Working Capital Management

4 Working Capital Management
4.1 Introduction
One of the most important day to day function of finance manager is to manage the
working capital. In first chapter we studied that there are two major functions of a
finance manager, one of them being procurement of funds. The function of procurement
of funds can be bifurcated between Procurement of long term funds to purchase fixed
assets etc. and procurement of funds for short term purposes like funding for working
capital. In this chapter we are going to study the methods of estimating, raising and
controlling the working capital.
4.2 Meaning of the term working capital
Working capital refers to the funds that are invested in current assets net of current
liabilities. Current assets include Cash, inventory (stock), debtors, advances and other
current assets. Current assets are required to use fixed assets profitably, for example If
company is not maintaining stock of raw materials, which is a current asset, then there
can be breakdown in production and result into losses. Similarly granting credit period to
customers (resulting into debtors) is absolutely essential to generate higher sales. It is
obvious that certain amount of funds will always be invested in the debtors, raw
materials, work in progress, finished goods and day to day cash requirements. On the
other hand the business will also receive some credit period from its suppliers resulting
into reduction in the funds requirement. However, generally the requirement of funds in
current assets is more than availability of funds from current liabilities.
The term working capital is defined in two different ways
a. Gross working capital The gross working capital refers to investment in all
current assets taken together
b. Net Working capital The term net working capital refers to excess of current
assets over current liabilities.
From the view point of time working capital can be defined as
a. Permanent working capital It also refers to hard core working capital. It is the
minimum level of investment in working capital required at all times by the
business to carry out minimum level of activities.
b. Temporary working capital It is the requirement of investment in working

capital over and above permanent working capital. This investment varies from
time to time and changes as per seasonal requirements. As the volume of
temporary working capital varies from time to time it can funded by very short
term sources of finance.
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Working Capital Management
Permanent and temporary working capital can be elaborated with the help of
diagrams as follows
A
m
o
u
n
t Permanent
of
WC
Time
Or
A
m
o
u
n
t Permanent
of
WC
Time
WC working capital in Rs.
4.3 Importance of adequate working capital
Every Business need funds for its day to day operations. Adequacy of funds will ensure
smooth running of such day to day operations. A Finance manager has to ensure the
smooth running of such operations by arranging adequate funds to the business and
simultaneously ensuring that the funds arranged are not excessive and is not resulting
to excessive cost. A very big amount of working capital would mean that the company
has idle funds. Since funds have a cost, the company has to pay large amount as
interest on such funds. Having excess funds, known as over capitalisation, has been a
big reason for sick companies in India
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If the firm has inadequate working capital it is termed as under capitalised. Such
firms always have risk of insolvency. This is because shortage of funds may lead to a
situation where the firm may not be able to meet its liabilities. It is interesting to note that
many firms which are otherwise prosperous may fail because of lack of liquidity.
4.4 How to determine optimum working capital
Current ratio (with acid test ratio to support it) has traditionally been considered best
indicator of the working capital situation; current ratio = Current assets / current
liabilities. Academically it is believed that a current ratio of 2 for a manufacturing firm is
ideal ratio i.e current assets = 2 * current liabilities (approx) is considered as ideal.
Another indicator for ideal working capital mix is quick ratio = quick current assets /
current liabilities. Academically it is believed that a quick ratio of 1 for a manufacturing
firm is ideal ratio. The reason to mention it as academic is that practically ideal ratios
vary from industry to industry and should be decided by finance manager for his own
company considering the production process, normal credit terms, location of the
company and customers etc.. An example can be taken of Hero Honda Motors Ltd, a
two wheeler manufacturing company. The company has current ration less than 1 as
company is already utilising its full capacities and due to excessive demand for its
products does not offer any credit period, eliminating debtors and huge turnover of its
products also result into very less finished goods inventory. Here it wont be correct to
say that company is not investing in current assets and hence is losing on profitability,
as the company is able to sell to its full capacity without pilling up stocks and debtors so
for Hero Honda current ratio less than 1 can be considered as ideal. On the other hand
a company who deals in a high credit period industry may have a current ratio of above
3. Here also we cant say that the company is over capitalised and is investing
excessively in its current assets, as the company is just following trend of the industry in
which it is operating. Hence ideal ratio should be determined on basis of facts of each
company and should be compared with the average of the industry in which it operates.
4.5 Working capital cycle
The working capital cycle refers to the length of time between the firms paying cash for
materials, etc., entering into production process and inflow of cash from debtors.
For example Company A buys material worth Rs 5,000 on 1 st January 2004, keeps it
in stock upto 15th January 2004 and then start processing, the material is in process till
31st January 2004. After completing the production it takes one month to sell the product
i.e Finished goods stock is maintained for 1 month and is sold on 2 nd March 2004, it
offers its customer 1 months credit and so recovers the cash only on 31 st March 2004.
Now it is clearly evident here that the investment of Rs 5,000 in materials gets
recovered only after three months and in between it takes various forms of current
assets viz. Cash, Raw materials, work in progress, finished goods, debtors and again
cash. Important point here is that we have only considered material cost and ignored
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labour and overheads cost other wise the invested amount will go up. Now consider a
situation where Company A is getting credit period of 1 month, it can be noticed that
though material is purchased on 1 st January 2004, amount of Rs 5,000 is invested only
from 31st of January and now the period of investment is reduced to 2 months.
The above example can be elaborated diagrammatically as
Cash
Debtors Raw Materials,

Labour & overheads
Work in progress
Finished goods
The working capital cycle consists of the following events for a manufacturing
company which keeps on repeating
a. Conversion of cash into raw materials

b. Conversion of Raw materials into work-in-progress
c. Conversion of work in progress into finished goods
d. Conversion of Finished goods into debtors
e. Conversion of debtors into cash again.
Working capital is always measured in terms of days, as follows -
Working capital cycle / operating cycle [in number of days] = R + W + F + D

C
R - Raw materials storage period in number of days

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W - Number of days of work in progress

F - Number of days of finished goods in stock
D Debtors collection period
C Credit period availed
In the current example
R = 15 days (1st January 15th January)

W = 15 days (16th January 31st January)
F = 30 days (1st February 2nd March)
D = 30 days (2nd March to 31st March)
C = 30 days (1st January 31st January)
Working capital cycle or operating cycle (in days) = 15+15+30+30 30 = 60 days
The various components of operating cycle can be calculated as follows -
1. Raw material storage period [R] = Average stock of raw materials
Average cost of consumption per day
2. Work in progress holding period [W]= Average work-in-progress inventory
Average cost of production per day
3. Finished goods storage period [F]= Average Finished goods inventory
Average cost of goods sold per day
4. Debtors collection period [D] = Average book debts
Average credit sales per day
5. Credit period availed [C] = Average creditors
Average credit purchases per day
The above formulas are applied to forecast the working capital cycle and can be
compared with other companies in the same industry. The deviation with industry
average shows the efficiencies or inefficiencies of the organisation. For example let
us assume that the average debtors collection period for competitors of company A
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is 15 days and company is offering a credit period of 30 days, then it can be said
that the company A higher risk and is locking excessive funds in current assets.
4.6 Solved problems on calculation of working capital cycle
Problem 4.6.1
From the following information calculate the period of operating cycle of A Ltd. :
Rs.
Raw material consumed during the year 7,20,000

