Prof.

SB Mishra
WORKING CAPITAL MANAGEMENT

OUTLINE Characteristics of Current Assets Factors Influencing Working Capital Requirements Level of Current Assets Current Assets Financing Policy Profit Criterion for Current Assets Operating Cycle Analysis Cash Requirement for Working Capital

CHARACTERISTICS OF CURRENT ASSETS

Short life span Swift transformation into other asset forms
Current Assets Cycle
Finished goods

Accounts receivable Wages, salaries, factory overheads

Work-inprocess

Raw materials

Cash

Suppliers

Concepts- Static View

Gross

Working Capital.

Refers to investment in Current Assets.

Net

Working capital.
(
and Current Liabilities ( CL)

Refers to difference between Current Assets

CA)

Concepts- CURRENT ASSETS

Inventories: Sundry

Debtors/ Accounts Receivable Cash and Bank Balance Short Term Investments. Loans and Receuivable including Bills Receivable. Prepaid Expenses Accrued Incomes

Concepts- CURRENT LIABILITIES

Sundry

Creditors: Provisions Short Term Bank Loans. Bank Overdrafts Outstanding Expenses.

Concepts- Dynamic View

Working Capital Investment = Investment in Raw Material + Investment in Work In Process + Investment in Finished Goods + Investment in Accounts Receivable + Investment in Minimum Cash Balance Accounts Payables

FACTORS INFLUENCING WORKING

CAPITAL

REQUIREMENTS
Nature of Business

Seasonality of Operations

Production Policy
Market Conditions Conditions of Supply

WORKING CAPITAL POLICY Two important issues in working capital policy are: What should be the level of investment in current assets?

What mix of long-term and short-term financing should

the firm employ to support current assets?

LEVEL OF CURRENT ASSETS

Flexible (Conservative) Policy High Large High Restrictive (Aggressive) Policy Low Small Low

Liquidity Inventories Debtors

A flexible policy results in fewer production stoppages, ensures quicker deliveries to customers, and stimulates sales .. but
HIGHER INVESTMENT IN CURRENT ASSETS

A restrictive policy leads to more production stoppages, delayed deliveries to customers, and lost sales but
LOWER INVESTMENT IN CURRENT ASSETS

CAPITAL REQUIREMENTS AND THEIR FINANCING

Fluctuating current asset requirement

Capital requirements
A B C

Permanent current asset-requirement

Fixed asset requirement

Time

CURRENT ASSETS FINANCING

POLICY
According to the matching principle, fixed assets and permanent current assets should be supported by long-

term sources of finance whereas fluctuating current assets

must be supported by short-term sources of finance.

PROFIT CRITERION FOR

WORKING CAPITAL
Investment in current assets is easily reversible. For reversible investments, the criterion of net profit per period (which here means residual income) is equivalent to the criterion of net present value

OPERATING CYCLE AND CASH CYCLE

Order placed Stock arrives Inventory period Goods sold Cash received Accounts receivable period

Accounts payable period Firm receives invoice Cash paid for materials Operating cycle Cash cycle Average inventory Inventory period = Average COGS / 365 Average accounts receivable Accounts receivable period = Annual sales / 365 Average accounts payable Average payable period = Average COGS / 365

FORMULA
Average Raw Material Inventory = (Annual RawMaterial Consumption ) /360

Raw Material Consumption Period

Work in Process Conversion Period

Average WIP Inventory

= (Cost of Production)/360

FORMULA
Average Finished Goods Inventory = (Cost of Goods sold) /360

Finished Goods Conversion Period

Debtors Conversion Period

Average Sundry Debtors

= (Credit Sales)/360

FORMULA

Average Creditors Creditors Payment Period = (Credit Purchases) /360

FORMULA contd..
Annual Consumption of Raw Material= Opening stock of Raw Material + Purchases Closing stock of Raw materials Annual Cost of Production = Opening stock of WIP + Annual Consumption of Raw material + Production Cost + Depreciation Closing WIP

Cost of Sales= Opening inventory of Finished Goods+ Annual Cost of Production +Sales and Distrn Cost + Excise Duty -Closing stock of Finished Goods

COST OF PRODUCTION. (COP) Add Opening Finished Goods Inventory Add Selling and Distribution Overheads Less Closing Finished Goods Inventory = COST OF GOODS SOLD (COGS)

ILLUSTRATION
Financial Information for Horizon Limited
Balance Sheet Data Profit and Loss Account Data Sales Cost of goods 800 720 Inventory Accounts receivable Beginning of 20X0 96 86 End of 20X0 102 90

Sold

Accounts payable

56

60

(96 + 102) / 2

Inventory period =
720 / 365

= 50.1 days

(86 + 90) / 2

Accounts receivable period =

800 / 365 (56 + 60) / 2

= 40.2 days

Accounts payable period

=
720 / 365

= 29.4 days

Operating cycle

50.1 + 40.2 = 90.3 days Inventory Accounts period receivable period

Cash cycle

90.3 29.4 = 60.9 days Operating Accounts cycle payable period

CASH REQUIREMENT FOR

WORKING CAPITAL
Step 1 : Estimate the cash cost of various current assets

required by the firm. Step 2 : Deduct the spontaneous current liabilities from
the cash cost of current assets

SUMMING UP

Current assets have a short life span and are swiftly transformed into other asset forms.
The working capital needs of a firm are influenced by numerous factors : nature of business, seasonality of operations, production policy, market conditions, and supply conditions. Determining the optimal level of current assets involves a tradeoff between carrying costs and shortage costs.

According to the matching principle, the maturity of the sources of finance should match the maturity of assets being financed.

 The operating cycle of a firm begins with the acquisition of raw materials and ends with the collection of receivables. The cash requirement of working capital is calculated by estimating the cash cost of various current assets required by the firm and deducting the spontaneous current liabilities from the cash cost of current assets.