Working Capital Management CA - IPCC

CA. Pramod Prabhu. S.H, B.Sc, P.G.D.B.A, F.C.A, C.I.S.A (U.S.A)

WCM Working capital management is a business strategy designed to ensure

that a company operates efficiently by monitoring and using its current
assets and liabilities to the best effect.

The primary purpose of working capital management is to enable the

company to maintain sufficient cash flow to meet its short-term
operating costs and short-term debt obligations.

Effective working capital management ensures that a company has

adequate ready access to the funds necessary for day-to-day operating
expenses, while at the same time making sure that the company’s assets
are invested in the most productive way.

Effective working capital management encompasses several aspects of

short-term finance: maintaining adequate levels of cash, converting
short-term assets (i.e., accounts receivable and inventory) into cash, and
controlling outgoing payments to vendors, employees and others. For
this, companies may invest short-term funds in working capital portfolios
of short-dated, highly liquid securities or they maintain credit reserves in
the form of bank lines of credit or access to financing by issuing financial
instruments.
Working Capital = (CA – CL)
Working capital management can improve a company's earnings and
profitability through efficient use of its resources.

Management of working capital includes estimation of working capital,

deciding optimal cash balance, Inventory management as well as
management of accounts receivables and accounts payables. 
Although numbers vary by industry, a working capital ratio below 1.0
generally indicates that a company is having trouble meeting its short-
term obligations.
That is, the company's debts due in the upcoming year would not be
covered by its liquid assets.
In that case, the company may have to resort to selling off assets,
securing long-term debt, or using other financing options to cover its
short-term debt obligations.
Working capital ratios of 1.2 to 2.0 are considered desirable, but a ratio
higher than 2.0 may suggest that the company is not effectively using its
assets to increase revenues.
A high ratio may indicate that the company is NOT managing finances
appropriately or managing its working capital efficiently.

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Working Capital Management CA - IPCC

CA. Pramod Prabhu. S.H, B.Sc, P.G.D.B.A, F.C.A, C.I.S.A (U.S.A)

Working capital serves as a metric for how efficiently a company is

operating and how financially stable it is in the short-term.

The working capital ratio, which divides current assets by current

liabilities, indicates whether a company has adequate cash flow to cover
short-term debts and expenses.
WCM Principle Every rupee invested in the current assets should contribute to the net
worth of the firm.
Types of Working Gross Working Capital: i.e. Current Assets only
Capital Net Working Capital: (CA – CL)

Permanent WC: Remaining same over all periods of time or changing

proportionately with activity levels. Is the minimum level of investment
required in WC of business at any point of time. Represents LT
investment.
Temporary WC: Working capital needs over and above Permanent WC.
Represents ST investment.
WC Cycle Is the amount of time it takes to turn the net current assets and current
liabilities into cash.

A longer cycle indicates longer tying up of capital in working capital

without earning a return on it. Therefore, companies strive to reduce its
working capital cycle by collecting receivables quicker or sometimes
stretching accounts payable.

A positive working capital cycle balances incoming and outgoing

payments to minimize net working capital and maximize free cash flow.
For example, a company that pays its suppliers in 30 days but takes 60
days to collect its receivables has a working capital cycle of 30 days. This
30-day cycle usually needs to be funded through a bank operating line,
and the interest on this financing is a carrying cost that reduces the
company's profitability.

Growing businesses require cash and being able to free up cash by

shortening the working capital cycle is the most inexpensive way to
grow.
Gross Operating (RMCP + WIPCP + FGCP + RCP)
Cycle
Net Operating Cycle [(RMCP + WIPCP + FGCP + RCP) – PDP]
RMCP (Ave Stock of RM/RM Consumption per day)
WIPCP (Ave Stock of WIP/Total COP per day)

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Working Capital Management CA - IPCC

CA. Pramod Prabhu. S.H, B.Sc, P.G.D.B.A, F.C.A, C.I.S.A (U.S.A)

FGCP (Ave Stock of FG/Total COGS per day)

