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Working Capital Manageme nt

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Definition of Working Capital   Working Capital refers to that part of the  firm’s capital, which is required for  financing short-term or current assets such a  cash marketable securities, debtors and  inventories.  Funds thus, invested in current  assets keep revolving fast and are  constantly converted into cash and this cash  flow out again in exchange for other current  assets.  Working Capital is also known as  revolving or circulating capital or short-

WORKING CAPITAL BASIS OF CONCEPT Gross Working Capital Net Working Capital BASIS OF TIME Permanent / Fixed WC Temporary / Variable WC Special WC

Seasonal WC Regular WC Reserve WC

Significance of Gross WC Optimum investment in CA      Investment in CA must be adequate  CA investment should not  be inadequate or excessive inadequate WC can disturb  production and can also threaten the solvency of firm . they should  not be kept idle   . if it fails  to meet its current obligation  excessive investment in CA  should be avoided . since it impairs firms profitability   Financing of CA      Need for WC arises due to increasing level of business activity  & it is to provided quickly some time surplus fund may arises  which should be invested in Short term securities .

Significance of Net Working Capital   Maintaining Liquidity position  For maintaining liquidity position there is a  need to maintain CA sufficiently in excess of  CL  Judge Financial Soundness of a firm  The Net working capital helps creditors and  investors to judge financial soundness of a  firm  .

BALANCE SHEET OF ABC COMPANY AS ON 31-3-2000 Liabilities Equity Shares 8% Debentures R’s 200000 Assets Goodwill R’s 20000 100000 Land and Building 150000 Plant and Machinery Inventories Finished Goods Work in process Prepaid Expenses Marketable Securities Sundry Debtors Bills Receivables Cash & Bank Balance 100000   60000 40000 20000 60000 90000 20000 90000 Reserve & Surplus 50000 Sundry Creditors Bills Payable Outstanding Expenses Bank Overdraft Provision for Taxation     150000 30000 20000 50000 20000 Proposed Dividend 30000     .

Difference between permanent & temporary working capital Amount of Working Capital Variable Working Capital Permanent Working Capital Time Permanent and temporary working capital for Stable firm .

                                  Variable Working Capital Amount of Working Capital Permanent Working Capital Time Permanent and temporary working capital for Growing firm .

  Operating cycle concept Maximization of share holder’s wealth of a firm is possible only when there are sufficient return from the operations Successful sales activity is necessary for earning profit sales do not convert into cash immediately There is invisible time lap between the sale of good and receipt of cash The time taken to convert raw material into cash is known as operating cycle Conversion of cash into raw material Conversion of raw material into work in progress Conversion of Work in progress into finished goods Conversion of finished good into Sales ( Debtors and cash )        .

Raw Materials WIP Cash Operating Cycle in Manufacturing firm Finished Goods Debtors SALES .

Operating cycle of Non Manufacturing Firm Receivables cash Stock of finished goods .

Formula for calculating Operating cycle for Manufacturing firm OC = ICP+ARP OC = Operating cycle ICP = Inventory Conversion period ARP = Account Receivable Period ICP = Average Inventory Cost of good sold /365 ARP = Average Account Receivable Sales/365 .

 closing  R’s 475 Lakhs   Receivable opening R’s 915 Lakhs. Closing  R’s 975 Lakhs  Cost of Goods Sold R’s 2675 Lakhs    . ABC Company Provide the following information . Compute the operating cycle   Sales 3000 Lakhs   Inventory  Opening R’s 610 Lakhs .

 CASH CONVERSION CYCLE The amount of time a firm’s resources are tied  up calculated by subtracting  the average  payment period from the operating cycle the  time period between the date a firm pays its  supplier and the date it receives cash from its  customer  CCC = OC – APP AAI = Average Inventory       Cost of good sold /365 ARP = Average Account Receivable         Annual Sales/365  APP = Account Payable Period      Cost of good sold /365 .

APP OC = AAI+ARP 80+50=130 CCC =130-40 =90 days .Calculate CCC (CASH CONVERSION CYCLE)  Average use of Inventory 80 days  Account receivable collection period 50 days  Account payable period is 40 days CCC= OC.

