Working Capital Management: Meaning of Working Capital, its components & types, Operating Cycle, Factors affecting working capital, Estimation of working capital requirement. (Total Cost Method & Cash Cost Method)

1. 202_ Financial Management
UNIT3:
Working Capital Management:
Meaning of Working Capital, its components
& types, Operating Cycle, Factors affecting
working capital, Estimation of working capital
requirement. (Total Cost Method & Cash
Cost Method) (8 + 2)

2. INTRODUCATION

3. DEFINITION
The term ‘working capital management’ primarily refers to the efforts
of the management towards effective management of current
assets and current liabilities. Working capital is nothing but the
difference between the current assets and current liabilities. In
other words, an efficient working capital management means
ensuring sufficient liquidity in the business to be able to satisfy short-
term expenses and debts.
In a broader view, ‘working capital management’ includes working
capital financing apart from managing the current assets and
liabilities. That adds the responsibility for arranging the working
capital at the lowest possible cost and utilizing the capital cost-
effectively.
WORKING CAPITAL MANAGEMENT DEFINITION

4. The primary objectives of working capital management include the following:
1. Smooth Operating Cycle: The key objective of working capital management is to
ensure a smooth operating cycle. It means the cycle should never stop for the lack of
liquidity whether it is for buying raw material, salaries, tax payments etc.
2. Lowest Working Capital: For achieving the smooth operating cycle, it is also important
to keep the requirement of working capital at the lowest. This may be achieved by
favorable credit terms with accounts payable and receivables both, faster production
cycle, effective inventory management etc.
3. Minimize Rate of Interest or Cost of Capital: It is important to understand that the
interest cost of capital is one of the major costs in any firm. The management of the
firm should negotiate well with the financial institutions, select the right mode of
finance, maintain optimal capital structure etc.
4. Optimal Return on Current Asset Investment: In many businesses, you have a liquidity
crunch at one point of time and excess liquidity at another. This happens mostly with
seasonal industries. At the time of excess liquidity, the management should have good
short-term investment avenues to take benefit of the idle funds.
OBJECTIVES OF WORKING CAPITAL MANAGEMENT

5. Working capital is a vital part of a business and can provide the following advantages to
a business:
HIGHER RETURN ON CAPITAL: Firms with lower working capital will post a higher return on
capital. Therefore, shareholders will benefit from a higher return for every dollar
invested in the business.
IMPROVED CREDIT PROFILE AND SOLVENCY: The ability to meet short-term obligations is a
pre-requisite to long-term solvency. And it is often a good indication of
counterparty’s credit risk. Adequate working capital management will allow a
business to pay on time its short-term obligations. This could include payment for a
purchase of raw materials, payment of salaries, and other operating expenses.
HIGHER PROFITABILITY: the management of account payables and receivables is an
important driver of small businesses’ profitability.
HIGHER LIQUIDITY: A large amount of cash can be tied up in working capital, so a
company managing it efficiently could benefit from additional liquidity and be less
dependent on external financing. This is especially important for smaller businesses as
they typically have limited access to external funding sources. Also, small businesses
often pay their bills in cash from earnings so efficient working capital management will
allow a business to better allocate its resources and improve their cash management.
IMPORTANCE OF EFFECTIVE W C M

6. INCREASED BUSINESS VALUE: Firms with more efficient working capital management
will generate more free cash flows which will result in higher business valuation
and enterprise value.
FAVORABLE FINANCING CONDITIONS: A firm with a good relationship with its trade
partners and paying its suppliers on time will benefit from favorable financing
terms such as discount payments from its suppliers and banking partners.
UNINTERRUPTED PRODUCTION: A firm paying its suppliers on time will also benefit from
a regular flow of raw materials, ensuring that the production remains
uninterrupted and clients receive their goods on time.
ABILITY TO FACE SHOCKS AND PEAK DEMAND: Efficient working capital
management will help a firm to survive through a crisis or ramp up production in
case of an unexpectedly large order.
COMPETITIVE ADVANTAGE: Firms with an efficient supply chain will often be able to
sell their products at a discount versus similar firms with inefficient sourcing
IMPORTANCE OF EFFECTIVE W C M

7. The components and determinants of working capital are
summarized in the table below.

8. ADVANTAGES OF WORKING CAPITAL
MANAGEMENT
1) Working capital management
ensures sufficient liquidity when
required.
2) It evades interruptions in
operations.
3) Profitability maximized.
4) Achieves better financial health.
5) Develops competitive advantage
due to streamlined operations
ADVANTAGES & DISADVANTAGES OF
WORKING CAPITAL MANAGEMENT
DISADVANTAGES OF WORKING CAPITAL
MANAGEMENT
1) It only considers monetary factors.
There are non-monetary factors that
it ignores like customer and
employee satisfaction, government
policy, market trend etc.
2) Difficult to accommodate sudden
economic changes.
3) Too high dependence on data is
another downside. A smaller
organization may not have such data
generation.
4) Too many variables to keep in mind
say current ratios, quick ratios,
collection periods, etc.

