Module – 1Working Capital ManagementIntroductionWorking capital management is also one of the important parts of the financial management.It is concerned with short-term finance of the business concern which is a closely relatedtrade between profitability and liquidity. Efficient working capital management leads toimprove the operating performance of the business concern and it helps to meet the shortterm liquidity. Hence, study of working capital management is not only an important part offinancial management but also are overall management of the business concern.Working capital is described as the capital which is not fixed but the more common uses ofthe working capital is to consider it as the difference between the book value of current assetsand current liabilities.Meaning:Working Capital is a part of the capital which is needed for meeting day to day requirementof the business concern. For example, payment to creditors, salary paid to workers, purchaseof raw materials etc., normally it consists of recurring in nature. It can be easily convertedinto cash. Hence, it is also known as short-term capital.Definitions:According to the definition of Mead, Baker and Malott, “Working Capital means CurrentAssets”.According to the definition of J.S.Mill, “The sum of the current asset is the working capitalof a business”.According to the definition of Weston and Brigham, “Working Capital refers to a firm’sinvestment in short-term assets, cash, short-term securities, accounts receivables andinventories”.According to the definition of Bonneville, “Any acquisition of funds which increases thecurrent assets, increase working capital also for they are one and the same”.According to the definition of Shubin, “Working Capital is the amount of funds necessary tocover the cost of operating the enterprises”.According to the definition of Genestenberg, “Circulating capital means current assets of acompany that are changed in the ordinary course of business from one form to another, forexample, from cash to inventories, inventories to receivables, receivables to cash”.Concept of Working CapitalWorking capital can be classified or understood with the help of the following two importantconcepts.A. Gross Working CapitalGross Working Capital is the general concept which determines the working capital concept.Thus, the gross working capital is the capital invested in total current assets of the businessconcern.Gross Working Capital is simply called as the total current assets of the concern.Gross Working Capital Current AssetsB. Net Working Capital

Net Working Capital is the specific concept, which, considers both current assets and currentliability of the concern.Net Working Capital is the excess of current assets over the current liability of the concernduring a particular period.If the current assets exceed the current liabilities it is said to be positive working capital; itis reverse, it is said to be Negative working capital.Net Working Capital Current Assets – Current LiabilitiesNature of Working Capital:The nature of working capital is as discussed below:1. It is used for purchase of raw materials, payment of wages and expenses.2. It changes form constantly to keep the wheels of business moving.3. Working capital enhances liquidity, solvency, creditworthiness and reputation of theenterprise.4. It generates the elements of cost namely: Materials, wages and expenses.5. It enables the enterprise to avail the cash discount facilities offered by its suppliers.6. It helps improve the morale of business executives and their efficiency reaches at thehighest climax.7. It facilitates expansion programmes of the enterprise and helps in maintaining operationalefficiency of fixed assets.Significance / Need for Working Capital:Working capital plays a vital role in business. This capital remains blocked in raw materials,work in progress, finished products and with customers.The needs for working capital are as given below:1. Adequate working capital is needed to maintain a regular supply of raw materials, whichin turn facilitates smoother running of production process.2. Working capital ensures the regular and timely payment of wages and salaries, therebyimproving the morale and efficiency of employees.3. Working capital is needed for the efficient use of fixed assets.4. In order to enhance goodwill a healthy level of working capital is needed. It is necessary tobuild a good reputation and to make payments to creditors in time.5. Working capital helps avoid the possibility of under-capitalization.6. It is needed to pick up stock of raw materials even during economic depression.7. Working capital is needed in order to pay fair rate of dividend and interest in time, whichincreases the confidence of the investors in the firm.Importance of Working Capital:Working capital is a vital part of a business and can provide the following advantages to abusiness:1. Higher return on capital: Firms with lower working capital will post a higher return oncapital. Therefore, shareholders will benefit from a higher return for every dollar invested inthe business.2. Improved credit profile and solvency: The ability to meet short-term obligations is a prerequisite to long-term solvency. And it is often a good indication of counterparty’s credit risk.Adequate working capital management will allow a business to pay on time its short-termobligations. This could include payment for a purchase of raw materials, payment of salaries,and other operating expenses.3. Higher profitability: According to some researchers, the management of account payablesand receivables is an important driver of small businesses’ profitability.