Average stock of raw materials 50,000
Cost of production 6,00,000

Average work in progress inventory 30,000
Cost of goods sold 7,20,000
Average finished goods inventory 40,000
Average collection period from debtors 35 days

Average credit period availed 25 days
Assume 360 days in a year
Solution
1. Raw material storage period [R] = Average stock of raw materials
Average cost of consumption per day
= 50,000 / (7,20,000 / 360)

= 50000 / 2000
= 25 days.
2. WIP holding period [W] = Average work-in-progress inventory
Average cost of production per day
= 30,000 / (6,00,000 / 360)

= 30,000 / 1667
= 18 days (approx)
3. Finished goods storage period [F]= Average Finished goods inventory
Average cost of goods sold per day
= 40,000 / (7,20,000/360)
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= 40,000/2,000
= 20 days
1. Debtors collection period [D] = 35 days

2. Credit period availed [C] = 25 days
Operating / working capital cycle = R + W +F+ D C
= 25 + 18 + 20 +35 25
= 73 days
Number of operating cycles in a year = 360 / 73 = 4.93
Problem 4.6.2
A ltd. has obtained the following data concerning the average working capital cycle
for other companies in the same industry:
Raw material stock turnover 25 days

Credit received -35 days
Work in progress turnover 10 days
Finished goods 32 days
Debtors collection period 55 days
87 days
Using the following data, calculate the current working capital cycle for A ltd. and
briefly comment on it.
(Rs. In 000)
Sales 500
Cost of production (also cost of goods sold) 210
Average Raw material inventory 8
Average work in progress 9
Average finished goods stock 18
Average debtors 35
Other information -
Out of cost of production Rs 60,000 is consumption of raw materials.60% of the

sales is on credit, credit period availed is 55 days. Assume 360 days of a year.
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Solution
Days (approx.)
1. R = 8 / (60 /360) = 48 days
2. W = 9 / (210 /360) = 15 days

3. F = 18 / (210 /360) = 31 days
4. D = 35 / (300 /360) = 43 days
5. C = 55 days
Operating cycle = R + W + F + D C
Operating cycle = 48 + 15 + 31 + 43 55 = 82 days.
Comments
Compan Industry Comments

yA average
R 48 25 The raw material storage period is
considerably higher than industry average,
so the company must try and reduce its
raw material stocks
W 15 10 Higher number of days in work in progress
indicates inefficiencies in production.
F 31 32 Almost at par with the industry
D 43 55 Debtors are offered lesser credit period
than average, the company can perhaps
increase the credit period in order to
achieve higher sales
C -55 -35 Credit period availed is higher than
average indicating availability of more
funds. Though it may result in higher cost
of raw materials or loss of goodwill
amongst the creditors.
Problem 4.6.3
From the following data, compute the duration of the operating cycle for each of
the two years
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Year 1 Year 2
Stock :
Raw Materials 20,000 27,000
Work in progress 14,000 18,000
Finished goods 21,000 24,000
Purchases 96,000 1,35,000
Cost of goods sold 1,40,000 1,80,000
Sales 1,60,000 2,00,000
Debtors 32,000 50,000
Creditors 16,000 18,000
Assume 360 days per year for computation purpose
Solution
Year 1 Year 2
Days Days
Raw material stock holding period [R]:

Year 1 20,000 / (96,000 /360) 75
Year 2 27,000 / (1,35,000 /360) 72
Work in progress [W]:

Year 1 14,000 / (1,40,000 /360) 36
Year 2 18,000 / (1,80,000 /360) 36
(As cost of production is not given calculation is done on
the basis of cost of goods sold)
Finished goods [F]:

Year 1 21,000 / (1,40,000 /360) 54
Year 2 24,000 / (1,80,000 /360) 48
Debtors [D]:
Year 1 32,000 / (1,60,000 /360) 72
Year 2 50,000 / (2,00,000 /360) 90
Creditors [C]:
Year 1 16,000 / (96,000 /360) 60
Year 2 18,000 / (1,35,000 /360) 48
Operating cycle = R + W + F + D - C 177 198
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4.7 Estimation of working capital requirements
In practice working capital cycle is mainly used for comparison with previous periods
and competitors, so that inefficiencies in operations can be pointed out and rectified.
Hence the main purpose of working capital cycle is control. But more essential thing is
perhaps funding for the working capital requirements, which can be done only when
working capital requirements is estimated in terms of money and not days. Banks
providing working capital and short term loans always demand such estimations and
give loan on the basis of such estimations. Such estimations can be done on the basis
of operating cycle. The formulas for estimation of current assets is given below
Formulas for Estimation of various current assets
a. Funds invested in Raw materials inventory can be calculated as follows The

funds invested in raw materials inventory can be estimated on the basis of
production budget, cost per unit and the estimated holding period as follows
The following formula can be used for this purpose
Estimated production in units * estimated cost of raw material per unit *

average raw materials holding period (in months / days)
12 months / 365 (or 360) days
ii. Funds invested in work in progress can be calculated as follows
Estimated production in units * estimated cost of production per unit * average

WIP holding period (in months / days)
iii. Funds invested in finished goods inventory can be calculated as follows
Estimated production in units * estimated cost of goods sold per unit *

average Finished goods holding period (in months / days)
iv. Funds tied up in debtors can be calculated as follows
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Estimated credit sales in units * estimated cost of sales per unit (excluding
depreciation) * average debtors collection period (in months / days)
Formulas for Estimation of various current liabilities
i. Calculation of estimated amount of trade creditors:
Estimated yearly credit purchases in units * estimated cost of raw materials

per unit * average credit period granted by creditors (in months / days)
ii. Calculation of estimated amount of direct wages:
Estimated production in units * estimated direct labour cost per unit * average
time lag in payment of wages (in months / days)
iii. Calculation of estimated amount of overheads (other than depreciation and

amortisation):
Estimated yearly production in units * estimated overheads cost per unit *

average time lag in payment of overheads (in months / days)
Note - The amount of overheads may be separately calculated for different

types of overheads. In case of sales overheads, the relevant item would be
sales volume instead of production volume.
Some important points

