Working

Capital
Manageme
nt
 Definition of Working
Capital
 
Working Capital refers to that part of the 
firm’s capital, which is required for 
financing short-term or current assets such a 
cash marketable securities, debtors and 
inventories.  Funds thus, invested in current 
assets keep revolving fast and are 
constantly converted into cash and this cash 
flow out again in exchange for other current 
assets.  Working Capital is also known as 
revolving or circulating capital or short-
KINDS OF WORKING CAPITAL

WORKING CAPITAL

BASIS OF BASIS OF
CONCEPT TIME

Gross Net Permanent Temporary

Working Working / Fixed / Variable
Capital Capital WC WC

Seasonal Special
WC WC
Regular Reserve
WC WC
 Significance of Gross WC

 Optimum investment in CA
     Investment in CA must be adequate  CA investment should not be 
inadequate or excessive inadequate WC can disturb production and 
can also threaten the solvency of firm , if it fails to meet its current 
obligation  excessive investment in CA should be avoided , since it 
impairs firms profitability 

 Financing of CA 
    Need for WC arises due to increasing level of business activity & it is 
to provided quickly some time surplus fund may arises which should 
be invested in Short term securities , they should not be kept idle 
 Significance of Net Working Capital

 Maintaining Liquidity position 
For maintaining liquidity position there is a need to 
maintain CA sufficiently in excess of CL 
 Judge Financial Soundness of a firm 
The Net working capital helps creditors and 
investors to judge financial soundness of a firm 
BALANCE SHEET OF ABC COMPANY AS ON 31-3-2000
Liabilities R’s Assets R’s
Equity Shares 200000 Goodwill 20000

8% Debentures 100000 Land and Building 150000

Reserve & Surplus 50000 Plant and 100000

Machinery
Sundry Creditors 150000 Inventories  

Bills Payable 30000 Finished Goods 60000

Outstanding 20000 Work in process 40000
Expenses
Bank Overdraft 50000 Prepaid Expenses 20000
Provision for 20000 Marketable 60000
Taxation Securities
Proposed Dividend 30000 Sundry Debtors 90000

    Bills Receivables 20000

    Cash & Bank 90000
 Difference between permanent &
temporary working capital

Amount Variable Working Capital

of
Working
Capital

Permanent Working Capital

Time
Permanent and temporary working capital for Stable firm
                                  Variable Working Capital
Amount
of
Working
Capital
Permanent Working Capital

Time
Permanent and temporary working capital for Growing firm
 Operating cycle concept

 Maximization of share holder’s wealth of a firm is possible

only when there are sufficient return from the operations
 Successful sales activity is necessary for earning profit
sales do not convert into cash immediately
 There is invisible time lap between the sale of good and
receipt of cash
 The time taken to convert raw material into cash is known
as operating cycle
 Conversion of cash into raw material
 Conversion of raw material into work in progress
 Conversion of Work in progress into finished goods
 Conversion of finished good into Sales ( Debtors and cash )
 Raw WIP
Materials

Operating Cycle in Finished

Cash
Manufacturing firm Goods

Debtors SALES
Operating cycle of
Non Manufacturing
Firm

Receivables

cash

Stock of finished goods

 Formula for calculating
Operating cycle for
Manufacturing firm
OC = ICP+ARP
OC = Operating cycle
ICP = Inventory Conversion period
ARP = Account Receivable Period

ICP = Average Inventory

Cost of good sold /365
ARP = Average Account Receivable
Sales/365
 ABC Company Provide the
following information , Compute
the operating cycle  
 Sales 3000 Lakhs 
 Inventory  Opening R’s 610 Lakhs ; 
closing R’s 475 Lakhs 
 Receivable opening R’s 915 Lakhs; 
Closing R’s 975 Lakhs
 Cost of Goods Sold R’s 2675 Lakhs  
 CASH CONVERSION CYCLE
The amount of time a firm’s resources are tied up 
calculated by subtracting  the average payment period 
from the operating cycle the time period between the 
date a firm pays its supplier and the date it receives cash 
from its customer 
CCC = OC – APP
AAI = Average Inventory
      Cost of good sold /365
ARP = Average Account Receivable 
       Annual Sales/365 
APP = Account Payable Period
     Cost of good sold /365
 Calculate CCC
(CASH CONVERSION CYCLE)
 Average use of Inventory 80 days

