WORKING CAPITAL MANAGEMENT

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Concept of working capital Importance of working capital

Determents of working capital

Source of working capital financing

Determination of Operating Cycle

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Gross working capital (GWC)

GWC refers to the firms total investment in current assets. Current assets are the assets which can be converted into cash within an accounting year (or operating cycle) and include cash, short-term securities, debtors, (accounts receivable or book debts) bills receivable and stock (inventory).

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Net working capital (NWC). NWC

refers to the difference between current assets and current liabilities.

It is the excess of current assets over current liabilities. It is that portion of a firms current assets which is financed by long-term funds.

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Net working capital (NWC). Current liabilities (CL) are those claims of outsiders which are expected to mature for payment within an accounting year and include creditors (accounts payable), bills payable, and outstanding expenses. NWC can be positive or negative.
Positive NWC = CA > CL Negative NWC = CA < CL

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 GWC

focuses on Optimization of investment in current liabilities Financing of current assets NWC focuses on Liquidity position of the firm Judicious mix of short-term and long-tern financing
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Nature of business Manufacturing cycle Production process Business cycle Seasonal variation Scale of Operation Inventory policy Credit policy Depreciation policy

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Business Standing Growth of business Market condition Supply Situation Nature of Raw Material Used Process Technology Used Nature of Finished Goods Degree of Competition in the Market Profit level Dividend policy
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Liquidity vs. Profitability

Choosing the Pattern of Financing

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Working capital management refers to the administration of all components of working capital-cash , marketable securities, debtors (receivables), stock (inventories),creditors (payables). The financial manager must determine the levels and composition of current assets. He must see that right sources are tapped to finance current assets, and that current liabilities are paid in time.

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There are many aspects of working capital management which make it an important function of the financial manager. Time: Working capital management requires much of the financial manager's time. Investment: Working capital represents a large portion of the total investment in assets. Criticality: Working capital management has great significance for all. Firms but it is very critical for small firms. Growth The need for working capital is directly related to the firm's growth.
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The financial manager should determine the optimum level of current assets so that the wealth of shareholders is maximized. A firm needs fixed and current assets to support a particular level of output. However, to support the same level of output, the firm can have different levels of current assets. As the firm's output and sales increase, the need for current assets increases.

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Generally, Current assets do not increase in direct proportion to output.

Current assets may increase at a decreasing rate with output.

The level of the current assets can be measured by relating current assets to fixed assets. Dividing current assets by fixed assets gives CA/FA ratio. Assuming a constant level of fixed assets,

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A higher CA/FA ratio indicates a conservative current assets policy. It implies greater liquidity and lower risk;

A lower CA/FA ratio means an aggressive current assets policy, it indicates higher risk and poor liquidity. Moderate Coverage current assets policy falls in the middle of conservative and aggressive policies. The current assets policy of the most firms may fall between these two extreme policies.

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Gross working capital and Net working capital. Gross working capital is equal to the total of all current assets (including loans and advances) of a company.

Net working capital is defined as the difference between gross working capital and current liabilities (including provisions). Sometimes net working capital is also referred to as net current assets.

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Working capital can be viewed as the amount of capital required for the smooth and uninterrupted functioning of the normal business operations of a company ranging from the procurement of raw materials, converting the same into finished products for sale and realizing cash along with profit from the accounts receivables that arise from the sale of finished goods on credit.

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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.

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The length of the operating manufacturing firm is the sum of: inventory conversion period (ICP).

cycle

of

Debtors (receivable) conversion period (DCP).

Creditors or payables deferral period (CDP)

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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)

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Inventory conversion period is the total time needed for producing and selling the product. Typically, it includes:

raw material conversion period (RMCP) Average Raw Materials =------------------x 365 Raw material consumed

work-in-process conversion period (WIPCP) finished goods conversion period (FGCP)

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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) Average work in process =------------------x 365 Total cost of production

finished goods conversion period (FGCP)

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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) Average stock (FG) =------------------x 365 Total cost of goods sold

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The debtors conversion period is the time required to collect the outstanding amount from the customers. Average debtors =------------------- x 365 Total credit sales

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Creditors or payables deferral period (CDP) is the length of time the firm is able to defer payments on various resource purchases. Average Creditors =------------------- x 365 Total credit Purchases

