WORKING

CAPITAL
MANAGEME
NT
UNIT - 1
WORKING CAPITAL
 Capital needed for meeting day to day operations
 Working capital typically means the firm’s holding of
current or short-term assets such as cash,
receivables, inventory and marketable securities.
 These items are also referred to as circulating
capital
 It measures how much in liquid assets a company
has available to build its business.
 A short term loan which provides money to buy
earning assets.
 Allows to avail of unexpected opportunities.

 Positive working capital is required to ensure
that a firm is able to continue its operations
and that it has sufficient funds to satisfy both
maturing short-term debt and upcoming
operational expenses. The management of
working capital involves managing
inventories, accounts receivable and payable
and cash.


 An increase in working capital indicates that the

business has either increased current assets
(that is received cash, or other current assets)
or has decreased current liabilities, for
example has paid off some short-term
creditors.

 T Y P E S O F W O R K IN G C A P IT A L

WORKING CAPITAL

BASIS OF BASIS OF
CONCEPT TIME

Gross Net Permanent Temporary

Working Working / Fixed WC / Variable
Capital Capital WC

Seasonal Special
WC WC
Regular Reserve
WC WC
CONCEPTS OF WORKING
CAPITAL
 Gross Working Capital


 Net working Capital

Gross Working Capital
 Refers the amount invested in C.A. that
are employed in the firm i.e. the total
current assets of the firm
 Where Current assets are the assets that
can be converted into cash within an
accounting year & include cash,
inventory, debtors etc.
 Referred as “Economics Concept” since
assets are employed to derive a rate of
return.
Net Working Capital
 CA – CL
 Referred as ‘point of view of an
Accountant’.
 It indicates liquidity position of a firm &
suggests the extent to which working
capital needs may be financed by
permanent sources of funds.
Permanent Working
Capital
The amount of current assets required to meet a
firm’s long-term minimum needs.
RUPEE AMOUNT

Permanent current assets

TIME
Temporary Working
Capital
The amount of current assets that varies with


seasonal requirements.

Temporary current assets

RUPEE AMOUNT

Permanent current assets

TIME
 Difference between permanent & temporary
working capital

Amount Variable Working Capital

of
Working
Capital

Permanent Working Capital

Time
 Variable Working Capital
Amount
of
Working
Capital
Permanent Working Capital

Time
WORKING CAPITAL
CYCLE
 Resource flows for a
manufacturing firm

Used in

Accrued Accrued Fixed

Direct Operating
Production Used in Labor and expenses
Process materials Used to
purchase
Generates
Cash and
Inventory Marketable
Securities Used to
Collection purchase
Via Sales Generator process
Fixed
External Financing Assets
Return on Capital
Accounts
receivable
Suppliers
Of Capital
Trade off between Profitability
and Liquidity
Profitability:
Profit after expenses

Liquidity:
Liquidity
Profitability
Ability to meet financial &
Liquidity

obligations when they Trade off point

Profitability
become due for payment
Net Working Capital


“Greater the net working

capital, greater the
liquidity, lesser will be the
profitability.”



Liquidity position
 Based on the 'current ratio' and the 'quick ratio'.
 The current ratio establishes the relationship
between current assets and current liabilities.
Normally, a high current ratio is considered to
be an indicator of the firm's ability to promptly
meet its short term liabilities.
 The quick ratio establishes a relationship
between quick or liquid assets and current
liabilities. An asset is liquid if it can be
converted into cash immediately or
reasonably soon without a loss of value.
Consequences of low
liquidity
 Delays in obligations
 Missed incentives or opportunities
 Increased cost
 Effects the company stakeholders relationship

Consequences of high
liquidity
 Low profitability due to idle funds
 Profitability
 Profitability is a measure of the amount by which a
company's revenues exceeds its relevant expenses
 ‘Profitability position' of a company is measured using
the 'gross profit margin' and the 'net profit margin’
 Gross profit margin is an indicator of the profit a
business makes on its cost of sales, or cost of
goods sold. It is the profit earned before any
administration costs; selling costs and so on are
removed.
 Net profit margin is an indicator of the amount of net
profit per rupee of turnover a business has earned.
That is, after taking account of the cost of sales, the
administration costs, the selling and distributions
costs and all other costs, the net profit is the profit
that is left, out of which the company will have to pay
interest, tax, dividends and so on.
Consequences of low
Profitability
 Suggest ineffective management
 Less attractive option for investors to invest
Three alternative working capital
investment policies

Policy C
Current Assets (Rs)

Policy B

Policy A

Sales (Rs)
  Policy C represents conservative approach
 Policy A represents aggressive/trade- off
approach
 Policy B represents a matching/hedging
approach


