Working Capital is refered to as a firms short

term assets like inventory and its short

term liabilities like money owed to
suppliers .
Managing a firms working capital is a day
to day activity that ensures that the firm
has sufficient resources to continue its
operations and avoid costly interruptions.
This involves a number of activities related
to a firms receipt and disbursement of cash

Questions involved in working capital

management:
How much cash and inventory should a firm
keep in hand?
Should a firm sell on credit ? If so on what
terms will it be offered and to whom it will
be extended ?
How will the firm obtain any need for short
term financing ?
Will a firm purchase on credit or will the firm
borrow in the short term and pay cash?

A firm requires two types of assets : fixed

assets and current assets. Fixed assets include
land , building, plant and machinery,
vehicles and equipment. These assets are
permanent in nature and are required for
carrying on the business .
Current assets are required to support day to
day activities and keep changing in the course
of business.
Current assets include cash, debtors, raw
materials , stock of finished goods etc.
Current assets constitute gross working capital.

Excess of current assets over current liabilities

is called net working capital. Current liabilities
are to be paid in the ordinary course of
business normally within one year out of
income generated by the firm or from the sale
of current assets.
Fixed assets are financed by owners, equity
holders and long term liabilities while current
assets are partly financed by long term
sources and partly by current liabilities and
short term loans given by banks.

Liabilities
Assets
--------------------------------------Share capital
Reserves & surpluses
Net fixed
assets
Long term liabilities
--------------------------------------Working capitial
Current liabilities
Current assets
---------------------------------------

Net working capital is also called the liquid

surplus of a firm .
Working capital is the funds required to carry
the required levels of current assets to enable
the company to carry on its operations at the
expected level without any disruption.
Working capital is a function of the level of
activity and the type of business
Working capital will be more for a trading
business than that of a manufacturing
company

Components of working capital

Cash
Inventory
Accounts receivable
Marketable securities
Loan from Banks

Cash:
Most liquid component of working capital
Cash balance required to meet day to day
expenses like raw material, wages , salaries ,
to meet contingencies or take advantage of
business opportunities that may arise
Inventory:
a major portion of current assets . Can be raw
material, work in progress, and finished goods.
Too much of inventory means low profitability
and too little means loss of sales or customer
goodwill.

Accounts receivable :
When goods are sold on credit inventories
are reduced and accounts receivable
created. In highly competitive markets firms
are often forced to give credit to get
business.
Credit policy of a firm will have four
components Credit period, credit
standards,
Discount policy and Collection policy

Marketable securities:
They are temporary investments that the
company tends to liquidate when cash is
required .They are a substitute for holding
idle cash balance.
Loan from Banks :
Companies often avail short term loans to
fund their working capital requirements.

The net working capital of a company is

compared with industry standards to find
out if the company is generating enough
sales for the investment in working capital
and to take action to correct the situation.
Cash flow from operations is affected by
investment in working capital .Higher the
investment in working capital ,the lower is
the cash flow.

Procurement of raw material ,components

stores and spares for the mfg of the
product.
Conversion of raw material into finished
goods
Storage of finished goods before they are
sold
Sales on credit to customers and
Collection of cash from customers
RM + WIP+FG+REC

Operating cycle is also called a cash to cash

cycle. A firm will have at any given time
several operating cycles which are at
various stage of completion.

Total working capital =

total expected operating expenses
no of operating cycles in a year

Operating cycles will be relatively long in

construction and machine tool business
and relatively short in trading companies.

Working capital is a function of operating

expenses and length of operating cycles.
Reducing operating expenses or the
length of the operating cycle will reduce
working capital requirement and hence
increase efficiency of the firm.

Cash conversion cycle is a good measure

of how well management is employing its
tangible capital base . Rising cash
conversion cycles often indicates
deterioration in cash flows , while declining
cash conversion cycles generally signals
improving cash flows.

Cash conversion cycle not only highlights

the drivers of working capital but also
reflects on the dynamics of supply chain .
It quantifies the time between the cash
payment to suppliers and cash receipt from
customers .
Components of cash conversion cycle are :
Days sales outstanding
Days in inventory
Days payable in outstanding

Self financeable growth rate is the rate at

which a company can sustain its growth
through the revenues it generates without
seeking outside capital .
the shorter the cycle , the faster a company
can redeploy its cash and grow from
internal revenue sources.

Extra money generated from each rupee of

sales over and above that invested in
working capital and operating expenses
can be re-invested in additional working
capital and operating expenses to
generate more revenue in the next cycle.

3 ways to increase growth rate:

1. Speeding cash flow by accelerating
receivables collection and improving
inventory turnover.
2. Reducing cost of sales.
3. Raising prices without hurting demand.

