Working Capital Management CBCFB6T11

Syllabus topics (RTMNU)

• Concept
• Definition
• Types
• Importance
• Need and Objectives of Working Capital
• Factors determining working capital requirements
• Advantages and disadvantages of Excessive working capital and inadequate working Capital
• Sources of working capital finance
• Latest committees regarding working capital - Kannan Committee, Marathe Committee

Concept and Definition of Working Capital

Working capital is the capital a business needs for its day-to-day operations — to buy raw materials, pay wages and expenses, hold stock and give credit to customers. It is the money tied up in current assets (assets converted into cash within one year).

There are two concepts:

1. Gross working capital: total investment in current assets — cash, bank, debtors (receivables), bills receivable, inventory (raw materials, work-in-progress, finished goods), short-term investments and prepaid expenses.
2. Net working capital: current assets minus current liabilities (creditors, bills payable, outstanding expenses, bank overdraft, short-term loans). Net WC = CA − CL. It shows the part of current assets financed by long-term funds and indicates liquidity.

Types of Working Capital

1. On the basis of concept: Gross working capital and Net working capital (explained above). Net WC can be positive (CA > CL) or negative (CL > CA).
2. Permanent (fixed) working capital: the minimum level of current assets that a firm must always keep to run without break, e.g. a minimum stock of raw material and a minimum cash balance. It is like a fixed asset and should be financed from long-term sources.
3. Temporary (variable / fluctuating) working capital: extra working capital needed above the permanent level because of seasonal demand or special orders. Example: a sweet shop in Nagpur needs much more stock before Diwali. It is financed from short-term sources like bank cash credit. It may be seasonal or special.
4. Regular and reserve working capital: regular WC is needed for the normal operating cycle; reserve WC is kept extra for emergencies such as strikes or a sudden rise in prices.

Importance, Need and Objectives of Working Capital

Working capital is called the life-blood of a business. Even a profitable firm can fail if it has no cash to pay wages and suppliers.

Need / importance:

1. Smooth production: regular supply of raw materials and payment of wages keeps the plant running.
2. Solvency and goodwill: the firm pays creditors on time and builds a good name.
3. Cash discounts: prompt payment to suppliers earns cash discounts and lowers cost.
4. Easy bank loans: banks give credit easily to firms with sound working capital.
5. Regular returns: the firm can pay regular dividends and interest.
6. Facing crises: it helps the firm survive a depression or a sudden fall in sales.
7. Use of fixed assets: machines can be used fully only if raw materials and labour are available.

Objectives of working capital management: (1) keep enough liquidity to pay short-term obligations; (2) avoid excess funds lying idle; (3) maximise profitability by a correct trade-off between liquidity and profit; (4) keep the operating cycle as short as possible; (5) minimise the cost of financing current assets.

Factors Determining Working Capital Requirements

1. Nature of business: trading firms and public utilities differ — a retailer like D-Mart needs heavy stock; an electricity company needs little because services are sold for cash/short credit.
2. Size of business: a bigger business needs more working capital.
3. Production cycle: a longer manufacturing process (e.g. heavy machinery) locks more funds in work-in-progress.
4. Seasonal variations: sugar, woollens and fertiliser businesses need more WC in the season.
5. Credit policy: liberal credit to customers increases debtors and WC; credit received from suppliers reduces it.
6. Business cycle: during a boom more WC is needed; during a depression less.
7. Growth and expansion: a growing firm needs more WC.
8. Price level changes: inflation raises the cost of stock and wages.
9. Operating efficiency: faster stock turnover and quicker collection reduce WC.
10. Availability of raw materials and dividend policy also affect the amount.

Excessive and Inadequate Working Capital

Advantage of adequate (not excess) WC: it gives solvency, credit standing and smooth operations. So the aim is an optimum level — neither too much nor too little.

Sources of Working Capital Finance

1. Long-term sources (for permanent WC): share capital, debentures, long-term loans, retained earnings (ploughing back of profits).
2. Short-term sources (for temporary WC): bank cash credit and overdraft, short-term loans, bill discounting, trade credit from suppliers, commercial paper (issued by large companies), factoring of receivables, public deposits, advances from customers, and accrued expenses (outstanding wages and taxes).
3. Spontaneous sources: trade credit and outstanding expenses that arise automatically in business without any formal arrangement.

