Working Capital

2. Nature of Working Capital
Working capital management is concerned with the problem arise in attempting to
manage the current assets, and current liabilities and the inter-relationships that
exist between them.
Current Assets: refers to those assets which in the ordinary course of business can
be, or will be, turned into cash within one year without undergoing a diminution
/decrease in value and without disrupting the operations of the firm.
The major current assets are- cash, marketable securities, accounts receivable and
inventory.
Current Liabilities: are those liabilities which are intended at their inception to be
paid in the ordinary course of business, within a year, out of current assets or
earnings of the concern.
The basic current liabilities are accounts payable, bills payable, bank over-draft, and
out standing expenses.
The goal of working capital management is to manage the firm’s current assets and
current liabilities in such a way that a satisfactory level of working capital is
maintained. The current assets should be large enough to cover its current
liabilities in order to ensure a reasonable margin of safety.

3. The interaction between current assets and current liabilities is,
therefore, the main theme of the theory of working capital
management.
The basic ingredients of the theory of working capital management
may be said to include its definition, need optimum level of current
assets, the trade-off between profitability and risk associated with a
firm’s level of current assets and liabilities, financing-mix
strategies and so on.

4. Concepts and definitions of Working capital
There are two concepts of working capital: gross and net
The term gross working capital, also referred to as working capital, means the total
current assets.
The term net working capital can be defined in two ways: i) the most common
definition of net working capital (NWC) is difference between assets and current
liabilities; (ii) alternative definition of NWC is that portion of current assets
which financed with long-term funds.
The task of the finance manager in managing working capital efficiently is to ensure
sufficient liquidity in the operations of the enterprise. The liquidity of a business
firm is measured by its ability to satisfy short-term obligations as they become
due.
The three basic measures of a firm’s overall liquidity are (i) the current ratio, (ii) the
acid-test ratio, and the net working capital. The NWC helps in comparing the
liquidity of the same firm over time. For purpose of working capital management,
therefore, NWC can be said to measure the liquidity of the firm. In other words,
the goal of working capital management is to manage the current assets and
liabilities in such a way that an acceptance level of NWC is maintained.

5. NWC is commonly defined as the difference between current assets and
current liabilities. The theoretical justification for the use of NWC to measure
liquidity is based on the premise that the greater the margin by which the
current assets cover the short-term obligations, the more is the ability to pay
obligations when they become due for payment. The NWC is necessary because
the cash outflows and inflows do not coincide.
NWC will be necessary to maintain current assets at a level adequate to cover
current liabilities, that is, there must be NWC.
Alternative Definition of NWC: as that part of the current assets which are financed
with long-term funds. Since current liabilities represent sources of short-term
funds, as long as current assets exceed the current liabilities, the excess must be
financed with long-term funds. This definition is more useful for the analysis of
the trade-off between profitability and risk.

6. A managerial accounting strategy
A measure of both a company's efficiency and its short-term financial
health.
The rule of working capital is

7. According to JERRY MCMAHON
We are excited that we now have a lot of working capital to
bring it to market.

8.  Also referred as working capital
 GWC=Total current assets

9. Can be defined as two ways:
1. Current assets-Current liabilities.
2. Current assets financed by long term funds
NWC is important because it determines the
firm’s profitability and risk,

10. NWC is necessary because-
 Cash outflows & inflows do not coincide
 Non synchronous nature of cash flows
Problems in cash inflows:
 Difficult to predict
 More predictable the cash inflows are the less
NWC will be required

11. Trade-off between Profitability and Risk
In evaluating a firm’s NWC position an important consideration is the
trade-off between profitability and risk.
Profitability:
The term profitability used in this context is measured by profits after
expenses.
Risk:
The term risk is defined as the probability that a firm will become
technically insolvent so that it will not be able to meet its
obligations when they become due to for payment.
It is assumed that the greater the amount of NWC, the less risk-prone
the firm is .Or, the greater the NWC, the more liquid is the firm
and, therefore, the less likely it is to become technically insolvent.
Conversely, lower levels of NWC and liquidity are associated with
increasing levels of risk. The relationship between liquidity, NWC
and risk is such that if either NWC or liquidity increase, the firm’s
risk decreases.

12. The trade-off between these variables is that
regardless of how the firm increases its profitability
through the manipulation of working capital , the
consequence is a corresponding increase in risk as
measured by the level of NWC. Three basic
assumption of trade-off:
i. We are dealing with a manufacturing firm.
ii. Current assets are less profitable than fixed
assets.
iii. Short-term funds are less expensive than long-
term funds.

