Working Capital Management

Abhinav Rajverma
 Operating Cycle

Purchases Payments Credit sales Collection

Days Inventory Outstanding Days Sales Outstanding
(DIO) (DSO)

Gross Operating Cycle (GOC)

Days Payable Outstanding Cash Conversion Cycle (CCC)

(DPO)

The CCC shows the amount of time taken by a firm to

convert its investments in inventory to cash.
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 Working Capital
Current Assets (CA)
Inventory
Account Receivables
Cash
Marketable Securities

Current Liabilities (CL) Zero Working

Accounts payable Capital (ZWC)

Net Working Capital (NWC)

Liquidity position
Operational efficiency
Short-term financial health
Note: Changes in working capital affect a firm’s cash flow
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 Example: Change in NWC
Problem: A company has Rs. 20 million in sales and an
inventory turnover ratio (ITR) of 2. If it can reduce its
inventory and improve it ITR to 2.5 with no losses in sales, by
how much will its FCF increases?

Solution:
Scenario 1: Inventory = Sales/ITR = Rs. 10 million
Scenario 2: Inventory = Rs. 8 million
Decrease in Inventory level = Rs. 2 million
Increase in FCF = Rs. 2 million
 Liquidity Ratios

Current Ratio (CR) = CA/CL

Measures short-term solvency

Quick Ratio (QR) = Quick Assets/CL

CA less Inventories and Prepaid expenses
Rigorous measure of short-term solvency
No dilution in value

Cash Ratio = Cash and Marketable Securities/CL

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 Inventory Management
Inventories
Raw Materials (RM) Inventory
Work-in-progress (WIP) Turnover Ratio
Finished Goods (FG) (ITR)

The Inventory Trade-off Economic

Ordering Cost Order Quantity
(EOQ)
Carrying Cost

Just-in-time Built-to-order

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 Working Capital Calculation
Raw Material (RM)
+ New Purchases 1,000
- Change in RM-stock (Closing - Opening) 100
RM Consumed 900
+ Processing Expenses* 200
- Change in WIP-stock (50)

Production Cost 1,150

+ Processing Expenses* 250
- Change in FG-stock 100
Cost of Goods Sold 1,300
+ Gross Profit Margin 200
Net Sales 1,500

*Processing expenses booked against WIP and FG 7

 Example: NWC required
Prepare a statement for net working capital required to
finance the production activity of 12,000 units in a year (360
days). The firm plans to maintain cash level of Rs. 200,000
and completion level at work-in-progress is 50%.
The table below provides a proforma cost sheet of the firm.

Particulars Amount per Particulars Average

unit (Rs.) Duration (days)
Element of Cost RM in stock 60
Raw Materials 200 WIP 30
Direct Labour 40 FG in stock 60
Overhead Cost 60 DSO 30
Total Cost 300 DPO 60
Selling Price 400
 Solution: NWC required
Raw Material (2 M) 12,000*2/12*200 400,000
WIP (1 M) 12,000*1/12*(200+100*50%) 250,000
Finished Goods (2 M) 12,000*2/12*300 600,000
Receivables (1 M) 12,000*1/12*400 400,000
Cash 200,000
Total Current Assets 1,850,000
Payables (2 M) 12,000*2/12*200 400,000
Net Working Capital 1,450,000

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 Activity Ratios
Assets Turnover = Sales/Avg. TA
Inventory Turnover (ITR) = COGS/Avg. Inventory
Inventory Days (DIO) = Avg. Inventory/COGS per day = 365/ITR

RM Turnover = Cost of RM used/Avg. RM

WIP Turnover = Cost of Goods Manufactured/Avg. WIP
FG Turnover = COGS/Avg. FG
Receivable Turnover (RT) = Sales/Avg. Receivable
Receivable Days (DSO) = Avg. Receivable/Daily Sales = 365/RT

