WORKING CAPITAL

MANAGEMENT
The Balance-Sheet Model of the Firm

The Capital Budgeting Decision

Current
Liabilities
Current Assets
Long-Term
Debt

Fixed Assets What long-

term
1 Tangible investments Shareholders’
2 Intangible should the Equity
firm engage
in?
The Balance-Sheet Model of the Firm

The Capital Structure Decision

Current
Liabilities
Current Assets
Long-Term
How can the firm Debt
raise the money
for the required
Fixed Assets
investments?
1 Tangible
Shareholders’
2 Intangible Equity
The Balance-Sheet Model of the Firm
The Net Working Capital Investment Decision
Current
Liabilities
Current Assets
Net
Working
Long-Term
Capital Debt

Fixed Assets How much short-

term cash flow
1 Tangible does a company
Shareholders’
need to pay its
2 Intangible bills? Equity
Tracing Cash and Net Working
Capital
 Current Assets are cash and other assets that are
expected to be converted to cash with the year.
 Cash
 Marketable securities
 Accounts receivables
 Inventory
 Current Liabilities are obligations that are expected to
require cash payment within the year.
 Accounts payable
 Accrued wages
 Taxes
Traditionally, working capital has been defined as the firm’s
investment in current assets. Current assets are required to
be maintained for day-to-day operations of the firm.
The assets keep changing from one form to another from
stocks, receivables and cash.
Working capital decisions are of tremendous importance for
any firm because:
Such decisions affect the business’s liquidity position.
They provide learning experience and require
management interventions at regular intervals.
 Features Of Working Capital Decisions

 Working capital decisions are typically

Short-term financial decisions, i.e., working capital decisions

typically affect the cash flows of the firm for a shorter time
frame, extending up to a maximum of one year, normally.
The concepts of risk and time value of money are less pertinent
to working capital decision-making.
They are modified from time to time unlike capital budgeting
decisions, which are one-time.
Concept of working capital is dynamic as market conditions
with respect to credit, stocking etc change more frequently.
 Meaning Of Working Capital
Working capital is subject to multiple connotations.
 From the accountants’ perspective working capital refers to
the differential of current assets and current liabilities.
 From production managers’ view it refers to the total funds
that a firm needs to carry out its day-to-day operations.
 From the finance managers’ angle it implies the total
investment made in current assets.
 Working capital integrates Purchasing – Production –
Marketing functions.
 The adequacy of working capital would enable smother
functioning of the three functions.
 Meaning Of Working Capital

 Working capital, alternatively referred to as current or circulating

capital, is the investment made by firms in their current assets.
 Current assets comprise all assets that the firm expects to
convert into cash within the year. This includes
Cash and bank balance (already in cash form),
marketable securities,
accounts receivable, and
inventories.
 Gross And Net Working Capital

Gross working capital (GWC) is defined as investment in

current assets.
Net working capital (NWC) is defined as excess of current
assets over current liabilities.
Both concepts (GWC and NWC) are equally important in the
management of working capital, as both are related.
One is a measure of the level of current assets while the
other measures the extent to which long-term sources of
financing have been used to finance current assets.
 Gross Working Capital (GWC)
 Gross working capital (GWC) refers to the total investment
made by a firm in current assets.
 It is termed as managers’ concept of working capital.
 It denotes the liquidity position of the firm.
 Other factors remaining the same, the higher the GWC of a
firm, the better its liquidity position.
 Increasing GWC affects profitability adversely as more funds
get tied up in current assets that have low/zero yield.
 Net Working Capital (NWC)
 Net Working capital (NWC) refers to the difference between current
assets and current liabilities (CA – CL).
 This differential denotes that part of current assets which is financed
by long-term sources of financing.
 It is referred to as the accountant’s definition of working capital.
 An increasing NWC indicates an improving liquidity position of the
firm.
 Operating Cycle
 Operating cycle refers to the time elapsed between
procurement of raw material to realization of cash from the
finished goods.
 Operating cycle and its management assumes significance in
the context of working capital management.
 Larger the operating cycle, larger is the requirement of working
capital.
The Operating Cycle and the Cash Cycle

Raw material
Cash
purchased Finished goods sold
received
Order Stock
Placed Arrives

Inventory period Accounts receivable period

Time
Accounts payable period

Firm receives invoice Cash paid for materials

Operating cycle
Cash cycle
 Operating And Cash Cycle

 Cash cycle refers to the time elapsed between payment of raw material to
realization of cash from the finished goods.
 Operating cycle generally is larger than the cash cycle.

