This document provides information on working capital management. It discusses key concepts related to working capital such as net working capital, gross working capital, and approaches to financing working capital. The conservative, aggressive, and matching approaches are explained. Components of working capital like cash, inventory, debtors, and creditors are also summarized. Techniques for managing these components like economic order quantity, stock levels, and cash management models are outlined as well.

1. Unit IV
Financial Management
• Management of Working Capital: Concepts of
working Capital
• Approaches to the financing of current
Assets
• Determining capital (with numerical problems)
• Management of different components
of working capital.
Prepared by:-
Dr. Waqar Ahmad
Asstt. Professor
Allenhouse Business School

2. WORKING CAPITAL
• Working capital management involves the
relationship between a firm's short-term assets
and its short-term liabilities.
• The basic goal of working capital management
is to ensure that a firm is able to continue its
operations and that it has sufficient ability to
satisfy both maturing short-term debt and
upcoming operational expenses.

3. SINGNIFICANCE OF WORKING CAPITAL
MANAGEMENT
 In a typical manufacturing firm, current assets exceed one-half
of total assets.
 Excessive levels can result in a substandard Return on
Investment (ROI).
 Current liabilities are the principal source of external financing
for small firms.
 Requires continuous, day-to-day managerial supervision.
 Working capital management affects the company’s risk,
return, and share price.

4. WORKING CAPITAL CONCEPTS
Net Working Capital
 Net working capital refers to the difference between
current assets and current liabilities. Current liabilities are
those claims of outsider, which are expected to mature
 For payment within an accounting year & include creditors,
bills payable & the outstanding expenses. In other words you
can say that this is the excess of current assets over current
liabilities.
Current Assets – Current Liabilities

5. WORKING CAPITAL CONCEPTS
Gross Working Capital
• It refers to the firm’s investment in current assets.
• Current assets are the assets, which can be converted into
cash within an accounting year or within an operating cycle
• cash, short-term securities, debtors (accounts receivable &
book debts), bills receivable and stock.
Working capital turnover
Working capital turnover= sales/working capital
Working Capital Management
The administration of the firm’s current assets and the
financing needed to support current assets.

6. CURRENT ASSETS
• Inventories: Inventories represent raw materials and
components, work-in-progress and finished goods.
 Trade Debtors: Trade Debtors comprise credit sales to
customers.
Prepaid Expenses: These are those expenses, which have been
paid for goods and services whose benefits have yet to be
received.
 Loan and Advances: They represent loans and advances given
by the firm to other firms for a short period of time.
 Investment: These assets comprise short-term surplus funds
invested in government securities, shares and short-terms bonds.
 Cash and Bank Balance: These assets represent cash in hand
and at bank, which are used for meeting operational
requirements. One thing you can see here is that this current
asset is purely liquid but non-productive.

7. CURRENT LIABILITY
 Sundry Creditors: These liabilities stem out of
purchase of raw materials on credit terms usually for a
period of one to two months.
 Bank Overdrafts: These include withdrawals in
excess of credit balance standing in the firm’s current
accounts with banks
 Short-term Loans: Short-terms borrowings by the
firm from banks and others form part of current
liabilities as short-term loans.
 Provisions: These include provisions for taxation,
proposed dividends and contingencies.

8. WORKING CAPITAL FORMAT
CURRENT ASSETS CURRENT LIABILITIES
• Cash
• Accounts receivable
• Notes receivable
• Marketable securities
• Inventory
• Prepaid expenses
Total current assets
• Accounts payable
• Notes payable
• Accrued expenses
• Taxes payable
Total current liabilities

9. POINTS KEPT IN MIND WHILE PLANNING
1. Excessive investment (Profitability)
• It results in unnecessary accumulation of
inventories. Thus, chances of inventory
mishandling, waste, theft & losses increase.
• It is an indication of defective credit policy &
slack collection period.
• Excessive WC makes management complacent,
which degenerates into managerial inefficiency.
• Tendencies of accumulating inventories tend to
make speculative profits grow.

10. POINTS KEPT IN MIND WHILE PLANNIN CONT…
2. Inadequate investment (Liquidity)
 It stagnates growth.
 It become difficult to implement operating plans and
achieve the firm’s operating profit target.
 Operating inefficiencies creep in when it becomes difficult
even to meet day-to-day commitments.
 Fixed assets are not efficiently utilized for the lack of
working capital funds. Thus, the firm’s profitability would
deteriorate.
 Paucity of WC funds render the firm unable to avail
attractive credit opportunities.
 The firm loses its reputation when it is not in a position to
honour its short-term obligations.

