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Module 6
Working Capital Management

In this part you will be learning about a measure of both a company's

efficiency and its short-term financial health. This is needed for
meeting the day-to-day requirements of the firm and is therefore
known as the working capital.

After going over this chapter, you should be able to

Define Working Capital Management

Learn the Concept and Importance of Working Capital Management
Know things about Inventory, Cash and Receivables Management

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6.1 The Concept and Importance of Working Capital Management

There are two important concepts in working capital and these are the
gross working capital and the net working capital.

Gross 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 business concern. This is simply

Gross Working Capital = Current Assets

Usually, when we say working capital, we are referring to the Net

Working Capital. This considers both current assets and current
liability of the concern. Net Working Capital is the excess of current
assets over the current liability of the concern during a particular
period and is therefore represented by the formula

Net Working Capital = Current Assets - Current Liabilities

If the current assets exceed the current liabilities it is said to be

positive working capital. However, if the current liabilities exceed the
current assets it is said to be Negative working capital.

Working capital may be classified into two major types, namely the
permanent and temporary working capital. Permanent Working Capital
is the minimum amount of capital that must be maintained at all times
to ensure a minimum level of uninterrupted business operations. Since
this is permanent, it will not change irrespective of time or volume of
sales while temporary working capital is the excess of working capital
over the permanent working capital.

The formula above depicts that working capital management is

essentially an accounting strategy with a focus on the maintenance of a
sufficient balance between a company’s current assets and liabilities.
An effective working capital management system allows businesses to
not only cover their financial obligations, but it also helps companies
boost their earnings. Managing working capital means managing
inventories, cash, accounts payable and accounts receivable. Working
capital management is needed in the proper cash controlling in
purchase of raw materials or goods, payment of salaries and wages,
coping with daily expenses and providing credit obligations. This also
strengthens solvency, improves inventory management, smoothens
business operations and gives the firm the ability to face crisis.

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An efficient working capital management system often uses key

performance ratios discussed the past modules such as the working
capital ratio, the inventory turnover ratio and the account receivable
turnover to help identify areas that require focus in order to maintain
liquidity and profitability.

6.2 Inventory Management

Inventories constitute the most significant part of current assets of the
business concern. It is also essential for smooth running of the
business activities.

Inventory management involves proper purchasing of raw material,

handling, storing and recording. It also considers things such as what
to purchase, how to purchase, how much to purchase, from where to
purchase, where to store and when to use for production.

Kinds of Inventories
Inventories can be classified into three major categories

Raw Material- these are goods which have not yet been committed to
production in a manufacturing business concern

Work in Progress - these include materials which have been put into
production process but have not yet been completed

Finished Goods - these are the completed products and is already final
output of the production process

Objectives of Inventory Management

The following are the major objectives of the inventory management
To efficient and smooth production process
To maintain optimum inventory to maximize the profitability
To meet the seasonal demand of the products
To avoid price increase in future
To ensure the level and site of inventories required
To plan when to purchase and where to purchase
To avoid both over stock and under stock of inventory

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Commonly Used Inventory Management Techniques

ABC Analysis

The ABC Analysis is based on the principle that a small portion of the
items may typically represent the bulk of money value of the total
inventory used in the production process, while a relatively large
number of items may from a small part of the money value of stores.
This is the inventory management techniques that divide inventory
into three categories based on the value and volume of the inventories.

Economic Order Quantity (EOQ)

This refers to the level of inventory at which the total cost of inventory
comprising ordering cost and carrying cost. Determining an optimum
level involves two types of cost such as ordering cost and carrying
cost. The EOQ is that inventory level that minimizes the total of
ordering of carrying cost.

EOQ can be calculated with the help of the mathematical formula:

EOQ =

Where,
a = Annual usage of inventories (units)
b = Buying cost per order
c = Carrying cost per unit

6.3 Cash Management

The business needs cash to make payments for acquisition of resources

and services for the normal conduct of business. Cash is one of the
most important parts of the current assets. This is the money which a
business concern can disburse immediately without any restriction.
The term cash includes cash on hand such as bills and coins and the
cash in bank.

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Motives of Holding Cash

Transactions motive: to meet payments, such as purchases, wages,

taxes, and dividends, arising in the ordinary course of business.

Speculative motive: to take advantage of temporary opportunities,

such as a sudden decline in the price of a raw material.

Precautionary motive: to maintain a safety cushion or buffer to meet

unexpected cash needs. The more predictable the inflows and outflows
of cash for a firm, the less cash that needs to be held for precautionary
needs. Ready borrowing power to meet emergency cash drains also
reduces the need for this type of cash balance.

Cash Management Techniques

Speed up Cash Collection

Prompt Payment by Customers

The business must find ways on how customers can pay promptly.
This may include the offering discounts and special offer. The firms
may use some of the techniques for prompt payments like billing
devices, self-address cover with stamp and online payments.

Early Conversion of Payments into Cash

The entity must be concerned regarding the quick conversion of the
payment into cash because cash on hand is needed for business
operations and this avoids risks that the instruments used are of no
value or have no sufficient funds.

