Working Capital Management

RT
 Introduction
• The capital of a business which is used in its day-to-day trading operations.

• Working capital is a measure of both a company's efficiency and its short-

term financial health.

• If a company's current assets do not exceed its current liabilities, then it

may run into trouble paying back creditors in the short term. The worst-
case scenario is bankruptcy. A declining working capital ratio (Current
Assets/Current Liabilities) over a longer time period could also be a red
flag that warrants further analysis.

• Working capital management- the administration of the firm’s current

assets and the financing needed to support current assets.
Indian Manufacturing Current Assets and
Liabilities, March 31, 2013 (Rs. Million)
Break-up of Current Assets, India, 2013
Gross and Net Working Capital
• Gross Working Capital-
– Total of investments in all current assets
– Focus on optimization of investment in current assets and the means
of financing current assets

• Net Working Capital-

– Excess of total current assets over total current liabilities.
– Indicates the extent to which working capital needs may be financed
by permanent sources of funds.
– Can be positive or negative
•Current Assets are cash and other assets that are expected to be
converted to cash within the year or the operating cycle of the firm.
– Cash and bank balances
– Marketable securities
– Accounts receivable
– Inventory

•Current Liabilities are obligations that are expected to require

cash payment within the year.
– Accounts payable
– Accrued wages
– Taxes
Permanent And Variable Working Capital
• The magnitude of current assets keeps on changing from time
to time.

• Permanent or fixed working capital:

– A minimum level of current assets continuously required by a firm to
carry on its business operations, is referred to as permanent or fixed
working capital.

• Fluctuating or variable working capital:

– The extra working capital needed to support the changing production
and sales activities of the firm is referred to as fluctuating or variable
working capital.
Permanent and Variable Working Capital

Permanent Working Capital

Simple Cycle of Operations
Cash Conversion Cycle
 ACCOUNTS RECEIVABLE, PAYABLE &
INVENTORY PERIOD
• Debtors period / Receivable period
– (Average Debtors/Total Sales) x 360

• Creditors period / Payable period

– (Average Creditor/Total Purchase) x 360

• Inventory days outstanding

– (Average Inventory/Cost of Goods Sold) x 360
 Cash Conversion Cycle, Indian
Manufacturing, 2013 (Rs. Millions)
 Working Capital and the Cash Conversion
Cycle
• Cash Conversion Cycle
= operating cycle – accounts payable period
= (inventory period + receivables period) – accounts payable
period
• Cash Conversion Cycle

Cash Conversion
Cycle:
 HOW MUCH WORKING CAPITAL DO WE
NEED?
• To answer this question, you need to understand how money
will flow through your business – in other words, you need to
understand your “working capital cycle.”
– The cycle consists of:
• (i) how quickly accounts receivables & inventory are turned
into cash and
• (ii) how quickly that cash is used to pay accounts payable.

• When starting a business, you will have projections for key

items such as sales, cost of goods sold and other expenses. 
 Contd…
• You also need assumptions on the following: 
– How many days of inventory do you need to keep in
hand (“inventory turnover”)? 
– How many days will you give customers to pay you
(accounts receivable terms)?
– How many days will your vendors give you to pay
them (accounts payable terms)?  

• Armed with this information, you can calculate how much

working capital is needed to start your business.
WORKING CAPITAL REQUIREMENT
ANALYSIS: FRAMEWORK
 Cash Conversion Cycle,
Selected Companies, 2013
Working Capital Financing Policies

Financing Policies Sources

Long-term Equity, Debentures, Reserves and

Surplus, and Long term borrowings

Short-term Commercial Papers, working capital

funds from banks, factoring of
receivables

Spontaneous Trade (suppliers) credits and

outstanding expenses.
Working Capital Financing Policies
Approach Features

Matching Long term financing for fixed assets and permanent current
assets.
Short term financing for variable / temporary current assets.

Conservative More focus on Long term financing used for fixed assets,
permanent current assets and partially also variable / temporary
current assets.
Short term financing for remaining variable / temporary current
assets.

Aggressive Short term financing partially for permanent current assets as

well as for variable / temporary current assets.
Matching Approach
Conservative Approach
Aggressive Approach
 Inventory management
• Components of Inventory
– Raw materials
– Work in progress
– Finished goods
• Goal: Minimize amount of cash tied up in
inventory
– Tools used to minimize inventory
• Just-in-time
• EOQ
Inventory Conversion Period
• Inventory conversion period (ICP) = RMPC + WIPCP + FGCP
•  
• Raw Material Conversion Period (RMCP) =
 
• Work-In-Process Conversion Period (WIPCP) =

 
• Finished Goods Conversion Period (FGCP) =

• However, assuming 30 Days = 1 Month is normal

practice in some books. Thus 1 year = 360 Days.
Managing Inventories
Determining Optimal
Order Size
 Inventories
• Economic Order Quantity
– Order size that minimizes total inventory costs

