Working Capital Management

Difference between managing fixed and current assets

The management of fixed and current assets, however, differs in three important ways: First,
time is a very important factor; consequently, discounting and compounding techniques play a
significant role in capital budgeting and a minor one in managing current assets.
Second, the large holding of current assets, especially cash, though reduces riskiness but also
reduces the overall profitability. Thus, a risk-return trade-off is involved in holding current
assets.
Third, fixed and current assets' levels depend upon expected sales, but it is only the current
assets that can be adjusted with sales fluctuations in the short run. Thus, the firm has a greater
degree of flexibility in managing current assets.

Working capital is composed of various current assets and current liabilities, which are as
follows:
Current Assets ➝ Current assets are converted into cash within a year.
Current Liabilities ➝ Conversely, the payments due within a year (<12 months).
Constituents of Current assets and Current liabilities are listed below:
Current assets Current liabilities
❖ Cash and Cash Equivalents ❖ Tax Payments Due
❖ Marketable Securities ❖ Bank Overdrafts
❖ Short-term Investments ❖ Bank Loans (short-term)

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 ❖ Prepaid Expenses ❖ Accounts Payable (AP)
❖ Accounts Receivable (AR)/debtors ❖ Bills Payable
❖ Bills Receivable ❖ Proposed Dividends
❖ Inventory (RM, WIP, FG, consumables store)
❖ Accrued Expense
❖ Accrued Income ❖ Deferred Revenue
❖ Short-Term Debt
❖ Current Portion of Long-Term Debt

There are two concepts of working capital—gross and net. Gross working capital refers to the
firm’s investment in current assets. Working capital is equal to current assets. Net working
capital is equal to current assets less current liabilities.
Net working capital
Net Working Capital = Current Assets – Current Liabilities
The balance sheet of Bharat Bijlee, a manufacturing firm has recorded $40 million in
current assets and $25 million in current liabilities,
Working Capital = $40 million — $25 million = $15 million
Working capital ratio
The working capital ratio is a method of analyzing the financial state of a company by
measuring its current assets as a proportion of its current liabilities, rather than as an integer.
Current Assets 40
Working Capital Ratio = = 25 = 1.6
Current Liabilities

A working capital ratio of more than 1.0 indicates a net positive working capital, whereas it
is less than 1 indicates a net positive working capital
Ace Company has the following selected assets and liabilities:
Particular Amount
Cash $10,000
Accounts receivable $30,000
Inventory $42,000
Machinery $90,000
Long-term investments $36,000
Patent (Long-term intangible asset) $4,000
Accounts payable $12,000
Taxes payable $3,000
Accrued expenses payable $5,000
Bonds payable $50,000
Common stock $70,000

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The net working capital is:
Current Assets
Cash $10,000
Accounts receivable $30,000
Inventory $42,000
$82,000
Current Liabilities
Accounts payable $12,000
Taxes payable $3,000
Accrued expenses payable $5,000
$20,000
Net working capital = Current Assets - Current Liabilities $62,000
Net working capital = Current Assets − Current Liabilities = 82000 − 20000
= $62,000
Current Assets 82
Working Capital Ratio = = 20 = 8.1
Current Liabilities

Management of net working capital involves regulating the various types of current assets and
current liabilities. Management of net working capital also requires decisions about how
current assets should be financed, for example, through short-term debt, long-term debt, or
equity. Net working capital is increased when current assets are financed through noncurrent
sources. The liquidity of current assets will affect the terms and availability of short-term credit.
The greater the liquidity, the easier it becomes, generally, to obtain a short-term loan at
favorable terms. Short-term credit, in turn, affects the amount of cash balance held by a firm.
current liabilities.
Ace Company has the following selected assets and liabilities:
Particular Amount
Cash $10,000
Accounts receivable (AR) $30,000
Inventory/stock $42,000
Machinery $90,000
Long-term investments $36,000
Patent (Long-term intangible asset) $4,000
Accounts payable (AP) $12,000
Taxes payable $3,000
Accrued expenses payable $5,000
Bonds payable $50,000

