WORKING
CAPITAL
MANAGEMENT
Module 4
WORKING CAPITAL
MANAGEMENT
■ Topics like capital budgeting, dividend policy, and
capital structure which fall in the domain of long-
term financial management.
■ Working capital management or short-term
financial management which is concerned with
decision relating to current assets and current
liabilities.
WORKING CAPITAL
MANAGEMENT
■ It has been often observed that the shortage of working capital
leads to the failure of a business. The proper management of
working capital may bring about the success of a business firm.
■ A firm may exist without making profits but cannot survive
without liquidity. The financial manager must determine the
satisfactory level of working capital funds and also the optimum
mix of current assets and current liabilities. He must ensure that
the appropriate sources of funds are used to finance working
capital and should also see that short term obligation of the
business are met well in time.
Working Capital Concept
■ Working capital is amount of funds necessary to cover the cost
of operating the enterprise. Working Capital refers to that
part of the firm’s capital, which is required for financing
short-term or current assets like Cash,short term marketable
securities, debtors and inventories etc. Funds invested in
current assets keep revolving fast and are constantly converted
into cash and this cash flow out again in exchange for other
current assets. Working Capital is also known as revolving or
circulating capital or short-term capital.
Classification of Working capital
Working
capital
BASIS OF BASIS OF
CONCEPT TIME
Net Working Temporary /
Gross Permanent / Variable WC
Capital Fixed WC
Working
Capital
Seasonal Special
Regular Reserve
On the Basis of Concept:
■ Gross working capital is the capital invested in total current
assets of the enterprise. Examples of current assets are : cash
in hand and bank balances, Bills Receivable, Short term
loans and advances, prepaid expenses, Accrued Incomes etc.
■ Net Working Capital = Current Assets – Current Liabilities
■ When current assets exceed the current liabilities the
working capital is positive and negative working capital
results when current liabilities are more than current assets.
■ Examples of current liabilities are Bills Payable, Sunday
debtors, accrued expenses, Bank Overdraft, Provision for
taxation etc. Net working capital is an accounting concept of
working capital.
Contd.
On the Basis of Time
■ Permanent or Fixed working capital
■ It is the minimum amount which is required to ensure effective utilization
of fixed facilities and for maintaining the circulation of current assets.
■ regular working capital is the capital required to ensure circulation of
current assets from cash to inventories, from inventories to receivables and
from receivables to cash and so on.
■ Reserve working capital is the excess mount over the requirement for
regular working capital which may be provided for contingencies that may
arise at unstated periods such as strikes, rise in prices, depression etc.
Contd.
Temporary or Variable working capital
It is the amount of working capital which is required to meet
the seasonal demands and some special exigencies.
Variable working capital is further classified as seasonal
working capital and special working capital.
The capital required to meet seasonal needs of the enterprise is
called seasonal working capital.
Special working capital is that part of working capital which is
required to meet special exigencies such as launching of
extensive marketing campaigns for conducting research etc.
Need of Working Capital
■ For purchase of raw materials, components and spares.
■ To pay wages and salaries.
■ To incur day-to-day expenses and overhead costs such as fuel, power etc.
■ To meet selling costs as packing, advertisement
■ To provide credit facilities to customers.
■ To maintain inventories of raw materials, work in progress, stores and
spares and finished stock.
The amount of working capital needed goes on increasing with growth and
expansion of business till it attains maturity.
Significance of Working Capital Management
1. Liquidity Management
Efficient WCM ensures that a business has enough cash to cover its short-term
liabilities (e.g., accounts payable, short-term debt). Without proper liquidity, a
company may struggle to meet operational needs, leading to potential insolvency.
2. Operational Efficiency
Proper management of working capital ensures smooth operations, as it prevents
overstocking, maintains optimal inventory levels, and allows for timely payments to
suppliers. This helps avoid disruptions in production or sales.
3. Profitability
Effective working capital management can reduce the cost of borrowing, improve
creditworthiness, and lower interest expenses. By balancing current assets and
liabilities, a company can generate more profits by reducing financing costs.
Significance of Working Capital Management
4. Business Expansion
Businesses with strong working capital management are more likely to have the financial
flexibility to take advantage of new opportunities or invest in growth strategies, such as new
product lines or entering new markets.
