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What is Working Capital ? | Operating & Cash Conversion Cycle

Working Capital Management

Contents :                             
  1. Meaning and Definition of Working Capital.
  2. Concept of Working Capital.
  3. Nature of Working Capital.
  4. Components of Working Capital.
  5. Operating and Cash Conversion Cycle.
  6. Computation of Operating Cycle and Cash Cycle with Example.


What is Working Capital ?


Cash required for conducting the business, i.e., purchase of raw material and conversion thereof into finished goods, on a daily basis is termed as 'Working Capital' (WC). 
The essential items of 'Working Capital' are :
1) Inventory (raw material, work-in-progress, and finished goods) level
2) Debtors
3) Creditors
They are considered as vital signals of a company's productivity and financial power.
A company managing its 'working capital' in an efficient manner may not be required to borrow funds. Efficient management of working capital involves a balanced approach, i.e. as far as possible there should be neither shortage of cash nor its surplus. Companies having burden of surplus cash, need to ensure that excess cash is invested suitably with a view to generating returns for their shareholders.

Definitions of Working Capital :


According to Shubin :
"Working capital is the amount of funds necessary to cover the cost of operating the enterprise".

According to Gerestenberg :
"Circulating capital means current assets of a company that are changed in the ordinary course of business from one form to another, for example, from cash to inventories, inventories to receivables, receivables into cash".

According to Hoagland :
"Working capital is descriptive of that capital which is not fixed. But, a more common use of working capital is to consider it as the difference between the book value of the current assets and the current liabilities".

There are two components of working capital, viz. current assets and current liabilities. Excess of a company's current assets over its current liabilities is the Working Capital Management of working capital, thus, involves management of its constituents, i.e., current assets and current liabilities and maintenance of an appropriate equilibrium between the two. Working Capital is also referred to as 'Revolving Capital, 'Circulating Capital', or 'Short Term Capital'.
Managing the 'Working Capital' of a company is of vital significance with a view to ensure that sufficient cash is held by it to conduct its daily business activities in a hassle-free manner. It is crucial for a company to keep its 'Cash Conversion Cycle' (CCC) at a lower level. The CCC measures how fast a company can convert cash-in-hand into even more cash-in-hand. CCC operates like this - the cash is first converted into inventory and Accounts Payable (AP), through sales and Accounts Receivable (AR), and then again converted into cash.

Generally, lower the CCC, better for the company. In order to reduce CCC following steps may be taken by a company :
1) Reduction in the credit period given to its customers.
2) Enhancement in its own credit period with the suppliers.
3) Maintenance of an appropriate level of inventory, which results in reduced raw material cost.
4) Efficient cash management, which results in reduction in cash-holding cost.
By taking the above steps mentioned, working capital requirement may be brought down considerably.


Concepts of Working Capital :


Working capital finance has two concepts they are as follows :

Gross Working Capital :

The investment made by the company into current assets is referred to as the Gross Working Capital.
Examples of current assets are :

Constituents of Current Assets

1) Cash in hand and bank balances,

2) Bills Receivables,

3) Sundry Debtors (less provision for bad debts),

4) Short-term loans and advances,

5) Inventories of stocks as :

  • Raw materials
  • Work-in-process
  • Stores and spares
  • Finished goods

6) Temporary Investment of surplus funds,

7) Prepaid Expenses,

8) Accrued Incomes.


Net Working Capital :

The difference between current assets and current liabilities of a company is referred to as the Net Working Capital.

Net Working Capital = Current Assets - Current liabilities

Examples of current liabilities are :

Constituents of Current Liabilities

1) Bills Payable,

2) Sundry Creditors or Accounts Payable,

3) Accrued or Outstanding Expenses,

4) Short-term loans, advances and deposits,

5) Dividends Payable,

6) Bank Overdraft,

7) Provision for taxation, if it does not amount to appropriation of profits.


From the above it is obvious that there is a marked difference between the 'Gross Working Capital' and the "Net Working Capital". "Gross Working Capital" is nothing but another name for the 'Current Assets' of a company. 'Net Working Capital' on the other hand is what remains after the 'Current Liabilities' are excluded from the 'Current Assets'.

Nature of Working Capital :


The nature/characteristics of working capital are outlined in the following paragraphs :

1) Short-Term Needs : 
Working capital is required to procure raw materials, which after going through a short process (WC Cycle), is converted into cash. Short period involved in the working capital, differentiates it from 'Fixed Capital', wherein funds remain locked for a fairly long period. The period for which working capital is required depends upon the duration of production cycle (conversion of raw material into finished goods, sale of finished goods and receipt of sale proceeds).

