1.

WORKING CAPITAL INTRODUCTION & MEANING

Core idea.

Working capital (WC) is the capital a firm needs for day-to-day operations — to buy raw
materials, pay wages, hold inventory, and collect receivables until cash comes in.

Two standard definitions

1. Gross working capital = total current assets (cash, short-term investments, receivables,
inventories, prepaid expenses).
2. Net working capital (NWC) = current assets − current liabilities (short-term borrowings,
creditors, bills payable).

NWC=Current Assets−Current Liabilities

Why it matters

 Ensures liquidity (ability to meet short-term obligations).

 Affects profitability (idle cash/inventory reduces returns).
 Affects solvency and credit rating.

Types of working capital

 Permanent (fixed) WC: minimum always required (e.g., safety stock).

 Temporary (variable) WC: seasonal/short-term peaks (festival demand, promotions).
 Positive NWC: CA > CL — healthy liquidity.
 Negative NWC: CA < CL — could indicate tight liquidity or efficient cash conversion
(depends on business).

Example (simple numeric):

Current assets = ₹ 600,000; Current liabilities = ₹ 240,000.

Compute NWC:

 Step 1: 600,000 − 240,000 = 360,000.

 So NWC = ₹ 360,000.

2. THE OPERATING CYCLE / CASH CONVERSION CYCLE

Operating Cycle (OC) = time between purchase of raw materials and collection of cash from
sale of finished goods.
Two related measures:

 Operating cycle (OC) = Inventory period + Receivables period.

 Cash conversion cycle (CCC) = Inventory period + Receivables period − Payables
period.

Why use CCC: Measures how many days cash is tied up before conversion back to cash.
Shorter CCC → better liquidity.

Component definitions

 Inventory period (days) = (Average inventory / Cost of goods sold) × 365

It’s how long inventory sits before sale.

 Receivables period / Days Sales Outstanding (DSO) = (Average receivables / Credit

sales) × 365

It’s how long customers take to pay.

 Payables period = (Average payables / Purchases) × 365

It’s how long the firm delays supplier payments.

Worked example — step-by-step

Given (annual figures):

 Cost of goods sold (COGS) = ₹ 3,650,000

 Average inventory = ₹ 300,000
 Credit sales (assume all sales on credit) = ₹ 4,000,000
 Average receivables = ₹ 400,000
 Purchases = ₹ 2,920,000
 Average payables = ₹ 200,000

1. Inventory period = (300,000 ÷ 3,650,000) × 365

o 300,000 ÷ 3,650,000 = 0.0821917808…
o 0.0821917808 × 365 = 29.999999… ≈ 30 days.
2. Receivables period (DSO) = (400,000 ÷ 4,000,000) × 365
o 400,000 ÷ 4,000,000 = 0.1
o 0.1 × 365 = 36.5 ≈ 37 days.
3. Payables period = (200,000 ÷ 2,920,000) × 365
o 200,000 ÷ 2,920,000 = 0.06849315068…
o × 365 = 25.0 ≈ 25 days.
4. Cash conversion cycle = 30 + 37 − 25 = 42 days.
Interpretation: Cash invested in raw material takes about 42 days to return as cash after sales
collections.

3. FACTORS AFFECTING WORKING CAPITAL

REQUIREMENT
1. Nature of business — manufacturing needs more WC than trading or services.
2. Production cycle length — the longer the cycle, the greater the WC.
3. Business size — larger scale often needs more absolute WC.
4. Seasonality — seasonal peaks (e.g., festive retail) increase temporary WC.
5. Credit policy — liberal credit to customers increases receivables and WC.
6. Supplier credit — longer payables reduces WC needed.
7. Inventory policy — high safety stocks raise WC.
8. Growth rate — rapid growth raises WC needs (inventory + receivables grow with sales).
9. Operating efficiency — faster inventory turnover reduces WC.
10. Inflation & interest rates — higher prices / interest increase WC cost.
11. Technology & payment systems — efficient billing/collection reduces WC (e.g., digital
payments, direct debits).

Real-life note: A manufacturing firm with long lead times (e.g., heavy engineering) typically
keeps higher permanent WC than a SaaS company where customers pay monthly and inventory
is negligible.

4. METHODS TO ESTIMATE WORKING CAPITAL

Multiple approaches; use the one that fits available data and business specifics.

