Principles of Working Capital

Management
 Introduction

 Every business requires capital, without which it cannot be

promoted.

 Investment decision is concerned with investment in current

assets and fixed assets.

 These two types of assets are financed by long-term capital

(or fixed capital) and working capital.

 In other words, the required capital can be divided into two

categories, long-term capital and working capital.
 Introduction

 Long term capital is required for establishment of a

business and for investing in fixed assets / projects,
whereas working capital is required to utilize fixed assets.

 Fixed assets cannot he utilized without current assets. It is

just like a blood in the human body, without which there is
no life.
 Introduction
 Effective provision of working capital can ensure the
success of a business while its inefficient management can
lead not only to loss but also to the ultimate downfall of
what otherwise might be considered as a promising
concern.

 In other words, efficiency of a business enterprise depends

largely on its ability to manage its working capital.

 Working capital management, therefore, is one of the

important facets of a firm’s overall financial management.
 What is Working Capital?
 Working capital refers to short-term funds to meet operating
expenses.

 It refers to the funds, which a company must possess to

finance its day- to-day operations.

 It is concerned with the management of the firm’s current

assets and current liabilities. It relates to the problems that
arise in attempting to manage the current assets, current
liabilities and inter-relationships that exist between them. If a
firm cannot maintain a satisfactory level of working capital, it
is likely to become insolvent and may even be forced into
bankruptcy.
 What is Working Capital?
 Two ways of looking at working capital:
 Gross Working Capital = Total Current Assets
 Net Working Capital = Current Assets – Current Liabilities

 Gross Working Capital Concept focuses attention on

optimum investment in current assets and their financing.

 Net Working Capital Concept indicates or measures the

liquidity and also suggests the extent to which working
capital needs may be financed by the permanent source of
funds.
 Permanent Working Capital
 Permanent working capital is the minimum investment kept
in the form of inventory of raw materials, work-in-process,
finished goods, stores & spares etc. to facilitate
uninterrupted operation in a firm.

 Though this investment is stable in short run, it certainly

varies in long run depending upon the expansion
programmes undertaken by a firm.

 It may increase or decrease over a period of time.

 Temporary Working Capital
 A firm is required to maintain an additional current assets
temporarily over and above permanent working capital to
satisfy cyclical demands. Any additional working capital
apart from permanent working capital required to support
the changing production and sales activities is referred to
as temporary or variable working capital.

 In other words, an amount over and above the permanent

level of working capital is temporary, fluctuating or variable
working capital. At times, additional working capital is
required to meet the unforeseen events like floods, strikes,
fire, and price hike tendencies and contingencies.
Permanent & Temporary Working Capital

If a firm is not growing:

Permanent & Temporary Working Capital

If a firm is growing:
 Components of Working Capital
 Components of Current Assets: Current assets are those
assets that in the ordinary course of business, can be or will
be turned into cash within an accounting period (not
exceeding one year) without undergoing diminution in value
and without disrupting the operations.

 Total current assets consists of cash, marketable securities

inventories, sundry debtors, one year fixed deposits with
banks, and prepaid expenses.
 Components of Working Capital
 Components of Current Liabilities: Current liabilities are
those liabilities that are intended to be paid in the ordinary
course of business within a year) out of the current assets
or revenue of the business.

 The current liabilities consist of sundry creditors, loans and

advances, bank over-draft, short-term borrowings, taxes
and proposed dividend.
 Importance of Working Capital
 Working capital is considered as central nervous system of
a firm. The importance of working capital management is
reflected in the fact that financial managers spend most of
their time in managing current assets and current liabilities.

 Adequate working capital needs to be maintained in order

to discharge day-to-day liabilities and protect the business
from adverse effects in times of calamities and
emergencies.

 In other words the goal of working capital management is to

minimize the cost of working capital while maximizing a
firm’s profits.
 Importance of Working Capital
 The efficiency of firm to earn profits depends largely on its
ability to manage working capital.

 Working capital management has acquired paramount

importance in the recent past, especially in view of tight
money conditions prevailing in the economy.

 Working capital management policies have a crucial effect

on firm’s liquidity and profitability.
 Aspects of Working Capital Management

 Determining the total funds required to meet the current

operations of the firm (i.e., determination the level of current
assets).

 To decide the structure of current assets (i.e., the proportion

of long-term and short-term capital to finance current
assets).

 To evolve suitable policies, procedures and reporting

systems for controlling the individual components of current
assets (mainly cash, receivables and inventory).

 To determine the various sources of working capital.

Objectives of Working Capital Management

 To ensure optimum investment in current assets.

 To strike a balance between the twin objectives of liquidity

and profitability in the use of funds.