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 Common stock $70,000
First, we will determine the Current Assets and Current Liabilities and then the net working
capital :
Current Assets
Cash $10,000
Accounts receivable $30,000
Inventory $42,000
Total $82,000
Current Liabilities
Accounts payable $12,000
Taxes payable $3,000
Accrued expenses payable $5,000
Total $20,000
Net working capital = Current Assets − Current Liabilities $62,000
Net working capital = Current Assets − Current Liabilities = 82000 − 20000
= $62,000
Current Assets 82
Working Capital Ratio = = 20 = 8.1
Current Liabilities

Winston Corporation has the following selected assets and liabilities

Particulars Amount
Cash $15,000
Accounts receivable (AR) $20,000
Inventory $37,000
Land $70,000
Building $190,000
Goodwill $26,000
Accounts payable (AP) $13,000
Salaries payable $7,000
Taxes payable $19,000
Mortagage payable $80,000
Common stock/ Ordinary equity shares $100,000
Retained earnings (RE) $82,000
The net working capital is:
Current Assets
Cash $15,000
Accounts receivable $20,000
Inventory $37,000

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 Total $72,000
Current Liabilities
Accounts payable $13,000
Salaries payable $7,000
Taxes payable $19,000
Total $39,000
Net working capital = Current Assets − Current Liabilities $33,000
Net working capital = Current Assets − Current Liabilities = 72000 − 39000
= $33,000
Current Assets 72
Working Capital Ratio = = 39 = 1.9
Current Liabilities

Working Capital Management

The need for working capital to run day-to-day business activities cannot be overemphasized.
We will hardly find a business firm that does not require working capital. Indeed, firms differ
in their requirements for working capital.
It involves short-term financial decisions typically involve cash flows within a year or the
operating cycle of the firm. There are two concepts of working capital: gross working
capital and net working capital. Gross working capital is the total of all current assets. The
net working capital is the difference between current assets and current liabilities.
Management of working capital refers to the management of current assets as well as current
liabilities. The major thrust, of course, is on the management of current assets. This is
understandable because current liabilities arise in the context of current assets.
Characteristics
Two important characteristics of current assets: (i) short life span, and (ii) swift
transformation into other asset forms. Current assets have a short life span. Cash balances
may be held idle for a week or two, accounts receivable (credit sales) may have a life span of
30 to 90 days, and inventories may be held for 1 to 60 days. The life span of current assets
depends upon the time required in the activities of procurement, production, sales, and
collection and the degree of synchronization among them.
Each current asset is swiftly transformed into other asset forms: cash is used for acquiring raw
materials; raw materials are transformed into finished goods (this transformation may involve
several stages of work-in-process); finished goods, generally sold on credit, are converted into
accounts receivable (book debt); and, finally, accounts receivable, on realization, generate
cash.

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Transformation Cycle

The consideration of the level of investment in current assets should avoid two danger
points- excessive and inadequate investment in current assets. Investment in current assets
should be just adequate to the needs of the business firm. Credibility. Excessive investment in
current assets should be avoided because it impairs the firm’s profitability, as idle investment
earns nothing. On the other hand, an inadequate amount of working capital can threaten the
credibility of the firm because of its inability to meet its current obligations. It should be
realized that the working capital needs of the firm may fluctuate with changing business
activity. This may frequently cause excess or shortage of working capital. The management
should be prompt to initiate an action and correct imbalances.

Another aspect of the gross working capital points to the need to arrange funds to finance
current assets. Whenever a need for working capital funds arises due to the increasing level of
business activity or for any other reason, financing arrangements should be made quickly.
Similarly, if suddenly, some surplus funds arise they should not be allowed to remain idle but
should be invested in short-term securities. Thus, the financial manager should know the
sources of working capital funds as well as investment avenues where idle funds may be
temporarily invested.
Current asset cycle
We know that a firm should aim at maximizing the wealth of its shareholders. In its endeavour
to do so, a firm should earn a sufficient return from its operations. Earning a steady amount of
profit requires successful sales activity. The firm has to invest enough funds in current assets
to generate sales. Current assets are needed because sales do not convert into cash

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instantaneously. There is always an operating cycle involved in the conversion of sales into
cash.

