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Working Capital Management

Session 8

What is working capital?

Working capital measures how much in liquid assets a company has available to build its business. The number can be positive or negative, depending on how much debt the company is carrying. Companies that have a lot of working capital will be more successful since they can expand and improve their operations. Companies with negative working capital may lack the funds necessary for growth. Working capital = Current assets - current liabilities

Purpose of Working Capital

Working capital is required to meet day to day operating expenses and for holding stocks of raw materials, spare parts, consumable, wrok in progress and finished goods. Working capital typically means the firms holding of current or short term assets such as cash, recievable,inventory and market securities. These items are also refered as circulating capital.

Purpose of Working Capital

To hold the stock of raw materials for such a period so as to facilitate an uninterrupted supply of raw material to production process. To hold the stock of work in progress for process peroid To hold the stock of finished goods for such a peroid so as to meet the demands of customers on continuous basis and sudden demand from some customer To grant credit to its customers for marketing and competitive reasons. To hold cash balances to meet the manufaturing, office and administraive, selling and distribution exp,taxes etc

Need for Working Capital

It is needed because of the existence of operating cycle Operating cycle is the duration of time between acquisition of supplies and the collection of cash from receivables Basically, working capital is required to finance operations during cycle for the business to run smoothly.

Concept of working capital

There are two possible interpretation of working capital : Balance sheet concept
There are two :
Excess of current assets over current liabilities is called net working capital Gross or total current assets

Operating cycle concept

Operating Cycle

Operating cycle
WCC is defined as the time period required for the whole operation starting with cash to cash plus (assumes profit). It expresses in month days. Operating cycle - OC is equal to the length of inventory and receivables conversion period. OC = R + W + F + D C R = Raw material W = Work in process F = Finished goods waiting period D = Debtors collection period C = Creditors payment period. It helps not only in forecasting working capital requirement but

Calculation of components of operating cycle (in days)

Average raw material Storage period Average work in progress holding period Average finished goods storage period Average Debtors collection period Average Creditors payment period Average time lag in payment of expenses Gross operation cycle Net operation cycle

Concepts of working capital

Balance sheet concept Gross Working Capital
It refers to the firms investment in current assets. Current asset refer to the assets which are held for their conversion into cash within a operating cycle.

Net Working Capital

It refers to the difference between current assets and current liability.

Gross Working Capital


+ = +
Inventories Raw Material Work in progress Finished goods

Gross working capital

Short term marketable securities and other current assets

Gross WC = all current assets Net WC = current assets current liabilities Current assets;
Raw material Work in progress Finished goods Others

Trade debtors Loans and advances Cash in hand and bank

Current liabilities
Sundry creditors Trade advances

Permanent Working Capital Temporary Working Capital

Importance or Advantages of Adequate Working Capital:

Helps in arranging loans from banks & others on easy and favourable terms Enables a concern to avail cash discount and hence reduce cost. Ensures regular supply of raw material. Regular payment of salaries, wages and other day to day comittment. Enables a concern to face business crisis.

Excess or Inadequate WC
Ideal funds. Loss of return on investment It may lead to unnecessary purchasing & accumulation of inventories. It may implies to defective credit policy or liberal policy

Disadvantages or Dangers of Inadequate WC

A concern which has inadequate WC, cannot pay its short term liabilities in time. Cannot buy its requirements in bulk & cannot avail of discounts etc. Create inefficiency Becomes difficult to use efficiently fixed assets due to non-availability of liquid funds.

Factors Determining Working Capital

Nature of the business Size of Business Manufacturing Cycle / Time Demand and supply of the product Volume of sale Credit policy

Growth and expansion activities Price level changes Inventory policy Dividend policy

Nature of Business
Nature of Business Small trading concern or retail shop Requirement of WC Small Reason Operating cycle period is small sinceMostly cash sales Carry small quantities of goods Small debtors balance Carry small amount of cash Operating cycle period is small sinceLarge quantity of stock Carry large amount of cash and debtors balance Carry large quantity of raw material, work in progress, finished goods, debtors and cash

Large trading firm


Manufacturing firm


Nature of business Public utility (electricity generation and supply, water supply) Hotels, Restaurants and eating houses

Requirement of WC Small

Reason They have cash sales They supply services and not products They mostly have cash sales and only small amount of debtors balance They require large quantities of goods to be held in stock They carry large debtors balance They carry large debtors balance


Trading firms


Financial firms


Factors influencing Working Capital

Nature of business
eg: manufacturing, transportation

Technology Management attitude Seasonality of operation

eg: cold drinks

Production policy
Production of ceiling fan through out the year

Market condition
Depends on competition.

