Working Capital

Management- Introduction
Prof Ravichandran
 Working Capital Management Module
Learning Outcome
• Understand the meaning of working capital,
• Understand the concepts of working capital,
• Describe the need and classification of working capital,
• Explain policies related to current asset management,
• Explain risk return trade off,
• Discuss the various approaches for financing of current assets,
• Analyse the need for working capital as related to operating/ cash
cycle, permanent and temporary working capital
Working Capital Management – Session 1 & 2
Outline
• Introduction
• Components of Working Capital
• Concepts of Working Capital
• Classification of Working Capital
• Need of Adequate Working Capital
 Introduction
Finance- Finance is the Art & Science of Managing Money . It is the Art
of passing currency from hand to hand until it finally disappears
Types & Sources of Finance
• Long Term Sources of Finance
• Finance required to meet Capital Expenditure. Also, known as Fixed
Capital Finance
• Short Term Sources of Finance
• Finance required to meet day-to-day Business requirements. Also,
known as Working Capital
 • Capital of the concern may be divided into two major
headings.

MEANING
OF
WORKING
CAPITAL
 • Fixed capital means that capital, which is used
for long-term investment of the business
concern. For example, purchase of permanent
assets.
MEANING • Normally it consists of non-recurring in nature.
OF Working Capital is another part of the capital
which is needed for meeting day to day
WORKING requirement of the business concern.
CAPITAL • For example, payment to creditors, salary paid
to workers, purchase of raw materials etc.,
normally it consists of recurring in nature. It
can be easily converted into cash. Hence, it is
also known as short-term capital
 Definitions of Working Capital
According to the definition of Mead, Baker and Malott,
“Working Capital means Current Assets”.
According to the definition of J.S.Mill, “The sum of the current
asset is the working capital of a business”.
According to the definition of Weston and Brigham, “Working
Capital refers to a firm’s investment in short-term assets, cash,
short-term securities, accounts receivables and inventories”.
 Definitions of Working Capital contd.
• According to the definition of Bonneville, “Any acquisition of
funds which increases the current assets, increase working
capital also for they are one and the same”.
• According to the definition of Shubin, “Working Capital is the
amount of funds necessary to cover the cost of operating the
enterprises”.
• According to the definition of Genestenberg, “Circulating
capital means current assets of a company that are changed
in the ordinary course of business from one form to another,
for example, from cash to inventories, inventories to
receivables, receivables to cash”
 Circulating capital

Circulating capital – working capital is also

known as ‘circulating capital or current
capital.’ “The use of the term circulating
capital instead of working capital indicates
that its flow is circular in nature.”
 Introduction:
• The efficient management of working capital is
essential for the profitability and overall financial
health of any company. Working capital is the cash
that companies use to operate and conduct their
businesses.
• A business enterprise should maintain a sound and
required working capital position to run the business.
 Introduction:
• The amount of working capital should neither be
inadequate nor excessive.
• Excessive working capital results in idle funds for a
firm which adds to the cost of capital and does not
result in profits for the firm.
• On the contrary, if the working capital is short of its
requirements, it results in production and sales
disruption and impairs the firm’s profitability.
Introduction:
• Working capital management is concerned with short
term financial decisions.
• Working capital for a firm is like the blood for the
human body. It is one of the most significant
ingredients of the business.
• Working capital management if carried out efficiently,
effectively and consistently, will result in a healthy and
robust organisation.
Introduction:
• The management of working capital is equally
important than as the management of long-term
financial investment.
• The adequacy of working capital determines the
survival of the company. The efficient working capital
management is mandatory to maintain a balance of
liquidity and profitability.
Working capital management – Key concepts

•Working capital management is concerned

with the problems that arise in attempting
to manage the current assets, the current
liabilities and the interrelations that exist
between them.
 Circulation of Working Capital

• At one given time both the current assets and current liabilities exist
in the business. The current assets and current liabilities are flowing
round in a business like an electric current.
• However, “The working capital plays the same role in the business as
the role of heart in human body. Working capital funds are generated
and these funds are circulated in the business.
• As and when this circulation stops, the business becomes lifeless. It is
because of this reason that the working capital is known as the
circulating capital as it circulates in the business just like blood in the
human body.
 The goal of working capital
management is to manage the firm’s
current assets and liabilities in such
a way that a satisfactory level of
Objective of working capital is maintained.
Working
Capital The interaction between current
assets and current liabilities is,
Management therefore the main theme of the
theory of the working capital
management.
 Components of Working Capital

Current Assets

Current Liabilities
 What are Current Assets ?
• 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 diminution in value and without
disrupting the operations of the firm.
Examples-
1. cash,
2. marketable securities,
3. accounts receivable and
4. inventory.
 What are Current Assets contd. ?