5. Reduced Risk of Financial Distress
Poor working capital management can lead to cash shortages and increase the likelihood of
financial distress or even bankruptcy. By monitoring and adjusting working capital,
companies can mitigate this risk.
6. Investor Confidence
Investors and lenders often look at working capital levels as a key indicator of financial
health. Strong working capital management boosts confidence and may result in better
access to capital or favorable credit terms.
7. Improved Supplier and Customer Relationships
Timely payments to suppliers and the ability to offer favorable credit terms to customers
can strengthen relationships and potentially lead to discounts, better deals, or more flexible
payment terms.
FACTORS INFLUENCING WORKING CAPITAL
REQUIREMENTS
The working capital needs of a firm are influenced by numerous factors. The
important ones are:
■ Nature of business
■ Volume of Sales
■ Seasonality of operations
■ Production policy
■ Market conditions
■ Conditions of supply
■ Nature of Business: - A service firm, like an electricity undertaking
or a transport corporation, which has a short operating cycle and which
sells predominantly on cash basis, has modest working capital
requirements. On the other hand, a manufacturing concern like a
machine tools unit, which has a long operating cycle and which sells
largely on credit, has very substantial working capital requirements
Current Assets (%) Fixed Assets (%)
Industries
10-20 80-90 Hotels and
Restaurants
20-30 70-80 Electricity Generation and
Distribution
30-40 60-70 Aluminium, Shipping
40-50 50-60 Iron and Steel, Basic Industrial
Chemicals
50-60 40-50 Tea Plantation
60-70 30-40 Cotton Textiles, Sugar
70-80 20-30 Edible Oils, Tobacco
80-90 10-20 Trading, Construction
■Volume of Sales:
This is the most important factor affecting the size and
components of working capital. A firm maintains current
assets because they are needed to support the
operational activities which result in sales. They volume
of sales and the size of the working capital are directly
related to each other. As the volume of sales increase,
there is an increase in the investment of working capital-
in the cost of operations, in inventories and receivables
■Seasonality of Operations
Firms which have marked seasonality in their operations usually
have highly fluctuating working capital requirements.
Example consider a firm manufacturing ceiling fans. The sale of
ceiling fans reaches a peak during the summer months and drops
sharply during the winter period. The working capital requirements
of such a firm are likely to increase considerably in summer months
and decrease significantly during the winter period.
On the other hand, a firm manufacturing a product like lamps,
which have fairly even sales round the year, tends to have stable
working capital requirements.
■ Production Policy
A firm marked by pronounced seasonal fluctuations in its sales may
pursue a production policy which may reduce the sharp variations in
working capital requirements.
For example, a manufacturer of ceiling fans may maintain a steady
production throughout the year, rather than intensify the production
activity during the peak business season. Such a production policy
may dampen the fluctuations in working capital requirements.
■ Market Conditions
The degree of competition prevailing in the market place has an
important bearing on working capital needs. When competition is
keen, a larger inventory of finished goods is required to promptly
serve customers who may not be inclined to wait because other
manufacturers are ready to meet their needs. Further, generous
credit terms may have to be offered to attract customers in a highly
competitive market. Thus, working capital requirements tend to be
high because of greater investment in finished goods inventory and
■Conditions of Supply
The inventory of raw materials, spares, and stores
depends on the conditions of supply. If the supply
is prompt and adequate, the firm can manage
with small inventory. However, if the supply is
unpredictable and scant, then the firm, to ensure
continuity of production, would have to acquire
stocks as and when they are available and carry
larger inventory, on an average. A similar policy
may have to be followed when the raw material is
available only seasonally and production
operations are carried out round the year.
Different Components of Working Capital
1. Current Assets:
Current assets are those assets which can be easily converted
into cash and which are required to meet the day to day
operations of the business. These includes
Cash and bank balances, Temporary investments, Temporary
investments, Inventory of raw materials, stores and spares,
Work-in-progress, Finished goods, Prepaid expenses etc.
2. Current Liabilities:
Current liabilities are those claims of outsiders which are
expected to mature for payment within an accounting year.
