WORKING CAPITAL MANAGEMENT

Dr. Sudhendu Giri

Types of Capital
Two types of Capital are needed in the busienss enterprise

Fixed Capital Working Capital

Dr. Sudhendu Giri

Fixed Capital
Business operations demand few Assets to be used in the business for a longer period of which are known as Fixed Assets. And Capital invested in the acquisition of such Assets is known as FIXED CAPITAL

Dr. Sudhendu Giri

WORKING CAPITAL
Capital is also needed for short-term purposes, i.e. meeting day to day operations. Capital invested for this purpose is known as - Current Capital OR Working Capital

Dr. Sudhendu Giri

 Thus, Working Capital refers to concerns investment in short term assets like Cash, Short term Securities, Debtors (Customers to whom goods have been sold on credit), And, Inventories of all types.

It can also be regarded as that portion of companys total capital which is employed in short term operations. In other words, Working Capital is the investment needed for carrying out day-to-day operations of the business smoothly.
Dr. Sudhendu Giri

TWO CONCEPTS OF WORKING CAPITAL

CURRENTLY TWO SCHOOLS OF THOUGHT ARE ACCEPTABLE NAMELY Gross Working Capital Concept- Quantitative Aspect, Net Working Capital Concept- Qualitative Aspect.

Dr. Sudhendu Giri

Gross Working Capital concept

According to this concept Companys investment in total current assets signifies the Working Capital. Amount of Current Liabilities is not considered and hence not deducted from total Current Assets. This concept considers aggregate Current Assets and Working Capital as both interchangeable terms. Gross Working Capital is also known as Circulating Capital or Current Capital.
Dr. Sudhendu Giri

Valid reasons for Gross Working Capital

1. When we consider fixed capital as the amount invested in fixed assets, then amount invested in current assets should be considered as Working Capital. 2. Current Assets, Whatever may be the sources of acquisition, are used in activities relating to day-to-day operations and their forms keep on changing. Therefore, they should be considered as Working Capital. 3. Total Current Assets represent the total funds available for operating purpose, naturally, management is more concerned with total Current Assets rather with the sources of the funds i.e. Current Liabilities.
Dr. Sudhendu Giri

Net Working Capital concept

According to this concept Current Assets minus Current Liabilities is known as Working Capital.

W.C. = C.A.- C.L. Positive W.C.= C.A.> C.L. (company position is sound) AND Negative W.C. = C.A.< C.L. (it indicates financial crisis)
Thus, the concept lays emphasis on qualitative aspect which indicates the liquidity position of the concern.
Dr. Sudhendu Giri

Valid Reasons for net Working Capital 1. The material thing in the long run is the surplus of current assets over current liabilities. 2. Financial health/soundness can easily be judged with this concept. 3. Excess of current assets over current liabilities represents the amount which is not liable to be returned and which can be relied upon to meet any contingency.

Dr. Sudhendu Giri

Components of Working Capital

Working Capital as per Net Concept has two components1. Current Assets and, 2. Current Liabilities.

Dr. Sudhendu Giri

Current Assets
Assets which can easily be converted into cash in the normal course of the business are known as current assets. These assets may include:1. Cash in hand or at Bank, 2. Debtors and Bills Receivable, 3. Stock or inventory of raw materials, stores, and spares,
-- Works in Progress, -- Finished Goods.

4. Advance payments towards expenses, purchases and other short term advances. 5. Temporary investment of surplus funds. 6. Accrued incomes. One common characteristics of all the above items of current assets is that each component is swiftly transformed into other assets forms. Dr. Sudhendu Giri

Current Liabilities
A part of the need for the funds to finance the current assets may be met from supply of goods on credit and deferment, on account of custom, usage of arrangement of payment of expenses. The remaining part of the need for Working Capital may be met from short term borrowings from financial institutions and bankers. These are collectively called CURRENT LIABILITIES. These are the liabilities which are to be met in the normal course of the business within an accounting period out of Current Assets or profit from operation.
Dr. Sudhendu Giri

Current Liabilities Includes Typical items of Current Liabilities are

1. Trade creditors i.e. goods purchased on credit and Bills Payable. 2. Outstanding and Accrued expenses. 3. Short term borrowings. 4. Taxes and Dividend payable. 5. Advances received from parties against goods to be sold to them or as short term deposits. 6. Bank overdraft. 7. Outstanding liabilities currently payable.

