Working Capital

Management
The goal of working capital
management is to manage the firm’s
current assets and current liabilities in
such a way that a satisfactory level of
working capital is maintained. This is
so because if the firm cannot
maintain satisfactory level of working
capital, it is likely to become insolvent
and may even be forced into
bankruptcy.
 Definition
• Net working capital is the difference
between current assets and current
liabilities.
• Net working capital is that portion of a
firm’s current assets which is financed
with long term funds.
Every firm operate with some level of
working capital depending upon the size
and nature of the industry and various
other factors.
 Trade-off between
profitability & Risk
The level of firm’s has a bearing on its
profitability as well as risk. The term
profitability used in this context is
measured by profits after expenses. The
term risk is defined as the probability
that a firm will become insolvent.
 Nature and assumption
The basic assumptions are as follows
•We are dealing with a manufacturing
firm
•Current assets are less profitable than
fixed assets
•Short term funds are less expensive than
long term funds
Total Assets=Current Assets +Fixed Assets
Net Working Capital = Current Assets- Current
Liabilities
For this two ratios are calculated
and analyzed on the criteria of risk
and profitability:
•Effect of level of current assets
on profitability and risk
•Effect of level of current liability.
Current Assets/Total Assets
Ratio
This ratio indicates the percentage of
total assets that are in the form of
current assets. A change in the ratio
will reflect a change in the amount of
current assets.
• Effect of higher ratio
• Effect of Decrease
Current Liability/Total Assets
ratio
This ratio will indicate the percentage
of total assets financed by current
liabilities. The effect of in the level of
current liabilities would reflect in the
profitability.
• Effect of increase
• Effect of decrease
Planning of working Capital

Cash Inventory

Receivables
 Operating Cycle
“The continuing flow from cash to
suppliers, to inventory, to accounts
receivables and back into cash is called
the operating cycle”.
Since the cash outflow and cash inflow do
not match, firms have to necessarily keep
or invest in short term liquid securities so
that they will be in a positions to meet
obligations when they become due.
 Types of working capital

• Permanent working capital (fixed)

• Temporary working capital (variable)
Estimating Working Capital
Requirement
For this purpose the length of cash to cash
cycle is measured:
Gross operating cycle=inventory
Conversion period + Debtors
conversion Period
=(RMCP+WIPCP+FGCP) + DCP
Conversion period depends on
• Consumption per day
• Inventory
RMCP=Raw Material
Inventoryx360/RMC
Similarly, WIPCP= WIPIx360/COP
FGCP = FGIx360/COGS
Debtors conversion period
=Debtors x360/Credit Sales
Payment Deferral Period (PDP)
= Creditors x 360/credit purchases
Net Operating Cycle= Gross
operating cycle- Payment
Deferral Period.
 Factors affecting Working
Capital
• Nature of Business:Public utility and trading
company
• Production Cycle: Distillery and Bakery
• Business Cycle: recession and boom
• Production Policy: seasonal variations
• Credit Policy: liberal and strict
• Growth and expansion:growing and static Comp
• Availability and fluctuations in raw material
• Profit Level: extent of cash profit
• Price level changes: rise in level high W.Cap
• Operating Efficiency
 Cash Management

Motives:
Transaction motive
Precautionary Motive
Speculative Motive
Compensation Motive
Factors determining Cash
needs
• Synchronization of cash needs
• Short costs
• Excess cash balance cost
• Procurement & management
cost
• Uncertainty cost
Cash Management
Techniques
• Efficient Inventory Management

• Speedy collection of accounts

receivable
4. Prompt payment by customers
5. Early conversion of payment into
cash
Speedy collection
techniques
• Concentration Banking
• Lockbox System
 Receivables Management

Receivables management is done to

evaluate the credit policy of the
organization as the credit policy
affects the working capital position
indirectly.
It is also known as Trade-Credit
Management because it has to strike
a balance between liquidity and
profitability.
 Cost associated with Debtors
Management
• Collection cost
• Capital cost (additional capital)
• Delinquency Cost (blocking of funds)
• Default Cost
 Benefits

• IT is oriented to sales expansion

• Protection to current sales against
competition
 Decision Areas

• Credit Standard- character, capacity

and condition
• Credit Terms- credit period and
discount
• Collection policies
 Inventory Management

Inventory is of three types:

• Raw Material
• Work in Process
• Finished Goods
 Objective

• To minimize the firm’s investments in

inventory
• To meet demand for the product by
efficiently organizing the firm’s
production and sales operations.
 Cost of Holding Inventory
• Ordering cost: it is the cost associated with
the ordering of inventory from suppliers. It
is inversely related to the size of inventory
ordered.
• Carrying cost: the cost associated with
maintenance or carrying of inventory such
as storage, insurance and opportunity cost
of funds. Carrying cost and size of the
inventory are positively related.
 Inventory
Control/management
• The classification problem (ABC
analysis)
• The order quantity problem (EOQ)
• The order point problem (Reorder
point)
• Safety Stock
 Economic Order Quantity
It is the level of inventory order that
minimizes the total cost associated with
inventory management.

EOQ=√2SO/C
Where, s=usage unit for the inventory
planning period
O=the ordering cost per unit
C=the carrying cost per unit
 Reorder point
That level of inventory when fresh order
should be placed with the suppliers for
procuring additional inventory equal to the
EOQ.
Reorder point=Safety Stock + (lead time
in days X avg. daily usage of inventory)
Lead time refers to the time normally
taken in receiving the delivery of inventory
after placing the order with the suppliers.
Average usage means the quantity of
inventory consumed daily.
 Safety Stock
The effect of increased usage and/or slower
delivery would be a shortage of inventory.
The firm may face stock-out situation.
Therefore, firm keeps a sufficient safety
margin by having additional inventory to
guard against stock-out situation. Safety
stock is defined as the minimum additional
inventory to serve as a safety margin or
buffer or cushion to meet contingent
needs.