1. Meaning and Overview of
Working Capital
Working Capital Management involves two fundamental
questions
• What is the appropriate amount and mix of current assets
for the firm to hold ?
• How should these current assets be financed.

2. Meaning and Overview of Working
Capital
• Firms must carry a certain amount of current assets to be able
to operate smoothly. A company without sufficient cash on hand
might not be able to pay any unexpected expense .
• Without an inventory of raw materials, production might be
subject to costly interruptions or shutdowns.
• Without an inventory of finished goods, sales might be lost
because a product is out of stock.

3. Meaning and Overview of Working
Capital
• Current assets are cash and other assets that the firm expects to
convert into cash in a year or less. These assets are usually listed
on balance sheet in order of their liquidities.
• Current liabilities are obligations that the firm expects to repay in a
year or less. They may be interest bearing such as short term notes
and current maturity of long term debt. Also non interest bearing
liabilities are accounts payable, accrued expenses or accrued taxes
and wages.
• For liquidity purpose only
Net working capital = C.A. – C.L. (Net working capital determines
firms’ liquidity and not Working capital requirement as cash and short
term debt should be part of working capital requirement).

4. Meaning and Overview of Working
Capital
• Financing: Working capital management involves management of
currents assets and their financing. The financial manager’s
responsibilities include determining the optimum balance for each
of the current asset accounts and deciding what mix of short term
debt, long term debt and equity to use in financing working capital.
• Conversion Cycle: Working capital efficiency is a term that refers
to how efficiently working capital is used. It is most commonly
measured by a firm’s cash conversion cycle, which reflects the
time between the point at which raw materials are paid for and
the point at which finished made from those materials are
converted into cash. The shorter is conversion cycle , the more
efficient is its use of working capital.

5. Levels of Working Capital
Management
The size and nature of the firm’s investment in current assets is a
function of number of factors, including
• The type of products manufactured
• The length of operating cycle
• Sales volume
• Inventory policies

6. • Shortage costs (cost incurred because of lost production and
sales).
• Carrying costs (cost of having inventory).
Shortage costs > carrying costs, flexible approach
Shortage costs < carrying costs, restrictive approach

7. Optimal Level of Working Capital
Investment
To determine the optimal investment strategy for current assets, the
financial manager must balance shortage costs against carrying costs.
• If the cost running short of working capital (shortage costs)
dominate the cost of carrying extra working capital (carrying costs),
a firm will move towards a more flexible approach policy.
• If carrying costs are greater than shortage costs, then firm will
maximize value by adopting a more restrictive strategy.
• Overall management will try to find the level of current assets that
minimize the sum of carrying costs and shortage costs.

8. Working capital strategies
Key decision to be made by financial manager involves the fact:
• How much money should be invested in current assets for a
given level of sales.
• Managers have limited control over extending Accounts payable
days without risking of incurring high costs ( losing discounts or
penalties).

9. Working capital strategies
Two kind of working capital strategies:
• Flexible current assets strategy
• Restrictive current asset strategy

10. Working capital strategies
Flexible Current asset Investment strategy:
• a firm that follows such strategy hold large balances of
cash, marketable securities and inventory.
• Such strategy generally followed by company’s that offer liberal
credit terms to customers, which results in high levels of accounts
payable.
• Flexible strategy is generally perceived to be a low risk-low return
course of action.
• Holding large cash balances can help in credit crunch (recession)
as with large cash in hand a company can survive the down turn in
economy.

11. Working capital strategies
Flexible current asset investment strategy:
• Downside of such strategy can include low returns on current
assets, potentially high inventory carrying costs and the cost of
financing liberal credit terms.
• Return on cash and marketable securities is low.

12. Working capital strategies.
Restrictive Current assets strategy:
• This strategy follows the concept of keeping levels of current assets
at a minimum.
• The firm invests the minimum possible in cash, marketable
securities and inventory
• has strict terms of sale intended to limit credit sales and accounts
receivables.
• As discussed in points above it clearly reflects this strategy is High
Risk –High Return.

