Principles of Working Capital Management 657

optimize investment in current assets? (2) How should there is a minimum amount of net working capital which
current assets be financed? is permanent. Therefore, a portion of the working capital
The coruideration of the level of inveshnmt in current should be financed with the permanent sources of funds
assets should avoid two danger points-cxcessioe and such as equity share capital, debenfures, long-term debt,
inadequate investment in current assets. Investment preference share capital orretained eamings. Management
in current assets should be just adequate to the needs must, therefore, decide the extent to which current assets
of the business firm. Excessive investment in current should be financed with equity capital and/or borrowed
assets should be avoided because it impairs the firm's capital.
profitability, as idle investment eams nothing. O5r the other In summary it may be emphasized that both gross
hand, inadequate amount of workingcapital canthreaten and net concepts of working capital are equally important
the solvency of the firm because of its inability to meet its for the efficient management of working capital. There is
current obligations. It shouldbe realized that the working no precise way to determine the exact amount of gross, or
capital needs of the firm may be fluctuating with changing net working capital for any firm. The data and problems
business activify. This may frequently cause excess or of each company should be analyzed to determine the
shortage of working capital. The management should be amount of working capital. There is no specific rule as to
prompt to initiate an action and correct imbalances. how current assets should be financed. It is not feasible
Another aspect of the gross working capital points, in practice to finance current assets by short-term sources
to the need of arranging funds to finance current assets. only. Keeping in view the constraints of the individual
Whenever a need for working capital funds arises due company, a judicious mix of long and short-term finances
to the increasing level of business activity or for any should be invested in current assets. Since current assets
other reason, financing arrangement should be made involve cost of funds, they shouldbe put toproductive use.
quickly. Similarly, if suddenly, some surplus funds arise
they should not be allowed to remain idle, but should
CHECK YOUR CONCEPTS
be invested in short-term securities. Thus, the financial
managershould have knowledge of the sources of working
capital funds as well as investment avenues where idle
l. Explain the gross and net concepb of working capihl.

funds may be temporarily invested. 2. What is the significance of the gross concept of
working capital?
3. What is the net concept of working capital?
Focussing on Liquidity Management
Net working capital is a qualitative concept. It indicates
the liquidity position of the firm and suggests the extent OPERATING AN D CASH CONVERSION CYCLE
to which the working capital needs may be financed by
permanent sources of funds. Current assets should be The need for working capital to run the day-to-day
sufficiently in excess of current liabilities to constitute business activities cannot be overemphasized. We will
a margin or buffer for maturing obligations, within hardly find a business firm which does not require any
the ordinary operating cycle of a business. In order to amount of working capital. Indeed, firms differ in their
protect their interests, short-term creditors always like a requirements of the working capital.
company to maintain current assets at a higher Ievel than We know that a firm should aim at maximizing the
It is a conventional rule to maintain
current liabilities. wealth of its shareholders. [n its endeavour to do so, afirm
the level of current assets twice the level of current should eam sufficient retum from its operations. Eaming
liabilities. However, the quality of current assets should a steady amotrnt of profit requires successful sales activity.
be considered in determining the level of current assets The firm has to invest mough funds in current asseb for
ais-h-ais current liabilities. Aweak liquidity position poses generating sales. Current assets are needed because sales
a threat to the solvency of the company and makes it do not convert into cash instantaneously. There is always
unsafe and unsound. A negative working capital means an operating cycle involved in the conversion of sales
a negative liquidity, and may prove to be harmful for into cash.
the company's reputation. Excessive liquidity is also There is a differencebetween current and fixed assets
bad. It may be due to mismanagement of current assets. in terms of their liquidity. A fum requires many years to
Therefore, prompt and timely action should be taken by recover the initial investment in fixed assets such as plant
the management to improve and correct the imbalances and machinery or land and buildings. On the contrary
in the liquidity position of the firm. invesknent in current asseb is fumed over many times in a
The net working capital concept also covers the year. Investment in current assets such as inventories and
question of judicious mix of long-term and short-term debtors (accounts receivable) is realized during the firm,s
funds for financing the current assets. For every firm, operating cycle that is usually less than a year.r What is
an operating cycle?

