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WORKING CAPITAL - AN INTRODUCTION

WORKING CAPITAL
Working capital is the difference between the current assets and current liabilities. It is also
called net current assets or current capital.

OBJECTIVES OF WORKING CAPITAL MANAGEMENT

The main objectives of working capital management are:
• Ensure that there are enough liquid assets for the business to operate day-to-day
operations.
• Ensure that profitability is not compromised at the expense of liquidity.
It is important for the management to strike a balance between the above objectives.

WORKING CAPITAL MANAGEMENT

There are two aspects in the working capital management:
Managing individual component of working Working capital ratio analysis (Discussed
capital such as inventory, receivables etc. below in detail)
WORKING CAPITAL RATIOS
These ratios can be used to judge whether the company is moving towards over capitalization
(discussed below) or over trading (discussed below) so that prompt actions can be taken.
Liquidity ratios
Current ratio: Current Asset
Current liabilities
Quick Ratio: Current Asset – stock
Current liabilities
Working Capital Turnover: Sales Revenue
Current Assets – Current Liabilities
It measures how much support the working capital is giving to support the sales.
Operating Cycle ratios
Inventory holding period (Raw Material): Average RM inventory X 365
Material usage or Annual purchases
Inventory holding period (Work In Progress): Average WIP X 365
Production cost or Cost of sales
Inventory holding period (Finished Goods): Average FG inventory X 365
Cost of sales
Note: Also all the above ratios could be used to calculate the inventory turnover by using:
_____Cost______
Inventory
These ratios will measure how many times the firm is able to sale and replace its inventory.
Account Receivable collection period: Trade receivables x 365
Credit sales
The lesser the days the better it is for the company’s liquidity position.
Account payable payment period: Average trade payables x 365
Credit purchases or Cost of sales
The higher payable days indicates greater use of suppliers as a source of finance. However
such an action can lead to worsening company’s goodwill which can affect

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1. Future purchase from current or new suppliers

2. Losing on prompt payment discount
3. Suppliers might increase prices in order to compensate late payment.

CASH OPERATING CYCLE also known as working capital cycle or cash conversion
cycle or trading cycle tells the length of time between the company’s cash outflow for
material, wages and overheads and inflow of cash from sale of goods.
The formula to calculate cash operating cycle is:
Raw materials holding period X
WIP holding period X
Finished goods holding period X
Accounts receivable collection period X
Accounts payable payment period (X)
CASH OPERATING CYCLE XX.
OVER-CAPITALIZATION
Over capitalization is the excessive investment made by the business in its current assets.
Indications of over capitalization are:
1. High level of inventories, receivables and cash, and lesser payables resulting in longer
turnover periods for inventory and account receivables and lesser credit period from
suppliers.
2. High liquidity ratios.

OVER-TRADING
Over-trading occurs when:
1. Business is growing its sales faster than actually it can finance through working capital.
2. Also over-trading situation arises when old loan repayment isn’t replaced with a new one.
3. In period of inflation it will have insufficient retained profit to finance non-current assets
and inventories replacements, as it will cost more even if it is a profitable business.
Following are the signs of over-trading which needs to be monitored:
1. Drastic increase in sales revenue.
2. Increase accounts inventory turnover days.
3. Increase accounts receivable days
4. Financing, assets and expanding sales through credit in form of lengthening of
account payable payment period and bank overdraft which even exceeds its limits.
5. Dramatic fall in current and quick ratio due to an excess of current liabilities over
current asset occurs.

Any signs of over trading need proper actions such as:

1. More capital needs to be introduced by the owner or the shareholders.
2. Inventories and the accounts receivable should be managed efficiently.
3. Non-current asset purchases and aggressive sales strategies should be postponed until
the business has built up its capital base with retained profi

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WORKING CAPITAL – INVENTORY

Inventory includes raw materials, work-in-process and finished goods.
Types of inventory cost
Purchase cost Holding cost Ordering cost Stock out cost

