CHAPTER ONE

WORKING CAPITAL MANAGEMENT

Working capital management is concerned with the problems that arise in attempting to manage the
current assets, the current liabilities and the interrelationship that exists between them. The term
Current Assets refer to those assets which in the ordinary course of business can be, or will be,
converted into cash within one year without undergoing a reduction in value and without disrupting
the operations of the firm. Current Liabilities are those liabilities which are intended, at their
inception, to be paid in the ordinary course of business, within a year, out of the current assets or
earnings of the concern.

Current Assets Current Liabilities

Cash and Bank Balances Short term Borrowings
Marketable Securities Accounts Payables
Accounts Receivables Notes Payables
Notes Receivables Trade Advances
Inventories: RMs, WIP, FGs

In the management of working capital two characteristics of current assets must be borne in mind: (i)
Short life span, and (ii) swift transformation into other asset form.
Current assets have a short life span. Cash balance may be held idle for a week or two, account
receivables may have a life span of 30 to 60 days, and inventories may be held for 30 to 100 days. The
life span of current assets depends upon the time required in the activities of procurement,
production, sales and collection and degree of coincide (synchronization) among them.

Each current asset is swiftly transformed into another asset forms: cash is used for acquiring raw
material; raw materials are transformed into finished goods ( this transformation may involve several
stages of work-in-progress); finished goods, generally sold on credit, are converted into accounts
receivables; and finally accounts receivables, on realization generate cash. The following figure 1.1
shows the cycle of transformation.

The goal of the working capital management is to manage the firm’s current assets and liabilities in
such a way that a satisfactory level of working capital is maintained. This is so because if the firm
cannot maintain a satisfactory level of working capital it is likely to become insolvent and may even
be forced into bankruptcy. The current assets should be large enough to cover its current liabilities in
order to ensure a reasonably margin of safety. Each of the current assets must be managed efficiently
in order to maintain the liquidity of the firm while not keeping too high level of any one of them.
Each of the short term sources of financing must be continuously managed to ensure that they are
obtained and used in the best possible way. The interaction between current assets and current
liabilities is, therefore, the main theme of the theory of working capital management.
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5.1 Concepts and Definitions of Working Capital
There are two concepts of working capital: “Gross” and “Net”.
The term Gross Working Capital also referred to as working capital means a firm’s investment in
assets that are expected to be converted to cash within one year (i.e. current assets).
Gross Working Capital = Total of Current Assets
When a firm is originally established there is a need for two types of investment, fixed asset
investments (land, building, machinery, vehicles, office equipment etc.) and working capital
investment. The working capital investment is meant for payments for raw material purchases,
payment for labor and to meet other expenditures in an attempt to produce goods (services) for sale.

The term Net Working Capital (NWC) can be defined in two ways (i) the most common definition of
NWC is the difference between current assets and current liabilities; and (ii) alternative definition of
NWC is that portion of current assets which is financed with long-term funds.

NWC = Current Assets – Current Liabilities

NWC is commonly defined as the difference b/n CA s and CLs. Efficient working capital requires that
firms should operate with some amount of NWC, the exact amount varying from firm to firm and
depending, among other things, on the nature of industry. The theoretical justification for the use of
NWC to measure liquidity is based on the basis that the greater the margin by which the current
assets cover the short term obligations, the more is the ability to pay obligations when they become
due for payment. The NWC is necessary because the cash outflows and inflows do not coincide. In
other words, it is the non-synchronous nature of cash flows that makes NWC necessary. The cash
inflows are, however, difficult to predict, therefore, NWC is necessary. The more predictable the cash
inflows are, the less NWC will be required and vise-versa.

NWC can alternatively be defined as that part of the current assets which are financed with long-term funds.
Since current liabilities represent sources of short term funds, as long as current assets exceed the
current liabilities, the excess must be finance with long-term funds.

5.2 Need for Working Capital and Operating Cycle

The need for working capital or current assets cannot be overemphasized. Given the objective of
financial decision making which is to maximize the shareholders’ wealth, it is necessary to generate
sufficient profits. The extent to which profits can be earned will naturally depend, among other
things, upon the magnitude (size) of the sales. A successful sales program is, in other words,
necessary for earning profits by any business enterprise. However, sales do not convert into cash
instantly; there is invariably a time-lag b/n the sales of goods and the receipt of cash. There is,
therefore, a need for working capital in the form of CAs to deal with the problem arising out of the
lack of immediate realization of cash against good sold. Therefore, sufficient working capital is
necessary to sustain sales activity. Technically, this is referred to as the “Operating Cycle”.