RCP (Ave a/cs receivable/Net Cr sales per day)
PDP (Ave a/cs payable /Net Cr Purchases per day)

1. From the following information extracted from books of a manufacturing concern,

compute the operating cycle (in days):

Period Covered 365 days

Average Credit Period allowed by suppliers 16 days
Rs
Average total of Debtors O/s 4,80,000
RM consumption 44,00,000
Total Production cost 100,00,000
Total COGS for the year 105,00,000
Sales for the year 160,00,000

Value of average stock maintained:

Raw Materials 3,20,000
WIP 3,50,000
FG 2,60,000

ANS:

Operating Cycle Computation:

Particulars Computation Days

     
RMCP (320000/(4400000/365)) 27
WIPCP (350000/(10000000/365)) 13
FGCP (260000/(10500000/365)) 9
RCP (480000/(16000000/365)) 11
     
Less: PDP Given (16)
     

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Working Capital Management CA - IPCC

CA. Pramod Prabhu. S.H, B.Sc, P.G.D.B.A, F.C.A, C.I.S.A (U.S.A)

Net Ope Cycle   44

Estimation of Working Capital:

 Estimating working capital means calculating future working capital

 Two conceptual approaches in WC estimation are:

1. Total Cost Approach: All expenses and profit margin are considered
2. Cash Cost Approach: Only Cash expenses are considered

ESTIMATION OF WORKING CAPITAL - Formulae:

Particulars Rate of Valuation Rate of Valuation

(Total Cost Approach) (Cash Cost Approach)
RM Purchase Price - Discount Purchase Price - Discount
WIP RM + 50% (DL+DE+POH) RM + 50% (DL+DE+POH - Depn)
FG COP COP - Depn
S Debtors SP SP – Profit Margin - Depn
S Creditors Purchase Price - Discount Purchase Price - Discount

MPBF – Tandon Committee Norms (& New Revised Norms):

Tandon Committee norms New Revised Norms

Method 1 75% (CA – CL) Upto 25 lacs Mutual discussion
Method 2 [(75% CA) – CL] 25 lacs - 5 Cr 20% Projected Sales
Method 3 [75% (CA-Core CA)] - CL Large borrowers Cash budget System

2. XYZ Co Ltd is a pipe manufacturing Co. Its production cycle indicates that materials are
introduced in beginning of the production cycle; Wages & OH accrue evenly throughout
the period of cycle. Wages are paid in next month following the month of accrual. WIP
include full units of RM used in beginning of the production process & 50% of wages &
OH are supposed to be the conversion costs. Details of production process &
components of working capital are as follows:

Production of Pipes 12,00,000 units

Duration of Production cycle One month
RM inventory held One month consumption
FG inventory held Two months
Credit period allowed by suppliers One month
Page 4 of 13
Working Capital Management CA - IPCC

CA. Pramod Prabhu. S.H, B.Sc, P.G.D.B.A, F.C.A, C.I.S.A (U.S.A)

Credit given to debtors Two months

Cost of RM Rs. 60 per unit
Direct Wages Rs. 10 per unit
Overheads Rs. 20 per unit
SP of finished pipes Rs. 100 per unit

 Calculate the amount of W Capital required by Co

 MPBF as suggested by Tandon Committee under all three methods assuming
that core current assets amount to Rs. 1 Crore.

ANS:

Estimation of W Capital (TC Approach)

Particulars Computation Rs
     
RM Stock [1200000*60]*1/12 60,00,000
WIP Stock [60 + 50% * (10+20)]*1200000*1/12 75,00,000
FG Stock (90*1200000)*2/12 1,80,00,000
Debtors (1200000*100)*2/12 2,00,00,000
   
  Total CA 5,15,00,000
   
Less:  
   
S Creditors [1200000*60]*1/12 60,00,000
Wages Payable [1200000*10]*1/12 10,00,000
   
  Total CL 70,00,000
   
W Cap reqd i.e CA - CL 445,00,000

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Working Capital Management CA - IPCC