When deciding on the optimum inventory levels it is important to consider two factors:
1. Profitability vs. Liquidity
2. The impact on different types of cost:
Too much inventory will increase Too less inventory will increase
1. Purchase cost. 1. Ordering cost such admin cost etc.
2. Holding cost such as warehousing etc. 2. Stock out cost such loss of sales etc.
3. Loss of quantity discount.
To minimize inventory cost following is required:
1. Inventory control levels
Re- order level = Maximum usage × Maximum lead time
Minimum level (buffer stock) = Re-order level – (Average usage × Average lead time)
Maximum level = Re-order level + Re-order quantity – (Minimum usage × Minimum lead time)
Re−order quantity
Average inventory = Buffer safety inventory +
2

2. Re-order quantity(Order size)

The Economic-Order Quantity [EOQ]
It is the order quantity at which the holding costs and the ordering costs are same and the sum of
these two is at minimum.
𝟐𝑪𝒐𝑫
Formula EOQ =√
𝑪𝒉
Co = Cost of placing one order
CH = Holding cost per unit of inventory per annum
D = Annual Demand
Assumptions:
1. The purchase price per unit is constant
2. No minimum inventory level (Buffer stock)
3. Demand and lead time are unchanged
EOQ and Bulk
The option having the lowest cost will then be accepted. Following are the cost that will be used in the
calculation & comparison

Cost of inventory = Purchase cost + Ordering Cost + Holding Cost

APPROACHES TO INVENTORY MANAGEMENT

1. Just-in-time (JIT) Procurement:
1. It is a demand pull system – eliminates the need to keep stocks of any kind
2. However this approach disturbs the balancing act (Liquidity vs. Profitability)
Suppliers and JIT
For such a responsive inventory management technique it is important to:

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1. Have Single or few suppliers who can guarantee reliability of delivery and quality.
2. Have long term contracts in relation to quality, delivery and prices
3. Ensure all the inventory related issues will be the responsibility of the supplier.

Advantages of using JIT approach

1. Decrease in holding costs
2. Elimination of all kind of waste
3. Decrease in scrap and warranty cost
4. Decrease in material handling cost
5. Reduced finance cost because of lower level of investment tied up in stock.

Disadvantages of using JIT approach

1. Companies may not be able to respond to periods of high demand.
2. Any disruption is supply from suppliers
3. Any increase in the prices by suppliers can cause problem

2. Other inventory management systems are: (Discussed in F2)

• Bin system • Order cycling method • ABC method

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WORKING CAPITAL - ACCOUNT

RECEIVABLES & PAYABLES
ACCOUNT RECEIVABLES
Here again the balancing act between the profitability and liquidity needs to be consider as
more sales on credit will increase profit but will affect liquidity.

CREDIT CONTROL POLICY

Following are the factors that need to be considered when establishing a credit control policy:
1. The administrative cost of credit control department.
2. The competitor credit terms.
3. The benefits and the cost of allowing more credit
4. The benefits and cost of giving discount for early payment.
5. The level of risk that is acceptable.
6. The liquidity position of the company.
7. The expertise available.

Credit control policy

1. Assessing credit worthiness 2. Setting credit limits
3. Collection of overdue debts 4. Monitor the credit system

Assessing credit worthiness

Following are the sources of information that can be used to assess the credit rating of
customers:
1. Two reference (bank and trade 2. Credit rating agencies
reference)
3. Published financial information 4. Press comments
5. Personal visit to the concerned 6. Past company records about customer
company
7. Credit rating system – Scores are calculated for new customer considering their age,
occupation, whether is a home owner etc.

Setting credit limits – Extension of credit request

1. After assessing the credit rating of the new customer credit limit will be established
2. As for the existing customer credit extension request should be carefully considered,
and it will be necessary to assess:
• The outstanding invoices
• The additional contribution
• The additional cost
• The length of additional time required for credit and the associated finance cost

General format used in the calculation of extending trade credit decision

The benefit arising from extending the trade credit
Increase in contribution/profit xxxx

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The cost arising from extending the trade credit

Increase in finance cost due xxxx
more cash tied in working capital
Increase in bad debts xxxx
Increase in administration cost xxxx

Collection of overdue debts

1. Once the credit limit decisions are taken and terms agreed then the next step is to send
invoice promptly to ensure beginning of the credit period.
2. Follow up system will include be started to ensure amount does not become overdue:
Reminders Telephone calls Personal visit
Supplies with held External debt agencies Legal case

Early Payment Discount

Offering early payment discount may make the collection process less difficult.
Annual cost of discount

The annual cost of discount will be compared with the rate of overdraft interest in order to
take a decision regarding the allowing for discount.

