Introduction to Working Capital
• The term working capital refers to current assets which may
be defined as (i) those which are convertible into cash or cash
equivalents within a period of one year, and (ii) those which
are required to meet day to day operations.
• Working Capital Management is management of firm’s
sources and uses of working capital in order to maximize the
wealth of the shareholders .
Term Working Capital-two
• GROSS WORKING CAPITAL :
• It refers to the firm’s investment in all the current assets taken
• NET WORKING CAPITAL :
• The term net working capital may be defined as excess of total
current assets over total current liabilities.
• Excess of current assets over current liabilities are called the
net working capital or net current assets.
• Working capital is really what a part of long term finance is
locked in and used for supporting current activities.
• The balance sheet definition of working capital is meaningful
only as an indication of the firm’s current solvency in repaying
• When firms speak of shortage of working capital they in fact
possibly imply scarcity of cash resources.
• In fund flow analysis an increase in working capital, as
conventionally defined, represents employment or application
• The operating cycle may be defined as the time duration
starting from the procurement of goods or raw materials and
ending with the sale realization.
• The operating cycle of a firm consists of the time required for
the completion of the chronological sequence of some or all
of d following
• Procurement of raw materials & services.
• Conversion of raw materials into work-in-progress.
• Sale of finished goods (cash or credit)
• Conversion of receivables into cash.
OPERATING CYCLE PERIOD= Inventory
Conversion period + Receivables Conversion Period
Inventory Conversion Period: It is the time required for the
conversion of raw materials into finished goods sales. ICP=
Receivables Conversion Period: It is the time required to convert
the credit sales into cash realization. It refers to the period
between the occurrence of credit sales and collection of
Calculation of TOCP & NOC
FGCP= Average finished goods
Total cost of goods sold
RCP= Average Receivable
Total Credit Sales
DP = Average Creditors
Total Credit Purchase
WPCP= Average work in progress
Total cost of production
RMCP= Average raw material stock
Total raw material consumption
Receivable Conversion Period
Inventory Conversion Period
Net Operating Cycle
THE OPERATING CYCLE
EXCESS OR INADEQUATE WORKING
Every business concern should have adequate working capital
to run its business operations. It should have neither
redundant or excess working capital nor inadequate or
shortage of working capital.
Both excess as well as shortage of working capital situations
are bad for any business. However, out of the two,
inadequacy or shortage of working capital is more dangerous
from the point of view of the firm.
Disadvantages of Redundant or
Excess Working Capital
Idle funds, non-profitable for business, poor ROI
Unnecessary purchasing & accumulation of inventories over
Excessive debtors and defective credit policy, higher incidence
Overall inefficiency in the organization.
When there is excessive working capital, Credit worthiness
Due to low rate of return on investments, the market value of
shares may fall
Disadvantages or Dangers of
Inadequate or Short Working
Can’t pay off its short-term liabilities in time.
Economies of scale are not possible.
Difficult for the firm to exploit favorable market situations
Day-to-day liquidity worsens
Improper utilization the fixed assets and ROA/ROI falls sharply
Different types of working capital policies
• Moderate Working Capital Policy : The increase in sales level
is coupled with proportionate increase in level of current
• Conservative working capital policy: For every increase in sale
there is more than proportionate increase in current assets. It
reduces the risk of shortage of working capital by increasing
the safety component of current assets.
• Aggressive working capital policy: the increase in sale does
not result in proportionate increase in current assets. It lead
to risk of insolvency & difficulty to face unexpected changes.
Reduced investment in current assets, result in increase in
profitability of the firm.
Types of Working Capital
• Permanent working capital: the minimum level of working
capital which is constantly required by a firm in order to
maintain its activities irrespective of the level of activities.
Even during slack season, every firm maintains some current
• Temporary working capital: The working capital required over
and above the permanent working capital to meet the
requirements arising out of fluctuations in sales volume
Difference between permanent &
temporary working capital
Variable working capital
Permanent working capital
Variable Working Capital
Permanent Working Capital
Financing of Current Assets
• An important aspects of working capital management is to
decide the pattern of financing the current assets and one of
the major problem in working capital management is the
decision whether to finance the working capital with one
source or the other. Breaking down working capital needs into
permanent and temporary components over time provides a
useful by product in terms of financing choice.
• So the two components of working capital needs to be finance
accordingly for which the different sources of fund can be
grouped as follows.
1. LONG TERM SOURCES
These provides fund for a relatively longer period.
