What is Working Capital?

Working Capital is the investment needed for carrying out day to day operations of the business smoothly. It refers to firms investment in short- term Assets.

What are all the components of Current (Short- term) Assets? Cash Short- term Securities Debtors/ Accounts Receivables Bills Receivables Inventory - Raw material - Work- in Process - Finished Goods - Stores and spare parts

What are the components of Current (Short- term) Liabilities? Accounts payable/ Creditors Bills Payable Short- term borrowings Advances/ Accrued liabilities

What is Working Capital Management?

A managerial accounting strategy focusing on maintaining efficient levels of both components of working capital, current assets and current liabilities, in respect to each other. Working capital management ensures a company has sufficient cash flow in order to meet its short-term debt obligations and operating expenses.

Difference in the management of fixed assets and current assets

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First, in managing fixed assets, time is a very important factor; consequently, discounting and compounding techniques play a significant role in capital budgeting and a minor one in the management of current assets. Second, the large holding of current assets, reduces the overall profitability. Thus, a risk-return trade-off is involved in holding current assets. Third, levels of fixed as well as current assets depend upon expected sales, but it is only the current assets which can be adjusted with sales fluctuations in the short run. Thus, the firm has a greater degree of flexibility in managing current assets.

Concepts of Working Capital

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Gross

working capital (GWC) GWC refers to the firms total investment in

current assets.

GWC

focuses on

Optimization of total investment in current assets Financing of current assets

Also referred as Current Capital or Floating Capital or Circulating Capital.

Concepts of Working Capital

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Net working capital (NWC) NWC refers to the difference between current assets and current liabilities. NWC focuses on
Liquidity position of the firm Judicious mix of short-term and long-tern financing

NWC

can be positive or negative.

Positive NWC = CA > CL Negative NWC = CA < CL

Operating Cycle
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Operating

cycle is the time duration required to convert sales, after the conversion of resources into inventories, into cash. The operating cycle of a manufacturing company involves three phases:
Acquisition of resources such as raw material, labour, power and fuel etc. Manufacture of the product which includes conversion of raw material into work-in-progress into finished goods. Sale of the product either for cash or on credit. Credit sales create account receivable for collection.

Operating Cycle
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The

length of the operating cycle of a manufacturing firm is the sum of:

Inventory conversion period (ICP). Debtors (receivable) conversion period (DCP).

Operating cycle of a manufacturing firm

Gross Operating Cycle (GOC)

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The

firms gross operating cycle (GOC) can be determined as inventory conversion period (ICP) plus debtors conversion period (DCP). Thus, GOC is given as follows:

Inventory Conversion Period

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Inventory

conversion period is the total time needed for producing and selling the product. Typically, it includes:
Raw material Conversion Period (RMCP) Work-In-Process Conversion Period (WIPCP) Finished Goods Conversion Period (FGCP)

Debtors (receivables) Conversion Period (DCP) Debtors Conversion Period (DCP) is the average time taken to convert debtors into cash. DCP represents the average collection period. It is calculated as follows:
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Creditors (payables) Deferral Period (CDP)

Creditors

(payables) Deferral Period (CDP) is the average time taken by the firm in paying its suppliers (creditors). CDP is given as follows:

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D.D. Manufacturers-Statement of Cost of Sales (Rs. Crores)

S.No. 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 Items Opening raw material inventory Purchase of raw material (Credit) Closing raw material inventory Raw material consumed (1+2-3) Wages and Salaries Other Manufacturing expenses Depreciation Total Cost(4+5+6+7) Opening Work- in- process inventory Closing Work- in- process inventory Cost of Production (8+9-10) Opening Finished Goods Inventory Closing Finished Goods Inventory Cost of Goods Sold (11+12-13) Selling, administrative and other expenses Cost of Sales (14+15) 20X1 5.2 25.6 6.8 24.0 8.1 3.2 1.8 37.1 1.8 2.0 36.9 3.2 2.8 37.3 1.3 38.6 20X2 6.8 33.5 7.6 32.7 11.2 4.4 2.0 50.3 2.0 3.1 49.2 2.8 3.6 48.4 1.9 50.3 20x3 7.6 45.6 9.2 44.0 15.3 5.8 2.6 67.7 3.1 4.6 66.2 3.6 2.9 66.9 2.1 69.0

D.D. Manufacturers- Sales and Debtors (Rs Crores) Additional Data 20X1 Sales (Credit) PBIT Debtors- Opening balance Debtors- Closing balance Creditors- Opening balance Creditors- Closing balance 20X2 20x3 82.7 13.7 14.9 20.5 8.0 12.0

45.9 7.3 8.3 10.8 3.7 4.6

60.1 9.8 10.8 14.9 4.6 8.0

You are required to calculate (i) operating cycle, (ii) net operating cycle, and (iii) cash conversion cycle for each of the three years.