The Operating Cycle can be said to be at the heart of the need for working capital. The continuing
flow from cash to suppliers, to inventory, to accounts receivable and back into cash is what is called
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the Operating Cycle.
Figure 1- Operating Cycle

Phase - 3
RECEIVABLES

CASH
Phase - 2

INVENTORY
Phase - 1

The Operating cycle consists of three phases. In the phase – 1, cash gets converted into inventory.
This includes purchase of raw materials, conversion of raw material into WIP, finished goods and
finally the transfer of goods to stock at the end of the manufacturing process. In the case of trading
organizations, this phase is shorter as there would be no manufacturing activity and cash is directly
converted into inventory. The phase is, of course, totally absent in the case of service organizations.

In phase – 2 of the cycle the inventory is converted into receivables as credit sales are made to
customers. Firms which do not sell on credit obviously not have phase – 2 of the operating cycle.

The last, phase, phase – 3, represents the stage of when receivables are collected. This is phase
completes the operating cycle. This, the firm has moved from the cash to inventory, to receivables
and to cash again.

5.3 Characteristics of Working Capital

A) Circulating Capital
Working capital, once invested, is constantly circulating from one component to other component of
working capital. Cash is used to buy RMs, pay labor and overhead costs. Then the result of
production becomes outputs and hence changed to finished goods inventories. The finished goods
will be sold either for cash or on account. The A/R is then changed back to cash. This circulation goes
on until the life of a project (see figure). Note that the working capital changes with the stage of life
cycle of product or condition of operation. Stable operation necessitates constant working capital.

The cycle is shown in the following figure.

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Figure 2: Working Capital as a Circulating Capital

WIP

Finished goods (or service)

Input (Raw Material)

Cash sales

Sales on account

Cash A/R

b) Liquidity

Each component of working capital has different degrees of liquidity. Cash is the most liquid asset.
Next is the marketable security (it is sometimes called near cash asset). A/R is more liquid than
inventories in the sense that inventories may first be converted to receivables before it is converted to
cash.

c) Risk

Each component of working capital has its own risk. For example, accounts receivable may be
uncollectible or becomes bad debt. The raw materials may be damaged, finished goods may be
unsalable.

d) Profitability

Generally, excess working capital may reduce profit as the money is tied up in current assets,
entailing high cost (interest or opportunity cost).

Policy A Policy B
Current Assets 2000 1200
Fixed Assets 5000 5000
Total Assets 7000 6200

Current Liabilities 1000 1000

EBIT 2000 2000

Indicators:
Risk (Current ratio) 2.00 1.20
Profitability (EBIT/TA) 0.29 0.32

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Policy A with high volume of current asset is less profitable and less risky, while
policy B with low investment in current asset is more profitable but also more risky since the current
assets to current liability ratio is too low leaving the firm with little safety margin.

5.4 Determinants of Working Capital

A firm should plan its operations in such a way that it should have neither too much nor too little
working capital. The total working capital requirement is determined by a wide variety of factors.
These factors, however, affect different enterprise differently.

a) Nature of Business
The working capital requirement of a firm is closely related to the nature of its business. A
service firm, like electricity undertaking or a transport corporation, which has a short
operating cycle and which sells predominantly on cash basis, has modest (low) working
capital requirement. On the other hand, a manufacturing concern likes a machine tools unit,
which has long operating cycle and which sells largely on credit, has a very substantial
working capital requirement.
b) Length of Operating Cycle
The longer the operating cycle the more the working capital requirement will be. Hence, more
working capital is needed:
 The more time the inventories (RMs or FGs) are stocked.
 The more the manufacturing cycle (i.e. the more the time it takes to convert the
raw materials to final output).
 The more time it takes to collect receivables (liberal credit policy).
c) Seasonality of Operations
Firms which have marked seasonality in their operations usually have highly fluctuating
working capital requirements. To illustrate, consider a firm manufacturing rain coats. The sale
of rain coats reaches a peak during the rainy season and drops sharply during the winter
period, and almost no sales in summer season. The working capital need of such a firm is
likely to increase considerably in rainy months and decrease significantly during winter
period. On the other hand, a firm manufacturing a product like lamps, which have fairly even
sales round the year, tends to have stable working capital needs.
d) Production Policy
A marked by pronounced seasonal fluctuation in its sales may pursue a production policy
which may reduce the sharp variations in working capital requirements. For example, a
manufacturer of rain coats may maintain a steady production throughout the year rather than
intensify the production activity during the peak business. Such a production policy may
dampen the fluctuations in working capital requirements.
e) Market Conditions
The degree of competition prevailing in the market place has an important bearing on working
capital needs. When competition is keen, a large inventory of finished goods is required to

