Comprehensive Notes on Working Capital Management

Fundamentals of Working Capital

• Capital structure in a business concern is broadly divided into two major classifications:

  • Fixed Capital: Capital utilized for long-term investments of the business concern, such as purchasing permanent assets. It is non-recurring in nature.

  • Working Capital (Circulating Capital): Capital required to meet the day-to-day operational requirements of the business concern, such as payments to creditors, worker salaries, and purchasing raw materials. It is recurring in nature, easily converted into cash, and also known as short-term capital.

• Definitions of Working Capital:

  • Mead, Baker, and Malott: "Working Capital means Current Assets".

  • Weston and Brigham: "Working Capital refers to a firm's investment in short-term assets, cash, short-term securities, accounts receivables and inventories."

  • Shubin: "Working Capital is the amount of funds necessary to cover the cost of operating the enterprises".

  • Genestenberg: "Circulating capital means current assets of a company that are changed in the ordinary course of business from one form to another, for example, from cash to inventories, inventories to receivables, receivables to cash".

• Concepts of Working Capital:

  • Gross Working Capital (GWC): General concept representing the capital invested in the total current assets of the business concern:

$GWC = CA$

• Net Working Capital (NWC): Specific concept defined as the excess of current assets over current liabilities during a particular period:

$NWC = CA - CL$

- **Positive Working Capital**: Occurs when current assets exceed current liabilities ($CA > CL$).
- **Negative Working Capital**: Occurs when current liabilities exceed current assets ($CA < CL$).

• Components of Working Capital:

  • Current Assets ($CA$):

  • Cash in Hand

  • Cash at Bank

  • Bills Receivable

  • Sundry Debtors

  • Short-term Loans and Advances

  • Inventories

  • Prepaid Expenses

  • Accrued Income

  • Current Liabilities ($CL$):

  • Bills Payable

  • Sundry Creditors

  • Outstanding Expenses

  • Short-term Loans and Advances

  • Dividend Payable

  • Bank Overdraft

  • Provision for Taxation

Types, Needs, and Determinants of Working Capital

• Classification of Working Capital (by Time):

  • Permanent / Fixed Working Capital: Minimum amount of capital that a business concern must maintain at all times. It depends on the nature of the business and does not change with time or sales volume.

  • Temporary / Variable Working Capital: Required to meet seasonal demands and special purposes. Sub-divided into:

  • Seasonal Working Capital: Capital required to meet seasonal business needs.

  • Special Working Capital: Capital required for special exigencies, such as launching extensive marketing campaigns or conducting research.

  • Semi Variable Working Capital: Remains fixed up to a certain stage, then increases depending upon changes in sales or time.

• Purposes and Needs of Working Capital:

  • Purchase of raw materials and spares: To frequently purchase raw materials, components, and spares essential for the manufacturing process.

  • Payment of wages and salary: Periodical wage/salary payments keep employees motivated and effective.

  • Day-to-day expenses: Meeting daily operational costs such as fuel, power, and office expenses.

  • Provide credit obligations: Extending credit facilities to customers and fulfilling short-term obligations.

• Balanced Working Capital Position:

  • Maintaining a sound working capital position improves operational efficiency and financial management.

  • Causes and Effects of Excessive Working Capital:

  • Unnecessary accumulation of raw materials, components, and spares.

  • Locking up of excess funds.

  • Creation of bad debts and reduction of collection efficiency.

  • Reduction in overall profitability.

  • Causes and Effects of Inadequate Working Capital:

  • Inability to purchase raw materials in bulk orders.

  • Difficulty in implementing operating plans and achieving profit targets.

  • Impossibility of efficiently utilizing fixed assets.

  • Fall in the rate of return on investments.

  • Overall reduction in business operations.

• Factors Determining Working Capital Requirements:

  • Nature of business: Firms with rigid credit policies selling only for cash need less working capital. Transport companies maintain lower working capital, whereas construction companies require larger working capital.

  • Production cycle: Shorter production cycles require less working capital; longer production cycles require larger working capital.

  • Business cycle: Booming economic conditions increase working capital needs, while depression conditions reduce working capital needs.

  • Production policy: Continuous production policies require regular working capital, whereas situation-dependent production policies cause working capital needs to fluctuate based on set conditions.

  • Credit policy: Liberal credit collection policies increase required working capital. Paying supplier dues on the final due date preserves cash balance in hand and bank.

  • Growth and expansion: Expanding businesses require higher initial working capital for additional expenses.

  • Availability of raw materials: Unavailability leads to production stoppage; hence, securing adequate raw materials requires dedicated working capital allocation.

  • Earning capacity: High earning capacity generates internal working capital through cash flow from operations.

