Working Capital Management
Introduction
Working Capital Management is concerned
with the problems that arise in attempting to
manage the current assets, the current
liabilities and the interrelationship that exists
between them.
Current Assets
• Current Assets refers to those assets which in
the ordinary course of business can be, or will
be, converted into cash within one year
without undergoing a diminution in value and
without disrupting the operations of the firm.
• Major current assets are Cash, Marketable
Securities, Account Receivables & Inventory.
Current Liabilities
• Current liabilities are those liabilities which
are intended, at their inception, to be paid in
the ordinary course of business, within a year,
out of the current assets or earnings of the
concern.
• Major ones are Bills Payable, Bank Overdraft &
Outstanding Expenses.
The goal working capital management is to
manage the firm’s current assets & liabilities
in such a way that a satisfactory level of
working capital is maintained.
Working Capital Concept
• Working capital concept can be broadly
divided into two categories:
1. Gross working Capital
2. Net Working Capital
Gross Working Capital
• GWC means the current assets which
represent the proportion of investment that
circulates from one form to another in the
ordinary conduct of business.
Net Working Capital
• NWC is the difference between current assets
& current liabilities.
ZERO Working Capital
• ZWC is Inventory + Receivables – Payables.
• The rationale is that inventories & receivables
are the major constituents of current assets
which affect sales. Thus, suppliers finance
inventories with through account payable.
Implication of ZWC
• In reality, it may not be possible for most firms to
operate at ZWC.
• Yet it focuses on important aspects such as
minimum safety stock of inventories, pursuing
good collection policies leading to minimum
investment in debtors and bargaining for
maximum credit payment period from suppliers.
• These measures would result in financial &
production economies, leading to higher return
on investments.
Current Asset Investment Policies
• There are 3 alternative policies related to the
total amount of investments made in current
assets:
1. Relaxed
2. Aggressive
3. Moderate
• Relaxed Policy: Relaxed Policy involve large
amount of cash / cash-equivalents, receivables
& inventory.
• Aggressive Policy: Aggressive Policy implies
minimum cash / cash-equivalents, receivables
& inventory.
• Moderate Policy: This falls between the above
two extreme policies in terms of current
assets carried as well as expected return &
risk.
Determining Financing Mix
• One of the important decision involved in the
management of working capital is HOW
Current Assets will be financed:
There are broadly 2 sources from which the
funds can be raised for current asset
financing:
1. Short-Term Sources (current liabilities)
2. Long-Term Sources (share capital, retained
earnings & so on)
Approaches to Determine Financing Mix
• There are 3 basic approaches to determine an
appropriate financing mix:
1. Hedging Approach (Matching Approach)
2. Conservative Approach
3. Trade-Off between these two.
Hedging Approach (Matching Approach)
• Matching Approach to financing is the process of
matching maturities of debt with the maturities
of financial needs.
• According to this approach, the maturity of the
source of funds should match the nature of the
assets to be financed. The current assets can be
broadly classified into 2 classes:
1. Those which are required in a certain amount
for a given level of operation and, hence, do not
vary over time. (PERMANENT)
2. Those which fluctuates over time. (SEASONAL)
Cont…
• According to hedging approach, the
permanent portion of funds required should
be financed with long-term funds and the
seasonal portion with short-term funds.
• Risk factor is high as compared to
Conservative Approach.
Conservative Approach
• Conservative financing approach is a strategy
which suggest that the estimated requirement
of total funds should be met from long-term
sources; the use of short-term funds should
be restricted to only emergency situations or
when there is an unexpected outflow of
funds.
• Risk factor is low as compared to Matching
Approach.
Trade-Off Approach
• A trade-off between these two extremes
would give an Acceptable Financing Strategy.
• It strikes a balance and provides a financing
plan that lies between the two extremes.
Three alternative working capital investment policies
Policy C
Policy B
Policy A
Current Assets
Sales
Financing needs over time
Total Assets
$
Fluctuating Current Assets
Permanent Current Assets
Fixed Assets
Time
Matching approach to asset financing
Total Assets
Short-term
Debt
$
Fluctuating Current Assets
Long-term
Permanent Current Assets Debt +
Equity
Capital
Fixed Assets
Time
Conservative approach to asset financing
Total Assets
Short-term
Debt
$
Fluctuating Current Assets
Long-term
Permanent Current Assets Debt +
Equity
capital
Fixed Assets
Time
Aggressive approach to asset financing
Total Assets
Short-term
Debt
$
Fluctuating Current Assets
Long-term
Permanent Current Assets Debt +
Equity
capital
Fixed Assets
Time
Need for Working Capital
• Sales do not convert into cash immediately; there
is invariably a time-lag between the sale of goods
& the receipt of cash.
• Therefore, a need for working capital in the form
of current assets to deal with the problem arising
out of lack of immediate realization of cash
against goods sold. So, sufficient working capital
is necessary to sustain sales activity.
• Technically, this is referred to as the Operating or
Cash Cycle.
Operating Cycle
• It implies the continuing flow from cash to
suppliers, to inventory to accounts receivables
and back into cash.
• In other words, the term cash cycle refers to
the length of time necessary to complete the
following cycle of events:
a. Conversion of cash into inventory;
b. Conversion of inventory into receivables;
c. Conversion of receivables into cash.
• Permanent Working Capital: It is a certain
minimum level of working capital on a
continuous & uninterrupted basis.
