CH - 27 - Working Capital Management

CHAPTE PRINCIPLES OF WORKING CAPITAL
R 27 MANAGEMENT
Syllabus topics
2
LEARNING OBJECTIVES
3
 Underline the need for investing in current assets, and

elaborate the concept of operating cycle
 Highlight the necessity of managing current assets and
current liabilities
 Explain current asset investment and financing
 Focus on the proper mix of short-term and long-term
financing for current assets
Difference in the management of
4
fixed assets and current assets
 First, in managing fixed assets, time is a very important factor;
consequently, discounting and compounding techniques play a
significant role in capital budgeting and a minor one in the
management of current assets.
 Second, the large holding of current assets, reduces the overall
profitability. Thus, a risk-return trade-off is involved in holding
current assets.
 Third, levels of fixed as well as current assets depend upon
expected sales, but it is only the current assets which can be
adjusted with sales fluctuations in the short run. Thus, the firm
has a greater degree of flexibility in managing current assets.
Concepts of Working Capital
5
 (GWC) Gross working capital = Current Assets
 (NWC) Net working capital= Current assets- Current liabilities
 Operating Cycle
6
 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).
7
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
8
 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
Operating Cycle
9
 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.
Operating Cycle in diagram
10
Cont…
11
 The length of the operating cycle of a manufacturing

firm is the sum of:
1) Inventory conversion period (ICP).
2) Debtors (receivable) conversion period (DCP).
Operating cycle= ICP + DCP

Cont…
12
Operating cycle of a manufacturing firm

Gross Operating Cycle (GOC)
13
 The firm’s gross operating cycle (GOC) can be

determined as inventory conversion period (ICP)
plus debtors conversion period (DCP). Thus, GOC
is given as follows:
Inventory conversion period
14
 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)
Debtors (receivables) conversion
15
period (DCP)
 Debtors conversion period (DCP) is the average
time taken to convert debtors into cash. DCP
represents the average collection period. It is
calculated as follows:
Creditors (payables) deferral period
16
(CDP)
 Creditors(payables) deferral period (CDP) is the
average time taken by the firm in paying its
suppliers (creditors). CDP is given as follows:
Cash Conversion or Net
17
Operating Cycle
 Netoperating cycle (NOC) is the difference between
gross operating cycle and payables deferral period.
 Netoperating cycle is also referred to as cash

conversion cycle.
PERMANENT AND VARIABLE
WORKING CAPITAL
18
 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.
19
Permanent and temporary working capital

Determinants of Working
20
Capital
1. Nature of business
2. Market and demand (policy of level of production)
3. Technology and manufacturing policy (ICP)
4. Credit policy (rationed c.p. based on credit standing)
5. Supplies’ credit
6. Operating efficiency (optimum utilization of all resources)
7. Price level changes
Issues in Working Capital
Management
21
 Current Assets to Fixed Assets Ratio

 Liquidity vs. Profitability: Risk–Return Trade-off
 The Cost Trade-off
Alternative current asset policies Cost Trade-off

Estimating Working capital
22
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.
Working Capital Finance
23
Policies
 Long-term
 Short-term (banks, money market, commercial paper, factoring of
receivables etc.)
 Spontaneous (trade credit, o/s expenses)
Working Capital Finance
24
Policies
 Matching Approach
 Conservative Approach
 Aggressive Approach
Matching Approach
25
Financing under matching plan

Conservative Approach
26
Conservative financing
Aggressive Approach
27
Aggressive financing
Short-term vs. Long-term
Financing:
28 A Risk-Return Trade-off
 Cost
 Flexibility
 Risk
 Risk-return trade-off

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CHAPTE PRINCIPLES OF WORKING CAPITAL

 Underline the need for investing in current assets, and

 (GWC) Gross working capital = Current Assets

 (NWC) Net working capital= Current assets- Current liabilities

 Gross working capital (GWC)

Net working capital (NWC)

 Operating cycle is the time duration required to convert

 The length of the operating cycle of a manufacturing

Operating cycle= ICP + DCP

Operating cycle of a manufacturing firm

 The firm’s gross operating cycle (GOC) can be

 Inventory conversion period is the total time

 Netoperating cycle is also referred to as cash

 Permanent or fixed working capital

Permanent and temporary working capital

 Current Assets to Fixed Assets Ratio

Alternative current asset policies Cost Trade-off

Current assets holding period

Ratio of fixed investment

Financing under matching plan

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