Working

Capital
Manageme
nt
 Definition of Working Capital

WorkingCapitalreferstothatpartofthe
firmscapital,whichisrequiredfor
financingshort-termorcurrentassetssucha
cashmarketablesecurities,debtorsand
inventories.Fundsthus,investedincurrent
assetskeeprevolvingfastandare
constantlyconvertedintocashandthiscash
flowoutagaininexchangeforothercurrent
assets.WorkingCapitalisalsoknownas
revolving or circulating capital or short-
term capital.
KINDS OF WORKING CAPITAL

WORKING CAPITAL

BASIS OF BASIS OF
CONCEPT TIME

Gross Net Permanent Temporary

Working Working / Fixed / Variable
Capital Capital WC WC

Seasonal Special
WC WC
Regular Reserve
WC WC
 Significance of Gross WC

OptimuminvestmentinCA
InvestmentinCAmustbeadequateCAinvestmentshouldnot
beinadequateorexcessiveinadequateWCcandisturb
productionandcanalsothreatenthesolvencyoffirm,ifitfails
tomeetitscurrentobligationexcessiveinvestmentinCA
shouldbeavoided,sinceitimpairsfirmsprofitability

FinancingofCA
NeedforWCarisesduetoincreasinglevelofbusinessactivity
&itistoprovidedquicklysometimesurplusfundmayarises
whichshouldbeinvestedinShorttermsecurities,theyshould
notbekeptidle
 Significance of Net Working Capital

MaintainingLiquidityposition
Formaintainingliquiditypositionthereisa
needtomaintainCAsufficientlyinexcessof
CL
JudgeFinancialSoundnessofafirm
TheNetworkingcapitalhelpscreditorsand
investorstojudgefinancialsoundnessofa
firm
 BALANCE SHEET OF ABC COMPANY AS ON 31-3-
2000
Liabilities Rs Assets Rs
20000
Equity Shares 0 Goodwill 20000
10000 Land and 15000
8% Debentures 0 Building 0
Plant and 10000
Reserve & Surplus 50000 Machinery 0
15000
Sundry Creditors 0 Inventories
Bills Payable 30000 Finished Goods 60000
Outstanding
Expenses 20000 Work in process 40000
Bank Overdraft 50000 Prepaid Expenses 20000
Provision for Marketable
Taxation 20000 Securities 60000
Proposed Dividend 30000 Sundry Debtors 90000
Bills Receivables 20000
Cash & Bank
 Difference between permanent &
temporary working capital

Amount Variable Working Capital

of
Working
Capital

Permanent Working Capital

Time
Permanent and temporary working capital for Stable firm
Variable Working Capital
Amount
of
Working
Capital
Permanent Working Capital

Time
Permanent and temporary working capital for Growing firm
 Operating cycle concept

Maximization of share holders wealth of a firm is

possible only when there are sufficient return from the
operations
Successful sales activity is necessary for earning profit
sales do not convert into cash immediately
There is invisible time lap between the sale of good
and receipt of cash
The time taken to convert raw material into cash is
known as operating cycle
Conversion of cash into raw material
Conversion of raw material into work in progress
Conversion of Work in progress into finished goods
Conversion of finished good into Sales ( Debtors and
cash )
 Raw WIP
Materials

Operating Cycle in Finished

Cash
Manufacturing firm Goods

Debtors SALES
Operating cycle of Non
Manufacturing Firm

Receivables

cash

Stock of finished goods

Formula for calculating Operating
cycle for Manufacturing firm
OC = ICP+ARP
OC = Operating cycle
ICP = Inventory Conversion period
ARP = Account Receivable Period