Dr. Sudhendu Giri

Kinds of WORKING CAPITAL

1. CORE, PERMANENT OR FIXED WORKING CAPITAL. 2. FLUCTUATING OR VARIABLE WORKING CAPITAL.

Dr. Sudhendu Giri

Fixed or Permanent Working Capital

This is irreducible minimum amount necessary for maintaining the circulation of the current assets. This is permanently locked up in the business and therefore, it is referred to fixed or Permanent Working Capital. This is minimum level of current assets which must be kept in order to carry on the business. It is the investment in current assets which is permanently locked up in the business. Fixed working capital constantly changes its form from one assets to another. It always remains in the business in one form or other. Dr. Sudhendu Giri

Variable Working Capital

Variable working capital refers to that portion of total working capital which is needed over and above fixed working capital. Such need for Variable Working Capital arise on account of:- Seasonal changes, - Abnormal and Unanticipated conditions, - To face tough conditions in the market, - To meet contingencies like strikes and lockouts, - Special Advertising Campaigns or other Promotional activities, Are financed by variable working capital
Dr. Sudhendu Giri

Firm A Steady Annual Sales

100 90 80 100 70 60 50 40 30 20 20 10 40 Variable W.C. Permanent W.C. 60 80 140

Firm B Growth Situation

120

Variable W.C. Permanent W.C.

Sept

July

Nov

Dec

Jan

May

Aug

Feb

Apr

June

Sept

July

Nov

Dec

May

Aug

Feb

Apr

Jan

June

Mar

Oct

Dr. Sudhendu Giri

Mar

Oct

Current Assets to Fixed Assets Ratio

The financial manager should determine the optimum level of current assets so that the wealth of shareholders is maximized. A firm needs fixed and current assets to support a particular level of output. However, to support the same level of output, the firm can have different levels of current assets. As the firm's output and sales increase, the need for current assets increases.
Dr. Sudhendu Giri

Current Assets to Fixed Assets Ratio

A higher CA/FA ratio indicates a conservative current assets policy. It implies greater liquidity and lower risk; A lower CA/FA ratio means an aggressive current assets policy, it indicates higher risk and poor liquidity. Moderate Coverage current assets policy falls in the middle of conservative and aggressive policies. The current assets policy of the most firms may fall between these two extreme policies.
Dr. Sudhendu Giri

Operating Cycle
Operating cycle is the time duration required to convert sales, after the conversion of resources into inventories, into cash. The operating cycle of a manufacturing company involves three phases:
Acquisition of resources such as raw material, labour, power and fuel etc. Manufacture of the product which includes conversion of raw material into work-in-progress into finished goods. Sale of the product either for cash or on credit. Credit sales create account receivable for collection.

Dr. Sudhendu Giri

Working Capital Cycle

The operating cycle begins with the arrival of the stock and ends when the cash is received. The cash cycle begins when the cash is paid for materials, and ends when cash is collected from receivable.
Raw Materials Purchased -------------------- Order Placed Stocks arrives Finished goods sold Cash Received work-in-process inventory period Accounts receivable Period ----------------------------------------------r----------------------------------------------- Time -------------------------------- Accounts Payable period Invoice received Cash paid for materails -------------------------------------------------------------------------------------------------Operating Cycle ----------------------------------------------------------Cash Cycle
Dr. Sudhendu Giri

