Working capital Working capital refers to the investment made by firm in current asset such as cash, accounts receivables, inventories and marketable securities. It measures firm’s liquidity position. Gross working capital is total investment in current assets while net working capital is the difference between current assets and current liabilities. Higher gross working capital adversely affect profitability. Permanent w.c. is met with long term financial resources while temporary wc through short term resources. NWC can be positive or negative. Positive is good sign NWC effects the value of firm. WC management affects and get affected by different operational decisions. Amount of working capital depends on the nature of business

Permanent and temporary W C A minimum level of working capital which is continuously requires by the firm in order to maintain its activities such as minimum cash, stock and other assets to meet business requirement irrespective of level of business. It is called permanent W C. It is usually finance by long term sources. Temporary w.c.- Requirement of additional working capital due to fluctuations in sales volume is temporary working capital. It is met with temporary (short term) sources.

W C Financing policies The working capital financing policies have significant on profitability and liquidity position of the firm. It has 3 approaches Matching Approach- the permanent (core) current assets are financed by long term sources while temporary current assets alone should be financed from short term sources. Conservative approach – it has more reliance on long term sources. It also finances a portion of short term requirement from long term sources. This is also called low profitability and high liquidity approach. Aggressive approach – it supports more of short term sources for wc financing. It even favours to finance a part of permanent wc through short term sources. This is highly profitable and low liquidity approach.

Net operating cycle It calculates the duration conversion period with the following approaches. Raw Material = (Av. RM inventory/ total RM consumed) x 365 Duration of WIP = (Av. WIP inventory/cost of production) x 365 Duration of finished goods = (Av. finished goods inventory/cost of production) x 365 Duration of debtors =(Av. Debtors/total credit sales) x 365 Duration of creditors = (Av. Creditors/ total purchases) x365 Net operating cycle= RM=WIP+F. stock + Debtors – creditors With the above we can obtain net number of operating cycle days for which working capital is required. The above is also known as cash conversion cycle.

Cash Cycle It is the length of time between payment of initial inventory purchased and cash received from sales. Cash cycle can be calculated by cash conversion cycle (ccc) CCC = Inventory days+ Accounts receivables days – Accounts payable days. Inventory days = Inventory/ Av. Cost of goods sold Accounts Receivable days = Accounts Receivable/Av. Sales Accounts Payable days = Accounts Payable/Av. Cost of goods sold. Another way is to arrive at inventory conversion period, receivable conversion period and payables deferred period. Gross operating cycle = inventory conversion period + receivable conversion period. Net operating cycle = Gross operating cycle – payables deferred period. Net operating cycle is also referred as cash cycle

Risk Return Trade off Increased inventory of current assets increases liquidity (decreases the risk) but reduces profitability (return) Current liabilities provide cheaper and flexible financing options but their availability and cost is uncertain. Short term liabilities increases the risk of liquidity whereas long term liabilities affects the profitability. Therefore risk and return trade off is needed.