12. NATURE OF THE INDUSTRY / BUSINESS: The management of working capital is
completely different from industry to industry. A simple comparison of the
service industry and manufacturing industry can clarify the point. In the service
industry, there is no inventory and therefore, one big component of working
capital is already avoided. So, the nature of the industry is a factor in
determining the working capital requirement.
SEASONALITY OF INDUSTRY AND PRODUCTION POLICY: Businesses based on seasons
like manufacturing of ACs whose demand peaks in summer and dips in winter.
The requirement of working capital will be more in summer compared to winter
if they are produced in the fashion of their demand. The policy of producing
throughout the year can smoothen the fluctuation of the working capital
requirement.
COMPETITION: If the industry is competitive, quick response to customer needs is
compulsory and therefore a higher level of inventory is maintained. Liberal
credit terms are also mandatory with good service to survive in the market. So,
higher the competition, higher would be the requirement of working capital.
FACTORS INFLUENCING WORKING CAPITAL MANAGEMENT

13. PRODUCTION CYCLE TIME: The production cycle time refers to the
time required for converting the raw materials into finished
goods. Higher, this time, higher would be the time of blocking
funds in the working capital.
CREDIT POLICY: Liberal credit policy demands a higher level of
working capital and tight credit policy reduces it.
GROWTH AND EXPANSION :Some industries are static and others
are growing. Obviously, growing industry grows the requirement
of working capital also as compared to static industry.
SHORTAGE OF SUPPLY OF RAW MATERIAL: If the raw material supply
is not smooth for any reason, companies tend to store more of
raw materials than needed and that increased requirement of
working capital.
FACTORS INFLUENCING WORKING CAPITAL MANAGEMENT

14. TAXES: Taxes are often paid in advance. This also blocks a part of
working capital. Depending on the tax environment of the industry,
working capital needs are also affected.
DIVIDEND POLICY: Dividend policy determines the level of retained
profits with the business and retained profits are also used for working
capital. This is how; dividend policy affects the need for working
capital.
PRICE LEVELS: The price levels of inventory and other expenses such as
labor rates etc increase the working capital requirement. If the
company also is able to increase the price of their finished goods, it
reduces this impact
FACTORS INFLUENCING WORKING CAPITAL MANAGEMENT

16. TYPES OF WORKING CAPITAL
On the basis of Balance Sheet View
GROSS WORKING CAPITAL (GWC)
Current assets in the balance sheet of a company are known as gross working
capital. Current assets are those short-term assets which can be converted into
cash within a period of one year. The grey area in the management of current
assets or gross working capital is its unpredictability i.e. it is very difficult to
ascertain the exact time of conversion of such assets. Why is such a nature
problematic? It is because the liabilities occur at their time and do not wait for
our current asset to realize. This mismatch or the gap creates a need for
arranging working capital financing.
NET WORKING CAPITAL (NWC) OR WORKING CAPITAL
Net working capital is a very frequently used term. There are two ways to
understand networking capital. First, one says it is simply the difference between
current assets and the current liabilities on the balance sheet of a business. The
other understanding discloses little deeper or hidden meaning of the term. As per
that, NWC is that part of current assets which are indirectly financed by long-term
assets. Compared to gross working capital, net working capital is considered more
relevant for effective working capital financing and management.

17. TYPES OF WORKING CAPITAL
On the basis of Operating Cycle View,
PERMANENT / FIXED WORKING CAPITAL
Dealing with current asset and fixed assets is totally different.
Determining the financing requirement in the case of fixed assets is
simply the cost of the asset. Same is not true for current assets
because the value of current assets is constantly changing and it is
difficult to accurately forecast that value at any point in time. To
simplify the complexity to some extent, on the basis of past trend
and experience, we can find a level below which current asset has
never gone. The current assets below this level are called
permanent or fixed working capital. See the example below:

18. TYPES OF WORKING CAPITAL
In the example, 2500 is the
permanent working capital
below which the net working
capital has not gone.
Regular Working Capital: It is the
permanent working capital
which is normally required in the
normal course of business for
the working capital cycle to flow
smoothly.
Reserve Working Capital: It is the
working capital available over
and above the regular working
capital. It is kept for
contingencies which may arise
due to unexpected situations.
Types of Working Capital
Net Working
Capital
Permanent /
Fixed Working
Capital
Temporary /
Variable
Working
Capital
Requirement
3000 2500 500
2500 2500 0
2800 2500 300
3200 2500 700

