Meaning and significance , types of working capital , working capital cycle

I. Management of Working Capital: Meaning and Significance

Definition: Planning and controlling current assets (cash, securities, receivables, inventory) and current liabilities (payables, short-term debt, accrued expenses) to ensure sufficient liquidity and efficient operation. It's managing the difference between current assets and current liabilities.

Formula: Working Capital = Current Assets - Current Liabilities

Goal: Optimal working capital level to support operations while minimizing asset holding costs.

Significance:

• Liquidity: Meet short-term obligations.
• Profitability: Minimize financing and holding costs, optimize credit policies.
• Operational Efficiency: Smooth operations, timely collections and payments.
• Solvency: Crucial for long-term financial stability.
• Creditworthiness: Easier access to financing.

II. Types of Working Capital

A. Based on Concept:

• Gross Working Capital:
  • Definition: Total investment in current assets.
  • Focus: Operational aspect (managing assets).
  • Advantage: Simple to calculate.
  • Disadvantage: Doesn't reflect true liquidity (ignores liabilities).
• Net Working Capital (NWC):
  • Definition: Difference between current assets and current liabilities.
  • Formula: Net Working Capital = Current Assets - Current Liabilities
  • Focus: Financial aspect (liquidity and solvency).
  • Significance: Accurate liquidity picture. Positive NWC indicates sufficient current assets to cover current liabilities.

B. Based on Time:

• Permanent (Fixed) Working Capital:
  • Definition: Minimum current assets needed to operate continuously. Remains relatively constant.
  • Example: Baseline inventory, minimum cash balance.
  • Financing: Long-term sources (equity, long-term debt).
• Temporary (Variable) Working Capital:
  • Definition: Additional assets to support sales/production fluctuations. Varies with business cycle/seasons.
  • Example: Increased inventory during peak seasons, higher receivables.
  • Financing: Short-term sources (bank loans, trade credit).

III. Working Capital Cycle

Definition: Time to convert investments in inventory and other current assets into cash. Measures time to turn raw materials into cash from sales. Also called cash conversion cycle.

Components:

• Inventory Conversion Period (ICP): Time to convert raw materials into finished goods and sell them.
  • Formula: ICP = (Average Inventory / Cost of Goods Sold) * 365 days
• Receivables Conversion Period (RCP) / Days Sales Outstanding (DSO): Time to collect cash from customers.
  • Formula: RCP = (Average Accounts Receivable / Credit Sales) * 365 days
• Payables Deferral Period (PDP): Time to pay suppliers.
  • Formula: PDP = (Average Accounts Payable / Purchases) * 365 days

Working Capital Cycle Formula:

Working Capital Cycle = Inventory Conversion Period + Receivables Conversion Period - Payables Deferral Period

WCC = ICP + RCP - PDP

Significance:

• Shorter Cycle: Generally desirable, more efficient cash conversion.
• Longer Cycle: Problems like slow inventory, collection difficulties, or generous payment terms.
• Cash Flow Management: Helps manage cash flow effectively.