Unit 7: Working Capital Management

BBA-FINANCE
4th Semester

By: Pitambar Shrestha

 Course Contents

Concept of Working Capital

Determinants of Size of working capital
Importance of working capital management
Operating cycle
Cash conversion cycle
Current assets investment and financing policy
 Concept of working capital and
working capital management
Working Capital is the short term fund required to run day to
day business activities. It is defined as all the short-term assets
used in daily operations.

Firm need cash to pay for all their day to day activities such as
pay for the raw materials, pay bills and so on. The money
available to do so, is known as working capital.

Working capital, sometimes called gross working capital, simply

refers to current assets used in operations

It is the all short term, or current assets such as cash,

marketable securities, inventories, and accounts receivable.
 Cont…
Working capital management consists in managing current assets
and current liabilities with due emphasis on the relationship
between them so as to help maintain working capital at the
optimum level; with a view to minimizing risk in the efficient
conduct of the operating cycle of the business firm and maximizing
the profitability.

Its main objective is to manage the current assets and current

liabilities of the firm in such a way that a satisfactory level of working
capital is maintained.

In other words a firm should plan its operations in such a way that it
should have neither too much nor too little working capital.
 Cont…
There are two concepts of working capital such as gross concept and net
concept.

a) Gross working capital (GWC): The gross working capital refers to the
total amount of current assets.

Gross working capital = Sum of Total Current Assets

b) Net working capital (NWC): Net working capital is the amount shown by
the difference between the current assets and current liabilities. A positive
net working capital denotes a position where current assets are greater
than current liabilities. Excess of current liabilities over the current assets
denotes a position of negative net working capital. It can be shown by the
equation

Net Working Capital = Current assets (CA) – Current liabilities (CL)

 Cont…
The firm's working capital may be viewed as being comprised
of two components:-

a. Permanent working capital:- These assets are required on

a continuing basis over the entire year. They represent the
amount of cash, receivables and inventory maintained as a
minimum to carry on operations at any time.

b. Variable Working Capital:- The extra working capital,

needed to support the changing production and sales
activity, is called temporary or variable working capital. The
excess amount over fixed or permanent working capital is
known as Variable working capital.
 Importance of Working Capital
The importance of working capital management can be outlined
as under:
• Optimal working capital policy
• Significant role on total asset
• Looks after the liquidity and profitability to the firm
• Appropriate mix of long term and short term sources of
financing
• It considers both associated risk-return trade off.

Beside these, there are other significant areas of working capital

management due to the following reason
 To increase turnover or sales,
 To keep cordial relationship with suppliers and customers,
 For prompt payment on contingencies,
 To increase creditworthiness.
 Objective of working capital management
As we have already explained, there are two main objectives of
working capital management.

i) To ensure the sufficient level of liquid assets: The first

objectives is to ensure the sufficient level of liquid assets to pay
the liabilities so that company can continue the business
smoothly and the second one is that company can increase the
profitability.

ii) Maintaining adequate working capital: Maintaining adequate

working capital is not just important in short run. Adequate
liquidity is needed to ensure the survival of the business in the
long run.

On the other hand and excessively conservative working capital

management resulting in high level of idle holdings will reduce
profits
 Determinants of working capital
• Natures of business
• Time period of manufactures
• Volume of business
• The proportion of cost of raw material to total cost
• Use of manual labor or mechanization
• Need to keep larges tocks of raw materials and
finished goods
• Turnover of working capital
• Terms of credit
• Seasonal variation
• Requirements of Cash
 Cash Conversion Cycle (CCC)
The length of time period, the funds are tied up in working
capital, or the length of time between paying for working capital
and collecting cash from the sale of the working capital

Cash conversion cycle includes the following there components

such as Inventory conversion period (ICP), Receivable collection
period (RCP) and Payable deferred period (PDP)
1) Inventory Conversion Period (ICP): The average time required to
convert raw materials into finished goods and then to sell them.

Days in a year Inventory x Days in a year

ICP = or
Inventory turnover Cost of goods sold or Sales

Inventory turnover ratio = Cost of goods sold or sales/ Average Inventory

 Cash Conversion Cycle (CCC)
2) Average Collection Period (ACP) or Receivable collection Period
(RCP): The average length of time required to convert the firm’s
receivables into cash, that is, to collect cash following a sale.