Estimation and Sources of Working Capital

• Methods for Computing/Estimating Working Capital:

  • Estimation of Components of Working Capital Method: Finance managers estimate the specific current assets (inventories, cash) required to meet short-term obligations over a given period.

  • Percent of Sales Method: Historical ratio between sales and working capital is used to project future working capital needs ($\text{Sales to Working Capital Ratio}$).

  • Operating Cycle Method: Measures the duration between acquiring raw materials and collecting cash from receivables.

  • Stages of the Operating Cycle:

    1. Raw Material and Storage Stage ($R$)

    2. Work in Process Stage ($W$)

    3. Finished Goods Stage ($F$)

    4. Debtors Collection Stage ($D$)

    5. Creditors Payment Period Stage ($C$)

  • Operating Cycle Formula:

$O = R + W + F + D - C$

- **Component Calculation Formulas**:

$R = \frac{\text{Average Stock of Raw Material}}{\text{Average Raw Material Consumption Per Day}}$

$W = \frac{\text{Average Work in Process Inventory}}{\text{Average Cost of Production Per Day}}$

$F = \frac{\text{Average Finished Stock Inventory}}{\text{Average Cost of Goods Sold Per Day}}$

$D = \frac{\text{Average Book Debts}}{\text{Average Credit Sales Per Day}}$

$C = \frac{\text{Average Trade Creditors}}{\text{Average Credit Purchase Per Day}}$

• Sources of Working Capital:

  • Financing Permanent / Fixed Working Capital Requirements:

  1. Shares: Issuing additional shares expands the equity base to fund long-term working capital.

  2. Debentures: Floating convertible debentures/bonds to attract investor funds.

  3. Public Deposits: Directly tied to the public reputation and image of the company.

  4. Retained Earnings: Generated by increasing profitability through cost control, managing the cash operating cycle, cost reduction, and rationalizing inventory stocks.

  5. Loans from Financial Institutions: Generally unavailable for working capital to all companies; impractical for small firms.

  • Financing Temporary Working Capital Requirements:

  1. Trade Credit: Credit extended by suppliers. Flexible and convenient, but may carry higher prices or cause loss of cash discounts.

  2. Advances: Short-term funding obtained from customers or agents against orders, particularly for long production cycles or industrial products.

  3. Commercial Banks: Tailored short-term loans provided in several forms:

     • Loans: Lump sum advanced against security; interest calculated quarterly on reduced balance; repayments stipulated in installments; term loans exceeding $1\, \text{year}$ are also available.

     • Cash Credits: Borrowing arrangement up to a specified limit against tangible assets; interest calculated daily on actual balance withdrawn.

     • Overdrafts (OD): Allows current account holders to draw beyond their balance; can be clean, partly secured, or fully secured.

     • Purchasing and Discounting of Bills: Bank advances funds against Bills of Exchange (BOE) drawn on buyers (clean or documentary with documents like railway receipts). Customer receives bill amount minus discount; acceptor pays bank at maturity; customer is liable if dishonored.

  4. Indigenous Bankers: Private moneylenders charging high interest rates; lost their market monopoly due to commercial bank development.

  5. Instalment Credit: Assets acquired with immediate possession; payments made in installments over a set period with interest charged on unpaid prices or adjusted into the purchase price.

Inventory Management Concepts and Control Techniques

• Definition and Scope:

  • Smith K.V Definition: "Working capital management is concerned with the problems that arise in attempting to manage the current asset, current liabilities and the inter-relationship that exist between them".

  • Weston and Brigham Definition: "Working capital generally stands for excess of current assets over current liabilities. Working capital management therefore refers to all aspects of the administration of both current assets and current liabilities".

  • Inventory Meaning: Stock of goods or list of goods. In accounting, it refers to finished goods; in manufacturing, it includes raw materials, work in process, and stores.

  • Inventories constitute $30\%\text{--}80\%$ of total current assets.

• Kinds of Inventories:

  • Raw Material: Unprocessed materials not yet committed to production.

  • Work in Progress (WIP): Materials committed to the production process but not yet completed.

  • Consumables: Materials required for the smooth running of the manufacturing process.

  • Finished Goods: Final completed outputs ready for consumers.

  • Spares: Small replacement parts and components.

• Objectives of Inventory Management:

  • Maintain smooth and efficient production processes.

  • Maintain optimum inventory to maximize profitability.

  • Meet seasonal product demands.

  • Avoid future price increases.

  • Ensure required quantity and site location of stock.

  • Plan purchase timing and sources.

  • Avoid both over-stocking and under-stocking.