 Account receivable collection period 50 days

 Account payable period is 40 days

CCC= OC- APP

OC = AAI+ARP
80+50=130
CCC =130-40 =90 days
    Purchase of                           Sale of Goods                        Collection of 
   Raw Material     on Credit         Account Receivables 
   On credit

    Average age  of  Account receivable
  Inventory  (AII)   period (ARP)

            
                Account Payable 
           Period (APP)

                                             Payment to 
                                              suppliers 

 Receipt of Invoice Operating Cycle (OC)

Cash Conversion cycle

 Resource flows for a
manufacturing firm

Used in

Accrued Direct Accrued Fixed

Used in Labour and
Operating
Production materials expenses
Process
Used to
Working purchase
Generates Capital
cycle 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
Calculate cash conversion cycle
 Sales R’s 1587.95

 Cost of Good sold R’s 1406.27

 Inventory opening 195.82, closing 202.29

 Account receivables opening 423.03

closing 449.46
 Account payable opening 140.40, closing
168.33
CCC = OC –APP
OC = AAI + ARP
 FORECASTING / ESTIMATION OF
WORKING CAPITAL
REQUIREMENTS
Factors to be considered
 Total costs incurred on materials, wages and overheads
 The  length  of  time  for  which  raw  materials  remain  in  stores  before  they  are  issued  to 
production.
 The length of the production cycle or WIP, i.e., the time taken for conversion of RM into 
FG.
 The length of the Sales Cycle during which FG are to be kept waiting for sales.
 The average period of credit allowed to customers.
 The amount of cash required to pay day-to-day expenses of the business.
 The amount of cash required for advance payments if any.
 The average period of credit to be allowed by suppliers.
 Time – lag in the payment of wages and other overheads
 PROFORMA - WORKING CAPTIAL
ESTIMATES
1. TRADING CONCERN
STATEMENTOF
STATEMENT OFWORKING
WORKINGCAPITAL
CAPITALREQUIREMENTS
REQUIREMENTS
Amount(Rs.)
Amount (Rs.)
CurrentAssets
Current Assets
(i)Cash
(i) Cash ----
----
(ii)Receivables
(ii) Receivables((For…..Month’s
For…..Month’sSales)----
Sales)---- ----
----
(iii)Stocks
(iii) Stocks((For……Month’s
For……Month’sSales)-----
Sales)----- ----
----
(iv)AdvancePayments
(iv)Advance Paymentsififany
any ----
----
Less::Current
Less CurrentLiabilities
Liabilities
(i)Creditors
(i) Creditors(For…..
(For…..Month’s
Month’sPurchases)-
Purchases)- ----
----
(ii)Lag
(ii) Lagininpayment
paymentofofexpenses
expenses -----_
-----_
WORKINGCAPITAL
WORKING CAPITAL((CA CA––CLCL)) xxx
xxx
Add::Provision
Add Provision //Margin
MarginforforContingencies
Contingencies -----
-----

NETWORKING
NET WORKINGCAPITAL
CAPITALREQUIRED
REQUIRED XXX
XXX
 1. MANUFACTURING CONCERN
STATEMENT OF WORKING CAPITAL REQUIREMENTS
Amount (Rs.)
Current Assets
(i) Stock of R M( for ….month’s consumption) -----
(ii)Work-in-progress (for…months)
(a) Raw Materials -----
(b) Direct Labour -----
(c) Overheads -----
(iii) Stock of Finished Goods ( for …month’s sales)
(a) Raw Materials -----
(b) Direct Labour -----
(c) Overheads -----
(iv) Sundry Debtors ( for …month’s sales)
(a) Raw Materials -----
(b) Direct Labour -----
(c) Overheads -----
(v) Payments in Advance (if any) -----
(iv) Balance of Cash for daily expenses -----
(vii)Any other item -----