Operating cycle and cash cycle

The operating cycle is the number of days between when you buy inventory and when
customers pay for the inventory. The cash conversion cycle is the number of days between
when you pay for inventory and when you get paid by your customers for the inventory.

The investment in working capital is influenced by four key events in the production and sales
cycle of the firm:

• Purchase of raw materials

• Payment for raw materials
• Sale of finished goods
• Collection of cash for sales

A firm begins with the purchase of raw materials which are paid for after a delay which
represents the accounts payable period. The firm converts the raw materials into finished goods
and then sells the same. The time lag between the purchase of raw materials and the sale of
finished goods is the inventory period. Customers pay their bills sometime after the sale. The
period that elapses between the date of sales and the date of collection of receivables is the
accounts receivable period (debtor period).

The time that elapses between the purchase of raw materials and the collection of cash for sales
is referred to as the operating cycle, whereas the time length between the payment for raw
material purchases and the collection of cash for sales is referred to as the cash cycle. The

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operating cycle is the sum of the inventory period and the accounts receivable period, whereas
the cash cycle is equal to the operating cycle less (minus) the accounts payable period.

Average Inventory Average Inventory

Inventory period (IP) = =
Daily inventory conversion COGS/365

Average accounts receivable Average accounts receivable

Accounts receivable (debt)period(ARP) = =
Sales per day Annual sales/365

Average accounts payable Average accounts payable

Accounts payable period (APP) = =
Annual COGS/365 COGS/365

The relevant financial information for CRI Pump Limited for the financial
year ended 2024 is given below. What is the length of the operating cycle
and the cash cycle? Assume 365 days to a year.

Profit and loss Account data Balance sheet data (Cr)

Cr 1.4. 2023 31.3.2024

Sales 800 Inventory 96 102

Cost of goods sold 720 Accounts receivable 86 90

Accounts payable 56 60

Average Inventory Average Inventory

Inventory period (IP) = Daily inventory conversion
= COGS
365

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 (96+102)
2 99 cr
= 720 = 1.97 cr = 50 days
365

This means that the company takes 50 days to conversion, or purchase inventory.
(86+90)
Average accounts receivable 2 88
Accounts receivable period (ARP) = = 800 = 2.19
Sales per day
365

= 40 days
(56+60)
Average accounts payable 2 58
Accounts payable period (APP) = = 720 = 1.97 = 30 days
Annual COGS/365
365

Operating cycle (OC) = inventory period + accounts receivable period (debt period)
= 50 + 40 = 90 days

Cash cycle (CC) = Operating cycle − accounts payable period

= 90 – 30 = 60 days

The operating cycle of a manufacturing company involves three phases:

❖ Acquisition of resources such as raw material, labour, power, fuel, etc.
❖ Manufacture of the product which includes conversion of raw material into work-in-
progress into finished goods.
❖ Sale of the product either for cash or on credit. Credit sales create accounts receivable for
collection.
These phases affect cash flows, which most of the time, are neither synchronized nor certain.
They are not synchronized because cash outflows usually occur before cash inflows. Cash
inflows are not certain because sales and collections that give rise to cash inflows are difficult
to forecast accurately. Cash outflows, on the other hand, are relatively certain. The firm is,

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therefore, required to invest in current assets for smooth, uninterrupted functioning. It needs to
maintain liquidity to purchase raw materials and pay expenses such as wages and salaries, other
manufacturing, administrative, and selling expenses, and taxes, as there is hardly a match
between cash inflows and outflows. Cash is also held to meet any future exigencies. Stocks of
raw material and working-process are kept to ensure smooth production and to guard against
the non-availability of raw material and other components. The firm holds a stock of finished
goods to meet the demands of customers continuously and suddenly demand from some
customers. Debtors (accounts receivable) are created because goods are sold on credit for
marketing and competitive reasons. Thus, a firm makes adequate investments in inventories,
and debtors, for smooth, uninterrupted production and sale.