13. Working capital strategy
• In restrictive strategy company invests larger fraction of its money
in higher yielding assets.
• The high risk comes in the form of exposure to shortage
costs, which can be either financial or operating costs.
• Financial shortage costs arise mainly due to illiquidity (low level of
cash and marketable securities).
• Operating shortage costs result from lost production and sales. If
the firm does not hold enough raw materials in inventory, precious
hours may be wasted by a halt in production. If firms runs out of
finished goods, sales may be lost.
• Highly restrictive credit policies, such as low margin on credit sales
(like only 50% of total sales volume will be on credit).

14. Profitability vs risk trade off for
alternative financing strategies
Working capital needs are of two types:
• Short term
• Long term (permanent in nature): the minimum level of working
capital in the sense that it reflects a level that will always be on
the firm’s books.
The amount of working capital at a firm tends to fluctuate over time
as its sales rise and fall because of cyclicality.

15. Profitability vs risk trade off for
alternative financing strategies
There are three basic strategies that a firm can follow to finance its
working capital and fixed assets needs.
• Maturity matching strategy
• Long term funding strategy
• Short term funding strategy

16. Profitability vs risk trade off for
alternative financing strategies
Maturity Matching strategy:
• All seasonal working capital needs are financed by short term
debt. As the level of sales varies seasonally, short-term
borrowing fluctuates with short term borrowing.
• All permanent working capital and fixed assets are funded with
long-term financing.
• The maturity of liability should match the maturity of assets that
fund it.

17. Profitability vs risk trade off for
alternative financing strategies
Long term funding strategy:
• Long term debt and equity are used to finance fixed assets, permanent
working capital and seasonal working capital.
• When the need for working capital is at its peak, it is funded entirely by long
term funds.
• As the need for working capital diminishes over the seasonal cycle and
cash becomes available, the excess cash is invested in short term money
markets instruments to earn interest until the funds are needed again.
• This strategy reduces the risk of funding current assets: there is less need
to worry about refinancing assets, since all funding is long term.

18. Profitability vs risk trade off for alternative financing strategies
Short term funding strategies:
• Whereby all seasonal working capital and a portion of the
permanent working capital and fixed assets are funded with short-
term debt.
• The benefit of using this strategy is that it can take advantage of an
upward-sloping yield curve and lower a firms’ overall cost of
funding. The short term borrowing costs are typically less than the
long term borrowing costs.
• the biggest risk in this strategy is that a portion of firm’s long term
assets must be periodically refinanced over their working
lives, which can pose a significant risk.

19. Concept of Operating Cycle
• The operating cycle starts with the receipt of raw materials and
ends with the collection of cash from customers for the sale of
finished goods made from those materials.
• The operating cycle can described in terms of two components
1. Days sales in inventory
2. Days sales outstanding

20. Concept of Operating Cycle
• Days sales in inventory (DSI): show on an average, how long a
firm holds inventory before selling it.
DSI = 365 / Inventory turnover
Inventory turnover = COGS/Inventory
COGS: Cost of goods sold

21. Concept of Operating Cycle
• Days sales outstanding (DSO) : indicates how long it takes, on
average, for the firm to collect its outstanding accounts
receivable.
DSO = 365 / Accounts receivable turnover
Accounts receivable turn over = net sales / accounts receivable

22. Operating Cycle = DSO Cycle
Concept of Operating + DSI

23. Calculation of Working Capital
Working capital = C.A. – C.L.
There are two modifications that should be done to the above equation.
The first modification is cash. It is inappropriate to consider cash as part of
working capital for two reasons:
• First cash is often held to cover day to day operations of the firm, it is also
held for other reasons. Second cash is used for future investments or future
buffer.
• Second cash usually earns a market interest rate and has no opportunity
cost. This makes it different from inventory and accounts receivable, where
investments made have an opportunity cost. For same reasons marketable
securities/short term investments should be removed from working capital
calculation.