13. Effect of the level of current Assets on the Profitability-Risk Trade-Off
Effect of the level of current assets on the profitability-risk trade-off can be shown,
using the ratio of current assets to total assets. This ratio indicates the
percentage of total assets that are in the form of current assets. A change in the
ratio will reflect a change in the amount of current assets. It may be either
increase or decrease.
Effect of the fact of Increase/ Higher Ratio: Increase in the ratio of current assets
to total assets will lead to a decline in profitability because current assets are
assumed to be less profitable than fixed assets. Second effect of the increase in
the ratio will be that the risk of technical insolvency would also decrease
because the increase in current assets, assuming no change in current liabilities,
will increase NWC. This shown in example 15.1.
Balance Sheet of Hypothetical Ltd
Liabilities Amount(in Lakhs) Assets Amount (in Lakhs)
Current liabilities TK. 3,200 Current assets Tk. 5,400
Long-term debt 4,800 Fixed Assets 8,600
Equity capital 6,000
14,000 14,000

14. If the company earns approximately 2% on its current assets and 12% on its fixed
assets, it can currently earn approximately Tk. 1,140[(0.02xTk. 5,400)
+(0.12xTk.8,600)] on its total assets. The NWC currently is Tk. 2,200(TK. 5,400-
Tk. 3,200). The current assets to total assets ratio is 0.386(Tk. 5,400/Tk 14,000).
Assuming the company increases the investment in current assets by investing an
additional Tk.600 in current assets( and thus Tk.600 less in fixed assets), the ratio
of current assets to total assets would be 0.429 (Tk. 6,000/Tk.14,000). The profits
on total assets would Tk. 1,080[(0.02 x Tk. 6,000) +(0.12 x Tk. 8,000)]. Thus, as
the current-total asset ratio increases from 0.386 to 0.429, the total profits
decrease from Tk.1,140 to Tk. 1,080. The risk measured by the amount of NWC
decreases, since NWC increases from Tk. 2,200 to Tk. 2,800, leading to an
improvement in liquidity.
Effect of Decrease/Lower Ratio: A decrease in the ratio of current assets to total
assets will result in an increase in profitability as well as risk. The current assets
decrease without a corresponding reduction in current liabilities, the amount of
NWC will decrease, thereby increase risk.
In the case of the above exam 15.1, the investment in fixed assets is increased by Tk.
600. As a result, the ratio of current assets to total assets would be 0.343 (Tk.
4,800/ Tk. 14,000). The profits on total assets will be Tk. 1,200[(0.02x Tk.4,800)
+ (0.12x Tk. 9,200)]. The NWC will be Tk. 1,600(Tk. 4,800-Tk.3,200).

15. The effect of changes (increase as well decrease) in current assets
are tabulated in Table 15.1:
Initial
value
Value after
increases(+)
Value after
decrease(-)
(1) (2) (3) (4)
Ratio of current assets to total assets 0.386 0.429 0.343
Profits on total assets Tk.1,140 Tk.1,080 Tk.1,200
Net working capital 2,200 2,800 1,600

16. For the hypothetical LTD in Example 15.1, let us assume that the current
liabilities cost approximately 3 percent while the average cost of long term
funds is 8 percent.
The cost would be Tk.960 [(0.03 × Tk.3,200) + (0.08 × Tk.10,800)]
So, NWC=Tk.2,200
The initial ratio of current liabilities to total assets is 0.229 (Tk.3,200 +
Tk.14,000)
Further assume that the company shifts Tk.600 from long term funds to
currents liabilities so that the former will decline, while the latter will increase
by the amount
As a result the ratio of current liabilities to total assets will increase to
0.271(Tk.3,800 ÷ Tk.14,000); the cost will decline to Tk.930[(0.03 × Tk.3,800) +
(0.08 × Tk.10,200)] and the NWC will be lower at the level of
Tk.1,600(Tk.5,400 – Tk.3,800)

17. • Increase from
0.386 to 0.429
Current-
Total
asset
ratio
• decrease from
Rs 1,140 to Rs 1080
Profit
• Increase from
Rs 2200 to Rs 2800
NWC
The Risk
decrease

18. First effect
(Profitability will increase)
Reasons:
• Current liabilities, which are short term sources of finance, will
increase and they are less expensive
• Long term sources of finance will be reduced and they are more
expensive
Second effect
(Risk will increase)
Reasons:
• A decrease in NWC
• Increase in current liabilities-total assets ratio
• Increase in profitability

19. Another important ingredient theory of working capital
management, Financing mix is the choice of sources of financing
of current assets. The management of working capital is how
current assets will be financed.
Features:
One of the most important decision involved in the
management of working capital.
It shows how current assets will be financed.
Sources of financing current assets:
1. Short-term sources→ Current Liabilities
2. Long-term sources→ Share Capital, Long-term borrowings,
Retained earnings and so on.