Less : Current Liabilities

(i) Creditors (For….. Month’s Purchases) -----
(ii) Lag in payment of expenses -----
(iii) Any other -----
WORKING CAPITAL ( CA – CL )xxxx
Add : Provision / Margin for Contingencies -----

NET WORKING CAPITAL REQUIRED XXX

Prepare an estimate of Working capital requirement
from the following information of a trading concern:

Projected annual sales  100000 units
Selling price R’s 8 per unit 
% age of Net profit on sales 25%
Average Credit Period allowed to  8 weeks 
customer
Average Credit Period allowed by  4 weeks
supplier
Average stock holding in terma of sales  12 weeks
requirement 
contingencies 10%
 Points to be remembered while
estimating WC
 (1) Profits should be ignored while calculating working capital
requirements for the following reasons.
 (a) Profits may or may not be used as working capital
 (b) Even if it is used, it may be reduced by the amount of Income tax,
Drawings, Dividend paid etc.
 (2) Calculation of WIP depends on the degree of completion as regards
to materials, labour and overheads. However, if nothing is mentioned
in the problem, take 100% of the value as WIP. Because in such a
case, the average period of WIP must have been calculated as
equivalent period of completed units.
 (3) Calculation of Stocks of Finished Goods and Debtors should be
made at cost unless otherwise asked in the question.
 Prepare statement of
working capital requirement,
Profit &Loss A/C, Balance
Sheet Assuming

 Share Capital 150000

 8% Debentures 200000
 Fixed asset 130000
 Material 40%
 Direct lab our 20%
 Overheads 20%
The following further particular are available
 It is proposed to maintain a level of activity of
2,00,000 units
 Selling price is R’s 12/- per unit
 Raw Material are expected to remain in stores for an
average period of one month
 Material will be in process , on average half a month
 Finished goods are required to be in stock for an
average period of one month
 Credit allow to debtors is two month
 Credit allow by supplier is one month
 Working Capital Financing Mix
Approaches to Financing
Mix

The Hedging or The Conservative The Aggressive

Matching Approach Approach Approach
Hedging approach to asset
financing
Total Assets
Short-term
Debt
Fluctuating Current Assets

Long-term
Permanent Current Assets Debt +
Equity
Capital

Fixed Assets

Time
 The Hedging approach
 Hedging approach refers to a process of matching
Hedging approach refers to a process of matching
maturities of debt with the maturities of financial
need . In this approach maturity of source of fund
should match the nature of asset to be financed
 This approach is also known as matching approach.

 The hedging approach suggests that the permanent

working capital requirement should be financed with
fund from long term sources while the temporary
working capital requirement should be financed with
short term funds.
Estimated Total Investment in Current Asset of company X for
the year 2000
Month Investment Permanent or Temporary
in Current Fixed or seasonal Invest
Asset Investments (R's)
(R's ) (R's)
January 50400 45000 5400
February 50000 45000 5000
March 48700 45000 3700
April 48000 45000 3000
May 46000 45000 1000
June 45000 45000 -
July 47500 45000 2500
August 48000 45000 3000
September 49500 45000 4500
October 50700 45000 5700
November 52000 45000 7000
December 48500 45000 3500
TOTAL 44300
 Conservative Approach
 This approach suggested that the entire
estimated investments in current asset should be
finance from long term source and short term
should be use only for emergency requirement
 Distinct features of this approach

 Liquidity is greater

 Risk is minimized

 The cost of financing is relatively more as

interest has to be paid even on seasonal
requirement for the entire period
Conservative approach to asset
financing
Total Assets
Short-term
Debt
Fluctuating Current Assets

