UNIT FIVE
MANAGEMENT
OF WORKING
CAPITAL
UNIT FIVE
CHAPTER ONE
WORKING
CAPITAL
MANAGEMENT
Lesson 34
Chapter-11
Working Capital Management
Unit 5
Management of Working Capital
After reading this lesson you will be able to: Understand Concept, need and determinants of working capital
Understand the concept of operating cycle
Computation of operating cycle
I will start this lesson with a question:
Why should managers be familiar with working capital management?
When we work in any organization, we find that most of the time managers are
concerned with working capital management.
What I mean is: #
Ensuring that enough cash exists to pay bills;
#
Ensuring that enough inventory exists to make and sell products;
#
Ensuring that any excess cash is invested in interest-bearing securities;
#
Ensuring that accounts receivable are at a level that maximizes earnings,
#
Ensuring that short-term borrowings such as salaries payable and trade
credit are used efficiently and at the lowest cost possible.
What is Working capital management?
You see, working capital management involves the relationship between a firm's shortterm assets and its short-term liabilities. The basic goal of working capital management is
to ensure that a firm is able to continue its operations and that it has sufficient ability to
satisfy both maturing short-term debt and upcoming operational expenses. The
management of working capital involves managing inventories, accounts receivable,
accounts payable and cash
This Topic extends the discussion to the management of the firm’s working capital
needed. There is a trade-off between the risk of having too little working capital on hand
and the reduced profitability that results from having excess working capital.
What is Working capital?
You can understand working capital in two different but interlinked senses. In the first
sense, working capital refers to gross working capital and in second sense it is understood
in terms of net working capital. We can explain both in following paragraphs: CONCEPTS OF WORKING CAPITAL
GROSS WORKING CAPITAL:
It refers to the firm’s investment in current assets. Current assets are the assets, which can
be converted into cash within an accounting year or within an operating cycle. You can
include here cash, short-term securities, debtors (accounts receivable & book debts), bills
receivable and stock.
NET WORKING CAPITAL:
But the net working capital refers to the difference between current assets and current
liabilities. Current liabilities are those claims of outsider, which are expected to mature
for payment within an accounting year & include creditors, bills payable & the
outstanding expenses. In other words you can say that this is the excess of current assets
over current liabilities.
CURRENT ASSETS constitute the following:
1
Inventories: Inventories represent raw materials and components, work-inprogress and finished goods.
2
Trade Debtors: Trade Debtors comprise credit sales to customers.
3
Prepaid Expenses: These are those expenses, which have been paid for goods
and services whose benefits have yet to be received.
4 Loan and Advances: They represent loans and advances given by the firm to
other firms for a short period of time.
5
Investment: These assets comprise short-term surplus funds invested in
government securities, shares and short-terms bonds.
6 Cash and Bank Balance: These assets represent cash in hand and at bank,
which are used for meeting operational requirements. One thing you can see
here is that this current asset is purely liquid but non-productive.
Current liabilities form part of working capital that represent obligations which the firm
has to clear to the outside parties in a short-period, generally within a year.
CURRENT LIABILITIES comprise the following:
I. Sundry Creditors: These liabilities stem out of purchase of raw materials on
credit terms usually for a period of one to two months.
II. Bank Overdrafts: These include withdrawals in excess of credit balance
standing in the firm’s current accounts with banks
III. Short-term Loans:
Short-terms borrowings by the firm from banks and
others form part of current liabilities as short-term loans.
IV. Provisions: These include provisions for taxation, proposed dividends and
contingencies.
Working capital
Current assets
Cash
Accounts receivable
Notes receivable
Marketable securities
Inventory
Prepaid expenses
Total current assets
Current liabilities
Accounts payable
Notes payable
Accrued expenses
Taxes payable
Total current liabilities
Net working capital is current assets minus current liabilities.
Gross working capital concept focuses on two aspects:
1. How to optimize investment in current assets?
2. How should current assets be financed?
The planning should be done keeping in mind two danger points i.e. excessive and
inadequate investment in current assets. Investment in current assets needs to be adequate
as it affects the profitability, solvency and liquidity. Why this issue comes up because it
ultimately affects the objectives of financial management.
Danger points to be kept in mind while planning
1. Excessive investment (Profitability)
a. It results in unnecessary accumulation of inventories. Thus, chances of
inventory mishandling, waste, theft & losses increase.
b. It is an indication of defective credit policy & slack collection period.
c. Excessive WC makes management complacent, which degenerates
into managerial inefficiency.
d. Tendencies of accumulating inventories tend to make speculative
profits grow.