 To ensure adequate flow of funds for current operations.

 To speed up the flow of funds or to minimize the stagnation

of funds.
 Operating Cycle
 The time that elapses to convert raw materials into cash is
known as operating cycle.

 In other words the time that elapses between the purchase

of raw materials and the collection of cash from customers
is referred to as the operating cycle.

 The operating cycle involves the following procedure:

 Conversion of cash into raw materials.
 Conversion of raw materials into work-in-process.
 Conversion of work-in-process into finished goods.
 Conversion of finished goods into sales [debtors and cash].
 Operating Cycle
Operating Cycle of a Manufacturing Firm:
 Operating Cycle
Operating Cycle of a Non - Manufacturing Firm:
 Cash Conversion Cycle
 The amount of time a firm’s resources are tied up is
calculated by subtracting the average payment period from
the operating cycle.

 In other words the time period between the dates from

when pays it suppliers to the date till it receives the cash
from its customers.
Operating Cycle & Cash Cycle
 Operating Cycle & Cash Cycle
 Cash Conversion Cycle (CCC) = Operating Cycle (OC) –
APP (Accounts Payable Period)

 OC = AAI (Average Age of Inventory) + ARP (Account

Receivables Period).
 Average Age of Inventory (AAI)
 The average number of days it takes for a firm to sell a product it
is currently holding as inventory to consumers. The formula to
calculate the average age of inventory is C/G x 365, where C is
the average cost of inventory at its present level and G is the
cost of goods sold, multiplied by the number of days in a year.

 For example, if the inventory is valued at Rs.100,000 and the

cost of goods sold is Rs.600,000, the average age of inventory is
60.8 days. 

 That means that on average it takes a firm approximately two

months to sell a piece of inventory.
 Account Receivables Period (ARP)
 ARP = (Average Accounts Receivables / Annual Sales) * 365
Need to maintain Balanced Working Capital

Dangers of Excessive Working Capital

 It results in unnecessary accumulation of inventories, which
leads to mishandling of inventories, waste, theft and losses.
 It is indication of defective credit policy and slack in collection
period. These lead to higher bad debt losses that reduce profits.
 It makes management complacent which degenerates into
managerial inefficiency.
Need to maintain Balanced Working Capital