19. Temporary working capital is easy to understand after getting hold over the
permanent working capital. In simple terms, it is the difference between net
working capital and permanent working capital. The main characteristic
which can be made out of the example is “fluctuation”. The temporary
working capital, therefore, cannot be forecasted. In the interest of
measurability, this can be further bifurcated as below which can create at
least some base to forecast.
○ Seasonal Working Capital: Seasonal working capital is that temporary increase in working
capital which is caused due to some relevant season for the business. It is applicable to
businesses having the impact of seasons, for example, the manufacturer of sweaters for
whom relevant season is the winters. Normally, their working capital requirement would
increase in that season due to higher sales in that period and then go down as the
collection from debtors is more than sales.
○ Special Working Capital: Special working capital is that rise in the temporary working capital
which occurs due to a special event which otherwise normally does not take place. It has no
basis to forecast and has rare occurrence normally. For example, a country where Olympic
Games are held, all the business require extra working capital due to a sudden rise in
business activity.
TEMPORARY / VARIABLE WC

21. This is probably the best of the methods because it takes into account the
actual business or industry situation into consideration while giving an
estimate of working capital. A general rule can be stated in this method.
Longer the working capital operating cycle, higher would be the
requirement of working capital and vice versa. We would agree to the
point also.
The following formula can be used to estimate or calculate the working
capital
Working Capital = Cost of Goods Sold (Estimated) * (No. of Days of
Operating Cycle / 365 Days) + Bank and Cash Balance.
○ If the cost of goods sold (estimated) is Rs. 35 million and operating cycle is 75 days and
bank balance required is 1.25 million. Therefore, Working Capital = 35 * 75/365 + 1.25 =
Rs. 8.44 Million.
○ In this method, each component can also be calculated. It means bifurcation of Rs. 8.44
million can be done in inventory, cash, accounts receivable, accounts payable etc.
OPERATING CYCLE METHOD:

22. As a first step, we have to compute the operating cycle as follows:
i) Inventory period: Number of days consumption in stock = I ÷ M/36
Where I – Average inventory during the year M = Materials consumed during the
year
ii) Work-in-process: Number of days of work-in-process = W ÷ K/365
Where W = Average work-in-process during the year K = Cost of work-in-process
i.e., Material + Labour + Factory overheads.
iii) Finished products inventory period = G ÷F/365
Where G = Average finished products inventory during the year F= Cost of finished
goods sold during the year
iv) Average collection period of Debtors = D ÷S/365
Where D = Average Debtors balances during the year S = Credit sales during the
year
v) Credit period allowed by Suppliers = C ÷P/365
Where C = Average creditors’ balances during the year P = credit purchases
during the year
vi) Minimum cash balance to be kept daily. Formula: O.C. = M + W + F + D – C
Note : It is also known as working capital cycle. Operating cycle is the total time gap
between the purchase of raw material and the receipt from Debtors.

23. The calculation of net working capital may also be shown as follows ;
Working Capital = Current Assets – Current Liabilities
= (Raw Materials Stock + Work-in-progress Stock + Finished Goods Stock + Debtors
+ Cash Balance) – (Creditors +Outstanding Wages + Outstanding Overheads).
Where,
Raw Materials = Cost (Average) of Materials in Stock
Work-in-progress Stock = Cost of Materials + Wages +Overhead of Work-in-progress.
Finished Goods Stock = Cost of Materials + Wages +Overhead of Finished Goods.
Creditors for Material = Cost of Average Outstanding Creditors.
Creditors for Wages = Averages Wages Outstanding.
Creditors for Overhead = Average Overheads Outstanding.
Thus,
Working Capital = Cost of Materials in Stores, in Work-in-progress, in Finished Goods
and in Debtors.
Less : Creditors for Materials
Plus : Wages in Work-in-progress, in Finished Goods and in Debtors.
Less :Creditors for Wages
Plus : Overheads in Work-in-progress, in Finished Goods and in Debtors.
Less : Creditors for Overheads.

42. •What is meant by working capital management?
•What are the determinants of working capital requirement of an
enterprise?
•What do you understand by working capital cycle?
•Discuss the various sources of working capital funds.
•Write a detailed note on analysis and control of working capital.
•What are the various methods of working capital analysis?
•Discuss the various approaches to determine the appropriate
financing mix of working capital.