Days in a year Days in a year x Receivable

RCP or ACP = or
Receivable turnover Credit sales or sales

Receivable turnover ratio = sales/ Average Receivable

3) Payables Deferral Period (PDP): The average length of time

between the purchase of materials and labor and the payment of
cash for them
Days in a year Days in a year x Account payable
PDP = or
Account payableayable turnover Cost of goods sold or sales

Account payable turnover ratio = COGS or sales/ Average Account Payable

 Cash Conversion Cycle (CCC)
The cash conversion cycle is a helpful way to look at the cash flow
for the firm. Cash conversion cycle can be found out as follows:-
Cash conversion cycle (CCC) = Inventory conversion period (ICP) +
Receivable conversion period (RCP or ACP) - Payable deferral
period (PDP)
CCC = ICP + RCP or ACP - PDP
CCC = Operating Cycle (OC) - PDP
Operating Cycle (OC): It encompasses two major short-term asset
categories: inventory and accounts receivable. It is measured in
elapsed time by summing the inventory conversation period and
receivable conversion period.
Operating Cycle (OC) = ICP + RCP
 Others important Ratio
1) Working capital Finance = Daily cost or investment ×
CCC

2) Working Capital Turn Over = Cost of goods sold or

sales/working capital Finance

3) Return on assets (ROA) = Net income/Total Assets

4) Return on equity (ROE) = Net income/ Total equity

5) Total assets = Fixed Assets + Current assets

 Example 1
RARA Foot Wares producing the smart shoes is reviewing is
policies regarding to WC management. On the average
inventories have an average of 60 days and Account receivable
are collected in 30 days and account payable is paid in 45 days
after they arises. It is assumed that there is 360 days in a year.
Required:
a. Calculation the firm's cash conversion cycle.
b. Calculate the firm's operating cycle.
c. If daily working capital is Rs.5,000, Find out the amount
investment in working capital.
Solution:
Inventory conversion period (ICP) = 60 days
Receivable conversion period (RCP) = 30 days
Payable deferral period (PDP) = 45 days
 Cont…
a) Cash conversion Cycle (CCC) = ICP + RCP – PDP
= 60 + 30 – 45= 45 days
b) Operating cycle = ICP + RCP = 60 + 30 = 90 days
c) Amount investment in working capital = Working capital
per day ×CCC = Rs. 5000 × 45= Rs. 2,25,000

How can we reduce the CCC and amount of working

capital?
• By reducing the inventory conversion period,
• By reducing the receivables collection period by
speeding up collections, or
• By increasing the payables deferral period by slowing
down its own payments
 Example 2
Nepal Sugar Corporation has an inventory conversion period of
75 days, a receivables conversion period of 38 days, and a
payables deferral period of 30 days.
a) What is the length of the firm's cash conversion cycle?
b) If the corporation's annual sales are Rs.3,375,000 and all
sales are on credit, what is the firm's investment in accounts
receivable?
c) How many times per year does the company turn over its
inventory?
Solution:
Given,
Inventory conversion period (ICP) =75 days, Receivable
collection period (RCP) = 38 days, Payable deferral period
(PDP)= 30 days
 Cont…
a) Calculation of cash conversion cycle (CCC)
Cash conversion cycle (CCC) = ICP + RCP – PDP = 75 + 38 – 30 = 83
days
b) Annual Credit Sales = 3375000, Account Receivable =?
Receivable × 360
Receivable conversion period (RCP) =
Credit Sales
Receivable × 360
Or, 38 days =
Rs. 3375000

Account Receivable = Rs. 356250

Therefore, the firm’s investment in account receivable is Rs.
356,250.
C) Calculation of inventory turnover ratio
Inventory Turnover ratio = Days in a year/ICP = 360 days/75 = 4.8 day
 Example 3
The Flamingos Corporation is trying to determine the effect of its inventory
turnover ratio and DSO on its cash flow cycle. Flamingo’s 2002 sales (all on
credit) were Rs. 180,000 and it earned a net profit of 5 percent. The cost of
goods sold equals 85 percent of sales. Inventory was turned over 8 times
during the year, and DSO was 36 days. The firm had fixed assets totaling Rs.
40,000. Flamingo’s payable deferral period is 30 days.
a) Determine cash conversion cycle and its effects.
b) Calculate total assets turnover ratio.
c)Calculate ROA assuming holding of cash and marketable securities in
negligible.
Solution:
Given,
Sales (all on credit) = Rs.1,80,000, Net profit margin = 5%, Net profit in
rupees = 5% of Rs. 1,80,000 = Rs. 9,000, Cost of goods sold (CGS) = 85% of
sales = 0.85 × Rs. 180,000 = Rs. 1,53,000, Inventory turnover ratio = 8 times.
DSO or RCP = 36 days, Fixed assets = Rs. 40,000, Payable deferred period
(PDP) = 30 days.
 Cont..
a) Calculation of cash conversion cycle (ccc)
360 days 360 days
Inventory Conversion Period (ICP) = = = 45 days
Inventory turnover ratio 8 times
Cash conversion Cycle (CCC) = ICP + RCP – PDP = 45 + 36 – 30 = 51 days

