WORKING CAPITAL MANAGEMENT
Learning objectives
After completion of this chapter, students will be able to understand:
1.
2.
3.
4.
5.
6.
7.
What is working capital?
Objectives of working capital management
Benefits of investment in working capital
Disadvantages for investment in working capital
Assessment of business liquidity or assessing the working capital performance
Assessment of working capital financing strategy
Estimation of Investment in working capital
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1) Working Capital
▪
▪
Working capital is the capital (finance) that an entity needs to support its everyday
operations.
Working capital can therefore be defined as the net current assets (or net current
operating assets) of a business and financed by long term funds.
Investment in working capital can be calculated as follows:
2) Objectives of working capital management and their conflict
Profitability and liquidity are usually cited as the twin objectives of working capital management.
•
•
The profitability objective reflects the primary objective of maximising shareholder wealth,
liquidity is needed in order to ensure that financial claims on an organization can be settled
as they become liable for payment.
The two objectives are in conflict because
▪
▪
liquid assets such as bank accounts earn very little return or no return, so liquid assets
decrease profitability.
Liquid assets in fact incur an opportunity cost equivalent either to the cost of short-term
finance or to the profit lost by not investing in profitable projects.
Whether profitability is a more important objective than liquidity depends in part on the particular
circumstances of an organization. Liquidity may be the more important objective when shortterm finance is hard to find, while profitability may become a more important objective when
cash management has become too conservative. In short, both objectives are important and
neither can be neglected.
In short, overinvestment should be avoided, because it reduces profits or returns to shareholders.
Under-investment should be avoided because it creates a liquidity risk.
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3) Benefits (advantages) of investment in working capital
There are significant benefits of investing in working capital:
i.
ii.
Holding inventory allows the entity to supply its customers on demand.
Entities are expected by many customers to sell to them on credit. Unless customers are
given credit (which means having to invest trade receivables) they will buy instead from
competitors who will offer credit.
It is also useful for an entity to have some cash in the bank to meet demands for
immediate payment.
iii.
4) Disadvantages of excessive investment in working capital
Money tied up in inventories, trade receivables and a current bank account earns nothing.
Investing in working capital therefore involves a cost.
The cost of investing in working capital is the reduction in profit that results from the money
being invested in inventories, receivables or cash in the bank account, rather than being
invested in wealth-producing assets and long-term projects.
The cost of investing in working capital can be stated simply as follows:
Annual cost of investment in working capital
= Average investment in working capital x Annual cost of finance (%)
5) Assessment of business Liquidity or Working capital performance
5.1) Definition of liquidity
Liquidity for an entity means having access to sufficient cash to meet all payment obligations
when they fall due
5.2) Sources of liquidity
The main sources of liquidity for a business are:
i.
ii.
iii.
Cash flows from operations
Holding liquid assets – cash in bank or marketable securities
Borrowing facility from bank when needed
5.3) Importance of liquidity
▪
▪
Having sufficient liquidity is the key to survival in a business.
Insufficient liquidity can result in litigation and liquidation of business by creditors.
5.4) Measurement of liquidity
The liquidity of a business entity can be assessed by analysing:
i.
ii.
Its liquidity ratios; and
The length of its cash operating cycle
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(A) LIQUIDITY RATIOS
The purpose of a liquidity ratio is to compare the amount of liquid assets held by a company
with its current liabilities. This is because the money to pay the current liabilities should be
expected to come from the cash flows generated by the liquid assets.
There are two main liquidity ratios to assess the liquidity position of business.
i.
Current ratio
Current ratio measures how much the current assets are available to cover and make payment
of current liabilities of the business over the period of 12 months horizon.
Current ratio = Current assets ÷ Current liabilities
This ratio assumes than all current assets can be liquidated in 12 months but it can be affected
by maturity mismatch problem.
ii.
Quick ratio
Quick ratio measures how much the quick assets (highly liquid assets) are available to cover and
make payment of current liabilities of the business over the period of 12 months horizon.
Quick ratio = (Current assets – Inventory) ÷ Current liabilities
This ratio also assumes than all current assets (except inventory) can be liquidated in 12 months
but it can be affected by maturity mismatch problem.
Which liquidity ratio is more important?
The answer to this question is that it depends on the normal speed of turnover for inventory.
