Unit 4: Working capital management
Financial Management notes · PTU syllabus (BCOM 501-18)
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Unit summary
Working capital keeps the business running day to day — cash to pay bills, stock to sell and credit to customers. This unit covers planning and forecasting working capital, the importance of adequate working capital, its determinants and sources, and the management of cash, receivables and inventory.
After this unit you can
- Explain concepts, types and the operating cycle of working capital
- Explain the importance and determinants of working capital and estimate requirements
- Explain sources of working capital
- Explain cash, receivables and inventory management techniques
PTU syllabus topics
- Planning and forecasting working capital
- importance of adequate working capital
- determinants of working capital requirement
- sources of working capital
- cash management
- receivables management
- inventory management
- 1. Cash: Pay for raw materials
- 2. Raw materials: Store and issue
- 3. Work in progress: Production
- 4. Finished goods: Ready to sell
- 5. Debtors: Credit sales collected as cash
Topic 1
Concept, types and planning of working capital
- Gross working capital: total current assets. Net working capital: current assets − current liabilities.
- Permanent (fixed) working capital: minimum level needed always; temporary (variable): fluctuates with seasons.
Operating cycle
Raw material storage period + WIP period + Finished goods storage period + Debtors collection period − Creditors payment period
Raw material storage period
Average RM stock ÷ RM consumed per day
Debtors collection period
Average debtors ÷ Credit sales per day
Planning and forecasting
- Methods: percentage of sales, operating cycle method, regression, cash forecasting.
Example
Estimate (per annum): production 60,000 units; RM ₹40, labour ₹20, overheads ₹10 per unit; RM held 1 month; WIP 0.5 month (fully material, 50% labour and overheads); FG 1 month at cost; debtors 2 months at cost; creditors 1 month. Monthly figures: RM 2,00,000; WIP = 0.5 × (2,00,000 + 50% of 1,50,000) = 1,37,500; FG 3,50,000; debtors 7,00,000; less creditors 2,00,000. Net WC = ₹11,87,500 (plus a safety margin if specified).
Topic 2
Importance and determinants
Effect on operations
Production stoppages, lost discounts, poor credit standing
Idle funds, low return on investment
Risk
Insolvency risk
Inefficiency, speculation, bad debts from liberal credit
Profitability
Lost opportunities
Lower ROI
- Determinants: nature and size of business, production cycle, business cycle and seasonality, credit policy, growth and expansion, operating efficiency, availability of raw materials, dividend policy, price level changes.
- Approaches to financing: matching (hedging) — finance permanent WC with long-term funds and temporary with short-term; conservative — mostly long-term; aggressive — mostly short-term.
Topic 3
Sources of working capital
| Long-term (for permanent WC) | Short-term (for temporary WC) |
|---|---|
| Equity and preference shares | Trade credit |
| Debentures and long-term loans | Bank overdraft and cash credit |
| Retained earnings | Bill discounting and factoring |
| Depreciation funds | Commercial paper |
| Public deposits (short-term), advances from customers |
- Bank finance norms: Tandon Committee (1975) — Maximum Permissible Bank Finance methods; Chore Committee (cash credit); now assessment by banks based on projected turnover and the working capital demand loan structure.
Topic 4
Cash, receivables and inventory management
Cash management
- Motives for holding cash (Keynes): transaction, precautionary, speculative; plus compensating balances.
- Tools: cash budget, speeding collections (lock-box, electronic transfer, UPI), controlling disbursements, investing surplus in money market instruments.
Baumol model
Optimum cash balance = √(2 × T × b ÷ i) — T annual cash need, b cost per transaction, i interest rate
Miller–Orr model
Spread = 3 × (¾ × b × σ² ÷ i)^(1/3); return point = lower limit + spread ÷ 3
Receivables management
- Credit policy variables: credit standards (5 Cs — character, capacity, capital, collateral, conditions), credit period, cash discount, collection policy.
- Evaluation: compare incremental contribution from more sales with incremental costs — bad debts, collection cost, cost of funds tied up.
- Tools: ageing schedule, average collection period, factoring, TReDS for MSME receivables.
Inventory management
- Motives: transaction, precautionary, speculative.
- Techniques: EOQ = √(2AO ÷ C); reorder level; safety stock; ABC analysis; VED; JIT; inventory turnover ratios.
Example
Annual demand 12,000 units; ordering cost ₹100; carrying cost ₹6 per unit per year. EOQ = √(2 × 12,000 × 100 ÷ 6) = √4,00,000 ≈ 632 units.
Key terms
- Net working capital
- Current assets minus current liabilities
- Operating cycle
- Time from cash to raw materials back to cash
- Matching approach
- Finance permanent needs long-term and temporary needs short-term
- Factoring
- Selling receivables to a factor for immediate cash
- EOQ
- Order quantity that minimises total inventory cost
Quick revision
- Gross vs net WC; permanent vs temporary.
- Operating cycle = RM + WIP + FG + debtors − creditors periods.
- Determinants: nature, cycle, seasonality, credit policy, growth.
- Financing: matching, conservative, aggressive.
- Cash (Baumol, Miller–Orr), receivables (5 Cs, factoring), inventory (EOQ, ABC).
Important exam questions
Practice questions written to the PTU exam pattern for this unit's syllabus: short answers (Section A style) and long answers (Sections B and C style).
Short-answer questions
- Q1.Distinguish gross and net working capital.
- Q2.What is the operating cycle?
- Q3.What are the dangers of excess working capital?
- Q4.State the motives for holding cash.
- Q5.What are the 5 Cs of credit?
- Q6.Write the EOQ formula.
Long-answer questions
- Q1.Explain the concept, types and importance of working capital.
- Q2.Explain the determinants of working capital and estimate requirements with an illustration.
- Q3.Explain the sources of working capital and approaches to financing.
- Q4.Explain cash, receivables and inventory management techniques.
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