WCM

2. Nature of Working
Capital
Working capital management is concerned with the problems
that arise in attempting to manage the current assets, the current
liabilities and the interrelations that exist between them.
Current assets refer to those assets which in the ordinary course
of business can be, or will be, converted into cash within one
year without undergoing a diminution in value and without
disrupting the operations of the firm.
Examples- cash, marketable securities, accounts receivable and
inventory.
Current liabilities are those liabilities which are intended, at
their inception, to be paid in the ordinary course of business,
within a year, out of the current assets or the earnings of the
concern.
Examples- accounts payable, bills payable, bank overdraft and
outstanding expenses.

3. Objective of Working Capital
Management
The goal of working capital management is to manage
the firm’s current assets and liabilities in such a way
that a satisfactory level of working capital is
maintained.
The interaction between current assets and current
liabilities is, therefore the main theme of the theory of
the working capital management.

4. Concepts and Definitions of
Working Capital
There are two concepts of working capital:
Gross and Net.
Gross working capital- means thetotal current
assets.
Net working capital- can be defined in two ways-
o The difference between current assets and current
liabilities.
o The portion of current assets which is financed
with long term funds.

5. Determining Financing-
mix
There are two sources from which funds can be raised
for current assets financing-
o Short term sources, like current liabilities and,
o long term sources, such as share capital, long term
borrowings, internally generated resources like
retained earnings, etc.

6. Working Capital Management
and the Risk-Return Tradeoff
18-6
• Working capital management encompasses
the day-to-day activities of managing the
firm’s current assets and current liabilities.
Examples of working capital decisions
include:
– How much inventory should a firm carry?
– Should the credit be extended to?
– Should inventories be bought on credit or
cash?
– If credit is used, when should payment be
made?

7. Measuring Firm Liquidity (cont.)
18-7
• Here the net working capital for two firms is very
different (due to differences in firm sizes) but the
current ratio is equal. Current ratio is a better
measure of comparison of liquidity among firms.
Firm A Firm B
Current Assets $100,000 $10,000
Current
Liabilities
$50,000 $5,000
Net Working
Capital
$50,000 $5,000
Current Ratio 2.0 2.0

8. Managing Firm Liquidity
18-8
• Managing a firm’s liquidity requires
balancing the firm’s investments in current
assets in relation to its current liabilities.
– This can be accomplished (fullfil) by minimizing
the use of current assets by efficiently
managing its inventories and accounts
receivable and
– by seeking out (search) the most favorable
accounts payable terms
– and monitoring its use of short-term
borrowing.

9. Working Capital Policy
18-9
• Managing the firm’s net working capital
involves deciding on an investment
strategy for financing the firm’s current
assets and liabilities.
• Since each financing source comes with
advantages and disadvantages, the
financial manager has to decide on the
optimal source for the firm.

10. The Principle of Self-Liquidating
Debt
18-10
• This principle states that the maturity of
the source of financing should be
matched with the length of time that
the financing is needed.

11. Permanent and Temporary
Asset Investments
18-11
• Temporary investments in assets
include current assets that will be
liquidated and not replaced within the
current year.
– For example, cash and marketable securities,
and seasonal fluctuation in inventories.

12. Permanent and Temporary
Asset Investments (cont.)
18-12
• Permanent investments are composed
of investments in assets that the firm
expects to hold for a period longer than
one year.
– For example, the firm’s minimum level of
current assets such as accounts receivable and
inventories, as well as fixed assets.

13. Spontaneous, Temporary, and
Permanent Sources of Financing
18-13
• Spontaneous sources of financing arise
spontaneously out of the day-to-day
operations of the business and consist of
trade credit and other forms of accounts
payable (such as wages and salaries
payable, tax payable, interest payable).

14. Spontaneous, Temporary, and Permanent
Sources of Financing (cont.)
18-14
• Temporary sources of financing
typically consist of current liabilities the
firm incurs on (expose) a discretionary
basis. The firm’s management must make
an overt (obvious) decision to use
temporary sources of financing.
– For example, unsecured bank loans,
commercial paper, short-term loans secured by
the firm’s inventories or accounts receivables.

15. Spontaneous, Temporary, and Permanent
Sources of Financing (cont.)
18-15
• Permanent sources of financing are
called permanent since the financing is
available for a longer period of time than a
current liability.
– For example, intermediate term loans, bonds,
preferred stock and common equity.

