Principles of
Working Capital Management
Concepts of Working Capital

Gross working capital (GWC)
GWC refers to the firm’s total investment in
current assets.
– Current assets can be converted into cash
within an accounting year (or operating
cycle)
– include cash, short-term securities, debtors,
(accounts receivable or book debts) bills
receivable and stock.
Concepts of Working Capital

Net working capital (NWC).

NWC refers to the difference between
current assets and current liabilities.

NWC can be positive or negative.
– Positive NWC = CA > CL
– Negative NWC = CA < CL
Concepts of Working Capital

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.
Concepts of Working Capital

GWC focuses on
– Optimisation of investment in current asset
– Financing of current assets

NWC focuses on
– Liquidity position of the firm
– Judicious mix of short-term and long-tern
financing
Operating Cycle

Operating cycle is the time duration required
to
convert
sales
into
cash,
after
conversion of resources into inventories,
the
Operating Cycle

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-inprogress into finished goods.
– Sale of the product either for cash or on
credit. Credit sales create account
receivable for collection.
Operating Cycle

The length of the operating cycle of a
manufacturing firm is the sum of:
– inventory conversion period (ICP).
– Debtors (receivable) conversion period
(DCP).
Inventory Conversion Period

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)
Debtors conversion period

The debtors conversion period is the time
required to collect the outstanding amount
from the customers.
Payables Deferral Period

Creditors or payables deferral period
(CDP) is the length of time the firm is able to
defer payments on various resource
purchases.
Types of Working Capital

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.
Determinants of Working Capital
Nature of business
 Market and demand
 manufacturing policy
 Credit policy
 Supplies’ credit
 Operating efficiency
 Inflation

Issues in Working Capital
Management
Levels of current assets
 Current assets to fixed assets
 Liquidity Vs. profitability
 Cost trade-off

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.
Estimating Working capital

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.
Working Capital Finance Policies
Long-term
 Short-term
 Spontaneous

Working Capital Financing Policies

Matching:
– Matches the maturity of the assets with the
maturity of the financing.

Aggressive:
– Uses short-term (temporary) capital to
finance some permanent assets.

Conservative:
– Uses long-term (permanent) capital to
finance some temporary assets.
Matching
Aggressive
Conservative
Choice of working capital policy

The choice of working capital policy is a
classic risk/return tradeoff.

The aggressive policy promises the highest
return but carries the greatest risk.

The conservative policy has the least risk but
also the lowest expected return.

The moderate (maturity matching) policy falls
between the two extremes.
Sources of short-term credit
 Debt requiring repayment within one year.

Major sources:
– Accounts payable (trade credit)
– Commercial paper
– Bank loans
Short-term debt

Short-term debt is riskier than long-term debt
for the borrower.
– Short-term rates may rise.
– May have trouble rolling debt over.
 Advantages of short-term debt.
– Typically lower cost.
– Can get funds relatively quickly with low
transactions costs.
Cost to accruals?

Accruals are free in the sense that no
explicit interest is charged.

However, firms have little control over
accrual levels, which are influenced more
by industry custom, economic factors, and
tax laws than by managerial actions.
What is trade credit?

Trade credit is credit furnished by a firm’s
suppliers.

Trade credit is often the largest source of
short-term credit for small firms.

Trade credit is spontaneous and relatively
easy to get, but the cost can be high.
Commercial Paper (CP)

CP are short term notes issued by large,
strong companies.

CP trades in the market at rates just above
the T-bill rate.

CP is bought by banks and other companies,
then held as marketable securities for liquidity
purposes.
What is a secured loan?

In a secured loan, the borrower pledges
assets as collateral for the loan.

For short-term loans, the most commonly
pledged assets are receivables and
inventories.

Securities are great collateral, but generally
firms needing short-term loans generally do
not have securities.