    Purchase of                           Sale of Goods                        Collection of     Raw Material     on Credit         Account Receivables     On credit     Average age  of    Inventory  (AII)  Account receivable  period (ARP)                              Account Payable             Period (APP)                                              Payment to                                                suppliers   Receipt of Invoice Operating Cycle (OC) Cash Conversion cycle .

Resource flows for a manufacturing firm Used in Accrued Direct Labour and materials Working Capital cycle Collection process Used to purchase Cash and Marketable Securities Accrued Fixed Operating expenses Production Process Generates Inventory Used in Used to purchase Fixed Assets Via Sales Generator Accounts receivable External Financing Return on Capital Suppliers Of Capital .

closing 168.40.95  Cost of Good sold R’s 1406.33 CCC = OC –APP .Calculate cash conversion cycle  Sales R’s 1587.27  Inventory opening 195.46  Account payable opening 140. closing 202.29  Account receivables opening 423.03 closing 449.82.

  the  time  taken  for conversion of RM into FG. The amount of cash required for advance payments if any.e.. The average period of credit allowed to customers. wages and overheads The  length  of  time  for  which  raw  materials  remain  in  stores  before they are issued to production. The average period of credit to be allowed by suppliers. The  length  of  the  production  cycle  or  WIP. The  length  of  the  Sales  Cycle  during  which  FG  are  to  be  kept  waiting for sales. Time – lag in the payment of wages and other overheads FORECASTING / ESTIMATION OF WORKING CAPITAL REQUIREMENTS .         Factors to be considered Total costs incurred on materials. The  amount  of  cash required to pay day-to-day expenses of the  business.  i.

. Month’s Purchases)(ii) Lag in payment of expenses (ii) Lag in payment of expenses WORKING CAPITAL CA – CL WORKING CAPITAL ((CA – CL )) Add Provision Margin for Contingencies Add ::Provision //Margin for Contingencies NET WORKING CAPITAL REQUIRED NET WORKING CAPITAL REQUIRED STATEMENT OF WORKING CAPITAL REQUIREMENTS STATEMENT OF WORKING CAPITAL REQUIREMENTS Amount (Rs.) -----------------------------------_ -----_ xxx xxx --------XXX XXX ..Month’s Sales)---(iii) Stocks For……Month’s Sales)----(iii) Stocks ((For……Month’s Sales)----(iv)Advance Payments if any (iv)Advance Payments if any Less Current Liabilities Less ::Current Liabilities (i) Creditors (For…..) Amount (Rs. Month’s Purchases)(i) Creditors (For….PROFORMA .WORKING CAPTIAL ESTIMATES 1. TRADING CONCERN Current Assets Current Assets (i) Cash (i) Cash (ii) Receivables For….Month’s Sales)---(ii) Receivables ((For…..

Month’s Purchases) (ii) Lag in payment of expenses (iii) Any other WORKING CAPITAL ( CA – CL )xxxx Add : Provision / Margin for Contingencies NET WORKING CAPITAL REQUIRED --------------------------------------------------------------------XXX .month’s consumption) (ii)Work-in-progress (for…months) (a) Raw Materials (b) Direct Labour (c) Overheads (iii) Stock of Finished Goods ( for …month’s sales) (a) Raw Materials (b) Direct Labour (c) Overheads (iv) Sundry Debtors ( for …month’s sales) (a) Raw Materials (b) Direct Labour (c) Overheads (v) Payments in Advance (if any) (iv) Balance of Cash for daily expenses (vii)Any other item Less : Current Liabilities (i) Creditors (For….) Current Assets (i) Stock of R M( for ….. MANUFACTURING CONCERN STATEMENT OF WORKING CAPITAL REQUIREMENTS Amount (Rs.1.

Prepare an estimate of Working capital requirement from the following information of a trading concern: Projected annual sales  Selling price % age of Net profit on sales Average Credit Period allowed to  customer Average Credit Period allowed by  supplier 100000 units R’s 8 per unit  25% 8 weeks  4 weeks Average stock holding in terma of sales  12 weeks requirement  contingencies 10% .

