02

Working Capital Management

Lesson Number 02
Allocated time: 2 weeks from the 15 weeks

DA 3523 Financial Management Lesson 01 Prepared by: Gayan Abeyrathna , Advanced Technological Institute: Kegalle
 Short term finance

 Short term finance is primarily concerned with the analysis of

decisions that affect current assets and current liabilities.
Frequently, the term networking capital is associated with short
term financial decision making.
 Net working capital is the difference between current assets
and current liabilities. Often, short term financial management
is called working capital management.
 Short term finance (cont.)

 There is no universally accepted definition of short- term finance. The

most important difference between short-term and long-term finance
is in the timing of cash flows. Short-term financial decisions typically
involve cash inflows and outflows that occur within a year or less.
 For example, short-term financial decisions are involved when a firm
orders raw materials, pays in cash, and anticipates selling finished
goods in one year for cash.
 In contrast, long-term financial decisions are involved when a firm
purchases a special machine that will reduce operating costs over,
say, the next five years.
 Short term finance (cont.)

 What types of questions fall under the general heading of short-

term finance? To name just a very few:
1. What is a reasonable level of cash to keep on hand (in a bank) to pay bills?
2. How much should the firm borrow in the short term?
3. How much credit should be extended to customers?
 Working capital management

Working capital is the money used to make goods and attract sales.
Working capital management is about the commercial and financial
aspects of inventory, credit purchasing, marketing and royalty and
investment policy.
 Gross working capital (GWC)

 This is simply called working capital and it refers to the firm’s

investment in current assets. GWC refers to the firm’s total investment in
current assets.
 Current assets are the assets which can be converted into cash within an
accounting year (or operating cycle) and include cash, short-term securities,
debtors, (accounts receivable or book debts) bills receivable and stock
(inventory).
 Net working capital (NWC)
 NWC refers to the difference between current assets and current liabilities.
 Current liabilities (CL) are those claims of outsiders which are expected to mature
for payment within an accounting year and include creditors (accounts payable),
bills payable, and outstanding expenses.
 NWC can be positive or negative.
Positive NWC= CA > CL
Negative NWC = CA < CL
NWC + Fixed assets = Long-term debt + Equity
NWC = (cash + other current assets) – Current liabilities
 GWC focuses on

✓ Optimization of investment in current assets

✓ Financing of current assets
 Investment in current assets should be just adequate to the needs of the
business firm. Excessive investment in current assets should be avoided
because it impairs the firm’s profitability, as idle investment earns nothing. On
the other hand, inadequate amount of working capital can threaten the
solvency of the firm because of its inability to meet its current obligations.
 NWC focuses on

✓ Liquidity position of the firm

✓ Judicious mix of short-term and long-term financing
 Net working capital is a qualitative concept. A weak liquidity position poses a
threat to the solvency of the company of the company and makes it unsafe and
unsound. A negative working capital means a negative liquidity, and may prove to be
harmful for the company’s reputation.

 Excessive liquidity is also bad. It may be due to mismanagement of current assets.

 Operating cycle

 Operating cycle involved in the conversion of sales into cash. Operating cycle is the time
duration required to convert sales, after the conversion of resources into inventories, into cash. The
operating cycle of a manufacturing company involves three phases:
✓ Acquisition of resources such as raw material, labour, power and fuel etc.
✓ Manufacture of the product which includes conversion of raw material into work-in- progress
into finished goods.
✓ Sale of the product either for cash or on credit. Credit sales create account receivable for
collection.
✓ The length of the operating cycle of a manufacturing firm is the sum of:
• Inventory conversion period (ICP).
• Debtors (receivable) conversion period (DCP).
 Gross Operating Cycle (GOC)

 The firm’s gross operating cycle (GOC) can be determined as

inventory conversion period (ICP) plus debtors’ conversion period
(DCP). Thus, GOC is given as follows:

GOC= ICP+DCP
 Inventory conversion period (ICP)

 Inventory conversion period is the total time needed for producing and
selling the product. Typically, it includes:
✓ raw material conversion period (RMCP)
✓ work-in-process conversion period (WIPCP)
✓ finished goods conversion period (FGCP)
 Debtors (receivables) conversion period (DCP)

 Debtor’s conversion period (DCP) is the average time taken to

convert debtors into cash. DCP represents the average collection
period. It is calculated as follows:

DCP= (Average Debtors/ Credit sales)*365

 Cash Conversion or Net Operating Cycle

 Net operating cycle (NOC) is the difference between gross operating

cycle and payables deferral period..
 Net operating cycle is also referred to as cash conversion cycle.

NOC= GOC-CDP
 Creditors (payables) deferral period (CDP)

 Creditors (payables) deferral period (CDP) is the average time taken

by the firm in paying its suppliers (creditors).