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i. Effect of shift working A company may operate in more than 1 shift in that
case the production is substantially higher. Let us say that for a 2 shift
working production is approx double that of 1 shift working, in such case
current assets like stocks should also get doubled, as daily requirement will
be twice. But in reality it hardly happens and though the stock levels go up it,
it is never in proportion with the production. Though in examination students
should assume the stock levels going up in same proportion as that of
production unless otherwise stated.
ii. Measurement of working capital in terms of Cash outflows Working

capital requirement should be estimated as accurately as possible so that
funds can be raised accordingly. Excess funds result into additional interest
expenditure. Hence in practice amount of debtors and finished goods etc are
adjusted for non-cash items, which are not required to be funded. Let us see
one example Company A has debtors worth Rs 25,000, but the total cost of
the goods sold to these debtors is Rs 20,000 which includes Rs 5,000
depreciation. Now here we can see that actual cash out flow on the goods
sold to these debtors is just Rs 15,000 (selling price profit depreciation),
or it can be said that only Rs 15,000 is blocked with the debtors and this is the
amount which needs to be funded. If the company A takes loan based on
debtors amount of Rs 25,000 then the company is unnecessary taking excess
loan to the extent of Rs 10,000 on which it will be bearing interest. To avoid
this current asset figures are estimated excluding all the non cash items.
iii. Work in progress Work in progress is half completed production. As the

product can be in any stage for estimating working capital WIP is always
assumed to be 50% complete. Important point here is WIP is always
assumed to be 100% material and 50% labour and overheads unless
otherwise stated.
4.8 Solved problems
Problem 4.8.1
The Cost sheet of A ltd. is as follows

Cost per unit (Rs)
Raw Materials 50
Labour 20
Overheads 30
Depreciation 10
Profit 10
Selling price 120
Average holding/realisation period is as follows

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Raw materials 1 month, Finished goods 1 month, creditors 2 month,

Debtors 2 months. Assume that there is no working capital.
Other information Expected output is 54,000 units per year.
Solution -
Rs.
A Current assets
1. Raw materials = (Cost per unit * production * estimated period
of stock in months) / 12 months
= (50*54,000*1) / 12 2,25,000
2. Finished goods = (Cost of production per unit * production *

estimated period of stock in months) /
12 months
= (100 * 54000*1) / 12 4,50,000
3. Debtors = (sales in units * cost of sales per unit (excluding

depreciation) * average debtors collection period
(in months) / 12 months
= (100* 54000 *2 ) / 12 9,00,000
Total current assets 15,75,000
4. Creditors = (purchases in units * purchase cost per unit *

average credit period availed (in months) / 12
months
= (50*54000 *2) / 12 4,50,000
Total current liabilities 4,50,000
Net working capital 11,25,000
Working notes
1. Calculation of cost of production for the purpose of calculation of Finished goods

stock
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Rs.
Raw Materials 50
Labour 20
Overheads 30
Total 100
2. Debtors are also valued at same rate as selling expenses are not given.
3. Debtors and finished goods exclude depreciation and profit as they are non-
cash items
4. Work in progress is assumed to be nil
Problem 4.8.2
The cost sheet of Hi-Tech Ltd. provides the following data:
Rs
Raw Material 30
Direct labour 20
Overheads (including depreciation of Rs.10) 20
------
Total Cost 70
Profit 10
------
Selling price 80
------
1) Average Raw material in stock is for 1 month

2) Work-in-progress (assume 50 % completion stage for Raw materials, wages
and overheads) will approximate to 1/2 months production
3) Finished goods lie in the warehouse for 1 month
4) Credit allowed to Debtors is 1 month. 25 % of Sales are on cash basis.
5) Cash balance expected to be Rs.2,00,000.00
6) Credit allowed by suppliers is 1 month
7) Average time lag in payment of wages is 2 months
8) Average time lag in payment of overheads is 1 month
9) Assume a 10 % margin
You are required to prepare a statement of the working capital needed to
finance a level of the activity of 60,000 units of output per year.
Solution:
As the annual level of activity is given at 60,000 units, it means that the monthly
turnover would be 60,000 / 12 = 5,000 units
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Estimation of Working Capital Requirement
I Current Assets: Amount (Rs.)

Minimum Cash Balance 2,00,000
Raw Material Stock (5000 x 30) 1,50,000
Work-in-progress [(5000 x 60) / 2] x 50 % 75,000
Finished Goods (5000 x 60) 3,00,000
Debtors (5000 x 60 x 75%) 2,25,000
Gross Working Capital 9,50,000
=======
II Current Liabilities:
Creditors for materials (5000 x 30) 1,50,000
Creditors for Wages (5000 x 20 x 2) 2,00,000
Creditors for Overheads (5000 x 10) 50,000
-------------
Total Current Liabilities 4,00,000
========
Excess of Current Assets over Current Liabilities (I II) 5,50,000
Add :- 10 % margin 55,000
Net working capital requirement 6,05,000
Problem 4.8.3
The management of Royal Industries has called for a statement showing the
working capital to finance a level of activity of 1,80,000 units of output for the year.
The cost structure for the companys product for the above mentioned activity level
is detailed below
Rs
Raw Material 20
Direct labour 5
Overheads (including depreciation of Rs.5) 15
------
Total Cost 40
Profit 10
------
Selling price 50
------
Additional information
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a. Minimum desired cash balance is Rs 20,000

b. Raw materials are held in stock for average period of 2 months
c. Work in progress (assume 50% completion stage for all labour, material and
overheads) will approximate to half months production.
d. Finished goods remain in warehouse, on an average for a month
e. Supplier for materials extend 1 months credit and debtors are given 2 months
credit period. Cash sales are 25% of total sales
f. There is a time lag in payment of wages of a month and half a month in case of
overheads
g. You are required to prepare a statement showing working capital requirements.
(CS final, Dec 90)
Solution -
Statement of working capital requirements
I Current Assets: Amount (Rs.)
Minimum Cash Balance 20,000
Raw Material Stock (15,000 x 20x2) 6,00,000
Work-in-progress [(15,000 x 35) / 2] x 50 % 1,31,250
Finished Goods (15,000 x 35) 5,25,000
Debtors (15,000 x 35 x 2 x 75%) 7,87,500
Gross Working Capital 20,63,750
=======
II Current Liabilities:
Creditors for materials (15,000 x 20) 3,00,000
Creditors for Wages (15,000 x 5) 75,000
Creditors for Overheads (15,000 x 10) / 2 75,000

-------------
Total Current Liabilities 4,50,000
========
Excess of Current Assets over Current Liabilities (I II) 16,12,750
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Notes
1. Work in progress, finished goods and debtors exclude depreciation being

non cash items.
2. production is assumed to be equal in all months i.e Production per month

= 1,80,000 / 12 = 15,000 units
Problem 4.8.4
H ltd plans to sell 30,000 units next year. The expected cost of goods sold is as
follows
Rs. (per unit)
Raw materials 100
Manufacturing expenses 30
Selling, administration and financial expenses 20
Selling price 200
The duration at various stages of operating cycle is expected to be as follows :
Raw material stage 2 months