• Techniques Based on Order Quantity:

  • Stock Levels:

  • Minimum Level: Threshold below which work stops due to material shortage.

  • Re-order Level: Fixed between minimum and maximum levels; triggers placement of a fresh order.

  • Maximum Level: Upper limit to prevent overstocking.

  • Danger Level: Below minimum level; leads to complete stoppage of production.

  • Average Stock Level Formula:

$\text{Average Stock Level} = \text{Minimum Stock Level} + \left(\frac{1}{2} \times \text{Re-order Quantity}\right)$

• Lead Time: Time taken processing and executing an order from placement to receipt of delivery.

• Safety Stock: Extra inventory held to buffer against unexpected lead times or usage rates. Determined by balancing opportunity cost (low safety stock) and carrying cost (high safety stock).

• Economic Order Quantity (EOQ): Inventory level that minimizes the total combined cost of ordering and carrying inventory:

$EOQ = \sqrt{\frac{2ab}{c}}$

- $a$ = Annual usage of inventories in units
- $b$ = Buying cost per order
- $c$ = Carrying cost per unit

• Techniques Based on Inventory Classification:

  • ABC Analysis: Divides inventory based on consumption value and volume:

  • Category A: $10\%$ of inventory items contribute to $70\%$ of consumption value.

  • Category B: $20\%$ of inventory items contribute to $20\%$ of consumption value.

  • Category C: $70\%$ of inventory items contribute to $10\%$ of consumption value.

  • Aging Schedule of Inventories (FNSD Analysis): Classifies inventory by holding period to evaluate movement for disposal decisions:

  • $F$ = Fast moving inventories

  • $N$ = Normal moving inventories

  • $S$ = Slow moving inventories

  • $D$ = Dead moving inventories

  • VED Analysis: Applied to spare parts based on operational usage criticality:

  • $V$ = Vital items

  • $E$ = Essential items

  • $D$ = Desirable items

  • HML Analysis: Classifies items based on unit cost/value:

  • $H$ = High value

  • $M$ = Medium value

  • $L$ = Low value

• Techniques Based on Records:

  • Inventory Budget: Functional budget estimating required inventory for a period based on historical data.

  • Inventory Reports: Periodical reports detailing order levels, procurement quantities, and inventory status to support managerial decisions.

• Methods of Inventory Valuation:

  1. First in First Out Method (FIFO)

  2. Last in First Out Method (LIFO)

  3. Highest in First Out Method (HIFO)

  4. Nearest in First Out Method (NIFO)

  5. Average Price Method

  6. Base Stock Method

  7. Standard Price Method

  8. Market Price Method

Cash Management Strategies and Analytical Models

• Definition: Cash includes coins, currency, held cheques, and bank account balances available for immediate disbursement without restriction.

• Motives for Holding Cash:

  1. Transaction Motive: Meeting routine cash obligations (raw material purchases, expenses, taxes, dividends).

  2. Precautionary Motive: Cash cushion for unexpected contingencies (floods, strikes).

  3. Speculative Motive: Taking quick advantage of non-routine business opportunities (discounted raw materials, favorable market prices).

  4. Compensating Motive: Maintaining bank balances to compensate financial institutions for services (cheque clearance, fund transfers) or credit facilities.

• Cash Collection and Disbursement Strategies:

  • Speedy Cash Collections:

  • Prompt Payment by Customers: Offering cash discounts, special offers, billing devices, and self-addressed stamped envelopes.

  • Early Conversion into Cash: Reducing postal float, processing float, bank float, and deposit float.

  • Concentration Banking: Decentralized billing and multiple collection points where payments are deposited into local regional banks for rapid clearing.

  • Lock Box System: Payers send cheques to a local post office box accessed directly by the bank multiple times daily, eliminating internal processing float and saving mailing time compared to concentration banking.

  • Slowing Disbursement:

  • Avoiding early payment: Retaining cash by paying suppliers on the precise final due date.

  • Centralised disbursement system: Centralizing disbursements prolongs cheque collection time while maintaining punctuality.

• Cash Management Models:

  • Baumol Model:

  • Determines the optimal cash conversion size under certain cash demand conditions to minimize total transaction and opportunity costs.

