CHAPTER- 3

WORKING CAPITAL
MANAGEMENT

Dr. Priya Gupta

 MEANING OF WORKING CAPITAL

▪After Plant & Machinery has been installed and the

manufacturing facility is put in place, the firm would
require investment made in Short-term assets.
▪Firms may be required to sell finished products/services on
credit leading to Receivables (or Debtors), or maintain
stocks of raw material/finished goods leading to
Inventories.
▪Investments in such short-term assets is called Working
Capital.
 Current Assets
• Those assets that are either in the form of cash or are expected to
be converted into cash in the short term (usually defined as less
than one year).
▪ Cash: most liquid asset
▪ Short Term Investments (Marketable securities) such as
Government bonds, generally can be converted into cash
quickly, at low cost and with minimum loss of value
▪ Inventory of Raw Materials, work-in-progress or Finished
goods
▪ Receivables (Debtors): When a firm sells goods on credit, it
creates receivables. On realization , they are converted into
cash
 Current Liabilities
• Those liabilities that are expected to be paid within a year.
▪ Non-interest bearing Current Liabilities
✓ Payables ( Creditors): when a firm buys goods on
credit, it
creates accounts payables
✓ Accrued expenses: Firms accrue wages & salaries
to their employees or taxes to government
✓ Provisions for Dividends/Taxes etc.
▪ Interest bearing Current Liabilities
✓ Current portion of long-term debt (Interest &
Principal)
✓ Short-term debt
Current Liabilities
CONCEPTS OF WORKING CAPITAL

• Working capital has its significance in two perspectives:

a) Gross Working Capital
b) Net Working Capital
 Gross & Net Working Capital
• Gross Working Capital is the aggregate investment in Current Assets.
✓ Trade-off between excessive and inadequate Current Assets;
✓ Financing of Current Assets.
• Net Working Capital is the difference between the Current Assets and
Current Liabilities of a firm.
✓ Indicates the liquidity position of a firm and indicates the extent to
which working capital requirements may be financed by long-term
sources.
✓ Current Assets should be sufficiently in excess of the current
liabilities and form a buffer for maturing obligations within a
operating cycle.
✓ Negative NWC (CL > CA) indicates negative liquidity, may prove
harmful to the firm.
✓ Excessive liquidity (high +ve NWC) is also not good.
 Contd…

• Working capital is also known as:

✓Circulating capital
✓Fluctuating capital
✓Revolving capital
▪The magnitude and composition keeps on changing
continuously in the course of business.
 NEED FOR WORKING CAPITAL

• The basic objective of financial management is to maximize

shareholders’ wealth.
• This is possible only when the company earns sufficient
profit.
• The amount of profit largely depends upon the magnitude
of sales.
• However, sales don’t convert into cash instantaneously.
• There is always a time gap between the sales of goods and
receipt of cash.
• Working capital is required for the period in order to
sustain the sales activity.
 Why do we need Working Capital?
• Current Assets are required as Sales do not convert into cash instantaneously.
• Operating Cycle – time duration required to
convert cash into R/M, then into finished goods and finally into cash.

Raw
Purchase Material Convert

Work-in-
Cash
Progress
Operating Cycle
Realise Convert

Finished
Debtors
Goods
Sale of
Goods
 Contd…

Gross Operating Cycle

Inventory Conversion Period Debtors Conversion

(RMCP + WIPCP + FGCP) Period

Purchases Credit Sales Collection

Payment

Payable Net Operating

Cycle
 Operating Cycle
Gross Inventory Receivables
Operating = Conversion + Conversion
Cycle Period Period

Inventory Raw Material WIP Finished

Conversion = Conversion + Conversion + Goods
Period Period Period Conversion
Period
Net
Operating Gross Payable
-
Cycle = Operating Deferral
Cycle Period
(Cash Conversion
Cycle)
 Contd…

• Raw Material = Average stock of Raw Material

Conversion Period
Average cost of Raw Material
Consumption per day*

▪Where,
Average cost of Raw Material Annual cost of Raw
Consumption per day = Material Consumption
360 days
 Contd…
◼WIP = Average stock of WIP
Conversion Period Average cost of WIP
Consumption per day*

▪ Where,
Average cost of WIP Annual cost of WIP
Consumption per day = Consumption
360 days
 Contd…

• Finished Goods = Average stock of Finished Goods

Conversion Period
Average cost of Finished Goods
Consumption per day*

Where,
Average cost of Finished Goods Annual cost of Finished
Consumption per day = Goods Consumption
360 days
 Contd…

• Debtors Conversion = Average Accounts Receivables

Period Average Credit Sales per day*
Where,
Average Credit Sales per day = Annual Credit Sales
360
• Creditors Deferral = Average Accounts Payable
Period Average Credit Purchases per day*
Where,
Average Credit Purchases = Annual Credit Purchases
per day 360
OPERATING CYCLE PERIOD
Question 1: From the following data, compute the duration of operating
cycle of each of the two years and comment on the increase/ decrease:
Assume 360 days per year for computational purposes.
Particulars Year 1 (Rs.) Year 2 (Rs.)

