This document outlines key concepts related to working capital management. It discusses working capital basics like current assets and liabilities. It also covers topics like the cash conversion cycle, permanent vs temporary working capital, and factors that influence working capital needs. Additionally, it addresses the objectives of working capital management and trade-offs companies consider around inventory, cash, receivables and payables levels. Maintaining an optimal level of working capital is important to ensure liquidity while maximizing profitability.
The matter includes concept and types of Working Capital. Further it explains Optimum Level of Current Assets, Various Approaches to Working Capital Financing. Then Operating Cycle, Cash Cycle and Working Capital Estimation Techniques are discussed.
The matter includes concept and types of Working Capital. Further it explains Optimum Level of Current Assets, Various Approaches to Working Capital Financing. Then Operating Cycle, Cash Cycle and Working Capital Estimation Techniques are discussed.
Meaning
Types of working capital
Factors of determining working capital
Operating working capital cycle
Importance of operating cycle concept
Internal factors
External factors
General factors
Types of capital structure
Characteristics of security
Introduction
Working capital typically means the firm’s holding of current or short-term assets such as cash, receivables, inventory and marketable securities.
These items are also referred to as circulating capital
Corporate executives devote a considerable amount of attention to the management of working capital
Definition
Working Capital refers to that part of the firm’s capital, which is required for financing short-term or current assets such a cash marketable securities, debtors and inventories. Funds thus, invested in current assets keep revolving fast and are constantly converted into cash and this cash flow out again in exchange for other current assets. Working Capital is also known as revolving or circulating capital or short-term capital.
Nature Of Working Capital
Working capital management is concerned with the problems that arise in attempting to manage the current assets, the current liabilities and the interrelations that exist between them.
Current assets refer to those assets which in the ordinary course of business can be, or will be, converted into cash within one year without undergoing a diminution in value and without disrupting the operations of the firm.
Examples- 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 the current assets or the earnings of the concern.
Examples- accounts payable, bills payable, bank overdraft and outstanding expenses.
Meaning
Types of working capital
Factors of determining working capital
Operating working capital cycle
Importance of operating cycle concept
Internal factors
External factors
General factors
Types of capital structure
Characteristics of security
Introduction
Working capital typically means the firm’s holding of current or short-term assets such as cash, receivables, inventory and marketable securities.
These items are also referred to as circulating capital
Corporate executives devote a considerable amount of attention to the management of working capital
Definition
Working Capital refers to that part of the firm’s capital, which is required for financing short-term or current assets such a cash marketable securities, debtors and inventories. Funds thus, invested in current assets keep revolving fast and are constantly converted into cash and this cash flow out again in exchange for other current assets. Working Capital is also known as revolving or circulating capital or short-term capital.
Nature Of Working Capital
Working capital management is concerned with the problems that arise in attempting to manage the current assets, the current liabilities and the interrelations that exist between them.
Current assets refer to those assets which in the ordinary course of business can be, or will be, converted into cash within one year without undergoing a diminution in value and without disrupting the operations of the firm.
Examples- 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 the current assets or the earnings of the concern.
Examples- accounts payable, bills payable, bank overdraft and outstanding expenses.
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Working capital management — factors determining working capital — estimation of working capital —inventory management techniques — receivables management — management of cash and marketable securities — techniques of cash management — committees on working capital and their findings and recommendations.
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Chapter 3 – Outline (1)
• Working Capital Basics
Working Capital and the Current Accounts
Working Capital and Funding Requirements
Objective of Working Capital Management
Working Capital Trade-offs
Operations—The Cash Conversion Cycle
The Operating Cycle and the Cash Conversion Cycle
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Chapter 3 – Outline (2)
Permanent and Temporary Working Capital
Maturity Matching Principle
Financing Net working Capital
Short-Term vs. Long-Term Financing
Working Capital Policy
4. • Working capital typically means the firm’s holding of current or
short-term assets such as cash, receivables, inventory and marketable
securities.
• These items are also referred to as circulating capital
• Corporate executives devote a considerable amount of attention to the
management of working capital.