1. Moyer, R.C. et. al., Contemporary Finance Managenen t, West publishing Co., 79g4,p.562,
658 FinancialManagement

Operating cycle is the time duration required and (c) finished goods conversion period (FGCp). The
to convert sales, after the conversion of resources debtors conversion period is the time required to collect
into inventories, into cash. The operating cycle of a the outstanding amount from the customers. The total
manufacturing company involves three phases: of inventory conversion period and debtors conversion
Q Acquisition of resources such as raw material, period is referred to as gross operating cycle (GOC).
labour, power and fuel, etc. ' Table 27.1: Statement of Cost of Sales
\. Manufacture ol the product which includes
conversion of raw material into work-in-progress F /akn.)
into finished goods.
Actuol Proimtcd
A Sab of the proiluct either for cash or on 6redit. 20x1 20x2
Credit sales create accounts receivable for
collection. 1.
These phases affect cash flows, which most of the 523
time, are neither synchronized nor certain. They are not 3,
synchronized because cash outflows usually occw before I

cash inflows. Cash injlows ar€ not certain because sales {1 +2-3) 4,34e 5,93 2
and collections which give rise to cash inflows are difficult 5. Direct labour 368 498
to forecast accurately. Cash outflows, on the other hand, b. Depreciation BZ s0
are relatively certain. The firm is, therefore, required 7. Other mfg. expenses S53 704
to invest in current assets for a smooth, uninterrupted B. 'lbtal cost [4 + 5 + 6 + 7) 5,352 7 r')t
functioning. It needs to maintain liquidity to purchase o Opening work-in-process inventorv 185 325
raw materials and pay expenses such as wages and 10. Closing rvork-in-process invcntorv 325 4$B
salaries, other manu-facturing, administrative and selling 11. Cost of production {B + I - 10) 5,212 7 ,O51
expenses and taxes, as there is hardly a match between
1.2. Opening linished goocls inventory 3L7 526
cash inflows and outflows. Cash is also held to meet
12 Closing finished goods inventorv 526 995
any future exigencies. Stocks of raw material and work-
t+. Cost of goods sold {rr + 72 - 13} 5,003 6,582
15. Selling, administratjve ald
in-process are kept to ensure smooth production and to
gcneral expenscs si4 457,
guard against non-availability of raw material and other 16. Cost of sales (14 + ts) 5,307 ?;oss
components. The firm holds stock of finished goods to
meet the demands of customers on continuous basis and
In practice, a firm may acquire resources (such as
sudden demand from some customers. Debtors (accounts
raw materials) on credit and may temporarily postpone
receivable) are createdbecause goods are sold on credit for
payment of certain expenses. Payables, which the firm
marketing and competitive reasons. Thus, a firm makes
can defer, are spontaneous sources of capital to finance
adequate investment in inventories/ and debtors, for
investment in current assets. The creditors (payables)
smooth, rmintemrpted production and sale.
deferral period (CDP) is the length of time the firm is
How is the length of operating cyde deiermined? Figure able to defer payments on various resource purchases.
27.1. illushates this.2 The length of the operating cycle-of a
The difference between (gross) operating cycle and
manufacturing firm is the sum of: (l) inventory conversion payables deferral period is net operating cycle (NOC). If
period (ICP) and (ir) debtors (receivables) conversion depreciation is excluded from expenses in the computation
period (DCP). The inventory conversion period is the of operating cycle, the net operating cycle also represents
total time needed for producing and selling the product. the cash conversion cycle (CCC). It is the net time interval
Typically, it includes: (a) raw material conversion period between cash collections from sale of the product and
(RMCP), (&) work-in-process conversion period (WIPCP),
cash payments for resources acquired by the firm. It also