Sale of finished goods and collection of cash Conditions of supply

Prompt or unpredictable.

Disadvantages of excess Working Capital Ideal funds Unnecessary purchasing Inefficiency in the organisation Due to low rate of return on investment, market value of shares may fall. Disadvantages of short Working Capital Cant pay off short term liabilities Difficult for firm to exploit favourable market conditions Improper utilisation of fixed assets.

Step 1:Make the estimates of various current assets as follows: Stock of = est annual cost of RM to be consumed x avg RM holding period raw mat. 12 months or 365 days Stock of = est annual cost of goods to be produced x avg WIP holding period WIP 12 months or 365 days Stock of = est annual cost of goods to be produced x avg FG storage period Fin Goods. 12 months or 365 days Average = estimated annual cost of credit sales x avg collection period Trade debtor 12 months or 365 days Cash and bank balance = minimum as desired by the firm

Estimate of future WC based on current assets and current liabilties

Estimate of future WC based on current assets and current liabilties

Step 2:Make the estimates of various current Liabilities as follows: Average = Estimated annual cost of credit purchases x avg credit period availed Trade Creditors 12 months or 365 days Average Creditors = Expenses for the year x avg time lag in payment For expenses 12 months or 365 days

Estimate of future WC based on current assets and current liabilties

Step 3: make estimate of WC by taking out the difference between the current asset and current liability


Session 8

Receivables Management
Receivables management means planning, directing and controlling of receivables. It answers the following questions:
To whom credit should be allowed How much credit should be allowed How much amount of credit should be alloed

Objective of Receivables Management

Consequences of Excessive Receivables High opportunity cost of investment in Receivables High Risk of Bad debts High Credit Administration Cost High Risk of Liquidity Consequences of Inadequate Receivables Decrease in Sales

Risk of Loosing Market Share

What are receivables? Receivables are sales made on credit basis. Receivab les Operating Cycle

Why do we need receivables? Reach sales potential Competition


Understanding Receivables As a part of the operating cycle Time lag b/w sales and receivables creates need for working capital Inventory

Basic decisions

1. To give credit or not


2. Duration of credit period (selecting the right policy)

Decision based on cost-benefit analysis Positive net benefit-Credit granted (Highest Net benefit policy chosen) Negative net benefit- Credit not granted


COLLECTION COST: Administrative costs incurred in collecting the accounts receivable. CAPITAL COST: Cost incurred for arranging additional funds to support credit sales. DELINQUENCY COST: Cost which arises if customers fail to meet their obligations. DEFAULT COST: Amounts which have to written off as bad debts.


Credit Trade Policy

Credit gives the customer the opportunity to buy goods and services, and pay for them at a later date. Advantages of credit trade Results in more customers than cash trade. Can charge more for goods to cover the risk of bad debt. Gain goodwill and loyalty of customers. People can buy goods and pay for them at a later date. Can be used as a promotional tool. Increase the sales. Disadvantages of credit trade Risk of bad debt. High administration expenses. People can buy more than they can afford. More working capital needed. Risk of Bankruptcy.

The 5 Cs of Credit
Customer Evaluation- The 5 Cs Character- Reputation, Track Record Capacity- Ability to repay( earning capacity) Capital- Financial Position of the co. Collateral- The type and kind of assets pledged Conditions- Economic conditions & competitive factors that may affect the
profitability of the customer

To get info on the 5 Cs a firm may rely on: Financial statement Bank references Experience of the firm Prices and Yields on securities

Obtaining Credit Information

Obtaining Credit Information is the first step in the evaluation process Application Forms Historical Financial Statements External Sources

External Sources of Credit Information

Credit Interchange Bureaus can provide firms with factual data regarding the credit history.

Direct Credit Information Exchanges provide participants with credit information Bank Checking may provide vague credit information (from the applicant's bank)
FCU check

Analyzing Credit Information

Analyzing Credit Information is the next step in the evaluation process Procedures Economic Considerations The Small Business Problem Credit Scoring is a good (and inexpensive) way for firms extending credit to a large number of small accounts to address credit analysis

Credit Policy- three decision variables

Credit Policy

Credit Standards

Credit Terms

Collection Efforts

1.Credit Standard
Credit Standards are the minimum requirements for extension of credit to a customer Liberal Credit Standards

Push sales by attracting more customers, higher incidence of bad debts loss, a larger investment in receivables, higher collection expenses.
Stiff credit standards

Opposite effect

Credit Standard
Standard Effect on sales Effect on Effect on credit bad debts administration cost Increase in credit administration cost