Work in progress stage 1 month
Finished goods month
Debtors 1 month
Assuming monthly sales level of 2,500 units, estimate the gross working capital
requirement if desired cash balance is 5% of the gross working capital
requirement, and work in progress is 25% complete with respect to manufacturing
expenses.
Solution:
Statement of working capital requirements
I Current Assets: Amount (Rs.) Amount (Rs.)
Raw Material Stock (2,500 x 100 x2) 5,00,000
Work-in-progress :
Raw materials in WIP ( 2500 x 100) 2,50,000
Manufacturing expenses 25% (2,500x30) 18,750
2,68,750
Finished Goods :
Raw materials in WIP ( 2500 x 100 x1/2) 2,50,000
Manufacturing expenses (2,500x30x1/2) 37,500
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1,62,500
Debtors (2,500 x 150 x 1) 3,75,000
13,06,250
Cash balance (13,06,250 *5/95) 68,750
Working Capital requirement 13,75,000
=========
Note Selling and distribution expenses never for part of finished goods and
WIP but is always included in Debtors
Problem 4.8.4
Happy Family is a small trading company whose balance sheet as at 31 st March

1998 was as under :
Liabilities Rs Assets Rs
Capital 50,500 Building 50,000
General reserve 7,000 Furniture 10,000
Bank loan 40,000 Cash 9,500
Creditors 11,300 Motor car 15,000
Liability for income tax 9,700 Stock in trade 12,000
Debtors 22,000
1,18,500 1,18,50
0
On the basis of following information pertaining to the year ended 31.3.1999, you
are required to prepare a statement of changes in working capital:
a. Sold motor car on 30.9.1998 for Rs 18,000 and on the same date purchased
100 equity shares of Rs 10 each in X ltd.
b. Sales for the year were 20% higher than that in the last year. Purchase of
materials increased by 10%. Customers were allowed 2 months credit and
suppliers allowed 1 month credit. Debtors on 31 st March 1998 represented
sales of February and march ( to be evenly allocated) and creditors also
represented purchases for March (monthly average)
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c. Business expenditure for the year amounted to Rs 1,800 per month (paid in
each month). There were no other receipts and payments during the year.
Gross profit rate was 30% on turnover.
d. Provide for interest on bank loan at 6% p.a and for income tax liability Rs 5,000
( ICWA final, June 1999)
Solution
Statement showing changes in working capital
31.3.98 31.3.99 Increas Decreas

e e
Current Assets
Stock 12,000 50,280 38,280
Debtors 22,000 26,400 4,400
Cash & Bank balance 9,500 1,170 8,330
42,680 8,330
Current liabilities
Creditors 11,300 12,430 1,130
Interest on bank loan 2,400 2,400
Liability for taxes 9,700 5,000 4,700
4,700 3,530
Net Increase in Working capital 35,520
Working notes
1. As sales are going up by 20%, debtors will also go up by 20%, as debtors are
equal to last 2 months sales (which is going up by 20%). Debtors as on
31.3.1999 = 22,000 + 20%(22,000) = 26,400
2. As purchases are going up by 10%, creditors will go up by 10%. Creditors =

11,300 + 10%(11,300) = 12,430
3. Amount of sales for 1999 = Debtors / 2 *12 = 26,400/ 2 * 12 = 1,58,400 (As

debtors = 2 months sales)
4. Amount of purchases for 1999 = creditors *12 = 12,430 *12 = 1,49,160 (As
creditors = 1 months purchases)
5. Stock in trade for 31.3.99 can be calculated as follows :
Trading Account for the year ended 31.3.1999

Rs Rs
To Opening stock 12,000 By sales 1,58,400
To purchases 1,49,160
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To gross profit (30% of 47,520 By closing stock 50,280

sales)
2,08,680 2,08,680
6. Calculation of Cash balance as on 31.3.99
Trading Account for the year ended 31.3.1999

Rs Rs
To Opening balance 9,500 By payment to creditors 1,48,030
To collection from debtors 1,54,000 By purchase of investment 1,000
To Sale of motor car 18,000 By other expenses 21,600
By income tax for last year 9,700
By closing balance 1,170
1,81,500 1,81,500
7. Collection from debtors = opening balance + sales during the year

closing balance = 22,000 + 158,400 26,400 = 154,000
8. Payment to creditors = opening balance + purchases during the year

closing balance = 11,300 + 149,160 12,430 = 1,48,030
4.9 Factors affecting the working capital requirement
i. Seasonality of business Seasonality of industry would obviously

affect the working capital requirements. Unlike we have seen in earlier
problems, it is difficult to predict working capital on the basis of assumptions
like sales accrue evenly throughout the period. Let us take an example of Air
condition manufacturing company, if we assume that sales are even
throughout the year then perhaps the company will be short of funds in
summers when demand (and so the working capital) is higher and company
may carry unnecessary funds in winter season. Thus a finance manager
should estimate working capital according to seasonality of business.
ii. Nature of business and production process Service industry

and trading activities require very less working capital whereas manufacturing
concerns always have huge working capital requirement. Companies having
shorter production process require lesser working capital as compared to
companies having lengthy production process.
iii. Credit policies of the company The credit policies of the

company plays a major role in determining the requirement of working capital.
Company allowing liberal credit may end up having lesser finished goods
stock but will have large investment in the debtors. A company having strict
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credit policies and efficient debt collection system will have lesser investment
in debtors. Credit policy of the company also depends upon the companys
reputation and demand for its products in the market, a well established
company may not offer any credit to its customers whereas a new company
having same product may offer few months credit.
iv. Inventory policy The inventory policy of a company also has a

impact on the working capital requirements since a large amount of funds is
normally locked up in the inventories. An efficient firm stock raw material for a
smaller period and may require lesser amount of working capital
v. Contingencies Contingencies play an important role in working

capital requirements, unpredicted shortage of raw materials, heavy rise in
demand for products, strikes etc. may shatter the estimates.
vi. Competition Working capital requirements are affected by

degree of competition. Large inventory is essential to assure timely delivery
and credit period may be higher to cope up with high level of competition in
buyers market
vii. Dividend and taxation policies - Level of working capital

requirements vary according to dividend and taxation policies.
4.10 Management of Working capital
Estimation of working capital requirements is just par of the finance manager. An equally
important job is management of working capital. We have already discussed that
operating cycle and working capital estimation are control tools as well, i.e. it gives the
management an idea whether the company is having an adequate level working capital
or it is carrying excess / lower working capital. Excess working capital leads to increase
in interest costs whereas lower working capital carries the risk of insolvency. It is
acumen of the finance manager to strike a balance between the risk and profitability. In
current Indian scenario especially after depression in industry since year 2000 the
concept of working capital management has gained significant importance. It will not be
wrong to say that many companies could recover from heavy losses and were able to
turnaround to profits only because of excellent working capital management. In last few
years companies have consistently taken efforts on reduction of unnecessary
inventories by following Just in time purchase techniques, improving delivery systems,
improving communications and co-ordination between marketing, production and
purchase departments. The companies also have taken special efforts to reduce their
debtors collection period and recovery of bad debts. Banking industry has paid a keen
role in cash management of companies by providing facilities like collection centres etc.
Though academically current ratio of 2 is considered to be ideal, currently most of the
companies are eying for a substantially lesser ratio. Well now discuss various aspects
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of working capital management bifurcating between management of each aspect of

