WORKING CAPITAL

THE CAPITAL FOR DAY-TO-DAY REQUIREMENTS

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WORKING CAPITAL
 Apart from financing for investing in fixed assets, every business
also requires funds on a continual basis for carrying on its day-to-
day operations.
 These include funding for expenses incurred for purchase of raw
material, manufacturing, selling, and administration expenses etc.
until such goods are sold and the monies realised.
 Business transactions are generally carried on credit with a number
of days elapsing between the sale of goods and realisation of
proceeds.

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WORKING CAPITAL
 While part of the raw material maybe purchased on credit, the
business would still need to pay its employees, meet
manufacturing & selling expenses (wages, power, supplies,
transportation and communication).
 Working capital refers to the need for funding and its sources of
financing by businesses on a continual basis for meeting these
needs.

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WORKING CAPITAL
Thus the need for working capital arises from
 Prevalence of credit in business transactions,
 Need to fund manufacturing expenses and maintaining support
for the manufacturing operations,
 Taking care of the variations in the supply of raw material,
 Providing for fluctuations in production schedules, and
 Providing for variations in demand for finished goods by
stocking.

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WORKING CAPITAL - DEFINITION
 Traditionally, working capital has been defined as the firm’s
investment in current assets.
 Current assets are those assets that are required to be maintained
for day-to-day operations of the firm.
 The form of assets keep changing from one form to another from
stocks to receivables to cash to stocks as time progresses.

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WORKING CAPITAL - FEATURES
 Working capital decisions are of tremendous importance for any
firm because:
 Such decisions affect the liquidity position.
 They provide learning experience and require interventions by
management at regular intervals.
 Working capital decisions are classified as short term.
 Long-term financial decisions have cash flow implications for a
period that may extend up to 20 years, or even more.

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WORKING CAPITAL - FEATURES
 Working capital decisions are typically
 Short-term financial decisions, i.e. less than one year.
 The concepts of risk and time value of money are less pertinent to
working capital decision-making as they typically span a time of less
than a year. As such concepts of time value of money, discounting for
risk etc. are ignored.
 They are modified as time progresses and offers opportunities for
learning and correcting managerial actions (unlike capital budgeting
decisions, which are one-time).
 Concept of working capital is dynamic as market conditions change with
respect to credit, stocking etc. more frequently making adjustments
necessary.

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CONNOTATIONS OF WORKING CAPITAL
Working capital is subject to multiple connotations.
 Accountants’ perspective working capital refers to the excess of
current assets over current liabilities.
 Production managers’ view it refers to the total funds that a firm
needs to carry out its day-to-day operations.
 Finance managers’ angle it implies the total investment made in
current assets.

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CURRENT ASSETS
 Current assets comprise all assets that the firm expects to convert
into cash within a year. These include
 cash and bank balance (already in cash form),
 marketable securities,
 accounts receivable, and
 inventories.
 Components of working capital keep changing their form as time
progresses. What is raw material today becomes finished goods
tomorrow, and account receivable another day and becomes cash
yet another day.

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OPERATING CYCLE
 Current assets keep changing
Account its form as time elapses.
Cash
Receivable
 Operating cycle refers to the
time elapsed between
procurement of raw material
to realisation of cash from the
Finished Raw finished goods.
Goods Material
 Larger the operating cycle,
larger is the requirement of
Work-in- working capital.
Process

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OPERATING AND CASH CYCLE
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.

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CASH CYCLE AND OPERATING CYCLE
CASH CYCLE

Realise
Sell cash
Process goods
Pay for materials
Procure materials
materials

OPERATING CYCLE

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OPERATING CYCLE AND VALUE ADDITION
Realise
Sell cash
Process goods
Pay for materials
Procure materials
materials

100% Cost of Cost of materials and Cost of materials and Cost of sales plus
materials 50% of overheads 100% of overheads profit margin

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WORKING CAPITAL AND
OPERATING CYCLE
Working capital is function of
1. Length of operating/cash cycle:
 Longer the operating/cash cycle larger is working capital required.
 As the cash takes longer to become cash again, the funds required
by the firm increase for it to sustain till the last round of cash
becomes available for use again.
2. Level of operation:
 Higher the level of operation larger is the working capital
required.
 For the same length of operating cycle, if the level of operation is
increased there would be almost a proportionate increase in the
requirements of working capital.
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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.
 GWC is a measure of the gross level of current assets while NWC
measures net level of current assets (CA – CL).
 NWC measures the extent to which long-term sources of financing have
been used to finance current assets.

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NET WORKING CAPITAL
Investment in current assets need to be financed. The sources can be two:
1. those available from the market i.e. current liabilities, and
2. through other long term means such as long term debt or equity.
Net working capital (NWC) refers to the difference between current assets
and current liabilities (CA – CL), is the LT financing for working capital.
GROSS WORKING CAPITAL
Investment in Current Assets

NET WORKING CAPITAL

CURRENT LIABILITIES
Funding current assets from
Funding current assets from business
long-term sources

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NEED FOR NET WORKING CAPITAL
 NWC needs to
 Be positive (CA must exceed CL)
 The excess of CA from CL must come from long term sources.
 Liquidity (positive NWC) is needed because
 Non-synchronous nature of current liabilities and current assets
warrants positive NWC.
 Maturity of current liabilities is predictable while timing of
conversion of current asset (stocks and debtors) into cash is not.
 Creditors can demand premature liquidation of liability while current
asset may not be mature for cash at that time.
 Business creditors would not be willing to fund entire current assets.

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ROE AND NET WORKING CAPITAL
 There is a risk–return trade-off 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 trade-
off between the cost of liquidity and the cost of illiquidity.
 NWC affects profitability and risk (risk of becoming insolvent in short
term)
 Larger NWC reduces risk of insolvency but decreases
 Lower net working capital increases risk (undesirable)and also increases
profitability and return on equity (desirable).
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COMPUTING WORKING CAPITAL
LEVEL OF OPERATION
 Expected level of production 10 lac units p.a.

VALUE ADDITION
 Selling price per unit Rs 10
 Raw material, wages and overheads constitute 40%, 20% and 20% respectively.

OPERATING CYCLE
Raw material : 3 months Work in process : 2 months
Finished goods : 2 months Credit given : 3 months
Credit availed : 4 months 15 days credit for wages and overheads
 Cash balance required Rs 1,50,000
 Contingency 10% of current assets
FIND Gross Working Capital and Net Working Capital

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COMPUTING WORKING CAPITAL
Current Assets Rs/unit x Level x Period 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

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WORKING CAPITAL GAP
 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.
 Working capital gap =
Current assets – Current liabilities w/o bank borrowings

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FINANCING WORKING CAPITAL
Method I
◦ 25% of WCG must come by long term sources
Method II
◦ 25% of current assets must come from long term sources
Method III
◦ All core current assets and 25% of remaining must come from long
term sources

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FINANCING METHODS
Method I Method II Method III
Projected current assets
400 400 400
(Assumed core assets:100)
Projected current liabilities other than
100 100 100
bank finance (creditors for materials)
Working Capital Gap (WCG) 300 300 300
Required equity contribution 75 100 175
Maximum Permissible Bank Finance
225 200 125
(MPBF)

Current ratio
Current ratio Current ratio
IMPACT always < 1.33 but
equals 1.33 always >1.33
> 1.00

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