Topic 10
🟢 Lite — Quick Review (1h–1d)
Rapid summary for last-minute revision before your exam.
- Working Capital (WC) = Current Assets − Current Liabilities; Net WC = CA − CL
- Operating Cycle = Days Inventory Outstanding + Days Sales Outstanding − Days Payable Outstanding
- Cash Conversion Cycle (CCC) measures how long cash is tied up in operations
- EOQ = √(2DS/H) — minimises total inventory ordering + holding costs
- Optimal credit policy balances the cost of carrying receivables against the cost of lost sales from strict credit
- ⚡ Reducing CCC by 10 days can meaningfully improve profitability without additional financing
🟡 Standard — Regular Study (2d–2mo)
Standard content for students with a few days to months.
Working Capital Management — Balancing Liquidity and Profitability
Working capital management is the day-to-day financial decisions that determine how efficiently a company runs its operations. It involves managing the relationship between a firm’s short-term assets (cash, inventory, receivables) and its short-term liabilities (payables, short-term debt). Too little working capital leads to operational disruptions; too much indicates inefficient asset deployment.
Gross Working Capital vs Net Working Capital
Gross Working Capital (GWC) = Total Current Assets
- A larger number; represents total investment in short-term assets
Net Working Capital (NWC) = Current Assets − Current Liabilities
- The “cushion” available after paying off short-term obligations
- NWC > 0: Company can meet its current obligations from current assets
- NWC < 0: Current liabilities exceed current assets — potential liquidity crisis
The Operating Cycle
The operating cycle measures the time between purchasing inventory and collecting cash from sales:
Operating Cycle (OC) = Days Inventory Outstanding (DIO) + Days Sales Outstanding (DSO)
Cash Conversion Cycle (CCC) = DIO + DSO − Days Payable Outstanding (DPO)
CCC = 80 + 45 − 30 = 95 days
This means cash is tied up for 95 days from the moment inventory is purchased until collection from customers.
Components of CCC:
1. Days Inventory Outstanding (DIO): DIO = (Average Inventory / COGS) × 365 = (Inventory at year-end / COGS) × 365
2. Days Sales Outstanding (DSO): DSO = (Average Receivables / Credit Sales) × 365 = (Accounts Receivable / Total Credit Sales) × 365
3. Days Payable Outstanding (DPO): DPO = (Average Payables / COGS) × 365 = (Accounts Payable / COGS) × 365
Reducing CCC:
- Reduce DIO: Sell faster, improve inventory management
- Reduce DSO: Collect faster, tighten credit policy
- Increase DPO: Pay later (without damaging supplier relationships)
Inventory Management — EOQ Model
The Economic Order Quantity (EOQ) model determines the optimal order size that minimises total inventory costs:
EOQ = √(2DS / H)
Where:
- D = Annual demand (units)
- S = Ordering cost per order (fixed cost per order)
- H = Holding/carrying cost per unit per year
Total Inventory Cost = Ordering Cost + Holding Cost = (D/Q) × S + (Q/2) × H
Example: Annual demand = 10,000 units; Ordering cost = ₹500/order; Holding cost = ₹20/unit/year EOQ = √(2 × 10,000 × 500 / 20) = √(10,00,000) = 1,000 units
Optimal number of orders = D / EOQ = 10,000 / 1,000 = 10 orders per year
Reorder Point (ROP):
ROP = (Average daily usage × Lead time) + Safety stock
If daily usage = 10,000/365 ≈ 27 units and lead time = 7 days, with safety stock = 50: ROP = (27 × 7) + 50 = 189 + 50 = 239 units
Receivables Management
Managing receivables involves a fundamental tradeoff:
- Strict credit policy: Lower DSO, lower bad debt risk, but potential loss of customers
- Lenient credit policy: Higher sales, but higher DSO and potential bad debts
Optimal credit policy is where: Marginal Cost of Strict Policy = Marginal Benefit of Strict Policy
Key Receivables Metrics:
Average Collection Period (ACP) = DSO = Receivables / (Credit Sales / 365)
Collection Efficiency = (Actual Collections / Total Billings) × 100
Ageing Analysis:
| Age | % of Receivables | Provision |
|---|---|---|
| 0-30 days | 60% | 0% |
| 31-60 days | 25% | 10% |
| 61-90 days | 10% | 25% |
| 90+ days | 5% | 50% |
🔴 Extended — Deep Study (3mo+)
Comprehensive coverage for students on a longer study timeline.
Liquidity vs Profitability Tradeoff
This is the central tension in working capital management:
- Excess Cash: Low risk (liquid) but low returns (opportunity cost)
- Excess Inventory: Avoids stockouts but ties up capital and incurs holding costs
- Excess Receivables: Higher sales but more bad debt risk and financing cost
- Minimum Payables: Good supplier relations but lost cash discounts
The goal is to find the optimal balance — not maximum liquidity, not maximum profitability, but the point that maximises firm value.
Cash Management — Baumol’s Model
Just as EOQ optimises inventory, Baumol’s model optimises cash holdings:
Optimal Cash Balance (C) = √(2TS / i)*
Where:
- T = Total cash needed for transactions per period
- S = Fixed cost per securities transaction
- i = Interest rate on securities (opportunity cost of holding cash)
Example: Annual cash disbursements = ₹72,00,000; Transaction cost = ₹1,000; Interest rate = 10% p.a. C* = √(2 × 72,00,000 × 1,000 / 0.10) = √(1,44,00,00,000) = ₹1,20,000
Number of transactions = 72,00,000 / 1,20,000 = 60 times per year
Financing Working Capital
Working capital can be financed through:
Permanent (Core) Working Capital:
- Funded by long-term sources (equity, long-term debt)
- Represents the minimum level of WC always needed
- e.g., maintaining minimum cash balance, permanent inventory
Temporary (Seasonal/Cyclical) Working Capital:
- Funded by short-term sources (bank credit, trade credit)
- Varies with seasonal or cyclical demand
- e.g., inventory buildup before festival season
Matching Principle: Long-term assets → Long-term financing; Short-term assets → Short-term financing
Impact of Working Capital on Profitability
Cash Conversion Cycle and Return on Capital Employed (ROCE):
- A shorter CCC releases cash → reduces financing needs → lowers interest costs → improves ROCE
- Every 1-day reduction in CCC = freed-up cash available for other uses
Working Capital Turnover Ratio: = Sales / Working Capital Higher ratio = more efficient use of working capital
Practical RBI Context
RBI’s assessment of borrower companies includes working capital analysis:
- Tandon Committee norms: Banks should not fund permanent working capital through CC/OD limits
- Turnaround Time (TAT): Speed of cash conversion matters for loan classification
- Companies with very high CCC relative to industry norms signal poor internal management
- RBI’s Prompt Corrective Action (PCA) framework considers liquidity metrics for banks
Common Working Capital Red Flags in Financial Analysis
- Rising DIO: Inventory accumulating faster than sales — demand slowdown or obsolescence risk
- Rising DSO: Customers taking longer to pay — potential bad debts ahead
- Declining DPO: Paying suppliers faster — possible early payment discounts being captured, or cash management issues
- Negative NWC: Current liabilities consistently exceed current assets — significant liquidity risk
- Rising Current Ratio with falling NWC: Indicates artificial window dressing at year-end
Content adapted based on your selected roadmap duration. Switch tiers using the selector above.