(2) Calculation of WIP depends on the degree of completion as regards to materials.Points to be remembered while estimating WC      (1) Profits should be ignored while calculating working capital requirements for the following reasons. (a) Profits may or may not be used as working capital (b) Even if it is used. if nothing is mentioned in the problem. the average period of WIP must have been calculated as equivalent period of completed units. Drawings. Because in such a case. labour and overheads. take 100% of the value as WIP. it may be reduced by the amount of Income tax. However. Dividend paid etc. (3) Calculation of Stocks of Finished Goods and Debtors should be made at cost unless otherwise .

Prepare statement of working capital requirement, Profit &Loss A/C, Balance Sheet Assuming
     

Share Capital 8% Debentures Fixed asset Material Direct lab our Overheads

150000 200000 130000 40% 20% 20%

The following further particular are available  It is proposed to maintain a level of activity of 2,00,000 units  Selling price is R’s 12/- per unit  Raw Material are expected to remain in stores for an average period of one month  Material will be in process , on average half a month  Finished goods are required to be in stock for an average period of one month  Credit allow to debtors is two month  Credit allow by supplier is one month

Working Capital Financing Mix
Approaches to Financing Mix

The Hedging or Matching Approach

The Conservative Approach

The Aggressive Approach

Hedging approach to asset financing Total Assets Short-term Debt Fluctuating Current Assets Permanent Current Assets Long-term Debt + Equity Capital Fixed Assets Time .

 The hedging approach suggests that the permanent working capital requirement should be financed with fund from long term sources while the  The Hedging approach .Hedging approach refers to a process of matching maturities of debt with the maturities of financial need . In this approach maturity of source of fund should match the nature of asset to be financed  This approach is also known as matching approach.

Estimated Total Investment in Current Asset of company X for the year 2000 Month Investment Permanent or Temporary in Current Fixed or seasonal Invest Asset Investments (R's) (R's ) (R's) January 50400 45000 5400 February 50000 45000 5000 March 48700 45000 3700 April 48000 45000 3000 May 46000 45000 1000 June 45000 45000 July 47500 45000 2500 August 48000 45000 3000 September 49500 45000 4500 October 50700 45000 5700 November 52000 45000 7000 December 48500 45000 3500 TOTAL 44300 .

Conservative Approach This approach suggested that the entire estimated investments in current asset should be finance from long term source and short term should be use only for emergency requirement  Distinct features of this approach  Liquidity is greater  Risk is minimized  The cost of financing is relatively more as interest has to be paid even  .

Conservative approach to asset financing Total Assets Short-term Debt Fluctuating Current Assets Permanent Current Assets Long-term Debt + Equity capital Fixed Assets Time .

low profit . One way of determining the trade off is . high profit and high risk while the conservative approach leads to high cost . low risk Both the approaches are the two extreme and neither of them serve the purpose of efficient working capital management A trade off between the two will then be an acceptable approach .Trade off between Hedging and conservative approaches  The hedging approaches implies low  cost .

Aggressive approach to asset financing Total Assets Short-term Debt Fluctuating Current Assets Permanent Current Assets Long-term Debt + Equity capital Fixed Assets Time .

Aggressive approach  The aggressive approach suggests that the entire estimated requirement of current asset should be financed from short-term sources and even a part of fixed asset investment be financed from short term sources This approach make the finance mix :  More Risky .

        Prepare a projected balance sheet . profit and loss a/c and then an estimation of working capital . Issued Share Capital 300000 6% Debentures 200000 Fixed asset 200000 Raw Material 50% Lab our 20% Overheads 20% Profit 10% There is a regular production and sales cycle .

       Raw Material are kept in stores for an average period of two month Finished goods remain in stock for an average period of three month Production during the previous year was 180000 units and it is planned to maintain the same in the current year also Each unit of production is expected to be in process for half a month Credit allow to customer is three month and given by supplier is two month Selling price is Rs 4 per unit Calculation of debtors may be made at selling price .

The basic goal of WCM is to manage the CA & CL of a firm in such a way that a satisfactory level of WC is maintained. Management of working capital therefore is concerned with the problems that arise in attempting to manage the CA. the CL and the interrelationship that exists between them.Management of Working Capital     Working capital in general practice refer to the excess of CA over CL. Working Capital Management Policies of a firm have a great effect on its .

