PRINCIPLES OF WORKING

CAPITAL MANAGEMENT

LECTURE - 1
 INTRODUCTION
 One of the most important areas in the day
to day management of the firm is the
management of working capital.
 Working capital refers to the funds held in
current assets.
 Current assets are essential to use fixed
assets.
 The requirements for current assets are
usually greater than the amount of funds
available through current liabilities.
Goal 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 the main theme
of the theory of working capital
management.
Current Assets & Current
Liabilities
 Current Assets refers to those assets
which in the ordinary course of
business, will be converted into cash
within one year or operating cycle and
include cash, short-term securities,
debtors, bills receivable and inventory.
 Current Liabilities are those liabilities
which are to be paid within a year and
include creditors, bills payable and
outstanding expenses.
 OPTIMUM INVESTMENT
 The importance of adequate working capital can never be over emphasized.

 A firm has to be very careful in estimating its working capital. The effective management of
working capital is the primary means of achieving the firm’s goal of adequate liquidity.

 A very big amount of working capital would mean that the firm has idle funds. This results
in over capitalization.

 Over capitalization implies that the firm has too large funds for its requirements, resulting
in a low rate of return, ie., profitability will be reduced.

 If the firm has inadequate working capital, it is said to be under capitalized. Such a firm
runs the risk of insolvency.

 Shortage of working capital may lead to a situation where the firm may not be able to meet
its liabilities.

 Hence it is very essential to estimate the requirements of working capital carefully and
determine the optimum level of investment in it.

 At the optimum level of working capital the profitability will be maximum.

CONCEPTS OF WORKING
CAPITAL
1. Gross Working Capital :

The Gross working capital(GWC) refers to investment in all the

current
Assets taken together.

2. Net working Capital :

The term ‘net working capital’ (NWC) refers to excess of total

current
assets over total current liabilities(CA-CL).
OR
NWC can be defined as that part of the current assets which are
financed with long term funds.

Net working capital can be positive (CA>CL) or negative (CA<

CL).
Trade off between
profitability and risk
 To increase profitability, the firm
must also increase its risk.
 The trade off between these
variables is regardless of how the
firm increases its profitability
through the manipulation of
working capital, the consequence
is a corresponding increase in risk
as measured by the level of NWC.
NEED FOR WORKING
CAPITAL MANAGEMENT
Firms differ in their requirements for the working capital.

A firm should aim at maximizing the wealth of its shareholders.

In its endeavour to do so, a firm should earn sufficient return from its
operations.

Earning a steady amount of profit requires successful sales activity.

The firm has to invest enough funds in current assets for generating sales.

Current assets are needed because sales do not convert into cash
instantaneously.

Similarly inventory cannot be converted into cash as and when the firm require.

All the above aspects result in the funds of the firm being blocked for a certain
period. To operate the business in this period, a firm needs working capital.
IMPORTANCE OF
ADEQUATE WORKING
CAPITAL
A firm needs funds for its day to day running. Adequacy or
inadequacy of these funds would determine the efficiency with which
the daily business may be carried on. It is to be ensured that the
amount of working capital available with in the firms is neither too
large nor too small for its requirements.

For the following reasons working capital should be adequate.

 To meet the short term obligations.

 To avail the market opportunities such as purchase of raw materials at

the lowest price, with discount etc.

 To enable the firm to operate more efficiently and meet the raising
turnover thus peak needs can be taken care off.

 To enable the firm to extend favourable credit terms to the customers.

 OPTIMUM WORKING
CAPITAL
 Current ratio has traditionally been considered the
best indicator of the working capital situation.
 It is considered that a current ratio of 2 for a
manufacturing firm implies that the firm has an
optimum account of working capital.
 Optimum working capital can be determined only
with reference to the particular circumstances of a
specific situation.
 In a firm where the inventories are easily saleable
and the sundry debtors are as good as liquid cash,
the current ratio may be lower than 2 and yet firm
may be sound.
 An optimum working capital ratio dependent upon
the business situation as such, and the nature and
composition of various current assets.
WORKING CAPITAL CYCLE

 The working capital cycle/ Operating

cycle refers to the length of time
between the firms paying cash for
materials etc., entering into the
production process/inventory and the
inflow of cash from sale of finished
goods.
PHASES OF OPERATING
CYCLE
The operating cycle (working capital cycle) in a manufacturing firm
consists of the following events, which continues throughout the life of
business.

 Conversion of cash into raw materials

 Conversion of raw materials into work in progress
 Conversion of working progress into finished goods
 Conversion of finished goods into accounts receivable through sales
and
 Conversion of account receivable into cash (OR finished good into cash
in the case cash sales)

The duration of the Gross operating cycle for the purpose of estimating
working capital is equal to the sum of the durations of each of above said
events. Net operating cycle is calculated as Gross operating cycle less the
credit period allowed by the suppliers.
 Determination of
operating cycle

 Operating cycle = R + W + F + D – C
= Raw material + Work in progress +
Finished goods + Debtors - Creditors
TYPES OF WORKING
CAPITAL
From the point of view of time, the term working capital can be divided
into two
categories:

1. Permanent working capital:

It is that minimum level of investment in the current assets that is carried
by the
firm at all times to carry out minimum level of its activities. It also refers
to the
Hard core working capital.