2. Inadequate investment (Liquidity)
a. It stagnates growth.
b. It become difficult to implement operating plans and achieve the firm’s
operating profit target.
c. Operating inefficiencies creep in when it becomes difficult even to meet
day-to-day commitments.
d. Fixed assets are not efficiently utilized for the lack of working capital
funds. Thus, the firm’s profitability would deteriorate.
e. Paucity of WC funds render the firm unable to avail attractive credit
opportunities.
f. The firm loses its reputation when it is not in a position to honour its
short-term obligations.
Kinds of Working Capital
1. Permanent working capital:
This component represents the value of the current assets required on a continuing
basis over the entire year, and for several years. Permanent working capital is the
minimum amount of current assets, which is needed to conduct a business even
during the dullest season of the year. The minimum level of current assets is called
permanent or fixed working capital as this part is permanently blocked in current
assets. This amount varies from year to year, depending upon the growth of the
company and the stage of the business cycle in which it operates. It is the amount of
funds required to produce the goods and services, which are necessary to satisfy
demand at a particular point of time. It represents the current assets, which are
required on a continuing basis over the entire year. It is maintained as the medium as
to continue the operations at any time.
Characteristics of Permanent working capital
•
It is classified on the basis of the time period
•
It constantly changes from one asset to another and continues to remain in
the business process.
•
2.
Its size increase with the growth of business operations.
Temporary working capital:
Contrary to the above you will find that temporary working capital represents a
certain amount of fluctuations in the total current assets during a short period. These
fluctuations are increased or decreased and are generally cyclical in nature.
Additional current assets are required at different times during the operating year.
Variable working capital is the amount of additional current asset that are required to
meet the seasonal needs of a firm, so is also called as the seasonal working capital.
For example: additional inventory will be required for meeting the demand during the
period of high sales When the peak period is over variable working capital starts
decreasing or very little during the normal period. It is temporarily invested in current
assets. Say for an example a shopkeeper invests more money during winter season
because he/ she requires to keep more amount of stock of woolen cloths. The same
happens in a sugar factory how: the factory manager buys more quantity of sugarcane
during the harvesting season and they continuously stops for some time.
Characteristics of Temporary working capital
•
It is not always gainfully employed, though it may change from one asset
to another asset, as permanent working capital does.
•
It is particularly suited to business of a seasonal or cyclical nature.
Diagrammatic representation of temporary and permanent working capital
Permanent or temporary working capital in case of stable firm
Amount of WC
Temporary or
fluctuating WC
Permanent WC
Time
Permanent & temporary working capital in case of growing firm
Amount of WC
Temporary or
fluctuating WC
Permanent WC
Time
Determinants of WC
We can explain the determinants of working capital as follows:
Nature of business:
The working capital requirements of an enterprise are basically related to the conduct of
the business. Public utility undertakings like Electricity, Water supply, Railways, etc.
need very limited working capital because they offer cash sales only and supply services,
not products and as such no funds are ties up in inventories and receivables. But at the
same time have to invest fewer amounts in fixed assets. The manufacturing concerns on
the other hand require sizable working capital along with fixed investments, as they have
to build up the inventories.
Terms of sales and purchases:
Credit sales granted by the concerns too its customers as well as credit terms granted by
the suppliers also affect the working capital. If the credit terms of the purchases are more
favorable and at the same time those of sales less liberal, less cash will be invested in the
inventory. With more favorable credit terms, working capital requirements can be
reduced.
Manufacturing cycle:
The length of manufacturing cycle influences the quantum of working capital needed.
Manufacturing process always involves a time lag between the time when raw materials
are fed into the production line and finished goods are finally turned out by it. The length
of the period of manufacture in turn depends o the nature of product as well as production
technology used by a concern. Shorter the manufacturing cycle; lesser the working
capital required.
Rapidity of turnover:
If the inventory turnover is high, the working capital requirements will be low. With a
better inventory control, a firm is able to reduce its working capital requirements. When a
firm has to carry on a large slow moving stock, it needs a larger working capital as
against another whose turnover is rapid. A firm should determine the minimum level of
stock, which it will have to maintain throughout the period of its operation.
Business cycle:
Cyclical changes in the economy also influence quantum of working capital. In a period
of boom i.e., when the business ism prosperous, there is s need of larger amount of
working capital due to increases in sales, rise in price etc and vice-a-versa during period
of depression.
Changes in technology:
Changes in technology may lead to improvements in processing of raw materials, savings
in wastage, greater productivity, and more speedy production. All these improvements
may enable the firm to reduce investments in inventory.