& Liquidity Risk. Profitability. & Liquidity nIII vel io I e el si n L enso &Lev n ime on Dim tion& D si i po it fCA p s o A om o of C C Com D Diime Com n Com p menssio n o possiti ion IIII ition & II on o C L offC L& Leevel vel L . Risk.Working capital management is 3 dimensional in Nature Dimension Dimension II Profitability.

000 maximum units of production Continuous production Three different policies for current asset levels are possible Policy A ASSET LEVEL Policy B Policy C Current Assets 0 25.Working Capital Issues Optimal Amount (Level) of Current Assets    Assumptions 50.000 OUTPUT (units) 50.000 .

000 . Policy A ASSET LEVEL Policy B Policy C Current Assets 0 25.000 OUTPUT (units) 50. all other factors held constant.Impact on Liquidity Optimal Amount (Level) of Current Assets Liquidity Analysis Policy Liquidity A High B Average C Low Greater current asset levels generate more liquidity.

000 ASSET LEVEL Policy A Policy B Policy C Current Assets .Impact on Expected Profitability Optimal Amount (Level) of Current Assets Return on Investment = Net Profit Total Assets Let Current Assets = (Cash + Rec. + Inv.000 OUTPUT (units) 50.) Return on Investment = Net Profit Current + Fixed Assets 0 25.

000 .000 OUTPUT (units) 50. total assets will decline and the ROI will rise.Impact on Expected Profitability Optimal Amount (Level) of Current Assets Profitability Analysis Policy Profitability A Low B Average C High As current asset levels decline. Policy A ASSET LEVEL Policy B Policy C Current Assets 0 25.

000 . More risk! Policy A ASSET LEVEL Policy B Policy C Current Assets 0 25. More risk! Lower inventory levels increase stockouts and lost sales.000 OUTPUT (units) 50. More risk! Stricter credit policies reduce receivables and possibly lose sales and customers.Impact on Risk Optimal Amount (Level) of Current Assets    Decreasing cash reduces the firm’s ability to meet its financial obligations.

Policy A ASSET LEVEL Policy B Policy C Current Assets 0 25.000 OUTPUT (units) 50.Impact on Risk Optimal Amount (Level) of Current Assets Risk Analysis Policy Risk A Low B Average C High Risk increases as the level of current assets are reduced.000 .

Profitability varies inversely with liquidity. Profitability moves together with risk. 2. (risk and return go hand in hand!) .Summary of the Optimal Amount of Current Assets SUMMARY OF OPTIMAL CURRENT ASSET ANALYSIS Policy A B C Liquidity High Average Low Profitability Low Average High Risk Low Average High 1.

The analysis of working capital can be conducted through a number of devices such as  Ratio analysis  Fund flow analysis  Working capital Budgeting  Ratio analysis : A ratio is a simple arithmetical expression of the relationship of one number to another . this technique can be Techniques of analysis of working capital .

The following ratios may be calculated for this purpose Liquidity Ratio a) Current Ratio b) Acid test ratio/quick ratio/liquid ratio c) Cash Position ratio/absolute liquid ratio  Inventory turnover ratio  Receivable turnover ratio  Payable turnover ratio  Working capital turnover ratio  .

(Working capital ration).  It is helpful to measure short – term financial position or liquidity of a firm Current ratio: Current asset . Current ratio may be define as the relationship between CA and CL  This ratio is also known as WCR.

CURRENT ASSETS Cash in hand Cash at bank Sundry Debtors CURRENT LIABILITIES Bills Payable Sundry Creditors Accrued or Outstanding Expenses Short term loan and advances Dividend payable Bank Overdraft       Marketable securities (Short term) Bills Receivable Inventories of Stock Work in progress Finished goods Prepaid Expenses .

Quick or Acid test or Liquid Ratio An asset is said to be liquid if it can be convert into cash with in a short period with out loss of value  Inventory cannot be termed to be liquid asset because they cannot be convert into cash immediately  The quick ratio can be calculated Quick ratio: liquid asset Current liabilities  .

Quick or liquid Cash in hand Cash at bank Sundry Debtors Current Liabilities Bills Payable Sundry Creditors Accrued or Outstanding Expenses Short term advances Marketable securities Temporary Investments Dividend payable Bank Overdraft  Income tax payable Convection quick ratio of 1:1 is consider satisfactory .