Soft Increase in Increase standards sales in Bad debts Tight Decrease standards in sales

Decrease Decrease in credit in Bad administration cost debts

Making The Credit Standard Decision

Two factors should be considered:
Average collection peroid Default risk
Character Capacity Condition
History of customer Good Marginal Bad Average collection period Within credit period Moderate collection period Very large collection period Default risk 0 Moderate High

Credit Term
Credit Period
It is the length of time for which credit is granted net 60

Cash Discount
2/20 net 60

Type of term Effect on sales

Effect on Effect on investment bad debts in accounts receivables Increase in Increase in investment bad debts in accounts receivables

Effect on credit administrati on cost Increase

Soft Term

Increase in sales

Tight Term

Decrease in Decrease in Decrease in Decrease sales investment bad debts in accounts receivables

Collection Efforts
Monitoring the state of receivables Dispatch of letter to customers whose due date is approaching Telegraphic and telephone advice around due date. Threat of legal action to overdue accounts. Legal action against overdue accounts. A rigorous collection programme

Decreases sales, shorten the average collection period, reduce bad debts %, increase the collection expenses.
A lax collection programme

Opposite influence

Collection Policy
Collection Policy is the set of procedures for collecting a firm's accounts receivable when they are due Introduction
Bad debt expenses are a function of both credit policy and collection policy
In general, increasing collection expenditures reduce bad debt

Types Of Collection Techniques

Letters of Reminder Phone Calls Personal Visits Collection Agencies or Attorneys Legal Action

Factors which influence credit conditions

Nature of the business's activities Financial position Product durability Length of production process Competition and competitors' credit conditions Country's economic position Conditions at financial institutions Discount for early payment

Effective credit control

Increases sales Reduces bad debts Increases profits Builds customer loyalty Builds confidence of financial industry Educating customers for credit history

Sources of information on creditworthiness

Business references Bank references credit agencies Chambers of commerce Employers Credit application forms

Opportunity Cost & its calculation

Debtors Policy-Total Approach (Proforma) Particular Present Proposed

policy A. Expected Profit: 1. Credit sales 2. Total Cost VC & FC 3. Bad debts 4. Cash discount 5. Expected profit 6. Less tax 7. Profit after tax B. Opportunity cost of investments in receivables locked up in collection period C. Net Benefits (A-B) policy


Debtors Policy-Incremental Approach


Pro policy

A. Incremental Expected Profit: 1. Incremental Credit sales 2. Incremental Credit Cost( VC & FC) 3. Incremental Bad debts losses 4. Incremental Cash discount 5. Incremental Expected profit 6. Less tax 7. Incremental Profit after tax B.Req return on incremental investments: 1. Cost of credit sales 2. Collection period 3. Investment in recievabless (1 x 2/365) 4. Incremental investment in rec. 5. Req rate of return 6. Req rate of return on incremental investment (4 x 5)

C. Incremental Net Benefits (A-B)

Inventory Management

Inventory Management
It means planning, organising, directing and controlling of inventory. How much inventory should be ordered at a particular point of time? It answers:
How much to order When to place an order

Objective of Inventory Management

To avoid the situation of excessive and inadequate inventory & to maintain optimum level of inventory
Consequences of Excessive Inventory Opportunity cost of funds ties up in inventory Excessive carrying costs such as storage cost, handling cost, insurance etc Risk of liquidity Consequences of Inadequate Inventory Interruption in production Excessive stock out costs

Need for Holding Inventory

Transaction Motive Precautionary motive Speculative motive

Techniques of managing inventory

ABC Analysis Economic Order Quantity (EOQ)

It is the order which is placed when the stock reaches re-order level. EOQ refers to the quantity of inventory, at which total of ordering and carrying cost is minimum. The objective of EOQ is to determine that order size which is most economical to order

Ordering cost

Carrying cost

The term ordering cost refers to the cost The term carrying cost refers to the cost incurred for aquiring inputs. These cost incurred in maintaining a given level of includes: inventory. These cost includes: 1. Cost of placing an order 2. Cost of transportation 1. Cost of storage cost 3. Cost of receiving goods 2. Cost of handling material 4. Cost of inspecting goods 3. Cost of Insurance 4. Cost of obsolescence There is inverse relation with ordering 5. Cost of store staff cost and ordering size There is positive relationship between order size and carrying cost Larger the order size Lower the ordering Larger the order costs because of size fewer order Higher the carrying costs because of high average inventory Lower the carrying costs because of low average inventory

Smaller the order size

Higher the ordering costs because of more order

Smaller the order size

Assumptions of EOQ
Annual usage (consumption) of inventory is known Rate of usage is known and constant Ordering cost are known and constant Carrying cost are known and constant Zero lead time/ delivery peroid.

