CHAPTER 21

WORKING CAPITAL MANAGEMENT: AN INTRODUCTION

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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Chapter 21 Working Capital Management: An Introduction

INTRODUCTION
Traditionally, working capital has been defined as the firms investment in current assets. Working capital decisions are of tremendous importance for any firm. Such decisions affect the businesss liquidity position. Long-term financial decisions have cash flow implications for a period that may extend up to 20 years, or even more.
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INTRODUCTION
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 decision-making
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INTRODUCTION
Operating cycle and its management assumes significance in the context of working capital management Working capital decisions are more flexible than long-term decisions.

Chapter 21 Working Capital Management: An Introduction

MEANING OF WORKING CAPITAL

Working capital is subject to multiple connotations. From the accountants perspective working capital refers to the current assetscurrent liabilities differential. From production managers view it refers to the total funds that a firm needs to carry out its day-to-day operations. From the finance managers angle it implies the total investment made in current assets.
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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, including
cash, marketable securities, accounts receivable, and inventories.

Chapter 21 Working Capital Management: An Introduction

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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GWC and NWC

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 longterm sources of financing have been used to finance current assets.
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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.
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SCOPE OF WORKING CAPITAL MANAGEMENT

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 Medicines Engineering Aluminium Paper Shipping

Chapter 21 Working Capital Management: An Introduction

7577 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 total duration taken by a firm to complete one chain of operations that begins with the procurement of inputs and ends with the realization of credit sales is known as operating cycle. Inventory conversion period (ICP), receivables conversion period (RCP) and payables deferral period (PDP) are the three constituents of the operating cycle
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OPERATING CYCLE AND WORKING CAPITAL MANAGEMENT Gross operating cycle (GOC) and net operating cycle (NOC) are the two measures of the operation cycle.
GOC = ICP + RCP NOC = GOC - PDP

NOC is alternatively referred to as cash cycle

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OPERATING CYCLE AND WORKING CAPITAL MANAGEMENT

Chapter 21 Working Capital Management: An Introduction

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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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Chapter 21 Working Capital Management: An Introduction

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)

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 (Current Assets)

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 (Current Assets)

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WORKING CAPITAL MANAGEMENT (Current Liabilities)

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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WORKING CAPITAL MANAGEMENT (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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ESTIMATION OF WORKING CAPITAL REQUIREMENTS Estimation of working capital requirements is based on past data and future projections. It requires estimation of the duration and weights of different components of the operating cycle
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ESTIMATION OF WORKING CAPITAL REQUIREMENTS

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:
RawMateria lConversio nPeriod (RMCP ) = AverageRaw MaterialIn ventory RawMateria lconsumed 360 Work - in - process inventory Cost of production 360

Work in process Co nversion P eriod (WIP CP) =

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ESTIMATION OF WORKING CAPITAL REQUIREMENTS

Finished goods Conversion Period (FGCP)= Finished goods inventory Cost of goods sold 360

Re ceivabled Conversion Period (R CP) =

Average Debtors Credit sales 360

Payables D eferral Pe riod (PDP) =

Average 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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Chapter 21 Working Capital Management: An Introduction

ESTIMATION OF WORKING CAPITAL REQUIREMENTS

Weight of Work in Process (Wwip)= Raw Material and Stores cost per unit + (Processing cost per unit) .5 Selling Price per unit
Cost of goods sold per unit Selling Price per unit

Weight of Finished Goods (Wfg) =

Weight of Accounts Receivable (War) =

Weight of Accounts Payable for credit purchases of material (Wap) =

Cost of Sales per unit Selling Price per unit

Raw Materials and Stores cost per unit Selling Price per unit
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Chapter 21 Working Capital Management: An Introduction

ESTIMATION OF WORKING CAPITAL REQUIREMENTS 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 is as follows:

Working Capital Requiremen t = Sales per day WOC + Cash Balance Required
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