Long-term
Permanent Current Assets Debt +
Equity
capital

Fixed Assets

Time
 Trade off between
Hedging and
conservative
The hedging approaches approaches
implies low cost , high
profit and high risk while the conservative
approach leads to high cost , low profit , low risk
Both the approaches are the two extreme and
neither of them serve the purpose of efficient
working capital management
 A trade off between the two will then be an
acceptable approach , One way of determining
the trade off is by finding the AVG of maximum
and minimum requirement of current asset or
working capital
Aggressive approach to asset
financing
Total Assets
Short-term
Debt
Fluctuating Current Assets

Long-term
Permanent Current Assets Debt +
Equity
capital

Fixed Assets

Time
 Aggressive approach
 The aggressive approach suggests that the
entire estimated requirement of current asset
should be financed from short-term sources and
even a part of fixed asset investment be
financed from short - term sources
This approach make the finance mix :
 More Risky
 Less costly
 More Profitable
 Prepare a projected balance
sheet , profit and loss a/c
and then an estimation of
working capital .
 Issued Share Capital 300000
 6% Debentures 200000
 Fixed asset 200000
 Raw Material 50%
 Lab our 20%
 Overheads 20%
 Profit 10%
 There is a regular production and
sales cycle
 Raw Material are kept in stores for an average
period of two month
 Finished goods remain in stock for an average
period of three month
 Production during the previous year was 180000
units and it is planned to maintain the same in the
current year also
 Each unit of production is expected to be in
process for half a month
 Credit allow to customer is three month and given
by supplier is two month
 Selling price is Rs 4 per unit
 Calculation of debtors may be made at selling
price
Management of Working
Capital
 Working capital in general practice refer to the
excess of CA over CL.
 Management of working capital therefore is
concerned with the problems that arise in
attempting to manage the CA, the CL and the
inter-relationship that exists between them.
 The basic goal of WCM is to manage the CA & CL
of a firm in such a way that a satisfactory level of
WC is maintained.
 Working Capital Management Policies of a firm
have a great effect on its profitability, liquidity
and structural health of the organization
 Working capital management is 3
dimensional in Nature

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

n IIII C DDiimmen
n siioon e
v v
eell Coom
mpo enssiion
i meens &LLe possiti on IIII
itioonn
DDim sittiioonn& & II
m ppoosi CAA ooffCCL& LLeevvel
Coom oo ffC L el
C
 Working Capital Issues

Optimal Amount (Level) of Current Assets

Assumptions
 50,000 maximum Policy A
units of production

ASSET LEVEL
Policy B
 Continuous
Policy C
production
 Three different
policies for current Current Assets
asset levels are
possible
0 25,000 50,000
OUTPUT (units)
 Impact on Liquidity
Optimal Amount (Level) of Current Assets
Liquidity Analysis
Policy Liquidity Policy A
A High

ASSET LEVEL
Policy B
B Average Policy C
C Low
Greater current asset Current Assets
levels generate more
liquidity; all other
factors held constant.
0 25,000 50,000
OUTPUT (units)
 Impact on
Expected
Profitability
Optimal Amount (Level) of Current Assets
Return on Investment =
Net Profit Policy A
Total Assets

ASSET LEVEL
Policy B
Let Current Assets = (Cash
+ Rec. + Inv.) Policy C

Return on Investment =
Current Assets
Net Profit
Current + Fixed Assets

0 25,000 50,000
OUTPUT (units)
 Impact on
Expected
Profitability
Optimal Amount (Level) of Current Assets
Profitability Analysis
Policy Profitability Policy A
A Low

ASSET LEVEL
Policy B
B Average Policy C
C High
As current asset levels Current Assets
decline, total assets will
decline and the ROI will
rise.
0 25,000 50,000
OUTPUT (units)
 Impact on Risk
Optimal Amount (Level) of Current Assets
 Decreasing cash
reduces the firm’s Policy A
ability to meet its