General format used in the calculation of early settlement discount decision

The benefit arising from offering early settlement discount
Increase in contribution/profit xxxx
Decrease in finance cost due xxxx
less cash tied in working capital
Decrease in bad debts xxxx
Decrease in administration cost xxxx
The cost arising from offering early settlement discount
Cost of discount xxxx
Decrease in contribution/profit xxxx
Increase in finance cost due xxxx
more cash tied in working capital
External debt collection and finance

The options available to business for external debt collection and finance are as follows:

Factoring Invoice discounting Credit insurance

Factoring
Factoring also known as accounts receivables financing is an arrangement with a third party
(usually bank) for the collection of company’s debts. The types of services offered by the
factoring are as follows:
Administration and collection Factor finance

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1. Administration and collection

1. This includes handling over the complete sales ledger, client’s invoicing and debt
collection.
2. Such selling of debt collection can be recourse or non-recourse:
1. With recourse factoring the factor will not bear the loss of any irrecoverable debt.
2. With non-recourse the factor will bear the loss of bad debts and will pay the client
the amount of debt. Non-recourse factoring is expensive than recourse factoring.

2. Factor financing
Here the factor becomes the financer for the company by paying the company up to
80% of the value of debt and in return charges 1.5% to 3% above the bank base rate
as finance cost.

General format used in the calculation of factoring decision

The benefit of factoring
Decrease in finance cost due xxxx
less cash tied in working capital
Decrease in bad debts xxxx
Decrease in administration cost xxxx
The cost of factoring
Factoring fee xxxx
Interest cost of factor finance xxxx
Decrease in contribution/profit xxxx
One off payment ** xxxx
** If annual payment = Take full charge
If only one off payment = Charge lost interest because of one off payment made
Factoring Advantages & Disadvantages
Advantages Disadvantages
1. Security against the irrecoverable debts 1. The company’s financial stability might be
2. Saving in administration cost questioned by suppliers and/or customers.
3. The company can keep optimum 2. As factor does intervene between the client
inventory levels and the customer this can upset the
4. Company receives 80% of the financing customers,
with in a day. 3. Factor decides what legal action to take
against irrecoverable debts if opts for non-
recourse factoring services. This can affect
the company’s image in the eyes of
customers.

Invoice discounting
Invoice discounting is an alternative method to factoring to improve the business working
capital and cash flow position.

Following are the procedures involved in invoice discounting arrangement:

1. The company deals the customers in normal way as customer is not aware of invoice
discounting services

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2. The business then sends the copy of the invoice to invoice discounter who the
advances up to 80% of the invoice value against the finance charge which is usually
3-4% above the base rate.
3. The company receives the payment from the customer in normal way but which is
paid in bank account (under the control of invoice discounter).
4. Invoice discounter then pay the company the remainder amount after deducting the
finance charges and the administration charges which are 0.5-1% of turnover
5. The finance company will require regular reports on sale ledger and credit control

Credit insurance
Credit insurance companies provide insurance to business against their irrecoverable debts.
The business arranging for credit insurance is required to submit credit proposals (customer
name, credit amount and time period) to credit insurance companies, which then will assess
the proposal thoroughly and will accept, amend or reject proposals depending on the
assessment results.

Monitoring the credit system

The position of accounts receivables should reviewed regularly so that corrective action can
be taken timely. For such a review, management will require different types of reports such
as:
1. Aging analysis will provide a list of outstanding debts
2. Ratio analysis will provide an indication about the trends
3. Credit utilization report will indicate the total credit limits utilized
4. Customer payment analysis will indicate breaches or attempted breaches of credit
limit

ACCOUNT PAYABLES
Accounts payables are the money which the company owes to its supplies.
An effective accounts payable management will involve:
1. Striking a balance between liquidity and profitability
2. Obtaining good credit term from suppliers.
3. In times of liquidity problems extending the credit period without affecting
relationship with suppliers.
4. Evaluation of the option of obtaining early payment discount.