Seasonal variation:
The inventory of raw materials, spares and stores depends on the condition of supply. If
the supply is prompt and adequate the firm can manage with small inventory. However, if
the supply were unpredictable and scant then the firm, to ensure the continuity of
production, would have to acquire stocks as and when they are available and carry larger
inventory on an average.
Market conditions:
The degree of competition prevailing in the market place has an important bearing on
working capital needs. When competition is keen, a larger inventory of finished goods is
required to promptly serve customers who may not be inclined to wait because other
manufacturers are ready to meet their needs.
Seasonality of operation:
Firms, which have marked seasonality in their operations usually, have highly fluctuating
working requirements. Let us take an example to illustrate this point. Consider a firm
manufacturing fans. The sale of fans reaches a peak during the summer months and drops
sharply during the winter period. The working capital need of such a firm is likely to
increase considerably in summer months and decrease significantly during winter season.
Dividend policy:
It has a dominant influence on the working capital position of a firm. If the firm is
following a conservative dividend policy, the need for working capital can be met with
retained earnings.
Working capital cycle:
Larger the working capital cycle, more is the requirement of working capital.
NEED FOR WORKING CAPITAL
The need for working capital to run the day-to-day business activities cannot be
overemphasized. We will hardly find a business firm, which does not require any amount
of working capital. Indeed, firms differ in their requirements of the working capital.
We know that a firm should aim at maximizing the wealth of its shareholders. In its
endeavor to do so, a firm should earn sufficient return from its operations. Earning a
steady amount of profit requires successful sales activities. The firm has to invest enough
founds in current for generating sales. Current assets are needed because sales do not
convert into cash instantaneously. There is always an operating cycle involved in the
conversion of sales into cash.
Operating Cycle
There is a difference between current and fixed assets in terms of their liquidity. A firm
requires many years to recover the initial investment in fixed assets such as plant and
machinery or land and buildings. On the contrary, investment in current assets in turned
over many times in a year. Investment in current assets such as inventories and debtors
(accounts receivable) is realized during the firm’s operating cycle, which is usually less
than a year. Then can you tell me what an operating cycle is?
Operating Cycle is the time duration required to convert resources or
inventories into sales and then into cash.
The operating cycle of a manufacturing company involves three phases:
Acquisition of resources: such as raw material, labor, power and fuel etc.
Manufacture of the product: which includes conversion of raw material into work-inprogress into finished goods.
Sales of the product: either for cash or on credit. Credit sales create account receivable
for collection.
In any of your business these phases affect cash flows, which most of the time, are
neither synchronized because cash outflows usually occur before cash inflows. Cash
inflows are not certain because sales and collections, which give rise to cash inflows,
are difficult to forecast accurately. Cash outflows, on the other hand, are relatively
certain. The firm is, therefore, required to invest in current assets for a smooth,
uninterrupted functioning. It needs to maintain liquidity to purchase raw materials and
pay expenses such as wages and salaries, other manufacturing, administrative and
selling expenses and taxes as there is hardly a matching between cash inflows and
outflows. Cash is also held to meet any future exigencies. Stocks of raw material and
work-in-process are kept to ensure smooth production and to guard against nonavailability of raw material and other components. The firm holds stock of finished
goods to meet the demands of customers on continuous basis and sudden demand
from some customers. Debtors (accounts receivable) are created because goods are
sold on credit for marketing and competitive reasons. Thus, a firm makes adequate
investment in inventories, and debtors, for smooth, uninterrupted production and sale.
Purchases
Payment
Credit sale
Collection
RMCP + WIPCP + FGCP
Inventory conversion period
Receivables conversion price
Payables
Net operating cycle
Gross operating cycle
How is the length of an operating cycle determined?
The length of the operating cycle of a manufacturing firm is the sum of:
(i)
Inventory conversion period (ICP) and
(ii)
Debtors’ conversion period (DCP).
Here the inventory conversion period is the total time needed for producing and selling
the product. Typically, it includes:
(a) Raw material conversion period (RMCP),
(b) Work-in-process conversion period (WIPCP), and
(c) Finished goods conversion period (FGCP).
The debtors’ conversion period is the time required to collect the outstanding amount
from the customers. The total of inventory conversion period and debtors’ conversion
period is referred to as gross operating cycle (GOC)
In practice, a firm may acquire resources (such as raw materials) on credit and
temporarily post-phone payment of certain expenses. Payables, which the firm can defer,
are spontaneous sources of capital to finance investment in current assets. The payables
deferral period (PDP) is the length of time the firm is able to defer payments on various
resource purchases. The difference between (gross) operating cycle and payable deferral
period is net operating cycle (NOC). If depreciation is excluded from expenses in the
commutation of operating cycle, the net operating cycle also represents the cash
conversion cycle. It is net time interval between cash collections from sale of the product
and cash payments for resources acquired by the firm. It also represents the time interval
over which additional funds, called working capital, should be obtained in order to carry
out the firm’s operations. The firm has to negotiate working capital from sources such as
commercial banks. The negotiated sources of working capital financing are called nonspontaneous sources. If net operating cycle of a firm increases, it means further need for
negotiated working capital.