Cash cycle = Operating cycle – Credit period availed on

raw material.
 Cash cycle would be larger if firms make advance payment for procuring raw
material.
 Example- Computing Working Capital
 Expected level of production 10 lac units
 Selling price per unit Rs 10
 Raw material, wages and overheads constitute 40%, 20% and 20% respectively.
 Holding periods:
 Raw material: 3 months Work in process; 2 months
 Finished goods: 2 months Credit given: 3 months
 Credit availed: 4 months
 15 days credit is available for wages and overheads
 Cash balance required Rs 1,50,000
 Contingency 10% of current assets
FIND Gross Working Capital and Net Working Capital.
 Computation Of Working Capital

Current Assets Rs lacs

 Raw materials 4 x 10L x 3/12 = 10.00
 Work in process 8 x 10L x 2/12 = 13.33
 Finished goods 8 x 10L x 3/12 = 20.00
 Debtors 8 x 10L x 3/12 = 20.00
 Cash = 1.50
 Contingencies 10% of 63.33 = 6.34
Current Assets = Gross working capital = 71.17
Current Liabilities; Creditors for
 Materials 4 x 10L x 4/12 = 13.34
 Wages 2 x 10L x 1/24 = 0.83
 Overheads 2 x 10L x 1/24 = 0.83
Current Liabilities = 15.00
Net working capital (CA – CL) = 56.17
 Scope Of Working Capital Management

 Working capital decisions affect the firm’s profits through their impact on sales,
operating costs, and interest expense.

 They affect the firm’s risk through their impact on the variability of the firm’s cash
flows, the probability of not receiving the cash flow, and the ability to generate
cash in a crisis.

 The working capital policy touches upon almost every functional area of the
business’s operation.

 Working capital management affects and gets affected by the different

operational decisions in a firm.
 Working Capital Needs Of Different Types Of
Business
 The amount of working capital requirement depends, inter alia, upon the
nature of business.
 Seasonal industries may require a much higher level of working capital in
peak seasons and a much lower requirement during slack seasons
Working Capital Needs Of Different Types Of
Business
Current assets to total assets ratio for
different industries
Industries Current assets to total assets (%)
Trading 75–77
Medicines 65–70
Engineering 60–65
Aluminium 45–50
Paper 40–45
Shipping 15–18
 Working Capital Management
And
Business Solvency
 The level and quality of current assets held by the firm determine its solvency.
 The higher the level of current assets, the higher would be the capacity to
transform these current assets and generate cash.
 Quality of current assets also affects the liquidity position of the business.
OPERATING CYCLE AND WORKING CAPITAL
MANAGEMENT
 The prominent techniques that the firms are taking recourse to for cutting
down their operating cycle are:
 Outsourcing of various processes (such as production, distribution, collection,
etc.)
 Setting up vendor-managed inventories
 Reducing the collection float by using banks with accelerated clearing
capabilities
 Bringing about technology up gradation to achieve reductions in the conversion
period for in-house operations
 Working Capital
Management
 Working capital management is alternatively referred to as current assets
management as it relates to the management of level and financing of firms’
current assets.
 The two issues that need to be addressed are
 What should be the optimal level of current assets held by the firm?
 How should these current assets be financed?
 Working Capital
Management
 Current assets are important as they determine the liquidity position of the firm.
 The level of investment in current assets depends on:
 Nature and type of business;
 Length of operating cycle;
 Seasonality of operations;
 Degree of uncertainty; and
 Prevailing and emerging market conditions.
 Working Capital
Management
 There is a risk–return tradeoff in holding current assets. Increased investment in
current assets increases liquidity (thus decreasing the risk) but reduces profitability
(return)
 The optimal level of current assets is decided in the light of the tradeoff between
the cost of liquidity and the cost of illiquidity.
 Working Capital
Management
 Current liabilities provide cheaper and flexible financing options. However
there are availability and cost related uncertainties with the current
liabilities
 Increased usage of short-term sources of financing (i.e., current liabilities)
increases profitability but reduces liquidity
 Financing Policy

 The working capital financing policy may have a significant impact on the
profitability–liquidity position of the firm.
 Theoretically, the policies of working capital financing can be categorized as:
 matching;
 conservative; and
 aggressive.
 Working Capital Policy

 Depending upon the current assets policy and the current assets financing
policy a firm’s working capital policy can be categorized as conservative,
aggressive or moderate
Working Capital Policy