Major long term sources:
• Share capital
• Retained earning
• Long term borrowings
SHORT TERM SOURCES
These provide funds for a short period say up to one year or so
Major short term sources:
• Bank credit
• Pubic deposit
• Commercial papers
3. TRANSACTIONARY SOURCES
These provide funds to a business through the normal business operations
Credit allowed by suppliers
• Outstanding labor
• Other expenses
Approaches related to financing
Hedging Approach: Fixed working capital is financed by long term
sources of funds while the additional or fluctuating working
capital needs are financed by short term sources
Short term sources
Long term sources
• Working Capital needs are primarily financed by long term
sources and the use of short term sources may be restricted to
unexpected and emergency situation only.
Long term sources
• The firm decide to finance a part of the permanent
working capital by short term sources. So, the short term
financing under the aggressive policy is more than the
short term financing under the hedging approach. It seek
to minimize excess liquidity while meeting the short term
Short term financing
Long term sources
Working Capital: Monitoring &
• Monitoring the operating cycle:
The actual operating cycle period should be ascertained for each
element that is the raw material, WIP, Finished goods etc. over a
period of time and should be compared with the standard
operating cycle period set for the same firm or for the industry as
There should always be an attempt to reduce the length of the
Efforts in particular are needed to control the receivable
Working Capital Ratios
• Another analytical tool that can be used to monitor the
working capital is the accounting ratios, mainly the working
1. Current ratios: CA/CL
2. Liquid ratio: quick assets/CL
3. current assets to total assets ratios.
4. Current assets to total sales ratios.
FORECASTING / ESTIMATION OF
WORKING CAPITAL REQUIREMENTS
Factors to be considered
• Total costs incurred on materials, wages and overheads
• The length of time for which raw materials remain in stores before
they are issued to production.
• The length of the production cycle or WIP, i.e., the time taken for
conversion of RM into FG.
• The length of the Sales Cycle during which FG are to be kept waiting
• The average period of credit allowed to customers.
• The amount of cash required to pay day-to-day expenses of the
• The amount of cash required for advance payments if any.
• The average period of credit to be allowed by suppliers.
• Time – lag in the payment of wages and other overheads
Estimation of Working Capital
I Minimum Cash Balance
Gross working capital
II Current liabilities:
Total Current Liabilities
Excess of CA over CL
+ Safety Margin
Net working capital
Meaning of Cash Management
• Cash management refers to management of cash and
bank balance, or in a broader sense it is the management
of each inflows and outflows. In ordinary parlance cash
implies ready money or its equivalent. However,
Management Accountants define cash as the most liquid
assets, need to carry out the day-to-day activities of the
business. For cash management purposes, the term cash
is used in broader senses i.e., it covers cash, cash
equivalents and those assets which are immediately
convertible into cash.
• It is the duty of finance manger to have liquidity at all
parts of the organization while managing cash
• He has also to ensure that there are no funds blocked in
idle cash. Idle cash resources entail a great deal of cost in
Objectives of Cash Management
• Meeting the cash outflows and minimizing the cost of cash balance.
• Management of cash is an important function of modern business.
The main objective of cash management is to determine the optimal
cash balance i.e., a balance which is neither in excess not
inadequate because idle cash produce nothing and shortage cash
affects firm’s liquidity. Thus, the objectives of cash management are
• to meet the disbursement needs, and
• to minimize funds committed to cash balances.
• The task of cash management is to reconcile these two conflicting
and mutually contradictory aspects. The idle cash should be invested
in temporary securities so as to earn some return and shortage of
cash should be arranged by raising short-term loans. Thus, cash
management is concerned with management of cash affairs in such
a way that gives the least possible cost of maintaining cash. The
objective is maximizing profitability without sacrificing liquidity.
The Need for Cash
• The following are three basic considerations in determining
the amount of cash or liquidity as have been outlined:
• 1.Transaction need: Cash facilitates the meeting of the day-today expenses and other debt payments. Normally, inflows of
cash from operations should be sufficient for this purpose. But
sometimes this inflow may be temporarily blocked. In such
cases, it is only the reserve cash balance that can enable the
firm to make its payments in time.
• 2. Speculative needs: Cash may be held in order to take
advantage of profitable opportunities that may present
themselves and which may be lost for want of ready
• 3. Precautionary needs: Cash may be held to act as for
providing safety against unexpected events.
Managing Cash Collection and
• (a) Speed up the mailing time of payments from
• (b) Reduce the time during which payments received by
the firm remain uncollected and speed up the movement
of funds to disbursement banks.
(i) Concentration Banking:
• Collection center are opened as near to the debtors as
possible, hence reducing the time in dispatch, collection
• The firm may instruct the customers to mail their
payment to a regional collection Centre rather than to
the central office.