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Working capital Introduction
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Working Capital Basics
• Working Capital
Assets/liabilities required to operate business on day-to-
day basis
• Cash
• Accounts Receivable
• Inventory
• Accounts Payable
• Accruals
Short-term in nature—turn over regularly
6. Concepts of Working Capital
• There are two possible interpretations of working capital
concept:
1. Balance sheet concept
2. Operating cycle concept
Balance sheet concept
There are two interpretations of working capital under the
balance sheet concept.
a. Excess of current assets over current liabilities.(CA-CL)
b. Gross or total current assets.(Fixed Assets + Current Assets)
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Working Capital and the Current Accounts
• Gross working capital = Current assets
Gross Working Capital (GWC) represents investment in
current assets
• (Net) working capital =
Current assets – Current liabilities
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Working Capital and Funding
Requirements
• Spontaneous Financing
Firm will also always have minimum level of Accounts
Payable—in effect, money you have borrowed
• Accounts Payable (and Accruals) are generated spontaneously
• Arise automatically with inventory and expenses
• Offset the funding required to support current assets
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Working Capital and Funding
Requirements
• Working Capital Requires Funds
Maintaining working capital balance requires permanent
commitment of funds
• Example: Firm will always have minimum level of Inventory,
Accounts Receivable, and Cash—this requires funding
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Working Capital and Funding
Requirements
• Net working capital is Gross Working Capital –
Current Liabilities (including spontaneous
financing)
Reflects net amount of funds needed to support routine
operations
11. Concepts Continues 2
• 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 its creditors.
• 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 of funds.
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• Operating cycle concept
• A company’s operating cycle typically consists of three primary
activities:
Purchasing resources,
Producing the product and
Distributing (selling) the product.
These activities create funds flows that are both unsynchronized and
uncertain.
Unsynchronized because cash disbursements (for example, payments for
resource purchases) usually take place before cash receipts (for example
collection of receivables).
They are uncertain because future sales and costs, which generate the respective
receipts and disbursements, cannot be forecasted with complete accuracy.
Concepts Continues 3
13. “ circulating capital means current assets of a company that
are changed in the ordinary course of business from one
form to another, as for example, from cash to inventories,
inventories to receivables, receivable to cash”
Genestenbreg
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Concepts Continues 4
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Objective of Working Capital Management
• To run firm efficiently with as little money as
possible tied up in Working Capital
Involves trade-offs between easier operation and cost of
carrying short-term assets
• Benefit of low working capital
• Money otherwise tied up in current assets can be invested in activities
that generate higher payoff
• Reduces need for costly financing
• Cost of low working capital
• Risk of shortages in cash, inventory
15. Figure 3.1: Types Of Working Capital
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•WORKING CAPITAL
•BASIS OF
CONCEPT
•BASIS OF
TIME
•Gross
Working
Capital
•Net
Working
Capital
•Permanen
t / Fixed
WC
•Temporar
y / Variable
WC
•Regular
WC
•Reserve
WC
•Seasonal
WC
•Special
WC
16. Figure 3.2: Operating cycle of a typical
company
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•Payable
•Deferral period
•Inventory conversion
•period
•Cash conversion
•cycle
•Operating
•cycle
•Pay for
•Resources
•purchases
•Purchase
•resources
•Sell
•Product
•On credit
•Receivable
•Conversion period
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Working Capital Trade-offs
Inventory
High Levels Low Levels
Benefit:
• Happy customers
• Few production delays (always have needed
parts on hand)
Cost:
• Expensive
• High storage costs
• Risk of obsolescence
Cost:
• Shortages
• Dissatisfied customers
Benefit:
• Low storage costs
• Less risk of obsolescence
Cash
High Levels Low Levels
Benefit:
• Reduces risk
Cost:
• Increases financing costs
Benefit:
• Reduces financing costs
Cost:
• Increases risk
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Working Capital Trade-offs
Accounts Receivable
High Levels (favourable credit terms) Low Levels (unfavourable
terms)
Benefit:
• Happy customers
• High sales
Cost:
• Expensive
• High collection costs
• Increases financing costs
Cost:
• Dissatisfied customers
• Lower Sales
Benefit:
• Less expensive
Accounts Payable and Accruals
High Levels Low Levels
Benefit:
• Reduces need for external finance--using a
spontaneous financing source
Cost:
• Unhappy suppliers
Benefit:
• Happy suppliers/employees
Cost:
• Not using a spontaneous
financing source
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Current Assets High Level Low Level
Profitability Lower Higher
Risk Lower Higher
Working Capital Trade-offs
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Operations—The Cash Conversion Cycle
• Firm begins with cash which then “becomes”
inventory and labour
Which then becomes product for sale
Eventually this will turn into cash again
• Firm’s operating cycle is time from acquisition of
inventory until cash is collected from product sales
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Figure 3.3: The Cash Conversion Cycle
Product is
converted into
cash, which is
transformed into
more product,
creating the cash
conversion cycle.
