WORKING CAPITAL MANAGEMENT

CONTENTS

Introduction Meaning of Working Capital Scope of Working Capital Management Working Capital Needs of Different Types of Businesses Relationship of Working Capital Management to Business Solvency Operating Cycle and its Relevance for Working Capital Management Managing Working Capital Estimation of Working Capital Requirements
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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.
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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 decisionmaking. 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.
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Meaning Of Working Capital

Working capital is subject to multiple connotations. From the accountants perspective working capital refers to the differential of current assets and current liabilities. From production managers view it refers to the total funds that a firm needs to carry out its day-today operations. From the finance managers angle it implies the total investment made in current assets. Working capital integrates Purchasing Production Marketing functions. The adequacy of working capital would enable smother functioning of the three functions.
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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. Working Capital Management

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 Working Capital Management 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. It is termed as managers concept of working capital. It denotes the liquidity position of the firm. 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.

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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.
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Operating Cycle
Operating cycle refers to the time elapsed between procurement of raw material to realization of cash from the finished goods. Operating cycle and its management assumes significance in the context of working capital management. Larger the operating cycle, larger is the requirement of working capital.

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Operating And Cash Cycle

Procure Pay for Realise Materials Materials

Process

Sell

Materials

Goods

Cash

Cash Cycle Operating Cycle

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Operating And Cash Cycle

Cash cycle refers to the time elapsed between payment of raw material to realization of cash from the finished goods. Operating cycle generally is larger than the cash cycle.

Cash cycle = Operating cycle Credit period availed on raw material.

Cash cycle would be larger if firms make advance payment for procuring raw material. Working Capital Management 12

Working Capital And Operating Cycle

Operating Cycle = Inventory holding period + Credit given Cash Cycle = Operating Cycle Credit period availed Working capital is function of

Length of operating/cash cycle: Longer the operating/cash cycle larger is working capital required Level of operation: Higher the level of operation larger is the working capital required.

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Estimating Working Capital

Estimation of working capital can be stated as a four step process: Step 1: Determining the duration (or conversion period) of blockage of funds. Duration of the various components of CA and CL is determined as follows:

Av erageRawMaterialInv entory RawMaterialconsumed 360 Work - in - process inv entory Work in process Co nv ersion P eriod (WIP CP) Cost of production 360 RawMaterialConv ersio nPeriod(RMCP)

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Estimating Working Capital

Finished g oods Conv ersion Peri od (FGCP) Finished goods inv entory Cost of goods sold 360

Re ceiv abled Conv ersion Period (R CP)

Av erage Debtors Credit sales 360

Payables D eferral Pe riod (PDP)

Av erage Creditors Credit Purchases 360

Step 2: Estimation of weights of the different components of operating cycle

Weight of Raw Material (Wrm) Raw Material and Stores cost per unit Selling Price per unit

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Estimating Working Capital

Step 3: Determination of weighted operating cycle (WOC). WOC can be computed as follows:
WOC RMCP Wrm WIPCP Wwip FGCP Wfg RCP Dar - PDP Dap

Step 4: Computation of working capital requirements as follows:

Working Capital Requiremen t Sales per day WOC Cash Balance Required
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Example Computing Working Capital

Expected level of production 10 lac units Selling price per unit Rs 10 Raw material, wages and overheads constitute 40%, 20% and 20% respectively. Holding periods:

Raw material: 3 months Finished goods: 2 months Credit availed: 4 months Work in process; 2 months Credit given: 3 months

15 days credit is available for wages and overheads

Cash balance required Rs 1,50,000 Contingency 10% of current assets FIND Gross Working Capital and Net Working Capital.

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Computation Of Working Capital

Current Assets lacs Raw materials 4 x 10L x 3/12 = 10.00 Work in process 8 x 10L x 2/12 = 13.33 Finished goods 8 x 10L x 3/12 = 20.00 Debtors 8 x 10L x 3/12 = 20.00 Cash = 1.50 Contingencies 10% of 63.33 = 6.34 Current Assets = Gross working capital = 71.17 Current Liabilities; Creditors for Materials 4 x 10L x 4/12 = 13.34 Wages 2 x 10L x 1/24 = 0.83 Overheads 2 x 10L x 1/24 = 0.83 Current Liabilities = 15.00 Net working capital (CA CL) Working Capital Management = 56.17 Rs

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Scope Of Working Capital Management

Working capital decisions affect the firms profits through their impact on sales, operating costs, and interest expense.
They affect the firms risk through their impact on the variability of the firms cash flows, the probability of not receiving the cash flow, and the ability to generate cash in a crisis. The working capital policy touches upon almost every functional area of the businesss operation. Working capital management affects and gets affected by the different operational decisions in a firm.
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Working Capital Needs Of Different Types Of Business

The amount of working capital requirement depends, inter alia, upon the nature of business. Seasonal industries may require a much higher level of working capital in peak seasons and a much lower requirement during slack seasons

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Working Capital Needs Of Different Types Of Business

Current assets to total assets ratio for different industries
Industries Current assets to total assets (%)

Trading

7577

Medicines Engineering Aluminium Paper

Shipping

6570 6065 4550 4045

1518

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Working Capital Management And Business Solvency

The level and quality of current assets held by the firm determine its solvency. The higher the level of current assets, the higher would be the capacity to transform these current assets and generate cash. Quality of current assets also affects the liquidity position of the business.

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OPERATING CYCLE AND WORKING CAPITAL MANAGEMENT

The prominent techniques that the firms are taking recourse to for cutting down their operating cycle are:
Outsourcing of various processes (such as production, distribution, collection, etc.) Setting up vendor-managed inventories Reducing the collection float by using banks with accelerated clearing capabilities Bringing about technology up gradation to achieve reductions in the conversion period for in-house operations

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Working Capital Management

Working capital management is alternatively referred to as current assets management as it relates to the management of level and financing of firms current assets. The two issues that need to be addressed are

What should be the optimal level of current assets held by the firm? How should these current assets be financed?

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Working Capital Management

Current assets that are important as they determine the liquidity position of the firm. The level of investment in current assets depends on:

Nature and type of business; Length of operating cycle; Seasonality of operations; Degree of uncertainty; and Prevailing and emerging market conditions.
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Working Capital Management

There is a riskreturn tradeoff in holding current assets. Increased investment in current assets increases liquidity (thus decreasing the risk) but reduces profitability (return) The optimal level of current assets is decided in the light of the tradeoff between the cost of liquidity and the cost of illiquidity.

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Working Capital Management

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Working Capital Management

Current liabilities provide cheaper and flexible financing options. However there are availability and cost related uncertainties with the current liabilities Increased usage of short-term sources of financing (i.e., current liabilities) increases profitability but reduces liquidity

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Financing Policy
The working capital financing policy may have a significant impact on the profitabilityliquidity position of the firm. Theoretically, the policies of working capital financing can be categorized as:

matching; conservative; and aggressive.

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Matching Approach
Matching approach to WC Financing

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Conservative Approach

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Aggressive Approach

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Working Capital Policy

Depending upon the current assets policy and the current assets financing policy a firms working capital policy can be categorized as conservative, aggressive or moderate

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Working Capital Policy

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