Let us now understand the computation of the length of operating cycle. Consider
the statement of costs of sales for a firm given in Table
Table STATEMENT OF COST OF SALES _______________________
Items
Actual
(Rs. Lakh)
19x1
19x2
1.
Purchase of aw material (credit)
4,653
6,091
2.
Opening raw material inventory
523
827
3.
Closing raw material inventory
827
986
4.
Raw material consumed (1+2-3)
4,349
5,932
5.
Direct labour
368
498
6.
Depreciation
82
90
7.
Other mfg. Expenses
553
553
8.
Total cost (4+5+6+7)
9.
Opening work-in process inventory
10.
Closing work-in-process inventory
11.
Cost of production (8+9-10 )
12.
Opening finished goods inventory
317
526
13.
Closing finished goods inventory
526
995
14.
Cost of goods sold (11+12-13)
5,003
6,582
15.
Selling, administrative and general exp.
304
457
16.
Cost of sales (14+15)
5,352
7,224
185
325
325
498
5.212
7,051
5,307
7,039
The firm’s data for sales and book debts and creditors are given as under
SALES AND DEBTORS_____________________________
(Rs. Lakhs)
19x1
Sales (credit)
6,087
19x2
8,006
Opening debtors
545
735
Closing debtors
735
1,040
Opening creditors
300
454
Closing creditors
454
642
The firm’s gross operating cycle (GOC) can be determined as inventory conversion
period (ICP) plus debtors’ conversion period (DCP).
Gross operating cycle = Inventory conversion period + Debtors conversion period
GOC=ICP+ DCP
The inventory conversion (ICP) is the sum of raw material conversion period (RMCP),
work-in-process conversion period (WIPCP) and finished goods conversion period
(FGCP):
ICP=RMCP+WIPCP+FGCP
What determines the inventory conversion period? The raw material conversion period
should depend on: (a) raw material consumption per day, and (b) raw material inventory.
Raw material consumption per day is given by the total raw material consumption
divided by the number of days in the year ( say, 360). The raw material conversion period
is obtained when raw material inventory is divided by raw material consumption per day.
Similar calculations can be made for other inventories, debtors and creditors. The
following formulate can be used:
=
Raw material
Raw material consumption (RMC)
Inventory (RMI) ÷------------------------------------------------360
RMI x 360
RMC
=RMI÷
360
=
RMC
Work-in-process conversion period (WIPCP)
= Work –in-process
Cost of production (COP)
Inventory (WIPI) ÷ --------------------------------360
COP
WIPI x 360
=WIPI÷
360
=
COP
Finished goods conversion period ( FGCP)
Finished goods
Cost of goods sold (CGS)
Inventory (FGI) ÷ ------------------------------------360
CGC
FGI x 360
=FGI÷ 360
=
CGS
Debtors’ conversion period (DCP)
= Debtors (D) ÷Credit sales at cost (CR SALES)
360
CRSALES
D x 360
=D÷
360
=
CR SALES
Payables deferral period (PDP)
= Creditors (CRS) ÷ Credit purchase (CR PUR)
360
CRPUR
CRS x 360
=CRS÷
360
=
CRPUR
Net Operating cycle (NOC) is the difference between gross operating cycle and payables
deferral period.
Net operating cycle = Gross operating cycle – payables deferral period
NOC = GOC – PDP
Net operating cycle is also referred to as cash conversion cycle. Depreciation and profit
should be excluded in the computation of cash conversion cycle since the firm’s concern
is with cash flows associated with conversion at cost. A contrary view is that a firm has to
ultimately recover total costs and make profits; therefore, the calculation of operating
cycle should include depreciation, and even the profits. Also, in using the above
mentioned formulate, average figures for the period may be used.
Table 22.3 shows detained calculations of the components of a firm’s operating
cycle. Table 22.4 provides the summary of calculations.
Table 22.3
OPERATING CYCLE CALCULATIONS_________________
(Rs. Lakh)
Items
1.
2.
