Chapter 03 working capital 1ce lecture

Khursheed Ahmad Bhat, HOD. Department of Hospital Administration TMU
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Chapter 3 – Outline (1)
• Working Capital Basics
 Working Capital and the Current Accounts
 Working Capital and Funding Requirements
 Objective of Working Capital Management
 Working Capital Trade-offs
 Operations—The Cash Conversion Cycle
 The Operating Cycle and the Cash Conversion Cycle

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Chapter 3 – Outline (2)
 Permanent and Temporary Working Capital
 Maturity Matching Principle
 Financing Net working Capital
 Short-Term vs. Long-Term Financing
 Working Capital Policy

• Working capital typically means the firm’s holding of current or
short-term assets such as cash, receivables, inventory and marketable
securities.
• These items are also referred to as circulating capital
• Corporate executives devote a considerable amount of attention to the
management of working capital.
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Working capital Introduction

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Working Capital Basics
• Working Capital
 Assets/liabilities required to operate business on day-to-
day basis
• Cash
• Accounts Receivable
• Inventory
• Accounts Payable
• Accruals
 Short-term in nature—turn over regularly

Concepts of Working Capital
• There are two possible interpretations of working capital
concept:
1. Balance sheet concept
2. Operating cycle concept
Balance sheet concept
There are two interpretations of working capital under the
balance sheet concept.
a. Excess of current assets over current liabilities.(CA-CL)
b. Gross or total current assets.(Fixed Assets + Current Assets)
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Working Capital and the Current Accounts
• Gross working capital = Current assets
 Gross Working Capital (GWC) represents investment in
current assets
• (Net) working capital =
Current assets – Current liabilities

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Working Capital and Funding
Requirements
• Spontaneous Financing
 Firm will also always have minimum level of Accounts
Payable—in effect, money you have borrowed
• Accounts Payable (and Accruals) are generated spontaneously
• Arise automatically with inventory and expenses
• Offset the funding required to support current assets

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Requirements
• Working Capital Requires Funds
 Maintaining working capital balance requires permanent
commitment of funds
• Example: Firm will always have minimum level of Inventory,
Accounts Receivable, and Cash—this requires funding

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Requirements
• Net working capital is Gross Working Capital –
Current Liabilities (including spontaneous
financing)
 Reflects net amount of funds needed to support routine
operations

Concepts Continues 2
• Excess of current assets over current liabilities are called the net
working capital or net current assets.
• Working capital is really what a part of long term finance is locked in
and used for supporting current activities.
• The balance sheet definition of working capital is meaningful only as
an indication of the firm’s current solvency in repaying its creditors.
• When firms speak of shortage of working capital they in fact possibly
imply scarcity of cash resources.
• In fund flow analysis an increase in working capital, as conventionally
defined, represents employment or application of funds.
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• Operating cycle concept
• A company’s operating cycle typically consists of three primary
activities:
 Purchasing resources,
 Producing the product and
 Distributing (selling) the product.
These activities create funds flows that are both unsynchronized and
uncertain.
Unsynchronized because cash disbursements (for example, payments for
resource purchases) usually take place before cash receipts (for example
collection of receivables).
They are uncertain because future sales and costs, which generate the respective
receipts and disbursements, cannot be forecasted with complete accuracy.

“ circulating capital means current assets of a company that
are changed in the ordinary course of business from one
form to another, as for example, from cash to inventories,
inventories to receivables, receivable to cash”
Genestenbreg
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Objective of Working Capital Management
• To run firm efficiently with as little money as
possible tied up in Working Capital
 Involves trade-offs between easier operation and cost of
carrying short-term assets
• Benefit of low working capital
• Money otherwise tied up in current assets can be invested in activities
that generate higher payoff
• Reduces need for costly financing
• Cost of low working capital
• Risk of shortages in cash, inventory

Figure 3.1: Types Of Working Capital
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•WORKING CAPITAL
•BASIS OF
CONCEPT
•BASIS OF
TIME
•Gross
Working
Capital
•Net
Working
Capital
•Permanen
t / Fixed
WC
•Temporar
y / Variable
WC
•Regular
WC
•Reserve
WC
•Seasonal
WC
•Special
WC

Figure 3.2: Operating cycle of a typical
company
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•Payable
•Deferral period
•Inventory conversion
•period
•Cash conversion
•cycle
•Operating
•cycle
•Pay for
•Resources
•purchases
•Purchase
•resources
•Sell
•Product
•On credit
•Receivable
•Conversion period

