PRINCIPLES OF WORKING
CAPITAL MANAGEMENT
www.velsuniv.org
BIM
Executive
2003
School of Placement
Management
Studies – Striving towards Excellence
Topics
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Vels University
Concept of working capital
Operating and cash conversion cycle
Permanent and variable working capital
Balanced working capital
Determinants of working capital
Issues I working capital management
Estimating working capital
Policies of working capital finance
Financial Management, Ninth
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BIM
Executive
2003
School of Placement
Management
Studies – Striving towards Excellence
Concepts of Working Capital
• Gross working capital (GWC)
GWC refers to the firm’s total investment in
current assets.
Current assets are the assets which can be
converted into cash within an accounting
year (or operating cycle) and include cash,
short-term securities, debtors, (accounts
receivable or book debts) bills receivable
and stock (inventory).
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Financial Management, Ninth
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BIM
Executive
2003
School of Placement
Management
Studies – Striving towards Excellence
Concepts of Working Capital
• Net working capital (NWC).
• NWC refers to the difference between current
assets and current liabilities.
• Current liabilities (CL) are those claims of outsiders
which are expected to mature for payment within
an accounting year and include creditors (accounts
payable), bills payable, and outstanding expenses.
• NWC can be positive or negative.
– Positive NWC = CA > CL
– Negative NWC = CA < CL
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Financial Management, Ninth
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BIM
Executive
2003
School of Placement
Management
Studies – Striving towards Excellence
Concepts of Working Capital
• GWC focuses on
– Optimisation of investment in current
– Financing of current assets
• NWC focuses on
– Liquidity position of the firm
– Judicious mix of short-term and long-tern financing
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Financial Management, Ninth
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BIM
Executive
2003
School of Placement
Management
Studies – Striving towards Excellence
Operating Cycle
• Operating cycle is the time duration required to
convert sales, after the conversion of resources into
inventories, into cash. The operating cycle of a
manufacturing company involves three phases:
– Acquisition of resources such as raw material, labour,
power and fuel etc.
– Manufacture of the product which includes conversion of
raw material into work-in-progress into finished goods.
– Sale of the product either for cash or on credit. Credit
sales create account receivable for collection.
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BIM
Executive
2003
School of Placement
Management
Studies – Striving towards Excellence
• The length of the operating cycle of
manufacturing firm is the sum of:
• inventory conversion period (ICP).
• Debtors (receivable) conversion period (DCP).
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Financial Management, Ninth
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a
BIM
Executive
2003
School of Placement
Management
Studies – Striving towards Excellence
• Inventory conversion period is the total time needed
for producing and selling the product. Typically, it
includes:
• raw material conversion period (RMCP)
• work-in-process conversion period (WIPCP)
• finished goods conversion period (FGCP)
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Financial Management, Ninth
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BIM
Executive
2003
School of Placement
Management
Studies – Striving towards Excellence
• The debtors conversion period is the time required
to collect the outstanding amount from the
customers.
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BIM
Executive
2003
School of Placement
Management
Studies – Striving towards Excellence
• Creditors or payables deferral period (CDP) is the
length of time the firm is able to defer payments on
various resource purchases.
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Financial Management, Ninth
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BIM
Executive
2003
School of Placement
Management
Studies – Striving towards Excellence
• Gross operating cycle (GOC)
The total of inventory conversion period and debtors
conversion period is referred to as gross operating cycle
(GOC).
• Net operating cycle (NOC)
NOC is the difference between GOC and CDP.
• Cash conversion cycle (CCC)
CCC is the difference between NOP and non-cash items
like depreciation.