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Cash Conversion or Net Operating Cycle

Net

Operating Cycle (NOC) is the difference between gross operating cycle and payables deferral period.

Net operating cycle (without taking into consideration of depreciation and profit element from the profit) is also referred to as Cash Conversion Cycle.

BEHAVIOUR OF WORKING CAPITAL

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Permanent

or fixed working capital A minimum level of current assets, which is continuously required by a firm to carry on its business operations, is referred to as permanent or fixed working capital. or variable working capital The extra working capital needed to support the changing production and sales activities of the firm is referred to as fluctuating or variable working capital.

Fluctuating

Non- Growth, Non- seasonal and Non- cyclical firms

Working capital

Time

Growing, Non- seasonal and Non- cyclical firms

Working Capital

Time

Growing, Seasonal and Noncyclical firms

Working capital

Time

Growing, Seasonal and Cyclical firms

Working Capital

Time

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Determinants of Working Capital

1. 2. 3. 4. 5. 6. 7.

Nature of business Market and demand Technology and manufacturing policy Credit policy Supplies credit Operating efficiency Inflation

Importance of Working capital Management Time: WCM needs much of financial managers time. Investment: Needs larger portion of the total investments. Criticality: Generally, WCM is great significance for all firms, but it is very critical for small firms. Growth: Directly related to the growth of the firm.

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Issues in Working Capital Management

Current

Assets to Fixed Assets Ratio Liquidity vs. Profitability: RiskReturn Tradeoff The Cost Trade-off

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Issues in Working Capital Management

Current

Assets to Fixed Assets Ratio :

Conservative Policy= Higher CA/FA Ratio Aggressive Policy = Lower CA/FA Ratio Average (Moderate) Policy= Neither too high or too low level of CA/ FA. (say- optimum level)

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Issues in Working Capital Management

Current

Assets to Fixed Assets Ratio

Alternative current asset policies

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Issues in Working Capital Management

The

Cost Trade-off

Cost Trade-off

Estimating Working capital

29 Current assets holding period To estimate working capital requirements on the basis of average holding period of current assets and relating them to costs based on the companys experience in the previous years. This method is essentially based on the operating cycle concept. Ratio of sales To estimate working capital requirements as a ratio of sales on the assumption that current assets change with sales. Ratio of fixed investment To estimate working capital requirements as a percentage of fixed investment.

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Working Capital Finance Policies

Long-term: Sources includes share capital,
preference capital, debentures, long- term borrowings, reserves and surplus.

Short-term: Less than a year- Advances from

Bank, other suppliers of short- term finances, public deposits, commercial paper, factoring of receivables etc.

Spontaneous: Automatic sources like, trade

credit, outstanding expenses, etc.

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Working Capital Finance Policies

Matching

Approach or Hedging Approach:

Long-term financing will be used to finance fixed assets and permanent current assets and short- term finance will be used to finance temporary/ variable/ fluctuating current assets.

Conservative

Approach: Depends more on long

term financing- even temporary current assets are financed with long-term finances.

Aggressive

Approach: Uses more of short-term

financing than warranted- part of fixed assets also financed with short- term finance.

Matching Approach
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Financing under matching plan

Conservative Approach
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Conservative financing

Aggressive Approach
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Aggressive financing

Short-term vs. Long-term Financing: A Risk-Return Trade-off

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Cost Flexibility Risk Risk-return

trade-off

Term structure of Interest rates: Yield Curve

Relationship between maturity of debt and interest rates (Cost). Higher the maturity period the interest (cost) will be high. (Liquidity Preference theory: Lenders are risk averse and risk generally increase with the length of lending time)

Estimation of Working Capital- Problem 1

X& Co. is desirous to purchase a business and has consulted you, and the one point on which you are asked to advise them is the average amount of working capital which will be required in the first years working. You are given the following estimates and are instructed to add 10% to your computed figure to allow contingencies:

Set up you calculations for the average amount of working capital required.

Estimation of Working Capital- Problem 1 contd.

