WORKING CAPITAL

MANAGEMENT
 Cash Inflows & Outflows do not
coincide i.e. NWC Necessary
 Cash Outflows are relatively predictable

 Cash Inflows are however, difficult to

predict.
 More predictable cash inflows – Less

NWC required. E.g. KESC

 Trade off b/w Profitability &
Risk

 The risk of becoming technically insolvent is

measured using NWC
 NWC ↓ Risk ↑ Liquidity ↓
 NWC ↑ Risk ↓ Liquidity ↑
 Assumptions for evaluating
Profitability Risk Trade off
 We are dealing with a manufacturing firm
 Current Assets are less profitable than
fixed assets
 Short term funds are less expensive than
long term funds.
 Current Assets are less
profitable than fixed assets

 ↑se in CA to TA Ratio will lead to

↓se in Profitability as well as Risk
 ↓se in CA to TA Ratio will lead to

↑se in Profitability as well as Risk

Liabilities Amt in $ Assets Amt in $
Current Liab Current Assets
3,200 5,400
Long term Debt Fixed Assets 8,600
4,800
Equity Capital
6,000
Total 14,000 Total 14,000
If Co earns 2 % on CA & 12% on FA then CO will currently
earn (0.02*5,400+0.12*8,600) = $ 1,140 on its TA. NWC is 2,200
& CA to TA Ratio would be (5,400/14,000) is 0.386.
Co ↑se investment in CA by investing an additional $ 600
Co ↑se investments in FA by investing an additional $ 600
 S/T Funds are less expensive
than L/T funds
 Can be depicted through current liabilities
to total assets ratio
 ↑se in CL to TA Ratio will lead to ↑se in
Profitability as well as Risk
 ↓se in CL to TA Ratio will lead to ↓se in
Profitability as well as Risk
Liabilities Amt in $ Assets Amt in $
Current Liab Current Assets
3,200 5,400
Long term Debt Fixed Assets 8,600
4,800
Equity Capital
6,000
Total 14,000 Total 14,000
If CL cost 3 % while the average cost of long term funds is 8%.
the cost would be (0.03*3,200+0.08*10,800) = $ 960. NWC is 2,200
& CL to TA Ratio would be (3,200/14,000) is 0.0229.
Co shifts $ 600 from long term funds to CL i.e. long term funds
↓se
Co ↓se CL to $ 600 as compared to the initial level of $ 3,200
 Effect of Changes in CA on
profitability Risk trade off

Particulars Initial Value after Value after

Value ↑se in Ratio ↓se in Ratio
Ratio of CA to TA 0.386 0.429 0.343
Profits on total $ 1,140 $ 1,080 $ 1,200
assets
NWC $ 2,200 $ 1,600 $ 1,600
 Effect of Changes in CL on
profitability Risk trade off

Particulars Initial Value after Value after

Value ↑se in Ratio ↓se in Ratio
Ratio of CA to TA 0.229 0.271 0.186
Profits on total $ 960 $ 930 $ 990
assets
NWC $ 2,200 $ 1,600 $ 2,800
 Combined Effect of Changes in
CA & CL on profitability Risk
trade off
 ↓se in the CA to TA Ratio & ↑se in the CL to TA
Ratio will lead to an increased profitability
coupled with a corresponding increase in Risk and
the same time decrease NWC.

Particulars Change in Profit Change in NWC

↓se in CA to TA Ratio $ + 60 $ (600)
↑se in CL to TA Ratio + 30 (600)
Net Effect + 90 (1,200)
DETERMINING FINANCING MIX
 How Current Assets will be financed
 2 sources from which funds can be raised for
current asset financing
 Short term sources
 Long term sources such as share capital, long
term borrowings, internally generated resources
like retained earnings and so on
 What proportion of CA should be financed by CL
& how much by long term sources?
 Decisions on such Qs will determine financing
mix
DETERMINING FINANCING MIX