ICP = Average Inventory

Cost of good sold /365
ARP = Average Account Receivable
Sales/365
 ABC Company Provide the
following information , Compute
the operating cycle
Sales3000Lakhs
InventoryOpeningRs610Lakhs;
closingRs475Lakhs
ReceivableopeningRs915Lakhs;
ClosingRs975Lakhs
CostofGoodsSoldRs2675Lakhs
CASHCONVERSIONCYCLE
Theamountoftimeafirmsresourcesaretiedup
calculatedbysubtractingtheaveragepayment
periodfromtheoperatingcyclethetimeperiod
betweenthedateafirmpaysitssupplierandthe
dateitreceivescashfromitscustomer
CCC=OCAPP
AAI=AverageInventory
Costofgoodsold/365
ARP=AverageAccountReceivable
AnnualSales/365
APP=AccountPayablePeriod
Costofgoodsold/365
 Calculate CCC
(CASH CONVERSION CYCLE)
Average use of Inventory 80 days

Account receivable collection period 50

days
Account payable period is 40 days

CCC= OC- APP

OC = AAI+ARP
80+50=130
CCC =130-40 =90 days
PurchaseofSaleofGoods Collectionof
RawMaterial onCredit AccountReceivables
Oncredit

Averageageof Accountreceivable
Inventory(AII) period(ARP)

AccountPayable
Period(APP)

Paymentto
suppliers

ReceiptofInvoice OperatingCycle(OC)

Cash Conversion cycle

 Resource flows for a
manufacturing firm

Used in

Accrued Direct Accrued Fixed

Used in Labour and
Operating
Production materials expenses
Process
Used to
Working purchase
Generates Capital
cycle Cash and
Inventory Marketable
Securities Used to
Collection purchase
Via Sales Generator process
Fixed
External Financing Assets
Return on Capital
Accounts
receivable
Suppliers
Of Capital
Calculate cash conversion cycle
Sales Rs 1587.95

Cost of Good sold Rs 1406.27

Inventory opening 195.82, closing

202.29
Account receivables opening 423.03

closing 449.46
Account payable opening 140.40,

closing 168.33
CCC = OC APP
OC = AAI + ARP
 FORECASTING / ESTIMATION OF
WORKING CAPITAL REQUIREMENTS
Factorstobeconsidered
Totalcostsincurredonmaterials,wagesandoverheads
Thelengthoftimeforwhichrawmaterialsremaininstoresbeforethey
areissuedtoproduction.
The length of the production cycle or WIP, i.e., the time taken for
conversionofRMintoFG.
ThelengthoftheSalesCycleduringwhichFGaretobekeptwaiting
forsales.
Theaverageperiodofcreditallowedtocustomers.
The amount of cash required to pay day-to-day expenses of the
business.
Theamountofcashrequiredforadvancepaymentsifany.
Theaverageperiodofcredittobeallowedbysuppliers.
Timelaginthepaymentofwagesandotheroverheads
 PROFORMA - WORKING CAPTIAL
ESTIMATES
1. TRADING CONCERN
STATEMENTOF
STATEMENT OFWORKING
WORKINGCAPITAL
CAPITALREQUIREMENTS
REQUIREMENTS
Amount(Rs.)
Amount (Rs.)
CurrentAssets
Current Assets
(i)Cash
(i) Cash ----
----
(ii)Receivables
(ii) Receivables((For..Months
For..MonthsSales)----
Sales)---- ----
----
(iii)Stocks
(iii) Stocks((ForMonths
ForMonthsSales)-----
Sales)----- ----
----
(iv)AdvancePayments
(iv)Advance Paymentsififany
any ----
----
Less::Current
Less CurrentLiabilities
Liabilities
(i)Creditors
(i) Creditors(For..
(For..Months
MonthsPurchases)-
Purchases)- ----
----
(ii)Lag
(ii) Lagininpayment
paymentofofexpenses
expenses -----_
-----_
WORKINGCAPITAL
WORKING CAPITAL((CA CACL
CL)) xxx
xxx
Add::Provision
Add Provision //Margin
MarginforforContingencies
Contingencies -----
-----