Annual saving from obtaining discount

Formula:

The annual saving of discount will be compared with the opportunity cost of investing the cash
in order to take a decision regarding obtaining discount.

FOREIGN TRADE – RECEIVABLES & PAYABLES

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Accounts Receivables
Selling goods in foreign countries requires an effective management of credit risk and
recovery of receivables from foreign customers. Exporters are to subject to following
problems:
1. Complex documentation.
2. Increase investment tied in inventories and receivables which have to be financed.
3. The risk of delay in payment or bad debts due to insolvency of customer,
unconvertible currencies, political risk, failure of bank.
4. The foreign exchange risk. The solution to this is hedging which will be discussed in
later chapters.

Ways of reducing the foreign currency credit risk

• General Policies

1. Assessing the credit worthiness of the customer for example by checking

credit rating or taking bank references.
2. Proper documentation should be made for sales, shipping and delivery.
3. Proper chase up procedure should be followed once the payment becomes due.
4. Goods should be released when the payment has been received or against
negotiable instruments such bills of exchange or promissory note.

• Banks as intermediaries

Banks can be used as intermediaries who will make receivables management easy for
the company. Following are the types of services which the banks can offer:

1. Advances against collection. This is when the banks are requested to handle
the collections by the exporters on their behalf and the bank might also
advance up to 80% to 90% of the value of receivable to exporters.

2. Negotiation of bills or cheques. This is same as advance against collection but

with the only difference is that the bills or cheques are payable outside the
exporter’s country.

3. Discounting bills of exchange. The banks buy the bills from the exporter but at
a discount.

4. Documentary credit. It is an arrangement made when the chances of non-

payment are high, between the bank, exporter and the buyer before the export
sales take place. It provides 100% security to the exporter against the risk of
bad debts. The procedure starts with the buyer, who request the local bank to
issues the letter of credit in favour of the exporter. Such LC then guarantees
the payment to the exporter but process is slow to administer.

• Export Factoring
The services offered by the foreign factor company are same as the local factor
services which were discussed above.
• Export credit insurance

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Private insurance companies will provide the export credit insurance services which
insure the company against the risk of bad debts. However the high amount of
premium charges makes it less attractive for exporters.

Despite all the above discussed ways to reduce the export credit risk businesses have to
accept that:

1. Not all the customer can arrange documentary credit due to their small business scale.
2. Those customer who can arrange it, might consider it costly for them because it
restricts their flexibility for example even in cash crisis they are required to pay the
bank.
3. The documentation should be proper against which the collections will be made from
bank.
4. The sales should be in a convertible currency and also in a form acceptable to
customer’s exchange authorities.

Accounts Payables

Companies that are required to pay in foreign currency are subject to exchange rate risk. The
risk is that if the company has to pay at a later date in foreign currency so it will be concerned
about local currency depreciating against the foreign currency thus making the imports
expensive and might become less attractive for the local market. The solution to this is
hedging which will be discussed in later chapters.

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WORKING CAPITAL – CASH

MANAGEMENT & WORKING CAPITAL
FINANCE
Following are the reasons for holding cash.
Transaction motive Precautionary motive Speculative motive
This motive requires cash to This motive requires cash to be This motive requires cash
be kept to meet day to day kept (as buffer of cash) to meet to be kept in order to take
expenses unforeseen contingencies. benefit of market
investment opportunities.
Businesses face cash flow problems due to following reasons:
1. Making losses continuously will take company into cash flow problems.
2. In period of high inflation business may face cash flow problems as it needs
increasing amount of cash to replace the depreciated assets.
3. In period of growth business will require cash for purchasing new non-current assets
and for supporting inventories and receivables.
4. When the nature of the business is seasonal so it may face cash flow problems at
certain times of the year.
5. Any one off expenditure can cause cash flow problem for the business.

