principles of working capital

8/8/2019 Principles of Working Capital

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Principles of WorkingCapital Management


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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 firms 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, (accountsreceivable or book debts) bills receivable

and stock (inventory).


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Net working capital (NWC).

NWC refers to the difference between currentassets and current liabilities.

Current liabilities (CL) are those claims ofoutsiders which are expected to mature forpayment within an accounting year andinclude 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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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 companyinvolves three phases: Acquisition of resources such as raw material, labour,

power and fuel etc.

Manufacture of the productwhich includes conversion ofraw material into work-in-progress into finished goods.

Sale of the producteither 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 orpayables 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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GROSSOPERATINGCYCLE

Gross Operating Cycle= Inventory

Conversion Period+ Debtor Conversion

Period.

GOC= ICP+ DCP

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InventoryConversion 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

( Cost of Production)/360

FGCP= Finished Goods Inventory

(Cost ofGoods sold)/360

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Debtor Conversion Period= Debtor

Credit Sale/360

Creditor Deferral Period= Creditors

Credit Purchases/360

Net Operating Cycle= (Gross Operating Cycle-

Creditors Deferral Period)

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Permanent orfixed working capital

A minimum level of current assets, which iscontinuously required by a firm to carry on its

business operations, is referred to aspermanent or fixed working capital.

Fluctuating orvariable working capital

The extra working capital needed to support

the changing production and sales activitiesof the firm is referred to as fluctuating orvariable working capital.


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Dangers OfExcessive 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 firms profit target.

Fixed assets are not efficiently utilised

Paucity of working capital funds render the

firm unable to avail attractive creditopportunities etc.

Firm looses its reputation when not able to

honour its short-term obligations.19


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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

Currentassets holding period

To estimate working capital requirements on thebasis of average holding period of current assets andrelating them to costs based on the companysexperience in the previous years. This method isessentially 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 changewith sales.

Ratio of fixed investment

To estimate working capital requirements as apercentage of fixed investment.


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Working Capital Finance Policies

Long-term

Short-term

Spontaneous

Short-term Vs.

Long-term

financing

Cost

Flexibility

Risk


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Working Capital Finance Policies

Matching

Conservative

Aggressive

principles of working capital

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