module 3 working capital mgt.ppt

Module 3
Working Capital Management
 Concept of Working Capital
 Need for working capital
 Source-estimation of working capital management,
 Receivable Management
 Inventory management

Introduction
 Cash is the lifeline of a company.
 Companies need enough cash to pay wages, salaries, a/c
payables.
 Maintaining sufficient liquidity and adequate working
capital is a must to ensure the survival of the business in
the short term and long-term as well.
 Even a profitable business may fail if it does not have
adequate cash flow to meet its liabilities as they fall due.
 Understanding a company's cash flow health is essential to
making investment decisions.
 A good way to judge a company's cash flow prospects is to
look at its working capital management (WCM).
 So, working capital management has become very
essential part of business concerns.

Look at these few cases
 A magi sauce company uses $100 to build up its inventory of tomatoes, onions, garlic, spices, etc. A week
later, the company assembles the ingredients into sauce and ships it out. A week after the checks arrive
from customers. That $100, which has been tied up for two weeks, is the company's working capital. The
quicker the company sells the magi sauce, the quicker the company can go out and buy new ingredients,
which will be made into more sauce sold at a profit. If the ingredients sit in inventory for a month, company
cash stays tied-up and can't be used to grow the magi business. Even worse, the company can be left
strapped for cash when it needs to pay its bills and make investments. Working capital also gets trapped
when customers do not pay their invoices on time or suppliers get paid too quickly or not fast enough.
The better a company manages its working capital, the less the company needs to borrow. Even companies
with cash surpluses need to manage working capital to ensure that those surpluses are invested in ways that
will generate suitable returns for investors.
Not All Companies Are the Same
Some companies are inherently better placed than others. Insurance companies, for instance, receive
premium payments up front before having to make any payments; however, insurance companies do have
unpredictable outgoings as claims come in.
Normally a big retailer like Wal-Mart has little to worry about when it comes to accounts receivable:
customers pay for goods on the spot. Inventories represent the biggest problem for retailers, who must
perform rigorous inventory forecasting or they risk being out of business in a short time.
Manufacturing companies, for example, incur substantial up-front costs for materials and labor before
receiving payment. Much of the time they eat more cash than they generate.

Concepts of Working Capital
 Working Capital: refers to a company’s Current
Assets
 Current Assets: Cash and Equivalents, Accounts
Receivable, and Inventory
 Gross Working Capital : Gross working capital is
the total investment made in current assets.
 Net Working Capital: Net working capital is the
difference between current assets and current
liabilities.
 Working Capital Management: The deployment of
current assets and current liabilities efficiently so
as to maximize short-term liquidity

Meaning & Definition of Working
Capital
 Working capital refers to the cash a business requires for day-to-day
operations, or, more specifically, for financing the conversion of raw
materials into finished goods, which the company sells for payment.
 Working capital may be defined by various authors as follows:
“Working capital refers to a firm’s investment in short term assets, such
as cash, accounts receivables, inventories etc. - Weston & Brigham
“ Working capital means current assets.” - Mead, Baker and Malott
“The sum of the current assets is the working capital of the business” -
- J.S.Mill
 So, the working capital management refers to the management of
the level of all these individual current assets.

Need for Working Capital
 The need for working capital management
arises from two considerations;
1. Existence of working capital is imperative in
any firm
(Fixed assets can be used to its optimum level
only if supported by sufficient working capital)
2. Working capital involves investment of funds of
the firm.

Investment Decision Applied
to Current Assets
 What current assets to own?
 What level of each item the firm should
have.?
 How much cash?
 How much accounts receivable?
 How much inventory is needed?

Financing Decision Applied to
Current Assets
 How to finance current assets?
– For most firms, CA exceed CL
– Therefore, part of CA is being financed by
long-term sources (debt or equity)
 How is financing of CA split between short-
term sources (CL) and long-term sources (
long-term debt and equity)?

Tradeoffs in Working Capital
Management
In making the investment and financing
decision for current assets, the finance
manager has to do tradeoff between
liquidity & Profitability.
 Liquidity: Ability to pay bills, keep sales
coming in, keep customers happy, play it
safe
 Profitability: Size of earnings after taxes

Classification of Working Capital

Classifying Current Assets
 Permanent Current Assets = minimum level
of cash, A/R, and inventory needed to stay
in business (PCA)
 Temporary Current Assets = fluctuations in
cash, A/R, and inventory corresponding to
fluctuations in sales (TCA)

Matching Principle of WCM
Fixed Assets
Permanent Current Assets
Total Assets
Fluctuating Current Assets
Time
$
Short-term
Debt
Long-term
Debt +
Equity
Capital

OBJECTIVE OF WORKING CAPITAL MANAGEMENT
(i) Maintenance of working capital at appropriate
level, and
(ii) Availability of ample funds as and when they are
needed.

