1. www.velsuniv.org PRINCIPLES OF WORKING CAPITAL MANAGEMENT

2. Executive Placement 2003 BIM School of Management Studies – Striving towards Excellence Vels University www.velsuniv.org 2Financial Management, Ninth Edition © I M Pandey Vikas Publishing House Pvt. Ltd. Topics Concept of working capitalConcept of working capital Operating and cash conversion cycleOperating and cash conversion cycle Permanent and variable working capitalPermanent and variable working capital Balanced working capitalBalanced working capital Determinants of working capitalDeterminants of working capital Issues I working capital managementIssues I working capital management Estimating working capitalEstimating working capital Policies of working capital financePolicies of working capital finance

3. Executive Placement 2003 BIM School of Management Studies – Striving towards Excellence Vels University www.velsuniv.org 3Financial Management, Ninth Edition © I M Pandey Vikas Publishing House Pvt. Ltd. Concepts of Working Capital Gross working capital (GWC)Gross working capital (GWC) GWC refers to the firm’s 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, (accounts receivable or book debts) bills receivable and stock (inventory).

4. Executive Placement 2003 BIM School of Management Studies – Striving towards Excellence Vels University www.velsuniv.org 4Financial Management, Ninth Edition © I M Pandey Vikas Publishing House Pvt. Ltd. Concepts of Working Capital Net working capital (NWC).Net working capital (NWC). NWC refers to the difference between current assets and current liabilities.NWC refers to the difference between current assets and current liabilities. Current liabilities (CL) are those claims of outsiders which are expected to mature for payment within an accounting year and include creditors (accounts payable), bills payable, and outstanding expenses.Current liabilities (CL) are those claims of outsiders which are expected to mature for payment within an accounting year and include creditors (accounts payable), bills payable, and outstanding expenses. NWC can be positive or negative.NWC can be positive or negative. –Positive NWC = CA > CL –Negative NWC = CA < CL

5. Executive Placement 2003 BIM School of Management Studies – Striving towards Excellence Vels University www.velsuniv.org 5Financial Management, Ninth Edition © I M Pandey Vikas Publishing House Pvt. Ltd. Concepts of Working Capital GWC focuses onGWC focuses on –Optimisation of investment in current –Financing of current assets NWC focuses onNWC focuses on –Liquidity position of the firm –Judicious mix of short-term and long-tern financing

6. Executive Placement 2003 BIM School of Management Studies – Striving towards Excellence Vels University www.velsuniv.org 6Financial Management, Ninth Edition © I M Pandey Vikas Publishing House Pvt. Ltd. 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 company involves three phases: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 company involves three phases: –Acquisition of resources such as raw material, labour, power and 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 account receivable for collection.

7. Executive Placement 2003 BIM School of Management Studies – Striving towards Excellence Vels University www.velsuniv.org 7Financial Management, Ninth Edition © I M Pandey Vikas Publishing House Pvt. Ltd. The length of the operating cycle of a manufacturing firm is the sum of:The length of the operating cycle of a manufacturing firm is the sum of: inventory conversion period (ICP).inventory conversion period (ICP). Debtors (receivable) conversion period (DCP).Debtors (receivable) conversion period (DCP).

8. Executive Placement 2003 BIM School of Management Studies – Striving towards Excellence Vels University www.velsuniv.org 8Financial Management, Ninth Edition © I M Pandey Vikas Publishing House Pvt. Ltd. Inventory conversion period is the total time needed for producing and selling the product. Typically, it includes:Inventory conversion period is the total time needed for producing and selling the product. Typically, it includes: raw material conversion period (RMCP)raw material conversion period (RMCP) work-in-process conversion period (WIPCP)work-in-process conversion period (WIPCP) finished goods conversion period (FGCP)finished goods conversion period (FGCP)

9. Executive Placement 2003 BIM School of Management Studies – Striving towards Excellence Vels University www.velsuniv.org 9Financial Management, Ninth Edition © I M Pandey Vikas Publishing House Pvt. Ltd. The debtors conversion period is the time required to collect the outstanding amount from the customers.The debtors conversion period is the time required to collect the outstanding amount from the customers.

10. Executive Placement 2003 BIM School of Management Studies – Striving towards Excellence Vels University www.velsuniv.org 10Financial Management, Ninth Edition © I M Pandey Vikas Publishing House Pvt. Ltd. Creditors or payables deferral period (CDP) is the length of time the firm is able to defer payments on various resource purchases.Creditors or payables deferral period (CDP) is the length of time the firm is able to defer payments on various resource purchases.

11. Executive Placement 2003 BIM School of Management Studies – Striving towards Excellence Vels University www.velsuniv.org 11Financial Management, Ninth Edition © I M Pandey Vikas Publishing House Pvt. Ltd. Gross operating cycle (GOC)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)Net operating cycle (NOC) NOC is the difference between GOC and CDP. Cash conversion cycle (CCC)Cash conversion cycle (CCC) CCC is the difference between NOP and non-cash items like depreciation.