These includes
Creditors for goods purchased, Outstanding expenses, Short-term
borrowings, Advances received against sales,
Part A : Current Part B: Current
Assets Liabilities
Inventories Sundry Creditors
Raw Materials Trade Advances
and Components Borrowings (short-
Work-in-Process term)
Finished Goods Commercial
Others Banks
Trade Debtors Others
Loans and Advances Provisions
Cash and Bank
Balances
■characteristics of current assets:
(i) short life span, and
(ii) swift transformation into other asset forms.
Current assets have a short life span. Cash balances may be held idle for a
week or two, accounts receivable may have a life span of 30 to 90 days, and
inventories may be held for 1 to 60 days. The life span of current assets
depends upon the time required in the activities of procurement, production,
sales, and collection and the degree of synchronization among them.
Each current asset is swiftly transformed into other asset forms: cash is used
for acquiring raw materials; raw materials are transformed into finished
goods (this transformation may involve several stages of work-in-process);
finished goods, generally sold on credit, are converted into accounts
receivable (book debt); and, finally, accounts receivable, on realisation,
generate cash
Current Asset Cycle
Finished Goods
Work in Progress
Accounts
Receivable
Wages, Salries,
Factory
overheads
Raw Materials
Cash Suppliers
Carrying cost and
shortage cost
Determining the optimal level of current assets involves a trade off between costs that
Carrying Cost & rise with current assets and costs that fall with current assets. The former are referred
Shortage Cost to as carrying costs and the latter as shortage costs. Carrying costs are mainly in the
nature of the cost of financing a higher level of current assets. Shortage costs are
mainly in the form of disruption in production schedule, loss of sales, and loss of
customer goodwill
Total Cost
Carrying Cost
Shortage Cost
CA* Level of current
assets (CA)
Traditional Methods of Estimating Working
Capital Requirements
Working Capital as ratio of sales
■ This approach to estimate the working capital requirement is based on
the fact that the working capital for any firm is directly related to the
sales volume of that firm. So, the working capital requirement is
expressed as a percentage of expected sales for a particular period.
The working capital estimation is thus, solely dependent on the sales
forecast. This approach is Based on the assumption that higher the
sales level, the greater would be the need for working capital
■ So, the firm has to find out on the basis of past experience, or on the
basis of other firm’s experience in the same competitive environment,
as to how much total current assets and total current liabilities should
be maintained for a given level of expected sales.
Working Capital as ratio of Fixed
assets
■ This approach of estimation of working capital requirement is based on the
fact that the total assets of the firm are consisting of fixed assets and
current assets. On the basis of past experience, a relationship between (i)
total current assets i.e., gross working capital; or net working capital i.e.,
Current assets - Current liabilities, and (ii) total fixed assets or total assets of
the firm is established.
■ In this approach, the working capital may also be estimated as a % of fixed
assets. The firm basically plans the future level of fixed assets in terms of
capital budgeting decisions. In order to use these fixed assets in an efficient
and optimal way, the firm must have sufficient working capital. So, the
working capital requirement depend upon the planned level of fixed assets.
The estimation of working capital therefore, depends upon the estimation of
fixed capital which depends upon the capital budgeting decisions.
Both the above approaches to the estimation of working capital
requirement are relatively simple in approach but difficult in calculation.
The main shortcoming of these approaches is that these require to
establish the relationship of current assets with the net sales or fixed
assets, which is quite difficult.
The past experience either may not be available, or even if available,
may not help much in correct estimation.
There is yet another approach to estimate the working capital
requirement based on the concept of operating cycle
Working Capital based on
operating cycle
■ The concept of operating cycle helps determining the time scale over
which the current assets are maintained. The operating cycle for
different components of working capital gives the time for which an
assets is maintained, once it is acquired.
■ However, the concept of operating cycle does not talk of the funds
invested in maintaining these current assets. The concept of
operating cycle can definitely be used to estimate the working capital
requirements for any firm.
■ In this approach, the working capital estimate depends upon the
operating cycle of the firm.
OPERATING CYCLE AND CASH
■CYCLE
The investment in working capital is influenced by four keys events in the
production and sales cycle of the firm:
■ Purchase of raw materials
■ Payment for raw materials
■ Sale of finished goods
■ Collection of cash for sales
The time that elapses between the purchase of raw materials and the collection of
cash for sales is referred to as the operating cycle.
Operating Cycle = Inventory Period + Accounts Receivable Period
The time length between the payment for raw material purchases and the collection
of cash for sales is referred to as the cash cycle.