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 promptly serve customers who may not inclined to wait because other manufacturer are ready
to meet their needs. Further, generous (liberal) credit terms may have to be offered to attract
customers in a highly competitive market. Thus, working capital needs tend to be high
because of greater investment in finished goods inventory and A/R.
f) Conditions of Supply
The inventory of raw material, spare parts, and stores depends on the conditions of supply. If
the supply is prompt and adequate, the firm can manage with small inventory. However, the
supply is unpredictable and scant then the firm, to ensure continuity of production, would
have to acquire stocks as and when they are available and carry larger inventory on an
average. A similar policy may have to follow when the raw material is available only
seasonally and production operations are carried out round the year.
g) Credit Policy
The credit policy related to sales and purchases also affect the working capital. The credit
policy influences the requirements of working capital in two ways:
(1) through credit terms granted by the firm to its customers; (2) credit terms available to the
firm from its suppliers. The credit terms granted to customers have a bearing on the
magnitude of working capital by determining the level of receivables. The credit sales results
in higher receivables; higher receivables mean more working capital. On the other hand, if
liberal credit terms are available from the supplier of goods, the need for working capital is
high. The working capital requirements of a business are thus, affected by the terms of
purchase and sale, and the role given to credit by a company in its dealing with suppliers and
customers.
h) Inflation
Inflation affects the value of cash and other elements of cash. More WC is required during high
inflation rate affecting price of inputs.

Consequences of Excess or Inadequate WC

 Excess WC
Unnecessary accumulation and deterioration of inventory items.
Underutilization of credit.
Inefficiency in collection of receivables.
Opportunity cost on cash on hand.
 Inadequate WC
Difficulty in smooth running of the operations.
Underutilization of facilities
Liquidity crisis and loss of reputation.
Leads to stagnation (no growth).

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Permanent and Temporary Working Capital

The operating cycle creates the need for the current assets (working capital). However, the need does
not come to an end after the cycle is completed. It continues to exist. To explain this continuing need
of current assets (working capital) a distinction should be drawn b/n “Permanent and Temporary
WC”.

To carry on business, a certain minimum level of working capital is necessary on a continuous and
uninterrupted basis. For all practical purposes, this requirement has to be met permanently as with
other fixed assets. This requirement is referred to as “Permanent or Fixed WC”.

Any amount over and above the permanent level of working capital is “temporary, fluctuating or
variable WC”. This is related to cyclical WC that does not have long term impact, changing with sales
and business cycles. The basic distinction b/n permanent and temporary WC is illustrated in the
figure 1.3.

Figure 1.3 – Permanent and Temporary WC

Y-axis

Amount of
WC Temporary WC

Permanent working capital

0 Time X - axis

Figure 1.3 shows that the permanent level is fairly constant, while temporary WC is fluctuating –
increasing and decreasing in accordance with seasonal demands. In the case of an expanding firm,
the permanent WC line may not be horizontal. This is because the demand for permanent current
assets might be increase (or decreasing) to support a rising level of activity. In that case the line
would be a rising one as shown in figure 1.4.

Y - axis Temporary

Amount of WC

WC

Permanent WC

0 Time X - axis

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5.5 Alternative Current Assets Investment Policy

An investment working capital policy decision is concerned with the level of investment in current
assets. Under a relaxed/flexible policy, the investment in current assets is high. This means that the
firm maintains huge balance of cash and marketable securities, carries large amount of inventories,
and grants generous terms of credit to customers which leads to high level of receivables.

Under a restricted/aggressive policy, the investment in current assets is high. This means that firm
keeps a small balance of cash marketable securities, manages with small amount of inventories, and
offers terms of credit which leads to a low level of receivables. A restricted currents asset investment
policy generally provides the highest expected return on investment (ROI). But, it entails the greatest
risk. The reverse is true under a relaxed policy.