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Gross operating cycle (GOC) The total of inventory conversion period and debtors conversion period is referred to as gross operating cycle (GOC).
Gross Operating Cycle = Raw Material Storage Period + Conversion period + Finished Goods Storage Period + Average Collection Period

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Net operating cycle (NOC) NOC is the difference between GOC and CDP.
Net Operating Cycle = Gross Operating Cycle Average Payment period

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RMCP +WPCP +FGCP +RCP(DCP) TOCP(Gross operating cycle) - CDP NOC

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What has been considered in figure above as working capital cycle is more popularly known as the operating cycle. This title is more expressive in the sense that the normal business operations of a manufacturing and trading company start with cash, go through the successive segments of the operating cycle, viz, raw material storage period, conversion period, finished goods storage period and average collection period before getting back cash along with profit. The total duration of all the segments mentioned above is known as gross operating cycle period.
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Calculate operational cycle

Inventory Work-in-process Finished products Credit allowed to customers Cash balance (approximate) Creditors

No.of days requirement 60 30 30 30 7 30

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From the following information, extracted from the books of a manufacturing company, compute the operational cycle in days. Period covered : 365 days. Average Period of credit allowed by Suppliers - 16 days. Rs.000 480 4,400 10,000 10,500 16,000 320 350 260
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Average total of debtors outstanding Raw-material consumption Total Production Cost Total Cost of Sales Sales for the year Value of Average Stock maintained -Raw-material Work - in -Progress Finished Goods

From the following details, prepare an estimate of the requirement of working Capital Production 60,000Units Selling price per unit Rs. 5 Raw Materials 60% of selling Price Direct wages 10% of selling Price Overheads 20% of selling Price Materials in hand 2 months requirements Production Time 1 month Finished Goods in Stores 3 months Credit for Material 2 months Credit allowed to Customers 3 months Average Cash Balance Rs. 20,000 Wages and overheads are paid at the beginning of the month following. in production all the required materials are charged in the initial stage and wages and overheads accrue evenly.
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Cash conversion cycle (CCC) CCC is the difference between NOP and non-cash items like depreciation. #NOP: net operating profit

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Gross Operating Cycle = Raw Material Storage Period + Conversion period + Finished Goods Storage Period + Average Collection Period Net Operating Cycle = Gross Operating Cycle Average Payment period

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Current Assets: (i) Cash (ii) Debtors or Receivables(for ..months sales ) (iii) Stock (formonths sales) (iv) Advance payment, if any (v) Others Total Current Assets Less: Current Liabilities (i) Creditors (for..months Purchases) (ii) Lag in payment of expenses(o/s expenses, if any) Total Current Liabilities Working capital(C.A. C.L. ) Add: Provision / Margin For Contingencies Net Working Capital Required

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Current Assets (i)Stock of Raw Material(formonths consumption) (ii) Work in- Process (For..months) (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) Payment in advance (vi) Balance of cash (Required to meet day-to-day exp.) Total current Assets Less: Current Liabilities: (i) Creditors (for..months Purchases) (ii) Lag in payment of expenses(o/s expenses, if any) Total Current Liabilities Working capital(C.A. C.L. ) Add: Provision / Margin For Contingencies Net Working Capital Required

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Prepare an estimate of working capital requirement from the following information of a trading concern (a) Project annual sales 100000 units (b) Selling price Rs. 8 per unit (c) Net profit on sales 25% (d) Average credit period allowed to customers 8 weeks (e) Average credit period allowed by suppliers 4 weeks (f) Average stock holding in terms of sales requirement 12 weeks (g) Allow 10% for contingencies

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Current Assets Debtors(8 weeks) Stock (12 weeks)

92,308 1,38,462 2,30,770

Less: Current Liabilities Creditors(4 weeks) 46,154 Net Working Capital 1,84,616 Add 10% for Contingencies 18,462 Working Capital Required 2,03,078

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Liquidity Availability of Cash

Inventory Turnover
Credit Extended to Customers Credit Obtained from Suppliers

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Current Ratio Quick Ratio Cash to Current Assets Sales to Cash Average Collection Period Inventory Turnover Ratio Working Capital to Sales
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Objective of Working Capital Management Static view of Working Capital

Dynamic view of Working Capital

Determination of Operating Cycle

Evaluating Working Capital Management

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