Working Capital Management

Transcription

1 Course : Commerce (CBCS) Paper : Fundamentals of Financial Management Lesson : Working Capital Decisions Lesson Developer : Dr. Arun Julka and Dr. Soma Garg Department/College: Department of Commerce, Maharaja Agrasen College, University of Delhi Reviewer s Name : Dr. Gurmeet Kaur Fellow in Commerce, ILLL Associate Professor, Daulat Ram College, University of Delhi University of Delhi 1

2 Lesson: Working Capital Management Table of Contents: 1. Learning Outcomes 2. Introduction 3. Components of Working Capital 4. Concepts of Working Capital 5. Classification of Working Capital 6. Need of Adequate Working Capital 7. Working Capital Financing Policy: Various Approaches for Financing of Current Assets 6.1. Hedging Approach/ Matching Approach 6.2. Conservative Approach 6.3. Aggressive Approach 8. Trade-off between Risk and Return 8. Operating Cycle/ Working Capital Cycle/Cash Cycle 9. Format for Calculation of Net Operating Cycle 10. Determination of Working Capital Requirement 11. Format for Calculation of Working Capital Requirement 12. Approaches to Working Capital Estimation Solved Problems Summary Glossary Exercises References 1. Learning Outcomes: After you have read this lesson, you should be able to: understand the meaning of working capital, understand the concepts of working capital, describe the need and classification of working capital, explain policies related to current asset management, explain risk return trade off, discuss the Various Approaches for Financing of Current Assets, analyse the need for working capital as related to operating/ cash cycle, permanent and temporary working capital, and review the computation of working capital, using both cash cost approach and total cost approach. University of Delhi 2

3 2. Introduction: A business enterprise should maintain a sound and required working capital position to run the business. The amount of working capital should neither be inadequate nor excessive. Excessive working capital results in idle funds for a firm which adds to the cost of capital and does not result in profits for the firm. On the contrary, if the working capital is short of its requirements, it results in production and sales disruption and impairs the firm s profitability. Working capital management is concerned with short term financial decisions. Working capital for a firm is like the blood for the human body. It is one of the most significant ingredients of the business. Working capital management if carried out efficiently, effectively and consistently, will result in a healthy and robust organisation. The management of working capital is equally important than as the management of longterm financial investment. The adequacy of working capital determines the survival of the company. The efficient working capital management is mandatory to maintain a balance of liquidity and profitability. 3. Components of Working Capital: Current Assets: Current assets are the assets which can be converted into cash within a period of one year in an ordinary course of business, without disrupting the operations of the firm. The current assets are namely, cash, marketable securities, account receivables (including debtors and bills) and inventories. These include: Cash and Bank balances Receivables Short Term Investments Inventory of Raw Materials, Stores and Spares Short Term Advances Inventory of Work-in-progress Prepaid Expenses Inventory of Finished Goods Current Liabilities: Current liabilities are claims of outsiders which are to be paid within a period of one accounting year in an ordinary course of business. The current liabilities are accounts payable, bills payable, bank overdraft and outstanding expenses. These include: Creditors for good purchased Advanced received against sales Outstanding expenses Taxes and dividends payable Short term borrowings Other short term liabilities maturing within a year Value Addition 1: Know More Components of Working Capital Management Visit the link below to know about the components associated with working capital management. Source: University of Delhi 3

4 4. Concepts of Working Capital: In accountancy, working capital means net working capital. It is the difference between current assets and current liabilities. The net working capital designates the liquidity position of a firm is a qualitative concept. It is also the measure of the extent to which the firm is sheltered from liquidity problem. In finance, working capital usually refers to gross working capital which is nothing but a firm s investment in total current assets. The current liabilities are not subtracted from the total of current assets because the management is more apprehensive about the total current assets than with the sources of these funds. Figure 1: Classification of Working Capital Value Addition 2: Know More Gross and Net Working Capital Visit the link below to know more about Gross and Net Working Capital. Source: University of Delhi 4

