51  Working Capital Management

51.1 What is Working Capital?

Working capital is the capital needed to finance a firm’s day-to-day operations — the gap between current assets and current liabilities. Working capital management (WCM) is the management of investment in current assets and the financing of those assets through current liabilities. While capital budgeting deals with the long-term, WCM keeps the firm running in the short term — managing cash, receivables, inventory and payables (khanjain2020?; pandey2021?).

TipThree Working Definitions

Author	Definition	What it foregrounds
Hampton	“Funds invested in a company’s cash, accounts receivable, inventory and other current assets.”	Investment view
Gerstenberg	“Working capital means current assets.”	Gross
Khan & Jain	“The capital required for the day-to-day operations of the business — the difference between current assets and current liabilities.”	Net

51.1.1 Gross vs Net Working Capital

TipTwo Views of Working Capital

Concept	Definition	Formula
Gross Working Capital	Total current assets	Cash + Debtors + Inventory + Marketable securities + Prepaid
Net Working Capital (NWC)	Current assets − current liabilities	CA − CL

A positive NWC means current assets exceed current liabilities — the firm can pay its short-term obligations. A negative NWC is a liquidity warning, though some efficient firms (Indian retail, FMCG) deliberately run negative NWC by collecting from customers before paying suppliers.

51.1.2 Permanent vs temporary working capital

TipPermanent vs Temporary Working Capital

Type	What it is
Permanent / Fixed	Minimum level always required to run operations
Temporary / Variable	Fluctuates with seasonal and cyclical demand

The financing-policy implication: permanent WC should be financed by long-term sources; temporary WC by short-term sources — the matching principle.

51.2 The Operating Cycle

The operating cycle (or cash conversion cycle) is the time between paying for raw materials and collecting cash from customers. Three sub-periods:

TipThree Components of the Operating Cycle

Component	Formula	Captures
Inventory period (DIO)	(Avg Inventory ÷ COGS) × 365	Days inventory is held
Receivables period (DSO)	(Avg Debtors ÷ Credit Sales) × 365	Days to collect from customers
Payables period (DPO)	(Avg Creditors ÷ Credit Purchases) × 365	Days taken to pay suppliers

The Cash Conversion Cycle (CCC):

\[\text{CCC} = \text{DIO} + \text{DSO} - \text{DPO}\]

A short CCC is generally desirable — Walmart and Amazon famously run negative CCCs.

flowchart LR
  RM[Buy raw material] --> P[Production]
  P --> FG[Finished goods]
  FG --> S[Sale on credit]
  S --> R[Receivables]
  R --> C[Cash collected]
  RM -. DPO .-> C
  RM -. DIO + DSO = Operating cycle .-> C
  style RM fill:#FFF3E0,stroke:#EF6C00
  style C fill:#E8F5E9,stroke:#1B5E20

51.3 Factors Affecting Working Capital

TipEight Factors Affecting Working-Capital Requirements

Factor	How it influences WC
Nature of business	Trading / service firms need less; manufacturing more
Production cycle length	Longer cycle → more WC
Sales volume and growth	Higher sales → more WC; growth needs more
Seasonality	Seasonal industries (sugar, tea) need fluctuating WC
Credit policy	Liberal credit raises receivables
Inventory policy	JIT lowers WC; stockpiling raises it
Operating efficiency	Better use of resources lowers WC
Inflation and price level	Rising prices increase WC needs

51.4 Financing Approaches

Three classical approaches to financing the WC mix (pandey2021?):

TipThree Financing Approaches for Working Capital

Approach	What it does	Risk
Matching / Hedging	Match the maturity of financing to the asset — long-term sources for permanent WC, short-term for temporary	Moderate
Conservative	Use long-term sources for both permanent and a part of temporary WC	Low risk, high cost
Aggressive	Use short-term sources for both temporary and a part of permanent WC	High risk, low cost

51.5 Sources of Working-Capital Finance

TipCommon Sources of Working-Capital Finance

Source	Type
Trade credit	Short-term, spontaneous
Cash credit / Overdraft from banks	Short-term, negotiated
Working-capital term loan	Medium-term
Bills discounting	Short-term
Commercial paper	Short-term, market-based
Factoring / Invoice discounting	Short-term
Inter-corporate deposit	Short-term
Public deposits	Short-to-medium-term
Long-term sources for permanent WC	Equity, retained earnings, term loan

51.6 Indian Banking Norms — the Tandon and Chore Committees

In India, two RBI committees shaped the post-1975 framework for bank lending toward working capital:

TipTandon and Chore Committees

Committee	Year	Recommendation
Tandon Committee	1975	Norms for inventory and receivables; three methods for max permissible bank finance (MPBF)
Chore Committee	1979	Strengthened the Tandon recommendations; preferred Method 2

The Tandon Committee’s three methods for Maximum Permissible Bank Finance (MPBF):

TipTandon’s Three Methods for MPBF

Method	MPBF formula	Borrower contribution
Method 1	0.75 × (CA − CL)	25% of WC gap
Method 2	0.75 × CA − CL	25% of CA
Method 3	0.75 × (CA − Core Assets) − CL	Higher contribution; “core assets” treated as long-term

The Chore Committee preferred Method 2 as standard practice and discouraged inappropriate reliance on cash credit. Modern banks supplement these with internal credit-risk frameworks.

51.7 Management of Cash

Cash management is the art of holding just enough cash to meet operating needs without sacrificing too much yield. Two classic models help calibrate the right cash balance.

