WORKING CAPITAL

MANAGEMENT
Introduction
Traditionally, working capital has been defined as the firms
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 businesss 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, 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.
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 accountants definition of
working capital.
An increasing NWC indicates an improving liquidity
position of the firm.
Operating Cycle
Operating cycle is the time duration required to convert
sales, after the conversion of resources into inventories,
into cash. The operating cycle of a manufacturing
company involves three phases:
Acquisition of resources such as raw material, labour, power and
fuel etc.
Manufacture of the product which includes conversion of raw
material into work-in-progress into finished goods.
Sale of the product either for cash or on credit. Credit sales create
account receivable for collection.
Cont
The length of the operating cycle of a
manufacturing firm is the sum of:
Inventory conversion period (ICP).
Debtors (receivable) conversion period (DCP).
Operating cycle of a manufacturing firm
Gross Operating Cycle (GOC)
The firms gross operating cycle (GOC) can be
determined as inventory conversion period
(ICP) plus debtors conversion period (DCP).
Thus, GOC is given as follows:
Inventory conversion period
Inventory conversion period is the total
time needed for producing and selling the
product. Typically, it includes:
raw material conversion period (RMCP)
work-in-process conversion period (WIPCP)
finished goods conversion period (FGCP)

Debtors (receivables) conversion period
(DCP)
Debtors conversion period (DCP) is the
average time taken to convert debtors into
cash. DCP represents the average collection
period. It is calculated as follows:
Creditors (payables) deferral period (CDP)
Creditors(payables) deferral period (CDP) is
the average time taken by the firm in
paying its suppliers (creditors). CDP is given
as follows:
Cash Conversion or Net Operating
Cycle
Net operating cycle (NOC) is the difference between
gross operating cycle and payables deferral period.




Net operating cycle is also referred to as cash
conversion cycle.
Determinants of Working Capital
1. Nature of business
2. Market and demand
3. Technology and manufacturing policy
4. Credit policy
5. Supplies credit
6. Operating efficiency
7. Inflation
CALCULATE THE NET WORKING CAPITAL FROM THE
FOLLOWING INFORMATIONN OF ABC LTD.
items Avg period of credit Estimate of 1
st
year
Purchase of material 6 weeks 26,00,000
Wages 11/2 weeks 19,50,000
Overheads:
Rents , rates etc 6 months 1,00,000
Salaries 1month 8,00,000
Other overheads 2 month 7,50,000
Sales(cash) - 2,00,000
Sales(credit) 2 months 60,00,000
Avg amount of stock and
work in progress
- 4,00,000
Cash Management
Cash management is concerned with the
managing of:
cash flows into and out of the firm,
cash flows within the firm, and
cash balances held by the firm at a point of time by
financing deficit or investing surplus cash

Motives for holding cash
Precautionary
Speculation
Transaction
Cash Planning
Cash planning is a technique to plan and
control the use of cash.
Cash Forecasting and Budgeting
Cash budget is the most significant device to plan for
and control cash receipts and payments.
Cash forecasts are needed to prepare cash budgets.
Short-term Cash Forecasts
The important functions of short-term cash
forecasts
To determine operating cash requirements
To anticipate short-term financing
To manage investment of surplus cash.
Short-term Forecasting Methods
The receipt and disbursements method
The adjusted net income method.

Cash budget
Cash Vs Marketable Securities
The issue of optimal level of working balance
is resolved in the light of tradeoff of
opportunity costs and transaction costs.

CASH VS MARKETABLE SECURITIES - Models

The models to determine the optimal working
balance of a firm can be classified into two
categoriescertainty-based models and
uncertainty-based models.
Certainty-based models follow the EOQ approach of
inventory management while uncertainty-based
models follow the stochastic modeling.
Baumol Model
Baumol Model uses the EOQ method of
inventory control to determine the optimal level
of working balance under conditions of certainty.
Like the EOQ model, the objective function of
the Baumol model is of cost minimization.

