Working Capital

Management
 Working Capital Management

• The working capital management

includes and refers to the procedures and
polices required to manage the Working
Capital.
 Working Capital - Introduction

Total capital is invested in two categories :

Fixed Assets Current Assets

Land & Building Raw Material

Machinery Cash
Furniture etc. Debtor etc.
Working Capital

• Working Capital refers to those assets which

are required for the day-to-day working of the
company.

Example:
Cash,
Raw Material
Working Capital - Introduction

Examples of Different Corporates

Significance of Working Capital

Operating Cycle Cash

Raw
Debtors Material

Finished
Sale Goods
Operating Cycle

Operating Cycle may be defined as the time stating

from the procurement of goods or raw materials and
ending with the sales realization.
 Types of Working Capital

Balance Sheet Concept Operating Cycle or

Circular Flow Concept

Gross Net Permanent Temporary

Working Working Working Working
Capital Capital Capital Capital
Types of Working Capital…

Gross Working Capital

Total funds invested in current assets.
Gross working capital = Current assets

Net Working Capital

It is excess of current asset over current liability.

NWC= Current assets- Current liabilities

Permanent Working Capitals

• It is the minimum investment in current assets

which is essential to carry on the business of a
firm even during dullest period.

Investment
(Rs.) PWC

Time period
Temporary Working Capital

To meet seasonal changes, fluctuations and unanticipated

condition.

Temporary working capital

Investment
(Rs.) PWC

Time period
Factors determining the size of Working Capital

• Size of business
• Length of operating cycle
• Seasonal availability of raw material
• Business fluctuations
• Nature of business

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Management of Working Capital

• The basic objective of working capital management is to

manage the firm’s current assets and current liabilities in
such a way that the satisfactory level of working capital is
maintained, i.e., it is neither inadequate nor excessive.

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 Importance

1. Solvency of the business

2. Goodwill
3. Cash Discounts
4. Regular supply of raw materials
5. Regular Payments
6. Exploitation of favorable market conditions
7. Ability to face crisis
8. Quick and Regular return on investment
9. High Morale

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 Disadvantages of Excess Working Capital

1. Idle Funds which earn no profits

2. Unnecessary purchasing and accumulation of inventories
3. Excessive debtors & defective credit policy
4. Inefficiency in the organization
5. Low rate of return on investment
6. Rise in speculative transactions

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 Disadvantages of Shortage of Working Capital

1. Unable to pay short-term liabilities

2. Unable to buy in bulk and avail discounts
3. Unable to exploit favorable market conditions
4. Unable to pay day-to-day expenses
5. Underutilization of Fixed Assets
6. Fall in return on investment

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 Sources of Working Capital

Short term Long term

• Commercial Banking • Equity Shares

• Cash Credit and Bank • Preference Shares

overdraft • Debentures
• Trade Credit • Public deposits
• Customer’s advances • Retained earnings
• Public deposits • Loan from financial
• Commercial Papers (CPs) institutions

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Approaches of WCM

• Hedging approach
• Aggressive approach
• Conservative Plan
Conservative Approach

• In this all the assets are financed through long-term financing.

• The short-term sources should be used only for emergency
requirement.

Emergency Requirement Short-Term financing

Investment
(Rs.) TWC
PWC Long-Term financing

Time period
Aggressive Approach

• This working capital policy is called an aggressive policy if the

firm decides to finance a part of the permanent working capital
by short-term sources.

Investment
(Rs.) TWC
Short term financing
PWC

Time period
Matching or Hedging Approach

• Permanent Working Capital should be financed form long-term

source of finance.
• Temporary Working Capital should be financed form short-term
source of finance.

Investment
(Rs.) TWC Short term financing
PWC
Long term financing

Time period
METHODS OF ESTIMATING WORKING CAPITAL REQUIREMENTS

• Percentage of Sales Method

• Regression Analysis Method (Average relationship between
sales and working capital)
• Cash Forecasting Method
• Operating Cycle Method
• Projected Balance Sheet Method

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METHODS OF ESTIMATING WORKING CAPITAL REQUIREMENTS...