▪
▪
If inventory is held only for a short time before it is used or sold (means fast moving
inventory), the current ratio is probably a more useful ratio, because inventory is a liquid
asset (convertible into cash within a short time).
On the other hand, if inventory is slow moving, and so fairly illiquid, the quick ratio is
probably a better guide to an entity’s liquidity position.
Comparison of liquidity ratios
The liquidity ratios of a company may be compared with:
▪
▪
the liquidity ratios of other companies in the same industry, to assess whether the
company’s liquidity ratios are higher or lower than the industry average or norm and
changes in the company’s liquidity ratios over time and whether its current assets are
rising or falling in proportion to its current liabilities.
Comments on liquidity ratios
A high ratio might be attributable to an unusually large holding of cash. When a company has
surplus cash or short-term investments, this might be temporary and the company might have
plans for how the cash will be used in the near future.
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B) CASH OPERATING CYCLE
In addition to liquidity ratios, length of operating cycle can be used as another method to assess
liquidity position and working capital management of the business.
Definition of cash operating cycle
Cash operating cycle is the average length of time between paying suppliers for goods and
services received to receiving cash from customers for sales of finished goods or services.
Computation of operating cycle for trading business
Operating cycle for trading business
Finished goods inventory holding period
Days
(FG inventory ÷ Cost of sales) x 365 days
x
Add: Receivable collection period
(Accounts Receivable ÷ Credit sales) x 365 days
x
Less: Payable’s payment period
(Trade payables ÷ Cost of credit purchases) x 365 days
= Operating cycle
(x)
x
Example 1
X Limited has the following figures from its most recent accounts:
Receivables
Trade payables
Finished goods inventory
Sales (80% on credit basis)
Purchases (all on credit basis)
Cost of sales
Rs.’m
4
2
4.3
30
18
25
Required: Calculate cash operating cycle of X Limited.
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Solution
Operating cycle for trading business
Finished goods inventory holding period
Days
(Rs. 4.3 m ÷ Rs. 25 m) x 365 days
62.78
Add: Receivable collection period
(Rs. 4 m ÷ Rs. 24 m) x 365 days
60.83
Less: Payable’s payment period
(Rs. 2 m ÷ Rs. 18 m) x 365 days
= Operating cycle
(40.56)
83.06
Operating cycle for manufacturing business
Operating cycle for manufacturing business
Raw material inventory holding period
(RM inventory ÷ Cost of material usage) x 365 days
Days
x
Add: WIP holding period or production cycle
(WIP inventory ÷ Production cost) x 365 days
x
Add: Finished goods inventory holding period
(FG inventory ÷ Cost of sales) x 365 days
x
Add: Receivable collection period
(Accounts Receivable ÷ Credit sales) x 365 days
x
Less: Payable’s payment period
(Trade payables ÷ Cost of credit purchases) x 365 days
= Operating cycle
(x)
x
Notes:
a) Where material usage is not given for raw material holding period then material purchase
can be used.
b) Where production cost is not given then cost of sales can be used for WIP holding period
Example 2
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Solution
Example 3
Solution
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Example 4
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Solution
Example 5 – ICAP Study Text Self Test Question 1
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Solution
(b)
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Example 6
Solution
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Example 7
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Solution
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6) Working Capital Financing Strategies
Working capital financing policies can be classified into
a) conservative,
b) moderate (or matching) and
c) aggressive,
depending on the extent to which fluctuating current assets and permanent current assets are
financed by short-term sources of finance.
Permanent current assets are the core level of investment in current assets needed to support a
given level of business activity or turnover, while fluctuating current assets are the changes in the
levels of current assets arising from the unpredictable nature of some aspects of business activity.
A conservative working capital financing policy uses long-term funds to finance non-current assets
and permanent current assets, as well as a proportion of fluctuating current assets. This policy is
less risky and less profitable than an aggressive working capital financing policy, which uses
short-term funds to finance fluctuating current assets and a proportion of permanent current
assets as well. Between these two extremes lies the moderate (or matching) policy, which uses
long-term funds to finance long-term assets (non-current assets and permanent current assets)
and short-term funds to finance short-term assets (fluctuating current assets).
Identification of working capital financing strategy
i.
ii.