current assets and current liabilities.
4.11 Management of cash - Management of cash has always been one of the
important functions of a finance manager, though now a days it appears to be a bit
simpler job as compared to earlier days thanks to technological advancement of
banking industry. The term management of cash includes management of actual cash
and cash equivalents like liquid bank balances and other liquid investments. A major
problem in cash management has always been the geographical diversity of business.
Let us see one example of a Pune based two-wheeler manufacturing company. The
company has its dealers network spread all over India and abroad but has its
production facilities and most of the suppliers in and around Pune. Now let us discuss a
case where the company has a receivable of an amount from a dealer in Assam, say on
1.1.2004 of Rs 10,00,000 and on the same day (or in 2-3 days time) has a payment due
to a Pune based supplier, Say Rs 5,00,000 then though company has a receivablefrom
its dealer in Assam, cannot use the same amount to settle the dues of the Pune based
supplier. Now the company has no option but to borrow from the banks till the time the
cheque gets cleared in the companys account (the payment may take a long time to
reach the company and even longer time to clear cheque from remote place). A similar
problem is faced when one department of the company has excess cash, whereas
another is short of cash. To summarise the requirement of proper cash management
can be highlighted as under
1. An effective cash management ensures that there is no shortage of funds as

well as there are no idle funds
2. Cash is required for meeting day to day expenses like petty expense,
payment to creditors, payment of wages, payment of various government dues
etc.
3. Liquidity can always be used for taking profitable opportunities which requires
liquidity. For example a sudden fall in share market may become right time for
investment in share market and company having enough liquid cash / bank
balance can only take shares and take the speculative advantages.
4. Cash balance is absolutely necessary to cope up with unforeseen

contingencies.
4.11.1 Estimation of cash requirements The first step of cash management is cash
estimation. These estimations are done with the help of cash budgets. Cash
budgets are prepared periodically to identify cash inflows and outflows, as cash
flows determine the requirement of funds and helps identifying investible funds.
Cash budgets are nothing but cash flow statements. One must note that cash flow
is different from profit or loss, to identify cash flow one must adjust all non cash
items to the profit / loss. Other popular way for preparing cash budgets is to
prepare estimated receipts and payments account. The preparation of cash
budgets offers following advantages
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Page 22 of 40
1. It gives information about timing and quantum of liquid funds required to be

raised
2. It shows the amount of internal accruals; management can assess how much is
needed fro day to day operations and how much is available for purchase of
long term assets.]
3. It shows the need for additional amount of cash required so that loans can be
raised accordingly.
Format of cash budget

XYZ Ltd.
Cash budget
Period
Month 1 Month 2 Month 3 Month 4 Month.. Month.

.
Opening Balance
Receipts:
1. Cash sales
2. Collection from
debtors
3. Issue of capital
4.Other income
(Scrap etc.)
5. Loans taken
6.Miscelleneous
receipts
(dividend,
interest etc.)
Total
Payments :
Creditors
Salaries
Wages
Interest
Overheads
- Fixed overheads
- Variable over heads
- selling overheads
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Dividend
Fixed assets
Taxes
Other items
Total
Closing balance
Minimum desired
balance
Surplus / (shortfall)
4.11.2 System of Cash Management The next step of cash management is proper
allocation of funds amongst various departments / locations and maintaining
appropriate balance / liquidity at each place. The collection mechanism can be
made efficient by
a. Speeding up the mailing time of payments from the customers
b. Reducing the time lag between collection of cheques and its deposition with
the banks.
Two important methods to speed up collection process are 1. concentration

banking and 2. lock box system
1. Concentration banking In concentration banking the company establishes

number of collection centres according to locations of its customers. Instead of
mailing the payments the customers deposits the money in the collection
centres, which it deposits immediately in the local branch of the main bank,
and the collection centres transfer the funds to the Head office of the company.
The importance of this can be elaborated as follows
Continuing with the example of the two-wheeler company discussed above, let
us see how concentration banking will help the company
a. The collection process (mailing time of the dealer + clearing time for the
cheque) will be very high as the place is quite far and mailing will take time,
again outstation cheques take long time to get cleared, where as under
concentration banking the time of mailing is completely avoided as the dealer
will deposit the cheque in the collection centre near to his dealership place
and clearing will also take lesser time as the dealer will obviously give cheque
drawn on a local bank.
b. let us assume that total such collections in a year are Rs 3,65,00,000 in a
year (365 days) and the collection process is expected to be reduced by 5
days by using the concentration banking, also the rate of interest on working
capital loan is 10% p.a. Now we can see that the total interest saving will be 5
days collection * 10% = (3,65,00,000 / 365 * 5 * 10%) = Rs 5,00,000 p.a. .
Even if the company incurs Rs 1,00,000 as charges for availing collection
bank facility, it will stand to gain Rs 4,00,000.
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An extension of concentration banking has been introduced by the bankers,

where they allow same day clearing i.e. when the dealer deposits the cheque,
bank gives immediate credit in the companys account, saving the days of
clearing also, of course the cheque is reversed if the dealers bank does not
honour the cheque.
2. Lock box facility The purpose of lock box system is to eliminate the time
between the receipt of remittance by the company and depositing it in the bank.
Under this system the company rents local post office boxes and authorise
banks at each location to collect the remittances in the box. After collecting the
remittances the bank deposits it in the companys account. This also relieves
the company from handling of the cheques.
3. Reducing the floats Float here means the time periods that affect the cash
movements in various stages of collection process. Floats can be bifurcated as
follows
a. Billing float An invoice is the formal document that a seller prepares and
sends to the purchaser as the payment request for goods sold or services
provided. The time between the sale and the mailing of invoice is the billing
float
b. Mail float This is the time when a cheque is being processed by post office
or currior
c. Cheque processing float This is the time required for the seller to sort,
record and deposit the cheque after it has been received by the company
d. Bank processing float This is the time from the deposit of the cheque to
the crediting of funds in the sellers account
Lesser the float faster will be the collection process. To achieve this aim finance
manager must ensure that some basic procedures are followed, like cheques are
deposited on time, timely delivery of invoices, regular analysis of uncleared
cheques etc.
4.12 System of debtors Management
The basic difference between cash management and management of other

current assets is that the system of cash management can be solely designed by
finance manager and he need not take consent of other departments and that makes
the task bit easier. Whereas in case of debtors and inventory management a finance
manager has to take into consideration decisions of other departments like Marketing
department and production department. Say for example if a finance manager,
considering the serious position of working capital, decides to grant no credit to debtors
then the marketing department will certainly object this decision as it wont be able to
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achieve the sales targets without appropriate credit period and perhaps in a competitive
market will substantially lose its market share. Similarly if a finance manager decided to
keep Raw material inventory to the extent of 30 days consumption, which is equal to the
industry average, Production manager may argue against it as reduction in raw material
stock may hamper the production. Selling goods on credit has a cost, the cost includes
a. Interest on the amount of loans raised to fund the investment in debtors

