Working Capital Management

Nature & Scope

¾ Introduction & Definitions
¾ Components of Working Capital
¾ Significance of Working Capital
¾ Operating Cycle
¾ Types of Working Capital
¾ Net Vs Gross Working Capital
¾ Causes of Changes in Working Capital
¾ Dangers of Excess Working Capital
¾ Dangers of Inadequate Working Capital
¾ Determinants of Working Capital
¾ Assessment of Working Capital Requirements
¾ Illustration
 Introduction & Definitions
In day to day business, working capital gets major
importance. It may be define as, excess of current asset
over current liabilities. According to Shubin working
capital means, it is the amount of funds necessary for the
cost of operating the enterprise. Thus, working capital in
going concern is revolving fund. It consist of continues
conversion of cash in to inventory, inventory into sales or
debtors, debtors into marketable investment or cash. So in
short we can say working capital is nothing but circulation
of Current Assets. Which is shown in chart format on next
slide
Introduction & Definitions

Marketable
Investments
Cash

Accounts
Inventories
Receivables
 Components of Working Capital
After knowing what is working capital, now let’s
look different components of the same. In narrow sense
working capital refers to net working capital. The same
is excess of current assets over current liabilities. In
terms of formula it can be express as below;
Net Working Capital=(C.A. – C.L.)
Now the question may come in to mind is that
what constitute Current Assets & Current Liabilities?
The same is depicted on the next slide in chart format.
 Components of Working Capital
Working Capital
Components

Current Assets

Cash & Bank Short Term

S. Debtors Bills Receivables Inventories
Balance Investment

Current Liabilities

Advance Short Term

S. Creditors Bills Payable Bank Overdraft
Payments Borrowings
 Significance of Working Capital
Working capital is backbone of the enterprise, as it
provides number of services, some of them are mentioned
below as significance of W.C. ;

a. It required for uninterrupted business operation.

b. It is essential to run day to day activities.
c. To ensure maximizing the wealth of the firm.
d. To meet short term obligation of enterprise.
e. To earn considerable profit.
 Operating Cycle
Operating cycle also
known as ‘cash cycle’ it is Accounts
Receivable Cash into
nothing but a time gap Into Raw Material
between sales and actual Cash
realisation of cash from
sales proceeds. Operating Cycle
The continuing flow from of
Manufacturing
cash to suppliers to WIP to Finished Goods Concern Raw Material
Into
F.G. to Debtors to Cash. Accounts
Into
W.I.P.
Aforesaid is the graphical Receivable
presentation of operating
cycle of manufacturing W.I.P.
concern. Into
Finished Goods
 Types of Working Capital

Balance Sheet
Gross Working Capital : It W.C.
refers to the total of all
Cash Temporary
current assets. It represents W.C. W.C.
short term securities, sundry
Types
debtors etc. This concept is of
very much suitable to those W.C.

firms, where ownership is Gross Permanent

W.C. W.C.
separated from management
and control. Net
W.C.
 Types of Working Capital
Net Working Capital :
This concept is qualitative, Balance Sheet
W.C.
indicating firms ability to
meet its operating expenses Cash Temporary
and current liabilities. It can W.C. W.C.

be presented by formula as Types

of
Net W.C. = C.A. – C.L. W.C.
It can be further classified in Gross Permanent
to Positive & Negative. W.C. W.C.

When C.A. exceeds C.L. we

Net
have Positive Net W.C. and W.C.
vise versa.
 Types of Working Capital

Balance Sheet
Permanent Working Capital: W.C.
It can be define as, the
minimum amount of working Cash Temporary
W.C. W.C.
capital kept by the firm to
ensure uninterrupted course of Types
of
operation. This amount may W.C.
vary from year to year
Gross Permanent
depending upon the changes in W.C. W.C.
sales due to seasonal changes.
Net
W.C.
 Types of Working Capital

Temporary Working Capital Balance Sheet

W.C.
Any amount over the
permanent level of working is Cash Temporary
Temporary W.C. It is also W.C. W.C.