Cash Cycle = Inventory Period + Accounts Receivable Period - Accounts Payable Period
The operating cycle is the sum of the inventory period and the accounts receivable
period, whereas the cash cycle is equal to the operating cycle less the accounts
payable period.
Order placed Stock arrives Finished goods sold Cash
received
Inventory period Accounts receivable
period
Accounts
payable period
Firm receives Cash paid for
invoice materials
Operating cycle
Cash cycle
■ Inventory period =
■ Accounts receivable period =
■ Accounts payable period =
Balance Sheet Data
Profit & Loss Account Data Beginning of 20X0 End of20X0
Sales 800 Inventory 96 102
Cost of goods 720 Accounts receivable 86 90
sold Accounts payable 56
60
Inventory period =
Accounts receivable period=
Accounts payable period=
Operating cycle = 50.1 + 40.2 = 90.3
days
Cash cycle = 90.3 - 29.4 - 60.9 days
Managing Liquidity
■ Properly managing liquidity ensures that the company possesses enough
cash resources for its ordinary business needs and unexpected needs of a
reasonable amount. It’s also important because it affects a company’s
creditworthiness, which can contribute to determining a business’s success
or failure.
■ The lower a company’s liquidity, the more likely it is going to face financial
distress, other conditions being equal.
■ However, too much cash parked in low- or non-earning assets may reflect a
poor allocation of resources.
■ Proper liquidity management is manifested at an appropriate level of cash
and/or in the ability of an organization to quickly and efficiently generate
cash resources to finance its business needs.
Managing Accounts
Receivables
■ A company should grant its customers the proper flexibility or level of
commercial credit while making sure that the right amounts of cash
flow in via operations.
■ A company will determine the credit terms to offer based on the
financial strength of the customer, the industry’s policies, and the
competitors’ actual policies.
■ Credit terms can be ordinary, which means the customer generally is
given a set number of days to pay the invoice (generally between 30
and 90). The company’s policies and manager’s discretion can
determine whether different terms are necessary, such as cash before
delivery, cash on delivery, bill-to-bill, or periodic billing.
Managing Inventory
■ Inventory management aims to make sure that the company keeps an
adequate level of inventory to deal with ordinary operations and
fluctuations in demand without investing too much capital in the
asset.
■ An excessive level of inventory means that an excessive amount of
capital is tied to it. It also increases the risk of unsold inventory and
potential obsolescence eroding the value of inventory.
■ A shortage of inventory should also be avoided, as it would determine
lost sales for the company.
Managing Short-Term Debt
■ Like liquidity management, managing short-term financing should also
focus on making sure that the company possesses enough liquidity to
finance short-term operations without taking on excessive risk.
■ The proper management of short-term financing involves the
selection of the right financing instruments and the sizing of the funds
accessed via each instrument. Popular sources of financing include
regular credit lines, uncommitted lines, revolving credit agreements,
collateralized loans, discounted receivables, and factoring.
■ A company should ensure there will be enough access to liquidity to
deal with peak cash needs. For example, a company can set up a
revolving credit agreement well above ordinary needs to deal with
unexpected cash needs
Managing Accounts Payable
■ Accounts payable arises from trade credit granted by a company’s
suppliers, mostly as part of the normal operations. The right balance
between early payments and commercial debt should be achieved.
■ Early payments may unnecessarily reduce the liquidity available,
which can be put to use in more productive ways.
■ Late payments may erode the company’s reputation and commercial
relationships, while a high level of commercial debt could reduce its
creditworthiness
summary
■ Working capital management involves balancing movements related to five main items –
cash, trade receivables, trade payables, short-term financing, and inventory – to make
sure a business possesses adequate resources to operate efficiently.
■ The levels of cash should be enough to deal with ordinary or small unexpected needs, but
not so high to determine an inefficient allocation of capital.
■ Commercial credit should be used properly to balance the need to maintain sales and
healthy business relationships with the need to limit exposure to customers with low
creditworthiness.
■ Managing short-term debt and accounts payable should allow the company to achieve
enough liquidity for ordinary operations and unexpected needs, without an excessive
increase in financial risk.
■ Inventory management should make sure there are enough products to sell and materials
for its production processes while avoiding excessive accumulation and obsolescence