2  annual sales  cost per order

Economic order quantity =
carrying cost

• As Order Size Increases

– Number of orders decreases
– Order cost decreases
– Average amount in inventory increases
– Carrying cost of inventory increases
 Credit Management
• Terms of Sale
– Credit, discount, and payment terms offered on
sale

– Example: 5/10 net 30

• 5: Percent discount for early payment
• 10: Number of days discount is available
• Net 30: Number of days before payment due
 Credit Management
• Terms of Sale
– Firm that buys on credit borrows from supplier
• Save cash today, pay later (implicit loan)
• Cost of implicit loan:

Effective annual rate


 1+ discount
discounted price
365/extra days credit
1
 Credit Management
• Example
– Calculate implied interest rate on Rs.100 sale with
terms 5/10 net 60
Effective annual rate

 1+ discount
discounted price
365/extra days credit
1
 1 + 
5 365/50
95  1 = .454, or 45.4%
 Credit Management
• Credit Analysis
– Procedure to determine likelihood that customer
will pay bills
• Credit agencies provide reports on credit
worthiness of potential customers
• Financial ratios can help determine a
customer’s ability to pay bills
• Set your credit policy to determine amount and
nature of credit extended to customers
Modelling credit risk: Credit Scoring Models

• Altman’s Z-Score Model

• – This model uses a statistical technique, Multiple

Discriminant Analysis (logit or probit models can also be
used) to classify firms into those which are likely to
become bankrupt/non-bankrupt over a given future
horizon

• – Past financial data on firm’s financial ratios and

bankruptcies were used to estimate the model
 Credit Management
• Credit Decision
– Based of probability of payoffs, expected profit
can be expressed as:
p  PV(rev  cost)  (1  p)  (PV(cost))
Credit Decision and Probable Payoffs
 Credit Management
• Collection Policy
– Procedure to collect and monitor receivables
(factoring services)

• Aging Schedule
– Classification of accounts receivable by time
outstanding
 Credit Management
• Sample Aging Schedule, Accounts Receivable
Customer' s Less than More than
1 - 2 Months 2 - 3 Months Total Owed
Name 1 Month 3 Months
A 10,000 0 0 0 10,000
B 8,000 3,000 0 0 11,000
* * * * * *
* * * * * *
* * * * * *
Z 5,000 4,000 6,000 15,000 30,000
Total $200,000 $40,000 $15,000 $43,000 $298,000
 Cash Management
• Cash Does Not Pay Interest
– Move money from cash accounts to short-
term securities
– Sweep programs
– Concentration banking
 Cash Management
• Electronic Funds Transfer (EFT)
– Allows instantaneous payment

• Automated Clearinghouse (ACH)

– Allows direct payment of recurring expenditures
Money-market Investments in India
Cash Budgeting
• A cash budget is a primary tool of short-run financial
planning.
• The idea is simple: Record the estimates of cash receipts
and disbursements.
• Cash Receipts
– Arise from sales, but we need to estimate when we actually
collect
• Cash Outflow
– Payments of Accounts Payable
– Wages, Taxes, and other Expenses
– Capital Expenditures
– Long-Term Financial Planning
 Example
• TKPL Inc. receives all income from sales
• Sales estimates (in millions)
– Q1 = 500; Q2 = 600; Q3 = 650; Q4 = 800; Q1 next year
= 550
• Accounts receivable
– Beginning receivables = Rs.250
– Average collection period = 30 days
• Accounts payable
– Purchases = 50% of next quarter’s sales
– Beginning payables = 125
– Accounts payable period is 45 days
 Example

• Other expenses
– Wages, taxes and other expense are 30% of sales
– Interest and dividend payments are Rs.50
– A major capital expenditure of Rs.200 is expected
in the second quarter

• The initial cash balance is Rs.80 and the company maintains a

minimum balance of Rs.50
 Example (Accounts Receivables)
 ACP = 30 days, this implies that 2/3 of sales are collected in the
quarter made, and the remaining 1/3 are collected the following
quarter.
 Beginning receivables of Rs.250 will be collected in the first
quarter.

Q1 Q2 Q3 Q4
Beginning Receivables 250 167 200 217
Sales 500 600 650 800
Cash Collections 583 567 633 750
Ending Receivables 167 200 217 267
 Example (Accounts Payables)
• Sales estimates (in millions)
– Q1 = 500; Q2 = 600; Q3 = 650; Q4 = 800; Q1 next year =
550
• Accounts payable
– Purchases = 50% of next quarter’s sales
– Beginning payables = 125
– Accounts payable period is 45 days

Q1 Q2 Q3 Q4
Beginning Payables 125 150 162 200
Purchases 300 325 400 275
Cash paid 275 313 362 338
Ending Payables 150 162 200 137
 Example
• Payables period is 45 days, so half of the purchases will be
paid for each quarter, and the remaining will be paid the
following quarter.
• Beginning payables = Rs.125