b. Administrative cost like cost of maintaining records
c. Collection cost
d. Bad debts debts which cannot be recovered
Some of the important determinants of the investment in working capital are

a. Credit policy of the company
b. Discount policy of the company
c. Collection policy
d. Credit analysis
1. Credit policy Credit policy determines the period of credit to be granted to

debtors, decides as to which types of debtors should be given credit period and
how much. Granting credit is absolutely essential as
a. It helps in increasing sales and market share
b. Credit sales generally has higher margins, thus it adds to profitability of
the company
c. In case of intense competition it is absolutely essential to grant credit
period
Credit policy plays a very important role in debtors management and hence it
should be decided carefully after considering various marketing and financial
aspects. It is necessary to keep on revising the credit policies with changing
market situations.
2. Discount policy Practically every business offers cash discount for speedy
collection of debts. It helps the seller to improve his liquidity. Cash discount is
generally granted in slabs like say discount of 2% for payment in 0-15 days from
sales, 1% for payment in 16-30 days and so on. Let us take an example to
elaborate the importance of the cash discount Trader A has an annual sale of
Rs 600 lakhs and has average credit period of 3 months. Trader A has decided to
offer 2% discount on cash sales, now suppose 50% of the customers avail this
discount, reducing the debtors from Rs 150 lakhs (3/12 *600) to Rs 75 lakhs.
Now suppose Trader A pays interest @ 18% p.a on working capital loans, then
he is saving Rs 75 lakhs * 18% p.a = Rs 13.5 lakhs against the cost of discount =
Rs 300 lakhs * 2% = Rs 6 lakhs.
3. Collection policy Efficient and timely collection of debtors is absolutely

essential for avoiding bad debts and reducing the unnecessary investment in the
debtors. Delay in collection period unnecessary adds up to investment in the
debtors, i.e. if credit period of 60 days is necessary to make a good sale then
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investment in debtors for these 60 days is only essential, additional recovery

period (say of 10 days) adds only to the investment without adding anything to
the sales. It is important that clear-cut procedures regarding credit collection are
set up. The procedures shall include guidelines regarding the time period of dues
after which the collection procedures should be initiated, what should be the
format of initial letters and legal letters, which cases of defaulters should be taken
to courts (this basically involves assessment of cost of legal action and actual
dues) etc. One important analytical tool used by the collection department is
aging analysis. Ageing analysis bifurcates the dues between various periods
throwing out dues that are outstanding beyond the credit period. It also highlights
dues outstanding for abnormally long period, which is generally provided for in
the accounts.
4. Credit analysis - Having determined the credit terms, the firm has to evaluate
credit worthiness of individual customers. It is an absolute essential procedure as
it helps the company in substantially reducing its bad debts. This procedure
includes credit rating, in which each and every customer (except for cash
customers) are rated according to their creditworthiness and their credit period
etc are determined according to their ratings. The credit rating depends upon
analysis of various factors like
a. Past experience of the company with the customer

b. Latest financial performance of the customer like Balance sheet
c. Trade references etc.
4.12.1 Factoring
Factoring is the debt collection service provided by the bankers. Bankers provide
like buying the debtors of a company and extending credit upto 70-80% of the
invoice value. It is nothing but financing the sundry debtors and is a type of working
capital finance. Operation of factoring is very simple, clients enter into an
agreement with the factor working out an factoring agreement according to his
requirements. The Factor then takes the responsibility of monitoring, follow up,
collection and risk taking and provision of advance. The factors generally fixes up a
limit customer wise for the seller. Some of the benefits and limitations of factoring
are
a. The company can convert directly its debtors into cash ( after deducting the
factoring commission)
b. Factoring ensures a definite pattern of cash inflows
c. Factoring eliminates the need of a credit and collection department in the
company saving on administration and staff costs. This is particularly very
useful for seasonal businesses where firms cant afford to maintain such
department for whole year, as work for such department is only for a season.
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d. Collection and recovery has been considered as a big problem by almost all
businesses and factoring reduces or nullifies this problem.
The limitations of factoring are
a. It is costlier source of finance as the cost includes both factoring fees and
interest on the advance till the amount is recovered from the debtors
b. Bad debts can still be the responsibility of the company and not the factor. If
factor agrees to take the risk as to the bad debts then the factoring fees are
even higher
Thus before availing the services of a Factor the finance manager must consider
the costs and benefits associated with factoring and should appraise its utility to his
company.
Some other popular ways of management of debtors are Debt securitisation, Invoice
discounting etc. Debt securitisation is used by financial concerns like banks NBFCs etc.
A detailed study of these tools will be done in next semester.
4.13 System of Inventory Management
In case of any manufacturing industry inventories is perhaps the biggest element of

working capital and hence maximum funds are blocked in the inventories (stocks).
Keeping inventories at its optimum level is always a tough task as excess or shortage of
inventories may create tremendous problems, like
1. Shortage of raw materials may lead to interruptions in production schedule resulting

in under utilisation of capacity. Interruption in production increases the cost of
production as wages and overheads are incurred even when production is halted.
2. Reduction in Finished goods may lead to excessive delay in deliveries to customers,

resulting into reduction in sales
3. Excessive stock blocks up funds which has a cost
4. Inventories are non liquid assets and cant be converted in cash easily.
Therefore inventory control should be done carefully. There are various techniques
developed for inventory control which are discussed in brief
1. Minimum and Maximum levels This is perhaps the simplest form of inventory
management, under his method management simply decides what should be the
minimum and maximum level of various items in inventory. These levels are decided
after considering the availability and importance of various items. It also takes into
consideration cost of purchases and lead time (time period between ordering of
material and actual receiving the material). Cost of procurement is an important point
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especially for imported items as carriage costs are heavy for imports and the cost
can be spread over only bulk quantity.
2. Re order quantity The re-ordering quantity is the level of stock where new
procurement orders are required to be placed without delay.
3. Economic order quantity [E.O.Q.] It is an important concept in the purchase of