Factors affecting composition of
Working Capital
 Nature of Business
 Nature of material
 Process technology
 Nature of finished goods
 Degree of competition in the market
 Size of business
 Time of production
 Rate of stock turnover
 Buying and selling terms
 Seasonal consumption
 Seasonal production

Method of Estimating working
capital
Conventional Method:
 Matching of Cash Inflows & Outflows. This method ignores Time Value of
Money
Operating Cycle Method:
 Debtors + Stock (RM/WIP/FG) - Creditors. This method takes into Account
length of Time which is required to convert cash into resources, resources
to final product, final product to Debtors and Debtors to Cash again.
Cash Cost Technique:
 Working Capital forecast is done on Cost Basis (i.e. taking P&L items into
account)
Balance Sheet Method:
 Working Capital forecast is done on various Assets & Liabilities (i.e. taking
B/S items into account)

Inter dependence among component of Working
Capital

Working Capital Cycle / OPERATING CYCLE
 Operating cycle: The time period from the acquisition of
inventory until cash is collected from sale of the product.
 Components of Operating Cycle
– Raw Material Storage Period
– Conversion Period
– Finished Goods Storage Period
– Average Collection Period
– Average Payment Period

THE WORKING CAPITAL
CYCLE
(OPERATING CYCLE)
Accounts Payable
Cash
Raw
Materials
W I P
Finished
Goods
Value Addition
Accounts
Receivable
SALES

OPERATING CYCLE
 Gross Operating Cycle = Raw material Storage period +
Conversion period + Finished goods storage period +
Average collection period
 Net Operating Cycle = Gross Operating Cycle – Average
Payment Period

RAW MATERIAL STORAGE PERIOD
 Raw Material Storage Period =
where,
 Average stock of raw materials =
 and Average daily consumption of raw materials =
n
comsumptio
material
raw
daily
Average
materials
raw
of
stock
Average
2
materials
raw
of
stock
Closing
materials
raw
of
Stock
Opening 
360
materials
raw
of
n
consumptio
Annual

CONVERSION PERIOD
 Conversion Period =
where,
 Average stock of work-in-process =
 Average Daily cost of production =
production
of
cost
daily
Average
process
-
in
-
work
of
Stock
Average
2
process
-
in
-
work
of
stock
Closing
process
-
in
-
work
of
Stock
Opening 
360
production
of
cost
Annual

FINISHED GOODS STORAGE PERIOD
 Finished Goods Storage Period =
where,
 Average stock of finished goods =
 and Average daily cost of sales =
sales
of
cost
daily
Average
goods
finished
of
stock
Average
2
goods
finished
of
stock
Closing
goods
finished
of
stock
Opening 
360
sales
of
cost
Annual

AVERAGE COLLECTION PERIOD
 Average Collection Period =
where,
 Average balance of sundry debtors =
 and Average daily credit sales of the company =
sales
credit
daily
Average
debtors
sundry
of
balance
Average
2
receivable
accounts
of
balance
Closing
receivable
accounts
of
balance
Opening 
360
sales
credit
Annual

AVERAGE PAYMENT PERIOD
 Average Payment Period =
where,
 Average balance of sundry creditors =
 and Average daily credit purchases made by the company =
purchases
credit
daily
Average
creditors
sundry
of
balance
Average
2
payable
accounts
of
balance
Closing
payable
accounts
of
balance
Opening 
360
purchases
credit
Annual

Receivable Management
 Meaning of Receivable: It is amount/Debt which is receivable
for the goods or services provided on credit.
 It is also know as Trade, Debtors, sundry Debtors, Book Debts
 Receivable originate only on account of credit sales.
Objectives of Receivable:
•Increase Sales
•Increase in Profit (Volume Increase & Margin Increase)
•Strategy to Face Competition

Meaning of Receivable
Management
 Receivable Management refer to maintaining of
Receivables at a level at which there is a trade off
between profitability & cost.
 Receivable Management covers 3 Aspects
– Establishing Credit Policy
– Establishing Collection Policy
– Control of Account Receivables

Inventory Management
 Meaning of Inventory: means Tangible Property which is held for
sale in the ordinary course of business or
 In the process of production (WIP) for sale or
 For consumption in the production of goods and service
 Inventory includes Raw material, FG, WIP, Spares,
Consumables
Inventory Management
Maintaining inventory in the optimum level is know as
Inventory management

module 3 working capital mgt.ppt

module 3 working capital mgt.ppt

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module 3 working capital mgt.ppt