 Optimal level of working capital investment



 Risk of long-term versus short-term debt

 Financing needs over time

Total Working Capital
Rs.
Temporary Working Capital

Regular Working Capital

Reserve Working Capital

Time
 Matching / Hedging Approach to
Asset financing


Total Working Capital

Short-term
Debt
Rs.
Temporary Working Capital

Long-term
Regular Working Capital Debt +
Equity
Capital
PWC

Reserve Working Capital

Time
 Maturity of debt i.e. source of funds should
match the maturity of the assets to be
financed
 Fixed portion of Current assets i.e. permanent
working capital (regular & reserve) should
be financed with long term debt/ funds
 As per this approach, short term financing
requirement (current assets) should be
equal to the short term financing available
(current liabilities)
 Cost involved in financial structure is low
 Risk of getting insolvent is high.
MONTH TOTAL LONG TERM SHORT TERM
JANUARY WORKING
8500 DEBT
6900 DEBT
1600
CAPITAL
FEBRUAR 8000 6900 1100
Y
MARCH 7500 6900 600
APRIL 7000 6900 100
MAY 6900 6900 0
JUNE 7150 6900 250
JULY 8000 6900 1100
AUGUST 8350 6900 1450
SEPTEMBE 8500 6900 1600
R
OCTOBER 9000 6900 2100
NOVEMBE 8000 6900 1100
R
DECEMBE 7500 6900 600
R
 Conservative approach to asset
financing


Total Working Capital

Short-term
Rs. Temporary Working Capital Debt

Long-term
Regular Working Capital Debt +
Equity
capital
PWC

Reserve Working Capital

Time
 Estimated requirement of total funds/working
capital should be met from long term funds


 Use of short term funds should be restricted

to the emergencies & contingencies


 Cost involved is high & risk is low

MONTH TOTAL LONG TERM SHORT TERM
JANUARY WORKING
8500 DEBT
9000 DEBT
CAPITAL
FEBRUAR 8000 9000
Y
MARCH 7500 9000 If &
APRIL 7000 9000
only if
MAY 6900 9000
JUNE 7150 9000 Any

JULY 8000 9000

AUGUST 8350 9000 Contingency
SEPTEMBE 8500 9000
R
OCTOBER 9000 9000
NOVEMBE 8000 9000
R
DECEMBE 7500 9000
R
 Aggressive/Trade - off Approach
to Asset Financing


Total Working Capital

Short-term
Temporary Working Capital Debt
Rs.

Long-term
Regular Working Capital Debt +
Equity
capital
Av. Of Max. & Min. WC Requirement

Reserve Working Capital PWC

Time
 Exact trade off between risk and profitability
will differ from case to case depending on
the risk perception of the decision maker
 One possible trade off could be as follows:
 Average of minimum and maximum monthly
requirements of funds during a given period of
time should be financed through long run
sources and for any additional need, short
term fund may be used.
MONTH TOTAL LONG TERM SHORT TERM
JANUARY WORKING
8500 DEBT
7950 DEBT
550
CAPITAL
FEBRUAR 8000 7950 50
Y
MARCH 7500 7950 0
APRIL 7000 7950 0
MAY 6900 7950 0
JUNE 7150 7950 0
JULY 8000 7950 50
AUGUST 8350 7950 400
SEPTEMBE 8500 7950 550
R
OCTOBER 9000 7950 1050
NOVEMBE 8000 7950 50
R
DECEMBE 7500 7950 0
R
FACTORS DETERMINING
WORKING CAPITAL
1.     Nature of the Industry
2. Production Policy
3.     Demand of Industry
4. Market Conditions
5.     Nature of the Business
6. Availability of Raw Material
7.     Volume of Sales
8.     Terms of Purchase and Sales/ credit policy
9.    Inventory Turnover
10.   Business Turnover
11. Business Cycle
12. Production Cycle

contd…
Working Capital
Determinants (Contd…)
13.     Credit control
14.     Inflation or Price level changes
15.     Cash reserves
16.     Operation efficiency
17.     Firm’s finance and dividend policy
18.     Attitude towards Risk
Assessment/ Computation of
Working Capital
 Operating Cycle Method
 Current Asset and Current Liability Method
 Cash Forecasting Method
 Projected Balance Sheet Method
 Profit & Loss Adjustment Method
Operating Cycle Method
 Working Capital is determined by
 (i) Total operating expenses for the year,
 include all expenses (excluding non cash)
 on raw materials, labor & overheads.