2) Circular Movement :
Working capital cycle (working capital - raw material - work in progress - finished goods - sales - sale proceeds - cash receipt - Working Capital) is a continuous and recurring process. The cash is used to acquire current assets, converted into finished goods and sold out, which is followed by receipt of cash as sale proceeds. The cycle of WC begins with cash and ends on cash. As it moves in a circular manner, working capital is also termed as 'Circulating Capital'.

3) Element of Permanency : 
Although, the working capital requirement is for a short duration, but it is demanded on an ongoing basis to ensure the sustainability of a company's production activity. As long as production in a company goes on, there would be a continuous demand for working capital. The working capital, which is required on a permanent basis, is termed as 'Permanent or Regular Working Capital'.

4) Element of Fluctuation : 
Although, working capital requirement of a company is permanent in nature, there is a fluctuation in its demand. This fluctuation is wider in comparison with that of the 'Fixed Capital'. Working capital requirement is variable and is in direct proportion to the level of production. With the changes in purchase policy, sales policy, price level, etc., the working capital requirement also changes. The part of working capital, which changes with production, sales, price, etc., is termed as ‘Variable Working Capital'.

5) Liquidity : 
Comparatively working capital is more liquid than the fixed capital. In the case of necessity, working capital is convertible into cash with ease and without loss of time. Emergent cash requirement may be choosing following options :
i) Insisting prompt recovery of bills receivables.
ii) Expeditious sale of goods.
ii) Speeding up the conversion of raw materials into finished goods.
Due to this benefit of being highly liquid, companies with huge working capital are considered to be safe and sound.

6) Less Risky : 
Money locked up in fixed capital is not easily recoverable, if required, as it is meant for long-term. There is also a threat of plant and machinery becoming obsolete, with the passage of time and due to frequent technological advancements. Investment in fixed capital is therefore burdened with comparatively high risk. Investment in working capital, on the other hand, is less risky, because it is of short duration. However, it is exposed to 'Physical Risk' to some extent. 'Financial or Economic Risks' associated with working capital are much less, which is due to less severity in the variations of product prices. Further, the working capital is converted into cash and cash into working capital and this cycle goes on. Due to this cyclical nature of working capital, it is not exposed to the risk generated out of technological advancement.

7) Special Accounting System not Needed : 
Long-term assets obtained through fixed capital are subject to some system for evaluation of its depreciation, every year. Short-term assets procured through the working capital, on the other hand, last only for a year. As such there is no need for adopting special accounting system for them.


Components of Working Capital :


Working capital is a category of resources that includes cash, inventory, and receivables, minus whatever a company owes in the short term. It comes straight from the balance sheet, and it's often calculated according to the following formula :

Working Capital = Current Assets - Current
Liabilities

Hence, the working capital has two components :

1) Current Assets : 
Cash and those assets which can be easily converted into cash (within one year) are kept under this category. Current assets are significant for a business as they are utilised for the conduct of day-to-day functioning and for meeting miscellaneous expenses.

2) Current Liabilities : 
Current liabilities are short-term liabilities, which need to be liquidated and converted into cash generally within one year.

Operating and Cash Conversion Cycle :


The time taken for the completion of the cycle of the process of conversion of raw material into finished goods, sale of goods, realisation of sale proceeds, and receipt of cash is termed as 'Operating and Cash Conversion Cycle' or 'Working Capital Cycle'. Operating cycle of a company determines the requirements of working capital.

The period of the operating cycle of a manufacturing unit is the total time taken by the following two steps :

1) Inventory Conversion Period : 
The 'Inventory Conversion Period' is the total time taken in the production and sale of the product from the raw material through the following :
i) Raw Material Conversion Period.
ii) Work-in-Progress Conversion Period.
iii) Finished Goods Conversion Period.

2) Debtors Conversion Period :
The time needed to realise the outstanding amount from the customers is 'Debtors Conversion Period'.

The total time taken by 'Inventory Conversion Period' and 'Debtors Conversion Period' is known as 'Gross Operating Cycle'.

Gross Operating Cycle of any manufacturing unit may be obtained by taking total of the days involved in each individual stage of the cycle as indicated below :
  1. Purchase of 'Raw Materials' (RM) on cash payment.
  2. Conversion of 'Raw Material' into Work-in-Process' (WIP).
  3. Conversion of work-in-process into 'Finished Goods' (FG).
  4. Sale of 'Finished Goods' and conversion into "Accounts Receivables' (Debtors and Bills Receivable).
  5. Realisation of sale proceeds (Accounts Receivables) and receipt of cash in due course of time.