4. Higher liquidity: A large amount of cash can be tied up in working capital, so a companymanaging it efficiently could benefit from additional liquidity and be less dependent onexternal financing. This is especially important for smaller businesses as they typically havelimited access to external funding sources. Also, small businesses often pay their bills in cashfrom earnings so efficient working capital management will allow a business to better allocateits resources and improve their cash management.5. Increased business value: Firms with more efficient working capital management willgenerate more free cash flows which will result in higher business valuation and enterprisevalue.6. Favorable financing conditions: A firm with a good relationship with its trade partnersand paying its suppliers on time will benefit from favorable financing terms such as discountpayments from its suppliers and banking partners.7. Uninterrupted production: A firm paying its suppliers on time will also benefit from aregular flow of raw materials, ensuring that the production remains uninterrupted and clientsreceive their goods on time.8. Ability to face shocks and peak demand: Efficient working capital management will helpa firm to survive through a crisis or ramp up production in case of an unexpectedly largeorder.Classification of Working Capital:Working capital may be of different types as follows:(a) Gross Working Capital: Gross working capital refers to the amount of funds invested invarious components of current assets. It consists of raw materials, work in progress, debtors,finished goods, etc.(b) Net Working Capital: The excess of current assets over current liabilities is known as Networking capital. The principal objective here is to learn the composition and magnitude ofcurrent assets required to meet current liabilities.(c) Positive Working Capital: This refers to the surplus of current assets over currentliabilities.(d) Negative Working Capital: Negative working capital refers to the excess of currentliabilities over current assets.(e) Permanent Working Capital: The minimum amount of working capital which evenrequired during the dullest season of the year is known as Permanent working capital.(f) Temporary or Variable Working Capital: It represents the additional current assetsrequired at different times during the operating year to meet additional inventory, extra cash,etc.Components of Working Capital:Working capital is composed of various current assets and current liabilities, which are asfollows:(A) Current Assets: These assets are generally realized within a short period of time, i.e.within one year.Current assets include:(a) Inventories or Stocks(i) Raw materials(ii) Work in progress(iii) Consumable Stores(iv) Finished goods(b) Sundry Debtors(c) Bills Receivable(d) Pre-payments

(e) Short-term Investments(f) Accrued Income and(g) Cash and Bank Balances(B) Current Liabilities: Current liabilities are those which are generally paid in the ordinarycourse of business within a short period of time, i.e. one year.Current liabilities include:(a) Sundry Creditors(b) Bills Payable(c) Accrued Expenses(d) Bank Overdrafts(e) Bank Loans (short-term)(f) Proposed Dividends(g) Short-term Loans(h) Tax Payments DueWorking Capital Investment Policies / Approaches to Financing CurrentAssetsWorking capital financing policy basically deals with the sources and the amount of workingcapital that a company should maintain. A firm is not only concerned about the amount ofcurrent assets but also about the proportions of short-term and long-term sources forfinancing the current assets. There are several working capital investment policies a firm mayadopt after taking into account the variability of its cash inflows and outflows and the levelof risk.1. Conservative Policy: As the name suggests, this policy tries to avoid the risk involved infinancing of current assets. Here, relatively high proportions of long-term sources are to beused for financing current assets. The firm not only matches the current assets with currentliabilities but also keeps some excess amount to meet any uncertainty.This is the lowest risk working capital policy and fails to ensure optimum utilization of funds.Hence it cuts down the expected returns of the shareholders. This policy is illustrated below.Line A denotes the fixed assets and Line B denotes the permanent working capital, which isfinanced through long-term sources. Certain portion of fluctuating current assets, which isshown by dashed Line C, is also financed by long-term sources. Under this policy some partof fluctuating current assets is financed through short-term sources.

