Working capital management
Working capital funds the operating cycle from cash back to cash. Manage cash, inventory, receivables and payables to balance liquidity against profitability.
The operating cycle
- back to Cash
The longer the cycle, the more working capital the firm needs.
Worked example 1: operating cycle
Use a 365-day year. Raw material consumed ₹7,30,000, average RM stock ₹60,000. Cost of production ₹10,95,000, average WIP ₹45,000. Cost of sales ₹12,04,500, average finished goods ₹82,500. Credit sales ₹14,60,000, average debtors ₹1,80,000. Credit purchases ₹7,30,000, average creditors ₹80,000.
- RM period = 60,000 ÷ (7,30,000 ÷ 365) = 60,000 ÷ 2,000 = 30 days.
- WIP period = 45,000 ÷ (10,95,000 ÷ 365) = 45,000 ÷ 3,000 = 15 days.
- FG period = 82,500 ÷ (12,04,500 ÷ 365) = 82,500 ÷ 3,300 = 25 days.
- Debtors' period = 1,80,000 ÷ (14,60,000 ÷ 365) = 1,80,000 ÷ 4,000 = 45 days.
- Creditors' period = 80,000 ÷ (7,30,000 ÷ 365) = 80,000 ÷ 2,000 = 40 days.
- Gross operating cycle = 30 + 15 + 25 + 45 = 115 days. Net = 115 − 40 = 75 days.
Gross operating cycle 115 days; net operating (cash conversion) cycle 75 days.
Worked example 2: EOQ and reorder level
Annual demand is 7,200 units. Ordering cost is ₹500 an order and carrying cost ₹20 a unit a year. Lead time is 10 days, daily usage 20 units and safety stock 100 units. Find the EOQ, number of orders, total cost and reorder level.
- EOQ = √(2 × 7,200 × 500 ÷ 20) = √3,60,000 = 600 units.
- Orders a year = 7,200 ÷ 600 = 12.
- Ordering cost = 12 × 500 = ₹6,000. Carrying cost = (600 ÷ 2) × 20 = ₹6,000. Total = ₹12,000 (not counting the cost of carrying safety stock).
- Reorder level = daily usage × lead time + safety stock = 20 × 10 + 100 = 300 units.
EOQ 600 units, 12 orders a year, total cost ₹12,000, reorder at 300 units. Ordering and carrying costs are equal at the EOQ.
Worked example 3: Baumol's cash model
A firm needs ₹36,00,000 of cash over the year, spread evenly. Each sale of securities costs ₹200, and securities earn 10% a year. Find the optimal cash balance.
- C* = √(2bT ÷ i) = √(2 × 200 × 36,00,000 ÷ 0.10).
- = √14,40,00,00,000 = ₹1,20,000.
- Conversions a year = 36,00,000 ÷ 1,20,000 = 30; average cash = 1,20,000 ÷ 2 = ₹60,000.
- Transaction cost = 30 × 200 = ₹6,000; opportunity cost = 60,000 × 10% = ₹6,000; total ₹12,000.
Optimal cash balance ₹1,20,000. The two costs are equal at the optimum, just as in the EOQ model.
Miller-Orr model
| Element | Rule |
|---|---|
| When used | Daily cash flows are random (normally distributed), not steady as in Baumol |
| Lower limit (L) | Set by management as the minimum cash balance |
| Spread | 3 × (3/4 × transaction cost × variance of daily cash flows ÷ daily interest rate)^(1/3) |
| Return point (Z) | L + spread ÷ 3 |
| Upper limit (H) | L + spread = 3Z − 2L |
| Action | At H, buy securities worth H − Z; at L, sell securities worth Z − L |
Inventory, receivables and payables tools
| Area | Tool | Key point |
|---|---|---|
| Inventory | ABC analysis | Ranks items by annual consumption value: a few A items (often 10-15%) carry most of the value (often 70-80%) and get the tightest control |
| Inventory | VED, FSN, HML | Vital, essential, desirable (spares); fast, slow, non-moving; high, medium, low unit price |
| Inventory | Just-in-time | Near-zero stock; supplies arrive as needed (from Toyota) |
| Receivables | Credit policy | Credit standards, credit period, cash discount and collection effort; judge customers by the 5 Cs: character, capacity, capital, collateral, conditions |
| Receivables | Monitoring | Days sales outstanding and the ageing schedule |
| Receivables | Factoring | A factor buys receivables, advances cash, keeps the sales ledger and collects; with or without recourse |
| Receivables | Forfaiting | Medium-term export receivables bought without recourse |
| Payables | Cost of forgoing a discount | [d ÷ (100 − d)] × [365 ÷ (credit period − discount period)] |
Worked example 4: cost of trade credit
A supplier offers 2/10, net 30. Using a 365-day year, what is the annual cost of not taking the discount?
- Paying on day 30 instead of day 10 means borrowing ₹98 for 20 days at a cost of ₹2.
- Cost = [2 ÷ (100 − 2)] × [365 ÷ (30 − 10)] = 0.020408 × 18.25 = 37.24%.
About 37.24% a year, so taking the discount is cheaper than almost any bank loan.
Determinants and financing approaches
- Determinants: nature and size of the business, length of the production cycle, seasonality, credit policy, growth, operating efficiency, price level and availability of credit.
- Permanent working capital is the minimum always needed; temporary (fluctuating) working capital varies with season and activity.
- Matching (hedging) approach: permanent needs from long-term funds, temporary needs from short-term funds.
- Conservative approach: long-term funds also cover some temporary needs (safer, costlier). Aggressive approach: short-term funds cover some permanent needs (cheaper, riskier).
- Factoring in India is governed by the Factoring Regulation Act 2011; MSMEs can also discount invoices on RBI-regulated TReDS platforms.
NET asks EOQ, reorder-level, Baumol and Miller-Orr numericals, operating-cycle days, the cost of forgoing a cash discount, and matching ABC/VED/FSN or factoring vs forfaiting.
Typical MCQ: “Miller-Orr: the lower limit is ₹10,000 and the return point ₹16,000. Find the upper limit.” H = 3Z − 2L = 48,000 − 20,000 = ₹28,000. Trap: ₹22,000 assumes equal gaps; the upper gap is twice the lower gap.
Typical MCQ: “At the EOQ, how do ordering cost and carrying cost compare?” They are equal, and their total is at its minimum.
Typical MCQ: “Which approach finances permanent current assets with long-term funds and temporary ones with short-term funds?” The matching (hedging) approach. Trap: the conservative approach uses long-term funds for part of the temporary needs too.
EOQ and Baumol are twins: √(2 × demand × cost per order ÷ holding cost). Miller-Orr: H = 3Z − 2L, so the upper gap is twice the lower gap.