Chapter 7: Working Capital Management
Working capital management deals with managing short-term assets (current assets) and short-term liabilities (current liabilities) to ensure a firm can meet its day-to-day operational needs and short-term obligations. This chapter covers working capital concepts, cash management, receivables management, and inventory management.
7.1 Working Capital Concepts
| Concept | Formula | Meaning |
|---|---|---|
| Gross Working Capital | Total Current Assets | Total short-term assets (cash, receivables, inventory) |
| Net Working Capital | Current Assets - Current Liabilities | Liquidity buffer; ability to meet short-term obligations |
| Permanent WC | Minimum CA required for operations | Fixed portion that doesn't fluctuate |
| Temporary/Variable WC | Fluctuating CA above permanent level | Seasonal or cyclical component |
Working Capital Financing Approaches
| Approach | Strategy | Risk | Return |
|---|---|---|---|
| Conservative | Long-term funds for permanent + some temporary WC | Low (high liquidity) | Low (cost of long-term funds higher) |
| Aggressive | Short-term funds for temporary + some permanent WC | High (liquidity risk) | High (short-term funds cheaper) |
| Matching/Hedging | Match asset maturity with financing maturity | Moderate | Moderate |
7.2 Operating Cycle and Cash Conversion Cycle
Operating Cycle = Inventory Period + Receivables Period
Cash Conversion Cycle = Operating Cycle - Payables Period
Example: Inventory period = 60 days, Receivables period = 45 days, Payables period = 30 days
Operating Cycle = 60 + 45 = 105 days
Cash Conversion Cycle = 105 - 30 = 75 days
This means the firm needs to finance 75 days of operations from its own funds or short-term borrowing.
7.3 Cash Management
Baumol Model (Optimal Cash Balance)
C* = √(2FT/K) where F = fixed transaction cost, T = total cash needed per period, K = opportunity cost (interest rate)
Example: Annual cash need = NPR 50,00,000, Transaction cost = NPR 500, Interest rate = 10%
C* = √(2 × 500 × 50,00,000 / 0.10) = √(50,00,00,00,000) = NPR 2,23,607
Number of transactions = 50,00,000 / 2,23,607 = 22.4 ≈ 23 per year
7.4 Receivables Management
| Aspect | Description | Tool/Metric |
|---|---|---|
| Credit Policy | Terms of sale on credit (credit period, discount) | "2/10, net 30" = 2% discount if paid in 10 days, otherwise full in 30 |
| Credit Analysis | Evaluating creditworthiness of customers | 5 C's: Character, Capacity, Capital, Collateral, Conditions |
| Collection Policy | Procedures for collecting overdue accounts | Aging schedule, collection period, bad debt ratio |
Key Ratios
| Ratio | Formula | Meaning |
|---|---|---|
| Current Ratio | Current Assets / Current Liabilities | Ideal: 2:1; measures short-term solvency |
| Quick Ratio | (CA - Inventory) / CL | Ideal: 1:1; liquid assets coverage |
| Inventory Turnover | COGS / Average Inventory | How many times inventory sold per year |
| Receivables Turnover | Credit Sales / Average Receivables | How quickly receivables collected |
| Average Collection Period | 365 / Receivables Turnover | Days to collect receivables |
7.5 Working Capital Estimation — Detailed Example
Nepal Trading Company — Annual Projections:
| Item | Annual Amount (NPR) |
|---|---|
| Annual Sales (all credit) | 1,20,00,000 |
| Cost of Goods Sold (70% of sales) | 84,00,000 |
| Raw Material Cost (50% of COGS) | 42,00,000 |
| Average credit period to customers | 45 days |
| Average credit from suppliers | 30 days |
| Average inventory holding period | 60 days |
| Minimum cash balance required | 5,00,000 |
Working Capital Calculation:
| Component | Formula | Amount (NPR) |
|---|---|---|
| Current Assets: | ||
| Debtors/Receivables | Sales × 45/365 | 14,79,452 |
| Inventory (raw material) | RM Cost × 60/365 | 6,90,411 |
| Inventory (finished goods) | COGS × 15/365 (assume 15 days) | 3,45,205 |
| Cash balance | Minimum required | 5,00,000 |
| Total Current Assets | 30,15,068 | |
| Current Liabilities: | ||
| Creditors/Payables | RM Cost × 30/365 | 3,45,205 |
| Net Working Capital Required | CA - CL | 26,69,863 |
Add 10% safety margin: 26,69,863 × 1.10 ≈ NPR 29,37,000
This means the company needs approximately NPR 29.37 lakhs in working capital before it can start operations.