A. Percentage of Sales Method

Assume current assets (or NWC) should be a constant percentage of projected sales.

Example: Projected sales ₹ 10,000,000; historical NWC is 20% of sales → Required NWC =
0.20 × 10,000,000 = ₹ 2,000,000.

B. Operating Cycle / Cash Conversion Cycle Method

(preferred for manufacturing)
Estimate cash tied up during OC.

Steps:

1. Calculate OC (inventory days + receivable days − payable days).

 2. Compute working capital requirement = (Operating cycle in days ÷ 365) × Annual
operating cost (or sales as appropriate).

Example: If OC = 42 days and annual operating costs (or cost of sales) = ₹ 3,650,000:

 WC required ≈ (42 ÷ 365) × 3,650,000

o 42 ÷ 365 = 0.11506849315…
o × 3,650,000 = 419,000 (approx).
o So about ₹ 419,000 required to finance the OC.

C. Detailed Forecasting (Project approach)

Prepare projected balance sheets and cash budgets month-by-month; compute current assets and
liabilities for each period. This is most accurate for planning.

D. Working capital cycle approach

Calculate funds tied up in inventory + receivables − payables for a given planning horizon.

5. CALCULATION / WORKED EXAMPLES OF WORKING

CAPITAL
A full worked balance approach

Suppose projected period (one year) estimates:

 Cash = ₹ 50,000
 Marketable securities = ₹ 30,000
 Receivables = ₹ 200,000
 Inventory = ₹ 300,000
 Prepaid expenses = ₹ 20,000
 Total current assets = sum = 50,000 + 30,000 + 200,000 + 300,000 + 20,000 = ₹
600,000.

Current liabilities:

 Creditors = ₹ 180,000
 Short term loan = ₹ 120,000
 Accrued expenses = ₹ 20,000
 Total current liabilities = 180,000 + 120,000 + 20,000 = ₹ 320,000.

NWC = 600,000 − 320,000 = ₹ 280,000.

Interpretation: Firm needs ₹ 280,000 of net short-term funds to run operations.

6. KEY WORKING CAPITAL RATIOS & KPI’S
(with formulas)
 Current ratio = Current assets ÷ Current liabilities. (Ideal >1.2–2 depending on
industry.)
 Quick ratio / Acid test = (Current assets − Inventory) ÷ Current liabilities. (Shows
immediate liquidity)
 Working capital turnover = Net sales ÷ Average working capital. (Higher = efficient
use.)
 Inventory turnover ratio = COGS ÷ Average inventory. (Higher is faster movement.)
 Days Inventory Outstanding (DIO) = 365 ÷ Inventory turnover (or (Avg inv / COGS) ×
365).
 Days Sales Outstanding (DSO) = (Average receivables / Credit sales) × 365.
 Days Payables Outstanding (DPO) = (Average payables / Purchases) × 365.
 Cash conversion cycle (CCC) = DIO + DSO − DPO.

[Link] MANAGEMENT (ACCOUNTS RECEIVABLE)

7.1 Meaning & Objectives
Receivables management is controlling credit sales and collections—balancing higher sales
(through credit) against risk of bad debts and cash delays.

Objectives

 Increase sales volume via credit while controlling default risk.

 Speed up collections (reduce DSO).
 Minimize bad debts and carrying cost of receivables.
 Optimize credit terms to match liquidity needs.

7.2 Credit Policy — Components

1. Credit standards — Who qualifies? (creditworthiness)
2. Credit period — How long to pay (e.g., 30 days).
3. Credit limit — Maximum outstanding allowed per customer.
4. Credit terms — Cash discount terms, penalty for late payment (e.g., 2/10 net 30).
5. Collection policy — Reminders, collection stages, escalation.

Trade-off: Relaxed policy → higher sales but higher receivables and bad debts. Strict policy →
lower sales but better cash.

7.3 Credit Evaluation / Analysis

Steps:

1. Gather information: financial statements, bank references, trade references, credit

bureau reports.
2. Analyze: liquidity (current ratio), solvency (debt ratios), profitability, cash flows.
3. Quantitative scoring: Use ratios and scorecards to produce a credit grade.
4. Decide: Approve/reject, set limit, set terms, require security if needed.

Tools: Credit scoring models, aging analysis, limit tables.