CASH MANAGEMENT MODELS

Baumol Model
𝟐𝑪𝒐𝑫
Formula Q =√
𝑪𝒉
Co = Transaction cost arising from sale of security or moving funds from deposit accounts.
CH = Cost of holding cash (The opportunity cost from investing somewhere or cost or borrowing)
D = Demand for cash over the period
Q = The amount that needs to be deposited in current account or transfer to short term investment
Assumptions:
1. The cash required for the period is predictable and remains constant
2. There is no buffer inventory of cash.
3. Daily cash needs are funded from current accounts

Miller-Orr-Model
Miller Orr model consider daily cash flow variation. There are two control limits – the upper
control limit and the lower control limit as well as a return point.
1. When cash touches the upper limit – make investment to reach return point.
2. When cash touches the lower limit – sell investment to reach return point.

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Upper limit = Lower limit + Spread

Return point = Lower limit + (1/3 x spread)
Where spread is calculated by using following formula
1/3
Spread= 3 (3/4 x transaction cost x variance of cash flows )
Interest rate
Note: Variances and interest rates should be expressed in daily terms. In case if you are given with standard
deviation then you will need to square it to calculate variance.

CASH BUDGETS
It is important for the businesses to forecast the cash flow needs of the future which will do
using cash budgets. Following are the cash position that will be identified by the cash flow
forecast and actions that can be taken:
Short-term surplus Short-term deficit
• Short term investment • Overdraft facility
• Payment to suppliers • Reduction in inventory
• Increase sales which will increase • Reduction in receivables
inventory and receivables • Increase in payables
Long-term surplus Long-term deficit
• Purchase new assets • Closure of loss making activities
• Diversify or Expand • Raising of long term finance
• Make long term investment
Important points to consider when making cash flow forecast
1. Items which are non-cash flow will not be considered
2. It is important to keep in mind the timing of cash receipts and payment.

Working capital policy

Investment policy
Aggressive policy
1. Company keeping lower levels of inventory and trade receivables will lead to a shorter
cash operating cycle.
2. It will result in less cost but higher risk of stock out.
2. Conservative
1. Company will keep higher levels of inventory and trade receivables, will lead to a longer
cash operating cycle.
2. It will result in higher cost but decreasing risk of stock out.
3. Moderate
The company will keep a balance level of inventory and receivables.

Financing policy
Important terms to understand
Non-current asset Permanent current asset Fluctuating current asset

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Benefits and cost of financing options

Source of finance Cost Risk
Short-term Low High
Long-term High Low

1. Aggressive approach to financing working capital

1. Company finances all its fluctuating current assets and most of its permanent current
assets using short term source of finance.
2. Only a small proportion of its permanent current assets is financed using long-term source
of finance.
3. This will result in less cost but with a corresponding high risk.
4. This has the effect of increasing its profitability but with a potential risk of facing liquidity

2. Conservative approach to financing working capital

1. Company predominantly finances all its permanent current assets and most of its
fluctuation current assets using long-term source of finance and it is
2. Only a small proportion of its fluctuating current assets that is financed using short-term
source of finance.
3. This will result in relatively high cost but low risk.
4. This has the effect of improving liquidity at the expense of decreasing its profitability.

3. Moderate approach to financing working capital

1. Short-term source of finance will be used to finance fluctuating current assets.
2. Long-term source of finance should be used to finance permanent current assets.
3. This will result in balance of risk and cost.
4. This will result in balance of liquidity and profitability.

Other factors to consider when deciding the optimum working capital

Nature of the business Working method Liquidity vs Profitability
Supplier terms Company credit terms Growth approach

Centralized or decentralized treasury department

Following are advantages of having centralized and decentralized treasury department.
Centralized treasury department Decentralized treasury department
1. The duplication of work will be 1. The local division will have a better idea
eliminated. of local the needs and will be able to
2. The borrowing requirement can be respond quickly to local requirement.
arranged in bulk resulting in lower rates 2. Such decentralization will lead to
and bulk deposit will attract higher rates. motivation due to greater autonomy given
3. Company can benefit from greater for the management of treasury
opportunities of short term investment. department.
4. The company will benefit from effective 3. Will improve skills of local managers
foreign exchange management. who will be trained for future corporate
5. Lower bank charges. positions.

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