NETWORKING
NET WORKINGCAPITAL
CAPITALREQUIRED
REQUIRED XXX
XXX
 1. MANUFACTURING CONCERN
STATEMENT OF WORKING CAPITAL REQUIREMENTS
Amount (Rs.)
Current Assets
(i) Stock of R M( for .months consumption) -----
(ii)Work-in-progress (formonths)
(a) Raw Materials -----
(b) Direct Labour -----
(c) Overheads -----
(iii) Stock of Finished Goods ( for months sales)
(a) Raw Materials -----
(b) Direct Labour -----
(c) Overheads -----
(iv) Sundry Debtors ( for months sales)
(a) Raw Materials -----
(b) Direct Labour -----
(c) Overheads -----
(v) Payments in Advance (if any) -----
(iv) Balance of Cash for daily expenses -----
(vii)Any other item -----

Less : Current Liabilities

(i) Creditors (For.. Months Purchases) -----
(ii) Lag in payment of expenses -----
(iii) Any other -----
WORKING CAPITAL ( CA CL )xxxx
Add : Provision / Margin for Contingencies -----

NET WORKING CAPITAL REQUIRED XXX

Prepare an estimate of Working capital requirement
from the following information of a trading concern:

Projectedannualsales 100000units
Sellingprice Rs8perunit
%ageofNetprofitonsales 25%
AverageCreditPeriodallowedto
customer 8weeks
AverageCreditPeriodallowedby
supplier 4weeks
Averagestockholdingintermaofsales
requirement 12weeks
contingencies 10%
 Points to be remembered while
estimating WC
(1) Profits should be ignored while calculating working
capital requirements for the following reasons.
(a)Profits may or may not be used as working capital
(b) Even if it is used, it may be reduced by the amount of
Income tax, Drawings, Dividend paid etc.
(2) Calculation of WIP depends on the degree of completion
as regards to materials, labour and overheads. However, if
nothing is mentioned in the problem, take 100% of the value
as WIP. Because in such a case, the average period of WIP
must have been calculated as equivalent period of completed
units.
(3) Calculation of Stocks of Finished Goods and Debtors
should be made at cost unless otherwise asked in the
question.
 Prepare statement of working
capital requirement, Profit
&Loss A/C, Balance Sheet
Assuming

Share Capital 150000

8% Debentures 200000
Fixed asset 130000
Material 40%
Direct lab our 20%
Overheads 20%
The following further particular are available
It is proposed to maintain a level of activity of
2,00,000 units
Selling price is Rs 12/- per unit
Raw Material are expected to remain in stores for
an average period of one month
Material will be in process , on average half a month
Finished goods are required to be in stock for an
average period of one month
Credit allow to debtors is two month
Credit allow by supplier is one month
 Working Capital Financing Mix
Approaches to Financing
Mix

The Hedging or The Conservative The Aggressive

Matching Approach Approach Approach
Hedging approach to asset
financing
Total Assets
Short-term
Debt
Fluctuating Current Assets

Long-term
Permanent Current Assets Debt +
Equity
Capital

Fixed Assets

Time
 The Hedging approach
Hedging approach refers to a process of
matching maturities of debt with the
maturities of financial need . In this
approach maturity of source of fund should
match the nature of asset to be financed
This approach is also known as matching

approach.
The hedging approach suggests that the

permanent working capital requirement

should be financed with fund from long
term sources while the temporary working
capital requirement should be financed
with short term funds.
Estimated Total Investment in Current Asset of company X for
the year 2000
Permanent or
Investment Fixed Temporary
in Current Asset Investments or seasonal Invest
Month (R's ) (R's) (R's)
January 50400 45000 5400
February 50000 45000 5000
March 48700 45000 3700
April 48000 45000 3000
May 46000 45000 1000
June 45000 45000 -
July 47500 45000 2500
August 48000 45000 3000
September 49500 45000 4500
October 50700 45000 5700
November 52000 45000 7000
December 48500 45000 3500
TOTAL 44300
 Conservative Approach
This approach suggested that the entire
estimated investments in current asset
should be finance from long term source
and short term should be use only for
emergency requirement
Distinct features of this approach