7.4 Credit Monitoring & Control Techniques

 Aging schedule: classify receivables into 0–30, 31–60, 61–90, >90 days; calculate
provisions.
 Collection procedures: reminder letters, calls, SMS, email automation, onsite visits.
 Early-payment discounts: e.g., 2% discount if paid in 10 days.
 Credit insurance: transfer default risk to insurer.
 Factoring: sell receivables to a factor for immediate cash (explained below).
 Legal action for chronic defaulters.

7.5 Receivables Performance Metrics

 DSO as earlier. Example: Avg receivables ₹ 400,000, credit sales ₹ 4,000,000 → DSO =
(400,000 ÷ 4,000,000) × 365 = 36.5 days.
 Bad debt ratio = Bad debts ÷ Credit sales.
 Collection effectiveness index (CEI) = (Actual collections ÷ Expected collections) ×
100.

7.6 Factoring — Detailed

Definition: Selling accounts receivable to a factor (a financial entity) in exchange for immediate
cash (less fees). Factor may provide credit control, collection, and credit risk services.

Types

 Recourse factoring: Seller retains bad-debt risk (if buyer fails to pay, seller reimburses
factor).
 Non-recourse factoring: Factor bears credit risk (higher fee).
 Maturity factoring: Factor makes payment at maturity date (delayed).
 Advance factoring: Factor pays a percentage (e.g., 80%) upfront, remainder on
collection minus fees.

Fees and cost

  Suppose receivables = ₹ 1,000,000; factor advances 80% = ₹ 800,000 immediately.
Factor fee = 3% of invoice value = ₹ 30,000. Interest on advance until collection 1%
(assume negligible time). When customers pay, factor pays the remaining 20% less fee:
200,000 − 30,000 = 170,000 net remainder (plus any interest adjustments). Seller
receives 800,000 + 170,000 = 970,000 total (net cost 30,000 or 3%).

Why firms use factoring

 Immediate cash flow.

 Outsourced credit collection.
 Useful for exporters and small firms without strong collateral.

Real-life example: Exporters in many countries use factoring to get cash faster and hedge
trading partner risk.

8. CASH MANAGEMENT
8.1 Meaning & Objectives
Cash management is planning and controlling cash inflows and outflows to maintain sufficient
liquidity, minimize idle cash, and maximize returns on temporary surpluses.

Objectives

 Ensure enough cash for daily needs and obligations.

 Maintain adequate liquidity without holding excess idle cash.
 Minimize cost of holding cash and cost of obtaining cash.
 Improve return on short-term investments.

8.2 Importance
 Prevents insolvency and late payments.
 Improves investment and credit rating.
 Enables quick response to opportunities (discounts, investments).

8.3 Factors Affecting Cash Requirement

 Cash flow pattern & predictability (steady vs. volatile).
 Sales collection lag and supplier payment terms.
 Seasonality and growth rate.
 Access to short-term finance.
 Banking and payment systems (electronic collections shorten DSO).
 Interest rates and investment opportunities.
8.4 Cash Forecasting & Cash Budget (Tool)
Cash budget predicts cash inflows & outflows for a period (monthly/weekly/daily).

Typical cash budget format (monthly)

Particulars Month 1 Month 2 …

Opening cash balance 20,000 … …
Cash receipts (collections) 150,000 … …
Total cash available 170,000 … …
Cash payments (suppliers, wages, taxes) 140,000 … …
Net cash flow 30,000 … …
Financing (loans/repayments) 0 … …
Closing cash balance 50,000 … …

Why it’s useful: Highlights anticipated shortfalls/surpluses so firm plans borrowing or

investment.

8.5 Cash Management Models (simple illustrations)

A. Baumol (Cash Management) Model (inventory analogy)

 Treats cash like inventory: firm withdraws large cash from bank into cash “inventory”
and spends it gradually.
 Assumptions: predictable cash outflows, fixed transaction cost per bank withdrawal,
opportunity cost of holding cash (foregone interest).
 EOQ-style formula for optimal cash withdrawal (C*):

C∗=2×F×TrC^* = \sqrt{\frac{2 \times F \times T}{r}}C∗=r2×F×T

where F = fixed cost per transaction (withdrawal fee), T = total cash required over period,
r = opportunity cost rate (interest rate).