7.6 Cash Management Models Comparison
| Aspect | Baumol Model | Miller-Orr Model |
|---|---|---|
| Assumption | Cash flows are predictable and steady | Cash flows are random and unpredictable |
| Cash Pattern | Steadily declines then replenished | Fluctuates randomly within bounds |
| Key Formula | C* = √(2FT/K) | Spread = 3 × (3Fσ²/4K)^(1/3) |
| Parameters | F=transaction cost, T=total cash need, K=opportunity cost | F=transaction cost, σ²=variance of daily cash flows, K=daily interest |
| Best For | Stable businesses with predictable cash flows | Businesses with volatile, uncertain cash flows |
| Nepal Example | Supermarket chain with steady daily sales | Construction company with irregular project payments |
7.7 Credit Policy Evaluation — Cost-Benefit Analysis
Should a company offer "2/10, net 30" discount?
Current: All sales on 30-day credit. Sales = NPR 50,00,000. Bad debts = 3%.
Proposed: 2% discount for payment within 10 days. Expected 60% of customers take discount. Bad debts reduce to 1.5%. Collection period reduces from 30 to 16 days average.
Benefits:
Reduced bad debts: (3%-1.5%) × 50,00,000 = NPR 75,000
Reduced receivables: Old receivables = 50,00,000 × 30/365 = 4,10,959. New = 50,00,000 × 16/365 = 2,19,178. Reduction = 1,91,781. Opportunity cost saved at 15% = NPR 28,767
Total Benefits = 75,000 + 28,767 = NPR 1,03,767
Cost:
Discount given: 2% × 60% × 50,00,000 = NPR 60,000
Net Benefit = 1,03,767 - 60,000 = NPR 43,767
Decision: OFFER the discount — net benefit of NPR 43,767.
7.8 Working Capital Ratios — Comprehensive Example
Balance Sheet Extract — Nepal Manufacturing Co.:
| Current Assets | NPR | Current Liabilities | NPR |
|---|---|---|---|
| Cash | 3,00,000 | Trade Payables | 8,00,000 |
| Receivables | 12,00,000 | Bank Overdraft | 4,00,000 |
| Inventory | 15,00,000 | Accrued Expenses | 3,00,000 |
| Prepaid | 50,000 | ||
| Total CA | 30,50,000 | Total CL | 15,00,000 |
Annual Sales = NPR 1,00,00,000 (80% credit). COGS = NPR 70,00,000.
Ratios:
Current Ratio = 30,50,000/15,00,000 = 2.03:1 (Healthy — above 2:1 benchmark)
Quick Ratio = (30,50,000-15,00,000-50,000)/15,00,000 = 15,00,000/15,00,000 = 1.0:1 (Adequate)
Cash Ratio = 3,00,000/15,00,000 = 0.2:1 (Low — may struggle with immediate obligations)
Inventory Turnover = 70,00,000/15,00,000 = 4.67 times (inventory held ~78 days)
Receivables Turnover = 80,00,000/12,00,000 = 6.67 times (collection period ~55 days)
Payables Turnover = 70,00,000/8,00,000 = 8.75 times (payment period ~42 days)
CCC = 78 + 55 - 42 = 91 days (company needs to finance 91 days of operations)
Practice Questions
Short Answer:
1. Define gross and net working capital.
2. Explain the operating cycle and cash conversion cycle.
3. Compare conservative, aggressive, and matching financing approaches.
4. What is the Baumol model for cash management?
5. Explain the 5 C's of credit analysis.
Long Answer:
6. Inventory period=45 days, Receivables=60 days, Payables=30 days. Daily operating expenditure=NPR 50,000. Calculate operating cycle, CCC, and working capital needed. (15 marks)
7. Annual cash need NPR 1 crore, transaction cost NPR 1,000, interest 8%. Using Baumol model, find optimal cash balance and number of transactions. (15 marks)
8. Discuss the three approaches to working capital financing with diagrams. Which is appropriate for a seasonal business in Nepal? (15 marks)
9. Explain receivables management including credit policy, credit analysis, and collection policy. (15 marks)
10. "Efficient working capital management is the key to survival for Nepali SMEs." Discuss with reference to cash, receivables, and inventory management. (15 marks)
Exam Tips: ✓ CCC calculation is very frequently asked ✓ Baumol model numerical is common ✓ Know all liquidity ratios ✓ Three financing approaches with diagram ✓ 5 C's of credit is popular short answer