Current Asset Includes:

• Cash and Bank balances
• Receivables
• Short Term Investments
• Inventory of Raw Materials, Stores and Spares
• Short Term Advances
• Inventory of Work-in-progress
• Prepaid Expenses
• Inventory of Finished Goods
 What Are Current Liabilities?
• 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 the earnings of the concern.
Examples-
1. accounts payable,
2. bills payable,
3. bank overdraft and
4. outstanding expenses.
 What Are Current Liabilities contd.?

Current liabilities include

• Creditors for good purchased
• Advanced received against sales
• Outstanding expenses
• Taxes and dividends payable
• Short term borrowings
• Other short term liabilities maturing within a year
 How are Current Liabilities Created?

Current liabilities
• The firm creates a Current Liability towards creditors (sellers)
from whom it has purchased raw materials on credit.
• This liability is also known as accounts payable and shown in the
balance sheet till the payment has been made to the creditors.
• The claims or obligations which are normally expected to
mature for payment within an accounting cycle are known as
current liabilities.
STRUCTURE OF CURRENT ASSETS AND CURRENT LIABILITIES Current Liabilities Current Assets
Balance Sheet of a Compnay
Gross Working Capital
Net Working Capital
 Classification of Working Capital

Based On
Based On Based On Financial
Concept Need & Time Reports

Permanent or Temporary or
Gross Working Net Working Fixed Working Fluctuating Cash Working Balance Sheet
Capital Capital Capital Working Capital Capital Working Capital

Level of Investment Required to Support

required in Current seasonal Variation in
Total of Current Current Assets – Assets to support Production and Sales
Assets Current Liabilities constant or minimum in usual course of
levels of Sales business
Classification of Working Capital - Concept

Based On
Concept

Gross Working Net Working

Capital Capital

Current Assets –
Total of Current
Current
Assets
Liabilities
 Conceptual classification
• Gross Working Capital is simply called as the total current assets of
the concern.
• GWC = CA
• Net Working Capital is the excess of current assets over the current
liability of the concern during a particular period.
• If the current assets exceed the current liabilities it is said to be
positive working capital; it is reverse, it is said to be Negative working
capital.
• NWC = C A – CL
 Conceptual classification
• There are two concept of working capital viz., quantitative and
qualitative.
• The quantitative concept takes into account as the current assets
while the qualitative concept takes into account the excess of current
assets over current liabilities.
• Deficit of working capital exists where the amount of current
liabilities exceeds the amount of current assets.
• (i) Gross Working Capital = Total Current Assets
• (ii) Net Working Capital = Excess of Current Assets over Current Liabilities
• (iii) Working Capital Deficit = Excess of Current Liabilities over Current Assets.
Classification on the basis of financial reports

Classification on the basis of financial reports – The information of working

capital can be collected from Balance Sheet or Profit and Loss Account

• Cash Working Capital – This is calculated from the

information contained in profit and loss account.
• This concept of working capital has assumed a great
significance in recent years as it shows the adequacy of
cash flow in business.
• It is based on ‘Operating Cycle Concept’s
Classification on the basis of financial reports

Balance Sheet Working Capital

•The data for Balance Sheet Working Capital is
collected from the balance sheet. On this basis
the Working Capital can also be divided in three
more types, viz., gross Working Capital, net
Working Capital and Working Capital deficit.
 Classification of Working Capital based on
Variability (Time and Need)

On the basis of time and need, working capital can also be classified as
1. Permanent working capital and
2. Temporary / fluctuating working capital.
Permanent working capital:
• It is the bottom level of the investment required to maintain current
asset at such a level so that day-to-day operations can be carried on
without any impediment or hurdles. These represent minimum levels
of inventories, receivables, etc., that will always be available to run
the business operations.
Classification of Working Capital:

“Permanent Working Capital is

the amount of working capital
that persists over time regardless
of fluctuations in sales.
 Classification of Working Capital:

Temporary or fluctuating working capital:

• It is dependent on the changes in production and sales. These
represent the seasonal stockpiles that arise, such as inventories
before Diwali and receivables after Diwali.
• This is over and above permanent working capital. Temporary
working capital is generated to meet liquidity necessities that are
of a purely momentary or temporary in nature.
• Temporary Working Capital = Total Current Assets – Permanent
Current Assets
Classification of Working Capital:

Temporary or fluctuating working capital:

• ”Temporary working capital is the additional assets
required to meet the variations in sales above the
permanent level”
Requirements of permanent and temporary working capital may
change over time: Why?
1. Changes in level of sales which may be due to these reasons:
• There may be an everlasting long term change in trend. For instant,
the demand of a particular product may rise permanently due to
change in lifestyle compelling to hold large inventory. This type of
trend would primarily affect the need for permanent current assets.
• There may be recurring fluctuations in the economy due to customary
ups and downs in business activity, which occur after a period from
time to time. Though they are more or less regular, they may not be
uniformly periodic. This results in alteration in both permanent and
temporary working capital.
• Seasonal influences may also result in changes in sales resulting in
deviation in the temporary working capital.
Requirements of permanent and temporary
working capital may change over time: Why?
2. Changes in the policy by the management will impact working
capital.
3. Technological changes:
• They would also result in significant changes in the level of working
capital. If a new process is invented due to technological
advancement, resulting in the shortening of the operating cycle, it
would shrink the necessity for working capital and vice versa.
 NEEDS OF WORKING CAPITAL

Purchase of raw materials and spares

Payment of wages and salary

Day-to-day expenses

Provide credit obligations

 NEEDS OF WORKING CAPITAL

Purchase of raw materials and spares:

• The basic part of manufacturing process is, raw materials. It should purchase
frequently according to the needs of the business concern. Hence, every business
concern maintains certain amount as Working Capital to purchase raw materials,
components, spares, etc.

Payment of wages and salary:

• The next part of Working Capital is payment of wages and salaries to labour and
employees. Periodical payment facilities make employees perfect in their work. So
a business concern maintains adequate the amount of working capital to make
the payment of wages and salaries.
 NEEDS OF WORKING CAPITAL

Day-to-day expenses:
• A business concern has to meet various expenditures regarding
the operations at daily basis like fuel, power, office expenses, etc.
Provide credit obligations:
• A business concern responsible to provide credit facilities to the
customer and meet the short-term obligation. So the concern
must provide adequate Working Capital.
 Danger of excessive working capital

Heavy investment in fixed assets

Reckless purchase of materials

Speculative tendencies

Liberal credit

Carelessness
 Paucity / Shortage / Inadequate - working
capital
1. Implementation of operating plans becomes difficult and a
concern may not achieve its profit target.
2. It is difficult to pay dividend due to lack of funds.
3. Bargaining capacity is reduced in credit purchases and cash
discount could not be availed.
4. An enterprise looses its reputation when it becomes
difficult even to meet day-to- day commitments.
 Paucity / Shortage / Inadequate - working
capital
5. Operating inefficiencies may creep in when a concern
cannot meet it financial promises.
6. Stagnates growth as the funds are not available for new
projects.
7. A concern will have to borrow funds at an exorbitant rate
of interest in case of need.
8. Sometimes, a concern may be bound to sale its product at
a very reduced rates to collect funds which may harm its
image.
Paucity of working capital
• 1. Implementation of operating plans becomes difficult and a concern may not achieve
its profit target.
• 2. It is difficult to pay dividend due to lack of funds.
• 3. Bargaining capacity is reduced in credit purchases and cash discount could not be
availed.
• 4. An enterprise looses its reputation when it becomes difficult even to meet day-to- day
commitments.
• 5. Operating inefficiencies may creep in when a concern cannot meet it financial
promises.
• 6. Stagnates growth as the funds are not available for new projects.
• 7. A concern will have to borrow funds at an exorbitant rate of interest in case of need.
• 8. Sometimes, a concern may be bound to sale its product at a very reduced rates to
collect funds which may harm its image.
 Meaning of Working Capital Management
• The management of current assets, current liabilities and inter-
relationship between them is termed as working capital
management.
• “Working capital management is concerned with problems that arise
in attempting to manage the current assets, the current liabilities and
the inter-relationship that exist between them.
• “There is usually a distinction made between the investment
decisions concerning current assets and the financing of working
capital”
 Meaning of Working Capital Management

Two aspects of working capital

management emerges:
•To determine the magnitude of current assets or
“level of working capital” and
•To determine the mode of financing or “hedging
decisions.”
 Importance of working capital management
stems from two reasons
• A substantial portion of total investment is invested in
current assets, and
• Level of current assets and current liabilities will change
quickly with the variation in sales. Though fixed assets
investment and long-term borrowing will also response to
the changes in sales, but its response will be weak.
 Factors Influencing Working Capital
Requirement
Nature of business

Conditions of supply

Production policy

Seasonal Operations

Credit Availability
 Factors Influencing Working Capital Requirement

Credit policy of enterprises

Growth and expansion

Price level change

Circulation of working capital

 Factors Influencing Working Capital Requirement

Volume of sale

Liquidity and profitability

Management ability

External Environment