2. Aggressive Policy: Aggressive working capital financing policy is a risky policy thatrequires maximum amount of investment in current assets. Fluctuating as well as permanentcurrent assets under this policy will be financed through short-term debt. In this policy debtis collected on time and payments to the creditors are made as late as possible. This policyhas been illustrated below. According to this approach long-term sources are used to financethe fixed assets, which are shown by Line A; but a portion of permanent current assets,shown by the dotted Line B, is also financed through long-term sources. The remaining partof permanent current assets, depicted by Line C, and the entire amount of fluctuating currentassets, shown by the curved Line D, are financed by short-term debt.3. Highly Aggressive Policy: This is a highly risky policy for financing the working capital.As per this policy, even some part of fixed assets is financed through short-term sources.Excessive reliance on short-term sources makes this policy highly risky. This policy has beenillustrated below. A major proportion of fixed assets as shown by dotted Line A are financed

through long-term sources and the remaining part of the fixed assets are financed by shortterm sources—shown by Line B. Short-term sources are also used for financing permanentcurrent assets—Line C; as well as fluctuating current assets as shown by the curved Line D.4. Hedging Policy: One of the policies by which a firm finances its working capital needs isthe hedging policy, also known as matching policy. This policy works in an arrangementwhere the current assets of the business are used perfectly to match the current liabilities.As per this approach, fixed and permanent current assets are financed through long-termsources and fluctuating current assets are financed through short-term sources. This policyis a medium risk proposition and requires a good amount of attention. For example, if a bankloan is due to be paid after six months, the company will ensure that sufficient amount ofcash will be available to repay the loan on the date of maturity even though it may or maynot currently have sufficient cash.In case of a growth firm, the amount of fixed assets and permanent current asset go onincreasing with the passage of time but the volume of fluctuating current assets change withthe change in production level. In the following figure, Line A and Line B is upward sloppedindicating that they go on increasing with the passage of time and as per hedging principlethey are financed through long-term sources like equity and long-term debt. Fluctuatingcurrent assets, which are shown by the curved Line C, should be financed through short termsources.

Operating Cycle Approach / Working Capital CycleEvery business organisation needs adequate working capital because the conversion of cashinto finished goods to debtors and back to cash is not instantaneous. It takes some time. Forexample, in a manufacturing firm, cash is used to purchase raw materials. They are notconsumed immediately. They remain some time in stores in order to ensure smoothproduction and to protect the firm against the risk of non-availability of raw materials infuture. Then they are issued from stores to production centre for conversion. This conversionalso generally takes some time. When certain expenses such as wages and overheads areincurred on it, it gets itself converted into semi-finished goods or work-in-progress and,finally, into finished goods. These finished goods will have to be stored for some time beforesale. Next, finished goods are sold to customers which may take the form of cash orreceivables/debtors. Receivable/ debtors, when realised, again take the form of cash and thecycle starts again.This can be explained with the help of the following diagram:The continuing flow from cash to suppliers, to inventory, to accounts receivable and backinto cash is called the working capital cycle or operating cycle. In other words, the termoperating cycle refers to the length of time which begins with the acquisition of raw materialsof a firm and ends with the final realisation of cash from debtors.The amount of working capital depends upon the length of working capital cycle. Longer theworking cycle, higher is the need of working capital to be maintained. This is because the