20. What proportion of the current assets should be
financed by current liabilities and how much by long
term resources?

21. There are three basic approaches to determine
an appropriate financing mix, such as:
1. Hedging Approach or Matching Approach
2. Conservative Approach
3. Trade of between Hedging and conservative
approach

22. The term “Hedging” is often used in the sense of a risk-reducing investment
strategy involving transactions of a simultaneous but opposing nature to
counterbalance the effects of one another.
Hedging/ Matching approach to financing is the process of matching
maturities of debt with the maturities of financial needs.
Features:
The maturities of the source of funds should match the nature of the
assets to be financed.
For the purpose of analysis, current assets can be broadly classified into
two classes:
1. Those which are required in a certain amount and do not vary over time
2. Those which fluctuate over time.

23. Table 15.4: Estimated total Funds Requirements of Hypothetical Ltd
Month Total funds
required
Permanent
requirements
(Long term funds)
Seasonal requirements
(Short-term funds)
(1) (2) (3) (4)
January TK. 8,500 TK. 6,900 TK. 1,600
February 8,000 6,900 1,100
March 7,500 6,900 600
April 7,000 6,900 100
May 6,900 6,900 0
June 7,150 6,900 250
July 8,000 6,900 1,100
August 8,350 6,900 1,450
September 8,500 6,900 1,600
October 9,000 6,900 2,100
November 8,000 6,900 1,100
December 7,500 6,900 600

24. This approach, therefore, divides the requirements of total funds into permanent
and seasonal components, each being financed by a different source. According
to the hedging approach, the permanent portion of funds required (col.3) should
be financed with long-term funds and the seasonal portion(col.4) with short-
term funds. With this approach, the short-term financing requirements (current
liabilities).
2. Conservative Approach: This approach suggests that the estimated requirement
of total funds should be met from long-term sources; the use of short-term funds
should be restricted to only emergency situations or when there is an
unexpected outflows of funds. Table 15.4, the total requirements, including the
entire Tk. 9,000 needed in October, will be financed by long-run sources. The
short-term funds will be used only to meet contingencies. The NWC reaches the
highest level (Tk.9000-6,900) Tk. 2,100 in October. Any long-term financing in
excess of Tk. 6,900 in permanent financing the needs of the company represents
NWC.
• Features:
 In this approach Long-term funds are appreciated.
 Short-term funds are restricted.
 Short-term funds are only used to meet contingencies.

25.  Comparison of Hedging Approach with Conservative Approach:
 hedging is an approach of financing where each asset would be offset with a
financing investment of the same approximate maturity.
On the other hand, conservative approach is an approach of financing where
intentionally huge amount are financed to fulfill current needs.
 hedging approach is an spontaneous and continuous approach , but conservative
approach is a planned approach.
 hedging approach fulfill short term need with short term loan . on the other hand
,conservative approach fulfill short term need with long term loan.
 hedging is a continuous approach , so there is no risk of short term need
shortage. Conservative approach is along term process so it may cause need of
refinancing.
 in hedging approach there is no uncertain future interest cost. But in
Conservative approach there can be uncertain future cost.
 hedging approach has high risk and high return but conservative approach has
low risk and low return.

26.  hedging approach fulfill short term need with short term loan . on the
other hand ,conservative approach fulfill short term need with long
term loan.
 hedging is a continuous approach , so there is no risk of short term
need shortage. Conservative approach is along term process so it may
cause need of refinancing.
 in hedging approach there is no uncertain future interest cost. But in
Conservative approach there can be uncertain future cost.
 hedging approach has high risk and high return but conservative
approach has low risk and low return.

27. • Cost considerations: The cost of these financing plans has a bearing
on profitability of the enterprise. We assume that the cost of short-
term funds and long-term funds, with profitability-risk trade-off, is
3% and 8% respectively.
• Hedging Plan: The cost of financing under the hedging plan can be
estimated as follows:
• (i) Cost of short-term funds: The cost of short-term funds = average
annual short-term loan x interest rate.
• Average annual short-term loan = total of monthly seasonal
requirements (Col.4) divided by the number of months.
• Average annual short-term loan= Tk. 11,600/12=Tk. 966.67
• Short-term cost= Tk. 966.67 x 0.03 =Tk.29
(ii) Cost of long-term funds= (Average annual long-term fund
requirement) x (annual interest rate) =Tk. 6,900 x 0.08= Tk.552
(iii) Total cost under hedging plan= total of (i) + (ii)
Tk.29+Tk.552=581