Banks provide finance for holding an

acceptable level of current assets for
achieving a predetermined level of
production and sales.

Each component of working capital needs to

be estimated to quantify the funds
required for working capital

Raw materials
A company has to stock a minimum quantity of raw
material to ensure smooth running of operations
.The required level of inventory can be estimated
by :
Average consumption of raw material
Availability of raw materials
Lead time between ordering and receipt of
material
Cost of holding stock
Transportation charges and seasonality of the
item.

Work in progress
There is a time lag between conversion of
raw material into a finished product. Time
taken for processing varies from industry
to industry. Factors affecting WIP are:
Processing time
Batch quantity
Number of shifts and plant capacity

Finished goods
A certain quantity of finished goods may
have to be held as stock awaiting sale.
Quantity stored will depend on :
Variation in demand
Transportation delay
Nature of business machine tools against
order and soaps against expected orders.
Seasonality

Expenses:
normally one months direct and indirect expenses
are included in the working capital requirement to
provide for temporary bottleneck.
When operating cycles are short ,provision may be
reduced and when operating cycles are long
provision for working capital has to be increased.
Credit available from suppliers and advance
payment received from customers will have to be
considered while determining the working capital
requirements.

Banks provide working capital finance by

way of advance against stocks and debtors.
Full amounts are not normally advanced
and the promoter is expected to bring in the
margins required to ensure promoter stake
in the business.

Motivations of credit sales

1. Selling on credit induces customers to buy
more .Growth in sales revenue is considered
as a healthy situation.
2. As sales increases profits generally increase
as long as benefit of granting credit exceeds
cost.
3. Credit sales can be a potential marketing
tool. Credit terms could be used to
differentiate from competitors or match
industry norms.

Cost of extending credit

Three types of costs are incurred in maintaining
receivables.
1. Cost of financing receivables
2. Administrative and collection expenses
3. Bad debt losses.
Receivables are financed from current income or new
debt or equity. Cost involved in maintaining sales
ledgers, personnel to follow up payments , etc are
admn and collection costs.
All customers may not pay on or before the due date .
Some of the receivables may become bad debts
losses.

Obtaining bank references

Obtaining references from other reliable

third parties

Financial statement analysis and

Obtaining formal credit rating from

agencies

Bad debts
When it is certain that a customer will not
pay dues it is prudent to write off the
amount as bad debt loss. Selling goods on
credit to high risk customers may increase
sales but it will also depress profit if the
account terms are bad.
A bad debt may turn to be good at a later
point of time

A sales organisation may classify its

outstandings or receivables age wise to
bring in sharp focus in collections. They
can be classified as
Receivables < 30 days
Receivables 30- 60 days
Receivables 60-90 days and
Receivables > 90 days

For monitoring, the data available in the

ageing schedule could be converted into
measures of effectiveness of credit policy
like average collection period (ACP) and
Days sales outstanding (DSO).

Credit evaluation
Five Cs of credit are:
Character willingness to meet obligations
Capacity -to meet credit obligations from
operating cash flows.
Capital the customers financial reserves
Collateral an asset pledged in case of
default
Conditions general economic conditions in
the customers line of business.

Working capital loans:

provided to meet day to day expenses like
purchase of raw materials ,consumable
stores/spares etc. These are of continuous
nature and are renewed every year.
Term loans : for acquiring fixed assets and also
for meeting long term working capital .
Normally repayable over 3-5 years
depending on profit generation capacity of
the unit

The borrower has to provide at least 25% of

the current assets from the long term funds.
Total current liabilities (incl bank finance
should not exceed 75% of current assets.
Maximum permissible bank finance (MPBF)
The Tandon committee report had
recommended 3 methods for calculation of
MPBF.
1. 0.75(CA-CL)
2. 0.75(CA)-CL
3. 0.75(CA-CCA)-CL

Types of Credit facilities

1. Cash credit borrower can withdraw funds as
and when required up to a predetermined
level. Interest is charged only on the utilised
portion and is similar to an overdraft facility.
2.Packing credit-given for exports , carries low
interest rates.
3.Bills purchased /discounted A banker
purchases /discounts the bill and credits the
amount in the sellers account after
deducting the discount.

4.Term loan sanctioned normally to acquire block assets

like buildings ,plant & machinery
,expansion,modernisation.Also given against long term
working capital requirements.
5.Working capital demand loan short term loan normally
for 3 months .
6.Letter of credit four parties to an LC are :
applicant (or opener)is the importer
Issuing bank which opens the LC.
Beneficiary ,exporter in whose favour the LC is
opened and Advising bank normally based in the
exporters place.