fund will then remain tied-up in various items of current assets for a longer period. The lengthof operating cycle varies from industry to industry and from business to business.A merchandising concern will have a shorter operating cycle as it deals in finished products.On the other hand, in a service enterprise, operating cycle is shortest and involve conversionof cash into debtors and debtors into cash.Thus, if raw materials remain in store for, say, 30 days, the conversion or processing periodis 45 days, finished goods remain in store for 30 days and debts collection period is 40 daysthen the total of this period (i.e., 30 45 30 40 or 145 days) is referred to as GrossOperating Cycle. Business enterprises receive credit in the purchase of raw materials fromsuppliers. This payment deferral period reduces the length of working capital.The net-working cycle period is ascertained by deducting from gross operation cycle thepayment deferral period or period of credit granted by suppliers of raw materials. If period ofcredit given by supplier is 45 days, then Net Operating Cycle is 100 days (i.e., 145 days – 45days). Similar conclusions can also be drawn for other elements of cost i.e., for direct wagesand overheads. In the case of direct wages and overheads, the operating cycle starts with thework- in-progress or processing time as there will be no raw materials storage period.Measurement of Operating Cycle:Strictly speaking, the volume of working capital depends upon the length of working capitalcycle. So, it is important to measure working capital cycle for management of working capital.The financial statements i.e., Profit and Loss Account and Balance Sheet, can guide us tomeasure working capital cycle.The steps involved in the determination of the operating cycle are shown below:ParticularsDays1. Raw materials holding period***2. Work-in-progress period***3. Finished goods holding period***4. Debtors collection period******Gross Operating Cycle5. Less: Creditors payment period(***)***Net Operating CycleThe procedure can be summarised as below:1. Raw Material Storage Period:It represents the average period during which raw materials are kept in stores.It is calculated as:Raw material storage periodAverage Stock of Raw materials Average daily consumption of Raw materialsHere, Average stock of raw materialsOpening Raw M aterial Clo sin g Raw M aterial 2Average daily consumption of raw materialTotal material consumption No. of working days in a year (360 days)*Note: 365 days also can be used in place of 360 days to calculate the average.If consumption of raw material is not available, average daily purchase can also be taken.2. Processing Period:

Once materials are issued to production, it again involves time gap between issue of materialsand production of finished product. This time gap is called processing period.It is calculated as:Processing PeriodAverage Stock of W ork in P r ogress Average daily factiry cos t of P r oductionAverage stock of work-in-progress Opening W ork in P r ogress Clo sin g W ork in P r ogress2Average daily factory cost of productionTotal factory cos t of production 360 days*Note: 365 days also can be used in place of 360 days to calculate the average.Factory cost of production during the year Raw materials consumed Direct wages Other direct expenses Manufacturing overhead Opening WIP – Closing WIP.3. Finished Goods Storage Period:Manufacturing enterprises produce the output in the expectation of future demand. Till thedemand for finished product materializes, the product would remain in the store. This periodis termed as finished goods storage period.This is calculated as:Finished goods storage PeriodAverage Stock of finished goods Average daily cos t of goods soldAverage stock of finished goods Opening stock of finished goods Clo sin g stock of finished goods2Average daily cost of goods soldTotal cos t of goods sold 360 days*Note: 365 days also can be used in place of 360 days to calculate the average.Cost of goods sold Opening stock of finished goods Factory cost of production – Closingstock of finished goods.4. Credit period Allowed to Debtors:The business enterprises due to competitive and other reasons—extend credit facilities tocustomers. The time gap between sale and realisation of cash is known as credit or collectiveperiod from debtors.It is computed as:Average DebtorsCredit period to debtors Average daily credit salesOpening debtors Clo sin g debtors2Total credit sales for the yearAverage daily credit sales 360 daysAverage debtors *Note: 365 days also can be used in place of 360 days to calculate the average.5. Credit Period Received from Suppliers:The business enterprises receive credit in the purchase of raw materials from suppliers. Itrefers to the average time taken for payment to suppliers from the date of purchase.