b) Calculation of total assets turnover

Total assets turnover = Sales/Total assets
= 180000/77125 = 2.33 times

c) Calculation of return on Assets (ROA)

Return on Assets (ROA) = Net profit after tax/Total Assets
= 9000/77125 = 0.1167 = 11.67%
 Cont..
Working Note
Inventory = COGS or Sales/Inventory turnover Ratio
= 153000/8 = Rs.19125
Receivable Collection Period (RCP) = (Receivable * 360)/Credit Sales
36 days = (Receivable * 360)/180000
Receivable = Rs.18000
Total current assets = Inventory + Receivables + cash
= Rs. 19,125 + Rs. 18,000 + 0
= Rs. 37,125
Total assets = Fixed assets + Current assets
= Rs. 40,000 + Rs. 37,125
= Rs. 77,125
 Concept of Zero Working Capital
Zero working capital is the one of the emerging trends in
working capital management.

According to this concept, current assets shall equal the

current liabilities at all time. Excess investment in current
assets is avoided and firm meets its current liabilities out of the
matching current assets.

Working capital = Inventories + Receivables - Payables

The rationale is that inventories and receivables are the keys to

making sales, and that inventories can be financed by suppliers
through accounts payables. This policy helps to generate cash.
Current Asset Investment and Financing Policies
It is the way of current assets are financed. There are three types of
current assets investment and financing policies such as Aggressive
(Tight ) policy, Maturity Matching, or Self-Liquidating (Moderate)
policy and conservative policy (Relaxed) policy.

1) Aggressive Policy (Tight Policy): Under this policy, the firm use
lower level of current assets and current assets are financed by using
short term debt (current liabilities). Therefore liquidity risk and
profitability will be higher.

2) Maturity Matching, or Self-Liquidating (Moderate) policy: Under

this policy, the firm use average or moderate level of current assets
and all current assets are financed by using long term (for fixed
current assets) and short term debt or current liabilities (for
temporary current assets). Therefore liquidity risk and profitability
will be average or moderate.
Current Asset Investment and Financing Policies

3) Conservative (Moderate) policy: Under this policy, the firm

use higher level of current assets and all current assets are
financed by using long term (for fixed current assets and
temporary current assets). Therefore liquidity risk and
profitability will be lower than other policies.
 Example 4
The Nepalgunj Soap Factory is attempting to establish a current assets
policy. Fixed assets are Rs.600,000, and the firm plans to maintain a
50 percent debt-to-assets ratio. The interest rate is 10 percent on all
debt. Three alternative current asset policies are under
considerations: 40, 50 and 60 percent of projected sales. The
company expects to earn 15 percent before interest and taxes on
sales of Rs.3 million. The company's effective tax rate is 40 percent.
What is the expected return on equity under each alternative?
Solution:
Given,
Fixed assets = 6,00,000, Debt to assets ratio = 50% , Interest rate =
10% on all debt
Current assets level = 40,50 and 60% of projected sales, Sales = 3 m =
3000000
Earning before interest and tax (EBIT) = 15% of sales = 15% of
3000000 = 4,50,000, Tax rate = 40%, Return on Equity (ROE) = ?
 Cont….

