Working Capital Management
Working Capital Management tests estimation of the working capital requirement, operating cycle arithmetic and the control of cash, receivables and inventory.
Core rules
- Operating cycle = raw material holding period + WIP period + finished goods period + receivables collection period − payables deferral period. A shorter cycle means a lower requirement.
- Gross working capital = total current assets; net working capital = current assets − current liabilities.
- Estimate receivables and inventory at cost, not at selling price, unless the question says otherwise; provide for depreciation, minimum cash and a contingency margin.
- EOQ = √(2AO/C), where A is annual demand, O ordering cost per order and C carrying cost per unit per year. At EOQ, ordering cost equals carrying cost.
- Finance permanent working capital from long-term funds and fluctuating working capital from short-term bank limits.
Worked example
Annual demand 36,000 units; ordering cost ₹500; unit price ₹100; carrying cost 20% = ₹20 per unit. EOQ = √(2 × 36,000 × 500/20) = √18,00,000 ≈ 1,342 units. Orders per year ≈ 27; average inventory ≈ 671 units. At the optimum, total ordering cost and total carrying cost are each about ₹13,416, which is the standard cross-check.
Traps
Using sales instead of cost of goods sold for inventory and debtor holding; omitting the payables deduction from the cycle; ignoring the opportunity cost of funds locked in inventory; assuming a high current ratio proves good liquidity; forgetting that a longer credit period to customers raises the requirement.