ASSET LEVEL
financial obligations. Policy B
More risk!
Policy C
 Stricter credit policies
reduce receivables and
possibly lose sales and Current Assets
customers. More risk!
 Lower inventory levels
increase stockouts and
lost sales. More risk! 0 25,000 50,000
OUTPUT (units)
 Impact on Risk
Optimal Amount (Level) of Current Assets

Risk Analysis
Policy Risk Policy A

ASSET LEVEL
A Low Policy B

B Average Policy C

C High
Current Assets
Risk increases as the
level of current assets
are reduced. 0 25,000 50,000
OUTPUT (units)
 Summary of the
Optimal Amount of
Current Assets
SUMMARY OF OPTIMAL CURRENT ASSET ANALYSIS
Policy Liquidity Profitability Risk
A High Low Low
B Average Average Average
C Low High High

1. Profitability varies inversely with

liquidity.
2. Profitability moves together with risk.
(risk and return go hand in hand!)
Techniques of analysis of
working capital
The analysis of working capital can be conducted
through a number of devices such as
 Ratio analysis

 Fund flow analysis

 Working capital Budgeting

 Ratio analysis : A ratio is a simple arithmetical

expression of the relationship of one number to
another , this technique can be employed for
measuring short term liquidity or working capital
position of a firm.
 The following ratios may be
calculated for this purpose
 Liquidity Ratio
a) Current Ratio

b) Acid test ratio/quick ratio/liquid ratio

c) Cash Position ratio/absolute liquid ratio

 Inventory turnover ratio

 Receivable turnover ratio

 Payable turnover ratio

 Working capital turnover ratio

 Current ratio may be define as the
relationship between CA and CL
 This ratio is also known as WCR.
(Working capital ration).
 It is helpful to measure short –
term financial position or liquidity
of a firm
Current ratio: Current asset
Current liabilities
CURRENT ASSETS CURRENT LIABILITIES
Cash in hand Bills Payable

Cash at bank Sundry Creditors

Sundry Debtors Accrued or Outstanding
Expenses
Short term loan and
Marketable securities advances
(Short term)
Bills Receivable Dividend payable
Inventories of Stock Bank Overdraft
Work in progress  
Finished goods  
Prepaid Expenses  
 Quick or Acid test or
Liquid Ratio
 An asset is said to be liquid if it can be
convert into cash with in a short period with
out loss of value
 Inventory cannot be termed to be liquid asset
because they cannot be convert into cash
immediately
 The quick ratio can be calculated

Quick ratio: liquid asset

Current liabilities
 Quick or liquid Current Liabilities
Bills Payable
Cash in hand

Cash at bank Sundry Creditors

Sundry Debtors Accrued or Outstanding
Expenses
Short term advances
Marketable securities
Temporary Dividend payable
Investments
Bank Overdraft
 Income tax payable
Convection quick ratio of 1:1 is consider
satisfactory
Cash Position ratio/absolute liquid
ratio
 Absolute Liquid assets include cash in hand and
cash at bank and marketable securities or
temporary investments
 The acceptable norms for this ratio is 50% or .05%