(ii) Lock Box System:
1. To eliminate the time between the receipt of remittances by the
company and deposited in the bank.
2. Under this arrangement, the company rents the local post-office box
and authorizes its bank at each of the locations to pick up
remittances in the boxes.
3. The bank picks up the mail several times a day and deposits the
cheques in the company’s account. The cheques may be microfilmed for record purposes and cleared for collection.
4. The company receives a deposit slip and lists all payments together
with any other material in the envelope.
5. This procedure frees the company from handling and depositing the
6. The main advantage of lock box system is that ‘lag between the time
cheques are received by the company and the time they are actually
deposited in the bank is eliminated.
7. The main drawback of lock box system is the cost of its operation.
8. Lock box arrangements are usually not profitable if the average
remittance is small.
Managing the Float
With reference to the control of inflows and outflows, float is an important
technique to lessen the length of the cash cycle. So when a firm receives or
makes payments in the form of cheques etc., there is usually a time gap
between the time the cheque is written and when it is cleared. This time gap is
known as float. The float of the paying firm refers to the time that elapses
between the point when it issues a cheque and the time at which the funds
underlying the cheque are actually debited in the bank account. For the payee
firm, float refers to the time between the receipt of the cheque and the
availability of the funds in its account. Float has 3 components:
(i) Mail Time : It is the period between the issue of a cheque and its receipt
by the payee.
(ii) Processing Time : It is the time between the cheque received by the payee
and the deposit of the cheque in the bank account of the payee, and
(iii) Collection Time : It is the amount of time for transferring funds, through
banking system, from the payer’s account to that of the payee. In India,
this collection time is generally three days, including the day of depositing
• Cash budget represents cash requirements of business during,
the budget period. It is the plan of receipts and payments of
cash during the budget period. Cash budget can be prepared
for short period or for long period.
• Purpose of cash budget
• Cash budget is a device for planning and controlling the
inflows & outflows of cash the ensure the availability of cash
when it is needed
• As regards receipts
1. Receipts from debtors;
2. Cash sales and;
3. Any other sources of receipts of cash (say, dividend from a
• As regards payments
1. Payments to be made for purchases;
2. payments to be made for expenses;
3. payments that are made periodically but not every
a. debenture interest;
b. income tax paid in advance;
c. sales tax etc.
4. Special payments to be made in a particular months, for
example, dividends to shareholders, redemption of
debentures, repayments of loan, payment for assets
• The following forcast has been made for ABC Ltd
• All sales are made on credit basis. 2/3 of debtors are collected in the
same month and balance in the next month. There is no expected
bad debts. The debtors on jan 1, 2014 were Rs. 30000.
• The minimum cash balance is Rs 5000. cash balance on jan 1 is
• Borrowing if any made in multiples of 100
Baumol’s Model of Cash
• William J. Baumol developed a model for optimum cash balance
which is normally used in inventory management. The optimum
cash balance is the trade-off between cost of holding cash
(opportunity cost of cash held) and the transaction cost (i.e. cost of
converting marketable securities in to cash held) . Optimum cash
balance is reached at a point where the two opposing costs are
equal and where the total cost is minimum. This can be explained
with the following diagram:
Optimum Cash Balance
• The optimum cash balance an also be computed
Optimum Cash Balance =
• A =
• T =
• H =
Annual Cash disbursements.
Transaction cost (Fixed cost) per transaction
Opportunity cost one rupee per annum (holding
The model is based on the following assumptions:
Cash needs of the firm are known with certainty.
The cash is used uniformly over a period of time and it is
also known with certainty
The holding cost is know and it is constant
The transaction cost also remains constant.
Miller-Orr Cash Management
• According to this model the net cash flow is completely
stochastic. When changes in such balance occur
randomly, the application of control theory serves a
useful purpose. The Miller – Orr model is one of such
control lime it models. This model is designed to
determine the time and size of transfers between and
investment account and cash account. In this model
control limits are set for cash balances. These limits may
consist of ‘h’ as upper limit, ‘z’ as the return point and
zero as the lower limit.
Upper Control Limit
Lower Control Limit
• When the cash balance reaches the upper limit, the
transfer of cash equal to ‘ h – z’ is invested in marketable
securities account. When it touches the lower limit, a
transfer from marketable securities account to cash
account is made. During the period when cash balance
stays between (h, z) and (z, o) i.e. high and low limits, n
transactions between cash and marketable securities
account is made. The high and low limits of cash balance
are set up on the basis of fixed cost associated with the
securities transaction, the opportunities cost of holding
cash and degree of likely fluctuations in cash balances.
These limits satisfy the demands for cash at the lowest
possible total costs.