Liquidity is greater

Risk is minimized

The cost of financing is relatively more as

interest has to be paid even on seasonal

requirement for the entire period
Conservative approach to asset
financing
Total Assets
Short-term
Debt
Fluctuating Current Assets

Long-term
Permanent Current Assets Debt +
Equity
capital

Fixed Assets

Time
 Trade off between
Hedging and
conservative approaches
The hedging approaches implies low cost ,
high profit and high risk while the
conservative approach leads to high cost ,
low profit , low risk Both the approaches
are the two extreme and neither of them
serve the purpose of efficient working
capital management
A trade off between the two will then be an
acceptable approach , One way of
determining the trade off is by finding the
AVG of maximum and minimum
requirement of current asset or working
capital
Aggressive approach to asset
financing
Total Assets
Short-term
Debt
Fluctuating Current Assets

Long-term
Permanent Current Assets Debt +
Equity
capital

Fixed Assets

Time
 Aggressive approach
The aggressive approach suggests that
the entire estimated requirement of
current asset should be financed from
short-term sources and even a part of
fixed asset investment be financed from
short - term sources
This approach make the finance mix :
More Risky
Less costly
More Profitable
 Prepare a projected balance
sheet , profit and loss a/c and
then an estimation of working
capital .
Issued Share Capital 300000
6% Debentures 200000
Fixed asset 200000
Raw Material 50%
Lab our 20%
Overheads 20%
Profit 10%
There is a regular production and
sales cycle
 Raw Material are kept in stores for an
average period of two month
Finished goods remain in stock for an
average period of three month
Production during the previous year was
180000 units and it is planned to maintain
the same in the current year also
Each unit of production is expected to be in
process for half a month
Credit allow to customer is three month and
given by supplier is two month
Selling price is Rs 4 per unit
Calculation of debtors may be made at
selling price
Management of Working
Capital
Working capital in general practice refer to
the excess of CA over CL.
Management of working capital therefore is
concerned with the problems that arise in
attempting to manage the CA, the CL and
the inter-relationship that exists between
them.
The basic goal of WCM is to manage the CA
& CL of a firm in such a way that a
satisfactory level of WC is maintained.
Working Capital Management Policies of a
firm have a great effect on its profitability,
liquidity and structural health of the
organization
 Working capital management is 3
dimensional in Nature

DimensionII
Dimension
Profitability,
Profitability,
Risk,&
Risk, &Liquidity
Liquidity

n IIII C DDiimmen
n siioon e
v v
eell Coom
mpo enssiion
i meens &LLe possiti on IIII
itioonn
DDim sittiioonn& & II
m ppoosi CAA ooffCCL& LLeevvel
Coom oo ffC L el
C
 Working Capital Issues

Optimal Amount (Level) of Current Assets

Assumptions
50,000 maximum Policy A

ASSET LEVEL
units of production Policy B
Continuous Policy C
production
Three different Current Assets
policies for
current asset
levels are possible
0 25,000 50,0
OUTPUT (units)
 Impact on Liquidity
Optimal Amount (Level) of Current Assets
Liquidity Analysis
Policy Liquidity Policy A

ASSET LEVEL
A High Policy B

B Average Policy C
C Low
Greater current asset Current Assets

levels generate more

liquidity; all other
factors held constant. 0 25,000 50,0
OUTPUT (units)
 Impact on
Expected
Profitability
Optimal Amount (Level) of Current Assets
Return on Investment =
Policy A
Net Profit

ASSET LEVEL
Total Assets Policy B
Let Current Assets = Policy C
(Cash + Rec. + Inv.)