24. Calculation of Working Capital
The second modification is that we should remove all interest
bearing current liabilities from the working capital. The interest
bearing liabilities include short –term debt (interest expense) and
current portion of long term debt (CPLTD).
Non cash working capital = non cash current assets – non interest
bearing current liabilities.

25. Meaning of Receivables
• Accounts receivables are assets accounts representing
amounts owed to the firm as a result of sale of goods and
services.
• On balance sheet these claims are under accounts receivables
in current assets section.

26. Meaning of Receivables
Management
• Receivables management refers to the decisions a business
makes regarding its overall credit and collection policies and the
evaluation of individual credit applicants.
• Receivables management has its merit and demerit where merit
is because of the promise of future cash flows and demerit is
because company needs financing while waiting for cash flows.

27. Determination of Appropriate
Receivables Policy
An appropriate receivables policy should include following factors:
• Nature of business of firm: if the industry is cyclical in nature or seasonal in
nature then line of credit should be extended or shortened accordingly.
• The discounts should be offered for cash payment (higher discount) as well
as payments (descent discount)before due date.
• The penalties imposed should be of high value if the payment is not made
on time.
• The credit manager should interact with credit team of buyer in order to get
timely payments.

28. Marginal Analysis
• First step in margins analysis is identifying the price and quantity
relationship.
• Second we determine the cost and revenue as function of quantity
(these relationships can be liner or non liner).
• Third we take first order derivative of TR (total revenue ) and TC
(total cost). The derivative of TR is called MR (marginal revenue)
and of TC is called MC (marginal cost).
• The price of product at certain quantity would make MR –MC = O
and this is the price of product at which cost will be minimum.

29. Evaluation of Credit Proposal
Credit proposal can be evaluation with the help of following:
• Financial statements: balance sheet and income statement
• Bank reference: bank of credit provider can help in credit check.
• Trade checking: company can cross check with other suppliers
in regard to credit facility provided and their experience with
credit requiring company.
• Credit bureaus: credit rating agencies can be contacted in
regard to the rating of particular company. Credit bureaus have
compiled reports on historical credit payment performance of
given company.

30. Credit analysis and Credit Decision

31. Heuristic Approach
In heuristic approach weights are given to eight factors that
influence the credit payments for credit scoring purpose and these
factors are
• Credit requirements (C) : how much of total requirement is
bought from respective company by the applicant (C< 25%, wt. =
0 , 25%< C < 50%, wt. 5, C>50%, wt = 10).
• Pay habits (P): It’s the measure of willingness as well as ability to pay.

32. Heuristic Approach
• Years in business (Y): is a measure of company’s ability to pay.
• Profit margin (M): this is operating margin and the it includes the
operating expenses.
• Current ratio (R): current ratio determines the liquidity of
company and is considered as best when equal or greater than
2.
• Total debt to assets ratio: lesser the debt ratio better is the
ability to pay (even when company runs at optimal debt ratio it
can get into trouble because of economic conditions.

33. Heuristic approach
• Inventory turnover (I): Higher the turnover ratio better it is. A
lower turnover ratio less efficiency.
• Qualitative factor (Q): this is subjective evaluation of applicant in
regard to general reputation and industry in which it operates.

34. Discriminant analysis
The discriminant analysis is a statistical approach of finding
relationship between variables to come up with statistical model.
• First take data of independent variables.
• Second take data of dependent variables for corresponding period.
• Run the regression analysis to come with equation of relation.
Equation is I = a0 + a1 X1 + a2 X2 + …………..+ an Xn
a1, a2……………an are the coefficients of respective variables
X1…….Xn.

35. Sequential Decision Analysis
In sequential approach step by step approach of credit analysis is
followed. This process helps in determining whether to go to next
stage or not. The three stages of sequential analysis are:
Stage 1: consult company credit files
Stage 2: examine agency credit rating
Stage 3: request interchange bank report.