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Figure 3.4: Time Line Representation
of the Cash Conversion Cycle
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The Operating Cycle and the Cash
Conversion Cycle
Inventory conversion period
plus: Receivable collection period
equals: Operating cycle
minus: Payables deferral period
equals: Cash conversion cycle
• Shortening cash conversion cycle frees up cash to reinvest
in business or to reduce debt and interest
24. Cash Conversion Cycle Analysis
• Inventory conversion period = Avg. inventory
Cost of sales/365
• Receivable conversion period =Accounts receivable
Annual credit sales/365
• Payables deferral period =Accounts payable + Salaries, etc
(Cost of sales + selling, general and admn. Expenses)/365
• Cash conversion cycle = operating cycle – payables deferral period.
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Cash Conversion Cycle
Purchase
Inventory
Pay for
Inventory
Sell Inventory
on Credit
Collect
Receivables
Operating Cycle
Inventory Conversion Period
Receivables Collection Period
Payables Deferral Period
Cash Conversion Cycle
26. Importance of working capital
• Importance of working capital
Risk and uncertainty involved in managing the cash flows
Uncertainty in demand and supply of goods, escalation in cost both
operating and financing costs.
• Strategies to overcome the problem
Manage working capital investment or financing such as
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27. Importance of working capital
Holding additional cash balances beyond expected needs
Holding a reserve of short term marketable securities
Arrange for availability of additional short-term borrowing
capacity
One of the ways to address the problem of fixed set-up cost may be
to hold inventory.
One or combination of the above strategies will target the problem
• Working capital cycle is the life-blood of the firm
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28. Figure 3.5:
Resource flows for a manufacturing firm
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•Fixed
•Assets
•Production
•Process
•Generates
•Inventory
•Accounts
•receivable
•Used in
•Accrued
Direct
•Labour
and
•materials
•Accrued Fixed
•Operating
•expenses
•Cash and
•Marketable
•Securities
•Suppliers
•Of Capital
•External Financing
•Return on Capital
•Collection
•process
•Used to
•purchase
•Used to
•purchase
•Used in
•Working
•Capital
•cycle
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Figure 3.6:
Working Capital Needs of Different Firms
30. Three alternative working capital
investment policies
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•Sales ($)
•Current
Assets($)
•Policy C
•Policy A
•Policy B
31. Three alternative working capital
investment policies-2
• Policy C represents conservative approach
• Policy A represents aggressive approach
• Policy B represents a moderate approach
• Optimal level of working capital investment
• Risk of long-term versus short-term debt
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Permanent and Temporary Working Capital
• Working capital is permanent to the extent that it
supports constant or minimum level of sales
• Temporary working capital supports seasonal
peaks in business
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•Amount Variable Working Capital
•of
•Working
•Capital
• Permanent Working Capital
Time
•
Difference between permanent &
temporary working capital
34. Difference between permanent &
temporary working capital-2
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Variable Working Capital
•
•Amount
•of
•Working
•Capital
• Permanent Working Capital
•
• Time
•
35. Financing needs over time
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•Fixed Assets
•Permanent Current Assets
•Total Assets
•Fluctuating Current Assets
•Time
•$
36. Matching approach to asset financing
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•Fixed Assets
•Permanent Current Assets
•Total Assets
•Fluctuating Current Assets
•Time
•$
•Short-term
•Debt
•Long-term
•Debt +
•Equity
•Capital
37. Conservative approach to asset financing
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•Fixed Assets
•Permanent Current Assets
•Total Assets
•Fluctuating Current Assets
•Time
•$
•Short-term
•Debt
•Long-term
•Debt +
•Equity
• capital
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•Fixed Assets
•Permanent Current Assets
•Total Assets
•Fluctuating Current Assets
•Time
•$
•Short-term
•Debt
•Long-term
•Debt +
•Equity
• capital
Aggressive approach to asset financing
