Working capital refers to the capital required to finance short-term operating needs such as inventory, accounts receivable, and cash. It is important for businesses to maintain adequate but not excessive working capital to support operations. Effective working capital management can improve cash flows and lower financing costs. Both too much and too little working capital can negatively impact a business's profitability and stock valuation.

1. WORKING CAPITAL FINANCE
CA. SANJAY
KOTHARI

2. DEFINITION
Working Capital refers to that part of the firm’s
capital, which is required for financing short-
term or current assets such as 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.

3. FACTORS DETERMINING WORKING
CAPITAL
Nature of the Production Cycle
Industry Credit control
Demand of Industry Inflation or Price
Cash requirements level changes
Nature of the Profit planning and
Business control
Manufacturing time Repayment ability
Volume of Sales Cash reserves
Terms of Purchase Operation efficiency
and Sales Change in Technology
Inventory Turnover Firm’s finance and
Business Turnover dividend policy
Business Cycle Attitude towards Risk
Current Assets
requirements

4. WORKING CAPITAL CYCLE
Cash
Debtors RM
Sales WIP
FG

5. TIME AND MONEY CONCEPTS IN
WORKING CAPITAL CYCLE
Each component of working capital (namely
inventory, receivables and payables) has two
dimensions ........TIME ......... and MONEY, when it
comes to managing working capital.
You can get money to move faster around the cycle or
reduce the amount of money tied up. Then, business
will generate more cash or it will need to borrow less
money to fund working capital.
As a consequence, you could reduce the cost of bank
interest or you'll have additional free money available
to support additional sales growth or investment.
Similarly, if you can negotiate improved terms with
suppliers e.g. get longer credit or an increased credit
limit, you effectively create free finance to help fund
future sales.

6. If you Then ......
Collect receivables You release cash from the
(debtors) faster cycle
Collect receivables Your receivables soak up
(debtors) slower cash
Get better credit (in terms You increase your cash
of duration or amount) resources
from suppliers
Shift inventory (stocks) You free up cash
faster
Move inventory (stocks) You consume more cash
slower

7. TYPE OF WORKING CAPITAL
Concept Basis
Gross WC
Net WC
Time Basis
Permanent/Fixed WC
Regular WC
Reserve WC
Temporary/variable WC
Seasonal WC
Special WC

8. SOURCES OF WORKING CAPITAL
Sources of working capital are:
Owned fund (Equity, Reserves, etc.)
Bank borrowings(Cash Credit, Packing Credit, B/D, L/C)
Sources of additional working capital include the
following:
Existing cash reserves
Profits (when you secure it as cash !)
Payables (credit from suppliers)
New equity or loans from shareholders
Bank overdrafts or lines of credit Long-term loans

9. METHODS OF ASSESSMENT OF WORKING
CAPITAL
TURNOVER METHOD
Mainly used for small trading companies
Not appropriate for manufacturing and big trading companies
CASH BUDGET SYSTEM
Mainly used for service sector companies
Cash inflow – Cash outflow = Bank finance in form of WC
TONDON COMMITTEE RECOMMENDATIONS
Out of 3 methods recommended, method II also known as
Maximum Permissible Bank Finance (MPBF) is mainly used by the
banks for assessment of WC finance

10. CREDIT MONITORING ARRANGEMENT
(CMA)
CMA data is a tool used by the bankers to assess the
requirement of working capital. It is divided into six parts as
follows:
Form I Particulars of Existing & Proposed Limits
Form II Operating Statement
Form III Analysis of Balance Sheet
Form IV Comparative Statement of Current Assets & Current
Liabilities
Form V Computation of Maximum Permissible Bank Finance (MPBF)
Form VI Funds Flow Statement

11. KEY RATIO LEVELS
PARTICULARS LOW RISK MEDIUM RISK HIGH RISK
Current Ratio > 1.40 1.20 - 1.40 < 1.20
11
TOL/TNW < 2.00 2.00 - 3.50 < 3.50
Interest Coverage > 3.50 2.00 - 3.50 < 2.00
PAT/SALES% > 10.00 4.00 - 10.00 < 4.00
Inventory (No. of days) < 60 60 - 90 > 90
Debtors (No. of days) < 45 45 - 90 > 90
Debt – Equity Ratio < 1.25 1.25 - 1.75 > 1.75
DSCR (For TL) > 2.00 1.25 - 2.00 < 1.25

12. FORECASTING/ESTIMATION OF WORKING
CAPITAL REQUIREMENT
Factors to be considered
Total costs incurred on materials, wages and overheads
The length of time for which raw materials remain in
stores before they are issued to production.
The length of the production cycle or WIP, i.e., the time
taken for conversion of RM into FG.
The length of the Sales Cycle during which FG are to be
kept waiting for sales.
The average period of credit allowed to customers.
The amount of cash required to pay day-to-day expenses
of the business.
The amount of cash required for advance payments if
any.
The average period of credit to be allowed by suppliers.
Time – lag in the payment of wages and other overheads

13. WORKING CAPITAL PRODUCTS
Fund based
Domestic
Cash Credit
Overdraft facility
Bill Discounting
Export
Preshipment Credit
Post shipment Credit
Non-fund based
Letter of credit
Bank Guarantee