12. Executive Placement 2003 BIM School of Management Studies – Striving towards Excellence Vels University www.velsuniv.org 12Financial Management, Ninth Edition © I M Pandey Vikas Publishing House Pvt. Ltd. Determinants of Working Capital Nature of businessNature of business Market and demandMarket and demand Technology and manufacturing policyTechnology and manufacturing policy Credit policyCredit policy Supplies’ creditSupplies’ credit Operating efficiencyOperating efficiency InflationInflation

13. Executive Placement 2003 BIM School of Management Studies – Striving towards Excellence Vels University www.velsuniv.org 13Financial Management, Ninth Edition © I M Pandey Vikas Publishing House Pvt. Ltd. Issues in Working Capital Management Levels of current assetsLevels of current assets Current assets to fixed assetsCurrent assets to fixed assets Liquidity Vs. profitabilityLiquidity Vs. profitability Cost trade-offCost trade-off

14. Executive Placement 2003 BIM School of Management Studies – Striving towards Excellence Vels University www.velsuniv.org 14Financial Management, Ninth Edition © I M Pandey Vikas Publishing House Pvt. Ltd. Estimating Working capital Current assets holding periodCurrent assets holding period To estimate working capital requirements on the basis of average holding period of current assets and relating them to costs based on the company’s experience in the previous years. This method is essentially based on the operating cycle concept.To estimate working capital requirements on the basis of average holding period of current assets and relating them to costs based on the company’s experience in the previous years. This method is essentially based on the operating cycle concept. Ratio of salesRatio of sales To estimate working capital requirements as a ratio of sales on the assumption that current assets change with sales.To estimate working capital requirements as a ratio of sales on the assumption that current assets change with sales. Ratio of fixed investmentRatio of fixed investment To estimate working capital requirements as a percentage of fixed investment.To estimate working capital requirements as a percentage of fixed investment.

15. Executive Placement 2003 BIM School of Management Studies – Striving towards Excellence Vels University www.velsuniv.org 15Financial Management, Ninth Edition © I M Pandey Vikas Publishing House Pvt. Ltd. Working Capital Finance Policies MatchingMatching ConservativeConservative AggressiveAggressive

16. Executive Placement 2003 BIM School of Management Studies – Striving towards Excellence Vels University www.velsuniv.org Working capital financing policies Moderate – Match the maturity of the assets with the maturity of the financing.Moderate – Match the maturity of the assets with the maturity of the financing. Aggressive – Use short-term financing to finance permanent assets.Aggressive – Use short-term financing to finance permanent assets. Conservative – Use permanent capital for permanent assets and temporary assets.Conservative – Use permanent capital for permanent assets and temporary assets.

17. Executive Placement 2003 BIM School of Management Studies – Striving towards Excellence Vels University www.velsuniv.org Moderate financing policy Years Lower dashed line would be more aggressive. $ Perm C.A. Fixed Assets Temp. C.A. S-T Loans L-T Fin: Stock, Bonds, Spon. C.L.

18. Executive Placement 2003 BIM School of Management Studies – Striving towards Excellence Vels University www.velsuniv.org Conservative financing policy $ Years Perm C.A. Fixed Assets Marketable securities Zero S-T Debt L-T Fin: Stock, Bonds, Spon. C.L.

19. Executive Placement 2003 BIM School of Management Studies – Striving towards Excellence Vels University www.velsuniv.org Impact on Risk Decreasing cash reduces the firm’s ability to meet its financial obligations. More risk!Decreasing cash reduces the firm’s ability to meet its financial obligations. More risk! Stricter credit policies reduce receivables and possibly lose sales and customers. More risk!Stricter credit policies reduce receivables and possibly lose sales and customers. More risk! Lower inventory levels increase stockouts and lost sales. More risk!Lower inventory levels increase stockouts and lost sales. More risk! Optimal Amount (Level) of Current Assets 0 25,000 50,000 OUTPUT (units) ASSET LEVEL ($) Current Assets Policy C Policy A Policy B

20. Executive Placement 2003 BIM School of Management Studies – Striving towards Excellence Vels University www.velsuniv.org Impact on Risk Risk Analysis PolicyRisk ALow ALow BAverage BAverage CHigh CHigh Risk increases as the level of current assets are reduced. Optimal Amount (Level) of Current Assets 0 25,000 50,000 OUTPUT (units) ASSET LEVEL ($) Current Assets Policy C Policy A Policy B

21. Executive Placement 2003 BIM School of Management Studies – Striving towards Excellence Vels University www.velsuniv.org Classifications of Working Capital TimeTime –Permanent –Temporary u Components u Cash, marketable securities, receivables, and inventory

22. Executive Placement 2003 BIM School of Management Studies – Striving towards Excellence Vels University www.velsuniv.org 22Financial Management, Ninth Edition © I M Pandey Vikas Publishing House Pvt. Ltd. Permanent or fixed working capitalPermanent or fixed working capital A minimum level of current assets, which is continuously required by a firm to carry on its business operations, is referred to as permanent or fixed working capital. Fluctuating or variable working capitalFluctuating or variable working capital The extra working capital needed to support the changing production and sales activities of the firm is referred to as fluctuating or variable working capital.

23. Executive Placement 2003 BIM School of Management Studies – Striving towards Excellence Vels University www.velsuniv.org Permanent Working Capital The amount of current assets required to meet a firm’s long-term minimum needs. Permanent current assets TIME DOLLAR AMOUNT

24. Executive Placement 2003 BIM School of Management Studies – Striving towards Excellence Vels University www.velsuniv.org Temporary Working Capital The amount of current assets that varies with seasonal requirements. Permanent current assets TIME DOLLAR AMOUNT Temporary current assets

25. Executive Placement 2003 BIM School of Management Studies – Striving towards Excellence Vels University www.velsuniv.org 25Financial Management, Ninth Edition © I M Pandey Vikas Publishing House Pvt. Ltd. Working Capital Finance Policies Long-termLong-term Short-termShort-term SpontaneousSpontaneous Short-term Vs. Long-term financing Cost Flexibility Risk