Operating Cycle
The length of the operating cycle of a manufacturing firm is the sum of: inventory conversion period (ICP). Debtors (receivable) conversion period (DCP). Creditors or payables deferral period (CDP)
Dr. Sudhendu Giri

Inventory conversion period (ICP)

Inventory conversion period is the total time needed for producing and selling the product. Typically, it includes:
raw material conversion period (RMCP) Average Raw Materials =------------------x 365 Raw material consumed work-in-process conversion period (WIPCP) Average work in process =------------------x 365 Total cost of production finished goods conversion period (FGCP) Average stock (FG) =------------------x 365 Dr. Sudhendu Giri Total cost of goods sold

Debtors (receivable) conversion period (DCP)

The debtors conversion period is the time required to collect the outstanding amount from the customers. Average debtors =------------------- x 365 Total credit sales

Dr. Sudhendu Giri

Creditors or payables deferral period (CDP)

Creditors or payables deferral period (CDP) is the length of time the firm is able to defer payments on various resource purchases. Average Creditors =------------------- x 365 Total credit Purchases

Dr. Sudhendu Giri

Gross operating cycle (GOC)

Gross operating cycle (GOC)
The total of inventory conversion period and debtors conversion period is referred to as gross operating cycle (GOC).
Gross Operating Cycle = Raw Material Storage Period + Conversion period + Finished Goods Storage Period + Average Collection Period

Dr. Sudhendu Giri

Net operating cycle (NOC)

Net operating cycle (NOC)
NOC is the difference between GOC and CDP.
Net Operating Cycle = Gross Operating Cycle Average Payment period

Dr. Sudhendu Giri

OPERATING CYCLE
RMCP +WPCP +FGCP +RCP(DCP) TOCP(Gross operating cycle) - CDP NOC
Dr. Sudhendu Giri

-----------------------------

OPERATING CYCLE APPROACH TO WORKING CAPITAL MANAGEMENT

What has been considered in figure above as working capital cycle is more popularly known as the operating cycle. This title is more expressive in the sense that the normal business operations of a manufacturing and trading company start with cash, go through the successive segments of the operating cycle, viz, raw material storage period, conversion period, finished goods storage period and average collection period before getting back cash along with profit. The total duration of all the segments mentioned above is known as gross operating cycle period.

OPERATING CYCLE
Gross Operating Cycle =
Raw Material Storage Period + Conversion period + Finished Goods Storage Period + Average Collection Period

Net Operating Cycle =

Gross Operating Cycle Average Payment period

Statement of working capital Requirements for a Trading Concern

Current Assets: (i) Cash (ii) Debtors or Receivables(for ..months sales ) (iii) Stock (formonths sales) (iv) Advance payment, if any (v) Others Total Current Assets Less: Current Liabilities (i) Creditors (for..months Purchases) (ii) Lag in payment of expenses(o/s expenses, if any) Total Current Liabilities Working capital(C.A. C.L. ) Add: Provision / Margin For Contingencies Net Working Capital Required -------------------------------------

Working Capital Requirements

Prepare an estimate of working capital requirement from the following information of a trading concern (a) Project annual sales 100000 units (b) Selling price Rs. 8 per unit (c) Net profit on sales 25% (d) Average credit period allowed to customers 8 weeks (e) Average credit period allowed by suppliers 4 weeks (f) Average stock holding in terms of sales requirement 12 weeks (g) Allow 10% for contingencies

Statement of Working Capital Requirement

Current Assets: Debtors(8 weeks) Stock (12 weeks)

92,308 1,38,462 2,30,770

46,154 1,84,616 18,462 2,03,078

Less: Current Liabilities: Creditors(4 weeks) Net Working Capital Add 10% for Contingencies Working Capital Required

CRITERIA FOR EVALUATION OF WORKING CAPITAL MANAGEMENT

Liquidity
Availability of Cash Inventory Turnover Credit Extended to Customers Credit Obtained from Suppliers