28. Conservative Approach: The cost of financing under conservative plan is
equal to the cost of the long-term funds, that, is annual average loan, multiplied
by the long-term rate of interest= Tk. 9,000x 0.08=Tk.720.
Thus, the cost of financing under the conservative approach (Tk. 720) is higher
than the cost using the hedging approach (Tk. 581). The conservative plan for
financing is more expensive because the available funds are not fully utilized
during certain periods; moreover, interest has to be paid for funds which are not
actually needed(i.e; the period when there is NWC).
A Trade-Off between the Hedging and Conservative Approaches: One possible
trade-off could be assumed to be equal to the average of the minimum and
maximum monthly requirements of funds during a given period of time. The
figures in Table-15.5 reveal that maximum fund required is Tk. 9,000(October)
and the minimum is Tk. 6,900(May). The average (Tk.9,000+Tk.6,900)/2=
Tk.7,950. In other words, the company should use Tk. 7,950 each month(Col.3)
in the form of long-term funds and raise additional funds, if needed, through
short-term resources(current liabilities). It is clear from the table that no short-
term funds are required during 5 months, namely, March, April, May, June, and
December, because long-term funds available exceed the total requirements for
funds. In the remaining 7 months, the company will have to use short-term
funds totaling Tk. 2,700(Col.4).

29. Table 15.5: Trade-off between Hedging and Conservative Approaches
Month Total funds
required
Permanent requirements
(Long term funds)
Seasonal requirements
(Short-term funds)
(1) (2) (3) (4)
January TK. 8,500 TK. 7,950 TK. 550
February 8,000 7,950 50
March 7,500 7,950 0
April 7,000 7,950 0
May 6,900 7,950 0
June 7,150 7,950 0
July 8,000 7,950 50
August 8,350 7,950 400
September 8,500 7,950 550
October 9,000 7,950 1050
November 8,000 7,950 50
December 7,500 7,950 0
Total= Tk.2,700

30. Cost of the Financing Plan Under the Trade-Off Approach
(i) Cost of short-term funds:= (Average annual short-term funds required) x (Rate
of short-term interest) Tk. 2,700/12= Tk. 225 x 0.03= Tk. 6.75
(ii) Cost of long-term funds=(Average long-term funds required) x (Rate of interest
on long-term funds) = Tk. 7,950 x 0.08= 636
(iii) Total cost of the trade-off plan= Tk. 6.75 + Tk. 636= Tk. 642.75.
Risk consideration:
The NWC under this plan would be Tk. 1,050 (tk. 7,950- Tk. 6,900).
Table 15.6: Comparison of Trade-Off Plan
Financing Plan Maximum NWC Degree of Risk Total cost of
financing
Level of
profits
(1) (2) (3) (4) (5)
Hedging 0 Highest Tk. 581.00 Highest
Trade-off Tk.1,050 Intermediate 642.75 Intermediate
Conservative 2,100 Lowest 720.00 Lowest

31. The Hypothetical Ltd has forecast its total funds requirements
for the coming year as follows:
The cost of short-term and long-term financing is expected to be 4% and
10% respectively.
a) Calculate the cost of financing using the hedging approach.
b) Calculate the cost of financing using the conservative approach.
c)Discuss the basic profitability-risk-trade-off associated with each of these
plans.
Month Amount (Tk.
Lakh)
Month Amount (Tk.
Lakh)
January 30 July 200
February 30 August 180
March 40 September 110
April 60 October 70
May 100 November 40
June 150 December 20

32. Solution: Table-1: Estimated total Funds Requirements of Hypothetical Ltd
Month Total funds
required
Permanent
requirements
(Long term funds)
Seasonal requirements
(Short-term funds)
(1) (2) (3) (4)
January Tk.30 TK. 110 0
February 30 110 0
March 40 110 0
April 60 110 0
May 100 110 0
June 150 110 40
July 200 110 90
August 180 110 70
September 110 110 0
October 70 110 0
November 40 110 0
December 20
Total:1030
110 0
Total 200

33. The figures in the above table reveal that the maximum fund required is Tk.
200(July) and the minimum is Tk. 20 (December)
The average 200 (highest-July) +20 ( lowest-December)=220/2=110
i) Cost of short term funds 200/12=16.67 x 0.04= Tk.0.6668
ii) Cost of long term funds 110x.10= 11
c) Total cost of trade-off plan Tk. 0.67+11=11.67
b) The cost of financing under the conservative plan is equal to the cost of the
long term funds, that is annual average loan, multiplied by the long-term
rate of interest Tk. 200x.10= Tk. 20 Lakh.
• Maximum NWC under this plan would be (Tk. 110- Tk.20)= Tk.90.
a) Tk.790 /12=65.83x4%=2.63
Tk. 20 Lakhs x 10% = 2.00
Total = Tk.4.63 lakhs