5 5. Classification of Working Capital: On the basis of time and need, working capital can also be classified as permanent working capital and Temporary / fluctuating working capital. Permanent working capital: It is the bottom level of the investment required to maintain current asset at such a level so that day-to-day operations can be carried on without any impediment or hurdles. These represent minimum levels of inventories, receivables, etc., that will always be available to run the business operations. Temporary or fluctuating working capital: It is dependent on the changes in production and sales. These represent the seasonal stockpiles that arise, such as inventories before Diwali and receivables after Diwali. This is over and above permanent working capital. Temporary working capital is generated to meet liquidity necessities that are of a purely momentary or temporary in nature. Figure 2: Classification of Working Capital based on Need and Time The requirements of permanent and temporary working capital may change over time because of the following reasons: 1. Changes in level of sales which may be due to these reasons: There may be an everlasting long term change in trend. For instant, the demand of a particular product may rise permanently due to change in lifestyle compelling to hold large inventory. This secular trend would primarily affect the need for permanent current assets. There may be recurring fluctuations in the economy due to customary ups and downs in business activity, which occur after a period from time to time. Though they are more or less regular, they may not be uniformly periodic. This results in alteration in both permanent and temporary working capital. Seasonal influences may also result in changes in sales resulting in deviation in the temporary working capital. 2. Changes in the policy by the management will impact working capital. 3. Technological changes: They would also result in significant changes in the level of working capital. If a new process is invented due to technological advancement, resulting in the shortening of the operating cycle, it would shrink the necessity for working capital and vice versa. University of Delhi 5

6 Value Addition 3: Know More Types of Working Capital Visit the link below to know more about types of Working Capital. 6. Need for Adequate Working Capital 1. Sufficient working capital helps to maintain solvency of a business concern. 2. Adequacy of working capital makes it possible for the firm to receive regular supplies of raw materials. As a result there is no interruption in production process. 3. A firm with an adequate working capital can take advantage of the cash discount by procuring the merchandises for cash. 4. Adequacy of working capital, say, stock of raw material, makes it possible for a firm to fully exploit its fixed assets. 5. If the firm pays all its short-term obligations in time, it will improve the credit rating of the firm and help the firm to take loans easily. 6. The firm can purchase ample quantity of raw material if it has adequate working capital. 7. Adequate working capital helps the firm to obtain bank loans as banks prefer to provide loans to the firms with the sufficient working capital. 8. Adequacy of working capital has a favourable psychological effect on the managers as they do not face any obstacle in the day-to-day business operations. The morale of manager does remain high as the creditors, wages and all other expenses are paid on time. 9. Sufficient working capital helps the firm in maintaining goodwill. Value Addition 4: Know More Importance of Working Capital Visit the link below to gain an insight into the importance of working capital. Source: Source: finance-textbook/introduction-to-working-capital-17/working-capital- 122/importance-of-working-capital / 7. Working Capital Financing Policy: Various Approaches for Financing of Current Assets The essential characteristic of working capital management is to resolve about the sources of funds which can be availed to make investment in current assets. The two major sources of working capital finance are: 1. Short term sources: They provide funds for a short period say up to one year. The main sources are: trade credit, Short term bank credit, factoring of receivables, commercial papers. 2. Long term sources They provide funds for a comparatively longer period. The main sources are equity share capital, Preference share capital, Debentures, long term borrowings, etc. University of Delhi 6

7 The three basic approaches to determine a suitable financing mix are: a) Hedging Approach b) Conservative Approach c) Aggressive Approach 6.1. Hedging Approach/ Matching Approach Under Hedging Approach, each asset should be counterbalanced with a financial instrument of the same estimated maturity. Short term or seasonal variations in current assets will be financed with short term debt; the permanent constituent of current assets and all fixed assets should be supported with long term debt or with equity. According to this approach only short term fluctuations would be financed with short term debt. Hence, the inconsistent current asset levels should be financed for a short-term since a firm would not want to pay financing charges all year if it only needs the money for a four-month period. Though the financing mix endorsed by hedging approach is a appropriate financing pattern, nevertheless precise matching of maturity period of current assets and sources of finance is at times not conceivable because of ambiguity involved. Figure 3: Hedging Approach to Working Capital Value Addition 5: Know More Advantages and Disadvantages of Hedging Approach Visit the link below to know about the advantages and disadvantages of Hedging Approach. Source: University of Delhi 7

8 6.2. Conservative Approach Under the conservative approach, the management allows itself a margin of safety and decides to finance a portion of short term working capital needs from long term sources. If the expected net cash flows do occur as forecast, it will pay interest on excess debt (Shown as shaded area in figure) when these funds are not needed. And in such a situation where a firm has no impermanent capital requisite then the sluggish long term funds can be invested in marketable securities. This will help the firm earn income. In an extremely conservative firm, the peak requirements might be financed entirely on a long term basis. Figure 4: Conservative Approach to Working Capital University of Delhi 8