  • Total Conversion Cost Formula:

$\text{Total Conversion Cost} = \frac{T \times b}{C}$

  - $T$ = Total transaction cash needs for the period
  - $b$ = Cost per conversion
  - $C$ = Value of marketable securities
- **Opportunity Cost Formula**:

$\text{Opportunity Cost} = \left(\frac{C}{2}\right) \times i$

  - $i$ = Interest rate earned
  - $\frac{C}{2}$ = Average cash balance
- **Optimal Cash Conversion Formula**:

$C = \sqrt{\frac{2bT}{i}}$

  - $C$ = Optimal conversion amount
  - $b$ = Cost of conversion per transaction
  - $T$ = Projected cash requirement
  - $i$ = Interest rate earned

• Miller-Orr Model:

  • Determines optimal cash balance levels under stochastic/fluctuating daily cash flows to minimize total cash management costs:

$C = \frac{b \times E(N)}{t} + i \times E(M)$

  - $C$ = Total cost of cash management
  - $b$ = Fixed cost per conversion
  - $E(N)$ = Expected number of conversions
  - $t$ = Number of days in the period
  - $i$ = Lost opportunity cost
  - $E(M)$ = Expected average daily cash balance

• Orgler's Model:

  • Integrates cash management with production and operational aspects using multiple linear programming based on specified firm objectives and constraints.

Receivables Management, Credit Evaluation, and Practice Problems

• Definition & Objectives:

  • Receivables: Debts owed to the firm by customers arising from credit sales of goods/services in the ordinary course of business (Account Receivables or Bills Receivables).

  • Objective: Maximize sales and profit up to the point where the return on additional investment in receivables equals or exceeds the cost of funds required to finance the credit.

• Costs Associated with Receivables:

  • Collection Cost: Incurred in collecting dues from credit customers.

  • Capital Cost: Opportunity cost or interest paid on capital tied up in supporting credit sales.

  • Administrative Cost: Operational overheads such as accounting staff salaries and credit investigation expenses.

  • Default Cost: Bad debt losses resulting from uncollectible overdue accounts due to customer insolvency.

• Factors Determining Size of Receivables:

  1. Sales Level

  2. Credit Policy (Liberal increases sales and receivables; Stringent decreases receivables)

  3. Credit Terms

  4. Credit Period (expressed in "Net days")

  5. Cash Discount incentives

  6. Systemic Receivables Management practices

• Aging Schedule:

  • Analysis statement evaluating debtor quality across comparative time periods (typically broken into $30\, \text{day}$ intervals: $0\text{--}30\, \text{days}$, $31\text{--}60\, \text{days}$, $61\text{--}90\, \text{days}$, $91\text{--}120\, \text{days}$) to track percentage defaults against historical performance.

• Credit Evaluation and Control (The "5 Cs"):

  • Character: Moral integrity, honesty, and promptness of the customer in fulfilling obligations.

  • Capacity: Ability of the customer to pay, evaluated via business dealings, history, possessions, and managerial competency.

  • Capital: Financial soundness evaluated via audited financial statements.

  • Collateral: Assets or securities pledged to secure credit.

  • Condition: Prevailing economic climate influencing industry performance.

• Credit Control Policies:

  • Credit Period: Kept as short as possible to maintain regular synchronized cash inflows.

  • Collection Policy: Short collection periods backed by regular debtor classification schedules and swift follow-ups.

  • Discounts: Prompt payment incentive; note that administrative surveys indicate discounts can create calculation errors, wrong deductions, and cumbersome processing.

• Working Capital Practice Problems:

  • Problem 1:

  • Projected annual sales: $1{,}00{,}000\, \text{units}$

  • Selling price per unit: $\text{Rs. } 8\, \text{PU}$

  • Profits on sales: $25\%$

  • Average credit period allowed to customers: $8\, \text{weeks}$

  • Average credit period allowed by suppliers: $4\, \text{weeks}$

  • Average stock holding in terms of sales requirements: $12\, \text{weeks}$

  • Allowance for contingencies: $10\%$

  • Problem 2:

  • Projected annual sales: $1{,}20{,}000\, \text{units}$

  • Selling price per unit: $\text{Rs. } 10\, \text{per unit}$

  • Percentage net profit on sales: $30\%$

  • Average credit period allowed to customers: $10\, \text{weeks}$

  • Average credit period allowed by suppliers: $5\, \text{weeks}$

  • Average stock holding in terms of sales requirements: $5\, \text{weeks}$

  • Allowance for contingencies: $15\%$

  • Problem 3:

  • Projected annual sales: $80{,}000\, \text{units}$

  • Selling price per unit: $\text{Rs. } 8\, \text{per unit}$

  • Percentage net profit on sales: $20\%$

  • Average credit period allowed to customers: $10\, \text{weeks}$

  • Average credit period allowed by suppliers: $8\, \text{weeks}$

  • Average stock holding in terms of sales requirements: $10\, \text{weeks}$

  • Allowance for contingencies: $20\%$

  • Problem 4:

  • X Co. is desirous to purchase a business and has consulted you to advise them on the requirements of working capital for the first year.