Raw Materials 20,000 27,000

Work In Progress 14,000 18,000

Finished Goods 21,000 24,000

Purchases 96,000 1,35,000

Cost of Goods Sold/ Cost of Production 1,40,000 1,80,000

Sales 1,60,000 2,00,000

Debtors 32,000 50,000

Creditors 16,000 18,000

 • Question 2: ABC Ltd. has obtained the following data concerning the average working
capital cycle for other companies in the same industry:

Raw material stock turnover 20 days

Credit received -40 days
WIP turnover 15 days
Finished Goods stock turnover 40 days
Debtors’ collection period 60 days
95 days

Using the following data, calculate the current working capital cycle for XYZ Ltd. and briefly
comment on it.
Rs. (‘000)
Sales 3,000
Cost of production 2,100
Purchases 600
Average Raw material stock 80
Average Work in process 85
Average Finished Goods Stock 180
Average Creditors 90
Average debtors 350

Assume Cost of Goods Sold to be equal to the Cost of production and 360 days in a year for
computational purposes.
PERMANENT AND TEMPORARY
WORKING CAPITAL
• For any company, production is continuous process and
hence there would be need for a regular supply of working
capital.
• However the magnitude of working capital would will not
be constant but will fluctuate over time, depending on the
activity level of the company.
• Permanent working capital represents the assets required
on continuous basis over the entire year.
• Temporary working capital represents additional assets
required at different times during the operation of the year.
Contd…

Y
Temporary/
Fluctuating
Amount of Working Capital

Permanent/
Fixed

X
O Time

In case of a Static Firm

Contd…

Y
Temporary/
Fluctuating
Amount of Working Capital

Permanent/
Fixed

X
O Time

In case of a Growth Firm

DETERMINANTS OF WORKING
CAPITAL
• A firm should plan in such a way that considering the
level of operations; it has neither too much nor too
little working capital.
• In general, following factors are involved in a proper
assessment of the quantum of working capital
required:
i. Nature and size of business
ii. Production cycle
iii. Business cycle
iv. Production policy
v. Profit level
vi. Level of taxes
 Contd…

vii. Dividend Policy

viii. Depreciation Policy
ix. Price level changes
x. Operating efficiency
xi. Credit policy
xii. Availability of credit from suppliers
 i. Nature & Size of Business

• Trading and financial firms have a very small investment

in fixed assets, but require a large sum of money to be
invested in working capital.
• Some manufacturing businesses, such as tobacco
manufacturers and construction firms, also have to invest
substantially in working capital and a nominal amount in
fixed assets.
• Public utilities may have limited need for working capital
and have to invest abundantly in fixed assets.
 Contd…

• Industry with larger operating cycle, like shipbuilding,

aircraft manufacturing, etc. may have larger amount of
working capital requirement.
• Industry having shorter operating cycle, like fan
manufacturing company may have smaller requirement
of working capital.
 ii. Production Cycle

• The term “production” or “manufacturing cycle” refers

to the time involved in the manufacture 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.
• Funds will be tied during the process of manufacturing,
necessitating enhanced working capital.
 iii. Business Cycle

• Business fluctuations lead to cyclical and seasonal

changes, which, in turn, cause a shift in the working capital
position, particularly for the temporary working capital
requirement.
• During the upswing, the need of working capital is likely to
grow to cover the lag between increased sales and receipt of
cash.
• Additional working capital may be required to finance
purchase of additional requirement of raw materials, etc.
during the boom phase.
• The downsizing phase will have exactly opposite effect on
the level of working capital requirement.
 iv. Production Policy

• Constant Production Policy would lead to accumulation

of inventory in off-season.
• Cost of maintaining inventory
• Risk - damage
• To minimize - firm may choose to vary its production schedules.
▪If production is confined only during the period of
demand.
▪ The firm will have to maintain its working force and physical facilities without adequate
production and sale.
 v. Profit Level