• Temporary working Capital: The working
capital needed to meet seasonal as well as
unforeseen requirements.
Difference between permanent & temporary working
capital
Amount Variable Working Capital
of
Working
Capital
Permanent Working Capital
Time
Variable Working Capital
Amount
of
Working
Capital
Permanent Working Capital
Time
Changes in Working Capital
• The reasons are:
1. Changes in the level of sales and / or
operating expenses.
2. Policy changes.
3. Changes in technology.
Determinants of Working Capital
1. Nature of Business
2. Production Cycle
3. Business Cycle
4. Production Policy
5. Credit Policy
6. Growth & Expansion
7. Vagaries in the availability of Raw-materials
8. Profit Level
9. Level of Taxes
10. Dividend Policy
11. Depreciation Policy
12. Price Level Changes
13. Operating Efficiency
Trade Credit
• An agreement where a customer can purchase
goods on account (without paying cash),
paying the supplier at a later date. Usually
when the goods are delivered, a trade credit is
given for a specific amount of days - 30, 60 or
90. Jewelry businesses sometimes extend
credit to 180 days or longer. Basically, this is a
credit a company gives to another for the
purchase of goods and services.
Cont…
• Trade credit is the largest use of capital for a
majority of business to business (B2B) sellers
in the United States and is a critical source of
capital for a majority of all businesses.
• For example, Wal-Mart, the largest retailer in
the world, has used trade credit as a larger
source of capital than bank borrowings; trade
credit for Wal-Mart is 8 times the amount of
capital invested by shareholders.
Example -
• The operator of an ice cream stand may sign
a franchising agreement, under which
the distributor agrees to provide ice cream stock under
the terms "Net 60" with a ten percent discount on
payment within 30 days, and a 20% discount on payment
within 10 days. This means that the operator has 60 days
to pay the invoice in full. If sales are good within the first
week, the operator may be able to send a cheque for all
or part of the invoice, and make an extra 20% on the ice
cream sold. However, if sales are slow, leading to a
month of low cash flow, then the operator may decide to
pay within 30 days, obtaining a 10% discount, or use the
money another 30 days and pay the full invoice amount
within 60 days.
Accrued Expenses
• An accounting expense recognized in the books before it
is paid for. It is a liability, and is usually current. These
expenses are typically periodic and documented on a
company's balance sheet due to the high probability that
they will be collected.
• Accrued expenses are the opposite of prepaid expenses.
Firms will typically incur periodic expenses such as
wages, interest and taxes. Even though they are to be
paid at some future date, they are indicated on the firm's
balance sheet from when the firm can reasonably expect
their payment, until the time they are paid.
Deferred Income
• Deferred income (also known as deferred
revenue, unearned revenue, or unearned
income) is, in accrual accounting, money
received for goods or services which have not
yet been delivered.
• According to the revenue recognition
principle, it is recorded as a liability until
delivery is made, at which time it is converted
into revenue.
Example -
• A company receives an annual software
license fee paid out by a customer upfront on
January 1. However, the company's fiscal
year ends on May 31. So, the company using
accrual accounting adds only five months'
worth (5/12) of the fee to
its revenues in profit and loss for the fiscal
year the fee was received. The rest is added to
deferred income (liability) on the balance
sheet for that year.
Example -
• An annual maintenance contract where the
entire contract is invoiced up front. “I received
Rs. 12,000 for an annual maintenance
contract, but need to recognize it as deferred
income, and then recognize Rs. 1,000 each
month as the service is rendered.”
Working Capital Financing
• Fund Based:
a. Cash Credit
b. Overdraft
c. Bills Discounting
d. Working Capital Demand Loan
• Non Fund Based:
a. Letter of Credit
b. Bank Guarantee
• Structured Product:
a. Factoring
b. Commercial Paper
c. Securitization of receivables
d. Buyers/Supplier credit
Bank Finance For Working Capital
• Cash Credit
• Overdraft
• Bills Purchase and Bill Discounting Working
• Capital Loan
Cash Credit
• The bank specifies a predetermined limit and
the borrower is allowed to withdraw funds
from the bank up to that sanctioned credit
limit against a bond or other security. The
borrower can not borrow the entire
sanctioned credit in lump sum; he can draw it
periodically to the extent of his requirement.
Repayment can be made whenever desired
during the period.
Cash Credit is secured against
• Cash Credit is primarily secured against Raw
Material, Work-in-progress or Semi Finished
Goods, Finished Goods.
Overdraft
• The borrower is allowed to withdraw funds in
excess of the actual credit balance in his
current account up to a certain specified limit
during a agreed period against a security.
• Overdraft can be availed against any financial
assets like Fixed Deposits, Bonds, Shares
Securities, Gold & Silver Jewelry Physical
Assets like Motor Car, Pool of Vehicles, etc.
Bills Purchase and Bill Discounting
• The bank purchases the bill of exchange of
the company receives against a product sale,
at a discount, thus doing away with the delay
in realizing the receivables.
Working Capital Loan
• Sometimes a borrower may require additional credit
in excess of sanctioned credit limit to meet
unforeseen contingencies.
• Banks provide such credit through a Working Capital
Demand Loan (WCDL).
• This arrangement is presently applicable to
borrowers having working capital requirement of
Rs.10 Crores or above.
• On such additional credit, the borrower has to pay a
higher rate of interest more than the normal rate of
interest.