Particulars Average amount backed up for stocks: - Stocks of finished product - Stocks of stores, materials etc Average Credit Given: - Inland sales - Export sales Lag in payment of wages and other outgoings: - Wages - Stocks, materials, etc. - Rent, royalties, etc. - Clerical staff - Manager - Miscellaneous expense Payment in Advance: 1 weeks 1 weeks 6 months month month 1 months 260000 48000 10000 62000 4800 48000 6 weeks credit 1 weeks credit 3,12,000 78,000 5000 8000 Period Figures for the year (Rs)

Estimation of Working Capital- Problem :2

From the following information prepare a statement showing the estimated working capital needs, in total and for each constituent.

Budgeted sales Analysis per unit of sales Raw Materials Direct labour Overheads Cost of sales Profit Sales price per unit

Rs. 52,00,000 Rs. 25 45 20 90 10 100

It is estimated that (a) Raw materials will be carried in stock for two weeks and finished goods for three weeks (b) Factory processing will take four weeks ( c) Suppliers will give four weeks credit and customers will require seven weeks credit. It may be assumed that the production and overhead arises evenly throughout the year.

Estimation of Working Capital : Problem: 3

A Proforma cost sheet of a company provides the following particulars: Amount per unit Rs. Raw material Direct labour Overheads Total cost Profit Selling price 80 30 60 170 30 200

The following further particulars are available: (a) Raw material in stock, on an average one month ; materials in process, on average half a month; finished goods in stock, on an average one month. (b) Credit allowed by suppliers is one month; credit allowed to debtors is two months; lag in payment of wages is one and a half weeks; lag in payment of overhead expenses is one month; one fourth of the out put is sold against cash; cash in hand and at bank is expected to be Rs. 25,000. You are required to prepare a statement showing working capital needed to finance a level of activity of 1,04,000 units of production. You may assume that production is carried on evenly throughout the year, and wages and overheads accrue similarly.

Estimation of Working Capital : Problem: 4

While preparing a project report on behalf of a client you have collected the following facts. Estimate the net working capital required for that project. Add 10% to your computed figure to allow for contingencies.
Particulars Estimated cost per unit of production is: Raw material Direct labour Overheads (excluding depreciation) Total cost Additional Information: Selling Price per unit Level of Activity- production per annum Raw material in stock W I P (assume 50% completion stage Finished goods in stock Credit allowed by suppliers Credit allowed to debtors Lag in payment of wages Cash at bank is expected to be 106.00 1,00,000 units Average 4 weeks Average 2 weeks Average 4 weeks Average 4 weeks Average 8 weeks Average 1 weeks Rs. 1,25,000 Amount / Unit Rs.

42.40 production is carried on 15.90 evenly throughout the year 31.80 (52 weeks) and wages and 90.10 All sales are on credit basis

You may assume that

overheads accrue similarly. only.

Estimation of Working Capital : Problem: 5 A firm is engaged in large- scale manufacturing company. From the following information you are required to forecast their working capital requirements, projected monthly sales of 32000 units are at Rs. 10 per unit. The expected ratio of cost to selling price are the following: Raw materials 40% and labour 30%. Budgeted overheads Rs. 16000 per week. Stock will include raw materials for Rs. 96000 and 16000 units of finished goods. Material will stay in process for 2 weeks. Credit allowed to debtors is 5 weeks. Credit allowed by creditors is 1 month. Lag in payment of overheads is 2 weeks. Wages will be paid at the beginning of the week following the week of work. Cash in hand is expected to be 10% of net working capital. Assume the production is carried on evenly throughout the year and overheads accrue similarly and a time period of 4 weeks to equivalent to a month.

Estimation of Working Capital : Problem: 6

A client of yours, Care Ltd., is about to commence a new business and finance has been provided in respect of fixed assets. They have, however, asked you to advice on the additional amount, which they should make available for the working capital. They provided you with the following estimate for their first year and they inform you that they have arranged an overdraft limit with their banker for Rs. 150000. Particulars Average Estimate for period of the first year credit (Rs.) Purchase of material Wages Overheads: Rent Directors and Managers salary Traveler's commission Other overheads Sales: Cash Credit Average amount of stock and WIP 7 weeks 1400000 6500000 300000 6 months 1 month 2 weeks 3 months 100000 360000 455000 600000 6 weeks weeks 2600000 1950000

Sales were made at an even rate for the year. You are required to prepare from the above figures and information, a table for submission to your client, giving an estimate of the average amount of working capital which are provided.