TipTwo Classical Cash-Management Models

Model	Author	Idea
Baumol Model	William Baumol (1952)	EOQ-style optimum cash transaction; balances transaction cost with opportunity cost
Miller-Orr Model	Miller & Orr (1966)	Stochastic — sets upper and lower control limits; optimum return point in between

Baumol’s optimum cash withdrawal:

\[C^* = \sqrt{\frac{2 \times T \times F}{i}}\]

where \(T\) = total cash needed in the period, \(F\) = fixed cost per transaction, \(i\) = opportunity cost of holding cash. The model is the cash-management cousin of the EOQ model.

51.8 Management of Receivables

The aim of receivables management is to maximise the value of incremental sales while keeping bad debts and collection costs in check. The three policy levers (Credit Standards, Credit Period, Cash Discount) jointly determine the credit policy.

TipThree Policy Levers in Receivables Management

Lever	What it controls
Credit standards	Who qualifies for credit
Credit terms	Period (e.g., 30 days), discount (e.g., 2/10 net 30)
Collection policy	How aggressively overdue accounts are pursued

A credit-policy change should be evaluated by comparing the incremental contribution from new sales with the incremental costs — additional bad debts, longer DSO, additional discount cost.

51.9 Management of Inventory

Inventory ties up cash but enables operations. Three classic models:

TipThree Classical Inventory Models

Model	Idea
EOQ (Economic Order Quantity)	Balance ordering and carrying costs to find the optimum order quantity
Reorder Point (ROP)	Lead time × Daily usage + Safety stock
Safety Stock	Buffer to handle demand and lead-time uncertainty

The EOQ formula:

\[\text{EOQ} = \sqrt{\frac{2 \times D \times S}{H}}\]

where \(D\) = annual demand, \(S\) = ordering cost per order, \(H\) = annual holding cost per unit.

Other inventory-control techniques tested in NTA papers: ABC analysis (Pareto principle), VED analysis (Vital, Essential, Desirable), HML analysis (High, Medium, Low value), FSN analysis (Fast, Slow, Non-moving), and JIT (just-in-time).

51.10 Practice Questions

Q 01 Net WC Easy

Net Working Capital is defined as:

• ATotal Assets − Total Liabilities
• BCurrent Assets − Current Liabilities
• CSales − Variable Cost
• DCash + Bank balance

View solution

Correct Option: B

NWC = Current Assets − Current Liabilities. Gross WC = total current assets.

Q 02 CCC Medium

A firm's DIO is 60 days, DSO is 45 days and DPO is 30 days. The cash-conversion cycle is:

• A75 days
• B90 days
• C105 days
• D135 days

View solution

Correct Option: A

CCC = DIO + DSO − DPO = 60 + 45 − 30 = 75 days.

Q 03 Matching Medium

In the matching (hedging) approach to working-capital financing:

• AAll current assets are financed by short-term sources
• BLong-term sources finance permanent WC; short-term finance temporary WC
• CAll assets are financed by long-term sources
• DEquity finances all current assets

View solution

Correct Option: B

The matching principle: maturity of financing matches the maturity of the asset. Long-term for permanent WC; short-term for temporary.

Q 04 Tandon Medium

The Tandon Committee (1975) was concerned with:

• ACapital structure of public-sector banks
• BNorms for bank lending against working capital
• CInsider trading regulation
• DMutual fund disclosures

View solution

Correct Option: B

Tandon Committee (1975) developed inventory and receivables norms and three methods for Maximum Permissible Bank Finance (MPBF). Chore Committee (1979) strengthened it.

Q 05 Baumol Medium

The Baumol cash-management model is conceptually:

• AA stochastic two-control-limit model
• BAn EOQ-style optimum applied to cash
• CA discounted cash-flow model
• DA regression-based forecasting model

View solution

Correct Option: B

Baumol (1952) — EOQ-type model for cash. Miller-Orr (1966) is the stochastic two-control-limit model.

Q 06 EOQ Medium

Annual demand is 5,000 units, ordering cost is ₹100 per order, and holding cost is ₹4 per unit per year. The Economic Order Quantity is:

• A250 units
• B500 units
• C750 units
• D1,000 units

View solution

Correct Option: B

EOQ = √((2 × 5,000 × 100) ÷ 4) = √250,000 = 500 units.

Q 07 ABC Analysis Easy

In ABC inventory analysis, "A-class" items are those with:

• ALowest unit value
• BFew items but a large share of total inventory value
• CItems most consumed by quantity
• DHighest movement per day

View solution

Correct Option: B

ABC analysis (Pareto principle): A-class = small number of items but high value (~70% of value, ~10% of items). C-class = large number of items but low value.

Q 08 Aggressive Medium

A firm using short-term sources to finance both temporary AND a part of permanent working capital is following:

• AConservative approach
• BMatching approach
• CAggressive approach
• DHedging approach

View solution

Correct Option: C

Aggressive = lower cost (short-term financing is usually cheaper) but higher liquidity risk. Conservative is the opposite.

ImportantQuick recall

• Working capital = capital for day-to-day operations. Gross WC = current assets; Net WC = CA − CL.
• Permanent vs temporary WC. Matching principle: long-term sources for permanent; short-term for temporary.
• Operating cycle sub-periods: DIO + DSO − DPO = CCC.
• Three financing approaches: matching · conservative · aggressive.
• Indian banking framework: Tandon Committee (1975) — three methods for MPBF; Chore Committee (1979) preferred Method 2.
• Cash management: Baumol (EOQ-style, deterministic) and Miller-Orr (two-control-limit, stochastic).
• Receivables: three levers — credit standards · credit terms · collection policy.
• Inventory: EOQ model; control techniques — ABC, VED, HML, FSN, JIT.