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Working Capital Trade-offs
Inventory
High Levels Low Levels
Benefit:
• Happy customers
• Few production delays (always have needed
parts on hand)
Cost:
• Expensive
• High storage costs
• Risk of obsolescence
Cost:
• Shortages
• Dissatisfied customers
Benefit:
• Low storage costs
• Less risk of obsolescence
Cash
Benefit:
• Reduces risk
Cost:
• Increases financing costs
Benefit:
• Reduces financing costs
Cost:
• Increases risk

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Accounts Receivable
High Levels (favourable credit terms) Low Levels (unfavourable
terms)
Benefit:
• Happy customers
• High sales
Cost:
• Expensive
• High collection costs
• Increases financing costs
Cost:
• Dissatisfied customers
• Lower Sales
Benefit:
• Less expensive
Accounts Payable and Accruals
Benefit:
• Reduces need for external finance--using a
spontaneous financing source
Cost:
• Unhappy suppliers
Benefit:
• Happy suppliers/employees
Cost:
• Not using a spontaneous
financing source

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Current Assets High Level Low Level
Profitability Lower Higher
Risk Lower Higher

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Operations—The Cash Conversion Cycle
• Firm begins with cash which then “becomes”
inventory and labour
 Which then becomes product for sale
 Eventually this will turn into cash again
• Firm’s operating cycle is time from acquisition of
inventory until cash is collected from product sales

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Figure 3.3: The Cash Conversion Cycle
Product is
converted into
cash, which is
transformed into
more product,
creating the cash
conversion cycle.

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Figure 3.4: Time Line Representation
of the Cash Conversion Cycle

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The Operating Cycle and the Cash
Conversion Cycle
Inventory conversion period
plus: Receivable collection period
equals: Operating cycle
minus: Payables deferral period
equals: Cash conversion cycle
• Shortening cash conversion cycle frees up cash to reinvest
in business or to reduce debt and interest

Cash Conversion Cycle Analysis
• Inventory conversion period = Avg. inventory
Cost of sales/365
• Receivable conversion period =Accounts receivable
Annual credit sales/365
• Payables deferral period =Accounts payable + Salaries, etc
(Cost of sales + selling, general and admn. Expenses)/365
• Cash conversion cycle = operating cycle – payables deferral period.
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Cash Conversion Cycle
Purchase
Inventory
Pay for
Inventory
Sell Inventory
on Credit
Collect
Receivables
Operating Cycle
Inventory Conversion Period
Receivables Collection Period
Payables Deferral Period
Cash Conversion Cycle

Importance of working capital
• Importance of working capital
 Risk and uncertainty involved in managing the cash flows
 Uncertainty in demand and supply of goods, escalation in cost both
operating and financing costs.
• Strategies to overcome the problem
 Manage working capital investment or financing such as
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Importance of working capital
 Holding additional cash balances beyond expected needs
 Holding a reserve of short term marketable securities
 Arrange for availability of additional short-term borrowing
capacity
 One of the ways to address the problem of fixed set-up cost may be
to hold inventory.
 One or combination of the above strategies will target the problem
• Working capital cycle is the life-blood of the firm
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Figure 3.5:
Resource flows for a manufacturing firm
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•Fixed
•Assets
•Production
•Process
•Generates
•Inventory
•Accounts
•receivable
•Used in
•Accrued
Direct
•Labour
and
•materials
•Accrued Fixed
•Operating
•expenses
•Cash and
•Marketable
•Securities
•Suppliers
•Of Capital
•External Financing
•Return on Capital
•Collection
•process
•Used to
•purchase
•Used to
•purchase
•Used in
•Working
•Capital
•cycle

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Figure 3.6:
Working Capital Needs of Different Firms

Three alternative working capital
investment policies
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•Sales ($)
•Current
Assets($)
•Policy C
•Policy A
•Policy B

Three alternative working capital
investment policies-2
• Policy C represents conservative approach
• Policy A represents aggressive approach
• Policy B represents a moderate approach
• Optimal level of working capital investment
• Risk of long-term versus short-term debt
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Permanent and Temporary Working Capital
• Working capital is permanent to the extent that it
supports constant or minimum level of sales
• Temporary working capital supports seasonal
peaks in business

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•Amount Variable Working Capital
•of
•Working
•Capital
• Permanent Working Capital
Time
•
Difference between permanent &
temporary working capital

Difference between permanent &
temporary working capital-2
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Variable Working Capital
•
•Amount
•of
•Working
•Capital
• Permanent Working Capital
•
• Time
•