A = annual consumption of Input O = ordering cost per order C = carrying cost per unit No. of orders per year = total annual consumption (in units) / order size Frequency of orders = 365 days / No. of orders in a year Total annual ordering & carrying cost at EOQ = 2AOC

Inventory Management

Session 7

Re-order Quantity

Reorder Level
The objective of fixing re order level is to determine when fresh order should be placed. ROL = Maximum rate of consumption X max re order period

Maximum level
It is that level of stock above which the stock in hand should not normally be allowed to exceed. It is the largest quantity of a particular material which may be held in the store at anytime. Objective is to avoid the cost of over stocking cost of storage, insurance,risk etc

The level is fixed after considering following factors:

Re order level & quantity Min. rate of consumption & reorder peroid Availability of working capital & storage space Extra cost of storage and insurance Price fluctuation Risk of deterioration

Max level = Re-order level + Re-order quantity (minimum consumption x min reorder period)

Minimum level
It is the lowest quantity of a particular material which must be held in the store at all time. The objective of fixing the min. level is to avoid the costs of under stockingsuch ascost of stoppage of production, cost of idle labour , cost of idle plant & machinery.

The level is fixed after considering following factors:

Re-order level Normal rate of consumption Normal Re-order peroid

Formula: Min level = Re-order Level (Normal consumption x normal re-order period)

Average Stock Level

Formula: Avg stock level = Max level + Min level 2

Danger level
It is the level at which normal issues of the raw material inventory are stopped and emergency issues are only made on special requisition approved by the authority The level is fixed after considering following factors:
Average consumption Max re-order period for emergency purchases

Formula =Average consumption x max re-order peroid for emergency purchases

ABC Analysis
ABC analysis is a system of inventory control. It exercises discriminating control over different items of stores classified on the basis of the investment involved.

Catego Composition ry A

Working of ABC Analysis

It consist of those items which require large investments ( say about 70% of total value of stores) but constitute a small percentage (say 10%) of total items of stores

Degree of control High degree of control is exercised by use of various techniques such as fixing stock level like max level, min level, reorder level. Moderate degree of control is exercised. Order are placed on a periodic review basis

It consist of those items which require relatively moderate investments ( say about 20% of total value of stores) but constitute relatively moderate percentage (say 20%) of total items of stores It consist of those items which require small investments ( say about 10% of total value of stores) but constitute a large percentage (say 70%) of total items of stores

Lower degree of control is exercised. Order of large size are placed either after 6 months or once in a year to minimize ordering costs and to take advantage of bulk purchase

Techniques for Managing Inventory

The ABC System The ABC System is a technique that divides inventory into three categories of descending importance based on the dollar investment in each category Group % of Items % of Investment Degree of Control A 20 70-80 Tight B 30 10-20 Average C 50 <10 Loose 'A' group items are controlled on a daily basis; 'B' group items are controlled on a periodic (e.g. weekly) basis; 'C' group items are often controlled by a red-line method under which a reorder is placed when a redline drawn inside an inventory bin is exposed

ABC Analysis

Advantages of ABC Analysis

It ensures effective control on costly items, which requires large investment (A) It saves time and cost by exercising economic systems of control over low value items (C) It ensures optimum investment in inventory considering the operational requirements and financial resources with use of EOQ It ensures minimum total cost

Inventory Management
Inventory is necessary to permit the production-sale process to operate with a minimum of disturbance Inventory may represent as much as 42% of a typical manufacturing firm's current assets and about 18% of its total assets Inventory is commonly under the control of the production/operations manager, but the financial manager generally acts as a watchdog and advisor in matters concerning inventory

Inventory Fundamentals
Types of Inventory include: Raw materials used in the manufacture of finished products Work-in-process which consists of items in production Finished goods which are produced but not yet sold Differing Viewpoints About Inventory Level Financial Manager: low levels to minimize cost Marketing Manager: high levels to minimize stockouts and maximize customer service Manufacturing Manager: high levels to ensure timely and low-cost production Purchasing Manager: high levels (of raw materials) to secure low cost per unit and ensure ready availability

The Relationship Between Inventory And A/cs Receivable

Inventory often becomes an account receivable before it becomes spendable cash. A decision to extend credit to a customer may increase sales, which will in turn be supported by higher levels of inventory and accounts receivable Generally the cost of carrying accounts receivable is less than the cost of carrying inventory since physical handling, storage, and insurance costs are reduced