Working

Capital
Management
 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-term
capital.
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 Machinery 100000
Sundry Creditors 150000 Inventories
Bills Payable 30000 Finished Goods 60000

Outstanding Expenses 20000 Work in process 40000

Bank Overdraft 50000 Prepaid Expenses 20000

Provision for Taxation 20000 Marketable Securities 60000

Proposed Dividend 30000 Sundry Debtors 90000
Bills Receivables 20000

Cash & Bank Balance 90000

TOTAL 650000 TOTAL 650000

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
STATEMENT OF WORKING CAPITAL REQUIREMENTS
Amount (Rs.)
Current Assets
(i) Cash ----
(ii) Receivables ( For…..Month’s Sales)---- ----
(iii) Stocks ( For……Month’s Sales)----- ----
(iv)Advance Payments if any ----
Less : Current Liabilities
(i) Creditors (For….. Month’s Purchases)- ----
(ii) Lag in payment of expenses -----_
WORKING CAPITAL ( CA – CL ) xxx
Add : Provision / Margin for Contingencies -----

NET WORKING CAPITAL REQUIRED 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
customer 8 weeks
Average Credit Period allowed by
supplier 4 weeks
Average stock holding in terma of sales
requirement 12 weeks
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 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
Permanent or
Investment Fixed Temporary
in Current Asset Investments or seasonal Invest
Month (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 approaches
 The hedging 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

Dimension I
Profitability,
Risk, & Liquidity
 Working Capital Issues

Optimal Amount (Level) of Current Assets

Assumptions
 50,000 maximum units Policy A

of production Policy B

ASSET LEVEL
 Continuous production Policy C
 Three different policies
for current asset levels Current Assets
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 Policy B

B Average ASSET LEVEL Policy C

C Low
Current Assets
Greater current asset 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 =
Policy A
Net Profit
Total Assets
ASSET LEVEL
Policy B

Let Current Assets = (Cash + Policy C

Rec. + Inv.)
Current Assets
Return on Investment =
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 Policy B

B Average ASSET LEVEL Policy C

C High
Current Assets
As current asset levels 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 ability to meet its Policy A
financial obligations. More
Policy B

ASSET LEVEL
risk!
 Stricter credit policies reduce Policy C
receivables and possibly lose
sales and customers. More
risk! Current Assets
 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

A Low Policy B

B Average ASSET LEVEL 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
Accrued or Outstanding
Sundry Debtors Expenses

Marketable securities Short term loan and

(Short term) advances
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

Cash in hand Bills Payable

Cash at bank Sundry Creditors

Accrued or Outstanding
Sundry Debtors
Expenses

Short term advances

Marketable securities
Temporary Investments Dividend payable
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 ratio
Liabilities Rs Assets Rs
9% preference
share 500000 Goodwill 100000
Equity share
capital 1000000 Land and building 650000
8% debentures 200000 Plant 800000
Furniture and
Long term loan 100000 fixtures 150000
Bills payable 60000 Bills receivable 70000
Sundry creditors 70000 Sundry debtors 90000
Bank over draft 30000 Bank balance 45000
Outstanding short term
expenses 5000 investments 25000
Prepaid expenses 5000
Stock 30000
1965000 1965000
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.
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 .