Percentage of Sales Method

• This method of estimating working capital
requirements is based on the assumption that the
level of working capital for any firm is directly related
to its sales value. Certain ratios based on past year’s
experience are established.

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METHODS OF ESTIMATING WORKING CAPITAL REQUIREMENTS...

Cash Forecasting Method

• Under this method, an estimate is made of cash
receipts and payments for the next period.
• Estimated cash receipts are added to the amount of
working capital which exists at the beginning of the
year and estimated cash payments are deducted
from this amount.
• The difference will be the amount of working capital.

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METHODS OF ESTIMATING WORKING CAPITAL REQUIREMENTS...

Projected Balance Sheet Method

• Under this method, an estimate is made of assets
and liabilities for a future date and projected balance
sheet is prepared for that future date. The difference
in current liabilities shown in projected balance sheet
will be the amount of working capital.

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METHODS OF ESTIMATING WORKING CAPITAL REQUIREMENTS...

Regression Analysis Method (Average relationship between sales and

working capital)
This method of forecasting working capital requirements is based upon the
statistical technique of estimating or predicting the unknown value of a
dependent variable from the known value of an independent variable. It is
the measure of the average relationship between two or more variables, i.e.
sales and working capital, the terms of the original units of the data.
The relationship between sales and working capital is represented by the
equation:
y = a + bx
Where,
y = Working capital (dependent variable)
a = Intercept of the least square
b = Slope of the regression line
x = Sales (independent variable)

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METHODS OF ESTIMATING WORKING CAPITAL REQUIREMENTS...

Operating Cycle Method

Operating cycle is the time span the firm requires in the
purchase of raw materials, conversion of raw materials into work
in progress and finished goods, conversion of finished goods into
sales and in collecting cash from debtors. Larger the time span of
operating cycle, larger the investment in current assets.

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METHODS OF ESTIMATING WORKING CAPITAL REQUIREMENTS...
Operating Cycle Method…
Illustration
Details of X Ltd. For the year 2014-2015, are given as under:
Cost of Goods sold Rs. 4800000
Operating Cycle 60 days
Minimum desired level of cash balance Rs. 75000
You are required to calculate the expected working capital
requirement by assuming 360 days in a year.

= 48,00,000 x (60/360) + 75000

= 48,00,000 x (0,1667) + 75000
= 8,00,000 + 75000
`
= 8,75,000 Ans.
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METHODS OF ESTIMATING WORKING CAPITAL REQUIREMENTS...

Operating Cycle Method…

For proper computation of working capital under this method, a
detailed analysis is made for following individual component of
working capital:
• Stock of raw material
• Stock of work-in-process
• Stock of finished goods
• Investment in debtors/ receivables
• Cash & bank balance
• Prepaid expenses
• Trade creditors
• Creditors for wages and other expenses
• Advanced received

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Management of Working Capital

• The basic objective of working capital management is to

manage the firm’s current assets and current liabilities in
such a way that the satisfactory level of working capital is
maintained, i.e., it is neither inadequate nor excessive.

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Working Capital Management

Cash Management
Inventory Management
Receivable Management

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Management of Cash

The term ‘Cash’ with reference to cash management is used in two

sense.
In narrower sense it includes coins, currency notes, cheques, bank
drafts held by a firm with it & the demand deposits held by it in banks.

In broader sense it also includes “near-cash assets” such as marketable

securities & time deposits with banks.

Cash Management
Cash management is the art of synchronizing cash receipt and cash
payments for effective cash management. Means no excessive cash or
no shortage or in other words optimum cash balance.

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Objectives of Cash Management

 To meet the cash disbursement needs as per the payment

schedule.
 To minimize the amount locked up as cash balance.