Return on Investment = Current Assets

Net Profit
Current + Fixed Assets
0 25,000 50,0
OUTPUT (units)
 Impact on
Expected
Profitability
Optimal Amount (Level) of Current Assets
Profitability Analysis
Policy Policy A

ASSET LEVEL
Profitability Policy B
A Low Policy C
B Average
C High
Current Assets
As current asset levels
decline, total assets will
decline and the ROI will
rise. 0 25,000 50,0
OUTPUT (units)
 Impact on Risk
Optimal Amount (Level) of Current Assets
Decreasing cash
reduces the firms Policy A
ability to meet its

ASSET LEVEL
financial obligations. Policy B
More risk!
Policy C
Stricter credit policies
reduce receivables and
possibly lose sales and Current Assets
customers. More risk!
Lower inventory levels
increase stockouts and
lost sales. More risk! 0 25,000 50,0
OUTPUT (units)
 Impact on Risk
Optimal Amount (Level) of Current Assets

Risk Analysis
Policy Risk Policy A

ASSET LEVEL
A Low Policy B

B Average Policy C

C High
Current Assets
Risk increases as the
level of current assets
are reduced. 0 25,000 50,0
OUTPUT (units)
 Summary of the
Optimal Amount of
Current Assets
SUMMARY OF OPTIMAL CURRENT ASSET ANALYSIS
Policy Liquidity Profitability Risk
A High Low Low
B Average Average Average
C Low High High

1. Profitability varies inversely with

liquidity.
2. Profitability moves together with risk.
(risk and return go hand in hand!)
 Techniques of analysis of
working capital
The analysis of working capital can be
conducted through a number of devices
such as
Ratio analysis

Fund flow analysis

Working capital Budgeting

Ratio analysis : A ratio is a simple

arithmetical expression of the relationship

of one number to another , this technique
can be employed for measuring short term
liquidity or working capital position of a
firm.
 The following ratios may be
calculated for this purpose
Liquidity Ratio
a) Current Ratio

b) Acid test ratio/quick ratio/liquid ratio

c) Cash Position ratio/absolute liquid ratio

Inventory turnover ratio

Receivable turnover ratio

Payable turnover ratio

Working capital turnover ratio

 Current ratio may be define as
the relationship between CA
and CL
This ratio is also known as
WCR. (Working capital ration).
It is helpful to measure short
term financial position or
liquidity of a firm
Current ratio: Current asset
Current liabilities
CURRENT ASSETS CURRENT LIABILITIES
Cash in hand
Bills Payable
Cash at bank Sundry Creditors
Accrued or Outstanding
Sundry Debtors Expenses

Marketable securities Short term loan and

(Short term) advances
Bills Receivable Dividend payable
Inventories of Stock Bank Overdraft
Work in progress
Finished goods
Prepaid Expenses
 Quick or Acid test or
Liquid Ratio
An asset is said to be liquid if it can
be convert into cash with in a short
period with out loss of value
Inventory cannot be termed to be
liquid asset because they cannot be
convert into cash immediately
The quick ratio can be calculated

Quick ratio: liquid asset

Current liabilities
 Quick or liquid Current Liabilities

Cash in hand Bills Payable

Cash at bank Sundry Creditors

Accrued or Outstanding
Sundry Debtors
Expenses

Short term advances

Marketable securities
Temporary
Dividend payable
Investments
Bank Overdraft
Income tax payable
Convection quick ratio of 1:1 is consider
satisfactory
Cash Position ratio/absolute liquid
ratio
Absolute Liquid assets include cash in
hand and cash at bank and marketable
securities or temporary investments
The acceptable norms for this ratio is