CA. Pramod Prabhu. S.H, B.Sc, P.G.D.B.A, F.C.A, C.I.S.A (U.S.A)

MPBF:

Particulars Computation Rs
   
Method 1:  
   

75% (CA - CL) 75% x 445 Lakhs 3,33,75,000

Method 2:

(75% CA - CL) (75% X 515L) – 70L 3,16,25,000

Method 3:

[75% x (515L-100L)] – 70L

75%( CA - Core CA) - CL 2,41,25,000

3. X Ltd manufactures items used in steel industry. Following information relating to the
company is provided. Estimate Working Capital requirement of the company using
Total Cost and Cash cost approach:
 Expected level of Production – 9000 units per annum
 Raw materials are expected to remain in store on an average for two
months before issue to production
 WIP (50% complete as to conversion cost) is approximately 1/2 months’
production
 FG remain in warehouse on an average for one month
 Credit allowed by suppliers is one month
 Two months’ credit is normally allowed to debtors
 A minimum cash balance of Rs 67500 is expected to be maintained
 Cash sales are 75% less than credit sales
 Safety margin of 20% to cover unforeseen contingencies is required
 Production pattern is assumed to be even during the year
Page 6 of 13
 Working Capital Management CA - IPCC

CA. Pramod Prabhu. S.H, B.Sc, P.G.D.B.A, F.C.A, C.I.S.A (U.S.A)

 Cost structure of the company is as follows:

Raw Materials Rs 80 per unit
Direct Labour Rs 20 per unit
Overheads (including depreciation – Rs 20) Rs 80 per unit
Total Cost Rs 180 per unit
Profit Rs 20 per unit
Selling Price Rs 200 per unit
Ans:

Note: Credit Sale (Units) Computation

Cash and credit sales: Given that cash sales is 75% less than Cr Sales,
If credit sales = C, Cash Sales = 0.25C
Thus total Sales = [C + 0.25C] = 1.25C ;
Thus C = Credit Sales (units) = [9000/1.25] = 7200 units

Estimation of Working capital

Total Cost Cash Cost

Particulars Computation Rs Computation Rs
Current Assets:
RM Stock (9000 x 80) x 2/12 120000 (9000 x 80) x 2/12 120000
WIP Stock {9000 x [80+(20+80)/2)]} x 48750 {9000 x [80+(20+60)/2)]} x 45000
0.50/12 0.50/12
FG Stock (9000 x 180) x 1/12 135000 [9000 x (180-20)] x 1/12 120000
Sundry debtors (7200 x 200) x 2/12 240000 [7200 x (180-20)] x 2/12 192000
Cash balance Given in Question 67500 Given in Question 67500
Total CA 611250 544500
Current Liabilities:
S Creditors (9000 x 80) x 1/12 60000 (9000 x 80) x 1/12 60000
Total CL 60000 60000
Working Capital [CA- 611250 - 60000 551250 544500 - 60000 484500
CL]
Add: 20% Margin 551250 x 20% 110250 484500 x 20% 96900
Total WC Required 661500 581400

WCM – Cash Management:

William J Baumol’s EOQ model of Optimum Cash Balance:

Optimum Investment Size = √2AT/I;
(A = Annual Cash Req; T = Cost per transaction; I = Interest rate per re p.a)
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 Working Capital Management CA - IPCC

CA. Pramod Prabhu. S.H, B.Sc, P.G.D.B.A, F.C.A, C.I.S.A (U.S.A)

4. A firm maintains a separate a/c for cash disbursement. Total disbursements are Rs.
2,62,500 per month. Administrative & transaction costs of transferring cash to
disbursement a/c is Rs. 25 per transfer. Marketable securities yield 7.50% p.a.
Determine the optimum cash balance using baumol’s model.

