Principles of Working

Capital Management
Topics
 Concept of working capital
 Operating and cash conversion cycle
 Permanent and variable working capital
 Balanced working capital
 Determinants of working capital
 Issues I working capital management
 Estimating working capital
 Policies of working capital finance

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Concepts of Working Capital
 Gross working capital (GWC)
GWC refers to the firm’s total investment in
current assets.
Current assets are the assets which can be
converted into cash within an accounting
year (or operating cycle) and include cash,
short-term securities, debtors, (accounts
receivable or book debts) bills receivable
and stock (inventory).

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Concepts of Working Capital
 Net working capital (NWC).
 NWC refers to the difference between current
assets and current liabilities.
 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.
 NWC can be positive or negative.
 Positive NWC = CA > CL
 Negative NWC = CA < CL
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 It is a conventional rule to maintain the level
of current assets twice the level of current
liabilities.
 A weal liquidity position poses a threat to the
solvency of the company and makes it unsafe
and unsound.

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Concepts of Working Capital
 GWC focuses on
 Optimisation of investment in current

 Financing of current assets

 NWC focuses on
 Liquidity position of the firm
 Judicious mix of short-term and long-tern financing

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Operating Cycle
 Operating cycle is the time duration required
to convert sales, after the conversion of
resources into inventories, into cash. 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-in-progress into finished goods.
 Sale of the product either for cash or on credit. Credit sales
create account receivable for collection.

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 The length of the operating cycle of a
manufacturing firm is the sum of:
 inventory conversion period (ICP).
 Debtors (receivable) conversion period
(DCP).

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 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)

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 The debtors conversion period is the time
required to collect the outstanding amount
from the customers.

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 Creditors or payables deferral period
(CDP) is the length of time the firm is able to
defer payments on various resource
purchases.

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 Gross operating cycle (GOC)
The total of inventory conversion period and debtors
conversion period is referred to as gross operating
cycle (GOC).
 Net operating cycle (NOC)
NOC is the difference between GOC and CDP.
 Cash conversion cycle (CCC)
CCC is the difference between NOP and non-cash
items like depreciation.

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GROSS OPERATING CYCLE
 Gross Operating Cycle= Inventory
Conversion Period+ Debtor Conversion
Period.

 GOC= ICP+ DCP

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Inventory Conversion Period
 Inventory Conversion Period is the sum of
raw material conversion period, work-in-
process conversion period and finished
goods conversion period.

 ICP= RMCP+ WIPCP+ FGCP

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 RMCP= Raw Material Conversion Inventory
(Raw Material Consumption)/360

 WIPCP= Work-in-process Inventory

 FGCP= Finished Goods Inventory

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Debtor Conversion Period= Debtor
Credit Sale/360

Creditor Deferral Period= Creditors

Net Operating Cycle= (Gross Operating Cycle-

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 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.

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Dangers Of Excessive working
capital
 It results in unnecessary accumulation of
Inventory.( waste, theft etc)
 Indication of Defective credit policies.
 Shows managerial Inefficiency.

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Dangers of Inadequate Working
Capital:
 It stagnates growth.
 It becomes difficult to implement operating plans
and achieve the firm’s profit target.
 Fixed assets are not efficiently utilised
 Paucity of working capital funds render the firm
unable to avail attractive credit opportunities etc.
 Firm looses its reputation when not able to
honour its short-term obligations.

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Determinants of Working Capital
 Nature of business
 Market and demand
 Technology and manufacturing policy
 Credit policy
 Supplies’ credit
 Operating efficiency
 Inflation

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Issues in Working Capital Management
 Levels of current assets
 Current assets to fixed assets
 Liquidity Vs. profitability
 Cost trade-off

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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.
 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.
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Working Capital Finance Policies
 Long-term  Short-term Vs.
 Short-term Long-term
 Spontaneous financing
 Cost
 Flexibility
 Risk

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Working Capital Finance Policies
 Matching
 Conservative
 Aggressive

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