Working Capital: Management, Policies & Real-World Trade-offs

TAKEAWAYS:

• Working capital = Current Assets – Current Liabilities; its optimal level balances liquidity (avoiding insolvency) and profitability (avoiding excess idle cash).
• Three policies (aggressive, moderate, conservative) trade off risk vs. return—e.g., Kathmandu’s retail shop vs. a hydropower company’s cash needs.
• Cash conversion cycle (CCC) = Inventory period + Receivables period – Payables period; shortening CCC (like Daraz’s same-day delivery) improves cash flow.
• Financing working capital via trade credit, bank loans, or factoring has costs and risks—e.g., Ncell’s 30-day supplier terms vs. immediate cash discounts.
• Tools like aging schedules (for receivables) and economic order quantity (EOQ) (for inventory) are exam staples—master the formulas and t-account impacts.
• Real-world link: Pathao’s aggressive working capital policy (high inventory turnover, tight credit terms) vs. a traditional Nepali grocery’s conservative policy (low debt, high cash reserves).

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1. What is Working Capital?

Working capital (WC) is the net liquidity a company has to fund its day-to-day operations. It is calculated as:

WC = Current Assets – Current Liabilities

Why it matters:

• Positive WC → Ability to pay short-term obligations (e.g., NTC’s utility bills).
• Negative WC → Risk of insolvency (e.g., a startup burning cash faster than revenue).
• Optimal WC → Enough to operate smoothly but not so high that cash sits idle (opportunity cost).

Visual: Working Capital Components

Example: A Kathmandu shop with Rs. 500,000 in inventory + Rs. 200,000 in cash (Assets) and Rs. 400,000 in trade payables + Rs. 100,000 in short-term loans (Liabilities) has:

WC = (500,000 + 200,000) – (400,000 + 100,000) = **Rs. 200,000**

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2. Why Manage Working Capital?

Poor WC management leads to:

• Liquidity crises (e.g., Daraz’s early cash flow struggles).
• Lost sales (e.g., a shop running out of stock due to poor inventory management).
• Higher costs (e.g., emergency loans at 18% vs. negotiated trade credit at 12%).

Key goals:

1. Ensure solvency: Ability to pay bills on time (e.g., Ncell’s AP management).
2. Maximize profitability: Avoid excess cash or inventory (opportunity cost).
3. Optimize cash flow: Shorten the cash conversion cycle (CCC).

Real-World Example: eSewa vs. Traditional Kirana Shop

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3. Working Capital Policies: Trade-offs

Companies choose one of three policies, each with pros/cons:

Visual: Policy Impact on Cash Flow

Worked Example: Kathmandu Manufacturing Co. (KMC) KMC sells furniture with:

• Average inventory: Rs. 800,000 (sells 40 units/month at Rs. 20,000/unit).
• Average receivables: Rs. 400,000 (30-day credit).
• Average payables: Rs. 300,000 (60-day terms).

Calculate CCC:

CCC = Inventory Period + Receivables Period – Payables Period
Inventory Period = 800,000 / (40 × 20,000) = 1 month
Receivables Period = 400,000 / (40 × 20,000) = 0.5 months
Payables Period = 300,000 / (40 × 20,000) = 0.375 months
CCC = 1 + 0.5 – 0.375 = **0.625 months (19 days)**

Action: KMC could shorten CCC by:

1. Reducing inventory (just-in-time ordering).
2. Offering 2% discount for 10-day payments (speeding up receivables).
3. Negotiating shorter payables terms (e.g., 45 days).

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4. Managing Individual Components

A. Cash Management

Goal: Hold enough cash to operate but minimize idle balances (opportunity cost).

Tools:

1. Cash Budgeting: Forecast inflows/outflows (e.g., NTC’s monthly collections vs. bill payments).
2. Lockbox System: Speed up collections (used by banks like NMB).
3. Marketable Securities: Invest excess cash short-term (e.g., T-bills).

Example: Ncell’s Cash Flow Ncell collects Rs. 500M/month but pays Rs. 450M in salaries/bills. It invests the Rs. 50M surplus in 90-day T-bills (8% return).