Baumol Model
The objective function is to minimize the total cost.
This will be done at the point where the opportunity
cost is equal to the transaction cost.
As per the model the optimal working balance (C)
can be calculated as:
F = total cash requirement yearly
T = Transaction cost
R rate of interest on Mark Sec.

r
FT
C
2

Baumol Model
A firm cash need of Rs 5,00,000 per annum, its rate of interest
is 15% and every time it has to pay Rs 25 to enter into a
transaction of marketable securities. Find out the optimal
cash balance.
Miller-Orr Model
The MillerOrr model adopts the stochastic approach to
decisions regarding the optimal working balance.
Following the control limits approach, the MillerOrr model
provides two control limits
the upper control limit,
the lower control limit, and
a return point.
The firms cash balance is allowed to fluctuate between the
upper control limit and the lower control limit.
Miller-Orr Model
No transaction is needed, as per the model, till the cash
balance fluctuates between the upper control limit and the
lower control limit.
Purchase or sale of marketable securities takes place only
when one of these limits is reached.
The Return Point (R) is calculated as follows:


T= transaction cost of conversion
V= Variance of cash flows
i= Daily % interest rate on investment.



3
4
3
Point) (Return
i
TV
L R
Miller-Orr Model
The Lower Control Limit (L) is set by the
management based on the past cash flow
pattern and expected future requirements.
The upper control limit (H) is defined as
follows:

L R 3 ) Limit Control Upper ( H
Miller-Orr Model
A firm has standard deviation of cash inflows of Rs 1200, the
daily interest earnings on the short term investment is
expected at .01% and transaction cost for each sale and
purchase of securities is Rs 20. Minimum level is Rs.1000
Find out the return point, upper limit and the spread.
Miller-Orr Model
Graphical View
Miller-Orr Model
As can be seen in the previous figure, when the firms cash
flow touches the lower limit on day t
2
, disinvestment of
marketable securities takes place to the tune of (R-L).
Such a transaction brings the cash balance of the firm back to
the normal level, i.e., the Return Point (R).
Similarly, when the firms cash balance touches the upper
limit on day t
5
, the firm undertakes investment transactions
and buys marketable securities to the tune of (H-R).
Miller-Orr Model
Such investment transactions bring the firm back to a normal
level of cash balance, i.e., the Return Point (R).
For the rest of the days no investment or disinvestment
transaction gets triggered, as the firms working balance is
within the upper and the lower control limits.


Inventory Management
Inventory Management
Inventory management is about determining and maintaining
an optimal level of inventory i.e. a level that is neither
inadequate nor excessive.
Inventory represents value locked up at both ends of the
production system.
The definition of inventory is specific to the nature of
business.
For a typical manufacturing firm inventory comprises of
raw material,
work-in-process and
finished goods.
For a trading business it refers to the finished goods stock
held for sale.
Transaction motive
Precautionary motive
Speculative motive
DECIDING OPTIMAL LEVEL OF INVENTORY
Optimal level of inventory involves a trade-off
between
carrying costs and
ordering costs.
At this trade-off point the total cost is minimum.
This point is referred to as Economic Ordering
Quantity (EOQ)
Deciding Optimal Level Of Inventory
Carrying Costs
Carrying Costs are the cost of maintaining inventory in a
company's warehouse. It is alternatively referred to as
holding cost.
They include both, costs associated with physically carrying
inventories, such as
warehouse rent,
insurance of inventory and
financial cost of funds tied up in the inventory i.e.
the opportunity cost of alternative investments.
Such costs have a positive correlation with the level of
inventory, and hence are assumed to be a variable cost in
inventory management.

Ordering Costs
Ordering cost refer to the costs that are incurred at
the time an order is placed.
These costs are periodic and are regardless of the
size of the order.
The examples include
cost of processing orders,
cost of follow up with the vendors,
cost of receiving new shipment,
cost incurred on handling the accounts payable invoice.
Ordering Costs
These costs do not vary with the size of the order but
with the number of orders.
Total order costs decrease as the number of units
ordered each time increases.
With more units being ordered each time, the
number of orders placed decreases.
Stock-out Costs
The stock-out costs involve implicit costs of lost sales due to
shortage in the finished goods inventory.
They are alternately called backorder cost.
They include discrete costs such as
lost profit due to loss of present sales,
cost of replacing a specific piece of inventory, and
certain intangible costs such as loss of goodwill.
Such costs vary inversely with the inventory.
The relationship between stock-out costs and carrying costs of
inventory determines whether a company should over - or
under-produce.
The Economic Order Quantity (EOQ) Model
The two questions that the inventory theory tries to
address are:
How much should be ordered?
When should it be ordered?
The EOQ model of inventory management provides
answer to the first question.
Economic Order Quantity (EOQ) refers to the lot size
of inventory that is most economical to procure and
hold.

