Chapter-07 Working Capital Management

Working Capital
It refers to the amount of long-term funds required to invest in current asset of
the business. It is also the capital available for conducting the day-to-day
operations of the organisation, investing in working capital has a cost, which can
be expressed either as:
➢ The cost of funding it, or
➢ The opportunity cost of lost investment opportunities
Objectives of working capital management
The main objective of working capital management is to get balance of current
assets and current liabilities right. This can also be seen as a balancing act
between profitability and liquidity.
Cash flow versus profit
Unprofitable companies can survive if they have liquidity. Profitable companies
can fail if they run out of cash to pay their liabilities. Cash balances and cash flow
need to be mentioned just as closely as trading profits.
a. Purchase of non-current assets for cash- The cash will be paid in full to the
supplier when the asset is delivered. However, the cost will be charged to profits
gradually over the life of the asset in the form of depreciation.
b. Sale of goods on credit- Profits will be credited in full once the sale has been
confirmed. However, the cash may not be received for some considerable period
afterwards.
c. With some payments such as tax there may be a significant timing difference
between the impact on reported profit and the cash flow.
Clearly, cash balances and cash flows need to be monitored just as closely as
trading profits. The need for adequate cash flow information is vital to enable
management to fulfil this responsibility.
Profitability versus liquidity
Liquidity in the context of working capital management means having enough
cash or ready access to cash to meet all payment obligations when this fall due.
The main sources of liquidity are usually:

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 ➢ Cash in the bank
➢ Short-term investment that can be cashed in easily and quickly
➢ Cash inflows from normal trading operations
➢ An overdraft facility or other ready source of extra borrowing.
The basis of the trade-off is where a company is able to improve its profitability
but at expense of tying up cash. For example:
➢ Receiving a bulk purchase discount for buying more inventory than is
currently required.
➢ Offering credit to customers.
Sometimes, the opposite situation can be seen where a company can improve
its liquidity position but at expense of profitability. For example, offering an early
settlement discount to customers.
Aggressive Approach
A firm choosing to have a lower level of working capital including cash rather
than rivals. An aggressive approach will result in lower working capital funding
costs and higher risk.
Conservative Approach
A firm with a higher level of working capital including high cash balances than
rivals. A conservative approach will result in lower working capital funding costs
and higher risk.
Over-capitalisation
Excessive inventories, accounts receivable and cash, and very few accounts
payable, will be an over-investment by the company in current assets. Working
Capital will be excessive and the company will be over-capitalised.
Overtrading
Effective and efficient management of the working capital investment is essential
to maintaining control of business cash flow. Management must have full
awareness of the profitability versus liquidity trade-off. For example, healthy
trading growth typically produces:
➢ Increased profitability
➢ The need to increase investment in non-current assets and working capital

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If the business does not have access to sufficient capital to fund the increase, it
is said to be ‘overtrading’. A business is said to be overtrading when it has
minimal inventories, accounts receivable and cash and very high accounts
payable balances. This can cause serious trouble for the business, as it is unable
to pay its business creditors.
The indicators of overtrading are:
➢ A rapid increase in revenue
➢ An increase in the values of the working capital days, particularly
receivables and payables
➢ Most of the increase in assets being financed by credit
➢ A dramatic drop in the liquidity ratios
Working Capital Ratio
Current Ratio
Measure how much of total current assets are financed by current liabilities. The
formula for current ratio is:
Current Ratio = Current assets / Current liabilities
Quick (acid test) ratio
It measures how well current liabilities are covered by liquid assets and is
particularly useful where inventory holding period are long and therefore distort
the current ratio. The formula for Quick (acid test) ratio is:
Quick ratio (acid test) = (Current assets – Inventory)/ Current liabilities
Cash Operating Cycle
The cash operating cycle is the length of time between the company’s outlay on
raw materials, wages and other expenditures and the inflow of cash from the
sale of goods. It refers to time taken to recover the amount that the business has
invested in its day-to-day operations.
Operating cycle= Inventory holding period + Trade receivable days – Trade
Payables days
Factors affecting the length of the operating cycle-
➢ Liquidity versus profitability decisions
➢ Terms of trade

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 ➢ Management efficiency
➢ Industry norms and practices, e.g., retail versus construction
Working Capital Ratios- Operating cycle
The periods used to determine the cash operating cycle are calculated by using
a series of working capital ratios. The main working capital ratio are:
Raw material stock = Annual cost of raw materials * raw materials
balance holding period / 365 days or 52 weeks or 12 months
Work-in-progress = Annual cost of WIP * WIP holding period / 365
days or 52 weeks or 12 months
Finished Goods = Annual cost of fininshed goods * Finished goods
holding period / 365 days or 52 weeks or 12 months
Stock / Inventory = Annual cost of goods sold * Inventory holding
balances period / 365 days or 52 weeks or 12 months
Debtors / Receivables = Annual credit sales * Debt collection period /365
balances days or 52 weeks or 12 months
Raw materials Creditors = Annual credit purchases * Suppliers credit period
/ Payables balances / 365 days or 52 weeks or 12 months
Wages creditors = Annual wages cost * Wages credit period / 365
balances days or 52 weeks or 12 months
Creditors for other = Annual cost of expenses * Expenses credit period
expenses balance / 365 days or 52 weeks or 12 months
The working capital ratio can also be used to predict the future level of
investment required. This is done by re-arranging the formulas.