raw materials and in the storage of finished goods and in-transit inventories. EOQ
techniques gives a formula to determine the optimum quantity to be ordered.
EOQ = 2AO/ C
A = Total usage in units for a period
O = ordering cost per order
C = Carrying cost per unit
4. Just in time purchase This is a relatively new concept and is far easier to
implement if stock records are maintained on computers. Under this method high
value inventories are procured only when it is required in production, suppliers are
specially developed so that they can arrange these items very promptly
This was just a brief introduction to the tools of inventories, as a detailed study is part of
subject of costing and not financial management.
4.14 Working capital financing in India
Indian banks have been traditionally been extending credit to industry and trade solely
on the basis of securities like hypothecation of stocks etc. The organisations ability to
repay these loans and actual usage of these loans were never checked. This resulted
into heavy losses to bankers and defalcation of funds by the promoters. To cure this
problem Reserve Bank of India has set up various committees to study the matter and
provide appropriate guidelines, analysis some of the committees are discussed below
1. The Dahejia committee report In 1969 Dahejia committee pointed out that there
was no relationship between optimum requirements for production and the bank
loans. It was general tendency of the businessmen to take short term loans and use
it for other than production purposes. It was also pointed out that there are multiple
hypothecations on the same stocks. The Dahejia committee suggested that the bank
should make appraisal of credit applications with reference to the total financial
situation of the client. It also suggested that all the Cash credit bank accounts
should be bifurcated between the hard core which would cover the permanent
working capital and a strictly short term component which should be fluctuating part
of the account.
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2. The Tandon committee report The Tandon committee was set up by the RBI in
1974. Along with the suggestions regarding to whom working capital loans should be
granted, how much loan should be granted, the committee gave three different
methods for calculation of working capital. Though earlier these methods were
mandatory for the bankers now it is only recommendatory in nature. The three
methods are as follows
Method I
Bank finance to be granted = 75% (Current Assets Current liabilities [excluding
bank borrowings])
Method II
Bank finance to be granted = 75% (Current Assets) Current liabilities [excluding
bank borrowings]
Method III
Bank finance to be granted = 75% (Current Assets Core current assets) Current
liabilities [excluding bank borrowings]
3. Chore committee In 1979 chore committee was formed by RBI to analyse funding
of working capital the committee gave certain major suggestions regarding
enhancement of borrowers contribution in the working capital, compulsory periodic
review of cash credit accounts by bankers etc.
4.15 Self examination questions
4.15.1 Problems
1. M/s A ltd. have approached bankers for their working capital requirements. The
bankers agreed to finance but decided to keep some margins as under (i.e agreed
to finance excluding the margins)
Raw materials 20%

Work in progress 40%
Finished goods 15%
Debtors 30%
Following are the estimates for the year 2002-03

Rs. 000s
Annual Sales 14,40
Cost of Production 12,00
Raw Materials purchased 7,05
Opening stock of Raw materials 1,40
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Opening stock of Raw materials 1,25
Other information Raw material is in stock for 2 months, WIP 15 days and FG 1
month. Debtors get 1 months credit and creditors give 15 days credit. Company
has received an advance of Rs. 15,000
1. Estimate the amount of working capital requirement

2. Estimate the amount of loan likely to be approved by the bankers.
Note - Margin is the amount which is not funded by the bankers e.g. if
bankers decide to fund debtors excluding 30% margin that means if
company estimates debtors to be Rs 100 then bank will fund only Rs 70
2. M/s B ltd. have approached bankers for their working capital requirements. The
bankers agreed to finance but decided to keep some margins as under (i.e agreed
to finance excluding the margins)
Raw materials 30%

Work in progress 35%
Finished goods 12.5%
Debtors 42%
Cash 0%
Estimated annual production is 60,000 units and break-up of selling price is as

under
Raw Materials 60%

Direct wages 10%
Overheads (includes depreciation 10%) 20%
Profit 10%
Selling price 100%
Other information Raw material is in stock for 2 months, work in progress (WIP) 1
month and FG 3 month. Debtors get 3 months credit and creditors give 2 months
credit, wages are paid after one month. Calculate WIP considering 100% RM +
50% wages and overheads. Selling price is estimated @ 5 Rs per unit. Cash
requirement is Rs 20,000

3. M/s C ltd. have approached bankers for their working capital requirements. The
bankers agreed to finance but decided to keep 30% margins on all current assets
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Page 31 of 40
excluding Cash balance (i.e agreed to finance excluding the margins) other
information is as follows -
Cost per unit

Raw Materials 40
Labour 10
Overheads 60
(Depreciation included in overheads Rs 20)
Selling price 120
Raw materials 1 month, WIP (Completion - Material 100%, labour & overheads
50%) 1 month,
Debtors 2 month, Creditors 1 month, wages 1/2 month, overheads 30 days,
Finished goods 2 month.
80 % of sales is on credit, Expected cash balance is 75,000

4. Explain in details what is working capital, with its definitions
5. Write short notes on
1. Reducing the floats in collection system

2. Factoring
3. Working capital cycle
4. Concentration banking
6. Discuss various formulas given by Tandon committee
7. How each item of current assets can be managed
8. Consider the following financial facts of Company A ltd.
Current assets
a. Inventory Rs. 140 lacs
b. Debtors Rs. 200 lacs

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Page 32 of 40
c. Other current assets Rs. 20 lacs
Current liabilities
a.Creditors Rs. 100 lacs
b.Other liabilities Rs. 20 lacs
Calculate the permissible bank finance according to methods given by Tandon

committee
9. The Cost sheet of A ltd. is as follows

Cost per unit
Raw Materials 50
Labour 18
Overheads 35
(Depreciation included in overheads Rs 10)
Selling price 125
Raw materials 11/2 month, WIP (Completion - Material 50%, labour & overheads
50%) 1 month, Debtors 2 month, Creditors 1 month, wages 1/2 month,
overheads 1/3rd month, Finished goods 1 month.
Other information 1. 75 % of sales is on credit

2. Expected cash balance is 55,000
Expected output is 60,000 units per annum. Calculate the amount of working
capital required.
1. T ltd is a trading company whose balance sheet as at 31 st March 2004 was as

under :
Capital 1,50,500 Building 1,10,00
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Page 33 of 40
0
General reserve 17,000 Furniture 70,000
Bank loan 34,000 Cash 19,500
Debtors 12,000
2,38,500 2,38,50
0
On the basis of following information pertaining to the year ended 31.3.2005, you
are required to prepare a statement of changes in working capital:
a. Furniture on 30.6.2004 for Rs 18,000 and on the same date purchased 100
units of UTI at Rs 100 each.
b. Sales for the year were 30% higher than that in the last year. Purchase of
materials increased by 15%. Customers were allowed 1.5 months credit
and suppliers allowed 1 month credit (Policy was same for 2004)
c. Overheads for the year amounted to Rs 3,500 per month (paid in next
month). There were no other receipts and payments during the year. Gross
profit rate was 40% on turnover.
d. Provide for interest on bank loan at 9% p.a and for income tax liability Rs
7,500
10. Compute the amount of working capital from the following balance sheet
Balance sheet as at 31.3.2004
Capital 50,000 Building 40,000

Long term loans 40,000 Furniture 20,000
Expenses payable 12,000 Cash 15,000
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Page 34 of 40
Bills payable 5,000 Debtors 20,000

Proposed dividend 8,000
1,35,000 135,00
0
11.You are given below the Profit & loss account for two years for a company
Profit & loss Account
Year 1 Year 2 Year 1 Year 2
Opening stock 80,000 1,00,000 Sales 8,00,000 10,00,00

0
Raw materials 3,00,000 4,00,000 Closing stock 1,00,000 1,50,000
Stores 1,00,000 1,20,000 Misc. income 10,000 10,000
Other expense 2,00,000 2,60,000
Depreciation 1,00,000 1,00,000
Net profit 1,30,000 1,80,000
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9,10,000 11,60,000 9,10,000 11,60,000
Sales are expected to be Rs 12,00,000 in year 3.
As a result, other expenses will increase by Rs 50,000 besides other charges.