Example (numbers illustrative):

 Annual cash needs T = ₹ 1,200,000 (₹100,000 per month).

 Transaction cost F = ₹ 100 per withdrawal.
 Annual opportunity cost r = 6% (0.06).
 Compute:
 2 × F × T = 2 × 100 × 1,200,000 = 240,000,000.
 Divide by r: 240,000,000 ÷ 0.06 = 4,000,000,000.
 Square root of 4,000,000,000 = 63,245.5532… ≈ ₹ 63,246.
 So optimal cash withdrawal ≈ ₹ 63,246 each time.
B. Miller-Orr Model

 For stochastic cash flows; sets upper and lower control limits and a target cash balance.
When cash hits limits, firm transfers between marketable securities and cash.

Use in practice: Applied by treasuries when daily cash flows volatile.

8.6 Short-term Investment of Surplus Cash

 Overnight deposits, treasury bills, commercial paper, money market funds.
 Trade-off: Liquidity vs. return vs. safety.

Real-life example: Large corporates (e.g., multinationals) maintain centralized treasury that
pools cash globally and invests surplus in short-term sovereign paper.

9. INVENTORY MANAGEMENT
9.1 Meaning & Objectives
Inventory management controls quantities of raw materials, WIP, and finished goods.

Objectives

 Ensure production continuity and meet customer demand.

 Minimize total inventory cost (ordering + holding + shortage).
 Optimize stock levels using techniques and systems (JIT, EOQ, ABC).

9.2 Types of Inventory

1. Raw materials — inputs for production.
2. Work-in-Progress (WIP) — partially completed goods.
3. Finished goods — ready for sale.
4. Stores & spares / MRO supplies — maintenance items.
5. Transit inventory — goods in transit between locations.
6. Buffer/safety stock — extra to avoid stockouts.

9.3 Importance
 Prevents production stoppage.
 Ensures customer service levels.
 Reduces ordering/transport costs via economies of scale.
 Affects working capital and profitability.
9.4 Factors Affecting Inventory Levels
 Demand variability and forecast accuracy.
 Lead time and supplier reliability.
 Holding cost (storage, insurance).
 Ordering cost (procurement, freight).
 Service level targets (desired probability of not stocking out).
 Product perishability or obsolescence.
 Minimum order quantities and supplier constraints.

10. TECHNIQUES OF INVENTORY MANAGEMENT

1. ABC Analysis (Always Better Control)
Meaning:

ABC analysis is a method of categorizing inventory items based on their value and usage
frequency.
It helps prioritize attention and control over high-value items.

Classification:

Category % of Items % of Total Value Control Level

A Items 10–20% 70–80% Very strict control
B Items 20–30% 15–25% Moderate control
C Items 50–70% 5–10% Simple control

Explanation:

 ‘A’ items are high-value goods (e.g., microchips in electronics) — require frequent
review and accurate records.
 ‘B’ items are medium-value goods — reviewed periodically.
 ‘C’ items are low-value goods (e.g., nuts, bolts) — bulk purchases and minimal control.

Real-life Example:

In an automobile plant:

 Engines = A items
 Tyres = B items
 Nuts & bolts = C items

This allows efficient focus on high-cost items.

2. VED Analysis (Vital, Essential, Desirable)
Meaning:

Used mainly for spare parts and maintenance materials.

Items are classified according to their importance in operations.

Classification:

Category Meaning Control Approach

V – Vital Without which production stops Highest control
E – Essential Needed but production can continue for a short time Moderate control
D – Desirable Not essential; used occasionally Minimum control

Example:

In a cement plant:

 Kiln spare parts = Vital

 Conveyor belts = Essential
 Decorative lights = Desirable

3. FSN Analysis (Fast, Slow, Non-moving)

Meaning:

FSN classification is based on the rate of consumption or movement of inventory.

Classification:

Category Description
Fast-moving (F) Frequently used items; require continuous replenishment.
Slow-moving (S) Occasionally used items; reviewed periodically.
Non-moving (N) Obsolete or unused items; should be disposed of.

Example:

A pharma company may find:

 Common painkillers → Fast-moving

 Seasonal medicines → Slow-moving
 Outdated drugs → Non-moving
4. HML Analysis (High, Medium, Low Cost)
Meaning:

Items are categorized based on unit price (cost per unit), not consumption value.