Creditors Turnover (CT) = Purchases/Avg. Payables

Credit Days (DPO) = Avg. Payable/Daily Purchases = 365/CT

Gross Operating Cycle = DIO + DSO

Net Operating Cycle = DIO + DSO - DPO
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 Practice Problem: WCM
Anand Furniture plans to produce 600 units of furniture. The
selling price of a unit is ₹500/-. The expected ratios of cost to
selling price are raw materials 60%, direct wages 10%, and
production overheads 20%. Raw materials (timber) are expected
to remain in store for an average of 2 months before issue to
production. Each unit of production is expected to be in process
for 1 month. Finished goods stay in the warehouse awaiting
dispatch to customers for about 3 months. Credit given to
debtors is 3 months from the dispatch of goods. Credit allowed
by creditors is 2 months from date of delivery of raw materials.
There is a regular production and sales cycle.
Comment on operating cycle and cash cycle of the firm.
 Example: Cash Conversion Cycle
Problem: A Company reported a Rs. 50,000 beginning inventory and Rs. 80,000
ending inventory for the FY ended 2019 with Rs. 400,000 cost of goods sold and sales
revenue of Rs. 600,000. The Company reported a Rs. 50,000 beginning accounts
receivable and Rs. 60,000 ending accounts receivable and posted a Rs. 30,000
beginning accounts payable and Rs. 50,000 ending accounts payable. Calculate cash
conversion cycle of the firm.
Solution:
Average Inventory = Rs. 65,000; COGS = Rs. 400,000; Sales = Rs. 600,000
Avg. Accounts Receivable = Rs. 55,000; Avg. Accounts Payable = Rs. 40,000
Inventory Days = 65,000/400,000 * 365 ≈ 59 days

Days Sales Outstanding = 55,000/600,000 * 365 ≈ 34 days

Days Payable Outstanding = 40,000/400,000 * 365 ≈ 37 days

Operating Cycle = DIO + DSO ≈ 93 days

Net Operating Cycle = DIO + DSO – DPO ≈ 56 days

Example: Benefit of Shortening the CCC
Problem: If the firm takes steps to reduce the DIO and DSO
by 10% and increase the DPO by 10%, what would be the
effect on CCC and NWC? [Refer Example: Cash Conversion
Cycle]

Solution:
CCC = 56 days [59 + 34 – 37]
CCC (new) = 56 – (5.9 + 3.4 + 3.7) = 43 days
NWC = 65,000 + 55,000 - 40,000 = Rs. 80,000
NWC (new) = Rs. 64,000
 Credit Management
Credit Decision
 Refuse Credit: No profit no loss
 Offer Credit
 Probability of payment (P) => Profit of [Rev – Cost]*P
 Probability of default (1-P) => Loss of [Cost]*(1-P)

Expected Profit = [Rev – Cost]*P - [Cost]*(1-P)

=> Exp(Profit) = P * Rev - Cost
Example: Cost of Anand Chair is Rs. 800 and firm decides
a profit of Rs. 200 per unit. Find the default rate for break
even, if credit is extended.
Solution:
Exp (profit) = P*Rev – Cost = 0
Þ P = 800/100 = 0.80
Þ Default rate for break even = 0.20
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 Credit Management
• 
Example: Cost of Anand Chair is Rs. 800 and firm decides a
profit of Rs. 200 per unit. The probability of Making payment is
75%. Find the expected profit and analyze credit decision.
Find the expected profit and analyze credit decision assuming
repeat order with 90% probability of making payment.

Solution: [ = 0.75]
Exp(profit) = *Rev – Cost = (-50)
[Credit should not be extended]
= 0.90
Exp(Profit) from repeat order = *Rev – Cost = 100
Þ Total Expected Profit = (-50) + PV(100)
[Credit should be extended]

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 Collection Policy
Credit Policy
Maximize Profit
Concentrate on the dangerous account
Look beyond the immediate order

How to decide terms of credit?