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Cash management Cycle

Cash
Collection

Business Deficit Borrow

Operation Surplus Invest

Cash
Payments

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 Motives for Holding Cash

Motives for
Holding Cash

Transactions Precautionary Speculative Compensation

Motive Motive Motive Motive

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Motives of Cash Holding

Transactions Motives cash is required for carrying on the business

operations. Means day to day transactions. Like factory expenses, office
expense etc.

Precautionary Motive cash is required by a firm for future contingencies.

Speculative Motive is concerned with the holding of a cash for making

profitable investments through opportunities arising in the arising in the
course. E.g. down fall in stock prices.

Compensation Motive this motive is usually related to the services

provided by banks. Like minimum balance required in account by the firm
for getting some services. (Free draft, Cash pick & drop facility.)

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Factors Determining Cash Requirements

Cash Inflows

Cash Outflows

Cash Cycle

Cost of Cash Balance

Short Cost/ Opportunity Cost

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Cash Management-Basic Problems

 Controlling levels of cash

Preparing Cash Budget
Providing for unpredictable discrepancies
Consideration of short cash
Availability of other sources of funds
 Controlling inflows of cash
Concentration Banking
Lock-Box System
 Control over cash outflows
Centralized system of disbursements
Payments should be made on the due dates
 Investing surplus cash
Determining of surplus cash
Determination of channels of investment

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Devices and Methods of Cash Management

 Cash Budget
 Cash Flow statement
 Funds flow statement
Receivable

The term receivable is defined as ‘debt owed to the firm by

customers arising from sale of goods or services in the
ordinary course of business.’

In other words accounts receivable represent an extension of

credit to customers, allowing them a reasonable period of time
in which to pay for the goods received.

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 Meaning of Receivables Management

Receivables management is the process of making decisions

relating to investment in trade debtors.

The objective of receivables management is to promote sales

and profits until that point is reached where the return on
investment in further funding of receivables is less than the cost
of funds raised to finance the additional credit.

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Purpose of Receivables

 Achieving growth in sales

 Increasing profits
 Meeting competition

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Costs of Receivables

 Cost of financing
 Administrative cost
 Collection cost
 Delinquency costs (delay)
 Cost of default by customers

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 Factors Affecting the Size of Receivables

 Level of sales
 Credit policies (Conservative or Liberal)
 Terms of trade
 Expansion Plan
 Credit Collection efforts
 Habits/ Attitude of customers

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Policies for Managing Receivables

 Credit standards
A firm should set Credit standard which should be applied in selecting
customers for credit sales. Credit standards represent the basic criteria
for extension of credit to customers.
 Credit terms
It refers to the terms under which a firm sells goods on credit to its
customers.
 Credit period
 Cash discount
 Collection procedures…

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Policies for Managing Receivables…

 Collection procedures
A stringent collection procedure is expensive for the firm
because of high out-of-pocket costs and loss of goodwill of the
firm among its customers. However, it minimizes the loss on
account of bad debts as well as increases saving in terms of
lower capital costs on account of reduction in the size of
receivables.

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Credit Evaluation Procedure

Obtaining Credit Information

Credit Investigation

Credit Analysis

Credit Limit

Collection Procedure

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Management of Inventory

Management of inventories involves two basic problems:

(i) Maintaining a sufficiently large size of inventories for
efficient and smooth production and sales operations;
(ii) Maintaining a minimum investment in inventories to
minimize cost associated with holding inventories to
maximize the profitability.

Means inventories should neither be excessive nor inadequate.

Inventory Management

Meaning of Inventory Inventories are goods held for sale by

firm.

Various Forms of Inventories

 Raw Materials
 Work-in-progress [Semi- Finished]
 Finished Goods
Benefits of Holding Inventory

 Avoiding Loss of Sales

 Reducing Ordering cost
 Achieving Efficient production runs
Cost of Holding Inventories

 Material Cost
 Ordering Cost
 Carrying Cost
 Objective of Inventory Management

Optimum Inventory

Costs Benefits

Cost for Cost of not

carrying carrying

 Storage Cost
 Ordering Cost
 Opportunity Cost Benefits in :
 Work Stoppages
 Maintenance Cost  Production
 Loss in Sales
 Administration Cost  Purchase
 Opportunity Cost
 Cost of Finance  Sales
Techniques of Inventory Management

 ABC Analysis
 VED Analysis
 Just In Time [JIT]
 Economic Order Quantity
Just In Time (JIT)

To have only the right materials, parts and products in the

right place at the right time.