Ans:

Note:
A = [262500 x 12] = 3150000; T = Rs. 25; I = 0.075

OCB √[(2 x 3150000 x 25)/0.075] Rs. 45,826

5. Annual cash requirement of Lakshmi Ltd is Rs. 15 lacs. The company has marketable
securities in lot sizes of Rs. 50,000, 1,50,000 & Rs. 2,50,000. Cost of conversion of
marketable securities per lot is Rs. 1,500. The company can earn 10% annual yield on its
securities. Prepare a table indicating the lot size to be sold by company. Show economic
lot size using baumol’s model.

Ans:

T Costs Carrying Costs Total C

Lot Size [(Annual Req/size) * 1500] (Size/2 * 10%) (TC + CC)
50000 (1500000/50000) x 1500 45000 (1/2 x 50000) x 10% 2500 47500
150000 (1500000/150000) x 1500 15000 (1/2 x 150000) x 10% 7500 22500
250000 (1500000/250000) x 1500 9000 (1/2 x 250000) x 10% 12500 21500

Analysis: Out of the three lot size given, Rs 250000 should be chosen being the least cost option

OCB √[(2 x 1500000 x 1500)/0.10] Rs. 2,12,132

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Working Capital Management CA - IPCC

CA. Pramod Prabhu. S.H, B.Sc, P.G.D.B.A, F.C.A, C.I.S.A (U.S.A)

6. Sun Ltd is a manufacturer of electronic gadgets. The annual turnover for last year was
730 lacs spread evenly over 50 weeks in the year. All sales are for credit & evenly
spread over the 5 working week days. All sale invoicing is done at HO in Mumbai. Sales
documentation are sent from each location to HO. Operational delay (Interval between
date of sale & dispatch of invoice) analysis are:

No of days delay in invoicing 3 4 5 6

% of week’s sale 20 10 40 30

Debtors take on an average 36 days credit (from date of dispatch of invoice) before
paying. It is proposed to hire an agency at various locations to take care of invoicing
work. Maximum delay in that case:

No of days delay in invoicing 0 1 3

% of week’s sale 40 40 20

Agency has offered to monitor collections reducing the credit period to 30 days.
Expected savings in postage costs are Rs. 4000 p.m. All working funds are borrowed
from a local bank at 20% p.a. simple interest. The fee quoted by agency is Rs. 2 lacs p.a.
for invoicing & Rs. 2.50 lacs p.a. for monitoring collections. Rs. 50000 discount will be
given on entrusting both works. Advice on acceptance of the proposal.

ANS:

WN – 1: Interest saved on reduction in invoicing delay

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Working Capital Management CA - IPCC

CA. Pramod Prabhu. S.H, B.Sc, P.G.D.B.A, F.C.A, C.I.S.A (U.S.A)

CREDITOR’S MANAGEMENT:

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 Working Capital Management CA - IPCC

CA. Pramod Prabhu. S.H, B.Sc, P.G.D.B.A, F.C.A, C.I.S.A (U.S.A)

7. PQ Ltd has been offered credit by its major supplier at 2/10 net 45. Should the company
avail discount or pay later, given that the invoice value is Rs. 10,000 & the opportunity
cost of funds is 25%.

ANS:

Particulars Computation Rs
Discount received if paid in 10 days 10000 x 2% 200
Interest loss on early payment by 35 days [(10000 x 25%) x 35/365] 240
(Instead of 45 days, payment is now made in
10 days to get discount)
Loss on early payment (40)
Decision: Avail Credit Period fully. Do not avail discount.

RECEIVABLES MANAGEMENT:

8. A Firm has current sales of Rs. 2,56,48,750. It has unutilized capacity. In order to boost
its sales it is considering relaxation of its credit policy. The proposed credit terms are 60
days credit against present policy of 45 days. As a result bad debts would increase from
1.50 to 2% of sales. Sales are expected to increase by 10%. Variable operating costs are
72% of sales. Tax Rate – 35%; After tax rate of return required is 15%. Should the firm
change its credit period

ANS:

Analysis of Change in Discount Policy:

Particulars Computation Rs
Incremental Benefit:
Increase in Sales 25648750 x 10% 2564875