It is computed as:Credit from Suppliers Average CreditorsAverage daily credit purchasesOpening creditors Clo sin g creditors2Total credit purchases for the yearAverage daily credit purchases 360 daysAverage creditors *Note: 365 days also can be used in place of 360 days to calculate the average.Illustration 1:The following information is available for Swagat Ltd.: ( . ‘000)Average stock of raw materials and storesAverage WIP inventoryAverage finished goods inventoryAverage accounts receivableAverage accounts payableAverage raw materials and stores purchase on credit and consumed per dayAverage WIP value of raw materials committed per dayAverage cost of goods sold per dayAverage sales per dayYou are require to calculate:(i) Duration of raw material stage(ii) Duration of WIP stage(iii) Duration of Finished goods stage(iv) Duration of accounts receivable stage(v) Duration of accounts payable stage, and(vi) Duration of operating cycle.Solution:(i) Duration of Raw Material StageAverage Stock of Raw materials and Stores200 20 days Average raw materials and stores purchased per day102003001803001801012.51820(ii) Duration of Work-in-progress StageAverage work in progress inventory300 Average work in progress value of raw materials committed per day12.5 24 days(iii) Duration of Finished Goods StageAverage Finished goods inventory180 10 days Average cos t of goods sold per day18(iv) Duration of Accounts Receivable StageAverage Accounts Re ceivable300 15 daysAverage Credit sales per day20(v) Duration of Accounts Payable StageAverage Accounts P ayable180 18 daysAverage Credit purchase per day10

(vi) Duration of Operating Cycle (i) (ii) (iii) (iv) – (v) 20 days 24 days 10 days 15 days – 18 days 51 daysIllustration 2:From the following information extracted from the books of a manufacturing company,compute the operating cycle in days and the amount of working capital required:Period Covered365 daysAverage period of credit allowed by suppliers16 daysAverage Total of Debtors Outstanding480Raw Material Consumption4,400Total Production Cost10,000Total Cost of Sales10,500Sales for the year16,000Value of Average Stock maintained:Raw Material320Work-in-progress350Finished Goods260Solution: Calculation of Operating Cycle(i) Raw material held in stock:275 daysAverage stocks of raw materials held320 Average consumption per day4,400 x 365Less: Average credit period granted by Suppliers16 days11 days(ii) Work-in-progress:Average W IP ma int ained350365 x 320 13 days Average cos t of production per day10,000 / 36510,000(iii) Finished goods held in Stock:Average Finished goods ma int ained260 x 365260 9 days Average cos t of goods sold per days10,500 / 36510,500(iv) Credit period allowed to Debtors:Average total of outs tan ding debtors365 x 480480 11 days Average credit sales per day16,000 / 36516,000 Total operating cycle period: (i) (ii) (iii) (iv) 44 days Numbers of operating cycles in a year 365/44 8.30 times Amount of working capital requiredTotal operating cos t10,500 Rs. 1,265Number of operating cycles in a year8.3Problem for Practice 1Calculate the operating cycle from the following figures:Annual salesManufacturing expensesDistribution and other expensesPurchase of materials (in Lakhs)1,00024040400

Opening stock:Raw materials80Work-in-progress20Finished goods60Closing stock:Raw materials120Work-in-progress60Finished goods20Opening balance of sundry debtors40Closing balance of sundry debtors40The company obtains a credit for 60 days from the suppliers. All goods are sold for credit.Assume 360 days in the year.(Ans: Operating Cycle 109 days)Problem for Practice 2From the following information, extracted from the books of a manufacturing company,compute the operating cycle in days:Period covered: 365 days Average period of credit allowed by suppliers, 16 daysOther data are as follows:(Rs. In ‘000)Average debtors (outstanding)480Raw material consumption4,400Total production cost10,000Total cost of sales10,500Sales for the year16,000Value of average stock maintained:Raw material320Work-in-process350Finished goods260(Ans: 44 days)Reasons for a Longer Operating Cycle:Working capital requirements depend on the operating cycle. It starts with payment foracquisition of raw materials and ends with the collection of receivables from debtors. Theduration of the working capital cycle varies according to the nature of business.The reasons for longer operating cycle are given below:1. Firstly the working capital cycle may be longer if the availability of raw materials is noteasy. As a result the organization will have to hold large amount of raw materials in stores.2. Secondly the processing period may be longer. The nature of the product is such that theproduct passes through various departments to get finished.3. Thirdly the product may be slow moving. In that case the time taken to deplete the finishedgoods stock will be longer.4. Finally the credit policy and the inefficiency of the organization in debt collection alsoincrease the length of operating cycle.Determinants of Working CapitalSome of the major determinants of working capital are discussed below:A company, as a general policy, wants to hold in balance as small a quantity of workingcapital as possible so long as undue solvency risks are not imposed on it. This is a logicalapproach indicating that working capital is a means to an end and not an end in itself.Quantitative amounts of working capital can hardly be set for individual firms. The corporatemanagement has to consider the various factors in making decision regarding balances. An

