WORKING CAPITAL MANAGEMENT

Defining Working Capital:

The term working capital refers to the amount of capital which is readily
available to an organization. That is, working capital is the difference between
resources in cash or readily convertible into cash (Current Assets) and
organizational commitments for which cash will soon be required (Current
Liabilities).
Current Assets are resources which are in cash or will soon be converted into
cash in “the ordinary course of business”.

Current Liabilities are commitments which will soon require cash settlement in
“the ordinary course of business”.
Thus:

WORKING CAPITAL = CURRENT ASSETS – CURRENT LIABILITIES

In a department’s Statement of Financial Position, these components of working

capital are reported under the following headings:

Current assets include:

➢ Sundry Debtors
➢ Inventories
➢ Loan an Advances
➢ Interest Receivable
➢ Cash and Bank.

Current Liabilities refer to those liabilities, which are to be paid in near future. It
includes:
 ➢ Bank Overdraft
➢ Bill Payable
➢ Creditors
➢ Outstanding expanses
➢ Short term loans.

The Importance of Good Working Capital Management

Working capital constitutes part of the Crown’s investment in a department.

Associated with this is an opportunity cost to the Crown. (Money invested in one
area may “cost” opportunities for investment in other areas.) If a department is
operating with more working capital than is necessary, this over-investment
represents an unnecessary cost to the Crown.

From a department’s point of view, excess working capital means operating

inefficiencies. In addition, unnecessary working capital increases the amount of
the capital charge which departments are required to meet further activities.

Approaches to Working Capital Management

The objective of working capital management is to maintain the optimum

balance of each of the working capital components. This includes making sure
that funds are held as cash in bank deposits for as long as and in the largest
amounts possible, thereby maximizing the interest earned. However, such cash
may more appropriately be “invested” in other assets or in reducing other
liabilities.

Working capital management takes place on two levels:

➢ Ratio analysis can be used to monitor overall trends in working capital

and to identify areas requiring closer management.
 ➢ The individual components of working capital can be effectively managed
by using various techniques and strategies.

When considering these techniques and strategies, departments need to

recognize that each department has a unique mix of working capital
components. The emphasis that needs to be placed on each component varies
according to department. For example, some departments have significant
inventory levels; others have little if any inventory.

The working capital requirement of a firm depends, to a great extent upon the
operating cycle of the firm. The operating cycle may be defined as the time
duration starting from the procurement of the goods and raw materials and
ending with the sales realization of the finished product (after going through the
various stages of production).

There is the time gap between the happening of the first event and the
happening of the last event. This time gap is called ‘operating cycle’.

Thus the operating cycle of a firm consists of the time required for the
completion of the chronological sequence of the following:

➢ Procurement of raw material and service.

➢ Conversion of raw material into work in progress.
➢ Conversion of work in progress into finished goods.
➢ Sale of finished goods.
 ➢ Conversion of receivable into cash.

Operating Cycle Period:

The length of time duration of the operating cycle of any firm can be defined as
the sum of its inventory conversion period and the receivable conversion period.

INVENTORY CONVERSION PERIOD:

Inventory:

The raw materials, work-in-process goods and completely

finished goods that are considered to be the portion of a
business’s assets that are ready of will be ready for selling.
Inventory represents one of the most important assets that most
businesses possess, because the revenue generation and
subsequent earnings for the companies’ shareholders/owners.

Possessing a high amount of inventory for long periods of time is

not usually good for a business, because there are inventory
storage, obsolescence and spoilage costs. However, possessing
not enough inventory isn’t good either because the business runs
the risk of losing out on potential sales and potential market
share as well.
 Inventory management forecasts and strategies, such as a just-

in-time inventory system, can help minimize inventory costs

because goods are created or received as inventory only when

needed.

Need to hold inventories

Holding inventories involves typing up of company’s funds

storage and handling costs. There are three general motives for
holding inventories:

1. The transaction motive emphasizes the need to maintain

inventories to facilitate smooth production and sales
operation.
2. The precautionary motive
3. The speculative motive.

Under Working Capital Management, we calculate:

Gross Operating Cycle (GOC)
The firm’s gross operating cycle(GOC) can be determined as inventory conversion
period(ICP) plus debtors conversion period(DCP).

GOC = ICP + DCP

Inventory conversion period(ICP)

It is the sum of :

Raw material conversion period (RMCP),

Work-in-process conversion period (WIPCP),

Finished goods conversion period (FGCP)

Debtors conversion period(DCP)

It is the average time taken to convert debtors into cash.

DCP represents the average collection period.

 Gross working capital (GWC)

GWC refers to the firm’s total investment in current assets.

Current assets are the assets which can be converted into cash within an accounting
year (or operating cycle) and include cash, short-term securities, debtors, (accounts
receivable or book debts) bills receivable and stock (inventory).

 Net working capital (NWC).

 NWC refers to the difference between current assets and current liabilities.

 Current liabilities (CL) are those claims of outsiders which are expected to
mature for payment within an accounting year and include creditors (accounts
payable), bills payable, and outstanding expenses.

 NWC can be positive or negative.

 Positive NWC = CA > CL

 Negative NWC = CA < CL

 GWC focuses on

 Optimization of investment in current

  Financing of current assets

 NWC focuses on

 Liquidity position of the firm

 Judicious mix of short-term and long-tern financing

Permanent or fixed working capital :

A minimum level of current assets, which is continuously required by a firm to

carry on its business operations, is referred to as permanent or fixed

working capital.

Fluctuating or variable working capital :

The extra working capital needed to support the changing production and sales
activities of the firm is referred to as fluctuating or variable working capital.

Determinants of Working Capital:

✔ Nature of business

✔ Market and demand

✔ Technology and manufacturing policy

✔ Credit policy

✔ Supplies’ credit

✔ Operating efficiency

✔ Inflation
 Gross operating cycle (GOC)

The total of inventory conversion period and debtors conversion period is

referred to as gross operating cycle (GOC).

 Net operating cycle (NOC)

NOC is the difference between GOC and CDP.

 Cash conversion cycle (CCC)

CCC is the difference between NOP and non-cash items like depreciation.

Working Capital Finance Policies

✔ Long-term

✔ Short-term

✔ Spontaneous

 Short-term Vs. Long-term financing

 Cost

 Flexibility

 Risk
Significance of Working Capital Management

u In a typical manufacturing firm, current assets exceed one-half of total

assets.

u Excessive levels can result in a substandard Return on Investment (ROI).

u Current liabilities are the principal source of external financing for small
firms.

u Requires continuous, day-to-day managerial supervision.

u Working capital management affects the company’s risk, return, and share
price.
 BIBLIOGRAPHY

Pandey. I. M. Financial Management, Eight Edition, Vikas

Publishing House Pvt. Ltd 2001

Chandra Prasana, Financial Management Theory & Practice,

Sixth Edition, Tata McGraw-Hill Publishing Company Limited,
2006

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