The Economic Order Quantity
EOQ Model
C
DO 2
) Q ( EOQ



Where;
D is the demand in units,
O is the ordering cost per order, and
C is the carrying cost per unit per period.


THE EOQ MODEL
The EOQ (Q) is the point at which both ordering costs
and carrying costs are equal.
This is the point of trade-off between carrying and
ordering costs.
At this point the total cost of inventory shall be
lowest.
This is the most economical quantity that can be
ordered by the firm.
EOQ MODEL An Example
Example:
A unit manufacturing plastic containers consumes 1350 units
of molded plastic uniformly through the month. The current
cost of acquisition is Rs. 20 per unit and the carrying cost for
the firm, 30% on average based on recent data available, is
not likely to change in the coming months. The firm has to
bear a cost of Rs. 2400 every time it places an order.
Compute the optimal inventory level for the year ahead
using the EOQ model.
THE ECONOMIC ORDER QUANTITY MODEL
Solution:



= 3600 units
(1350 per month 12= 16200, i.e., annual demand)
Thus the firm will be able to minimize its
total cost if it places orders for 3600 units
(the EOQ).
C
2DO
(Q) EOQ
6
2400 16200 2
(Q)

EOQ MODEL
Level Of Inventory
EOQ MODEL
Nos. Of Orders
The basic EOQ model can be re-arranged to
arrive at the following results that aids in proper
inventory planning and management:
Optimal number of orders (N):


O 2
DC
N
Assumptions Of
EOQ Model
The EOQ model is based on the assumptions of certainty
as regards demand, costs, price, and delivery time.
The assumptions of the EOQ model can be listed as:
Constant or uniform demand
Constant unit price
Constant carrying costs
Constant ordering costs
Instantaneous delivery
Deciding When To Order
The level of inventory at which the firm should
place an order for replenishment is its reorder
point.
It depends on the lead time, average usage, and the
EOQ.

usage Average time Lead point Reorder
Techniques Of Inventory Control And
Reduction
Ratio analysis
ABC Analysis
Vendor Managed Inventory (VMI)
Just-In-Time (JIT)
Outsourcing
Improving supply chain management
Re-engineering
Flexible manufacturing

ABC Analysis
ABC analysis is a selective approach to inventory
control and is used in firms that have multiple
items in inventory.
Based on Paretos 80-20 principle, it advocates a
greater emphasis on controlling those inventory
items that account for the bulk of the usage value.
Inventory is categorized according to relative
importance for the purpose of monitoring and
control.
ABC Analysis
ABC classification is also referred to as the VED (Vital, Essential, and
Desirable) classification.
Categorization of items under the three categories can be described as a
four-step process.
Step 1: Rank all the items of inventory in descending order, on the basis of
their usage value, and number them serially from 1 through n.
Step 2: Record the total of annual usage values of all the items and
express this as a percentage of the value of total usage. Also find out the
cumulative percentage of the total usage
Step 3: Classify the inventory items, looking at the cumulative percentage
of the total usage and the percentage of items, into categories A, B, and
C
ABC ANALYSIS
A Graphical View
Vendor Managed Inventory (Vmi)
VMI refers to an arrangement between the buyer and the
supplier of a product.
As per the arrangement, the responsibility to monitor and
replenish the inventory is that of the vendor and not of the
buyer in the VMI.
The buyer passes on selected information regarding the level
of inventory in the buyers stock.
The supplier takes full responsibility for maintaining an
agreed inventory.
VENDOR MANAGED INVENTORY (VMI)
A third party logistics provider is involved who makes
sure that the buyer has the required level of
inventory.
One of the keys to making VMI work is shared risk.
It helps foster a closer understanding between the
supplier and the manufacturer by using Electronic
Data Interchange formats.
Just-in-time (Jit)
It is a Japanese concept of an inventory management.
The underlying philosophy of JIT is to reduce the level of
inventory to zero so that the firm is able to cut down its
carrying cost.
The focus of JIT is on shedding the excess inventory: the
safety stock that does not contribute to the production
process.
JIT inventory system is all about having the right material,
at the right time, at the right place, and in the exact
amount.
Just-in-time (Jit)