11. KINDS OF WORKING CAPITAL
1.Permanent working capital
 Permanent working capital is the minimum amount of
current assets, which is needed to conduct a business even
during the dullest season of the year.
 The minimum level of current assets is called permanent or
fixed working capital as this part is permanently blocked in
current assets.
Characteristics of Permanent working capital
 It is classified on the basis of the time period
 It constantly changes from one asset to another and
continues to remain in the business process.
 Its size increase with the growth of business operations.

12. Permanent working capital

13. Permanent working capital CONT…
2.Temporary working capital
 Temporary working capital represents a certain amount of
fluctuations in the total current assets during a short period.
 Variable working capital is the amount of additional current
asset that are required to meet the seasonal needs of a
firm, so is also called as the seasonal working capital.
Characteristics of Temporary working capital
It is not always gainfully employed, though it may change
from one asset to another asset, as permanent working
capital does.
 It is particularly suited to business of a seasonal or cyclical
nature.

14. TEMPORARY WORKING CAPITAL

15. DETERMINANTS OF WORKING CAPITAL
• Nature of business
• Terms of sales and purchases
• Manufacturing cycle
• Rapidity of turnover
• Business cycle
• Changes in technology
• Seasonal variation
• Market conditions
• Seasonality of operation
• Dividend policy
• Working capital cycle

16. Importance of Working Capital:
• It helps measure profitability of an enterprise. In its absence, there
would be neither production nor profit.
• Without adequate working capital an entity cannot meet its short-
term liabilities in time.
• A firm having a healthy working capital position can get loans easily
from the market due to its high reputation or goodwill.
• Sufficient working capital helps maintain an uninterrupted flow of
production by supplying raw materials and payment of wages.
• Sound working capital helps maintain optimum level of investment
in current assets.
• It enhances liquidity, solvency, credit worthiness and reputation of
enterprise.
• It provides necessary funds to meet unforeseen contingencies and
thus helps the enterprise run successfully during periods of crisis.

17. Approaches of Working Capital

18. Approaches of Working Capital
1.Conservative Approach
2.Aggressive Approach
3.Matching Approach or Hedging
Approach

19. Conservative Approach
1. Conservative approach is a risk-free strategy
of working capital financing.
2. A company adopting this strategy maintains a higher
level of current assets and therefore higher working
capital also.
3. The major part of the working capital is financed by
the long-term sources of funds such as equity,
debentures, term loans etc. So, the risk associated
with short-term financing is abolished to a great
extent.

20. Conservative Approach
In the conservative approach, fixed assets,
permanent working capital and a part of temporary
working capital is financed by long-term financing
sources and the remaining part only is financed by
short-term financing sources.
Financing Strategy in Equation:
Long Term Funds will Finance = Fixed Assets +
Permanent Working Capital + Part of Temporary
Working Capital
Short Term Funds will Finance = Remaining Part
of Temporary Working Capital

21. Conservative Approach Diagram

22. Conservative Approach Diagram
The dotted lines horizontal line indicates the point till
which the long-term funds will be utilized. The dotted
vertical lines indicate the sources of finance and they
are tagged as ‘long-term financing’ and ‘short term
financing’.
We can easily make out that long term funds are
financing total fixed assets, total permanent assets and
a part of the temporary or seasonal working capital
also. Seasonal requirement or temporary working
capital has peaks and troughs. The two areas of troughs
below the long-term financing line indicate that there
are idle long term funds incurring unnecessary interest
cost.

23. Conservative Approach
Advantage of Conservative Approach
1. Smooth Operation
2. No Insolvency Risk
Disadvantage of Conservative Approach
1. Higher Interest Cost
2. Idle Fund
3. Higher Carrying Cost
4. Inefficient working capital Management

24. Aggressive Approach
The aggressive approach is a high-risk strategy
of working capital financing wherein short-term finances
are utilized not only to finance the temporary working
capital but also a reasonable part of the permanent
working capital.
In this approach of financing, the levels of inventory,
accounts receivables and bank balances are just
sufficient with no cushion for uncertainty. There is a
reasonable dependence on the trade credit.

