Working Capital Management

Important Ratios
Cash + Cash Equivalents + Inventory + Accounts receivable + prepaid expenses
current asset is an asset on the balance sheet which can either be converted to cash or used to pay current liabilities within 12 months.

Current Assets Current Liabilities Working Capital

Receivables turnover Number of days of receivables Inventory turnover Number of days of inventory Payables turnover Number of days of payables

Account payable + outstanding expenses Current Assets Current Liabilities

credit sales / average receivables 365 / receivables turnover cost of goods sold / average inventory 365 / inventory turnover purchases / average trade payables 365 / payables turnover.

Obligations due within one year of the balance sheet date. (If a company's operating cycle is longer than one year, an item is a current liability if it is due within the operating cycle.)

The operating cycle and the cash conversion cycle are summary measures of the effectiveness of a companys working capital management.

Operating cycle Cash conversion cycle

Days of inventory + days of receivables Days of inventory + days of receivables days of payables.

Operating and cash conversion cycles that are high relative to a companys peers suggest the company has too much cash tied up in working capital.

Example: Following Balance sheet and profit & Loss Account has been extracted from the 2011 Annual report of Hero MotoCorp

Various ratios of the company for 2011 can be calculated asCurrent Assets for 2011 Particulars Cash Accounts receivable Inventory prepaid expenses Total Amount (in Rs. Millions) 715 1305 5250 7775 15045

Add: Add: Add:

Current Liabilities for 2011 Particulars Accounts Payable outstanding expenses other current liability current portion of long term debt Total Amount (in Rs. Millions) 14268 420 31560 7261 53509

Add: Add: Add:

Working Capital for 2011 Particulars Current Assets Current Liabilities Total Amount (in Rs. Millions) 15045 53509 -38464

Less:

Inventory Turnover Ratio Cost of goods sold/ Average Inventory 1 2 3 4 COGS for 2011 Opening inventory for 2011 Ending inventory for 2011 Average inventory for 2011 156578 4364 5249 4806.5 32.58 (given) (given) (given) (opening + closing)/2

5 Inventory turnover ratio

Account Receivable (AR) Turnover Ratio Credit sales/ Average accounts receivable It has been assumed that 192450 entire sales is credit sales 1083 (given) 1305 (given) 1194 (opening + closing)/2 161.18

1 2 3 4

Credit sales for 2011 Opening AR for 2011 Closing AR for 2011 Average AR for 2011

5 AR turnover ratio

Account payable (AP) Turnover Ratio Credit Purchases/ Average accounts receivable 1 Credit Purchases for 2011 141716.7 Total Purchases has been calculates as = COGS (+) Closing inventory (-) opening inventory. It has been assumed that 90% of the total purchases are credit purchases. 11114 (given) 14268 (given) 12691 (opening + closing)/2 11.17

2 Opening AP for 2011 3 Closing AP for 2011 4 Average AP for 2011 5 AP turnover ratio

Ratio Number of days inventory on hand Number of days of receivables Number of days in payables

Formula 365/ inventory turnover ratio

No. Of days 11.20

365/AR turnover ratio

2.26

365/AP turnover ratio

32.69

Ratio Operating Cycle Cash Cycle

Formula No. Of days Inventory (+) No. Of days in receivables Operating cycle (-) No. Of days in payables

No. Of days 13.47 -19.22

Practice problems: 1. Calculate working capital related ratios from the following information:

Balance sheet
Liabilities Equity Share Capital Reserves & surplus Preference Share capital (Dividend rate- 25%) Secured Loan - 15% Unsecured Loan- 22% Accounts Payable Outstanding Expenses Total 2011 5000 10000 4000 2010 Assets

(Amt in Rs. Lakhs) 2011 5000 5000 15000 5000 5000 5000 5000 2010 6000 5000 11700 8000 2000 4000 1000

5000 Plant & Machinery 2700 Land 4000 Investments cash 10000 Inventory 10000 Accounts receivable Prepaid expenses 5000 1000 37700 Total

10000 10000 5000 1000 45000

45000

37700

Profit & Loss Account for 2011 Expenses Opening stock Purchases Depreciation Interest on secured loan Interest in unsecured loan profit (balancing figure) Amount income 2000 12000 1000 1500 2200 8300 Sales

(Amt in Rs. Lakhs) Amount 20000 2000

interest received

Closing stock

5000

Total

27000

Total

27000

Additional Informtion: 75% of the sales are credit sales All purchases made during the year are credit purchases.

Solution

Current Assets for 2011 Particulars cash Inventory Accounts receivable Prepaid expenses Total Amount 5000 5000 5000 5000 20000

Add: Add: Add:

Current Liabilities for 2011 Particulars Accounts Payable Outstanding Expenses Total Amount 5000 1000 6000

Add:

Working Capital for 2011 Particulars Current Assets Current Liabilities Total Amount 20000 6000 14000

Less:

Inventory Turnover Ratio Cost of goods sold/ Average Inventory opening inventory + purchases -closing inventory (given) (given) (opening + closing)/2

1 2 3 4

COGS for 2011 Opening inventory for 2011 Ending inventory for 2011 Average inventory for 2011

9000 2000 5000 3500 2.57

5 Inventory turnover ratio

Account Receivable (AR) Turnover Ratio Credit sales/ Average accounts receivable 1 Credit sales for 2011 2 Opening AR for 2011 3 Closing AR for 2011 4 Average AR for 2011 5 AR turnover ratio 15000 4000 5000 Given (given) (given) (opening + closing)/2

4500 3.33

Account payable (AP) Turnover Ratio Credit Purchases/ Average accounts receivable 1 Credit Purchases for 2011 2 Opening AP for 2011 3 Closing AP for 2011 4 Average AP for 2011 5 AP turnover ratio 12000 5000 5000 5000 2.40 (given) (given) (given) (opening + closing)/2

Ratio Number of days inventory on hand Number of days of receivables

Formula

No. Of days

365/ inventory turnover ratio

141.94

365/AR turnover ratio

109.50

Number of days in payables

365/AP turnover ratio

152.08

Ratio

Formula

No. Of days

Operating Cycle

No. Of days Inventory (+) No. Of days in receivables

251.44

Cash Cycle

Operating cycle (-) No. Of days in payables 99.36