Actual Projected
19x1
19x2
4349
5932
Raw Material Conversion Period
(a)
Raw material consumption
(b)
Raw material consumption per day
©
Raw material inventory
(d)
Raw material inventory bolding days 68d
12.1
16.5
827
986
60d
Work-in-Process Conversion Period
(a)
Cost of production*
5130
6961
(b)
Cost of production per day
14.3
19.3
©
Work-in-process inventory
325
498
(d)
Work-in-process inventory holding days
23d
26d
3.
4.
Finished Goods Conversion Period
(a)
Cost of goods sold*
4921
6492
(b)
Cost of production per day
13.7
18.0
©
Finished goods inventory
526
995
(d)
Finished goods inventory holding days
38d
55d
5307
7039
Collection Period
(a)
Credit sales (at cost)**
(b)
Sales per day
©
Book debts
(d)
Book debts outstanding days
14.7
19.6
735
50d
1040
53d
5. Payment Deferral periods
(a)
Credit purchase
4653
6091
(b)
Purchase per day
12.9
16.9
©
Creditors
454
642
(d)
Creditors outstanding
35d
28d
*Depreciation is excluded on the assumption that the firm is interested in cash conversion
period. Depreciation is a non-cash item.
** All sales are assumed on credit. Cost of sales figure should be used for calculation of
collection period.
During 19x1 the daily raw material consumption was Rs. 12.1 lakh and the
company held an ending raw material inventory of Rs. 827 lakh. If we assume that this is
the average inventory held by the company, the raw material consumption period works
out to be 68 days. You may notice that for 19x2, the projected raw material conversion
period is 60 days. This has happened because both consumption (Rs. 16.5 lakh per day)
and level of inventory (Rs. 986 lakh) have increased, but the consumption rate has
increased (by 36.4 per cent) much more than the increase in inventory holding (by 19.2
per cent). Thus, the raw material conversion period has declined by 8 days. Raw material
is the result of daily raw material consumption and total raw material consumption during
a period given the company’s production targets. Thus, raw material inventory is
controlled through control over purchases and production. We can similarly interpret
other calculations in Table 22.3
Table 22.4
SUMMARY OF OPERATING CYCLE
CALCULATIONS____________
Actual
Projected
GROSS OPERATING CYCLE
1.
Inventory Conversion Period
(i)
Raw material
68
60
(ii)
Work-in-process
23
(iii)
Finished goods
38
26
129
55
2.
Debtors Conversion Period
50
53
3.
Gross Operating Cycle ( 1+2)
179
194
141
Net Operating Cycle
4.
Payment Deferral Period
35
38
5.
Net Operating Cycle ( 3-4)
144
156
We note a significant change in the company’s policy for 19x2 with regard to
finished goods inventory. It is expected to increase to 55 days holding from 38 days in
the previous year. One reason could be a conscious policy decision to avoid stock-out
situations and carry more finished goods inventory to expand sales. But this policy has a
cost; the company, in the absence of a significant increase in payables deferral period,
will have to negotiate higher working capital funds. In the case of the firm in or example,
its net operating (cash conversion) cycle is expected to increase from 144 days to 156
days (Table 22.4), How does a company manage its inventories, debtors and suppliers’
credit? How can it reduce its operating cycle? We shall attempt to answer these questions
in the next four chapters.
The operating cycle concept as shown in Figure 22.1 relates to a manufacturing
firm. Non-manufacturing firms such as wholesalers and retailers will not have the
manufacturing phase. They will acquire stock of finished goods and convert them into
debtors (book debts) and debtors into cash. Further, service and financial enterprises will
not have inventory of goods (cash will e their inventory). Their operating cycles will be
the shortest. They need to acquire cash, then lend (create debtors) and again convert
lending into cash.
COMPUTATION OF OPEARTING CYCLE
Formulae:
RMCP
= (RMI*360) / RMC
WIPCP = (WIPI*360) / COP
FGCP = (FGI*360) / COGS
DCP
= (DRS *360) / Cr.Sales
PDP
= (CRS*360) / Cr. purchases
GROSS OP. CYCLE = ICP+DCP
ICP = RMCP + WIPCP +FGCP
NET OP. CYCLE = GOC-PDP
Where:
RMC is the consumption of raw material
RMI is the closing stock of raw material inventory
WIPI is the closing stock of work-in process inventory
FGI is the closing stock of finished goods inventory
COP is the cost of production
COGS is the cost of goods sold
The important points to be considered
Time value of money not important
Liquidity position of a firm is dependent on investment in current assets
Any short run, immediate need of the company whether it be cash or adjustments
in sales can be made only through adjusting the levels of the various components
of the current assets. This calls for efficient management of current assets, which
form part of management of working capital.
We will cover more exercises in next session