05% Cash ratio: Cash & bank + Short –term securities Current liabilities  .Cash Position ratio/absolute liquid ratio Absolute Liquid assets include cash in hand and cash at bank and marketable securities or temporary investments  The acceptable norms for this ratio is 50% or .

Calculate all the three ratio Liabilities Rs Assets Rs 9% preference share Equity share capital 8% debentures Long term loan Bills payable Sundry creditors Bank over draft Outstanding 500000Goodwill 1000000Land and building 200000Plant 100000Furniture and fixtures 60000Bills receivable 70000Sundry debtors 30000Bank balance 5000short term 100000 650000 800000 150000 70000 90000 45000 25000 .

CONCLUSION:  Current ratio of the company is not satisfactory because the ratio 1:6 is much below then the expected Standards .42 where as the accepted standard is 0.5 .  Acid test ratio on the other hand is more than the normal standard of 1:1  Absolute ratio is slightly low because it is 0.

Inventory turnover ratio Inventory turn over ratio = Cost of good sold Average Inventory at cost Generally . the cost of good sold may not be known from the published financials . in such circumstances Inventory turn over ratio = Net Sales Average Inventory at cost .

Inventory conversion period Inventory conversion period = Days in a year Inventory Turnover Ratio M/s Rakesh & Co supplies you the following information for the year ending 31st Dec 1999 Credit Sales Rs 150000 Cash Sales Rs 250000 Return Inward Rs 25000 .

No provision for doubtful debt be deducted from them but when the information about opening and closing balance of trade debtor and credit sales is not available . then the debtors turnover ratio calculated by dividing the total sales by the balance of debtors(inclusive of Bills receivables) given Debtors turn over Ratio = Total sales Debtor/Receivable turnover ratio /Debtor velocity .Debtor(Receivable) = Net credit Annual sales Average Trade debtors Trade debtors = Sundry debtor + Bill Receivable and account receivable s Average Trade Debtors = Opening Trade debtor + Closing Trade Debtor /2 Note : Debtor should always be taken at gross value .

Average Collection Period The average collection period represent the average number of days for which a firm has to wait before its receivable are converted into cash Average Collection period = Average Trade Debtors (Drs + B/R) Sales per day Sales Per day = Net Sales .

Or Average collection period =Average trade debtors Net Sales No of working days If the period is in months: Average collection period =No of working days Debtors turnover ratio The two basis component of the ratio are debtors and sales per day .

The analysis for credit turnover is basically the same as of debtors turnover ratio except that in place of trade debtor. the trade creditor are taken and in place of sales . average daily purchase are taken as the other component of the ratio. Creditors turnover ratio = Net credit annual purchase Average Trade creditors Creditor/Payable turnover ratio .

Average Payment Period = No of .Average Payment period Ratio = Average Trade Creditors( Creditors+ Bills payable)/Average Daily purchases. Average daily purchase = Annual Purchase /No of working days in a year. Average Payment Period = Trade creditor * No of working days / Net annual purchase.

then the figure of sale can be used .Working capital of a concern is directly related to sales and current asset like debtors . O n Working capital turnover ratio . stock etc . bills receivable . cash . Working capital turnover ratio = Cost of Sales / Average working capital Average working capital = Opening working capital + Closing Working capital/2 ** If cost of sales is not given .

The following information is given about M/s S.P Ltd for the year ending Dec 31 2000  Stock turnover ratio = 6times  Gross Profit ratio = 20% on sales  Sales for 2000 = Rs 300000  Closing stock is Rs 10000 more than the opening stock  Opening Creditors = Rs 20000  Closing Creditors = Rs 30000  Trade debtor at the end = Rs 60000  Net Working Capital = Rs 50000 .

 FIND OUT  Average Stock  Purchases  Credit turnover ratio  Average Payment Period  Average Collection Period  Working Capital turnover ratio .

It is an effective management tool to study change in the financial position of business The fund flow analysis consists of  Preparing schedule of change in working capital .Fund flow analysis : Fund flow analysis is a technical device designated to study the sources from which additional fund were derived and the use to which these sources were put .

 The objective of a working capital budget is to ensure . is prepared estimating future long term and short term working capital need and the sources of finance them . Working capital Budgeting : Working capital budget as a part of total budgeting process of a business .