25. Aggressive Approach
Fixed assets and a part of permanent working capital are
financed by long-term financing sources and the
remaining part of permanent working capital and total
temporary working capital is only is financed by short-
term financing sources. It is explained in the equation
below:
Financing Strategy in Equation:
Long Term Funds will Finance = Fixed Assets +
Part of Permanent Working Capital
Short Term Funds will Finance = Remaining Part
of Permanent Working Capital + Temporary Working
Capital

26. Aggressive Approach Diagram

27. Aggressive Approach
The dotted lines horizontal line indicates the point till
which the long-term funds will be utilized. The dotted
vertical lines indicate the sources of finance and they
are tagged as ‘long-term financing’ and ‘short term
financing’.
We can easily make out that long term funds are
financing total fixed assets and a part of permanent
assets. A major part of Seasonal requirement or
temporary working capital is financed by short term
source of finance. In this approach, the difficult area is
the part of permanent working capital which is
financed by short-term sources. It can pose problems
of liquidity and bankruptcy to the firm.

28. Aggressive Approach
Advantage of Aggressive Approach
1. Lower Financing Cost, High Profitability
2. Lower Carrying and Handling Cost
3. Highly Efficient Working Capital Management
Disadvantage of Aggressive Approach
1. Insolvency Risk
2. Lost Opportunities and Unexpected Shocks

29. Matching Approach or Hedging
Approach
Maturity matching or hedging approach is a strategy
of working capital financing wherein short term
requirements are met with short-term debts and long-
term requirements with long-term debts.
The underlying principal is that each asset should be
compensated with a debt instrument having almost the
same maturity.

30. Matching Approach or Hedging
Approach
Maturity Matching or Hedging Approach Equation
This matching approach of working capital
financing can be explained in terms of a simple
equation as follows:{
Long Term Funds will Finance = Fixed Assets +
Permanent Working Capital
Short Term Funds will Finance = Temporary
Working Capital

31. Matching Approach or Hedging
Approach

32. Matching Approach or Hedging Approach
In the diagram, we can see three levels, each of fixed assets,
permanent working capital and temporary working capital.
The red vertical line with white spaces represents the type of
financing.
The bigger line which stretches till permanent working capital
is long-term financing and a smaller line is the temporary
working capital. The line from where the temporary working
capital starts and the line of a hedging strategy is the same.
Any strategy below this line will be an aggressive strategy and
a strategy above it will be a conservative strategy.

33. Matching Approach or Hedging Approach
RATIONALE BEHIND MATURITY MATCHING
OR HEDGING APPROACH
Knowing why to apply maturity matching strategy is
very important. It suggests financing permanent
assets with long-term financing and temporary with
short-term financing. Now let us suppose opposite
situations and see. There can two such situations.

34. Matching Approach or Hedging Approach
1. Permanent Assets Financed with
Short Term Financing
2. Temporary Assets Financed with
Long Term Financing

35. Management for different
components of working capital
1.Cash Management
2.Inventory Management
3.Debtors Management
4.Creditors Management

36. 1.Cash Management
Business concern needs cash to make payments for acquisition
of resources and services for the normal conduct of business.
Cash is one of the important and key parts of the current
assets.
Cash is the money which a business concern can disburse
immediately without any restriction. The term cash includes
coins, currency, cheques held by the business concern and
balance in its bank accounts. Management of cash consists of
cash inflow and outflows, Cash flow within the concern and
cash balance held by the concern etc.

37. Motives for Holding Cash
1. Transaction motive
It is a motive for holding cash or near cash to meet routine cash requirements to
finance transaction in the normal course of business. Cash is needed to make
purchases of raw materials, pay expenses, taxes, dividends etc.
2. Precautionary motive
It is the motive for holding cash or near cash as a cushion to meet unexpected
contingencies. Cash is needed to meet the unexpected situation like, floods strikes
etc.
3. Speculative motive
It is the motive for holding cash to quickly take advantage of opportunities typically
outside the normal course of business. Certain amount of cash is needed to meet
an opportunity to purchase raw materials at a reduced price or make purchase at
favourable prices.
4. Compensating motive
It is a motive for holding cash to compensate banks for providing certain services or
loans. Banks provide variety of services to the business concern, such as clearance
of cheque, transfer of funds etc.