16. Operating and Cash Conversion
Cycles
18-16
• Operating and cash conversion cycles
indicate how effectively a firm has
managed its working capital.
• The shorter these two cycles are, the
more efficient is the firm’s working
capital management.

17. Measuring Working Capital
Efficiency
18-17
• The operating cycle measures the time
period that elapses from the date that an
item of inventory is purchased until the
firm collects the cash from its sale.
• If an item is sold on credit, this date is
when the accounts receivable is collected.

18. Checkpoint 18.2
18-18

19. Measuring Working Capital
Efficiency (cont.)
• When the firm is able to purchase (get)
items of inventory on credit, cash is not
tied up (attached) for the full length of its
operating cycle.
• This is known as the accounts payable
deferral (obligation) period.
18-19

20. Measuring Working Capital
Efficiency (cont.)
• Cash conversion cycle is shorter than
the operating cycle as the firm does not
have to pay for the items in its inventory
• This period equal to the length of
Operating Cycle - The Account Payable
Deferral Period.
18-20

21. Checkpoint 18.2
18-21

22. Calculating the Operating and
Cash Conversion Cycle
18-22
• Figure 18-3 calculations are based on the
following information:
– Annual credit sales = $15 million
– Cost of goods sold = $12 million
– Inventory = $3 million
– Accounts receivable = $3.6 million
– Accounts payable outstanding = $ 2million

23. Calculating the Operating and
Cash Conversion Cycle (cont.)
• To calculate the operating cycle, (1) we
first need to compute the inventory
conversion period.
18-23

24. Checkpoint 18.2
18-24

25. Calculating the Operating and
Cash Conversion Cycle (cont.)
• To calculate the cash conversion cycle, we
(2) need to calculate the accounts
payable deferral period.
Accounts payable deferral period
=365/(12m:2m)= 61 days
18-25

26. Calculating the Operating and
Cash Conversion Cycle (cont.)
The second half of the operating cycle is the
number of takes it takes to convert accounts
receivable to cash (or average collection
period).
(3) Average collection period =
3,6m/(15m:365)=85 days
18-26

27. Calculating the Operating and
Cash Conversion Cycle (cont.)
• Hence, the Operating Cycle = Inventory
conversion period + Average collection
period = 91 + 85 days = 176 days
• Finally
Cash conversion cycle = 176 days – 61 days
= 115 days
18-27

28. Working capital: Policy and
Management
The working capital management includes and refers to the
procedures and policies required to manage the working
capital.
There are three types of working capital policies which a
firm may adopti.e.
Moderate working capitalpolicy
Conservative working capitalpolicy
Aggressive working capital policy.
These policies describe the relationship between the sales
level and the level of current assets.

29. Three alternative working capital investment
policies
Sales ($)
Current
Assets
($)
conservative
moderate
aggressive

30. Liquidity versus Profitability- A
Risk- Return Trade-off
An important aspect of a working capital policy is to
maintain and provide sufficient liquidity to the firm.
The decision on how much working capital be
maintained involves a trade-off i.e., having a large net
working capital may reduce the liquidity-risk faced by
the firm, but it can have a negative effect on the cash
flows. Therefore, the net effect on the value of the firm
should be used to determine the optimal amount of
working capital.

31. Types of working capital
needs
The working capital need can be bifurcated into permanent
working capital and temporary working capital.
Permanent working capital- There is always a minimum
level of working capital which is continuously required by a firm
in order to maintain its activities like cash, stock and other
current assets in order to meet its business requirements
irrespective of the level of operations.
Temporary working capital- Over and above the permanent
working capital, the firm may also require additional working
capital in order to meet the requirements arising out of
fluctuations in sales volume. This extra working capital needed
to support the increased volume of sales is known as temporary
or fluctuatingworking capital.

32. Difference between permanent & temporary working
capital
Variable Working Capital
Amount
of
Working
Capital
Permanent Working Capital
Time

33. Variable Working Capital
Amount
of
Working
Capital
Permanent WorkingCapital
Time

34. Approaches to determine an
appropriate Financing-mix
There are three basic approaches to determine an
appropriate financing mix:
• Hedging approach, also called the matching approach,
• Conservative approach,
• Aggressive approach.