50% or .05%
Cash ratio: Cash & bank + Short term
securities
Current liabilities
 Calculate all the three
Liabilities Rs ratio
Assets Rs
9%
preference
share 500000 Goodwill 100000
Equity share Land and
capital 1000000 building 650000
8%
debentures 200000 Plant 800000
Long term Furniture
loan 100000 and fixtures 150000
Bills
Bills payable 60000 receivable 70000
Sundry Sundry
creditors 70000 debtors 90000
Bank over Bank
draft 30000 balance 45000
Outstanding short term
expenses 5000 investments 25000
CONCLUSION:
Current ratio of the company is not
satisfactory because the ratio 1:6 is
much below then the expected
Standards .
Acid test ratio on the other hand is
more than the normal standard of 1:1
Absolute ratio is slightly low because
it is 0.42 where as the accepted
standard is 0.5
In this company need to improve its
short term financial position
 Inventory turnover ratio
Inventory turn over ratio = Cost of good sold
Average Inventory at cost
Generally , the cost of good sold may not be known
from the published financials , in such
circumstances
Inventory turn over ratio = Net Sales
Average Inventory at cost
Inventory turn over ratio = Cost of good sold
Average Inventory at selling price
 Inventory conversion
period
Inventory conversion period = Days in a
year Inventory Turnover Ratio
M/s Rakesh & Co supplies you the
following information for the year ending
31st Dec 1999
Credit Sales Rs 150000
Cash Sales Rs 250000
Return Inward Rs 25000
Opening Stock Rs 25000
Closing Stock Rs 35000
 Debtor/Receivable turnover ratio
/Debtor velocity
Debtor(Receivable) = Net credit Annual sales
Average Trade debtors
Trade debtors = Sundry debtor + Bill Receivable and
account receivable s
Average Trade Debtors = Opening Trade debtor +
Closing Trade Debtor /2
Note : Debtor should always be taken at gross value
, No provision for doubtful debt be deducted from
them but when the information about opening and
closing balance of trade debtor and credit sales is
not available , then the debtors turnover ratio
calculated by dividing the total sales by the balance
of debtors(inclusive of Bills receivables) given
Debtors turn over Ratio = Total sales
Debtors
 Average Collection
Period
The average collection period
represent the average number of days
for which a firm has to wait before its
receivable are converted into cash
Average Collection period =
Average Trade Debtors (Drs + B/R)
Sales per day
Sales Per day = Net Sales
No of working days
 Or
Average collection period =Average
trade debtors Net Sales
No of working days
If the period is in months:
Average collection period =No of
working days Debtors turnover ratio
The two basis component of the ratio are
debtors and sales per day
 Creditor/Payable
turnover ratio
The analysis for credit turnover is basically the
same as of debtors turnover ratio except that
in place of trade debtor, the trade creditor are
taken and in place of sales , average daily
purchase are taken as the other component of
the ratio.
Creditors turnover ratio
= Net credit annual purchase
Average Trade creditors
 Average Payment period Ratio
= Average Trade Creditors( Creditors+
Bills payable)/Average Daily purchases.
Average daily purchase = Annual
Purchase /No of working days in a year.
Average Payment Period = Trade
creditor * No of working days / Net
annual purchase.
Average Payment Period = No of
working days / Credit turnover Ratio.
Working capital turnover
ratio
Working capital of a concern is directly
related to sales and current asset like
debtors , bills receivable , cash , stock etc .
Working capital turnover ratio = Cost of
Sales / Average working capital
Average working capital = Opening working
capital + Closing Working capital/2
** If cost of sales is not given , then the
figure of sale can be used . O n the other
hand if opening working capital is not
disclosed then working capital at the end of
the year will be used.
Cost of sale /Net working capital
The following information is given
about M/s S.P Ltd for the year ending
Dec 31 2000
Stock turnover ratio = 6times

Gross Profit ratio = 20% on sales

Sales for 2000 = Rs 300000

Closing stock is Rs 10000 more than

the opening stock

Opening Creditors = Rs 20000

Closing Creditors = Rs 30000

Trade debtor at the end = Rs 60000

Net Working Capital = Rs 50000

 FIND OUT
Average Stock

Purchases

Credit turnover ratio

Average Payment Period

Average Collection Period

Working Capital turnover ratio

Fund flow analysis : Fund flow analysis
is a technical device designated to study
the sources from which additional fund
were derived and the use to which these
sources were put . It is an effective
management tool to study change in the
financial position of business
The fund flow analysis consists
of
Preparing schedule of change in working
capital
Statement of sources and application of

funds
 Working capital Budgeting :
Working capital budget as a part
of total budgeting process of a
business , is prepared estimating
future long term and short term
working capital need and the
sources of finance them .
The objective of a working capital

budget is to ensure availability of

fund as and when needed and to
ensure effective utilization of these
resources .