Management of working capital

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Russell Riley
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1 Management of working capital Gross Working Capital = Total of Current Assets. Net Working Capital (Working Capital Gap) = Current Assets - Current Liabilities Net Working Capital is also called Working Capital. Working Capital Forecast - Working Capital is the lifeblood of a business. An adequate amount of working capital is essential for the smooth running of business. To avoid shortage or excess of working capital an estimate of working capital is to be done. This estimation of working capital requirement is known as Working Capital Forecast. Adequate Working Capital - The importance of adequate working capital in commercial undertakings can be judged from the fact that a concern needs funds for its day-to-day running. Adequacy or inadequacy of these funds would determine the efficiency with which the daily business may be carried on. Management of working capital is an essential task of the finance manager. He has to ensure that the amount of working capital available with his concern in neither too large nor too small for its requirements.

2 Following factors have to be taken into consideration while forecasting working capital requirement: 1) Total costs to be incurred on raw material, wages and overheads. 2) The storage time of raw materials, finished goods. 3) The length of production cycle. 4) The amount of cash required to pay day to day expenses. 5) The average period of credit allowed to customer. 6) The average period of credit allowed by supplier. Raw Materials Stock Factors on which raw materials stock will depend are: 1. Holding Time Period. 2. Consumption Capacity Raw Materials Stock = Raw Materials Consumed X Raw Materials Period Raw Materials Stock Calculation of Finished Goods:- Factors on which finished goods depends are: COGS = Raw Materials Consumption Raw Materials Turnover Finished Goods Stock = Finished Goods Stock = Calculation of Debtors:- Cost of Goods Sold Cost of Goods Sold Finished Goods Turnover Finished Goods Period Factors on which debtors will depend are:

3 Credit Sales Debtors = Credit Sales X Credit Period Calculation of Cash:- Factors on which cash will depend are: Annual requirements of cash. Cash = Annual Requirement of Cash X Time Period Calculation of Outstandings:- Factors on which outstanding exp. will depend are: Annual cash expenses. it does not include materials & depreciation. Non cash item Outstanding Exp. = Annual Cash Expenses X Time Period Calculation of Creditors:- Factors on which creditors will depend are: Credit Purchases Credit purchases Creditors = X Credit Period

4 Nutshell Raw Materials Stock Raw Materials Consumed Finished Goods Stock C O G S Debtors Credit Sales Cash Annual Cash Requirement Creditors Credit Purchases Outstanding & Prepaid Annual Cash Expenses Excluding Materials & Depreciation Old & New Organizations. Old Organization In case of Old Organization the opening & closing balance of every item will remain same i.e. of a) Raw Materials b) WIP Stock c) Finished Goods Stock. In case of old organization purchase of raw materials will always be equal to consumption of raw material unless otherwise mentioned. In case of old organization Purchases = Consumption New Organization In case of new organization there will be no opening balance but only closing balance of every item i.e. of a) Raw Materials b) WIP Stock c) Finished Goods Stock. In case of new organization purchase (in the 1st year of operation) will always be more than consumption. In case of new organization Purchases = Consumption + Cl. Stock of Raw Materials If nothing is mentioned assume the Co. as Old Co.

5 Nutshell Agar old Organization hai toh Sales units Prodn. units units for calculating Expense aur aur aur Raw Materials Purchase hamesha same rahega. Agar New Organisation hay toh Sales units se jyada Prodn. units Prodn. units se jyada units for calculating Exp units for calculating Exp se jyada R.M. Purchase rahega. Concept of W.I.P. Situation 1 : When units of WIP is given. Situation 2 : When processing time is given with annual production. Situation 3 : When processing time is given without annual production. Cash Cost of Working Capital It is the amount of cash required to finance the working capital. To calculate Cash cost of Working Capital, we need to deduct: Profit from Debtors Depreciation from Debtors, Finished Goods & WIP Concept of Double Shift Working of Extra shift after completion of first shift, and continuation of first shift production, is known as Double shift. Because of double shift WIP T/O will increase in same proportion as that of Production. However, Units in WIP will remain same even after Double shift. Turnover and time period of all other item will remain same.

6 Steps for calculating Double Shift. 1. Calculate % increase in production. 2. Calculate WIP Turnover of single shift & double shift. 3. Draft a cost statement of single shift & double shift separately considering % increase in production. 4. Now, Calculate Working Capital treating single shift & double shift as 2 separate questions. (Only WIP turnover of double shift will be different. Operating Cycle It is the time period involved in the conversion of Raw Materials / Resources into Finished goods or Services including the credit period involved for selling Products / Services. Estimation of working capital need based on Operating Cycle Process. One of the methods for forecasting working capital requirement is based on the concept of operating cycle. The determination of operating capital cycle helps in the forecast, control and management of working capital. The length of operating cycle is the indicator of performance of management. The net operating cycle represents the time interval for which the firm has to negotiate for working capital from its Bankers. It enables to determine accurately the amount of working capital needed for the continuous operation of business activities. The duration of working capital cycle may vary depending on the nature of the business.

7 Various forms of Bank Credit in financing Working Capital of a Business Organization. The various forms of Bank Credit in financing the working capital of a Business Organization are: 1) Cash Credit, 2) Bank Overdraft, 3) Bills Discounting, 4) Bill Acceptance, 5) Line of Credit, 6) Letter of Credit, and 7) Bank Guarantees. Liquidity v/s Profitability issue in Management of Working Capital Working capital management entails the control and monitoring of all components of working capital i.e. cash, marketable securities, debtors, creditors etc. Finance manager has to pay particular attention to the levels of current assets and their financing. To decide the level of financing of current assets, the risk return trade off must be taken into account. The level of current assets can be measured by creating a relationship between current assets and fixed assets. A firm may follow a conservative, aggressive or moderate policy.

8 A conservative policy means lower return and risk while an aggressive policy produces higher return and risk. The two important aims of the working capital management are profitability and solvency. A liquid firm has less risk of insolvency i.e. it will hardly experience a cash shortage or a stock out situation. However, there is a cost associated with maintaining a sound liquidity position. So, to have a higher profitability the firm may have to sacrifice solvency and maintain a relatively low level of current assets.

INTRODUCTION MEANING OF WORKING CAPITAL

INTRODUCTION MEANING OF WORKING CAPITAL INTRODUCTION Working capital management is also one of the important parts of the financial management. It is concerned with short-term finance of the business concern which is a closely related trade