The above operating cycle, which begins with cash (purchase of raw material) and ends with cash (realisation of sale proceeds) is recurring in nature and the time taken for completion of one cycle depends upon the nature of the business a company is engaged into, and the kind of finished goods manufactured by it, credit period availed by it, credit period extended by it, etc.

Net Operating Cycle of a manufacturing unit may procure resources (raw material) on credit and the payment of miscellaneous expenses may also be deferred. Such credit or deferment may be considered as a source of finance. The duration of time, for which a manufacturing unit is able to defer payment of RM and other expenses, is termed as the 'Creditor Deferral Period' (CDP).

The difference between the 'Gross Operating Cycle' and the 'Creditor Deferral Period' is known as 'Net Operating Cycle', 'Cash Cycle' or 'Cash Conversion Cycle' (CCC). 
Some economists are of the view that during the calculation of 'Cash Cycle', 'Depreciation' and 'Profit' needs to be excluded, as 'Depreciation' is a non-cash item and Profit' is not a cost. Thus, cash cycle is the time gap between the amount of cash received from sale of goods and payment made by the company for the delivered goods.

Computation of Operating Cycle and Cash Cycle :


The quantum of working capital requirement depends upon the duration of the operating cycle. For the computation of 'Gross Operating Cycle' and 'Net Operating Cycle', separate formulae are used as follows :

1) Gross Operating Cycle : 
It is the total of Inventory Conversion Period (ICP) and Debtor Conversion/Collection Period (DCP). It is expressed as :

Gross Operating Cycle = ICP (R+W+F) + DCP (D)

Where, ICP = Inventory Conversion Period, it consists of following components :

R = Raw Material Conversion Period =

Average Stock of Raw Materials
---------------------------------------------------------
Average Cost of Production per Day

W = Work-in-Progress Conversion Period =

Average Work-in-Progress Inventory
----------------------------------------------------
Average Cost of Production per Day

F = Finished Goods Conversion Periods =

Average Stock of Finished Goods
-----------------------------------------------------
Average Cost of Goods Sold per Day

And DCP = Debtor Conversion Period

D = Debtor Collection Period =

Average Book Debts
---------------------------------------------
Average Credit Salesper Day

2) Net Operating Cycle/Cash Cycle : 
It is the difference between the Gross Operating Cycle and Creditor (Payable) Deferral Period (CDP). It is expressed as :

Net Operating Cycle/Cash Cycle = Gross Operating Cycle - CDP (C)

Where, CDP = Creditor (Payable) Deferral Period

C = Creditor Payment/De ferral Period =

Average Trade Creditors
-----------------------------------------------
Average Credit Purchases per Day

Example :

From the following data, compute the duration of the operating cycle for each of the two years and comment on the increase/decrease :

Particulars

 

Rs. (in Thousands)

Year 1

Year 2

Stocks :

 

20

 

27

Raw materials

Work-in-progress

14

18

Finished Goods

21

24

Purchases

96

135

Cost of Goods Sold

140

180

Sales

160

200

Debtors

32

50

Creditors

16

18


Assume : 360 days per year for computational purposes.

Solution :

Calculation of Operating Cycle :

Particulars

 

Year 1

Year 2

Raw Material Stock

= Raw Material Inventory

------------------- X 360

Purchases

20

--- x 360 = 75 days

96

27

--- x 360 =72 days

135

Less: Credit Period

Creditors

= --------------X 360

Purchases

16

--- x 360 = 60 days

96

18

--- x 360 = 48 days

135

W.L.P. Turnover

Work-in-progress

= -------------------X 360

Cost of Goods Sold

14

--- x 360 = 36 days

140

18

--- x 360 = 36 days

180

Finished Goods Turnover

Finished Goods

= -------------------X 360

Cost of Goods Sold

21

--- x 360 = 54 days

140

24

--- x 360 = 48 days

180

Debtors Turnover

Debtors

= ---------- x 360

Sales

32

--- x 360 = 72 days

160

50

--- x 360 = 90 days

200

Operating Cycle

177 Days

198 Days


There is an increase in length of operating cycle by 21 days i.e., 12% increase approximately. Reasons for increase are as follows :

Particulars

Days

Debtors taking longer time to pay (90 -72)

Creditors receiving payment earlier (60 - 48)

 

Less: Finished goods turnover lowered (54 - 48)      6

Raw material stock turnover lowered (75-72)           3

 

Increase in Operating Cycle

18

12

30

 

 

9

21



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