Financing needs over time
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•Fixed Assets
•Permanent Current Assets
•Total Assets
•Fluctuating Current Assets
•Time
•$

Matching approach to asset financing
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•Fixed Assets
•Total Assets
•Time
•$
•Short-term
•Debt
•Long-term
•Debt +
•Equity
•Capital

Conservative approach to asset financing
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•Fixed Assets
•Total Assets
•Time
•$
•Short-term
•Debt
•Long-term
•Debt +
•Equity
• capital

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•Fixed Assets
•Total Assets
•Time
•$
•Short-term
•Debt
•Long-term
•Debt +
•Equity
• capital
Aggressive approach to asset financing

FACTORS DETERMINING WORKING CAPITAL
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1. Nature of the Industry
2. Demand of Industry
3. Cash requirements
4. Nature of the Business
5. Manufacturing time
6. Volume of Sales
7. Terms of Purchase and Sales
8. Inventory Turnover
9. Business Turnover
10. Business Cycle
11. Current Assets requirements
12. Production Cycle
•13. Credit control
14. Inflation or Price level changes
15. Profit planning and control
16. Repayment ability
17. Cash reserves
18. Operation efficiency
19. Change in Technology
20. Firm’s finance and dividend policy
21. Attitude towards Risk

EXCESS OR INADEQUATE WORKING CAPITAL
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Every business concern should have adequate working capital to run
its business operations. It should have neither redundant or excess
working capital nor inadequate or shortage of working capital.
Both excess as well as shortage of working capital situations are bad
for any business. However, out of the two, inadequacy or shortage of
working capital is more dangerous from the point of view of the
firm.

Disadvantages of Redundant or Excess
Working Capital
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Idle funds, non-profitable for business, poor ROI
Unnecessary purchasing & accumulation of inventories
over required level
Excessive debtors and defective credit policy, higher
incidence of B/D.
Overall inefficiency in the organization.
When there is excessive working capital, Credit worthiness
suffers
Due to low rate of return on investments, the market value
of shares may fall

Disadvantages of Inadequate Working
Capital
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 Can’t pay off its short-term liabilities in time.
 Economies of scale are not possible.
 Difficult for the firm to exploit favourable market situations
 Day-to-day liquidity worsens
 Improper utilization the fixed assets and ROA/ROI falls sharply

Management Of Working Capital ( WCM )
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Management of working capital is concerned with the problems
that arise in attempting to manage the current assets, the current
liabilities and the inter-relationship that exists between them. In
other words, it refers to all aspects of administration of CA and
CL.
Working Capital Management Policies of a firm have a great
effect on its profitability, liquidity and structural health of the
organization.

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3D Nature of Working Capital Management
•Dimension I
•Profitability,
•Risk, & Liquidity

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Principles Of Working Capital
Management
•PRINCIPLES OF
WORKING CAPITAL
MANAGEMENT
•Principle
of Risk
Variation
•Principle
of Cost of
Capital
•Principle
of Equity
Position
•Principle of
Maturity of
Payment

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Maturity Matching Principle
• Maturity (due date) of financing should roughly
match duration (life) of asset being financed
 Then financing /asset combination becomes self-
liquidating
• Cash inflows from asset can be used to pay off loan

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Financing Net Working Capital
• According to maturity matching principle
 Temporary (seasonal) should be financed with short-
term borrowing
 Permanent working capital should be financed with
long-term sources, such as long-term debt and/or equity
• In practice, firms may use more or less short-term
funds to finance working capital

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Figure 3.7(a):
Working Capital Financing Policies

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Figure 3.7(b):
Working Capital Financing Policies

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Short-Term vs. Long-Term Financing
• The mix of short- or long-term working capital
financing is a matter of policy
 Use of long-term funds is a conservative policy
 Use of short-term funds is an aggressive policy

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• Short-term financing
 Cheap but risky
• Cheap—short-term rates generally lower than long-term rates
• Risky—because you are continually entering marketplace to
borrow
• Borrower will face changing conditions (ex; higher interest rates and
tight money)

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• Long-term financing
 Safe but expensive
• Safe—you can secure the required capital
• Expensive—long-term rates generally higher than short-term
rates

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Working Capital Policy
• Firm must set policy on following issues:
 How much working capital is used
 Extent to which working capital is supported by short-
vs. long-term financing
 How each component of working capital is managed
 The nature/source of any short-term financing used

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Chapter 03 working capital 1ce lecture

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