called as Variable or Types

Fluctuating Working Capital. of
W.C.
Its termed as Fluctuating
Gross Permanent
because requirement of C.A. W.C. W.C.
changes due to seasonal
variations. Net
W.C.
 Types of Working Capital

Balance Sheet
Balance Sheet Working W.C.
Capital : Balance Sheet
Cash Temporary
working capital is one W.C. W.C.
which is calculated from the
Types
items appearing in the of
Balance Sheet. Both Gross W.C.

and Net working capital are Gross Permanent

W.C. W.C.
examples of Balance Sheet
working capital. Net
W.C.
 Types of Working Capital
Cash Working Capital :
Cash working capital refers Balance Sheet
to narrow concept of W.C.
working capital, which itself
is cash. This capital is Cash Temporary
W.C. W.C.
required by firms to pay
salaries, wages, interests Types
of
and dividends etc. Items of W.C.
this working capital appears
Gross Permanent
in profit & loss a/c. It shows W.C. W.C.
the impact of various
transactions on cash Net
position of a firm. W.C.
 Net Vs Gross Working Capital
Net Working Capital Gross Working Capital.
1. By nature it is qualitative. 1. By nature it is quantitative.
2. Its indicates firms ability 2. It points out funds available
to meets current liability to meets current liability for
& operating expenses. financing current assets.
3. It expressed as C.A. C.L. 3. It indicates total of C.A.
4. Popular in accounting. 4. Popular in management.
5. Suitable for Sole Traders. 5. Suitable for companies.
6. Its useful to find out true 6. It can’t reveal true financial
financial position of a firm. position of company.
Causes of Changes in Working Capital
As we have seen earlier, working capital is not
fixed and its changes according to the requirement.
Following are some of the reasons which leads to same.
1. Changes in the level of Sales activities.
2. Changes in operating expenses.
3. Technological changes.
4. Cyclical changes in economy.
5. Changes in operating cycle.
6. Changes in the fixing the level of inventory.
 Danger of Excess Working Capital
Working capital is key factor for success in
business. But one thing always kept in mind that it
should be maintained at desired level. Because both
excess or inadequate level leads to serious problem to
organisation. Excessive working capital means idle
funds which earn no profits. Following are some of the
problems faced by company when working capital is
excess.
Danger of Excess Working Capital

a. It leads to unnecessary accumulation of inventory.

b. Results in imbalance between liquidity &
profitability.
c. It is an indication of defective credit policy.
d. This makes management complacent which
degenerates into managerial inefficiency.
Danger of Inadequate Working Capital
In contras to excessive working capital,
inadequate working capital impairs firm’s profitability
and liquidity. Following are some problems faces by
firms when working capital is inadequate.
a. It causes growth and expansion of firm.
b. It may not able to utilise production facilities.
c. It may not able to meet short term liabilities.
d. Firm may not take cash discount facilities.
e. It may not able to efficiently utilised fixed
assets, this leads to low profitability.
 Determinants of Working Capital
Working capital requirements are
determined by variety of factors. These factors
affect different enterprises differently. The
determinants of working capital can be classify
broadly in to two.
1] Internal Factors. 2] External Factors.
Both Internal and External factors are
further depends on several other factors. Those are
listed in next slides.
Determinants of Working Capital
Internal Factors
1. Nature of Enterprise
2. Size of Business
3. Firms Credit Policy
4. Access to Money Market.
5. Manufacturing Cycle.
6. Expansion & Growth of Business
7. Depreciation Policy
8. Profit Margin & Dividend Policy
9. Operating Efficiency of Firm.
10.Co-ordination Activities of Firm.
Determinants of Working Capital

