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Working capital management


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  • 1. Working Capital 1
  • 2. Session Outline • What is working capital? • Importance of working capital • Factors affecting working capital • Sources of working capital finance • Finance mix for working capital • Working capital cycle • Calculation over working capital requirement Prabhat MittalPut your queries on 2
  • 3. 3 Working capital management? Working capital management involves the relationship between a firms short-term assets and its short-term liabilities. The goal of working capital management is to ensure that a firm is able to continue its operations and that it has sufficient ability to satisfy both maturing short-term debt and upcoming operational expenses. Sources of Finance Short Long Tem Term Finance required to meet capital Finance required to meet day-to-day expenditure Business requirementsPut your queries on www.financeclubb.comPrabhat Mittal
  • 4. Working Capital <-----> Net Current Assets Current Assets Inventory Accounts Receivables Cash Management /Payables Working Capital is the difference between resources in cash or readily convertible into cash (Current Assets) and organizational commitments for which cash will soon be required (Current Liabilities) Prabhat MittalPut your queries on 4
  • 5. Importance of adequate working capital • A large amount of working capital would mean that the company has idle funds. Since funds have a cost, the company has to pay huge amount as interest on such funds. • If the firm has inadequate working capital, such firm runs the risk of insolvency. Paucity of working capital may lead to a situation where the firm may not be able to meet its liabilities Prabhat MittalPut your queries on 5
  • 6. Factors affecting working capital • Nature of Business/Industry; Size of Business/Scale of Operations; Growth prospects • Business Cycle; Manufacturing Cycle; Operating Cycle & Rapidity of Turnover; • Operating Efficiency; Profit Margin; Profit Appropriation • Depreciation Policy; Taxation Policy; Dividend Policy and Government Regulations Prabhat MittalPut your queries on 6
  • 7. Working Capital Cycle across Industries Prabhat MittalPut your queries on 7
  • 8. Sources of Working Capital Finance Sources of Working Capital Long Tem Short Term Internal Sources Internal Sources External Sources External Sources (Retained (Accrual, (Trade Credit, (Equity, Loan) Earnings) Depreciation funs) advances) Prabhat MittalPut your queries on 8
  • 9. Current asset policy Assuming a constant level of fixed assets, a higher current assets/fixed assets ratio indicates a conservative current assets policy and a lower current assets/fixed assets ratio means an aggressive current assets policy assuming all factors to be constant.Put your queries on 9Prabhat Mittal
  • 10. Financing mix for Working Capital Hedging Approach Conservative Approach (Long + Short Term) (Mostly Long Term) Financing Mix Trade off Approach Aggressive Approach (Avg. of min/max WC to be funded (Mostly Short Term) by Long term and rest by short term) Prabhat MittalPut your queries on 10
  • 11. Working Capital Cycle Working Capital cycle indicates the length of time between a company’s purchasing materials, entering into stock and receiving the cash from sales of finished goods. It can be determined by adding the number of days required for each stage in the cycle. Prabhat MittalPut your queries on 11
  • 12. Calculation In the form of an equation, the operating cycle process can be expressed as follows: Working Capital Cycle = I + D – C Where, I = Inventory period D = Debtors collection period. C = Credit period availed. Prabhat MittalPut your queries on 12
  • 13. Calculation ……cont. The various components of operating cycle may be calculated as shown below: 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝐼𝐼 𝐼𝐼 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 𝐼𝐼 𝐼𝐼𝐼𝐼 𝐼𝐼 𝐼𝐼 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 𝐼𝐼 𝐼𝐼𝐼𝐼 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 𝑝𝑝 𝑝𝑝 = 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 / 𝑑𝑑𝑑𝑑𝑑𝑑 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 𝑅𝑅 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 𝑅𝑅 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 𝑝𝑝 𝑝𝑝 = 𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 𝑝𝑝 𝑝𝑝 = 𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝ℎ𝑎𝑎𝑎𝑎𝑎𝑎 Prabhat MittalPut your queries on 13
  • 14. Illustration From the following information of XYZ Ltd., you are required to calculate : (a) Operating cycle period. (b) Cash Cycle (c) Number of operating cycles in a year. 1.1.2012 31.12.2012 P&L Data Balance Sheet Data Sales 1000 Inventory 100 120 COGS 700 AR 80 90 AP 50 60 Prabhat MittalPut your queries on 14
  • 15. Illustration Inventory Period = 57.3 days Accounts Receivable Period = 31 days Accounts Payable Period = 28.6 days Operating Cycle = 57.3 + 31 = 88.3 days Cash Cycle = 88.3 – 28.6 = 59.7 days No. of Operating Cycles in a year = 365 / 88.3 = 4.13 Prabhat MittalPut your queries on 15
  • 16. How to calculate working capital? Daily requirement in Rs. x Average holding period Illustration On 1st January, the Managing Director of Naureen Ltd. wishes to know the amount of working capital that will be required during the year. From the following information prepare the working capital requirements forecast. Production during the previous year was 60,000 units. It is planned that this level of activity would be maintained during the present year. The expected ratios of the cost to selling prices are Raw materials 60%, Direct wages 10% and Overheads 20%. Raw materials are expected to remain in store for an average of 2 months before issue to production. Each unit is expected to be in process for one month, the raw materials being fed into the pipeline immediately and the labour and overhead costs accruing evenly during the month. Finished goods will stay in the warehouse awaiting dispatch to customers for approximately 3 months. Credit allowed by creditors is 2 months from the date of delivery of raw material. Credit allowed to debtors is 3 months from the date of dispatch. Selling price is ` 5 per unit. There is a regular production and sales cycle. Wages and overheads are paid on the 1st of each month for the previous month. The company normally keeps cash in hand to the extent of ` 20,000. Prabhat MittalPut your queries on 16
  • 17. Statement of working capital required ` ` Current Assets Raw materials inventory 30,000 Debtors 75,000 Working–in-process 18,750 Finished goods inventory 67,500 Cash 20,000 2,11,250 Current Liabilities Creditors 30,000 Direct wages payable 2,500 Overheads payable 5,000 Estimated working 37,500 capital requirements 1,73,750 Prabhat MittalPut your queries on 17
  • 18. Summary • Current assets have a short life span and are swiftly transformed into other asset forms. • The working capital needs of a firm are influenced by numerous factors : nature of business, seasonality of operations, production policy, market conditions, and supply conditions. • Determining the optimal level of current assets involves a tradeoff between carrying costs and shortage costs. • According to the matching principle, the maturity of the sources of finance should match the maturity of assets being financed. Prabhat MittalPut your queries on 18
  • 19. Summary ………..cont.. • The operating cycle of a firm begins with the acquisition of raw materials and ends with the collection of receivables. • The cash requirement of working capital is calculated by estimating the cash cost of various current assets required by the firm and deducting the spontaneous current liabilities from the cash cost of current assets. Prabhat MittalPut your queries on 19