Only raw materials are in stock. Assume sales and purchases are in cash terms
and closing stock is expected to go up by the same amount as between year 1 and
year 2. You may assume that no dividend is being paid. Estimate the cash
generated from operations in year 3.
12. Prepare a working capital forecast from the following information :
Production during the previous year was 10,00,000 units. The same level of
activity is intended to be maintained during the current year.
The expected ratios of cost to selling are :
Raw materials 40%
Direct wages 20%
Overheads 20%
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The raw materials ordinarily remain in stores for 3 months, WIP for 2 months
and finished goods for 3 months. Credit period given by creditors is 4 months and
given to debtors is 2 months. Wages and overheads are overdue for months and
minimum cash balance should be Rs 2,00,000. selling price is 8 per unit you are
required to make a 10% provision for contingencies ( except cash).
4.15.2 Objective questions / problems
1. state whether following statements are true or false, giving reasons
e. A company should have large balances of cash in hand so that it can meet
all contingencies
f. A finance manager must aim at reducing inventories without considering

production requirements
g. A company should never sale on credit to avoid investment in debtors.
h. Working capital cycle is useful for analyzing efficiency of the organization
i. Higher the credit period, the greater are the chances of recovery of a debt
j. Factoring is not recommended for companies having lesser collection

periods
2.Company D ltd.
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Page 37 of 40
Current assets
a. Inventory Rs. 330 lacs
b. Debtors Rs. 150 lacs
c. Other current assets Rs. 20 lacs
Current liabilities
a. Creditors Rs. 120 lacs
b. Other liabilities Rs. 30 lacs
Core current assets are Rs. 200 lacs
Q1. The maximum permissible bank finance as per Tandon

committee recommendations is
a. Rs. 180 lacs
b. Rs. 262.5 lacs
c. Rs. 250.75 lacs
d. Rs. 120 lacs
Q2.The minimum permissible bank finance as per Tandon

committee recommendations is
k. Rs. 180 lacs
l. Rs. 20 lacs
m. Rs. 75 lacs
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Page 38 of 40
n. Rs. 175 lacs
Q 3. Calculate the maximum permissible bank finance as per

Tandon committee recommendations if Core current assets
are Rs. 170 lacs
a. Rs. 180 lacs
b. Rs. 20 lacs
c. Rs. 15 lacs
d. Rs. 262.5 lacs
3. The Cost sheet of A ltd. is as follows

Cost per unit
Raw Materials 500
Labour 200
Overheads 300
Depreciation 100
Selling price 1100
Raw materials 1 month, Finished goods 1 month, creditors 1

month
Other information Expected output is 4500 units per month.
O 1. The estimated figure of raw materials for calculation of working

capital is
a. 33,75,000
b. 22,50,000
c. 12,50,000
d. none of the above.
Q 2. The estimated figure of Finished goods is

a. 22,50,000
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Page 39 of 40
b. 58,00,000
c. 43,55,000
d. 45,00,000
Q3. Which other figure is same as the estimated figure of raw

materials
a. Creditors for materials
b. Creditors for overheads
c. Work in progress
d. None of the above
4. state whether following statements are true or false, giving reasons
1. Increasing the sales should be the only criterion before giving credit to the
customers
2. Credit rating refers to ranking the various debtors who seek credit.
3. Inventories constitute very small portion of working capital
4. Collection floats can never be reduced
5. ----------------- is the method of granting loans against collection debtors
6. The cash investment in working capital is lower because ----------------- and

---------------- includes non cash items
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Working Capital Management

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4 Working Capital Management

4.2 Meaning of the term working capital

From the view point of time working capital can be defined as

b. Temporary working capital It is the requirement of investment in working

WC working capital in Rs.

4.3 Importance of adequate working capital

4.4 How to determine optimum working capital

4.5 Working capital cycle

The above example can be elaborated diagrammatically as

Debtors Raw Materials,

a. Conversion of cash into raw materials

Working capital is always measured in terms of days, as follows -

Working capital cycle / operating cycle [in number of days] = R + W + F + D

R - Raw materials storage period in number of days

W - Number of days of work in progress

In the current example

R = 15 days (1st January 15th January)

The various components of operating cycle can be calculated as follows -

1. Raw material storage period [R] = Average stock of raw materials

Average cost of consumption per day

2. Work in progress holding period [W]= Average work-in-progress inventory

Average cost of production per day

3. Finished goods storage period [F]= Average Finished goods inventory

Average cost of goods sold per day

4. Debtors collection period [D] = Average book debts

Average credit sales per day

5. Credit period availed [C] = Average creditors

Average credit purchases per day

4.6 Solved problems on calculation of working capital cycle

Raw material consumed during the year 7,20,000

Cost of production 6,00,000

Average collection period from debtors 35 days

1. Raw material storage period [R] = Average stock of raw materials

Average cost of consumption per day

= 50,000 / (7,20,000 / 360)

Average cost of production per day

= 30,000 / (6,00,000 / 360)

3. Finished goods storage period [F]= Average Finished goods inventory

Average cost of goods sold per day

1. Debtors collection period [D] = 35 days

Operating / working capital cycle = R + W +F+ D C

Number of operating cycles in a year = 360 / 73 = 4.93

Raw material stock turnover 25 days

Out of cost of production Rs 60,000 is consumption of raw materials.60% of the

2. W = 9 / (210 /360) = 15 days

4. D = 35 / (300 /360) = 43 days

Operating cycle = 48 + 15 + 31 + 43 55 = 82 days.

Compan Industry Comments

Assume 360 days per year for computation purpose

Raw material stock holding period [R]:

Work in progress [W]:

Finished goods [F]:

Operating cycle = R + W + F + D - C 177 198

4.7 Estimation of working capital requirements

Formulas for Estimation of various current assets

a. Funds invested in Raw materials inventory can be calculated as follows The

Estimated production in units * estimated cost of raw material per unit *

12 months / 365 (or 360) days

ii. Funds invested in work in progress can be calculated as follows

The following formula can be used for this purpose

Estimated production in units * estimated cost of production per unit * average

12 months / 365 (or 360) days

iii. Funds invested in finished goods inventory can be calculated as follows

The following formula can be used for this purpose

3. Amount of sales for 1999 = Debtors / 2 12 = 26,400/ 2 12 = 1,58,400 (As