Negative Cash Cycle

Internet-based bookseller Amazon.com manages its cash cycle extremely well. It turns its
inventory over 26 times a year, making its inventory period very short. It charges its customer’s
credit card when it ships a book and it gets paid by the credit card firm usually in a day. Finally,
it takes about 46 days to pay the suppliers. All this means that Amazon.com has a negative cash
cycle.
Factors affecting the working capital requirement
The working capital needs of a firm are influenced by numerous factors. The important ones
are:
• Nature of business
• Seasonality of operations
• Production policy
• Market conditions
• Conditions of supply
Nature of Business
The working capital requirements of a firm are closely related to the nature of its business. A
service firm, like an electricity undertaking or a transport corporation, which has a short
operating cycle and sells predominantly on a cash basis, has modest working capital
requirements. On the other hand, a manufacturing firm like a machine tools unit (HMT or Praga
Tools), which has a long operating cycle and which sells largely on credit, has very substantial
working capital requirements.

Industries Current Assets Fixed assets

Electricity generation and distribution 20 - 30 70 - 80
Aluminium, shipping 30 - 40 60 - 70
Steel, Basic Chemical industries 40 - 50 50 - 60

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 Cotton textiles, Sugar 60 - 70 30 - 40
Trading, Construction 80 - 90 10 - 20

Seasonality of Operations
Firms that have marked seasonality in their operations usually have highly fluctuating working
capital requirements. To illustrate, consider a firm manufacturing ceiling fans, Havels. The sale
of ceiling fans reaches a peak during the summer months and drops sharply during the winter
period. The working capital requirements of such a firm are likely to increase considerably in
the summer months and decrease significantly during the winter period. On the other hand, a
firm manufacturing a product like lamps, which have fairly even sales around the year, tends
to have stable working capital requirements.
Production Policy
A firm marked by pronounced seasonal fluctuations in its sales may pursue a production policy
that may reduce the sharp variations in working capital requirements. For example, a
manufacturer of ceiling fans may maintain a steady production throughout the year, rather than
intensify the production activity during the peak business season. Such a production policy
may dampen the fluctuations in working capital requirements.
Market Conditions
The degree of competition prevailing in the marketplace has an important bearing on working
capital needs. When competition is keen, a larger inventory of finished goods is required to
promptly serve customers who may not be inclined to wait because other manufacturers are
ready to meet their needs. Further, generous credit terms may have to be offered to attract
customers in a highly competitive market. Thus, working capital requirements tend to be high
because of greater investment in finished goods inventory and accounts receivable. If the
market position is strong and competition is weak, a firm can manage with a smaller inventory
of finished goods because customers can be served with some delay. Further, in such a situation
the firm can insist on cash payment and avoid lock-up of funds in accounts receivable—it can
even ask for advance payment, partial or total.
Conditions of Supply
The inventory of raw materials, spares, and stores depend on the conditions of supply. If the
supply is prompt and adequate (standardized and ubiquitous goods), the firm can manage with
a small inventory. However, if the supply is unpredictable and scant, then the firm, to ensure
continuity of production, would have to acquire stocks as and when they are available and carry
a larger inventory, on average. A similar policy may have to be followed when the raw material
is available only seasonally (cotton yarn, oilseeds) and production operations are carried out
around the year.

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Policy and level of current assets
Under a flexible policy, the investment in current assets is high. This means that the firm
maintains a huge balance of cash and marketable securities, carries large amounts of
inventories, and grants generous terms of credit to customers which leads to a high level of
debtors. Under a restrictive policy, the investment in current assets is low. This means that the
firm keeps a small balance of cash and marketable securities, manages with the small amounts
of inventories, and offers stiff terms of credit which leads to a low level of debtors.

The implication of these policies is as follows. Very broadly, a flexible policy result in fewer
production stoppages (on account of inventory shortages), ensures quick deliveries to
customers, and stimulates sales because liberal credit is granted to customers. Of course, these
benefits come at the cost of higher investment in current assets. A restrictive current assets
policy, on the other hand, may lead to frequent production stoppages, delayed deliveries to
customers, and loss of sales. These are the costs that the firm may have to bear to keep its
investment in current assets low.