Committees on Working Capital: Kannan Committee and Marathe Committee

The RBI appointed several committees to guide bank lending for working capital. Background: the Tandon Committee (1974) introduced the Maximum Permissible Bank Finance (MPBF) with three methods, and the Chore Committee (1979) made the second method compulsory and reduced dependence on cash credit.

Marathe Committee (1982–83): headed by Shri S.S. Marathe, it reviewed the RBI's Credit Authorisation Scheme (CAS). Main points:

1. Accepted the Tandon and Chore norms on inventory and receivables.
2. Introduced the "fast track" concept: banks could release a part of the credit without waiting for RBI approval if the borrower met conditions such as proper inventory norms, current ratio of at least 1.33, regular submission of information and good accounts.
3. Changed the name of CAS to Credit Monitoring Arrangement (CMA) — RBI moved from prior approval to post-sanction monitoring.

Kannan Committee (1997): a working group of the Indian Banks' Association headed by Shri K. Kannan. Main points:

1. Recommended abolition of the MPBF method of Tandon/Chore.
2. Banks were given freedom to assess working capital needs by their own methods, such as the turnover method, cash budget method or the old MPBF itself.
3. Banks to fix their own margins and current ratio norms, based on the borrower's credit rating.
4. The RBI accepted these ideas from 1997, giving banks full freedom in WC lending.

Also note the Nayak Committee (1991) for small industries: WC = 25% of projected turnover, of which 5% from the borrower and 20% as bank finance.

Likely exam questions

1. (Long, 8/16 marks) What is working capital? Explain its types and the factors determining working capital requirements.
2. (Long, 8/16 marks) Explain the dangers of excessive and inadequate working capital. Describe the recommendations of the Kannan Committee and the Marathe Committee on working capital finance.
3. (Short, 4 marks) Distinguish between gross working capital and net working capital.
4. (Short, 4 marks) What is permanent and temporary working capital?
5. (Short, 4 marks) State any four sources of working capital finance.

Syllabus topics (RTMNU)

• Assessment and forecasting of working capital requirements
• Operating cycle
• Weighted Operating cycle
• Computation (Estimation) of Working Capital Requirement

Assessment and Forecasting of Working Capital Requirements

Assessment of working capital means estimating, in advance, how much money the firm will need to finance its current assets for a coming period. Under-estimation causes shortage; over-estimation keeps funds idle.

Methods of estimation:

1. Percentage of sales method: WC is taken as a fixed percentage of sales, based on past experience. Simple, but assumes a fixed relationship.
2. Regression analysis method: a statistical relation between sales and WC is found from past years and used to forecast.
3. Operating cycle method: WC is estimated from the length of the operating cycle and the cost of operations.
4. Estimation of components (cash cost) method: each current asset and current liability is estimated separately from the budgeted production and holding periods; the most common method in exams.

Operating Cycle

Operating cycle is the time taken to convert cash into raw materials, raw materials into work-in-progress, WIP into finished goods, finished goods into debtors (sales) and debtors back into cash. It is also called the working capital cycle or cash cycle.

Components:

1. R = Raw material storage period = Average stock of RM ÷ RM consumed per day
2. W = WIP (conversion) period = Average WIP ÷ Cost of production per day
3. F = Finished goods storage period = Average FG stock ÷ Cost of goods sold per day
4. D = Debtors collection period = Average debtors ÷ Credit sales per day
5. C = Creditors payment (deferral) period = Average creditors ÷ Credit purchases per day

Illustration 1 (Operating cycle): From the following data of Shree Sai Industries, Nagpur, calculate the operating cycle (take 360 days).

Solution:

Number of operating cycles = 360 ÷ 98 = 3.67 times a year. A shorter cycle means less working capital is needed.

Weighted Operating Cycle

The simple operating cycle adds up days, but the money locked at each stage is not the same — raw material is worth less than finished goods. The weighted operating cycle gives each stage a weight equal to the value tied up at that stage as a proportion of the selling price (or of sales value), and then adds the weighted days.

Illustration 2: Selling price ₹100 per unit; cost: RM ₹50, labour ₹20, overheads ₹10 (total ₹80). RM stock 30 days; WIP 10 days (valued at full RM + half conversion = ₹65); FG 20 days (at cost ₹80); debtors 45 days (at cost ₹80); creditors 30 days (on RM ₹50). Daily sales ₹20,000.

Working capital = ₹20,000 × 58.5 = ₹11,70,000.