36. Meaning of Cash management
• Cash management is a broad term that covers a number of
functions that help individuals and businesses process receipts
and payments in an organized and efficient manner.
• The range of cash management services range from simple
checkbook balancing to investing cash in bonds and other types
of securities to automated software that allows easy cash
collection.

37. Motives for Holding Cash
• The first reason for holding cash is the transaction motive: that
is, the cash is held to meet the needs that arise in the course of
doing business.
• The transactions demand for cash is also affected by any
seasonal factors that may affect revenues and operations.
• Firms also maintain cash as a precaution, that is, to meet
contingencies and unforeseen needs. These unforeseen needs
vary across firms operating in different industries.

38. Motives for Holding Cash
• At times external financing can carry a high transaction cost and
to cover this cost some firms hold more cash than others do.
• Firms, need the services of banks, and in order to get these
services, they are sometimes required to maintain a specified
cash balance, which is called compensating balance (better
liquidity ratios).

39. The cash balance that a firm has to maintain is determined largely
by the nature of its business. Some businesses are more cash
intensive than others and require large operating cash balances.
The factors that largely affect any given firms cash balances are :
• Size of the firm
• Sophistication of both banking technology and payment
procedures
Factors determining Cash
• Availability of investments
Balances

40. Factors determining Cash Balances
Size of the firm:
• Larger firms maintain lower cash balances , relative to
revenues, then smaller firms. This is because large firms enjoy
economies of scale and greater bargaining power with their
banks, suppliers and customers.

41. Factors determining cash balances
Sophistication of both banking technology and payment
procedures.
• A firm that operates in sophisticated financial system, where
suppliers and employees are paid with checks and customers
pay with checks or credit cards, will find itself using cash less
than a firm in a less sophisticated system.

42. Factors determining Cash Balances
Availability of Investments
• Investments that can be converted into cash at short notice, with
little or no cost, affects operating cash balances.

43. Collection System
• When a firm provides a buyer with its products, it transfers value
through provision of goods and services.
• There is opportunity cost incurred if value is not promptly received
in return.
• A primary objective of collection system is to receive value from the
buyer as quickly as possible.
• A second objective is to receive and process information
associated with the payment.
• A third objective is to take into consideration the relationship the
firm has with those making payments.

44. Disbursement tools
The commercial banks offer a number of tools and assist managers in
designing efficient disbursement systems.
• Zero balance accounts: zero balance accounts are very common
strategy, an account for disbursement is first established at the
bank.
• For zero balance account to be effective, the participating bank
must be one on which most disbursements are made via the
clearance system (not at bank).
• As implied by the name, the disbursing firm does not keep any
permanent stock of cash in the disbursing system. The participating
banks agrees that when the morning disbursements for the firm are
presented to it, the bank will advice the firm of the amount of cash
required to cover these disbursements.

45. Disbursement tools
• The money will then be wired transferred into the zero balance
account and the cheques honored.
Controlled Disbursing: if the bank doesn’t agree to provide company
with zero balance account, then the firm has to do controlled
disbursing.
• QAB: Quarterly averaged balance is calculated at the end of the
quarter and if the QAB is below the actual minimal QAB
maintenance amount agreed upon by company and bank, then
bank will put penalty charges according to mentioned in contract.

46. Investments in Marketable
Securities
Marketable securities are near cash investments that earn a market
return, with little or no risk, and can be quickly converted into cash.
• Firms can buy and sell treasury bills at little or no cost, treasury bills
have no default risk, and as short term investments they don’t have
large price changes, even when interest rate changes.
• There are other near cash investments, and they all tend to be
issued by entities with little or no default risk and to be short term.
This is because long term investments, even if issued by entities
with no default risk, can have a price risk (changes in interest rate).

