WORKING CAPITAL MANAGEMENT

By: Noor ul hadi Lecturer GCMS Peshawar

Working Capital Management

• Working Capital Management is another important area of financial management.

• – Working Capital Management is component of financial management that focuses on Current Assets & Liabilities of Balance Sheet in day-to-day operation.

Working Capital Terminology:

• Working capital is also called gross working capital, simply refers to current assets used in operations.

• Working Capital (Gross) = Current Assets • – Current Assets = Inventory + Accounts Receivables +

Cash + Marketable Securities + • …(The mentioned items are four major items) • – Working Capital is different from “Capital” (as used

in Capital Budgeting) which refers • to Capital Expenditure in Fixed Assets • – Also it is different from “Capital” (as used in Capital

Structure) which refers to • Financing in the form of Debt or Equity (Loans or share

capital)

Working Capital Terminology:• Net Working Capital = Current Assets – Current Liabilities • Net working capital is slightly different from gross working capital. • – working capital is different from Net Worth • = Assets – Liabilities = Equity • = Stock + Retained Earnings • – Current Liabilities • = Accounts Payables + Accruals + Short Term Loans + (as well as

other minor items) • • Important Measure of the Short-term Liquidity of a Firm • – Working capital is a measure of how easy it is for a firm to

convert short-term assets • into “Liquid” Cash in order to meet the Current Obligations by selling

assets

Terminology

• – Some ratios to measure liquidity of firm are: • Current Ratio = Current Assets / Current Liabilities • Acid Test or Quick Ratio = Quick Assets / Current

Liabilities • • Quick Assets = Current Assets – Inventory • • Fundamental Tradeoff in Working Capital (or Current

Assets) • Decision in working capital management is how much

working capital should be maintained by a firm. It requires how much money needs to be invested in Inventory, Accounts Receivables, Marketable Securities and how much cash should be maintained.

Current Assets• Advantages of Large Current Assets:• less risk of shortages & interruptions and less loss • of sales due to availability of funds for lo an payments and purchases and

inventory. • High Liquidity so better CREDIT Rating. • Advantages of Small Current Assets: • Less investment in current assets means less amount of money tied to the

assets which are generating no return. So lower Opportunity Cost of Capital. • – Find the Optimum Current Assets (working capital) At Any Given Time

and for a • Given Level of Sales & Growth: • • For this Alternative Investment Policies have been proposed and a good • business judgment is required

Working Capital Policies:

• • What is the Optimum Working Capital (or Current Assets) for a Firm at any given time given in level of Sales and Growth Strategy? This requirement fluctuates with time depending on sales and seasons.

Type of policy in Working Capital

Practically the following policies are used by the mangers to decide what is the best amount of current assets or mix of assets to be kept for the firm:

1. Relaxed Policy

2. Moderate Policy

3. Restricted Policy

1. “Fat Cat” or Relaxed Policy

– It requires Large Amount of Current Assets not to loose any sales i. e. when a customer

• places order for a large amount, there is no shortage of inventory

– Occurs when High sales driven by lot of credit facility to buyers

– Good Credit Rating because High Liquidity and good Current Ratio

– Case: Wall Mart retail chain during New Year and Christmas

2.“Lean & Mean” or Restricted Policy

– Small Amount of Current Assets – It increases turnover and therefore Profits • Current Asset Turnover = Sales / Current Assets. Higher than 20. • Lowers Carrying Costs of Inventory – Frees up cash and speeds up production (operational efficiency) – Small Current Assets means Lower Opportunity Cost of Capital. Firms have

raised Capital from Investors (Debt Holders and Shareholders) which comes at a Cost

(the WACC includes Interest paid to Debt Holders and Dividends paid to Shareholders).

Firms must mobilize the capital in high-return investments in order to repay their investors.

– “Zero Working Capital Policy” (Extreme form of Lean & Mean Policy) It can not be 0 in reality but its objective is to minimize. • Japanese Just in Time (JIT) i.e. Toyota Motor Co. It means the spare parts

reach just a few hours ago from the assembly time.

3.Moderate Policy

– In between the Fat Cat and Lean & Mean Policies

Impact of working capital on Firm Value:

There is a link between working capital policy and our basic objective of financial management of maximizing shareholder’s wealth.

MANAGING THE COMPONENT OF WORKING CAPITAL

• WORKING CAPITAL CONSIST FOUR MAIN COMPONENT– CASH– MARKETABLE– INVENTORIES– ACCOUNT RECIEVABLEFor each type of assets, fundamental trade off: that current assets

are necessary to conduct business, and the greater the holding of current assets, the smaller the danger of running business, holding current asset is costly if inventories are too large, then the firm will have asset with zero or negative return.

Cash Management

• The cash conversion cycle:Conversion cycle include purchase of inventory, sell goods

on credit, and the collect account receivable. The cycle is referred to as the cash conversion cycle, sound working capital is designed to minimizes the time between cash expenditures on material and the collection of cash on sale.

The cash conversion cylce model focused on the length of time between when the company makes payment and when it receives cash inflow, the following term are used in the model.

1. Inventory conversion period.

It is the average time required to convert material into finashied goods and thet o sell those good. It is calculated as follow:

Inventory conversion period=

inventory /sale per day

For example average inventory is 2,000,000 and sale are 10000000 then conversion period

=2000000/(10000000)360 =72 days

2. Receivable collection period

RCP is the average length of time required to convert the firm’s receivable into cash, it is also called days sale outstanding.

RCP or DSO= Receivable / (sale/360)

If average receivable are 666,667 and sale is 10 million.

DSO=666667 / (10000000/360) =24 days

3. Payable deferral period.

• PDP is averagge length of time between purchase of materials and labor and payment of cash for them.

• PDP= payable / avg purchases per day• = payables / cost of goods sold/360

If cost of goods sold is 8million and account payable average is 666,667;

PDP = 666667/ (8000000/360)

PDP = 30 days.

Cash conversion Cycle

It is nets out the three periods (ICP,RCP,PDP)