 (ii) No. of operating cycles during the year

 is calculated by dividing 365 days of the
 year by the duration of operating cycle
 The duration of operating cycle is the sum of
inventory conversion period (ICP) & debtors
conversion period (DCP)
 GOC = ICP+DCP
 ICP = RMCP+WIPCP+FGCP
 Firm may require resources on credit &
temporarily postpone payment, we also
calculate creditors (payable) deferral period
(CDP)
 NOC = GOC – CDP
 NOC = RMCP+WICP+FGCP+DCP - CDP


 GOC = Gross Operating Cycle (No. of Days)
 NOC = Net Operating Cycle (No. of Days)
 RMCP = Average Period (in days) of materials
 holdings/ Raw Material Conversion Period
 WIPCP = Average period (in days) of converting
 raw materials into finished goods (in
 holding WIP)/ WIP Conversion Period
 FGCP = Average Period (in days) of finished goods
 storage/ Finished Goods Conversion Period
 DCP = Average credit collection period/ Debtors
 Conversion Period (in days)
 CDP = Average debt payment period/ Creditors
 Deferral Period (in days)
 RAW MATERIAL CONVERSION PERIOD

Av. Stock of Material

Material Storage Period( R) =
Daily Av. Consumption
Opening Stock + Closing Stock
Av. Stock of Material =
2
Consumption for the year
Daily Av. Consumption =
365
 WORK IN PROGRESS CONVERSION PERIOD

Av. Stock of WIP

WIP Holding Period (W) =
Av. Daily Factory or Production Cost
Op. Stock + Cl. Stock
Av Stock Of WIP =
2
Total Factory Cost
Av. Daily Factory/Production Cost =
365

Total Factory/ Production Cost =

Raw Material Consumed +
Opening WIP +Direct Expenses
 FINISHED GOODS CONVERSION PERIOD

Av.stock of Finished Goods

Finished Goods Storage Period =
Av. Daily Cost of Sales
Opening Stock + Closing Stock
Av. Stock of Finished Goods =
2
Total Cost of Sales for the Year
Av. Daily Cost of Sales =
365
Cost of Sales
= Opening Stock of FG + Annual Production Cost
+ Custom & Excise Duty + General Expenses
+ Selling & distributi on Expenses - Closing FG Stock
 DEBTORS COLLEECTION PERIOD

Av. Debtors & B/R

Debtors Collection Period =
Net Credit Sales Per Day
or
Av. Debtors & B/R × 365
Debtors Collection Period =
Total credit sales for the year

Opening Debtors + Closing Debtors

Av. Debtors & B/R =
2
Total credit sales for the year
Net Credit sales per day =
365
 CREDITORS DEFERRAL PERIOD
Av. Creditors & B/P
Creditors Deferrals Period =
Net Credit Purchase Per Day
or
Av. Creditors & B/P × 365
Creditors Deferrals Period =
Total credit Purchase for the year

Opening Creditors + Closing Creditors

Av. Creditors & B/P =
2
Total credit Purchase for the year
Net Credit Purchase per day =
365
 365
No. of Operating Cycle =
Duration of OC

Working Capital Required =

Total Operating Expenses or cost of sales
No. of OC
ILLUSTRATION : 1
 The following are the data of Z Ltd. taken from the
accounting records:
Particulars Rs.
Average stock of RM during the year 180000

Average Stock of WIP during the year 100000

Average stock of FG during the year 54000

Average Balance of debtors 150000

Average Balance of creditors 120000

Average Daily Sales 2000

Average Daily Cost of finished goods sold 1800

Average Daily consumption of Raw Material 1200

Average Period of credit available from the suppliers is 100 days

Based on the data calculate:


 Average Period of RM holding in Stores

 Credit Period Available to Customers
 Average Period for which finished goods stay
in godowns.
 Average period of conversion of raw material
into finished goods
 Working Capital Cycle
ILLUSTRATION : 2
Particulars Amount (Lakhs)
Sales 1400
Increase in stock 100
Other Income 50
Total Revenues 1550
Purchase of Raw Material 700
Wages & Salaries 150
Power & Fuel 120
Depreciation 40
Excise Duty 100
Advertising & Promotions 100
Freight on Finished Goods 50
General Administrative Expenses 80
Interest & Financial Charges 50
Total Expenses 1390
PBT 160
Tax (40)
PAT 120
Other Information:


 Opening stock of RM = 105

 Opening stock of WIP = 30
 Opening stock of FG = 134
 Increase in stock of RM = 50
 Increase in stock of WIP = 60
 Increase in stock of FG = 10
 The sales are entirely on credit basis
 The opening balance of Debtors was Rs. 180 L
 Collection from Debtors = Rs. 1340 L
 Purchases are entirely on credit basis
 Opening balance of Creditors = 160 L
 Payments made to creditors = 740 L
 Wages, salaries & depreciation is entirely related to manufacturing
operations
 Total No. of days in a year are 360