Computation (Estimation) of Working Capital Requirement

Steps in the component method:

1. Find the budgeted production/sales per month (or per week).
2. Find the cost per unit of each element: raw material, labour, overheads.
3. Value each current asset: RM stock = monthly RM cost × months held; WIP = units in WIP × (full RM + degree of completion × labour and overheads); FG = monthly cost of production × months held; Debtors = monthly cost of sales (or sales) × credit months; plus cash balance.
4. Value each current liability: creditors = monthly purchases × credit months; lag in payment of wages and overheads.
5. Net WC = Total CA − Total CL; add a margin for contingency if given.

Illustration 3: Gondia Engineering Ltd. plans to produce 60,000 units a year. Cost per unit: raw material ₹40, labour ₹15, overheads ₹25; selling price ₹100. Raw material in stock 1 month; WIP ½ month (full material, 50% labour and overheads); finished goods 1 month; credit to debtors 2 months; credit from suppliers 1 month; lag in wages ½ month; lag in overheads 1 month; cash balance ₹50,000. Add 10% contingency. Activity is even through the year. Estimate the working capital.

Working note: monthly production = 60,000 ÷ 12 = 5,000 units; WIP = 5,000 × ½ = 2,500 units.

Likely exam questions

1. (Long, 8/16 marks) What is the operating cycle? Explain its components and how it is used to estimate working capital.
2. (Long, 8/16 marks) A firm plans to produce 48,000 units a year. Cost per unit: raw material ₹30, labour ₹10, overheads ₹20; selling price ₹80. Raw material stock 1 month, WIP ½ month (full material, 50% labour and overheads), finished goods 1 month, debtors 2 months, creditors 1 month, lag in wages and overheads 1 month, cash balance ₹40,000. Prepare a statement of working capital requirement (debtors at cost).
3. (Short, 4 marks) Calculate the net operating cycle: R = 40 days, W = 15 days, F = 20 days, D = 45 days, C = 30 days.
4. (Short, 4 marks) What is the weighted operating cycle?
5. (Short, 4 marks) State the methods of forecasting working capital requirements.

Syllabus topics (RTMNU)

• Receivable Management: Concept and definition of receivables
• Cost of maintaining receivables
• Objectives of receivable management
• Discount Policy
• Determination of optimal credit policy
• Creditors management
• Inventory Management: Meaning and nature of inventory
• Purpose and benefit of holding Inventory
• Cost of holding inventory
• Economic Order Quantity and various inventory levels

Receivables: Concept and Definition

Receivables (debtors and bills receivable) are amounts owed to the firm by customers who bought goods or services on credit. They arise because firms sell on credit to increase sales and meet competition.

Cost of Maintaining Receivables

1. Capital (financing) cost: money is blocked in debtors; the firm pays interest on funds used or loses the return it could earn.
2. Administration cost: credit investigation of customers, keeping debtors' accounts and staff salaries.
3. Collection cost: reminders, phone calls, travelling of collection staff, legal charges.
4. Delinquency cost: extra cost when customers delay beyond the due date.
5. Default cost (bad debts): amounts that can never be recovered.

Objectives of Receivable Management

The main objective is to increase sales and profit up to the point where the extra return from more credit sales equals the extra cost of receivables. Other aims: optimum investment in debtors, low bad debts, quick collection and good customer relations.

Discount Policy

A cash discount is a reduction offered for early payment, written as "2/10, net 30" — 2% discount if paid within 10 days, otherwise full amount in 30 days. A discount speeds up collection, reduces bad debts and the investment in debtors, but costs the discount amount. A discount policy is worth adopting when the savings (lower capital cost and bad debts) are more than the cost of the discount.

Determination of Optimal Credit Policy

Credit policy has four parts: credit standards (who gets credit), credit period, cash discount and collection effort. A loose (liberal) policy increases sales but also bad debts and investment; a tight (strict) policy does the opposite. The optimal credit policy is the one that gives the highest net benefit (incremental contribution − incremental costs).

Illustration 1: Present credit sales ₹10,00,000, credit period 30 days, bad debts 1%. Proposed policy: sales rise to ₹12,00,000, credit period 60 days, bad debts 2%. Variable cost is 70% of sales; fixed costs do not change; required return 15%; take 360 days. Should the firm change its policy?

The proposed policy gives ₹33,750 more, so it should be adopted.

Creditors Management

Creditors (accounts payable) arise when the firm buys on credit. Trade credit is a spontaneous, usually free source of finance. Good creditors management means: using the full credit period without delay, taking cash discounts when the saving is more than the cost of funds, keeping good relations with suppliers and never stretching payments so far that goodwill is lost. Under the MSMED Act 2006, payments to micro and small suppliers must be made within the agreed time (maximum 45 days) — check latest rules.