Collection

RMCP+WIPCP+FGCP

lnventory convers:ion period Receivable conv-ersion price

operating cycle

Net operating cyclc

Figure 27.1: Operating cycle of a manufacturing firm

2. Richards, V.D. and E.]. Laughlin. A Cash{onversion Cycle Approach to Liquidity Analysis, Financial Manageneflt, (Spring, 1980),
pp. 32-38. Also see Moyer ef. al., op. cit., 7984, pp.5624.
 Principles of Working Capital Management 659
represents the time interval over which additional funds, made for other inventories, debtors and creditors.
called working capital, should be obtained, in order to The following formula canbe usedl
carry out the fum's operations. The firm has to negotiate
working capital from sources such as commercial Lanks. Raw material
Raw material inventory
Th9
legotiated sources of working capital financing are conversion =
called non-spontaneous sources. If the net operating cycle period Imw materi[
of a firm increases, it means further need for negotiited
working capital. RMIx36o
RMCp=RMI*RMC (3)
Let us illustrate the computation of theJmgth of an
operating cycle. Consider the statement of costs of sales
360- RMC
for a firm given in Table 27.1. A Work-in-process cotn etsioa peioil (WpCp):
Work-in-process conversion period (WIpCp) is
The firm's data for sales and debtors and creditors
are given rnTable27.2.
the average time taken to complete the semi-
finished work or work-in-process. It is given by
Table 27,2: Sales and Debtors the following formula:
[t /okh,)
Work-in-process
Work-in-process inventory
20x1 20x2 r conversron =
SaIes (credit) 6,087 8.006
period @
Opening balance of debtors 5.ti 735
Closing balance of debtors
Opening balance of creditors
735
30$
1,040
454 wPCp=wtpr*C?^P= wllllf6o $)
Closing bala;rce of creditors 48e 642
360 COP
I Finisheil goods conoersion period (FGCp):
Finished goods conversion period (FGCp) is the
Gross Operatlng Gycle (GOC) av€rage time taken to sell the finished goods.
FGCP can be calculated as follows:
The firrr's gross operating cycle (GOC) can be determined
as inventory conversion period (ICp) plus debtors Finished goods Finished goods
co-nversion period (DCP). Thus, GOC is given as conversion _
follows: period [Costofgoods
Gross operating cycle = Invento4r conversionperiod soldl/360
+ Debtors conversion period

GOC=ICp+DCp FGCP = FGI *'act FGrx360 /q\

\v/
(1) 360 CGS
lnoentory conoersion perioil What determines the
inventory conversion period? The inventory conversion Debtors (receiaableil conoersion pertod @Cp) Debtors
(ICP) is the sum of raw material conveision period conversion period (DCP) is the average time taken to
(RMCP), work-in-process conversion period (WIpCp) and convert debtors into cash. DCP represents the average
finished goods conversion period (FeCp): collection period. It is calculated as follow:

ICP=RMCP+WIPCP+FGCP Q) Debtors Debtors Debtorsx360

conversion =
Q Rcar material comtersion peioil (RMCP) The period (DCP) Credit sales/360 Credit sales
(6)
raw material conversion period (RMCp) is the
average time period taken to convert material Creilitors (payables) ilefenal peioil (CDp) Creditors
in to work-in-process. RMCP depends on: (a) (payables) deferral period (CDp) is the average time
raw material consumption per day, and (D) raw taken by the firm in paying its suppliers (creditori;. COf,
material inventory. Raw material consumption per is given as follow:

{1f s qyen Uy the total raw material consumption Creditors

divided by the number of days in the year (using Creditors
30 days for 1.2 months, i.e., 350 daysy. the rai
deferral =
period (CDP) Credit purchases/35O
material conversionperiod is obtained when raw
material inventory is divided by raw material Creditorsx360 (n
consumption per day. Similar calculations can be C*Jrtp*.h"*t
 660 FinancialManagement

Cash Gonversion or Net Operating Cycte Table 27.3: Operating Cycle Calculation
Net operating cycle (NOC) is the difference between gross
operating cycle and payables deferral period.
Net operating cycle = Gross operating cycle aa a' ,,.a$,YE