34. Solution: Table-1: Estimated total Funds Requirements of Hypothetical Ltd
Month Hedging Conservative
(1) Short term Long term funds Long term funds
January Tk.10 TK. 20 0
February 10 20 0
March 20 20 0
April 40 20 0
May 80 20 0
June 130 20 40
July 180 20 90
August 160 20 70
September 90 20 0
October 50 20 0
November 20 20 0
December 0
Total:790
20 0
Total 200

35. Problem:15.1:The balance sheet of Company X stood as follows as on
March 31, of the current year.
If the current assets earn 2%, fixed assets earn 14%, current liabilities
cost 4% and long-term funds cost 10%, calculate a) total profits on
assets and ratio of current assets to total assets, b) the cost of
financing and the ratio of current liabilities to total assets, and c)
net profitability of the current financing plan.
Liabilities Tk. Assets Tk.
Current liabilities 2,000 Current assets 8,000
Long- term funds 22,000 Fixed assets 16,000
Total 24,000 Total 24,000

36. Solution:
a) Total profits on assets and ratio of current assets to total assets:
Total profits on assets=(profits on current assets + profits on fixed assets)
i) Profits on current assets=0.02x Tk. 8,000= Tk. 160
ii) Profits on fixed assets = 0.14x Tk.16,000= Tk. 2,240
(i) + (ii)= Tk. 160+ Tk. 2,240= Tk. 2,400
Ratio of current assets to total assets= Tk. 8,000/24,000 = 0.33
(b) Cost of financing and ratio of current liabilities to total assets:
Total costs of financing= cost of financing of current liabilities + cost of
financing pf fixed assets.
(i) Cost of current liabilities= 0.04x Tk. 2,000= Tk.80
(ii) cost of long-term funds= 0.10x Tk. 22,000= Tk.2,200
(i) +(ii)= Tk. 80+ Tk. 2,200= Tk. 2,280
Ratio of current liabilities to total assets= Tk. 2,000/ 24,000=0.08
(c) Net profitability of the current financial plan= Total profits- Total cost
= Tk. 2,400- Tk. 2,280= Tk. 120

37. Problem:15.2: assume that in P.15.1 above, the company has simultaneously shifted
Tk. 2,000 in current assets to fixed assets and Tk. 3,000 in long-term funds to
current liabilities. Answer parts (a), (b) and (c) of P.15.1. explain the differences,
if any, in the ratios and the returns that result.
a) Total profits on assets and ratio of current assets to total assets:
Total profits on assets=(profits on current assets + profits on fixed assets)
i) Profits on current assets=0.02x Tk. 6,000= Tk. 120
ii) Profits on fixed assets = 0.14x Tk.18,000= Tk. 2,520
(i) + (ii)= Tk. 120+ Tk. 2,520= Tk. 2,620
Ratio of current assets to total assets= Tk. 6,000/24,000 = 0.25
(b) Cost of financing and ratio of current liabilities to total assets:
Total costs of financing= cost of financing of current liabilities + cost of financing pf
fixed assets.
(i) Cost of current liabilities= 0.04x Tk. 5,000= Tk.200
(ii) cost of long-term funds= 0.10x Tk. 19,000= Tk.1,900
(i) +(ii)= Tk. 200+ Tk. 1,900= Tk. 2,100
Ratio of current liabilities to total assets= Tk. 5,000/ 24,000=0.208
(c) Net profitability of the current financial plan= Total profits- Total cost

38. From the above computations, it is clear that a decline in the ratio of current
assets to total assets from about 0.33(1/3) in P.15.1 to 0.25(1/4) in P.15.2 and a
rise in the ratio of current liabilities to total assets from 0.08(P.15.1) to 0.208
(P.15.2) has caused an increase in the net profit to the extent of Tk. 420(Tk
540 in second case- Tk. 120 in first case). The result are tabulated below:
The result supports the profitability-risk-trade-off as related to current assets and
current liabilities
Value in P.15.1 Value in P.15.2
1. Ratio of current assets to total assets 0.33 0.25
2. Ratio of current liabilities to total assets 0.08 0.208
3. Net Profits Tk.120 Tk.540
4. Net working capital Tk. 6,000
(8000-2000)
Tk.1,000
(6000-5000)