• Net profit earned by the firms, may provide a source of

their working capital needs.
• The availability of internal funds for working capital
requirements is determined not merely by the profit
margin but also on the manner of appropriating profits.
 vi. Level of Taxes

• Tax payment being statutory liability of the firm, forms a

very important aspect in determining the available working
capital.
• However, tax liability can be reduced with proper tax
planning.
 vii. Dividend Policy

• The payment of dividend consumes cash resources,

thereby, affects working capital availability of the firm.
• In some cases, shortage of working capital has been a
powerful reason for reducing or even skipping the
dividend.
 viii. Depreciation Policy

• The depreciation charges do not involve cash outflow.

• Higher depreciation will mean lower disposable profits,
hence lower payment of dividends, however, the cash will
be available with the firm.
 ix. Price Level Changes

• Rising prices would necessitate the use of more funds for

maintaining an existing level of activity.
• For the same level of current assets, higher cash outlays
would be required.
• Thus, the effect of rising prices will be that a higher
amount of working capital will be needed.
 x. Operating Efficiency

• Efficiency of operations accelerates the pace of the cash

cycle and improves working capital turnover.
• It releases the pressure on working capital by improving
profitability and improving the internal generation of
funds.
 xi. Credit Policy

• Liberal Credit Policy means high debtors, high

collection period, and high bad debts - hence more
working capital would be required.
• Therefore, company should follow a rational credit policy
– evaluate the credit worthiness of customers and review
them.
 xii. Availability of credit from suppliers

▪If a firm gets liberal credit from its suppliers, the

requirements of working capital would be less.
▪Suppliers’ credit finances the firm’s inventory and
reduces the requirement of working capital.
▪Also, if bank credit is easily available and on favourable
conditions, company would require less working capital.
 POLICIES FOR FINANCING
CURRENT ASSETS
• Different financing policies can be adopted vis-à-vis
current assets.
• Three types of financing may be distinguished:
i. Long-term Financing
ii. Short-term Financing
iii. Spontaneous Financing
 i. Long- Term Financing

• Examples:
➢Ordinary share capital
➢Preference share capital
➢Debentures
➢Long-term borrowings from financial institutions
➢Reserves and surplus (Retained Earnings)
 ii. Short- term Financing

• Arranged in advance from banks and other suppliers of

short- term finance in the money market.
• Short- Term Finances include:
➢Working Capital funds from Banks
➢Public Deposits
➢Commercial Paper
➢Factoring of Receivables
 iii. Spontaneous Financing

• Refers to the automatic sources of short- term funds arising

in the normal course of a business.
• Examples:
➢Trade (suppliers’) credit and
➢Outstanding expenses
▪No explicit cost of this financing
▪A firm is expected to utilize these sources of finances to the
fullest extent.
APPROACHES TO WORKING CAPITAL
FINANCING
▪Based on the mix of Short Term (Spontaneous Sources/
Current Liabilities) and Long Term sources of financing
Working Capital and the Fixed & Variable Current Assets,
there are three approaches to Working Capital
Financing:
➢Matching Approach
➢Conservative Approach
➢Aggressive Approach
 i. Matching Approach

▪Expected life of an asset should match the tenure of the

financing source.
➢Fixed assets should be financed by long term sources while the
current assets should be financed by short term sources.
➢Applying to Working Capital Management, Fixed Current Assets
should be financed by long-term sources while the Variable
Current Assets should be financed by short-term sources.
Contd…
Y Short Term
Financing
Amount of Working Capital

Long Term
Financing

Fixed Assets
X
O Time

FINANCING UNDER MATCHING APPROACH

 ii. Conservative Approach

• Under this approach, more reliance is on long-term

sources.
• Long term sources are used to finance Fixed Assets +
Fixed Current Assets + Part of the Variable Current
Assets.
• Lower level of risk of shortage of funds.
Contd…

Y Short Term
Financing
Amount of Working Capital

Long Term
Financing

Fixed Assets
X
O Time

FINANCING UNDER CONSERVATIVE APPROACH

 iii. Aggressive Approach

▪Under this approach, more reliance is on Short-term

sources of funds to finance assets.
▪Part of Fixed Current Assets + Temporary Current
Assets are financed by short-term sources.
Contd…