Classification:

Category Meaning
H – High Cost Expensive items needing strict control.
M – Medium Cost Moderate control.
L – Low Cost Less control; purchased in bulk.

Example:

Hospital purchases:

 MRI machine parts = High cost

 Syringes = Medium cost
 Cotton rolls = Low cost

5. SDE Analysis (Scarce, Difficult, Easy to obtain)

Meaning:

This classification is based on the availability of items or supply position.

Classification:

Category Description
S – Scarce Imported or rare items — require advance purchase.
D – Difficult Items available from limited suppliers.
E – Easy Easily available in local markets.

Example:

A car manufacturer importing special engine parts from Japan will classify them as Scarce
items.

6. EOQ (Economic Order Quantity)

Meaning:
EOQ determines the optimum quantity of inventory to be ordered at one time to minimize total
inventory costs (ordering + holding).

Formula:

Where:
A = Annual demand (units)

S = Ordering cost per order

C = Carrying cost per unit per year

Example:

If annual demand = 10,000 units, ordering cost = ₹200/order, carrying cost = ₹2/unit/year:

Interpretation:

The firm should order 1,414 units per order to minimize cost.

7. JIT (Just-in-Time)
Meaning:

A Japanese inventory management system (developed by Toyota) aiming at zero inventory by

receiving materials exactly when needed.

Key Features:

 No storage or excess inventory.

 Strong supplier relationship.
 High production coordination.
 Focus on efficiency and waste reduction.
Advantages:

 Lower carrying costs.

 Reduced wastage.
 Higher efficiency.

Disadvantages:

 Risk of stock-outs if supply chain is delayed.

Example:

Toyota receives auto parts just before assembly — minimizing storage costs.

8. Reorder Level (ROL)

Meaning:

The stock level at which a new purchase order should be placed to replenish inventory before it
runs out.

Formula:

Example:

If max usage = 200 units/week and lead time = 3 weeks:

ROL = 200 × 3 = 600 units

→ New order should be placed when inventory drops to 600 units.

9. Safety Stock
Meaning:

Extra stock maintained to guard against uncertainties in demand or supply.

Purpose:

 Avoid stock-outs.
 Maintain production continuity.
 Handle unexpected demand increases.
Example:

If average usage = 100 units/day, lead time = 5 days, safety stock = 200 units, then reorder is
made when balance = (5×100) + 200 = 700 units.

10. Perpetual Inventory System

Meaning:

Continuous recording of inventory transactions (receipts, issues, balance) using real-time

software.

Features:

 Maintains up-to-date stock levels.

 Supports audit and verification.
 Detects theft or discrepancies early.

Example:

Walmart uses advanced barcoding and ERP systems for perpetual inventory tracking.

11. Inventory Turnover Ratio

Meaning:

Indicates how quickly inventory is sold and replaced in a period.

Formula:

Interpretation:

 High ratio: Fast sales, efficient inventory.

 Low ratio: Slow-moving, overstocking.

Example:

COGS = ₹10,00,000, Average Inventory = ₹2,00,000

→ Turnover = 10,00,000 / 2,00,000 = 5 times per year.

12. Minimum, Maximum, and Average Stock Levels
Stock Type Formula Meaning
Minimum Reorder Level – (Average Usage × Average Lowest allowable level before
Level Lead Time) shortage.
Maximum Reorder Level + EOQ – (Minimum Usage × Highest level to avoid
Level Minimum Lead Time) overstocking.
Average Level (Maximum Level + Minimum Level) / 2 Normal stock level.

Example:

ROL = 600 units, EOQ = 400, usage = 100–200 units/week, lead time = 2–3 weeks:

 Minimum = 600 – (150×2.5) = 225

 Maximum = 600 + 400 – (100×2) = 800
 Average = (800 + 225)/2 = 512.5 units.

✅ Summary Table of Techniques

Technique Basis Objective Example
ABC Value Focus on costly items Automobile parts
VED Criticality Spare parts control Cement plant
FSN Movement speed Avoid dead stock Pharma products
EOQ Cost optimization Ideal order quantity Retail store
JIT Timely supply Zero inventory Toyota
ROL Stock alert Timely reorder Manufacturing units
HML Unit cost Cost control Hospital equipment
SDE Availability Ensure supply Imported parts