 Hedging Approach also called Matching

Approach
 Conservative Approach
 Trade off between the two
 HEDGING APPROACH
 Risk Reducing Investment Strategy
 Process of matching maturities of debt
with the maturities of financing needs
 The maturity of the source of funds should
match the nature of the assets to be
financed. For the purpose of analysis, the
CA can be broadly classified into 2 classes
 Required in a certain amount for a given level
of operation & do not vary over time
 Those which fluctuate over time
 HEDGING APPROACH
 Long term funds should be used to finance the
fixed portion of CA requirements in a manner
similar to the financing of fixed assets.
 The purely temporary requirements that is the
seasonal variations over & above the permanent
financing needs should be appropriately financed
with short term funds.
 This approach therefore divides the
requirements of total funds into permanent &
seasonal components each being financed by a
different source.
Month Total funds Permanent Seasonal
Required Requirements Requirements
Jan 8,500 6,900 1600
Feb 8,000 6,900 1100
Mar 7,500 6,900 600
Apr 7,000 6,900 100
May 6,900 6,900 0
Jun 7,150 6,900 250
Jul 8,000 6,900 1,100
Aug 8,350 6,900 1,450
Sep 8,500 6,900 1,600
Oct 9,000 6,900 2,100
Nov 8,000 6,900 1,100
Dec 7,500 6,900 600
11,600
CONSERVATIVE APPROACH
 Is a strategy by which the firm finances
all funds requirement, with long term
funds & uses short term funds for
emergencies or unexpected outflows.
 COMPARISON OF HEDGING &
CONSERVATIVE APPROACH
 The comparison of the two approaches can
be made on the basis of
 Cost Considerations
 The cost of s/term & long term funds is 3% &
8 % respectively.
Risk Considerations
 The two approaches can also be contrasted on
the basis of the risk involved.
 COST CONSIDERATIONS
HEDGING APPROACH
 Cost of S/term fund
 Cost of S/term funds = avg annual short
term loan * interest rate
 Avg Annual S/T Loan = total of monthly
seasonal requirements divided by no of
months
 Avg Annual S/T Loan = 11,600/12 = $ 966.67
 Short term cost = 966.67 * 0.03 = $ 29
 COST CONSIDERATIONS
HEDGING APPROACH
 Cost of L/term funds = Avg annual long
term fund requirement * annual interest
rate
 = 6,900 * 0.08 = $ 552
 Total Cost Under Hedging Plan
 = 29 + 552 = $ 581
 COST CONSIDERATIONS
CONSERVATIVE APPROACH
 Cost of financing under the conservative
plan = cost of long term funds
 Annual Avg loan * long term rate of
interest 9000 * 0.08 = $ 720
 COST CONSIDERATIONS
CONCLUSION
 The cost of financing under the conservative
plan ( $ 720) is higher than the cost using
the Hedging approach ($ 581)
 The conservative plan for financing is more
expensive coz
 Available funds are not fully utilized during
certain periods
 Interest has to be paid for funds which are not
actually needed
 RISK CONSIDERATIONS
No NWC with the Fairly high level of NWC
hedging approach coz as company donot use
no long term funds are any of its short term
used to finance short borrowings.
term seasonal needs,
that is CA are just equal
to CL.
Risky - almost full Sufficient s/term
utilization of NWC so borrowing capacity to
difficult to satisfy short cover unexpected
term needs in financial needs & avoid
emergency technical insolvency
 Trade off b/w Hedging &
Conservative Approach
 Trade off between hedging & conservative
approach would give an acceptable financing
strategy.
 Strikes a balance & provides a financing
plan that lies between these two extremes.
 The exact trade off will differ from case to
case depending about risk perception of the
decision makers.
 Trade off b/w Hedging &
Conservative Approach
 One possible trade off could be assumed
to be equal to the avg of the min & max
monthly requirements of funds during a
given period of time.
 This level of requirement of funds may be
financed through long term sources & for
any additional financing needs, short term
fund may be used.
Month Total funds Permanent Seasonal
Required Requirements Requirements
Jan 8,500 7,950 550
Feb 8,000 7,950 50
Mar 7,500 7,950 0
Apr 7,000 7,950 0
May 6,900 7,950 0
Jun 7,150 7,950 0
Jul 8,000 7,950 50
Aug 8,350 7,950 400
Sep 8,500 7,950 550
Oct 9,000 7,950 1,050
Nov 8,000 7,950 50
Dec 7,500 7,950 0
2,700
 Trade off b/w Hedging &
Conservative Approach
 The maximum fund requirement is $ 9,000
(October) and the minimum is $ 6,900 (May).
 The average (9,000 + 6,900)/2 = $ 7,950
 The company should use $ 7,950 each month in
the form of long term funds & the raise additional
funds, if needed, through short-term resources
(CL).
 No short term funds are required during 5 months
 In remaining 7 months co will have to use short
term funds totaling $ 2,700
 COST OF FINANCING PLAN
UNDER TRADE OFF APPROACH
 Cost of short term funds = (Avg S/T funds
required) * (Rate of S/T interest)
 = 2,700/12 = 225 * 0.03 = $ 6.75
 Cost of long term funds = (Avg L/T funds
required) * (Rate of L/T funds)
 = 7,950 * 0.08 = $ 636
 Total Cost of the trade off plan = 6.75 + 636
= $ 642.75
 RISK CONSIDERATION
 The NWC under this plan would be $
1,050 ($ 7,950 – 6,900)
 COMPARISON OF THE 3
APPROACHES

Financing Plan Max NWC Degree of Risk Total Cost of Level of
Financing Profits

Hedging 0 Highest $ 581 Highest

Trade off $ 1,050 Intermediate $ 642.75 Intermediate

Conservative $ 2,100 Lowest $ 720 Lowest

 INTERPRET ATION
 The lower the NWC, the higher is the risk
present
 The higher the risk of insolvency, the
higher is the expected profits.