Inventory: Meaning, Nature, Purpose and Benefits

Inventory means the stock of raw materials, work-in-progress, finished goods and stores & spares held by a firm. Inventory management aims to keep stock at a level that avoids both shortage and over-stocking.

Motives / purposes of holding inventory: (1) transaction motive — smooth production and sales; (2) precautionary motive — protection against delays in supply or sudden demand; (3) speculative motive — gain from expected price rise. Benefits: uninterrupted production, quantity discounts on bulk buying, prompt service to customers and protection against price rise.

Cost of Holding Inventory

1. Ordering cost: cost of placing and receiving an order — paperwork, transport, inspection. It falls as order size rises (fewer orders).
2. Carrying (holding) cost: interest on capital, storage rent, insurance, deterioration, obsolescence. It rises with order size.
3. Stock-out (shortage) cost: lost sales, idle labour, loss of goodwill.

Economic Order Quantity (EOQ)

EOQ is the order size at which the total of ordering cost and carrying cost is the lowest. At EOQ, annual ordering cost = annual carrying cost.

Illustration 2: Annual demand 9,000 units; ordering cost ₹200 per order; carrying cost ₹10 per unit per year. EOQ = √(2 × 9,000 × 200 ÷ 10) = √3,60,000 = 600 units. Number of orders = 9,000 ÷ 600 = 15. Ordering cost = 15 × 200 = ₹3,000; carrying cost = (600 ÷ 2) × 10 = ₹3,000; total = ₹6,000.

Various Inventory Levels

Illustration 3: Usage: minimum 300, normal 400, maximum 500 units per week; re-order period 4–6 weeks (normal 5); re-order quantity (EOQ) 2,000 units; emergency period 2 weeks.

Likely exam questions

1. (Long, 8/16 marks) What is receivables management? Explain the costs of maintaining receivables and the determination of optimal credit policy.
2. (Long, 8/16 marks) Annual consumption 12,000 units; ordering cost ₹150 per order; carrying cost ₹4 per unit per year. Usage: minimum 200, normal 300, maximum 400 units per week; re-order period 3–5 weeks (normal 4). Calculate EOQ, re-order level, minimum level, maximum level and average stock level.
3. (Short, 4 marks) Calculate EOQ: annual demand 4,000 units, ordering cost ₹100, carrying cost ₹5 per unit per year.
4. (Short, 4 marks) State the motives of holding inventory.
5. (Short, 4 marks) What is meant by discount policy in receivables management?

Syllabus topics (RTMNU)

• Meaning, definition and nature of cash Asset management
• Motives for holding cash
• Factors determining the optimum cash balance
• Determination of optimum cash balance
• Cash Management Models (Baumol, Miller Orr)
• Types of float
• Cash Planning
• Cash budget

Meaning, Definition and Nature of Cash Management

Cash is the most liquid current asset — coins, currency notes, bank balances and near-cash items like marketable securities that can be turned into cash quickly. Cash management means managing the inflows and outflows of cash, cash held within the firm, and investing surplus cash, so that the firm always has enough cash but no idle cash.

Nature: cash itself earns nothing (non-earning asset), yet it is essential for paying wages, suppliers, taxes and loans. So there is a conflict between liquidity and profitability. The aims are: meet payment schedules, keep the minimum cash, speed up collections, slow down payments (within limits) and invest surplus cash.

Motives for Holding Cash

Lord J.M. Keynes gave three motives; a fourth is added in business finance.

1. Transaction motive: to pay day-to-day expenses — wages, raw materials, rent, taxes — because receipts and payments do not happen at the same time.
2. Precautionary motive: to meet unexpected needs such as a strike, a fall in sales, delay in collection or a sudden rise in prices.
3. Speculative motive: to take advantage of profitable chances, such as buying raw material cheaply or buying securities when interest rates are expected to change.
4. Compensating motive: banks require a minimum balance in the current account as compensation for their services and loans.

Factors Determining the Optimum Cash Balance

1. Synchronisation of cash flows: if inflows and outflows match in time, less cash is needed.
2. Short costs: cost of running short of cash — penalty, lost discounts, emergency borrowing.
3. Excess cash balance cost: interest lost on idle cash (opportunity cost).
4. Procurement and management cost: staff, security and handling costs of cash.
5. Uncertainty: more uncertain cash flows need a bigger safety balance.
6. Credit standing and borrowing facility: a firm with an easy overdraft facility can keep less cash.
7. Nature and size of business and the availability of liquid investments.