• Inventory management means planning, organizing,
directing & controlling of inventory. The basic objective of
inventory management is to place an order for material
• at the right time
• for the right source
• to acquire the right quantity
• at right place and
• of right quality.
Inventories constitute a major element of working capital.
Inventory management covers a large number of problems including:
a. fixation of minimum and maximum levels,
b. determining the size of inventory to be carried,
c. deciding about the issues,
d. receipts and inspection procedures,
e. determining the economic order quantity,
f. proper storage facilities,
g. keeping check over obsolescence and ensuring control over
movement of inventories
• Inventory means stock of goods that is maintained to
facilitate the continuous production of goods and
services. Investment involves the commitment of firm’s
resources. If the inventories are too big, they become a
strain on the firm’s resources. However, if they are too
small, the firm may lose the sales. Therefore, the firm
must have an optimum level of inventories.
Objective of inventory
To avoid the situation of excessive and inadequate
To determine and maintain optimum level of inventory
After achieving a trade off between the profitability and
So as to maximize the wealth of shareholders as a whole
Opportunity cost of funds tied up in Interruption of production
Excessive carrying cost eg. Storage Excessive stock out cost
cost, insurance cost, handling cost
Risk of liquidity
Need for holding inventory
1. Transaction motive
Sufficient stock of raw material is to be held by the stores so as to ensure continuous
and uninterrupted supply of raw material to production
Sufficient stock of WIP is to be held due to production cycle
Sufficient stock of finished goods is to be held to facilitate continuous supply of
product to customers
2. Precautionary motive
To hold inventory to meet contingencies
3. Speculative motive
To hold inventory in order to take advantage of profitable opportunities.
Types of Inventory
• Raw materials: the raw materials inventory consists of goods
which are to be converted into finished goods through the
• Work-in-progress: It refers to the raw materials engaged in
various phases of production process. The degree of completion
may be varying for different units. Some units might have been
just introduced, while some others may be 40% complete others
may be 90% complete. The work-in-progress refers to semifinished goods. The quantity and the value of work-in-progress
depend on the length of the production cycle.
Finished Goods: Finished goods consist of final products which
are ready for sale.
Economic order quantity/
The quantity for which order is placed when the stock reaches
Quantity which is most economical to order
The quantity of inventory, at which total of ordering costs and
carrying costs is minimum.
Ordering costs refers to the cost incurred for acquiring material
i.e. inputs. These costs include:• cost of placing an order
• cost of transportation
• cost of receiving goods
• cost of inspecting goods
There is an inverse relationship relationship between order size
and ordering cost .
• Carrying cost refers to the cost incurred in maintaining a given
level of inventory. These costs include:• cost of storage space
• cost of handling material
• cost of insurance
• cost of deterioration or obsolescence
• cost of store staff
There is positive relationship between order size and carrying
Ordering cost per order & carrying cost per unit, per annum are
given & they are fixed.
Usage of material in units is known.
Cost p.u of material is constant & is known.
The quantity of material ordered is lead immediately i.e. lead
• Determination of EOQ
• There are three methods for determination of EOQ
a) Graphical method
b) Tabular method
c) Formula method
Tabular method/ trial & error
Order size I
Order size II
a. Annual consumption
b. Order size
c. No. of orders
d. Cost per order
e. Total ordering cost
f. Average inventory
g. Carrying cost per unit
h. Total Carrying cost
i. Total cost
• Formula method
• The optimum cash balance an also be computed
Optimum Cash Balance =
= Annual Requirement
= Ordering cost
= Carrying cost
• This technique is based on selective control of inventory. Under this
technique various item of inventory are classified into three group of
priority and allocates managerial efforts in proportion of the priority.
The most important items are Classified as Class A, those of
intermediate importance are classified as Class B and the remaining
items are classified as Class C. in other words, under this system, all
items of inventory are categorized according to their value
• ‘Category A’ includes high value, low volume items. These constitute
only a small percentage share in the total value of inventory.
• ‘Category B’ includes medium value items. Their percentage share in
total quantity is nearly equal to their percentage share in the total
value of inventory.
• ‘Category C’ includes low value, high volume items. Their percentage share in total quantity of inventory is very large, bur their
percentage share in the total value of inventory is small.
On the basis of physical quantities and value of material used a table as follow may be
% share in total % share in total
value of total quantities – units,
weight or volume of
A (High value, Low 70
B (Medium value) 20
C (Low value, High 10
‘Category A’ item represent 70% of the total value of total inventories but 10% of total
quantity of inventory. Maximum control must be exercised on this category. ‘Category
C’ comprising 70% in quantity but only 10% in value, needs a simple and economic
system of control.