Y
Short Term
Financing
Amount of Working Capital

Long Term
Financing

Fixed Assets
X
O Time

FINANCING UNDER AGGRESSIVE APPROACH

 SHORT TERM VS. LONG TERM

▪Short-term funds are less costly and more flexible but at

the same time more risky.
▪Hence, a Risk-Return trade-off has to be achieved while
deciding the financing mix.
ESTIMATION OF WORKING
CAPITAL REQUIREMENTS
 Estimating Working Capital Requirements
1. Ratio of Sales: Working capital requirement is estimated as a ratio of
CA to Sales, based on past trend, keeping in mind the future scenario.
• Estimated WC requirement : 20% of Sales

2. Ratio of Fixed investment: Based on the ratio of CA to Fixed Assets.

• Estimated WC requirement : 15% of Fixed Assets

3. Current Assets Holding period: Based on the concept of

Operating Cycle
You are given the details of per unit cost of a product and additional information as follows:
Particulars Rs.
Raw Material 52.0
Direct Labour 19.5
Overheads 39.0
Total Cost (per unit) 110.5
Profit 19.5
Selling Price 130.0

Additional information: • Credit allowed to debtors: two months

• Average raw material stock: One month • Time lag in payment of wages: 10 days
• Average WIP stock : ½ month • Overheads: one month
• Average Finished Goods : one month • Cash Sales: 25% of total sales
• Credit Allowed by suppliers: one month • Cash balance : Rs 1,20,000/-

You are required to prepare a statement of working capital requirements, assuming output of
70,000 units.
 Based on Operating Cycle
A. Build-up of Current Assets: Amount (Rs)B. Build-up of Current Liabilities: Amount (Rs)
1. Raw Material Inventory: 1. Creditors
(RM Consumption per (RM purchased per day)*PDP
day)*RMCP (70,000*52)/360)*30 303,333
(70,000*52)/360)*30 303,3332. Wages
2. WIP Inventory:
(Labour cost per day)*Time lag
(COP per day)*WIPCP
(70,000*110.5)/360)*15 322,292
(70,000*19.5)/360)*10 37,917
3. Finished Goods Inventory:
(COS per day)*FGCP 3. Overheads
(Overheads cost per day)*Time lag
(70,000*110.5)/360)*30 644,583
4. Investment in Debtors (70,000*39)/360)*30 227,500
(Credit Sales per day)*RCP
4. Total Current Liabilities 568,750
(70,000*0.75*130)/360)*60 11,37,500 Net Working Capital required
C. (A-B) 19,58,625
5. Cash Balance 120,000

6. Total Current Assets 25,27,708

 Estimating Working Capital Requirements
Given below are the projected Income Statement of XYZ Limited:

The company has a policy to keep:

1.2 months’ consumption of Raw
material in stock.
2.15% of years’ production (in terms of units) as WIP (full material + 40% of Wages & Mfg
exp)
3.All expenses are paid one month in arrears
4.Suppliers of material grant 1 ½ months of credit
5.Cash Sales: 20% of total sales
6.Credit period : 2 months
Estimate the working capital requirement.
Contd…
Particulars Amount(Rs.)
1. Sales 22,47,000
Less:
Material used 8,98,800
Wages & Mfg Expenses 6,68,750
Depreciation 2,51,450
Add: Stock of Finished Goods 1,81,900
2. Cost of Goods Sold 16,37,100
3. Gross Profit (1-2) 6,09,900
4. Admisitrative Expenses 1,49,800
5. Selling Expenses 1,39,100
6. Profit Before Taxes 3,21,000
7. Tax provision 1,07,000
8. Profit After Taxes 2,14,000
 Based on Operating Cycle
1Investment in Inventories Current Liabilities:
(a) Raw Material (2 Months) 1,49,800 1Creditors 1,12,350
(RMC/12*2) (1 ½ months of Purchases/12)
(b) Work-in-Progress 1,74,945 (=1 ½ * 898800/12)
(15% of Adjusted COP) = 15% of 1166300
Adj COP = Material Cost + 40% of Wages Deferred Wages & Other
& 2 expenses 79,804
Mfg Exp (Wages + Mfg Expenses + Adm exp +
(= 898800 + 40% of 668750) = 1166300 Selling Exp)/12
(c) Finished Goods (given) 1,81,900 (668750+149800+139100)/12
2Investment in Debtors 2,99,600
(Credit Sales /12)*2 Total Build-up of Current
((80% of 2247000)/12)*2 Liabilities 1,92,154
3Cash Balance 0
Net Working Capital 6,14,091
Total Build-up of Current Assets 8,06,245