basic principles of working capital management

1. BY-

2. DEFINING WORKING CAPITAL
 Holding of the firm in current assets.
 Part of firm’s capital that is required for financing
short term current assets.
 It is never exhausted.
 Revolves in the operating cycle.

3. CURRENT ASSETS
 That can be converted into cash within one
accounting year.
 Includes :
 cash
 receivables
 Inventory
 Marketable securities

4. TYPES OF WORKING CAPITAL
CONCEPT TIME
Gross
working temporary
capital
Net
working permanent
capital

5. NET WORKING CAPITAL
GROSS WORKING CAPITAL
 FOCUSSES ON :-  FOCUSSES ON :
 Liquidity position of the  Financing of current
firm assets
 Judicious mix of short
term and long term  Optimization of
financing. investments in current
assets.

6. TYPES OF WORKING CAPITAL
ON THE BASIS OF CONCEPT
 NET WORKING  GROSS WORKING
CAPITAL CAPITAL
 CA-CL
 Investment in CA
 +ive CA>CL
 -ive CA < CL

7. OPERATING CYCLE

8. OPERATING CYCLE
 Time required to convert sales into cash
 Three major phases are :
PURCHASING
THE RESOURCES
PRODUCING THE
PRODUCT
SELLING THE
PRODUCT

9. OPERATING CYCLE TYPES
 NET OPERATING  GROSS OPERATING
CYCLE CYCLE
 RM IHP+WIP PIH + FG  DCP+ICP
IHP + DCP - CDP
 RM IHP+ WIP IHP+ FG
IHP+DCP

10. GROSS OPERATING CYCLE
 Can be determined by –
GOC = ICP+DCP
ICP = RMCP+WIPCP+FGCP
 DCP= debtors collection period
 ICP = inventory conversion period

11. INVENTORY CONVERSION PERIOD
 RMCP
 WIPCP
 FGCP

12. RAW MATERIAL CONVERSION PERIOD
(RMCP)
 Average time taken to convert material into work in
process.
 It depends upon – ( i ) raw material
consumption per day
( ii ) raw material inventory
RMCP = RM inventory*360
RM consumed

13. WORK IN PROCESS CONVERSION
PERIOD (WIPCP )
 Average time taken to complete the semi finished
work
WIPCP=(WIPinventory*360)
COP

14. FINISHED GOODS CONVERSION
PERIOD (FGCP )
 Average time taken to sell the finished goods.
FGCP= FGI*360
COGS

15. DEBTORS CONVERSION PERIOD (DCP
)
 Average time taken to convert debtors into cash.
DCP = debtors*360
credit sales

16. GROSS OPERATING CYCLE
RMCP
DCP GOC WIPCP
FGCP

17. NET OPERATING CYCLE
 NOC = GOC – CDP
NOC = RMIHP + WIPIHP +
FGIHP + ACP – APP

18. CREDITORS DEFERRAL PERIOD (CDP)
 Average time taken by the firm in paying its debts.
CDP= creditors*360
credit purchases

19. PERMANENT AND TEMPORARY
WORKING CAPITAL
 PERMANENT WC – minimum level of required
current assets.
 TEMPORARY WC – extra WC needed to support
the changing production and sales activities of the
firm.

20. GRAPHICAL INTERPRETATION OF
WORKING CAPITAL
Permanent and temporary working capital

21. DETERMINANTS OF WORKING CAPITAL
 Nature of business
 Market and demand conditions
 Technology and manufacturing policy
 Credit policy
 Availability of credit from suppliers
 Operating efficiency
 Price level changes

22. ISSUES IN WORKING CAPITAL
MANAGEMENT
 Current assets to fixed assets ratio
 Liquidity Vs profitability – RISK RETURN
TRADE OFF
 THE COST TRADE--OFF

23. (1.) CURRENT ASSETS TO FIXED
ASSETS RATIO
Alternative current asset policies

24. CURRENT ASSETS TO FIXED ASSETS
RATIO
 Optimum level of current assets so that the wealth
of the shareholders is maximized.
 APPROACHES TO DETERMINE OPTIMUM
LEVEL OF CA/FA RATIO
- conservative
- aggressive
- moderate

25. CA/FA RATIO APPROACHES
( CONSTANT LEVEL OF FIXED ASSETS )
 CONSERVATIVE  AGGRESSIVE
 Higher CA/FA ratio
 Lower CA/FA
ratio
 Higher liquidity
 Lower risk
 Lower return  Higher risk
 Poor liquidity
 Higher return

26. (2.)THE COST TRADE--OFF
Cost Trade-off

27. THE COST TRADE OFF
 cost of liquidity :
 If a firm’s level of CA is very high it has excessive
liquidity.
 Its return on assets is very low because funds are
tied up in idle stocks which earns nothing.
 Cost of illiquidity:
 Cost of holding insufficient current assets.

28. OPTIMUM LEVEL OF CURRENT ASSETS
 With the level of CA the cost of liquidity increases
while the cost of illiquidity decreases.
 The firm should maintain current assets at that level
where the sum of these two cost is minimized.

29. ESTIMATING WORKING CAPITAL
NEEDS
 BEST METHOD – OPERATING CYCLE
 THREE APPROACHES ARE :-
i. Current assets holding period
ii. Ratio of sales
iii. Ratio of fixed investments.
ROR = PBIT / NET FIXED INVEST. + WC

30. POLICIES FOR FINANCING CURRENT
ASSETS ( TYPES )
 LONG TERM FINANCING – sources are ordinary
share capital , preference share capital ,
debentures , long term borrowings.
 SHORT TERM FINANCING : banks, public deposit,
factoring of receivables etc.
 SPONTANEOUS FINANCING – automatic sources
of short term funds arising from normal course of a
business.

31. THREE APPROACHES FOR MIX OF
SHORT TERM AND LONG FINANCNG
 Matching approach
 Conservative approach
 Aggressive approach

32. MATCHING PLAN ( HEDGING
APPROACH )
Financing under matching plan

33. MATCHING APPROACH
 Firm can adopt a financial plan that matches the
expected life of assets.
 Long term financing – fixed assets
 Short term financing – variable current assets.

34. CONSERVATIVE APPROACH
Conservative financing

35. CONSERVATIVE APPROACH
 Financing policy depends more on long term funds.
 The firm finances its permanent current assets and
also a part of temporary current assets with long
term financing.

36. AGGRESSIVE FINANCING

37. AGGRESSIVE APPROACH
 When a firm relies more on short term financing.
 Permanent fixed assets are also financed with short
term funds.

38. (3.) RISK RETURN TRADE OFF
 If firm wants to use short term financing it must
determine it its portion in total financing.
 Short term financing is preferred because:
 cost advantage
 flexibility

39. RISK RETURN TRADE OFF
 Short term financing  Long term financing
 Less expensive  Less expensive
 Greater risk  Lower risk
 High returns  Lower return