To calculate the return on equity in each policy, 1st we need

to prepare projected balance sheet and projected income
statement.
Balance sheets under each alternative
Consevative Moderate Aggresive
Policy Policy Policy
Current Assets 18,00,000 15,00,000 12,00,000
Fixed Assets 6,00,000 6,00,000 6,00,000
Total Assets 24,00,000 21,00,000 18,00,000
Debt (50% of Total 12,00,000 10,50,000 9,00,000
assets) 12,00,000 10,50,000 9,00,000
Equity
Total liabilities and 24,00,000 21,00,000 18,00,000
equity
 Cont…
Alternative Income Statement for Nepalgunj Soap Company
Consevative Moderate Policy Aggresive
Policy Policy
EBIT 4,50,000 4,50,000 4,50,000
Less: Interest 10% * debt 1,20,000 1,05,000 90,000
EBT 3,30,000 3,45,000 3,60,000
Less: Tax @ 40% 132,000 138,000 3,60,000
EAT (NI) 198,000 2,07,000 2,16,000
Equity 12,00,000 10,50,000 9,00,000
ROE = NI/Total Equity 198000/1200000 207000/1050000 2160000/900000
= 0.165 = 16.5% = 0.1971 = 19.71% = 0.24 = 24%

 Return on equity under Relax policy = 16.5%

Return on equity under Moderate policy = 19.71%
Return on equity under Restricted policy = 24%
 Example 5

Sundershan Press Inc. and the Himal Publishing Company had the
following balance sheets as of December 31, 1998 (thousand of
rupees):
Assets and liabilities Sudershan Press Himal Publishing
Current assets Rs. 100,000 Rs. 80,000
Fixed assets 100,000 120,000
Total assets Rs. 200,000 Rs. 200,000
Current liabilities Rs. 20,000 Rs. 80,000
Long term debt 80,000 20,000
Retained earnings 50,000 50,000
Common stock 50,000 50,000
Total liabilities Rs.200,000 Rs.200,000

Earnings before interest and taxes for both firms are Rs. 30 million,
and the effective tax rate is 40 percent
 Cont…
a) What is the return on equity for each firm if the interest rate on
current liabilities is 10 percent and the rate on long-term debt is 13
percent?
b) Which company is in a riskier position? Why?

Solution:
Given,
Earnings before interest and Tax (EBIT) = Rs. 30 million for both firm,
Tax rate = 40%,
Interest rate on current liabilities = 10%
Interest rate on long-term debt = 13%
Return on equity (ROE) = ?
 Cont…
a) Calculation of return on equity of each Company
Income statement for both company Dec. 31, 1995 (Thousands of Rs.)
Sudershan Press Himal Publishing
EBIT 30,000 30,000
Less: Ineterest 12,400 10,600
EBT 17,600 19,400
Less: Tax @ 40% 7,040 7,760
EAT (Net Income) 10,560 11,640
Shareholders equity = 50,000 + 50,000 = 50,000 + 50,000 =
Common stock + Retained 100,000 100,000
earning
NI 10560 11640
ROE = = 10.56% = 11.64%
Shareholder's equity 100000 100000
Working Notes
Calculation of interest : Sudershan Press Himal Publishing
Interest on current liabilities @ 10% = 2,000 8,000
Interest on long-term fund@ 13% = 10,400 2,600
Total interest = 12,400 10,600
 Cont…
b) Himal publishing company is riskier position. First, its Net Income
and Return on equity are more volatile than Sudershan Press when
interest rate is changed. Second, Himal must renew its large short-
term loan every year and if the renewal problem comes up at a time
when money is very tight, when its business is depressed or both,
then Himal could be denied credit, which could put it out of business.
 Numerical Problems for Assignment
Problem 1: The LP Gas Corporation has an inventory conversion period of 75
days, a receivable conversion period of 38 days, and a payable deferral
period of 30 days.
a)What is the length of the firm's cash conversion cycle?
b) If the corporation's annual sales are Rs. 33,75,000 and all sales are on
credit, what is the firm's investment in account receivables?
C) How many times per year does the corporation turn over its inventory?
Ans: a. 83 days; b. Rs. 3,56,250; c. 4.8 times
Problem 2: Rudra Electronics Company Ltd. is concerned about managing
cash efficiently. On the average, inventories have an average age of 75 days,
and accounts receivable are collected in 40 days. Account payable is paid
approximately after 35 days they arise. The firm spends Rs. 50 million in
operating cycle each year, at a constant rate. Assume a 360-day a year.
a)Calculate the firm's operating cycle.
b) Calculate the firm's cash conversion cycle.
c) Calculate the amount of negotiated financing required to support the
firm's cash conversion cycle.
d)Discuss how management might be able to reduce the cash conversion
cycle.
Ans: a. 115 days ; b. 80 days ; c. Rs. Rs. 11.11m
 Numerical Problems for Assignment
Problem 3: Makalu Pasmina Factory turns its inventory 8 times each year, has an average
payment period of 35 days, and average collection period of 50 days. The firm's total
annual outlays for operating cycle investments are Rs. 3.5 million. Assuming 360-days a
year:
a) Calculate the firm's operating and cash conversion cycles.
b) Calculate the firm's daily cash operating expenditure. How much negotiated financing
is required to support its cash conversion cycle?
c) Assuming the firm pays 14 percent for its financing, by how much would it increase its
annual profits by favourable changing its current cash conversion cycle by 20 days?
Ans: a. 95 days, 60 days ; b. Rs. 583333.33 ; c. Rs. 54444.45