- Creditors deferral period 1. Raw Material Conversion periocl

NOC = GOC-CDP (o) Raw material consumption 4,34S 5,932
(8)
(b) Raw material consumption 12.1. 16,5
Net operating cycle is also referred to as cash per day
conversion cycle. Some people argue that depreciation (c) Raw material in\.entor\, BZ7 986
and profit should be excluded in the computation'of cash [d) Raw matorial inventorv 68rl 60d
conversion cycle since the firm,s concern is with cash holding days
flows associated with conversionat cost;depreciation is a 2. \Vork-in-Process Conver.sion per.iod
non<ash item and profits are not costs. Acontrary view is (o) Cost of prorlrrc;tion * i,212 7,051
that a firm has to ultimately recover total costs and. make (b) Cost ofproduction per day 14.s x9i6
profits; therefore, the calculation of operating cycle should (cJ Work-in-proccss inventorv 32S {98
rlclu{e depreciation, and even the profits. Also, in using (d) \,Vork-in-process invcntory 22d, .ZSd
the above.mentioned formulae, average figures for thi holding days
period may be used. g. Finished Goods Conversion period
' (o) Cost ofgoods solcl" Si003 o,c oz
For our example, Table ZT_3 shows detained
of the components of a firm,s operatingcycle.
[b) Cost ofgoods sold per clay
(cJ Finished goods inver.rtory
is :i5?e
:u1."9{* 905
Table 27.4 ptovides the summary of calculitions. [d) Finished goods inventory , H&d 54d
holding days
Bri.g 20X1, the daily raw material consumption
was {12.1 lakh
4. Collection Period
and the company held an ending raw
material inventory of 7827 lakh. If we assume ttrit ttris
[n) Credit sa]es (at costJ** 6,087 8,006
(b) Sales per clav 16.9 22.2
is the average inventory held by the company, the raw (cJ Debtors
material consumption period works out tb Ut eS aays.
35 7 1,040
[d) Dobtors outstanding clays
'5. Creditors 43cl 47d
You may notice that for 20X2, the projected raw material Defer.ral Period
conversion period is 60 days. This has happened because (c) Crcdit purchases 4,653 6,091
both consumption (t16.5 lakh per dayi and level of (b) Purchase per clay 12.9 16.9
invltory @85 lakh) have increased, but the consumption (c) Creditors 4b4 t)42
rate has increased @y 36.aper cent) much more than the (dJ Creditors outstanding days 35d 3Bd
increase in inventory holding (by 19.2 per cent). Thus, the
raw material conversion period has declined by g days.
* Depreciation is included.
Raw material inventory is the result of daily raw material
** All sales are assumed on credit.
consumption and total raw material consumption during Table 27.4: Summary of Operating Cycle Calculations
a period raw material? given the company,i productioi (Number of Dovsl
targets. Thw, raw material inventory is controlied through : Actual projected
gonhol over purchases and production. We can similarly
interpret other calculations in Table 27.3. GNOSS OPENATINC CYCLE
1. Inventory Conversion period
. ^I:-.oh-u significant change in the company,s policy (j) Raw material 68 60
for 20X2 with regard to the finished goods inventory. lt is {ii) Work-in-process ')') )t
expected to increase to 54 days holding from 3g diys in (iii) Finished goods 38 128 54 xss'
the previous year. One reason could be i conscious p'olicy !1. Debtors Conversion period {3 lar,
decision to avoid stock-out sifuations and carry more 3. Gross 0perating Cycle (i + 2) 771 186
finished goods inventory to expand sales. But thii policy 4. Pa1'rnont DefomaI Period :,35,r JO
has a cosf the company, in the absence of a significant NET OPEfrATING CYCL-E t3 - 4) 136 lz6-
increase in payables (creditors) deferral period, will have
to negotiate higher working capital funds. L:r the case of _ The operating cycle concept as shown in Figure 27.1
relates to a manufacturing firm. Non-manufacturing
the firm in our example, its net operating cycle is expected
firms such as wholesalers and retailers will not have thi
to increase from 136 days to 148 days (Table 22.4). How
manufacturing phase. They will acquire stock of finished
does a company manage its inventories, debtors and
goods and convert them into debtors (receivables) and
guppliers'credit? How can it reduce its operating cycle? those debtors into cash. Further, service and financial
We shall attempt to answer these questions in the-next
erterprises will not have inventory of goods (cash will be
four chapters.
their inventory). Their operating cycles will be the shortest.
They need to acquire cash, then lend (create debtors) and
again convert the lending into cash.