Collection Policy
Preference for cash sale over credit sales.
Average Receivables or Days Sales Outstanding
Impact of credit policy over DSO and Sales

Credit Policy: 2/10 net 30

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 Example: Collection Policy
Problem: Anand Furnitures sell on terms of 3/10, net 30. Total
sales for the year are Rs. 912,500. 40% of the customers pay on
the 10th day and take discounts; the others pay, on average after
40 days of their purchases.
a) Find DSO and Average Accounts receivables.
b) What if collection policy is tightened up so that the non-
discount customers paid up on 30th day.
Solution:
c) DSO = 0.4 * 10 + 0.6 * 40 = 28 days
Avg. accounts receivable = 28 * 912,500/365 = Rs. 70,000
b) DSO (new) = 0.4 * 10 + 0.6 * 30 = 22 days
Avg. accounts receivable = 22 * 912,500/365 = Rs. 55,000
=> Working Capital requirement decreased by Rs. 15,000.
 Example: Credit Terms
Credit Policy: 2/10 net 30

Discount (D) = 2%; Discount Period (DP) = 10 days

Credit Days (CD) = 30 days; Days after discount period (CD – DP) = 20 days

Periodic Cost (PC) = D/(100-D) = 2/98

Periods (No.) = 365/(CD – DP) = 365/20 = 18.25
Nominal Annual Cost (NAC) = PC * Periods
Effective Annual Cost = [1 + PC]^(Periods) - 1

Problem: A company has credit terms of 2/10, net 30. What is

the nominal and effective annual cost for the firm?

Solution:
Periodic Cost = 2/98 = 2.04%
Nominal Cost (annualized) = 2.04% * (365/20) = 37.2%
Effective Annual Cost = 1.0204^(18.25) – 1 = 44.6%
 Current Assets Investment Policy
Factors affecting Working Capital Policy
Uncertainty of sales
Expected Lead time
Minimum Safety Stock Policy
Competition Time
Brand Value

CA Investment Policies
Relaxed: Large investments in CA, Liberal Credit Policy
Aggressive: Low investments in CA, low level of safety stocks, Tight Credit
Policy
Moderate: Falls between the above two extreme policies
 Financing Mix of Current Assets
Short-term borrowing & Long-term borrowings
Matching Approach – Matching maturity of the assets
with maturity of financing.
Aggressive Approach - Short-term financing to finance
permanent assets.
Conservative Approach - Permanent capital for
permanent assets and temporary assets.

$ Temp. CA
Perm CA

Fixed Assets
Years
 Short-term Financing
Trade Credit (accounts payable) (“spontaneous financing”)
Missed discounts
Higher supply cost
Commercial Bank Loan
Line of Credit
Secured Loans
Unsecured loans
Commercial Papers: By large organizations
 Short-term debt vs. long-term debt
Disadvantages
Required repayment comes quicker
Trouble rolling over loans.

Advantages
Low-cost yield curve usually slopes upward.
Can get funds relatively quickly.
Can repay without penalty.

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 Cash and Marketable Securities
Cash Management
 Cash-in-hand: A cost
How Much cash?
 Synchronizing Cash Flows
 Efficient check clearing process
 Speeding up receipts

Marketable Securities Where to invest?

 Short-term investments: Money Markets
 Money Market Instruments: T-Bills, Certificate
of Deposits, Commercial Papers, Repo
 Cash Requirements
Idle Cash: Lost opportunity cost
Lost opportunity cost = Interest Rate (i) * Avg. Cash
Balance (C/2)
Investment in Marketable Securities: Cash conversion cost
Cash conversion cost per period = Avg. Cash required
per conversion (T/C) * Cost per conversion (b)
Total Cost per period = i * (C/2) + (Tb/C)

𝑂𝑝𝑡𝑖𝑚𝑎𝑙𝐶𝑎𝑠h
 
𝐴𝑚𝑜𝑢𝑛𝑡 ( 𝐶 ) =√ 2𝑏𝑇 /𝑖
 Example: Cash Requirements
Problem: A firm requires Rs. 30 lakh in cash to meet its transaction needs
during the next 3-month period. It holds marketable securities of an equal
amount having annual yield of 20%. Converting to cash entails a fixed cost of
Rs. 3,000 per transaction. Compute the amount of marketable securities
converted into cash per transaction.

Solution:
C = sqrt (2 * 3,000 * 3,00,000/0.05) = Rs. 6,00,000

No. of Conversion = 5; Avg. cash balance = Rs. 3,00,000

Interest foregone = Avg. Cash Balance * interest rate (periodic) = Rs. 15,000
Cash Conversion Cost = Conversion cost per order * Number of conversions
Total cost (converting & holding cash) = Interest foregone + Conversion Cost
Thank You

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