appraisal of these would provide guidance to management in estimating prospective needs.These are called as determinants of working capital.1. Nature of business: A company’s working capital requirements are basically related to thekinds of business it conducts. Generally speaking, trading and financial firms requirerelatively large amounts of working capital, public utilities comparatively small amounts,whereas manufacturing concerns stand between these two extremes, their needs dependingupon the character of industry of which they are a part.2. Production policies: Depending upon the kind of items manufactured, a company is ableto offset the effect off- seasonal fluctuations upon working capital by adjusting its productionschedules. The choice rests between varying output in order to adjust inventories to seasonalrequirements and maintaining a steady rate of production and permitting stocks ofinventories to build up during off-season periods. It will thus be obvious that a levelproduction plan would involve a higher investment in working capital.3. Manufacturing process: If the manufacturing process in an industry entails a longerperiod because of its complex character, more working capital is required to finance thatprocess. The longer it takes to make an approach and the greater its cost, the larger theInventory tied up In Its manufacture and, therefore, higher the amount of working capital.4. Turnover of circulating capital: The speed with which the circulating capital completesits round I.e., conversion of cash into inventory of raw material Into Inventory of finishedgoods. Inventory of finished goods into book debts or accounts receivables and book debt intocash account, plays an Important and decisive role in judging the adequacy of workingcapital.5. Growth and expansion of business: As a company grows, it is logical to expect that largeramount of working capital will be required though It Is difficult to draw up firm rules for therelationship between the growth in the volume of a company’s business and the growth of itsworking capital.6. Business cycle fluctuations: Requirements of working capital of a company vary with thebusiness variation. At a time when the price level comes up and boom condition prevail, thepsychology of the management is to pile up a big stock of raw material and other goods likelyto be used in the business operations as there is an expectation to take advantage of lowerprices. The expansion of business units caused by the inflationary conditions creates demandfor more and more capital.7. Terms of purchase and sales: A business unit, making purchases on credit basis andselling its finished products on cash basis, will require lower amount of working capital, onthe contrary, a concern having no credit facilities and at the same time forced to grant creditto its customers may find itself in a tight position.8. Dividend policy: A desire to maintain an established dividend policy may affect workingcapital, often changes in working capital bring about an adjustment of dividend policy. Therelationship between dividend policy and working capital is well established and very fewcompanies declare a dividend without giving due consideration to its effects on cash and theirneeds for cash. A shortage of working capital often acts as a powerful reason for reducing orskipping a cash dividend. On the other hand, a strong position may justify continuingdividend payment.9. Other determinants:The following are the other determinants of working capital: Absence of co-ordination in production and distribution policies in a company resultsin a high demand for working capital. The absence of specialisation in the distribution of products may enhance the need ofworking capital.

If the means of transport and communication in a country like India are not welldeveloped, the industries may face a great demand for working capital in order tomaintain big inventory of raw materials and other accessories.The import policy of the Government may also effect the requirement of the workingcapital for the companies as they have to arrange for funds for imposing the goods atspecified times.The hazards and contingencies inherent in a particular type of business decide themagnitude of working capital in terms of keeping liquid resources.Sources of Working Capital FinanceWorking Capital requirement can be normalized from short-term and long-term sources.Each source will have both merits and limitations up to certain extract. Uses of WorkingCapital may be differing from stage to stageShort-Term Sources of Working Capital:1. Indigenous Bankers:Private money-lenders and other country bankers used to be the only source of

According to the definition of Mead, Baker and Malott, "Working Capital means Current Assets". According to the definition of J.S.Mill, "The sum of the current asset is the working capital of a business". According to the definition of Weston and Brigham, "Working Capital refers to a firm's