This document discusses working capital management. It defines working capital as the funds used in a business for day-to-day operations, and explains that adequate working capital is important for efficiency and survival. It distinguishes between gross and net working capital, and discusses factors that influence working capital requirements like nature of business and credit terms. The document also outlines methods for estimating working capital needs based on current assets, operating cycles, and cash costs.

1. Working Capital Management
Roshankumar S Pimpalkar
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2. Working Capital Management Part-1
Working capital is business’s life blood. A concern needs funds for its day-to-day
working. Adequacy or inadequacy of these funds would determine the efficiency with
which the daily business may be carried on. A finance manager has to ensure that
the amount of working capital the concern is holding is not too less or too much.
Since large working capital indicates idle funds for which the entity has to bear cost
to hold such funds and low working capital gives rise to risk of insolvency. The
various studies conducted by the Bureau of Public Enterprises have shown that one
of the reasons for the poor performance of public sector undertaking in India has
been the large amount of funds locked up in working capital. This results in over
capitalization. Over capitalization implies that a company has too large funds for its
requirements, resulting in low rate of return. Most of the times a company is not
perform well despite of the fact that its product has really good demand, just because
its working capital management is poor. Maintaining working capital is not just
important for short term but it is necessary to ensure long term survival.
There are two concept of working capital- gross and net. Gross working capital refers
to firm’s investment in current assets. Net working capital refers to difference
between current assets and current liabilities. Current assets are those assets which
can be converted into cash within an accounting year. It includes stock of raw
material, work-in-progress, finished goods, trade receivables, prepayments, cash
balances etc. Current liabilities are those liabilities which mature for payment within
an accounting year. It includes trade payables, accruals, tax payable, bills payables,
outstanding expenses, dividends payable, short term loans etc. A positive working
capital means that the entity is able to pay off its short term liabilities, whereas a
negative working capital indicates its inability to pay off its short term liabilities.
The term working capital is divided in two categories viz. Permanent and temporary.
Permanent working capital is the hard core working capital. It’s the minimum
investment in the current assets that the entity needs to carry out minimum level of
activities. Temporary working capital on the other hand is the working capital over
and above permanent working capital. It’s also called variable working as its volume
keeps changing with change in business activities.
Liquidity Vs Profitability:
Profitability and liquidity are inversely related to each other. A firm with good liquidity
has less risk of insolvency, it will hardly experience a cash shortage or a stock out
situation, but at the same time the cost of maintaining high liquidity will reduce
profits. On the other hand if the firm maintains low level of current assets the risk of
insolvency is high but profitability is high due to low cost of maintaining liquidity.
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3. Various combinations of policies and technique are used for working capital
management. The various steps in management of working capital are:
o Cash management- cash level should be maintained at a level so that the
day-to-day expenses can be met and cash holding cost is low.
o Inventory management- maintain quantity of inventory at such level so that
production is not interrupted and at that same time too much money is not
blocked in raw materials.
o Debtors’ management- an appropriate credit policy should be adopted so that
the credit term which will attract customers, such that the impact on cash
flows and the cash conversion cycle will be offset by increased revenue and
hence return on capital. The tools like discounts and allowances are used for
this.
o Short term financing- inventory is normally financed by credit granted by
suppliers and to finance other components of working capital other sources
are needed such as bank loan ( or overdraft), or to convert debtors to cash
through factoring.
Following are the factors which generally influence the working capital requirements
of the firm:
o Nature of business
o Credit policy of firm
o Availability of credit from suppliers
o Technology and manufacturing policy
o Operating efficiency
o Market demand and conditions
o Price level changes
Estimation of Working capital needs:
o Current assets holding period: working capital needs are estimated based on
average holding period of current assets and relating them to costs based on
company’s experience in the previous year. This method is based on the
Operating cycle concept.
o Ratio of sales: to estimate working capital needs as a ratio of sales on the
assumption that current assets change with change in sales.
o Ratio of fixed investment: to estimate working capital requirement as a
percentage of fixed investment.
