 62,400
Manager = ½ month 4800
Miscellaneous expenses = 1.5 months 48,000
Payment of sundry expenses in advance 8000
Types of working capital
MCQ 1
• Which of the following would not be financed from working
capital?

a) Cash float.
b) Accounts receivable.
c) Credit sales.
d) A new personal computer for the office.
MCQ 2
• Which asset-liability combination would most likely result in
the firm's having the greatest risk of technical insolvency?

a) Increasing current assets while lowering current liabilities.

b) Increasing current assets while incurring more current
liabilities.
c) Reducing current assets, increasing current liabilities, and
reducing long-term debt.
d) Replacing short-term debt with equity.
MCQ 3
• Financing a long-lived asset with short-term financing would
be:

a) an example of "moderate risk -- moderate (potential)

profitability" asset financing.
b) an example of "low risk -- low (potential) profitability" asset
financing.
c) an example of "high risk -- high (potential) profitability" asset
financing.
d) an example of the "hedging approach" to financing.
MCQ 4
• Which one of the following actions should a manager take if
he or she wants to decrease the operating cycle?

a) delay payments to suppliers to decrease the cash cycle.

b) increase the inventory level while maintaining constant sales.
c) decrease the rate at which the average inventory is sold.
d) decrease the period of time for which credit is granted to
customers.
 Approaches of financing working
capital/assets
• Matching approach
• Conservative approach
• Aggressive approach
• Highly aggressive approach
 1.)Matching Approach
• Matches the expected life of asset with the
expected life of source of funds.

• For example:-
• 10 year loan raised to finance a plant with
expected life of 10 years.
• Stock of goods to be sold in 30 days is financed
with 30 day bank loan.
 Why matching approach?
• The purpose of financing is to pay for assets,
the source of finance & asset should be
relinquished simultaneously.

• This approach is also known as ‘Hedging

Approach’.
• Use of long term financing for short term
asset is expensive as funds will not be utilized
for full period.
• Use of short term financing for long term
assets is costly and inconvenient as funds have
to be arranged on continuous basis.
 Fixed assets
Long term
financing
Permanent
current assets
 Temporary
current assets
Short term
financing
Variable
current assets
• Line A and Line B is upward slopped indicating
that they go on increasing with the passage of
time and as per hedging principle they are
financed through long-term sources like
equity and long-term debt.
• Fluctuating current assets, which are shown
by the curved Line C, should be financed
through short term sources.
 2.) Conservative Approach
• Firm depends upon more on long term funds
for financing.
• Since firm relies heavily on long term funds, it
has less risk of facing shortage of funds.
 Fixed assets +
Permanent
Long term current assets
financing
Temporary
current assets
• When the firm has no need for temporary
current assets then idle long term funds are
invested in tradable securities to conserve
liquidity.
• Line A denotes the fixed assets and Line B
denotes the permanent working capital, which
is financed through long-term sources.
• Certain portion of fluctuating current assets,
which is shown by dashed Line C, is also
financed by long-term sources.
• Under this policy some part of fluctuating
current assets is financed through short-term
sources.
 3.) Aggressive Approach
• When the firm uses more of short term
financing than long term sources to finance its
current assets.
• Larger the %age of funds obtained from short
term sources for financing current assets, the
more aggressive is the financing policy.
• According to this approach long-term sources are
used to finance the fixed assets, which are shown
by Line A;
• but a portion of permanent current assets, shown
by the dotted Line B, is also financed through
long-term sources.
• The remaining part of permanent current assets,
depicted by Line C, and the entire amount of
fluctuating current assets, shown by the curved
Line D, are financed by short-term debt.
 4.) Highly Aggressive Policy
• This is a highly risky policy for financing the
working capital.
• As per this policy, even some part of fixed
assets is financed through short-term sources.
• Excessive reliance on short-term sources
makes this policy highly risky.
• A major proportion of fixed assets as shown by
dotted Line A are financed through long-term
sources and
• the remaining part of the fixed assets are
financed by short-term sources—shown by Line
B.
• Short-term sources are also used for financing
permanent current assets—Line C;
• as well as fluctuating current assets as shown by
the curved Line D.
 Determinants of working capital
• Size Of Business
Working capital requirement of a firm is
directly influenced by the size of its business
operation.
• Big business organizations require more
working capital than the small business
organization.
• Therefore, the size of organization is one of
the major determinants of working capital.
• Nature Of Business
Working capital requirement depends upon the nature
of business carried by the firm.
• Normally, manufacturing industries and trading
organizations need more working capital than in the
service business organizations.
• A service sector does not require any amount of stock
of goods. In service enterprises, there are less credit
transactions.
• But in the manufacturing or trading firm, credit sales
and advance related transactions are in large amount.
So, they need more working capital.
• Storage Time Or Processing Period
Time needed for keeping the stock in store is
called storage period.
• The amount of working capital is influenced by
the storage period.
• If storage period is high, a firm should keep more
quantity of goods in store and hence requires
more working capital.
• Similarly, if the processing time is more, then
more stock of goods must be held in store as
work-in-progress.
• Credit Period
Credit period allowed to customers is also one
of the major factors which influence the
requirement of working capital.
• Longer credit period requires more
investment in debtors and hence more
working capital is needed.
• But, the firm which allows less credit period to
customers needs less working capital.
• Seasonal Requirement
In certain business, raw material is not available
throughout the year.
• Such business organizations have to buy raw
material in bulk during the season to ensure an
uninterrupted flow and process them during the
entire year.
• Thus, a huge amount is blocked in the form of
raw material inventories which gives rise to more
working capital requirements.
• Potential Growth Or Expansion Of Business
If the business is to be extended in future,
more working capital is required. More
amount of working capital is required to meet
the expansion need of business.
• Changes In Price Level
Change in price level also affects the working
capital requirements.
• Generally, the rise in price will require the firm
to maintain large amount of working capital as
more funds will be required to maintain the
sale level of current assets.
• Dividend Policy
The dividend policy of the firm is an important
determinant of working capital.
• The need for working capital can be met with
the retained earning.
• If a firm retains more profit and distributes
lower amount of dividend, it needs less
working capital.
• Access To Money Market
If a firm has good access to capital market, it
can raise loan from bank and financial
institutions.
• It results in minimization of need of working
capital.
• Working Capital Cycle
When the working capital cycle of a firm is
long, it will require larger amount of working
capital.
• But, if working capital cycle is short, it will
need less working capital.
• Operating Efficiency
The operating efficiency of a firm also affects
the firm's need of working capital.
• The operating efficiency of the firm results in
optimum utilization of assets.
• The optimum utilization of assets in turn
results in more fund release for working
capital.