Dangers of Inadequate Working Capital

 It stagnates growth. It becomes difficult for the firm to undertake
profitable projects for non- availability of capital.
 It becomes difficult to implement operating plans and achieve the
firm’s target profit.
 Operating inefficiencies creep in when it becomes difficult even
to meet day-to- day commitments.
 It leads to inefficient utilization of fixed assets. Thus, firm’s
profitability would deteriorate.
 Firm loses its reputation when it is not in a position to honor its
short-term obligations.
 Factors influencing Working Capital
Nature of Business
 Trading and finance firms have a very small investment in fixed
assets, but they require relatively more working capital.
 In contrast, public utility concerns rendering public services
require huge investment in fixed assets and comparatively lesser
amount of working capital.
 In trading concerns, the amount of working capital required is
less than the manufacturing concern, since there is no
production of goods and services involved.
 In service industry like banks the amount of working capital
required is very high.
 Factors influencing Working Capital
Size of Business
 A firm having with large-scale operations will need more working
capital required then a small firm having small-scale operations.
 A small firm may use extra current assets as a cushion against
cash flow interruptions.
 Bigger firms have many sources of funds, thereby it will require
less amount of working capital as compared to the smaller ones.
 Factors influencing Working Capital
Production Cycle Process
 The term production or manufacturing cycle refers to the time
involved in the manufacturing of goods. It covers the time span
between the procurement of raw materials and the completion of
the manufacturing process leading to the production of finished
goods.
 Longer the production cycle, the higher will be the working
capital requirement and vice versa.
 Manufacturing firms have large production cycle, so they require
high working capital, but in the case of short production cycle
firms require less working capital.
 Factors influencing Working Capital
Production Policy
 In case of seasonal products, there are two options before a
company, either it can confine its production only to periods when
goods are purchased or it can follow a steady production policy
throughout the year and produce goods at a level to meet peak
demand.
 If demand for a product is uniform throughout the year,
production and sales goes on simultaneously, the amount of
working capital required is less (example is FMCG goods
business); but if the sales is only seasonal but production will
take place throughout the year, the amount of working capital
required is very high (Umbrella business).
 Factors influencing Working Capital
Credit Policy or Terms of Purchase and Sales
 If a company purchases raw materials in cash and sells goods on
credit, it will require larger amount of working capital.
 On the contrary, a concern having credit facilities for the
purchase of raw materials and allowing no credit to its
customers, will require lesser amount of working capital.
 Factors influencing Working Capital
Business Cycle
 The variations in business conditions may be in two directions:
(a) Upward phase when boom conditions prevail – in this case
more working capital is required to cover the lag between the
increased sales and receipt of cash as well as to finance
purchase of additional material. (b) Downswing phase – in this
case, the need for working capital will be less, since there is no
growth in sales.
 Factors influencing Working Capital
Growth and Expansion
 As a company grows, it is logical to expect that a larger amount
of working capital in required.
 Other things being equal, growth industries require more working
capital than those that are static.
 Factors influencing Working Capital
Availabilty of raw materials
 The availability of certain raw materials on a continuous basis
without interruption would sometimes affect the working capital
requirement.
 There maybe some materials, which cannot be procured easily
either because their sources are few or they are irregular.
 Therefore, the firm might be compelled to purchase more than
required to manage smooth production.
 In this case, the amount of working capital required is large.
 Factors influencing Working Capital
Profit Level
 The net profit is a source of working capital to the extent that it
has been earned in cash.
 A high net profit margin contributes towards the working capital
pool.
 A firm with high profit level requires less working capital and vice
versa.
 Factors influencing Working Capital
Level of Taxes
 If tax liability increases, it leads to an increase in the requirement
of working capital and vice versa.
 So tax planning can, therefore, be said to be an integral part of
working capital planning.
 Factors influencing Working Capital
Dividend Policy
 payment of dividend reduces cash resources and thereby, affects
working capital to that extent.
 Conversely, if the firm does not pay dividends but retains profits,
the working capital increases.
 In other words, declaration of dividends leads to more working
capital requirement and vice versa.
 Factors influencing Working Capital
Depreciation Policy
 Depreciation charge is out of pocket cost. The affect of
depreciation policy on working capital is indirect.
 More depreciation provisions reduce the amount of required
working capital and vice versa.
 Factors influencing Working Capital
Price level changes
 Increasing prices necessitate the use of more funds for
managing an existing level of activity. At the same level of current
assets, higher cash outlays are required. The effect of raising
prices is that a higher the amount of working capital is required.
 However, in the case of companies, which can raise their prices
proportionately, there is no serious problem regarding working
capital required.
 Factors influencing Working Capital
Operating Efficiency
 The operating efficiency of the firm relates to the optimum
utilization of resources at minimum costs.
 Efficiency of operations accelerates the pace of cash cycle and
involves the working capital turnover.
 In this case the amount of working capital needed is less since it
releases pressure by improving profitability and improving the
internal generation of funds.
 Factors influencing Working Capital
Availability of credit
 A firm enjoying bank credit facilities can secure funds to finance
its working capital requirement very easily, whenever it requires.
 It can therefore, perform its business activities with less working
capital than a firm without such credit facility.
 An illustration
 From the following information of X Company Ltd., estimate the
working capital needed to finance a level of activity of 1,10,000
units of production after adding a 10% safety contingency.

Amount per unit

Raw Materials 78
Direct Labour 29
Overheads (excluding depreciation) 58
Total Cost 165
Profit 24
Selling Price 189
 An illustration
Additional information:
 Average raw materials in stock: One month
 Average materials-in-process (50 per cent completion stage): Half a month
 Average finished goods in stock: One month
 Credit allowed by suppliers: One month
 Credit allowed to customers: Two months
 Time lag in payment of wages: One and half weeks
 Overhead expenses: One month
 One-fourth of the sales is on cash basis. Cash balance is
expected to be Rs. 2,15,000. You may assume that production is
carried on evenly throughout the year and wages and overhead
expenses accrue similarly.
 An illustration
Particulars Amount (Rs.) Amount (Rs.)
A. Estimation of Current Assets:
i) Raw Materials in inventory (110000*78*4/52) 660000
ii) Work in process inventory (50% completion stage):
Raw Materials (110000*78*2/52) 330000
Direct Labour (110000*14.5*2/52) 61346.15
Overheads (110000*29*2/52) 122692.31
514038.46
iii) Finished goods inventory (110000*165*4/52) 1396153.85
iv) Debtors (110000*3/4*165*8/52) 2094230.77
v) Cash Balance Required 215000
Total Current Assets 4879423.08

B. Estimation of Current Liabilities:

i) Creditors (110000*78*4/52) 660000
ii) Expenses:
Direct Labour (110000*29*3/104) 92019.23
Overheads (110000*58*4/52) 490769.23
582788.46
Total Current Liabilities 1242788.46
C. Working Capital (A - B) 3636634.62
Add 10% contingency 363663.46
D. Working Capital Required 4000298.08
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