UNIT IV: Introduction to

Working Capital
Meaning of Working Capital
⚫ This traditional definition of working capital shows how
much cash (or liquid assets) is available to satisfy the
short-term cash requirements imposed by current
liabilities.
⚫ The primary purpose of working capital management is to
enable the company to maintain sufficient cash flow to
meet its short-term operating costs and short-term debt
obligations.
Nature of Working Capital
⚫ Working capital management is concerned with the
problems that arise in attempting to manage the current
assets, the current liabilities and the interrelations that
exist between them.

⚫ Current assets refer to those assets which in the ordinary

course of business can be, or will be, converted into cash
within one year without undergoing a diminution in value
and without disrupting the operations of the firm.
Examples- cash, marketable securities, accounts
receivable and
inventory.

⚫ Current liabilities are those liabilities which are intended,

at their inception, to be paid in the ordinary course of
business, within a year, out of the current assets or the
earnings of the concern.
Objective of Working Capital
Management
⚫The goal of working capital management is
to manage the firm’s current assets and
liabilities in such a way that a satisfactory
level of working capital is maintained.
⚫The interaction between current assets
and current liabilities is, therefore the
main theme of the theory of the working
capital management
Concepts and Definitions of
Working Capital
⚫ There are two concepts of working
capital: Gross and Net.
⚫ Gross working capital- means the
total current assets.
⚫ Net working capital- can be defined
in two way so
The difference between current assets
and current liabilities.
The portion of current assets which is
financed with long term funds.
Types of working capital needs
⚫ The working capital need can be bifurcated into
permanent
working capital and temporary working capital.
⚫ Permanent working capital- There is always a
minimum
level of working capital which is continuously required
by a firm in order to maintain its activities like cash,
stock and other current assets in order to meet its
business requirements irrespective of the level of
operations.
⚫ Temporary working capital- Over and above the
permanent
working capital, the firm may also require additional
working capital in order to meet the requirements
arising out of fluctuations in sales volume. This extra
working capital needed to support the increased
Difference between permanent &
temporary working capital
Permanent or fixed, working capital is the minimum level of current assets. It
is permanent in the same away as the firm’s fixed assets. It is permanent in the
same way as the firm’s fixed assets are. Depending upon the changes in
production and sales, the need for working capital, over and above permanent
working capital, will fluctuate. For example, extra inventory of finished goods will
have to be maintained to support the peak periods of sale, and investment in
debtors (receivable) may also increase during such periods, On the other
hands, investment in raw material, work-process and finished goods will fall if
the market is slack.
If is shown that permanent working capital is stable over time, while
temporary, working capital is fluctuating sometimes increasing and
sometimes decreasing. However, the permanent working capital line
need not be horizontal if the firm’s requirement for permanent capital
is increasing (or decreasing ) over a period. For a growing firm the
difference between permanent and temporary working capital can be
depicted through figure 2.
Determinants of Working capital Requirement
⚫ General nature of
business
⚫ Production cycle
⚫ Business cycle
fluctuations
⚫ Production policy
⚫ Credit policy
⚫ Growth and expansion
⚫ Profit level
⚫ Level of taxes
⚫ Dividend policy
⚫ Depreciation policy
⚫ Price level changes
⚫ Operating efficiency
Working capital financing Policies
⚫The working capital management includes
and refers to the procedures and policies
required to manage the working capital.
⚫There are three types of working capital
policies which a firm may adopt i.e.
• Moderate working capital policy (Hedging
approach)
• Conservative working capital policy
• Aggressive working capital policy.
These policies describe the relationship
between the sales level and the level of
Approaches to determine an appropriate
Financing-mix
⚫ There are three basic approaches to
determine an appropriate financing mix:

• Hedging approach (Matching

approach),
• Conservative approach,
• Aggressive approach.
Hedging Approach/ Matching Approach
⚫ According to this approach, the maturity of the sources of
the funds should match the nature of the assets to be
financed. For the purpose of analysis, the current assets
can be broadly classified into two classes-
1 which are required in a certain amount for a given level of
operation and, hence, do not vary over time.
2 those which fluctuate over time.
⚫ The Hedging approach suggests that long term funds
should be used to finance the fixed portion of current
assets requirements in a manner similar to the financing of
fixed assets.
⚫ The purely temporary requirements, that is, the seasonal
variations over and above the permanent financing needs
should be appropriately financed with short term funds.
⚫ This approach, therefore, divides the requirements of total
funds into permanent and seasonal components, each
Matching approach to asset financing
Conservative Approach
⚫This approach suggests that the
estimated requirement of total funds
should be met from long term
sources; the use of short term funds
should b restricted to only
emergency situations or when there
is an unexpected outflow of funds.
Conservative approach to asset financing
Aggressive approach
⚫ A working capital policy is called an aggressive
policy if the firm decides to finance a part of the
permanent working capital by short term
sources. The aggressive policy seeks to minimize
excess liquidity while meeting the short term
requirements. The firm may accept even greater
risk of insolvency in order to save cost of long
term financing and thus in order to earn greater
return.
⚫ The trade-off between risk and profitability
depends largely on the financial manager’s
attitude towards risk, yet while doing so he must
take care of the following factors
1)Flexibility of the mix
2)Cost of financing
Aggressive approach to asset financing
Forecasting / Estimation of Working
Capital Requirements
Factors to be considered
1)Total costs incurred on materials, wages and
overheads
2)The length of time for which raw materials
remain in stores before they are issued to
production.
3)The length of the production
cycle or WIP, i.e., the time taken
for conversion of RM into FG.
4)The length of the Sales Cycle during which
FG are to be kept waiting for sales.
Continued…
6)The amount of cash required to pay
day-to-day expenses of the business.
7)The amount of cash required for advance
payments if any.
8)The average period of credit
to be allowed by suppliers.
9)Time – lag in the payment of wages
and other overheads.
The Operating-cycle and Working Capital Needs
⚫ The working capital requirements of a firm depends,
to a great extent upon the operating cycle of the firm.
The operating cycle may be defined as the time
duration starting from the procurement of goods or
raw materials and ending with the sales realization.
⚫ The length and nature of the operating cycle may
differ from one
firm to another depending upon the size and nature of
the firm.
⚫ The operating cycle of a firm consists of the time
required for the completion of the chronological
sequence of some or all of the following-
1)Procurement of raw materials and services.
2)Conversion of raw materials into work-in-progress.
3)Conversion of work-in-progress into finished goods.
4) Sale of finished goods.
5)Conversion of receivables into cash.
Operating Cycle
⚫ Working capital is also a circulating
called
revolving capital. That is the capital
money/capitalorwhich
circulates in various forms of current assets in a
continued manner. For example, at a point of
time, funds may be tied up in raw materials, then
later converted into semi-finished products, then
into finished/ final products and when these
finished products are sold, it is converted either
into account receivables or cash.
⚫ The American Institute of Certified Public
Accountants defined the operating cycle as: “the
average time intervening between the acquisition
of material or services entering the process and
the final cash realization.”
The operating cycle or circulation flow of money
can best be projected in the following manner
Formula
⚫ Inventory conversion
period
Avg. inventory
= Cost of
Goods Sold /365
⚫ Receivable
conversion period
Accounts receivable
= Total Net
Sales /365
Continued…
⚫ Payables period
Average Accounts payable
= Cost of Goods
Sold/365

⚫ Cash conversion cycle =

operating cycle –
payables
period