Incremental Contribution 2564875 x 28% 718165

Increase in bad debts:
Bad debts after policy change [25648750 x 110%] x 2% =
564273
Bad debts before policy change
[25648750 x 1.50%] = 384731
Increase in bad debts 179542

Net Incremental Benefit 718165 - 179542 538623

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 Working Capital Management CA - IPCC

CA. Pramod Prabhu. S.H, B.Sc, P.G.D.B.A, F.C.A, C.I.S.A (U.S.A)

After tax incremental benefit 538623 x 65% 350104

Incremental Investment:
Increase in investment in debtors: 1496177

Debtors after policy change

(25648750 x 110%) x 60/360 =
Debtors before policy change 4702271
(25648750 x 45/360) = 3206094
Incremental Debtors
[4702271 – 3206094] = 1496177
After tax return on Investment [350104/1496177] x 100 23.40%
% ROI required after tax Given in Question 15%
Decision: As ROI achieved (23.40%) exceeds required ROI (15%) the policy change may be implemented

9. A Company has sales of Rs. 25 lacs. Average collection period is 50 days, bad debt losses
are 5% of sales & collection expenses are Rs. 25,000. The cost of funds is 15%. Company
has two alternative programs:

Program I Program II
Ave collection period reduced to 40 days 30 days
Bad debt losses reduced to 4% of sales 3% of sales
Collection expenses Rs. 50,000 Rs. 80,000

Evaluate which program is viable.

ANS:

Particulars Present Program I Program II

Interest loss on Debtors [25 lakhs x 15% x [25 lakhs x 15% x [25 lakhs x 15% x
50/360] 40/360] 30/360]
= 52083 =41667 = 31250
Bad debts [25 lakhs x 5%] [25 lakhs x 4%] [25 lakhs x 3%]
= 125000 = 100000 = 75000
Collection expenses 25000 50000 80000
Total Expenses 202083 191667 186250
Decision: Prefer Program II being least cost option

10. The Turnover of PQR Ltd is 120 lacs of which 75% is on credit. The VC ratio is 80%.
Credit terms are 2/10 net 30. On current sales level, bad debts are 1%. The company

Page 12 of 13
 Working Capital Management CA - IPCC

CA. Pramod Prabhu. S.H, B.Sc, P.G.D.B.A, F.C.A, C.I.S.A (U.S.A)

spends 1.20 lacs p.a administering credit sales. 60% customers avail cash discount &
remaining pay on an average 60 days after sale date. The book debts of the company
are presently financed in 1:1 ratio by a mix of bank borrowings & own funds which cost
15% p.a. & 14% p.a. each. A factoring firm has offered to buy the firm’s receivables.
Details are i) Factor reserve – 12% ii) Guaranteed Pay – 25 days; Interest – 15% p.a. &
Commission – 4% of value of receivables. Assume 360 days a year. Advice whether to
continue in-house management of receivables or to accept factoring offer.

ANS:

Note: As company is presently financed by own funds costing 14% and bank loan costing 15%,
net cost is [(15+14)/2] = 14.50%

Computing cost of in house management of Receivables:

Particulars Computation Rs
Opp Cost of funds in
receivables
- Availing discount [(120 lakhs x 75%) x 60% x 10/360] x 14.50% 21750
- Not availing Disc [(120 lakhs x 75%) x 40% x 60/360] x 14.50% 87000
Bad debt losses (120 lakhs x 75%) x 1% 90000
Adm Costs Given in Que 120000
Cash discount [(120 lakhs x 75%) x 60%] x 2% 108000
Total Costs 426750

Cost of Factoring Option:

Particulars Computation Rs
Cost of Own funds in [(120 lakhs x 75%) x 12% ] x 14% x 25/360 10500
debtors
Interest Paid [(120 lakhs x 75%) x 88%] x 15% x 25/360 82500
Factor Commission (120 lakhs x 75%) x 4% 360000
Total Cost 453000

Decision:

As in house management option is the least cost option, it should be preferred

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