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Financial Management, Ninth
11
BIM
Executive
2003
School of Placement
Management
Studies – Striving towards Excellence
Determinants of Working Capital
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Vels University
Nature of business
Market and demand
Technology and manufacturing policy
Credit policy
Supplies’ credit
Operating efficiency
Inflation
Financial Management, Ninth
12
BIM
Executive
2003
School of Placement
Management
Studies – Striving towards Excellence
Issues in Working Capital
Management
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•
•
•
Vels University
Levels of current assets
Current assets to fixed assets
Liquidity Vs. profitability
Cost trade-off
Financial Management, Ninth
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BIM
Executive
2003
School of Placement
Management
Studies – Striving towards Excellence
Estimating Working capital
• Current assets holding period
• To estimate working capital requirements on the
basis of average holding period of current assets and
relating them to costs based on the company’s
experience in the previous years. This method is
essentially based on the operating cycle concept.
• Ratio of sales
• To estimate working capital requirements as a ratio
of sales on the assumption that current assets
change with sales.
• Ratio of fixed investment
• To estimate working capital requirements as a
percentage of fixed investment.
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Financial Management, Ninth
14
BIM
Executive
2003
School of Placement
Management
Studies – Striving towards Excellence
Working Capital Finance Policies
• Matching
• Conservative
• Aggressive
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Financial Management, Ninth
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Executive
2003
School of Placement
Management
Studies – Striving towards Excellence
BIM
Working capital financing policies
• Moderate – Match the maturity of the assets with the
maturity of the financing.
• Aggressive – Use short-term financing to finance
permanent assets.
• Conservative – Use permanent capital for permanent
assets and temporary assets.
Vels University
BIM
Executive
2003
School of Placement
Management
Studies – Striving towards Excellence
Moderate financing policy
$
Temp. C.A.
S-T
Loans
Perm C.A.
L-T Fin:
Stock,
Bonds,
Spon. C.L.
Fixed Assets
Years
Lower dashed line would be more aggressive.
Vels University
BIM
Executive
2003
School of Placement
Management
Studies – Striving towards Excellence
Conservative financing policy
$
Marketable
securities
Perm C.A.
Zero S-T
Debt
L-T Fin:
Stock,
Bonds,
Spon. C.L.
Fixed Assets
Years
Vels University
BIM
Executive
2003
School of Placement
Management
Studies – Striving towards Excellence
Impact on Risk
Optimal Amount (Level) of Current Assets
Vels University
Policy A
ASSET LEVEL ($)
• Decreasing cash reduces
the firm’s ability to meet
its financial obligations.
More risk!
• Stricter credit policies
reduce receivables and
possibly lose sales and
customers. More risk!
• Lower inventory levels
increase stockouts and
lost sales. More risk!
Policy B
Policy C
Current Assets
0
25,000
OUTPUT (units)
50,000
BIM
Executive
2003
School of Placement
Management
Studies – Striving towards Excellence
Impact on Risk
Optimal Amount (Level) of Current Assets
Risk increases as the level
of current assets are
reduced.
Vels University
Policy A
ASSET LEVEL ($)
Risk Analysis
Policy
Risk
A
Low
B
Average
C
High
Policy B
Policy C
Current Assets
0
25,000
OUTPUT (units)
50,000
Classifications of Working Capital
Executive
2003
School of Placement
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Studies – Striving towards Excellence
 Components

Cash, marketable securities,
receivables, and inventory
• Time
–
–
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Permanent
Temporary
BIM
BIM
Executive
2003
School of Placement
Management
Studies – Striving towards Excellence
• Permanent or fixed working capital
A minimum level of current assets, which is
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.
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Financial Management, Ninth
22
Permanent Working Capital
Executive
2003
School of Placement
Management
Studies – Striving towards Excellence
DOLLAR AMOUNT
The amount of current assets required to
meet a firm’s long-term minimum needs.
Permanent current assets
TIME
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BIM
Temporary Working Capital
Executive
2003
School of Placement
Management
Studies – Striving towards Excellence
The amount of current assets that varies
with seasonal requirements.
DOLLAR AMOUNT
Temporary current assets
Permanent current assets
TIME
Vels University
BIM
BIM
Executive
2003
School of Placement
Management
Studies – Striving towards Excellence
Working Capital Finance Policies
• Long-term
• Short-term
• Spontaneous
 Short-term Vs.
Long-term
financing
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

Vels University
Financial Management, Ninth
Cost
Flexibility
Risk
25