38. Cash Management Techniques
Managing cash flow constitutes two important parts:
A. Speedy Cash Collections.
B. Slowing Disbursements.
The techniques aim at, the customer who should be encouraged to
pay as quickly as possible and the payment from customer without
delay. Speedy Cash Collection business concern applies some of the
important techniques as follows:
•Prompt Payment by Customers
•Early Conversion of Payments into Cash
•Concentration Banking
•Lock Box System

39. Slowing Disbursement
An effective cash management is not only in the part of
speedy collection of its cash and receivables but also it
should concentrate to slowing their disbursement of cash
to the customers or suppliers. Slowing disbursement of
cash is not the meaning of delaying the payment or
avoiding the payment. Slowing disbursement of cash is
possible with the help of the following methods:.
1. Avoiding the early payment of cash
2. Centralised disbursement system

40. Cash Management Models
Baumol model
The basic objective of the Baumol model is to determine the minimum cost
amount of cash conversion and the lost opportunity cost. Total conversion cost
per period can be calculated with the help of the following formula:
t= Tb
C
Opportunity cost can be calculated with the help of the following formula;
i = C
2
Optimal cash conversion can be calculated with the help of the following formula;
C = 2bT
i
where,
T = Total transaction cash needs for the period
b = Cost per conversion
C = Value of marketable securities
where,
i = interest rate earned, C/2 = Average cash balance,
C = Optimal conversion amount
b = Cost of conversion into cash per lot or transaction
T = Projected cash requirement
i = interest rate earned

41. Management for different
components of working capital
Orgler’s model
Orgler model provides for integration of cash
management with production and other aspects of
the business concern. Multiple linear programming
is used to determine the optimal cash management.
Orgler’s model is formulated, based on the set of
objectives of the firm and specifying the set of
constrains of the firm.

42. 2. Inventory Management
Inventory constitutes a major part of total working
capital. Efficient management of inventory results in
maximization of earnings of the shareholders.
Efficient inventory management consists of managing
two conflicting objectives:
1. Minimization of investment in inventory on the one
hand
2. Maintenance of the smooth flow of raw materials
for production and sales on the other.

43. Types of Inventory
1. Raw-Materials Inventory
2. Work-in-Process Inventory
3. Finished-Goods Inventory
4. Stock of Cash

44. Inventory Management
Techniques
1. Economic order quantity
2. Fixation of stock levels
3. ABC Analysis
4. Just in Time (JIT)

45. Inventory Management Techniques
1. Economic order quantity
Economic Order Quantity (EOQ) is one of the important
techniques of inventory management. EOQ represents
that level of inventory which minimizes the total
inventory cost.
The formula for calculating EOQ is given below:
EOQ = √2QA / K
Where,
Q = Annual requirement or Production,
A = Ordering Cost per order, and
K = Carrying Cost per unit per Year.

46. Inventory Management Techniques
2. Fixation of stock levels
Efficient inventory management requires an
effective stock control system. One of the
important aspects of inventory control is
stock level.
Level of stock has a significant bearing on the
profitability. Over-stocking requires large
capital investments whereas under-stocking
affects flow of the production process.
The following are the levels of stock fixed for
efficient management of inventory.

47. Inventory Management Techniques
1. Re-order Level
2. Minimum Stock Level
3. Maximum Stock Level
4. Average Stock Level

48. Inventory Management Techniques
3. ABC Analysis
ABC Analysis is one of the important inventory control
techniques.
In a big manufacturing concern it is not always possible to pay
equal attention to each and every raw material.
In such cases raw materials are classified according to their
value so that proper control may be exercised on materials
having high value.
ABC Analysis is an analytical technique that tries to group
materials into three categories on the basis of cost involved.

49. Inventory Management Techniques
3. ABC Analysis
The categories are:
A – High value materials
B – Medium value materials
C – Low value materials

50. Inventory Management Techniques
4. Just in Time (JIT)
Just in time (JIT) inventory control system was developed by Taiichi
Okno of Japan and was first introduced in Toyata Manufacturing
Company of Japan. So it is also known as Toyata Production
Method. The basic idea behind this system is that a firm should
keep minimum level of inventory on the assumption that suppliers
will deliver the raw materials as and when required. This system
tries to make inventory carrying cost as zero.
Three important elements of JIT are Just in time purchasing, just in
time production and just in time supply. Just in time purchasing,
just in time production and just in time delivery can be effectively
applied through adoption of advanced manufacturing technology.

51. 4. Accounts Payable Management:
Payables or creditors are one of the important components
of working capital. Payables provide a spontaneous source of
financing of working capital. Payable management is very
closely related with the cash management. Effective payable
management leads to steady supply of materials to a firm as
well as enhances its reputation.
It is generally considered as a relatively cheap source of
finance as suppliers rarely charge any interest on the amount
owed. However, trade creditors will have a cost as a result of
loss of enjoying cash discount on cash purchases.

52. Thank You