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In this topic we will discuss about:
.Data Verification Sources
.Notice
.Essential Guidelines
.Discussions about working capital and its concept and theories
Data Verification Sources
1 = Theories and problems in financial management by M.Y khan and P.K Jain third
edition
2 = Wikipedia the free encyclopedia (http://en.wikipedia.org/)
3 = www.investopedia.com
Notice
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Essential Guidelines
(back to top)
Note: Before going through these discussion and cases you should have read basic
financial concepts, cost of capital and capital structure theories if you have
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Discussions about working capital (WC) and its concept and theories (back to
top)
This topic will cover three main theories of Working Capital (WC) that are
(I) Profitability risk trade-off
(II) Financing Mix and
(III) Determination of level of WC
(I) Profitability risk trade-off
This concept is simple to understand suppose two firms with same cash to invest
if one firm use its own cash to buy assets and other use debt financing for this
then this means which firm use its own cash its more cash is freeze in the shap
e of assets so this firm will not enjoy to use that cash for profitable opportun
ities like the other firm which use debt to finance the assets but the firm whic
h use debt is actually handling more risk than the other because of low current
ratio so that is the basic concept that describe that one has to decide between
risk and profitability as more profit will encounter more risk and vice versa we
will further discuss this topic in details
(II) Financing Mix
This concept describe that portion of Current Assets financed by Current Liabili
ties and long term liabilities should be appropriate and this describe that Curr
ent assets or their core portion should be financed by long-term liabilities and
purely temporarily and seasonal requirements should be financed by short-term l
iabilities this approach is called high profit, high risk financing mix.
Other approach is called Conservative approach according to this approach the wh
ole portion of current assets should be financed through long-term loans and sho
rt-term loans should only be used in emergency situations this approach is also
called low risk, low profitability approach.
None of the approach is suitable to be adopted by an entity there should be a go
od mix of these two approaches according to the nature of the entity and many ot
her factors
(III) Determination of level of WC
No doubt that when there is some operation then there is need of some current as
sets (cash, inventory etc) but how much current assets particularly cash is need
ed by an entity it depends upon the cash Or operating cycle of the entity and ca
sh cycle means that how much it take time to convert cash into inventory of fini
shed goods and inventory to receivables and receivables into cash please see cas
h conversion cycle at the following link
http://en.wikipedia.org/wiki/Cash_conversion_cycle
Suppose a situation where this cycle was possible to complete instantaneously th
en no need to maintain current assets but in practical it is nearly in-existent
Practical Problems and solutions:
(back to top)
Formulas to determine value of different items in Current Assets
Raw material inventory:
(BP * PUCRM *AIHP)/ N
Where:
BP = Budgeted production (units) for a given period
PUCRM = per unit cost of raw material(s)
AIHP = average inventory holding period (month or days)
N = number of months or days for given period like for a year 12 months (365 day
s)
Work-in-process inventory:
(BP * EWCPU *AWTS)/ N
Where:
BP = Budgeted production (units) for a given period
EWCPU = Estimated work-in-process cost per unit
AWTS = average work-in-process time span (month or days)
N = number of months or days for given period like for a year 12 months (365 day
s)
Finished goods inventory:
(BP * MCC *FGHP)/ N
Where:
BP = Budgeted production (units) for a given period
MCC = Manufacturing cash costs (Means no non-cash cost like depreciation should
be included)
FGHP = Finished goods holding period (month or days)
N = number of months or days for given period like for a year 12 months (365 day
s)
Formulas to determine value of different items in Current liabilities
(back to top)
Trade creditors:
(BP*PURMR*CP)/ N
Where:
BP = Budgeted production (units) per period
PURMR = per unit raw material requirements
CP = credit period limit
N = number of months or days for given period like for a year 12 months (365 day
s)
Note: Proportional adjustments should be made for cash purchases of raw material
Direct wages:
(BP*DLCPU*ATL)/ N
Where:
BP = Budgeted production (units) per period
DLCPU = Direct labor cost per unit
ATL = Average time-lag in payment of wages
N = number of months or days for given period like for a year 12 months (365 day
s)
Cash overheads:
(BP*PUOC*ATL)/ N
Where:
BP = Budgeted production (units) per period
PUOC = per unit over-head cost
ATL = Average time-lag in payment of over-heads
N = number of months or days for given period like for a year 12 months (365 day
s)
Note: different overheads should be calculated based on different bases like sel
ling overheads should be calculated on units sold etc
Solution:
(A) Estimation of current assets
Minimum desired cash and bank balance 25
Add:
Inventory;
Raw material, (300/12)*2 50
Work-in-process, (No work-in-process inventory mentioned)
0.00
Finished goods (0.8*sales = 1000*0.8* = (800/12)*1.5 *20% profit on sal
es) 100
Debtors [(800/12)*3] 200
Expenses paid in advance (sales expenses) (50/2
) 25
Total 400
(B) Estimation of current liabilities (CL):
Creditors for materials (monthly consumption * credit limit in months = [
(300/12)*1] 25
Add:
Creditors for expenses;
Wages [(240/12)*0.5] 10
Manufacturing expenses [(300/12)*1] 25
Selling overheads (Paid in advanced) 0.00
Administrator expenses [(120/12)*1]
10
Total 70
Net working capital = total of A less Total of B (NWC) (A-B)
(400-70) 330
Add 10% margin (330*1.1) 363
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