39. FACTORS DETERMINING WORKING CAPITAL
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1. Nature of the Industry
2. Demand of Industry
3. Cash requirements
4. Nature of the Business
5. Manufacturing time
6. Volume of Sales
7. Terms of Purchase and Sales
8. Inventory Turnover
9. Business Turnover
10. Business Cycle
11. Current Assets requirements
12. Production Cycle
•13. Credit control
14. Inflation or Price level changes
15. Profit planning and control
16. Repayment ability
17. Cash reserves
18. Operation efficiency
19. Change in Technology
20. Firm’s finance and dividend policy
21. Attitude towards Risk
40. EXCESS OR INADEQUATE WORKING CAPITAL
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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.
41. Disadvantages of Redundant or Excess
Working Capital
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Idle funds, non-profitable for business, poor ROI
Unnecessary purchasing & accumulation of inventories
over required level
Excessive debtors and defective credit policy, higher
incidence of B/D.
Overall inefficiency in the organization.
When there is excessive working capital, Credit worthiness
suffers
Due to low rate of return on investments, the market value
of shares may fall
42. Disadvantages of Inadequate Working
Capital
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Can’t pay off its short-term liabilities in time.
Economies of scale are not possible.
Difficult for the firm to exploit favourable market situations
Day-to-day liquidity worsens
Improper utilization the fixed assets and ROA/ROI falls sharply
43. Management Of Working Capital ( WCM )
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Management of working capital is concerned with the problems
that arise in attempting to manage the current assets, the current
liabilities and the inter-relationship that exists between them. In
other words, it refers to all aspects of administration of CA and
CL.
Working Capital Management Policies of a firm have a great
effect on its profitability, liquidity and structural health of the
organization.
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3D Nature of Working Capital Management
•Dimension I
•Profitability,
•Risk, & Liquidity
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Principles Of Working Capital
Management
•PRINCIPLES OF
WORKING CAPITAL
MANAGEMENT
•Principle
of Risk
Variation
•Principle
of Cost of
Capital
•Principle
of Equity
Position
•Principle of
Maturity of
Payment
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Maturity Matching Principle
• Maturity (due date) of financing should roughly
match duration (life) of asset being financed
Then financing /asset combination becomes self-
liquidating
• Cash inflows from asset can be used to pay off loan
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Financing Net Working Capital
• According to maturity matching principle
Temporary (seasonal) should be financed with short-
term borrowing
Permanent working capital should be financed with
long-term sources, such as long-term debt and/or equity
• In practice, firms may use more or less short-term
funds to finance working capital
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Figure 3.7(a):
Working Capital Financing Policies
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Figure 3.7(b):
Working Capital Financing Policies
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Short-Term vs. Long-Term Financing
• The mix of short- or long-term working capital
financing is a matter of policy
Use of long-term funds is a conservative policy
Use of short-term funds is an aggressive policy
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Short-Term vs. Long-Term Financing
• Short-term financing
Cheap but risky
• Cheap—short-term rates generally lower than long-term rates
• Risky—because you are continually entering marketplace to
borrow
• Borrower will face changing conditions (ex; higher interest rates and
tight money)
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Short-Term vs. Long-Term Financing
• Long-term financing
Safe but expensive
• Safe—you can secure the required capital
• Expensive—long-term rates generally higher than short-term
rates
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Working Capital Policy
• Firm must set policy on following issues:
How much working capital is used
Extent to which working capital is supported by short-
vs. long-term financing
How each component of working capital is managed
The nature/source of any short-term financing used