Compute short term financing ratio = Current liabilities ÷ Current assets x 100
If short term financing ratio is more than 50% then it is aggressive and vice versa in
conservative
Example 8
X Ltd. has the following statement of financial position for year ended 31st December, 2012.
Non-current assets
Property, plant and Equipment
Goodwill
Current assets
Inventory
Receivables
Cash
Equity
Share Capital ($1 each)
Reserves
Non-current liabilities
8% bonds
Current liabilities
Trade Payables
Bank overdraft
$
500,000
200,000
50,000
100,000
50,000
200,000
300,000
700,000
200,000
900,000
500,000
340,000
40,000
20,000
60,000
900,000
Req: Identify financing strategy of X Ltd.
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Solution
Short term financing ratio
Short term financing ratio = Current liabilities ÷ Current assets
Short term financing ratio = 60,000 ÷ 200,000 x 100 = 30%
Conclusion
In above scenario, short term financing ratio is less than 50% so company is using conservative
working capital financing strategy.
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7) Investment in Working Capital
Investment in working capital can be estimated for future accounting periods by using:
i.
ii.
Income statement figures; and
Working capital ratios like Inventory days, receivable days and payable days
Note: Investment in working capital is also known as:
•
•
Working capital requirement
Funds required for working capital
7.1) Working capital Requirement – Trading Business
Rs.
Current assets:
Finished goods inventory
(Cost of sales x Finished goods inventory period ÷ 365 days)
Add: Trade receivables
(Credit Sales Revenue x Debtor collection period ÷ 365 days)
Less: Current liabilities:
Trade payables
(Credit purchase cost x Payable payment period ÷ 365 days)
= Working capital requirement
x
x
(x)
x
7.2) Working capital Requirement – Manufacturing Business
Rs.
Current assets:
Material inventory
(Cost of material used x Material inventory period ÷ 365 days)
Add: WIP production period
(Production cost x WIP production period ÷ 365 days)
Finished goods inventory
(Cost of sales x Finished goods inventory period ÷ 365 days)
Add: Trade receivables
(Credit Sales Revenue x Debtor collection period ÷ 365 days)
Less: Current liabilities:
Trade payables for material
(Credit Material purchase cost x Payable payment period ÷ 365 days)
Trade payables for wages cost
(Wages cost of labour x payable period ÷ 365 days)
Trade payables for overheads cost
(All overheads cost x payable period ÷ 365 days)
Sales tax payable
(Output tax on sales – Input tax on purchase)
= Working capital requirement
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x
x
x
x
(x)
(x)
(x)
(x)
x
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Example 9
Solution
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Example 10
X Limited provided following extracts of balance sheet for the recent year ended 31st December
2020:
Rs.
Current assets:
Inventory
Trade receivables
Short term investments
Cash at bank
Current liabilities:
Trade payables
Bank overdraft
400,000
500,000
300,000
100,000
80,000
100,000
During the coming year, following changes are expected:
i.
ii.
iii.
iv.
v.
vi.
vii.
Level of inventory balance will increase by 20% in order to meet unexpected demand of
next year.
Balance of trade receivables will increase by 25%.
30% of the short-term investments will be sold in order to remove some cash shortages.
Bank balance will remain same at the same level as in the recent year.
Trade payables will increase by 10% due to delayed payment.
Currently bank overdraft facility is fully used and it is expected that bank will revise the
financing limit to Rs. 150,000 during the next year.
Presently working capital is financed at a cost of 15% and it is expected to be 18%
during the next year.
Required: Calculate working capital requirement and annual cost of financing the working
capital for each year.
Solution
Current
Year
Rs.
Current assets:
Inventory
Trade receivables
Short term investments
Cash at bank
Next
Year
Rs.
400,000 +20%
480,000
500,000 +25%
625,000
300,000 -30%
210,000
100,000
100,000
1300,000
1415,000
Less: Current liabilities:
Trade payables
Bank overdraft
(80,000)
(100,000)
= Working capital requirement
1120,000
1177,000
168,000
211,860
Annual cost of finance
(Rs. 1120,000 x 15%) (Rs. 1177,000 x 18%)
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+10%
(88,000)
(150,000)
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Example 11
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Solution
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Example 12
Solution
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(The End)
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