Concentration Banking
A concentration bank is a financial institution that is considered as the
primary bank of an entity or the bank where the entity does most of its
transactions. Several businesses use multiple banks, but generally deal
significantly with one bank in particular. This is a collection
procedure in which payments are made to regionally dispersed
collection centers, and deposited in local banks for quick clearing. It is
a system of decentralized billing and multiple collection points.

Lock Box System

It is a collection procedure in which payers send their payment or
cheques to a nearby post box that is cleared by the firm’s bank. Several
times that the bank deposits the cheque in the firms account. Under the
lock box system, the business entity hires a post office lock box at

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important collection centers where the customers remit payments. The

local banks are authorized to open the box and pick up the remittances
received from the customers. As a result, there is some extra savings
in mailing time compared to concentration bank.

Slow Down Cash Disbursement

Playing the Float

This is refers to the period that elapses from the time you write a check
until it clears your account, which can work to your advantage. If you
are the one disbursing the money through check, it would more
beneficial that the money would not immediately be deducted against
your account. However, as checks are increasingly cleared
electronically at the point of deposit, this float is disappearing.

Centralized Disbursement System

Hence centralized disbursement of cash system takes time for
collection from the entity’s accounts as well as they can pay on the
date. This allows the corporate headquarters’ staff to oversee each
disbursement and possibly also initiate each disbursement. It also
ensures disbursement account balance adequacy.

6.4 Receivable Management

Accounts receivable is the amount of money owed to a firm by
customers who have bought goods or services on credit. A current
asset, the accounts receivable account is also called receivables.
Receivable management is defined as the process of making decision
resulting to the investment of funds in these assets which will result in
maximizing the overall return on the investment of the firm. This also
refers to the decision that a business makes regarding to the overall
credit, collection policies and the evaluation of individual credit
applicants.

Objectives of Receivable Management

The main purpose of receivables management is to promote sales and
profit until that point is reached where the return on investment in
further funding receivables is less than the cost of funds raised to
finance that additional credit. Specifically the following are its purpose
 To evaluate the creditworthiness of customers before granting or
extending the credit.
 To minimize the cost of investment in receivables.
 To minimize the possible bad debt losses.
 To minimize the cost of running credit and collection department.

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 To maintain a tradeoff between costs and benefits associated to

credit policy.

Credit Policies

Credit policies provide the framework to determine whether or not to

extend credit to a customer and how much credit to extend. It has two
broad dimensions namely the credit standards and the credit analysis.

Credit standards represent the basic criteria for the extension of credit
to customers. The quantitative basis of establishing credit standards
are credit ratings, average payment period and financial ratios. In
deciding the credit standards, it considers factors such as collection
costs, investments in receivables or the average collection period, bad
debt expenses and sales volume

Credit analysis is the method by which one calculates

the creditworthiness of a business or organization. It is also considered
as the evaluation of the ability of a company to pay its financial
obligations. The following are the two basic steps are involved in the
credit investigation process

1. Obtaining credit information

Internal sources
Filling up of various forms
Internal records

External sources
Financial statements
Bank references
References

2. Analysis of credit information

Quantitative
Qualitative

It must be clear that the main purpose of credit analysis is to

assess the credit worthiness of the customers.

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Credit Terms

These are the terms under which goods are sold on credit are referred
as credit terms. This basically includes credit period, cash discount and
cash discount period

Credit Policies

This refers to the procedures followed to collect account receivables

when they become due after the expiry of the credit period. Their
purpose should be the speed up the collection of dues. Various steps to
collect dues from customer by firm are letter, telephone calls etc.

Activity/Excercise 6

Answer the following questions with at least 300 words in each item.
Your score here will be part of both activity and exercise grade.

1. Conduct an interview of an owner or staff of a business of any

size (sole proprietorship would be the most practical). Tell
something about their business. What are their simple ways to
manage inventory, cash and receivable? (15 pts)

If you are working, you may get data from the company where
you are employed. If you are a business owner, you can simply
describe your own working capital management.

2. Research and discuss the modern technological tools that are

being used in inventory management, cash management and
receivable management? (15 points)

3. If you are the financial manager of a business what will be your

strategies when it comes to inventory management, cash
management and receivable management? (15 points)

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Glossary
Credit Terms- these are the terms under which goods are sold on credit
are referred

Credit Policies -provide the framework to determine whether or not to

extend credit to a customer and how much credit to extend

Gross Working Capital is the general concept which determines the

working capital concept

Inventory - the raw materials, work-in-process goods and completely

finished goods that are considered to be the portion of a business's
assets which are ready or will be ready for sale.

Net Working Capital is the excess of current assets over the current
liability of the concern during a particular period

References
C. Paramasivan and T. Subramanian. (2005). “Financial
Management”, New Age International Ltd., Publishers.

Investopedia.com

J. Van Horne and J. Wachowics(2008). “Fundamentals of Financial

Management”, Pearson Education Limited.

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