Estimation of Current
Assets & Current
Liability
 Traditional Method of estimating working
capital requirement


 WC = Current Assets – Current Liability


Estimation of Current
Assets:
Current Assets include:


 Raw Material Inventory

 Work in Progress Inventory
 Finished Goods Inventory
 Debtors
 Cash & Bank Balance
 Finished Goods Inventory
Budgeted Cost of Prod. Av. FG Holding
Production× Per unit × Period(in Months/Days)
=
12 Months/ 365 Days

WIP Inventory
Completion Budgeted Cost of WIP Av. Time Span
Stage × Production × Per unit × WIP Progress
Inv. (in Months/Day s)
=
12 Months/ 365 Days

Finished Goods Inventory

Budgeted Cost of Prod. Av. FG Holding
Production × Per unit × Period( in Months/Days)
=
12 Months/ 365 Days
Finished Goods Inventory
Budgeted Cost of Prod. Av. FG Holding
Production × Per unit × Period( in Months/Days)
=
12 Months/ 365 Days

Debtors
Budgeted Cost of Sales Av. Debt Collection
Credit Sales× Per unit × Period (in Months/Days)
=
12 Months/ 365 Days
 Estimation of Current
Liabilities
TRADE CREDITORS
Budgeted Cost of RM Credit Period Allowed
Production × Per unit × By Creditors(in Months/Days)
=
12 Months/ 365 Days

DIRECT WAGES
Budgeted Direct Labor Av. Time Lag in Payment
Production × Cost Per unit × of Wages(in Months/Days)
=
12 Months/ 365 Days
OVERHEADS
Budgeted Overhead Av. Time Lag in Payment
Production × Cost Per unit × of Overheads(in Months/Days)
=
12 Months/ 365 Days
CASH FORECASTING
METHOD
 Related to cash budgeting


 Estimates the cash surplus and deficiency by

estimating receipts and payments during
the year
PROJECTED BALANCE SHEET
METHOD
 Various items of assets and liability (both long
term & short term) after taking into account
the transactions expected for future period
 On the basis of these assets & liabilities, a
projected balance sheet is prepared
 Working capital Requirement
 = Projected CA – Projected CL
PROFIT & LOSS ADJUSTMENT
METHOD
 Estimated profit is calculated on the basis of
transactions likely to place in the future
 Working capital magnitude is ascertained by
making necessary adjustments for cash
inflows & cash outflows in the profit
 MANAGEMENT OF WORKING CAPITAL
( WCM )

Management of working capital is concerned with

the problems that arise in attempting to manage the
current assets, the current liabilities and the inter-
relationship that exists between them. In other
words, it refers to all aspects of administration of CA
and CL.

Working Capital Management Policies of a firm have

a great effect on its profitability, liquidity and
structural health of the organization.
3D Nature of Working Capital
Management

DimensionII
Dimension
Profitability,
Profitability,
Risk,&
Risk, &
Liquidity
Liquidity

n I I
I I DDiim
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men ossiittiioon
im mpo onnIIIII
D i
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EXCESS OR INADEQUATE
WORKING CAPITAL
Every business concern should have adequate
working capital to run its business operations.
It should have neither redundant or excess
working capital nor inadequate or shortage of
working capital.

Both excess as well as shortage of working

capital situations are bad for any business.
However, out of the two, inadequacy or
shortage of working capital is more dangerous
from the point of view of the firm.
Redundant or Excess
Working Capital
õ  Idle funds, non-profitable for business,
poor ROI
õ  Unnecessary purchasing &
accumulation of
inventories over required level
õ   Excessive debtors and defective credit
policy, higher
incidence of B/D.
õ Overall inefficiency in the organization.
õ When there is excessive working
capital, Credit
worthiness suffers
õ   Due to low rate of return on
investments, the market
value of shares may fall
Disadvantages or Dangers of Inadequate or
Short Working Capital
CAN’T PAY OFF ITS SHORT-TERM LIABILITIES IN
TIME.

ECONOMIES OF SCALE ARE NOT POSSIBLE.

DIFFICULT FOR THE FIRM TO EXPLOIT FAVORABLE

MARKET SITUATIONS

DAY-TO-DAY LIQUIDITY WORSENS

IMPROPER UTILIZATION THE FIXED ASSETS AND

ROA/ROI FALLS SHARPLY