14. SPECIAL SITUATIONS
CYCLICAL PRODUCTION/SALES
PHASED EXPANSION PROGRAMS
EXPANSION PROGRAMS WITH ENHANCEMENT IN EXISTING LIMITS
MAJOR ORDERS
ENHANCEMENT DURING THE YEAR
SHORT TERM FUND USED FOR ACQUISITION OF LONG TERM ASSETS
DRAWING POWER NOT ALLIGNED TO MPBF
DEVALUATION / EROSION OF CURRENT ASSETS

15. STRUCTURED WORKING CAPITAL
PRODUCTS
Commercial Paper
Corporate Loan
Suppliers/ Buyers Credit
Securitisation of receivables
Factoring
Forfeiting

16. IMPORTANCE OF ADEQUATE WORKING
CAPITAL
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.

17. DISADVANTAGE OF INADEQUATE
WORKING CAPITAL
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.
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.
Due to low rate of return on investments, the market value of
shares may fall.

18. OVERTRADING
Trying to operate without adequate working capital. It
is often caused by an expansion in credit sales, and
thus in trade receivables. This causes a shortage of
cash.
Early warning sign of overtrading include:
Pressure on existing cash
Exceptional cash generating activities e.g. offering high
discounts for early cash payment
Bank overdraft exceeds authorized limit
Seeking greater overdrafts or lines of credit
Part-paying suppliers or other creditors
Paying bills in cash to secure additional supplies
Management pre-occupation with surviving rather than
managing
Frequent short-term emergency requests to the bank (to
help pay wages, pending receipt of a cheque
Declining liquidity ratio

19. CURING OVERTRADING
Overtrading may be cured or reduced by:
Borrowing or increasing in capital to increase
current assets
Sale of non-trading assets
Tightening terms of credit granted to customers
Negotiating longer credit terms from major suppliers.

20. CASH FLOW STATEMENT –BACKBONE OF
GROWTH
Regular cash flow are the backbone of long-term growth
and sustainability. It highlight the strength of the
company’s business model in meeting its working capital
and capex requirements, coupled with its ability to ensure
orderly operations even during a cyclical downturn.
A company with healthy operating cash flow is in a position
to plough this cash into its projects/wc cycle. It can thus
grow at a steady space, compared to the companies that
mostly rely on external sources to fund their growth. This
was on display during the credit crisis last year, which put
the future of companies with poor cash flows in doubt.
It may be possible that company reports very good earnings
but it may not be generating sufficient cash. Cash flow can
be negative while profitability is positive. Income
statement and cash flow statement should be analyzed to
assess the operational efficiency of the company

21. SIGN OF POTENTIAL LIQUIDITY
PROBLEMS
Buildup of inventories and declining inventory
turnover.
Increases in debt and debt ratios.
Increases in costs that cannot be passed on.
Increases in accounts receivables and collection
periods.
Decline in net working capital and daily cash flows.

22. NECESSITY TO EFFECTIVELY MANAGE
WORKING CAPITAL
Working capital doesn't come free -- there is an
opportunity cost (returns that it could have
generated from any other avenue) besides the
interest burden due to the short-term bank
borrowings.
This cost can be substantial during an economic
slowdown, when a company's inventories and
receivables rise, bloating current assets. But
current liabilities do not rise in proportion to
current assets, since creditors tend to shy away
at such times. It becomes more expensive to
finance working capital, and profits are hit to
that extent.

23. ADVANTAGE OF EFFECTIVE
MANAGEMENT OF WORKING CAPITAL
The important thing for a shareholder is how
well the working capital is managed. Though
measured at a point of time, it still says a lot
about how healthy a company's revenues are.
In last 2 years, companies that managed their
working capital well have reported relatively
strong profits, and their shareholders have been
rewarded with capital appreciation despite an
overall trend of declining share prices. Others,
especially commodity producers and companies
whose products face cyclical demand, have
floundered.

24. IMPACT ON STOCK VALUATIONS
As there is a cost associated with working capital, a company
that can generate more revenues from a specified amount of
working capital than others will eventually be more profitable,
with better cash flows and will command superior valuation.
Most commodity-based companies are capital-intensive and have
high working capital requirements. Their business is cyclical in
nature, which puts an additional burden on the working capital
when the chips are down. That explains why these companies are
not able to extract a higher valuation from the stock markets.
Also, with piling receivables and inventories, cash inflows are
affected. This can lead to problems in paying large cash outflows
like interest and dividend. Many companies can do nothing other
than use their long-term funds to finance this shortfall -- which
can also lead to falling profits.
Companies that prefer to maintain low levels of working capital
score well on working capital turnover ratio (Net sales / Net
working capital).Though this level varies with the nature and
scale of operations, the stock market attaches a premium to
companies with low working capital requirements. Likewise, a
company with a high working capital turnover ratio vis-a-vis its
peers tends to get a higher price to earnings (PE) ratio.

25. CONCLUSION
Any change in the working capital will have an
effect on a business's cash flows. A positive change
in working capital indicates that the business has
paid out cash, for example in purchasing or
converting inventory, paying creditors etc. Hence,
an increase in working capital will have a negative
effect on the business's cash holding. However, a
negative change in working capital indicates lower
funds to pay off short term liabilities (current
liabilities), which may have bad repercussions to
the future of the company.