Moderate policy is a policy that is b/n the relaxed and restricted policy. It falls in between the two
extremes in terms of expected risk and return.

CAs Relaxed

Moderate

Restricted

Sales

Fig. 1.5 Alternative current assets investment policies

Determining the optimal level of current assets involves a trade-off between costs that rise with
currents assets and costs that fall with current assets. The former are referred to as “carrying cost”
and later as “shortage costs”. Carrying costs are mainly in the form of the cost of financing a higher
level of current assets. Shortage costs are mainly in the form of disruption in production schedule,
loss of sales, and loss of customer goodwill.

5.6 Sources of Financing Working Capital

Working capital can be financed from different sources:

a) Spontaneous current liabilities: this source of working capital financing mainly emanated
from operational activities between a credit customer and a supplier. The customer finances
his purchases through a credit that he obtains from the supplier. Other spontaneous liabilities
include accrued wages, accrued taxes, etc.
b) Short – term financing sources: the sources include bank loans, private loans, and
commercial papers.

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c) Long – term loans: this usually involves bank loans on long term basis.
d) Equity Capital: this is usually the major source of initial WC investment. It is the money put in
the firm by the owner or investor.

In assessing the suitability of the above sources one needs to evaluate the risk and the costs
involved, in relation to the returns from each of the sources. Spontaneous liabilities usually do not
involve costs. The short and long term sources have explicit cost (interest) while equity capital has
implicit costs (opportunity costs).

5.7 Alternative CA Financing Policies/Strategies

There are three basic option of financing WC, i.e., options of matching-expected cash inflows from
assets with outflows from their respective sources of financing.

a) Perfect Hedge (Maturity matching) Policy

It is a strategy of financing temporary current assets from short term sources and permanent
current assets and fixed assets from long term sources of funds. This strategy is considered
sound because temporary obligations are paid from the sale of temporary current assets i.e.
the temporary obligations are used to finance the acquisition of current assets (a self-
liquidating principle).
For eg., a purchase policy of 2/10, n/30 may be matched with a sales policy of 2/10, n/30.

Birr Short- term Financing

Temporary CAs

Permanent CAs Long-term Financing

Fixed Assets

Time

Fig. 1.7 perfect hedge

b) Conservative Hedge Policy

This strategy finances all the fixed assets, all permanent current assets and significant portion
of temporary current assets with a long term sources. The short term source of finance is used
to finance just little of temporary CAS. This policy is conservative because it makes sure that
most of its current assets are acquired from a stable long term source. The advantage is that
such long term sources may be obtained when credit terms are favorable and at times of

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 credit restraint the firm will have already enough funds and will have less risk. Excess funds
at firms may be invested in marketable securities.

Birr Temporary CAS Short term financing

Permanent CAS Long term financing

Fixed Assets

Time

c) Aggressive Hedge Policy

In aggressive hedge policy, all fixed assets and portion of permanent assets are financed from
long term sources. All temporary current assets and a portion of permanent current assets are
financed from the short term sources. It is a dangerous strategy in the sense that it may create
a problem of liquidity crisis and sometimes it may lead to a bankruptcy.

Birr Short term financing

Temporary CAS

Permanent CAS Long term financing

Fixed Assets

Time

Which policy is better?

This depends on how individuals view risks in relation to return on equity. Basically, higher returns
involve higher risk or conversely, for taking higher risk, there should be compensating higher return.
In the same manner, lower risks are associated with lower returns. Relating this to the hedging
policy, one should realize that conservative hedge policy has less risk and less return on equity and
aggressive hedge policy has higher risk and higher return.

The following illustration shows that the risk of conservative policy as measured in current ratio is
less than that of aggressive policy. But, aggressive policy has higher return on equity.

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 The Effect of Conservative and Aggressive Financing

Assets Current Assets 1,000

Fixed Assets 1,000
Total Assets 2,000

Financing Options Conservative Aggressive

Short term loan (12%) 200 1000
Long term loan (15%) 900 100
Equity 900 900
Total 2,000 2,000

Summary of operation:
EBIT 1,000 1,000
less: Interest
Short term (24) (120)
Long term (135) (15)
EBT 841.00 865.00
less: Tax(50%) 420.50 432.50
Net Income 420.50 432.50

Financial Indicators:
Risk: current ratio 5 times 1 times
Return: ROE 46.7% 48.06%

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