Visual: Cash Budget (Nepali Retail Shop)

| Month       | Cash In (Rs.) | Cash Out (Rs.) | Net Cash | Beginning Balance | Ending Balance |
|-------------|---------------|----------------|----------|--------------------|-----------------|
| Jan         | 1,200,000     | 900,000        | +300,000 | 100,000            | 400,000         |
| Feb         | 1,500,000     | 1,300,000      | +200,000 | 400,000            | 600,000         |
| Mar         | 800,000       | 1,000,000      | -200,000 | 600,000            | 400,000         |

Action: Borrow Rs. 200,000 short-term in March to avoid a deficit.

B. Inventory Management

Goal: Minimize holding costs (storage, spoilage) while avoiding stockouts.

Key Metrics:

1. Inventory Turnover Ratio = COGS / Average Inventory
   • Example: If COGS = Rs. 2,000,000 and avg. inventory = Rs. 500,000 → 4 times/year.
2. Economic Order Quantity (EOQ):

   EOQ = √[(2 × Annual Demand × Order Cost) / Holding Cost per Unit]
   

   • Example: A Kathmandu grocery orders 50 kg rice/month (Rs. 100/kg), orders cost Rs. 200, holding cost Rs. 5/kg.

     EOQ = √[(2 × 600 × 200) / 5] = √48,000 = **219 kg per order**
     

Visual: EOQ Graph

C. Receivables Management

Goal: Speed up collections without losing sales.

Tools:

1. Aging Schedule: Track overdue receivables (e.g., Ncell’s past-due bills).
2. Credit Policy: Set terms (e.g., 2/10, net 30 = 2% discount if paid in 10 days, else due in 30).
3. Factoring: Sell receivables to a bank (e.g., Daraz uses factoring for supplier payments).

Example: Kathmandu Exports Ltd.

• Credit sales: Rs. 10,000,000/month.
• Average collection period: 45 days (industry standard: 30 days).
• Bad debts: 3% of sales.

Action:

1. Offer 1% discount for 10-day payments → Reduces collection period to 35 days.
2. Hire a credit manager to chase overdue accounts.

Visual: Aging Schedule (Rs. in thousands)

| Age of Receivables | Amount Outstanding | % of Total |
|--------------------|---------------------|------------|
| Not yet due        | 4,000               | 40%        |
| 1-30 days          | 3,000               | 30%        |
| 31-60 days         | 1,500               | 15%        |
| 61-90 days         | 1,000               | 10%        |
| >90 days           | 500                 | 5%         |
| **Total**          | **10,000**          | **100%**   |

D. Payables Management

Goal: Delay payments as long as possible without damaging supplier relationships.

Strategies:

1. Stretch credit terms (e.g., pay in 60 days instead of 30).
2. Take discounts if the cost of financing < discount rate.
   • Example: Supplier offers 2/10, net 30.
     • Cost of not taking discount = (2% × Rs. 10,000) / (98% × 20 days) = 10.2% annual cost.
     • If bank loan rate > 10.2%, take the discount.

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5. Financing Working Capital

Sources:

1. Short-term debt:
   • Trade credit (e.g., suppliers giving 60-day terms).
   • Bank loans (e.g., NMB’s working capital loan at 12%).
   • Commercial paper (for large firms like NEPSE-listed companies).
2. Spontaneous sources: Accounts payable, accruals.
3. Long-term debt/equity: For permanent WC needs.

Example: Gandaki Hydropower Company (GTC)

• Permanent WC need: Rs. 200M (inventory + receivables).
• Temporary WC need: Rs. 100M (seasonal demand). Solution:
• Finance permanent WC with long-term debt (8% loan).
• Finance temporary WC with bank overdraft (12% interest).

Visual: Financing Mix

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6. Working Capital and Financial Performance

Key Ratios to Watch:

Example: Comparing Two Firms

| Metric               | Kathmandu Retail (Traditional) | Pathao (Digital) |
|----------------------|-------------------------------|-------------------|
| Current Ratio        | 2.5                           | 0.8               |
| Inventory Turnover   | 8x/year                       | 120x/year         |
| CCC (days)           | 60                            | 5                 |
| WC Financing         | Mostly cash/equity            | Trade credit + loans |

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In the Real World

1. Pathao’s Aggressive WC Policy:

   • Idea Used: Short cash conversion cycle (CCC) and just-in-time inventory.
   • How: Pathao’s riders deliver same-day orders, turning inventory into cash in <5 days (vs. a grocery’s 30+ days). They use factor financing to get immediate cash from suppliers.

2. Nepal Rastra Bank’s Cash Reserve Ratio (CRR):

   • Idea Used: Cash management and liquidity requirements.
   • How: Banks must keep 3% of deposits as cash reserves with NRB. This ensures they have enough liquidity to meet eSewa/Khalti payment demands without running dry.