Q1 Q2 Q3 Q4
Payment of accounts 275 313 362 338
Wages, taxes and other expenses 150 180 195 240
Capital expenditures 200
Interest and dividend payments 50 50 50 50
Total cash disbursements 475 743 607 628
 Example
Q1 Q2 Q3 Q4
Total cash collections 583 567 633 750
Total cash disbursements 475 743 607 628
Net cash inflow 108 -176 26 122
Beginning Cash Balance 80 188 12 38
Net cash inflow 108 -176 26 122
Ending cash balance 188 12 38 160
Minimum cash balance -50 -50 -50 -50
Cumulative surplus (deficit) 138 -39 -12 110
Cash Management Models
• Cash management models address the issue
of split between marketable securities and
cash holdings. Two such models are :

• Baumol model
• Miller and Orr model
 Baumol Model
• Baumol’s EOQ Model of Cash Management

• William J. Baumol (1952) suggested that cash should be

managed in the same way as any other inventory

• And that the inventory model could reasonably reflect the

cost- volume relationships as well as the cash flows.

• In this way, the economic order quantity (EOQ) model of

inventory management could be applied to cash management.
• The Baumol’s model assumes that the firm uses cash
at a constant rate per period.

• In the model, the carrying cost of holding cash-

namely the interest forgone on marketable securities
is balanced against the fixed cost of transferring
marketable securities to cash, or vice-versa.
•According
  to this model, the optimal conversion amount
of marketable securities into cash, C, is given by the
following formula:
C= 
– b is the cost of conversion into cash per transaction.
– T is the projected cash requirement during the
period.
– i is interest rate earned per planning period on
investments in marketable securities.
Question 1: Find out the optimum cash balance using Baumol's Model
          Annual cash needed                      Rs.48,00,000
        Transaction cost                          Rs.90 per conversion
         Interest rate                               9% 

Solution: As per Baumol's Model

C = Cash required each time to restore balance to minimum cash

F= Total cash required during the year = Rs.48,00,000
T= Cost of each transaction between cash and marketable securities
=Rs.90
r = Rate of interest on marketable securities = 9%
 Implication
• As per Baumol’s Model, the firm should start each
period with the cash balance equaling ‘C’ and spend
gradually until its balance comes to zero.

• At this time, the firm should replenish the equaling

‘C’ from the sale of marketable securities.
 Miller-Orr Model
• Baumol’s model is based on the basic assumption that the
size and timing of cash flows are known with certainty.

• This usually does not happen in practice.

• The cash flows of a firm are neither uniform nor certain.

• The Miller and Orr model overcomes the shortcomings of

Baumol model.
• Miller and Orr (A Model of the Demand for Money)
expanded on the Baumol model and developed
Stochastic Model for firms with uncertain cash
inflows and cash outflows.

• The Miller and Orr model provides two control limits-

the upper control limit and the lower control limit
along-with a return point as shown in the figure
below:
• When the cash balance touches the upper control limit (h),
marketable securities are purchased to the extent of hz to
return back to the normal cash balance of z.

• In the same manner when the cash balance touches lower

control limit (o), the firm will sell the marketable securities to
the extent of oz to again return to the normal cash balance.

• The spread between the upper and lower cash balance limits
(called z) can be computed using Miller-Orr model as below:
Miller-Orr Model

•   formula for determining the distance between the return

The
level and lower control limits (called Z) is as follows:
Z=
where:
is the variance of daily changes in cash balances
b is the cost of conversion into cash per transaction.
i is interest rate earned on investments in marketable
securities
Miller-Orr Model
The distance between lower limit and the upper limit should be
three times the distance between the lower limit and the return level.

Upper Limit = Lower Limit + 3 Z

Return Point ( Optimal Balance) = Lower Limit + Z

The net effect is that the firms hold the average the cash balance
equal to:

Average Cash Balance = Lower Limit + 4/3Z

Example
•  
Given conversion cost= Rs. 150, interest rate 14 percent per annum , minimum cash
balance of Rs.5,00,000and the standard deviation of daily net cash flows Rs. 2,00,000,
find the optimum cash balance and average cash balance using Miller-Orr Model.
• Z=
 
Z= = Rs. 2,27,227/=
 
Upper Limit = Lower Limit + 3 Z = Rs. 5,00,000 + 3 x 2,27,227 =
Rs.11,81,681 

Return Point = Lower Limit + Z = Rs. 5,00,000 + Rs. 2,27,227 =Rs.7,27,227

 Average cash balance = Lower Limit + 4 / 3 Z = Rs. 5,00,00 +( x 2,27,227)

= Rs. 8,02,969
• Suppose, a company pays suppliers of inventory
after 30 days, completes production and sells the
finished products to customers after 60 days of
procuring the inventory and receives cash from
the customers after 30 days from sale.

Day Activity
0 Procure inventory
30 Pay suppliers of inventory
60 Complete production and sell to customers
90 Collect cash from customers
• Answer
Operating Cycle = 90 days
Cash Cycle = 60 days
Thank you