47. Investments in Marketable
securities
• Treasury bills are short-term obligations issued by the US government.
Since they backed by the full faith and credit of the government, they are
perceived as riskless and carry no default risk. In general T-bills have
maturity of less than one year.
• Commercial Paper: is a short term note issued by corporations to raise
funds. Although the original purpose of commercial paper was to raise
short-term financing to cover working capital needs, firms have also issued
commercial paper as a way of bridging the gap between funds needed now
and long term funds that can be raised in the market. Generally the time to
maturity of commercial paper is 30 days to 270 days.
• Repurchase agreement: is the sale of security, with an agreement that the
security will be bought back at a specified price at the end of the agreement
period.

48. Determining Optimal level of Cash
Optimal Cash balance can be determined by two methods:
• Baumol model
optimal cash = ((2* annual cash usage rate* cost per sale of
securities)/annual interest rate))^(1/2)

49. Determining optimal level of cash
Miller-Orr model
Spread between upper and lower cash balance limits
= 3 ((3/4* (transaction cost * variance of cash flows)/interest rate))^(1/3).
In miller-orr model you have to specify lower limit of cash balance.
Upper limit = spread + lower limit of cash balance.

50. Four optimization models
• Baumol model
• Beranek model
• Miller-Orr Model
• Stone model

51. Determining Optimal Level of
Cash
Baumol Model:
In this model firm assumed to receive cash periodically but to pay cash continuously as steady
rate.
• Let Y be the amount of cash a company holds at the beginning of the period.
• If a company initially withdraws half of its income, Y / 2, spends it, then in the middle of the
period goes back to the bank and withdraws the rest then it has made two withdrawals
(N=2) and her average money holdings are equal to Y / 4.
• If there are N number of withdrawals then average money holding equals Y/2N
• So the company has lost interest income on the cash it has withheld with itself . This loss of
interest income = Y*I /2N
• Also there is cost associated with every transaction the company does. So for N transactions the cost
will be NC, Where C is the cost of every transaction.

52. Determining Optimal Level of
Cash
• As seen from the previous slide the total cost to the company for
holding cash for N periods and performing N transactions
money management cost = NC + I*Y/2N
• Next take the derivative of above equation to see the minimum value
of N (number of withdrawals) and the condition of minimum is
C – Y*I / 2N^2 = 0
N = (Y*I/2C)^(1/2)…..using this equations you can find the number of
withdrawals a company should a make in given
period

53. Determining Optimal Level of
Cash
Beranek Model
• In Beranek’s model cash inflows are steady, but the cash outflows are
periodic.
• Those companies which sells and bills uniformly throughout the month on
net 30-days terms but writes cheques only a few times per month.
• In this kind of scenario a company can keep collecting cash for few days
and then invest that cash for certain days until the day it has to write a
cheque.
• The formula for calculating the number of transactions remain the same as
of Baumol model.

54. Determining Optimal Level of
Miller and Orr Model:
Cash
• As per the Miller and Orr model of cash management the
companies let their cash balance move within two limits - the
upper limit and the lower limit.
• The companies buy or sell the marketable securities only if the
cash balance is equal to any one of these.
• When the cash balances of a company touches the upper limit it
purchases a certain number of saleable securities that helps
them to come back to the desired level.

55. Determining Optimal Level of
Cash
•Ifthe cash balance of the company reaches the lower level then
the company trades its saleable securities and gathers enough
cash to fix the problem.
R = (3aV/4I)^(1/3)
V is the daily variance of cash flows, I is the daily interest rate and a is the
transaction cost
Return point is calculated by summing R + L (L is lower limit)
Upper limit is calculated by summing 3R + L

56. Determining Optimal Level of
Cash
Stone Model:
• Like Miller’s model takes a control limit approach.
• Under stone model company does no analysis of its cash balance
until it goes out of control limits.
• If sum of the current cash balance and expected cash flows in
coming few days fall outside the limit, investment is done.
• If sum of the current cash balance and expected cash flows in
coming few days fall short of lower limit, disinvestments are done.

57. Financial Forecasting
Financial forecasting is the estimation of the future value of a
financial variable often a cash flow, asset or debt. Financial
forecasting can be done by following:
• General liner model
• Spot method
• Proportion of another account
• Compounded growth