3. Daraz’s Inventory Turnover:

   • Idea Used: EOQ and inventory optimization.
   • How: Daraz uses algorithm-driven reordering to maintain <7 days of stock (vs. a physical store’s 30+ days). This reduces holding costs and prevents obsolescence (e.g., electronics becoming outdated).

4. NTC’s Accounts Payable Strategy:

   • Idea Used: Stretching payables for cash flow.
   • How: NTC negotiates 90-day payment terms with equipment suppliers (e.g., Siemens) to delay cash outflows while maintaining service quality.

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Exam Tip

What Examiners Love to Test

1. Calculations:

   • CCC, inventory turnover, EOQ, aging schedules.
   • Example Question: "Calculate the CCC for a firm with Rs. 1.5M inventory, Rs. 500K receivables, Rs. 300K payables, and COGS of Rs. 6M. Suggest improvements."
   • Key: Always show steps and interpret results (e.g., "CCC is 45 days; target <30 days").

2. Policy Trade-offs:

   • Compare aggressive vs. conservative policies with real Nepali examples (e.g., Pathao vs. a local bakery).
   • Example Answer:

     "Pathao adopts an aggressive policy with a CCC of 5 days, enabling high growth but risking stockouts. A Kathmandu bakery’s conservative policy (30-day CCC) ensures bread supply but ties up cash in inventory."

3. Financing Decisions:

   • When to use short-term vs. long-term funds for WC.
   • Example Question: "Should a hydropower company finance seasonal WC with a loan or trade credit?"
   • Key: Link to cost of capital (e.g., "Trade credit at 10% is cheaper than a 12% loan").

4. Ratio Analysis:

   • Given a balance sheet, calculate current ratio, quick ratio, and inventory turnover.
   • Example: If current assets = Rs. 2M, current liabilities = Rs. 1.5M, inventory = Rs. 800K, COGS = Rs. 4M:

     Current Ratio = 2M / 1.5M = 1.33 (⚠️ borderline)
     Inventory Turnover = 4M / 800K = 5x/year (✅ good)
     

5. Real-World Applications:

   • Always tie answers to Nepali businesses (e.g., "Like Ncell, firms should use lockbox systems to speed up collections").
   • Avoid generic answers; use numbers (e.g., "Nepal’s average CCC is 50 days; Daraz’s is 5 days").

Common Mistakes to Avoid

• Ignoring the time value of money: If calculating NPV of WC changes, discount cash flows.
• Assuming all policies are equal: Always discuss risk vs. return trade-offs.
• Skipping interpretations: After calculations, explain what the numbers mean (e.g., "A quick ratio of 0.8 means the firm can’t cover liabilities with liquid assets").
• Overlooking qualitative factors: E.g., "Supplier relationships may limit stretching payables beyond 60 days."

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Practice Question (Solve Like an Exam)

Question: The balance sheet of Himalayan Beverages Ltd. shows:

• Cash: Rs. 200,000
• Inventory: Rs. 1,000,000
• Receivables: Rs. 500,000
• Payables: Rs. 600,000
• Other current liabilities: Rs. 200,000
• COGS: Rs. 4,000,000 (annual)

Tasks:

1. Calculate the current ratio and inventory turnover.
2. Compute the cash conversion cycle (CCC) in days.
3. Suggest two improvements to reduce CCC, using real Nepali examples.
4. If the firm offers 2/10, net 30 credit terms, calculate the cost of not taking the discount.

Solution Outline:

1. Current Ratio = (200K + 1M + 500K) / (600K + 200K) = 1.5.
2. Inventory Turnover = 4M / 1M = 4x/year → 91 days inventory period.
3. CCC = 91 (inventory) + (500K / (4M/365)) (receivables) – (600K / (4M/365)) (payables) = ~120 days.
4. Improvements:
   • Adopt just-in-time inventory like Pathao’s suppliers (reduce inventory period to 30 days).
   • Offer 1% discount for 10-day payments (like Ncell’s early payment incentives).
5. Discount Cost:
   • Cost = (2% × Rs. 100,000) / (98% × 20 days) = ~10.2% annual cost.

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Final Tip: Draw t-accounts or flowcharts in exams to visualize transactions (e.g., how a sale on credit affects assets/liabilities). Examiners reward structured, visual answers!