Cash ratio: Cash & bank + Short –term securities

Current liabilities
 Calculate all the three
Liabilities Rs ratio
Assets Rs
9% 500000Goodwill 100000
preference
share
Equity share 1000000Land and 650000
capital building
8% 200000Plant 800000
debentures
Long term 100000Furniture and 150000
loan fixtures
Bills payable 60000Bills 70000
receivable
Sundry 70000Sundry 90000
creditors debtors
Bank over 30000Bank balance 45000
draft
Outstanding 5000short term 25000
CONCLUSION:
 Current ratio of the company is not
satisfactory because the ratio 1:6 is much
below then the expected Standards .
 Acid test ratio on the other hand is more
than the normal standard of 1:1
 Absolute ratio is slightly low because it is
0.42 where as the accepted standard is 0.5
 In this company need to improve its short
term financial position
 Inventory turnover ratio
Inventory turn over ratio = Cost of good sold
Average Inventory at cost
Generally , the cost of good sold may not be known from
the published financials , in such circumstances
Inventory turn over ratio = Net Sales
Average Inventory at cost
Inventory turn over ratio = Cost of good sold
Average Inventory at selling price
 Inventory conversion
period
Inventory conversion period = Days in a year
Inventory Turnover Ratio
M/s Rakesh & Co supplies you the following
information for the year ending 31st Dec 1999
Credit Sales Rs 150000
Cash Sales Rs 250000
Return Inward Rs 25000
Opening Stock Rs 25000
Closing Stock Rs 35000
 Debtor/Receivable turnover ratio
/Debtor velocity
Debtor(Receivable) = Net credit Annual sales
Average Trade debtors
Trade debtors = Sundry debtor + Bill Receivable and
account receivable s
Average Trade Debtors = Opening Trade debtor +
Closing Trade Debtor /2
Note : Debtor should always be taken at gross value ,
No provision for doubtful debt be deducted from them
but when the information about opening and closing
balance of trade debtor and credit sales is not available
, then the debtors turnover ratio calculated by dividing
the total sales by the balance of debtors(inclusive of
Bills receivables) given
Debtors turn over Ratio = Total sales
Debtors
 Average Collection
Period
The average collection period represent the
average number of days for which a firm has
to wait before its receivable are converted into
cash
Average Collection period =
Average Trade Debtors (Drs + B/R)
Sales per day
Sales Per day = Net Sales
No of working days
 Or
Average collection period =Average trade
debtors Net Sales
No of working days
If the period is in months:
Average collection period =No of working
days Debtors turnover ratio
The two basis component of the ratio are
debtors and sales per day
 Creditor/Payable
turnover ratio
The analysis for credit turnover is basically the
same as of debtors turnover ratio except that
in place of trade debtor, the trade creditor are
taken and in place of sales , average daily
purchase are taken as the other component of
the ratio.
Creditors turnover ratio
= Net credit annual purchase
Average Trade creditors
 Average Payment period Ratio
= Average Trade Creditors( Creditors+ Bills
payable)/Average Daily purchases.
Average daily purchase = Annual Purchase
/No of working days in a year.
Average Payment Period = Trade creditor *
No of working days / Net annual purchase.
Average Payment Period = No of working
days / Credit turnover Ratio.
Working capital turnover
ratio
Working capital of a concern is directly related to
sales and current asset like debtors , bills
receivable , cash , stock etc .
Working capital turnover ratio = Cost of Sales /
Average working capital
Average working capital = Opening working
capital + Closing Working capital/2
** If cost of sales is not given , then the figure of
sale can be used . O n the other hand if
opening working capital is not disclosed then
working capital at the end of the year will be
used.
Cost of sale /Net working capital
The following information is given
about M/s S.P Ltd for the year ending
Dec 31 2000
 Stock turnover ratio = 6times

 Gross Profit ratio = 20% on sales

 Sales for 2000 = Rs 300000

 Closing stock is Rs 10000 more than

the opening stock
 Opening Creditors = Rs 20000

 Closing Creditors = Rs 30000

 Trade debtor at the end = Rs 60000

 Net Working Capital = Rs 50000

 FIND OUT
 Average Stock

 Purchases

 Credit turnover ratio

 Average Payment Period

 Average Collection Period

 Working Capital turnover

ratio
Fund flow analysis : Fund flow analysis is a
technical device designated to study the
sources from which additional fund were
derived and the use to which these sources
were put . It is an effective management tool
to study change in the financial position of
business
The fund flow analysis consists of
 Preparing schedule of change in working
capital
 Statement of sources and application of
funds
 Working capital Budgeting : Working
capital budget as a part of total
budgeting process of a business , is
prepared estimating future long term and
short term working capital need and the
sources of finance them .
 The objective of a working capital budget
is to ensure availability of fund as and
when needed and to ensure effective
utilization of these resources .