The basic philosophy behind JIT is that the firm should keep a
minimum level of inventory on hand, relaying on suppliers to
furnish ‘stock’ ‘just in time’ as and when required.

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Advantage - Just In Time (JIT)….

 The right quantities of materials at right time.

 Investment in inventory is reduced.
Wastes are eliminated.
Carrying or holding cost is reduced.

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ABC Analysis

This technique classifies inventories into

different types and then controls them.
(1) A Control most Expensive Items - Tight
Security
(2) B Control Less Expensive Items - Medium
Security
(3) C Control Least Expensive Items - Low
Security
VED

V Vital
E Essential
D Desirable

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 VED

• VED – Vital, Essential and Desirable classification is applicable largely to

spare parts. Stocking of spare parts is based on strategies different from
those of raw materials because of there consumption pattern is different.
Here the spare parts are classified in to three categories.

• ·      Vital     -           The spares, the stock out of which even for a short time
will stop the production.

• ·      Essential -         The spares, the absence of which cannot be tolerated for

more than a few hours or a day.

• ·      Desirable -        The desirable spares are those spares which are needed
but this absence for even a week or so will not stop the production.
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Re-order Level
Re-order Level
The re-order level is the level of inventory at which the fresh
order for that item must be placed to procure fresh supply.

R = M+ tU

Where , R = Re-order Level

M= Minimum level of inventory
t =Time gap/ delivery time, and
U= Usage rate

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Re-order Level
Re-order Level
Min Quantity = 1000 units
Delivery time = 5 weeks
Usage = 50
R = M+ tU

Re-order Level = 1000 + (5 x 50)

1000 + 250
= 1250 Ans

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Economic Order Quantity (EOQ)

In this technique manager wants to reduce the cost of carrying and cost of
ordering.
Manager try to find out the quantity which should be purchased in a lot.
Which result reduction in the cost of the inventory.

2xRxCp
Ch

Where R = Annual Requirement

Cp = Cost of order placing
Ch = Cost of holding

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Economic Order Quantity (EOQ)
The following information is available in respect of an item:
Annual usage, R = 20000 units
Ordering cost, Cp= Rs. 1875 per order
Carrying cost, CH = Rs. 3 per unit per/ year.
Find out the economic order quantity.

2 x 2000 x 1875

75,00,000

25,00,000 1581.11 Units

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Economic Order Quantity (EOQ)
The following information is available in respect of an item:

Annual usage, A = 10000units

Ordering cost, O= Rs. 2 per order
Carrying cost, C = 2%
Cost per unit, P = 8
Find out the economic order quantity.

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Economic Order Quantity (EOQ)
Annual usage, R = 10000 units
Ordering cost, Cp= Rs. 4 per order
Carrying cost, CH = Rs. 2% per unit per/ year.
Cost per unit = Rs. 8
Find out the economic order quantity.

2 x 1000 x 4

0.16

4000

0.16

25,000
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Economic Order Quantity (EOQ)

What is EOQ?
EOQ stands for Economic Order Quantity. It is a measurement
used in the field of Operations, Logistics, and Supply
Management. In essence, EOQ is a tool used to determine the
volume and frequency of orders required to satisfy a given level
of demand while minimizing the cost per order.

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Economic Order Quantity (EOQ)

The Importance of EOQ

The Economic Order Quantity is a set point designed to help
companies minimize the cost of ordering and holding inventory.
The cost of ordering an inventory falls with the increase in
ordering volume due to purchasing on economies of scale.
However, as the size of inventory grows, the cost of holding the
inventory rises. EOQ is the exact point that minimizes both these
inversely related costs.

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