Problem 4: MRF Tyre Corporation is trying to determine the effect of its inventory
turnover ratio and days sales outstanding (DSO) on its cash flow cycle. MRF's 2012 sales
(all on credit) were Rs. 1,80,000 and it earned a net profit of 5 percent, i.e. Rs. 9,000. The
cost of goods sold equals to 85 percent of sales. Inventory was turned over 8 times during
the year, and the average collection period was 36 days. The firm had fixed assets totalling
Rs. 40,000. NTC's payables deferral period was 30 days.
a) Calculate MRF's cash conservation cycle.
b) Assuming MRF holds negligible amounts of cash and marketable securities, calculate its
total assets turnover and ROA.
Suppose MRF's managers believe that the inventory turnover can be raised to 10 times.
c) What would MRF's cash conservation cycle, total assets turnover, and ROA have been,
if the inventory turnover has been 10 times for 2012?
Ans: a. 51days ; b. 2.33 times
 Numerical Problems for Assignment
Problem 5: You are given the following information
Sales for the year just ended were Rs. 50,000 and cost of goods sold was 60 percent
of sales.
Item Beginning (Rs.) Ending (Rs.)
Inventory 5,000 7,000
Accounts 1,600 2,400
receivable
Account payable 2,700 4,800
a. How long does it take to collect its receivables?
b. How long does inventory stay around before it is sold?
c. How long does it take to pay its bills?
d. Compute the cash conversion cycle.
e. What measures should management take to improve cash conversation cycle?
Ans: a. 14.4 days ; b. 72 days ; c. 27 days; d. 59.4 days
 Numerical Problems for Assignment
Problem 6: ABC Company has an inventory turnover of 2.4 times,
receivables collection period of 75 days and payable deferred period of
60 days. Assume 360 days.
i) What is the length of cash conversion cycle?
ii) If the company's annual sales is Rs. 6.75 million and 80% of sales are
on credit, what is the firm's investment in receivables?
iii) What is the level of inventory of ABC Company?

Problem 7: The Biratnagar Biscuit Factory has an inventory turnover is

2.4 times, a receivables collection period of 76 days, and a payables
deferral period of 60 days. Assume 360 days per year.
i) What is the length of the firm's cash conversion cycle?
ii) If the company's annual sales are Rs. 6.75 million and 80% sales are
on credit, what is the firm's investment in accounts receivable?
iii) How many times per year does the company turn over its
inventory?
 Numerical Problems
Problem 8: The Hawley Corporation is attempting to determine the
optimal level of current assets for the coming year. Management
expects sales to increase to approximately $2 million as a result of an
asset expansion presently being undertaken. Fixed assets total $1
million, and the firm finances 60 percent of its total assets with debt
and the rest with equity (common stock). Hawley’s interest cost is
currently 8 percent on both short-term and longer-term debt (which
the firm uses in its permanent structure). Three alternatives regarding
the projected current asset level are available to the firm: (1) a tight
policy requiring current assets of only 45 percent of projected sales,
(2) a moderate policy of 50 percent of sales in current assets, and (3)
a relaxed policy requiring current assets of 60 percent of sales. The
firm expects to generate earnings before interest and taxes (EBIT) at a
rate of 12 percent on total sales.
a) What is the expected return on equity under each current asset
level? (Assume a 40 percent marginal tax rate.)
b) In this problem we have assumed that the level of expected sales is
independent of current asset policy. Is this a valid assumption?
c) How would the overall riskiness of the firm vary under each policy?.
THANK YOU