CDP=(Average Creditors/Credit Purchasing)*365

Below information is related to the financial year 2022 of X PLC.
Number of days of inventory – 65 days
Number of days of receivables- 55 days
Number of days of payables- 40 days
Calculate the length of working capital cycle for 2022
You are given the following information of T PLC for the financial year 2022.
Number of days of raw materials- 60
Number of days of work in progress-25
Number of days of finish goods- 30
Number of days of receivables-65
Number of days of payables-55
Calculate the length of working capital cycle for 2022.
  The following mention information was extracted from the ABC
Company,(in thousands)
Item Beginning Ending Average

Inventory (Rs.) 2000 3000 2500

Account receivable 1600 2000 1800

Accounts payable 750 1000 875

Additional information, (in thousands) Net sales Rs:11,500

Cost of goods sold
Calculate the operating cycle and cash cycle
  You have provided the following information for the X company,

Item අයිතමය Beginning ආරම්භය Ending අවසානය

Inventory (Rs.) 5000 7000

තතාග (රු)
Account receivable 1600 2400

ලැබිය යුතු ත ේෂ
Accounts payable 2700 4800

තගවිය යුතු ත ේෂ

Credit sales for the year just ended were Rs. 50,000 and cost of goods
sold was Rs. 30,[Link] the operating cycle and cash cycle
The table below provides the information extracted from the
annual accounts of G PLC for past 2 years. (figures in millions)

2022 2021
Raw materials 20 15
Work in Progress 25 20
Finished Goods 15 10
Material 100 80
Purchases
Cost of goods 180 130
sold
Sales 225 162
Receivables 40 35
Payables 25 20

Calculate the length of working capital cycle for the financial

year 2022
 The determinants of working capital
1. Nature of business: Service organizations may not hold any level of inventory or their level of inventory
may be very low. Hence, they require very less amount of working capital, while the working capital
requirements of trading or manufacturing organizationsare relatively very high.
2. Volume of sales: The higher the volume of sales, the higher is the requirement ofworking capital.
3. The larger the manufacturing cycle, the higher is the volume working capital needed to finance blockage
of money in raw material, work-in- progress and finished goods.
4. If the firm is following a liberal credit policy for its customers, it will result in higher investment in
receivables, leading to requirement of more working capital.
5. During the periods when inflation rate is high, need for working capital will also be high.
6. If the creditworthiness of an organization is good, it may manage the business with less amount of
working capital.
7. Seasonal fluctuations: During peak season, higher working capital is needed; while during dull
season, lower working capital is required.
8. If the organization’s expected growth rate is high, than working capital requirement will be higher to
sustain higher volume of sales, etc.
 (Nature of business, Market and demand , Technology and manufacturing policy, Credit policy,
Supplies’ credit, Operating efficiency, Inflation)
 PERMANENT AND VARIABLE WORKING
CAPITAL
 Permanent or fixed working capital : A minimum level of current assets,
which is continuously required by a firm to carry on its business
operations, is referred to as permanent or fixed working capital.
 Fluctuating or variable working capital :The extra working capital needed to
support the changing production and sales activities of the firm is referred to
as fluctuating or variable working capital.
Working Capital Finance Policies

 A firm can adopt different financing policies vis-a-vis current assets.

Three types of financing may be distinguished as,
✓ Long-term – The sources of long term financing include ordinary share
capital, preference share capital, debentures, long term borrowings
from financial institutions and reserves and surplus (retained earnings)
✓ Short-term- The short term financing is obtained for a period less than
one year. It is arranged in advance from banks and other suppliers of
short term finance in the money market. Short term finance includes
working capital funds from banks, public deposits, commercial paper,
factoring of receivables, etc.
✓ Spontaneous- refers to the automatic sources of short term funds arising
in the normal course of a business. Trade (suppliers’) credit and
outstanding expenses are examples of spontaneous financing.
Working Capital Finance Policies
(Cont.)
Depending on the mix of short term and long term financing, the approach
followed by a company may be referred to on,
1. Matching approach/ Hedging approach
2. Conservative approach
3. Aggressive approach
Matching Approach
 Long term financing will be used to finance fixed assets and permanent
current assets and short term financing to finance temporary or variable
current assets.
Conservative Approach
 Under a conservative approach, the firm finances its permanent assets and
also a part of temporary current assets with long term financing.
Aggressive Approach
 An aggressive policy is said to be followed by the firm when it uses more
short term financing than warranted by the matching plan.
Working capital estimation

 Working capital estimation involves calculating the amount of capital

required to manage an organization’s short-term operational needs. It is the
difference between current assets and current liabilities and represents the
funds available to cover the day-to-day operations of a business or
institution.
 Past Paper 2019 Q2, ii
The management of Roba (pvt) Ltd has called for a statement showing the working
capital needed to finance a level of activity 100,000 units of output for the year 2020.
The cost structure for the company’s product for the above-mentioned activity level is
detailed below.

 Past trends indicate that the raw materials and finished goods are held in stocks, on
an Average, for 3 months. Work-in process (75% complete) will approximate to years
Production. Suppliers of materials gram 6 months credit period. Sales are 20% cash
while remaining on two month's credit. A minimum cash balance of Rs. 250,000 is
expected to be maintained. All overhead expenses arc paid 3 months in arrears.
The production pattern is assumed to be even during the year.
 You are required to prepare a statement of working capital determination for the
year 2020. (Add 10% to your computed figure to allow for contingencies)
 Past Paper 2018 Q2, iii
A forecasted cost sheet of a company provides the following particulars.

Further the following particulars are also available:

Raw materials are in stock nearly one month. Materials are in process on an average for half a month. Finished goods are in stock on an
average for one month. Credit allowed by suppliers is one month. Credit nil owed to customers is two months. Lag in payment of wages
is 1 ½ weeks. Lag in payment of overhead expenses is one month. One-fourth of the output is sold against cash. Cash in hand and at
bank is expected to be Rs.25, 000.

You are required to prepare a statement showing the working capital needed to finance a level of activity of 1,04,000 units of
production.

You may assume that production is carried on evenly throughout the year, wages and overheads accrue similarly, and assume that 52
weeks per annum.
Past Paper 2022 Q3, iii