External Factors
1. Business cycle Fluctuations.
2. Technological Development.
3. Seasonal Fluctuations.
4. Environment Factor.
5. Taxation Policy.
 Assessments of Working Capital
Requirements
The working capital means excess of current
assets over current liabilities. It reality such excess may
be more or less than organisations requirement. So the
question arise is how one can judge the requirement?
There are three techniques, which determine the
working capital requirement. Those are ;
1] Percentage Sales Method
2] Estimation of Components of Working Capital
3] Cash Working Capital Method.
 Assessments of Working Capital
Requirements
Percentage Sales Method : This is simple and
traditional method for calculating working capital
requirements. In this method working capital is
calculated and presented as a percentage to sales. This
method is useful for planning short term working capital
needs. The basic criticism on this method is that it
assumes a linear relationship between sales and working
capital. Hence it is not universally accepted.
 Assessments of Working Capital
Requirements
Estimation of components of Working Capital
Method : This is a second method and it is calculated
after considering components of current assets and
current liabilities. These components include inventories,
Debtors, Short Term Obligations etc. It is particularly
suitable for long term forecasting. Symbolically it
presented as below;
Working Capital=Current Assets – Current Liabilities
 Assessments of Working Capital
Requirements

Cash Working Capital Method : This method is also

known as ‘operating cycle method’. This method suggest
that operating cycle refers to the period that firms takes
from acquisition of raw material and ends with the
collection of receivables. Following formula may be used
to express the duration of operating cycle.
O = (R + W + F + D) – C
 Assessments of Working Capital
Requirements
O = (R + W + F + D) – C
Where,
O = Total Period of Operating Cycle
R = Number of days for holding raw material
W = Number of days for holding stock of W.I.P.
F = Number of days for holding stock of F.G.
D = Debtors Collection Period
C = Creditors Payment Period
 Assessments of Working Capital
Requirements
Factors to be Considered : Following are some of the factors,
which has to be taken into account while making an estimation of
working capital requirement by manufacturing concern.
1. Total units of output made by a firm throughout the year
2. The length of time to issue material for production
3. The average credit period allowed to debtors.
4. The average credit period allowed by suppliers.
5. The amount of cash required for making advance
payment. If any.
 Illustration
Pavan Industries Ltd. Plans to sell 30000 units next year. The expected cost of
goods sold is as below;
Raw Materials 200
Manufacturing Expenses 60
Operating Expenses including selling & distribution 40
Selling Price 400
The duration at various stages of the operating cycle is expected to be as below;
Raw material stage 2 months
Work-in-progress stage 1 month
Finished goods stage 1/2 month
Debtors stage 1 month
Assuming the monthly sales level of 2500 units:
1] Calculate the investment in various current assets
2] Estimate working capital requirement if the desired cash balance is 5% of working
capital requirements.
 Solution
Calculation of profitability :
Proposed Sale = 30000 units
Selling Price per unit = Rs. 400
Sales for the year = 1,20,00,000
Less: Raw Material = 60,00,000
Mfg. Expenses = 18,00,000
Operating Exp. = 12,00,000
Net Profit : 30,00,000

Calculation of Investment in Various current Assets :

(a) Raw Material (1/6 of Rs. 60,000) 10,00,000
(b) Work-in-progress (Taken to be complete
25% as to Mfg. Expenses):
Raw Material 60,00,000
Mfg. Expenses
25% of 18,00,000 4,50,000
64,50,000
Stage of Work-in-progress for one month (64,50,000/12) 5,37,500
 Solution
( c ) Finished Goods :
Raw Materials 60,00,000
Mfg. Expenses 18,00,000
78,00,000
Stage of finished goods for half of (1/2/12 x 78,00,000) = 3,25,000
( d ) Debtors one month of Rs. 1,20,00,000 (1,20,00,000 x ½) = 10,00,000
Total Current Assets ( a +b +c + d ) = 28,62,500

Estimation of Working Capital Requirement :

Stock of Raw Material 10,00,000

Stock of Work-in-progress 5,37,000
Finished Goods 3,25,000
Debtors 10,00,000

Cash Balance (5/95 x 28,62,500) 1,50,658

Working Capital Required : 30,13,158