35. Hedging Approach/ Matching
Approach
• According to this approach, the maturity of the sources of the
funds should match the nature of the assets to be financed. For
the purpose of analysis, the current assets can be broadly
classified into twoclasses-
o those which are required in a certain amount for a given level of
operation and, hence, do not vary over time.
o those which fluctuate over time.
• The Hedging approach suggests that long term funds should be
used to finance the fixed portion of current assets requirements
in a manner similar to the financing of fixed assets.
• The purely temporary requirements, that is, the seasonal
variations over and above the permanent financing needs should
be appropriately financed with short term funds.
• This approach, therefore, divides the requirements of total funds
into permanent and seasonal components, each being financed
by a different source.

36. Matching approach to asset
financing
FixedAssets
Permanent CurrentAssets
Total Assets
Fluctuating Current Assets
Time
$
Short-term
Debt
Long-term
Debt +
Equity
Capital

37. Conservative
Approach
This approach suggests that the estimated
requirement of total funds should be met from long
term sources; the use of short term funds should be
restricted to only emergency situations or when there
is an unexpected outflow of funds.

38. Conservative approach to asset
financing
FixedAssets
Permanent CurrentAssets
Total Assets
Fluctuating Current Assets
Time
$
Short-term
Debt
Long-term
Debt +
Equity
capital

39. Aggressive
approach
A working capital policy is called an aggressive policy if the
firm decides to finance a part of the permanent working
capital by short term sources. The aggressive policy seeks to
minimize excess liquidity while meeting the short term
requirements. The firm may accept even greater risk of
insolvency in order to save cost of long term financing and
thus in order to earn greater return.
The trade-off between risk and profitability depends
largely on the financial manager’s attitude towards risk, yet
while doing so he must take care of the following factors-
o Flexibility of the mix
o Cost of financing
o Risk attached withfinancing mix

40. Aggressive approach to asset
financing
FixedAssets
Permanent CurrentAssets
Total Assets
Fluctuating Current Assets
Time
$
Short-term
Debt
Long-term
Debt +
Equity
capital

41. Forecasting / Estimation of
Working Capital
Requirements
Factors to beconsidered
Total costs incurred on materials, wages and overheads
The length of time for which raw materials remain in stores before they
are issued toproduction.
The length of the production cycle or WIP
, i.e., the time taken for
conversion of RM into FG.
The length of the Sales Cycle during which FG are to be kept waiting for
sales.
The average period of credit allowed to customers.

42. The amount of cash required to pay day-to-day expenses
of the business.
The amount of cash required for advance payments if any.
The average period of credit to be allowed by suppliers.
Time – lag in the payment of wages and other overheads.

43. PROFORMA - WORKING CAPTIAL
ESTIMATES
1. TRADING CONCERN
STATEMENT OF WORKING CAPITALREQUIREMENTS
Amount (Rs.)
----
----
----
----
CurrentAssets
(i) Cash
(ii) Receivables ( For…..Month’s Sales)----
(iii) Stocks ( For……Month’s Sales)-----
(iv)Advance Payments if any
Less : Current Liabilities
(i) Creditors (For….. Month’s Purchases)-
(ii) Lag in payment of expenses
WORKING CAPITAL ( CA – CL)
Add : Provision / Margin for Contingencies
----
-----_
xxx
-----
NET WORKING CAPITALREQUIRED XXX

44. MANUFACTURING
CONCERN
STATEMENT OF WORKING CAPITALREQUIREMENTS
Amount (Rs.)
-----
-----
-----
-----
-----
-----
-----
CurrentAssets
(i)Stock of R M( for ….month’s consumption)
(ii)Work-in-progress (for…months)
(a) Raw Materials
(b) Direct Labour
(c) Overheads
(iii) Stock of Finished Goods ( for …month’ssales)
(a) Raw Materials
(b) Direct Labour
(c) Overheads
(iv) Sundry Debtors ( for …month’s sales)
(a) Raw Materials
(b) Direct Labour
(c) Overheads
(v) Payments in Advance (ifany)
(iv) Balance of Cash for dailyexpenses
(vii)Any other item
-----
-----
-----
-----
-----
-----
-----
-----
-----
Less : Current Liabilities
(i) Creditors (For….. Month’s Purchases)
(ii) Lag in payment of expenses
(iii) Any other
WORKING CAPITAL ( CA – CL)xxxx
Add : Provision / Margin forContingencies -----
NET WORKING CAPITALREQUIRED XXX