Determining the optimal level of current assets involves a trade-off between costs that rise with
current assets and costs that fall with current assets. The former is referred to as carrying costs
and the latter as shortage costs. Carrying costs are mainly like the cost of financing a higher
level of current assets. Shortage costs are mainly in the form of disruption in the production
schedule, loss of sales, and loss of customer goodwill. The optimal level of current assets is
denoted by CA, as the total costs (the sum of carrying costs and shortage costs) are minimized
at that level.

The optimum level of CA

Current assets financing policy

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After establishing the level of current assets, the firm must determine how these should be
financed. It is to determine the mix of long-term capital and short-term debt the firm employs
to support its current assets.

The investment in current assets may be broken into two parts: permanent current assets and
temporary current assets. The former represents what the firm requires even at the bottom of
its sales cycle; the latter reflects a variable component that moves in line with seasonal
fluctuations.

Several strategies are available to a firm for financing its capital requirements. Three strategies
are illustrated in lines A, B, and C.

Strategy A: Long-term financing is used to meet fixed asset requirements as well as peak
working capital requirements. When the working capital requirement is less than its peak level,
the surplus is invested in liquid assets (cash and marketable securities).

Strategy B: Long-term financing is used to meet fixed asset requirements, permanent working
capital requirements, and a portion of fluctuating working capital requirements. During
seasonal upswings, short-term financing is used; during seasonal downswings, the surplus is
invested in liquid assets.

Strategy C: Long-term financing is used to meet fixed asset requirements and permanent
working capital requirements. Short-term financing is used to meet fluctuating working capital
requirements.

Capital requirements and their financing

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Illustration – determine NWC requirement
Max Limited sells goods at a profit margin of 25 %, counting depreciation as part
of the cost of manufacture. Its annual figures are as follows:
Annual Sales (Two months credit is given) = ₹ 240 million
■ Material cost (Suppliers give three months credit) = 72 million
■ Wages (Wages are paid one month in arrears) = 48 million
■ Manufacturing expenses outstanding at the end of the year = 4 million
(Cash expenses are paid one month in arrears)
■ Administrative and sales expenses for the year
(These are paid as incurred) = 30 million
Max Limited keeps two months’ stock of raw materials and one month’s stock of
finished goods. It wants to maintain a cash balance of ₹ 5 million. Estimate the
requirement of working capital on a cash cost basis, assuming a 10 percent safety
margin. Ignore work-in-process.
Working note on total cash cost
Total expenses include cash (out-of-pocket expenses) and non-cash expense like
depreciation. Therefore, we need to identify non-cash expenses such as
depreciation.
1 Sales 240
Less: gross profit (25%) 60
Total cost (cash expenses + depreciation) 180
Less: materials 72
: wages 48 120
Total manufacturing expenses (180 -120) 60
2. Cash manufacturing indirect expenses paid 48
(Rs.4 million x 12)
3. Depreciation (1) – (2) [non-cash expenses] 12
4 Total cash cost

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 Total manufacturing cost 180
Less: Depreciation 12
Cash manufacturing cost 168
Add: Administration and selling expenses 30
Total cash (out-of-pocket) cost 198
A: Current Assets

Item Calculation Amount

Total cash cost 198

Debtors (a/c receivable) for credit ×2= ×2 33.00
12 12
sale

Raw material inventory worth at the Material cost × 2 = 72

×2 12.00
12 12
cost (months)

Cash manufacturing cost

Value of Finished goods ×1= 14.00
12
inventory/stock with the company 168
×1
12

Cash balance maintained A predetermined amount of 5.00

Rs.5 million

A Current asset 64.00

B: Current Liabilities

Item Calculation Amount

Sundry creditors (A/c payable to Material cost 72 18.00

×3= ×3
12 12
vendor credit)

Manufacturing expenses One month’s cash 4.00

outstanding (electricity) manufacturing expenses

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Wages outstanding 48 4.00
One month’s wages =
12

B Current Liabilities 26

Working capital = (A- B) = (64 – 26) = Rs. 38 million

Add safety margin 10% = 3.8
Net working-capital requirement = Rs. 41.8 million

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