Operating OR Working capital cycle
CASH
RAW MATERIAL/LABOUR/OVERHEAD
WIP
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4. FINISHED GOODS
DEBTORS
CASH
Operating cycle is one of the most useful tools for managing working capital. The
operating cycle analyzes the accounts receivable, inventory and accounts payable
cycle in number of days. Most of the businesses cannot finance the operating cycle
with accounts payable alone so working capital financing is needed. This shortfall is
covered by the net profits generated internally or by externally borrowed funds or by
combination of two.
Each component of working capital has two dimensions i.e. ‘time’ and ‘money’. If the
money moves faster around the cycle or the amount of money tied up is reduced, the
business will generate more cash or it will need to borrow less money to fund
working capital which will ultimately reduce bank interest or the entity will have
additional free money to support additional sales growth or investment. If increased
credit limits can be negotiated from suppliers, entity gets free finance.
Working capital cycle indicates the length of the time between a company’s paying
for materials, entering into stock and receiving the cash from sales of finished goods.
It can be determined by adding the number of days required for each stage of cycle.
For example, a company holds raw material on an average of 60 days, it gets credit
from the supplier for 15 days, production process needs 15 days, finished goods are
held for 30 days and 30 days credit is extended to debtors.
Operating cycle = R+W+F+D-C
Where,
R= Raw material storage period
W= Working capital holding period
F= Finished goods storage period
D= Debtors collection period
C= Credit period availed
Operating cycle= 60+15+30+30-15
= 120 days.
Now the above components may be calculated as:
RM storage period = Avg stock of RM / Avg cost of RM consumption per day
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5. WIP holding period = Avg WIP / Avg cost of production per day
FG storage period = Avg stock of FG / Avg COGS per day
Debtors collection period = Avg book debts / Avg credit sales per day
Credit period availed = avg trade creditor / Avg credit purchases per day
The net operating cycle represents the net time gap between investment of cash and
its recovery of sales revenue. If depreciation is excluded from expenses in the
computation of operating cycle, the net operating cycle also represents the cash
conversion cycle. The net operating cycle represents the time interval for which the
firm has to negotiate for working capital from its Bankers.
Estimation of Working Capital based on current asset and current liabilities
The holding period of various components of operating cycle may either expand or
contract the net operating cycle period. Longer the operating cycle, higher will be the
requirement of working capital and vice-versa.
Estimation of current assets
o Raw materials inventory:
(Estimated production in units * estimated cost of RM p.u. * Avg RM holding
period) / 360 days
o WIP Inventory:
(Estimated production in units * estimated WIP cost p.u. * Avg WIP holding
period) / 360 days
o Finished goods:
(Estimated production in units * Cost of production p.u. excluding
depreciation * Avg FG holding period) / 360 days
o Debtors:
(Estimated credit sales in units * cost of sales p.u. excluding depreciation *
Avg debtors collection period) / 360 days
o Minimum desired Cash and Bank balances to be maintained by the entity
have to be added to current assets for computation of working capital.
Estimation of current liabilities
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6. o Trade creditors:
(Estimated production in units * RM requirements p.u. * credit period granted
by suppliers) / 360 days
o Direct wages:
(Estimated production in units * Direct labour cost p.u. * Avg time lag in
payment of wages) / 360 days
o Overheads (other than depreciation and amortization)
(Estimated production in units * overhead cost p.u. * Avg time lag in payment
of overheads) / 360 days
In simple words it’s just the reverse of the process used to determine the operating
capital cycle.
Estimation of working capital requirement on cash cost basis
This approach is based on the fact that in case of current assets like debtors and
finished goods etc, the exact amount of funds blocked is less than the amount of
such current assets. For example, if we have sundry debtors worth Rs 1 lakh and our
cost of production is Rs 80000, the actual amount of funds blocked in debtors is Rs
80000 the balance Rs 20000 is profit. Now suppose out of this Rs 80000, Rs 5000 is
depreciation then actual funds blocked are Rs 75000. In other word Rs 75000 is the
amount needed to finance debtors worth Rs 1 lakh. Thus this approach ignores profit
and non cash item while determining working capital requirement.
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