Determination of Optimum Cash Balance and Cash Management Models

The optimum cash balance is the level where the total of holding (opportunity) cost and transaction (conversion) cost is minimum. Two well-known models help to find it.

1. Baumol Model (1952, W.J. Baumol): applies the EOQ idea to cash. It assumes cash payments are known and steady, the firm holds marketable securities and sells them in lots when cash runs out, the conversion cost per transaction is fixed, and the interest rate is known.

Illustration 1: Annual cash requirement ₹36,00,000; cost per conversion ₹200; interest on securities 10%. C = √(2 × 36,00,000 × 200 ÷ 0.10) = √14,40,00,00,000 = ₹1,20,000. Number of conversions = 36,00,000 ÷ 1,20,000 = 30. Conversion cost = 30 × 200 = ₹6,000; holding cost = (1,20,000 ÷ 2) × 10% = ₹6,000; total cost = ₹12,000.

Limitation: cash flows are rarely steady and certain in real life.

2. Miller–Orr Model (1966, M.H. Miller and D. Orr): assumes cash flows are random (uncertain). The firm sets a lower limit (L) and an upper limit (H). When cash touches H, securities are bought to bring cash down to the return point (R); when cash falls to L, securities are sold to bring it back up to R. Between the limits, nothing is done.

Illustration 2: Minimum cash (L) ₹20,000; variance of daily cash flows ₹7,20,00,000; cost per transaction ₹150; interest 0.03% per day. Z = (3 × 150 × 7,20,00,000 ÷ (4 × 0.0003))^1/3 = (27,00,00,00,00,000)^1/3 = ₹30,000. Return point = 20,000 + 30,000 = ₹50,000; upper limit = 20,000 + 90,000 = ₹1,10,000; average cash = 20,000 + 40,000 = ₹60,000.

Types of Float

Float is the difference between the balance shown in the firm's books and the balance in the bank, due to time delays in handling cheques and payments.

1. Collection float: delay between the customer sending a payment and the money becoming usable by the firm. It has three parts: mail float (time in post/transit), processing float (time to record and deposit), and clearing (availability) float (time for the bank to clear the cheque).
2. Disbursement (payment) float: delay between the firm issuing a cheque and the amount being deducted from its account. It benefits the payer.
3. Net float = Disbursement float − Collection float.

Methods to reduce collection float: concentration banking, lock-box system, electronic payments (NEFT, RTGS, UPI, IMPS). With UPI and real-time payments in India, float has become very small today.

Cash Planning and Cash Budget

Cash planning means forecasting future cash receipts and payments to avoid shortages and idle surpluses. The main tool is the cash budget — a statement of estimated cash receipts, cash payments and cash balance for each month (or week) of a future period. It shows when the firm must borrow and when it can invest surplus. Methods: (1) receipts and payments method (most common), (2) adjusted profit and loss method, (3) balance sheet method.

Illustration 3: Prepare a cash budget for January–March from: Sales — Dec ₹1,00,000, Jan ₹1,20,000, Feb ₹90,000, Mar ₹1,10,000; 20% are cash sales and the rest is collected in the next month. Purchases — Dec ₹60,000, Jan ₹70,000, Feb ₹50,000, paid in the next month. Wages paid in the same month — Jan ₹20,000, Feb ₹18,000, Mar ₹22,000. Rent ₹5,000 per month. Machinery bought in Feb ₹40,000. Opening cash on 1 Jan ₹25,000.

Likely exam questions

1. (Long, 8/16 marks) Explain the motives for holding cash and the Baumol and Miller–Orr models of cash management.
2. (Long, 8/16 marks) Prepare a cash budget for April–June: Sales — Mar ₹80,000, Apr ₹90,000, May ₹1,00,000, Jun ₹70,000 (25% cash, balance collected next month). Purchases — Mar ₹50,000, Apr ₹60,000, May ₹45,000 (paid next month). Wages ₹15,000 per month paid the same month. Rent ₹4,000 per month. Opening cash on 1 April ₹30,000.
3. (Short, 4 marks) Using the Baumol model, find the optimum cash balance: annual cash need ₹18,00,000, cost per conversion ₹100, interest 8%.
4. (Short, 4 marks) What is float? Explain its types.
5. (Short, 4 marks) State the factors determining the optimum cash balance.