2. Temporary working capital:

It refers to that part of total working capital, which is required by a

business over
and above permanent working capital. It is also called as variable or
fluctuating
working capital. Since the volume of temporary working capital keeps
on
fluctuating from time to time, according to the business activities it may
be financed
Estimation of working
capital
 This involves two steps

3. Estimation of Current Assets

5. Estimation of Current Liabilities

Estimated Working Capital requirement =

Estimated Current Assets – Estimated
Current
Liabilities
DETERMINANTS OF
WORKING CAPITAL
There are no hard fast rules or
formulae
to determine working capital needs
of the
firms. A large number of factors
influence
working capital needs of firms. All
factors
are of different importance. The
Nature & Size of
business

 The shorter the manufacturing process,

the lower is the requirements for the
working capital. This is because, in
such a case, inventories have to be
maintained at a low level. Longer the
manufacturing process the higher would
be the requirements of working capital.
This is the reason why highly capital
intensive industries require a large
amount of working capital to run their
sophisticated and long production
process.
Business cycle

 Business fluctuations lead to

cyclical and seasonal changes in
production and sales and affect the
working capital requirements.
Production Policy
 The plan for production, has great
influence on the level of inventories.
The raw material procurement varies
from industry to industry. In all such
cases, the need for working capital will
vary in accordance with production
plans. Similarly, the decision of the
management regarding automation,
etc., also affect working capital
requirements.
Conditions of supply

 If prompt and adequate supply of raw

materials, spares, stores etc., is
available, it is possible to manage with
small investments in inventory of work
on ‘Just in Time’ inventory principles.
However if supply is erratic, scanty,
seasonal, channelised through
government agencies etc., it is essential
to keep larger stocks increasing working
capital requirements.
Inventory policies
 Since a large amount of funds is
normally locked up in inventories,
the inventory policy of a company
has an impact on the working
capital requirements. An efficient
firm may stock raw material for a
smaller period and may, therefore,
require lesser amount of working
capital.
Credit Policy

 The credit policy of the firm also determines the

requirements of working capital. A firm, which allows
liberal credit to its customers may have higher sales but
consequently will have larger amount of funds tied up in
sundry debtors. Similarly a firm, which has a very
efficient debt collection machinery and offers strict
credit terms, may require lesser amount of working
capital than the one where debt collection system is not
so efficient or where the credit terms are liberal.
 The credibility of a firm in the market also has an effect
on the working capital requirements. Reputed and
established concerns can purchase raw material on
credit and enjoy many other services also like door
delivery, after sales service etc.,. This would mean that
they can easily have large current liabilities. Therefore
the required working capital may not be very high.
Market conditions

 Working capital requirements are also

affected by market conditions like
degree of competition. Large inventory
is essential as delivery has to be off the
shelf or credit has to be extended on
liberal terms when market competition
is fierce or market is not very strong or
is a buyer’s market.
Growth and expansion:

 The growth in volume and growth

in working capital go hand in hand.
However, the change may not be
proportionate and the increased
need for working capital is felt
right from the initial stages of
growth.
Level of taxes/Dividend
Policy
Level of taxes:
 The amount of taxes paid depends on taxation

laws. These amounts usually have to be paid

in advance. Thus need for working capital
varies with tax rates and advance tax
provisions.

Dividend policy:
 Payment of dividend utilizes cash, while

retaining profits acts as a source of working

capital. Thus dividend policies affect working
capital.
Price level
changes/Operating
efficiency
Price level changes:
 Inflationary trends in the economy

necessitate more working capital

to maintain the same level of
activity.
Operating efficiency:
 Efficient and coordinated utilization

of capital reduces the amount

required to be invested in working
capital.
Abnormal factors

 Abnormal conditions like strikes and

lockouts, also require additional working
capital. Recessionary conditions,
necessitate a higher amount of stock of
finished goods remaining in stock.
Similarly, inflationary conditions
necessitate more funds for working
capital to maintain the same amount of
current assets.
Approach to working
capital

 A firm can adopt different financing

policies namely long term, short term
and spontaneous.
 A firm should take maximum advantage
of the Spontaneous finance sources
such as trade credit.

 The approach a firm used in mixing

these sources can be matching,
conservative or aggressive.
Approaches
1. Matching or Hedging approach:

 When the firm uses long term sources to finance fixed assets and
permanent current assets, and short term financing to finance
temporary current assets.

2. Conservative approach:

 Under this approach a firm finances its permanent assets and also a
part of temporary current assets with long term financing. It relies
heavily on long term financing and is less risky so far as solvency is
concerned, however, the funds may be invested in such instruments,
which fetch small returns to build up liquidity. This adversely affects
profitability.

3. Aggressive Approach:

 The firm uses more short term financing than what is justified, in this
approach. The firm finances a part of its permanent current assets
with short term financing. This is more risky but may add to the return
on assets.