Working Capital Management by I M Pandey

1. Working Capital
Management

2. Working Capital Management
Management of the current assets held by a firm is known
as working capital management.
It involves administering and controlling current assets as
well as the procuring and financing of the current assets.
Working capital management deals with funds involved in
the day-to-day operations of the firm.
Management of working capital is important for
protecting the firm from liquidity problems.

3. Liquidity of Current Assets
Liquidity simply means converting an asset into cash.
Liquidity depends on the ease with which the asset can be
converted into cash.
Liquidity of a business firm is measured by its ability to
satisfy short term obligations.

4. Financing of Current Assets
GWC (Gross working capital) = TCA (Total current
assets)
NWC = TCA - TCL
NWC, or net working capital, is also called the liquid
surplus of the firm.
Level of Cash outflow and cash inflow define the
requirement of NWC.
Ex. Electricity department- cash inflow predictable so
little NWC required.

5. Need for Working Capital
Operating cycle signifies the time taken by the firm to
process the raw material into finished goods for earning
sales revenue.
Permanent Working Capital
Temporary Working Capital
Figure: The operating cycle

6. Permanent and Variable Working
Capital
The part of current assets, which is fixed and is the
mandatory requirement of the firm is known as permanent
or fixed working capital.
Figure: Changes in permanent and variable working capital over time

7. Level of Current Assets
Conservative Working Capital Policy -When the
firm maintains huge investments in its current assets
then its liquidity will be very high as current assets can
be easily converted into cash.
Aggressive Policy- The investment is current asset is
low. This means that the firm keeps a small balance of
cash , small amount of inventories .
The Optimal level of current asset involves a trade off
between costs that rise with current asset(Carrying
cost) and costs that fall with current asset(Shortage
cost)

8. Optimum level of Current Asset

9. Example 1
The firm has the option of three possible current asset
levels of Rs. 6,00,000, 5,00,000, and 4,00,000. If the level
of fixed assets and sales remains constant, what will be
the effect of the three current asset policies on firm's
liquidity and return on total assets (ROTA)?
The following financial data relates to a firm for the current
financial year:

10. Example 1 (contd)
Solution: The return on total assets will be as
follows:

11. Example 1 (contd)
Thus, policy I (conservative) provides the firm maximum
liquidity and lowest return on total assets. In contrast
policy III (aggressive) provides the firm minimum liquidity
and maximum return on total assets. Policy II is medium
policy. It earns a return on total assets which is higher than
policy I but less than policy III. Risk wise policy II is more
risky than policy I but less risky than policy III.

12. Different Policies for Current Asset
Investment
The optimum policy of a firm is a trade-off between risk
and return of the firm. The concept of optimum working
capital is also supported by the following formula for return
on investment (ROI) for a firm.
Figure: Different policies for current asset investment

13. The Hedging Approach
The hedging approach is also known as matching
approach-high profit-high risk approach
This approach states that permanent assets should be
financed with long-term capital (long-term liabilities +
equity) and temporary assets should be financed with
short- term credit.
Figure: The hedging/matching
approach

14. Conservative Approach
When it depends more on long term funds for financing
needs.
The firm finance its permanent CA and a part of temporary
CA with long term financing.
The released long term funds can be invested in CA, so less
risk of facing problem of shortage of funds.

15. Aggressive Approach
When firm uses it short term financing to finance its
permanent current assets, even some time a part of
fixed assets with short term financing. More risky as
level of minimum CA is difficult to maintain.

16. Factors Affecting the Composition of
Working Capital
Nature of business
Availability of raw material used
Production cycle
Business Cycle
Production Policy
Credit Policy
Growth and Expansion
Profit Level
Price level changes
Operating Efficiency