9 6.3. Aggressive Approach Under this approach, a firm finances some of its enduring requirements using short-term sources. The financing would be considered more aggressive if the greater proportions of permanent assets are financed through short term debts. The risk of financing permanent needs with short-term financing is dual: the short-term interest rates oscillate much more than long-term interest rates. Rolling over short-term debt year after year will subject a firm to greater variability in its financing costs as a result. Probably a bigger risk is the incompetence to roll over the short-term debt every year. The firm may accept even greater risk of insolvency in order to save cost of long term financing. Figure 5: Aggressive Approach to Working Capital Value Addition 6: Know More Aggressive Vs. Hedging Approach Visit the link below to know the difference between aggressive and hedging approach. Source: University of Delhi 9

10 7. Trade off Between Risk and Return: Management of working capital assumes utmost significance due to the fact that the working capital decisions have a direct impact on companies risks and returns and inturn on its share prices. The following two decisions have to be made by a manager to have a sound working capital: Optimum level of current assets, Apposite mix of short-term and long-term financing to upkeep this investment in current assets. The above decisions facilitate a firm to make a trade off between profitability and risk. The appropriateness of working capital together with its competent usage essentially regulates the existence of the company. The efficient working capital management is crucial to sustain a balance of liquidity and profitability. But the apparent advantage of this strategy would result in increased risk to the enterprise. The firm might not be able to meet its cash obligations as they occur and it might also not be able to support the proper level of sales as it might run out of inventory. Hence, the level and financing of current assets have to be studied in this context of a trade-off between risk and profitability. A conservative policy specifies higher current assets to fixed assets ratio whereas an aggressive policy signifies lower current assets to fixed assets ratio. The conservative policy results in lower risk and higher liquidity and thus lower risk and return whereas an aggressive policy explains higher risk and lower liquidity and thus higher risk and return. The firm might have to give up solvency to attain higher profitability and to maintain a low level of current assets. As lesser funds are tied up in idle current assets, it will help the firm to improve its profitability but at the cost of being exposed to the risk of shortage of cash. On the other hand, a liquid firm has less risk of insolvency. It will scarcely experience cash shortage or a stock out situation but only with the higher cost of capital. There are basically two varieties of costs involved: cost of liquidity and cost of illiquidity. If the firm s level of current assets is very high, it has excessive liquidity but with low return. Thus, the cost of liquidity will increase with the level of current assets. The cost of illiquidity is the cost of holding inadequate current assets. If the firm carries too little cash, it will not be able to honour its obligations pushing the firm to borrow at high rates of interest. This will also adversely affect the credit worthiness of the firm forcing the firm to become insolvent. 8. Operating Cycle/ Working Capital Cycle/Cash Cycle: The prerequisite of working capital for a firm hinges on the operating cycle of the firm which is an unceasing process. 8.1 Operating Cycle of a Manufacturing Concern For a manufacturing concern the operating cycle refers to the average time intervened between the procurement of raw materials and the final cash realisation from sale of finished goods. Cash is used to procure raw materials, so cash is firstly converted into an inventory of raw materials; then these raw materials are issued to the production department; a huge variety of expenditures are incurred in the process and finally work-in process comes into existence; then Work In Progress becomes finished goods; finished goods are sold to customers on credit; then customers pay cash for the goods purchased by them. Hence, the cash is repossessed and the cycle is complete. This length of operating cycle generally differs from one firm to another contingent upon the size and the nature of the firm and the kind of good being produced. University of Delhi 10

11 Thus, the operating cycle of a manufacturing organisation consists of the following stages: Raw materials and storages inventory stage Work in-progress stage Finished goods inventory stage Receivable stage The operating cycle process of the manufacturing organisation can be expressed in the form of the following equation: Operating Cycle = Raw Material Storage Period + Work In Progress Holding Period +Finished Goods Storage Period + Debtors Collection Period Creditors Collection Period Figure 6: Operating Cycle of Manufacturing Business Collection from debtors Cash Purchase of raw material Debtors Raw Material Inventory Sales made to customers Conversion into work in progress Finished Goods Work-inprogress Conversion into finished goods University of Delhi 11

12 8.2 Operating Cycle of a Trading Concern In case of trading organisation, the operating cycle process can be expressed as follows: Operating Cycle= Stock Holding Period + Debtors Collection Period Credit Payment Period Figure 7: Operating Cycle of Trading Concern Cash Recovery from customers Payment to suppliers Debtors Inventory Sales to customers In case of service concerns, the operating cycle embraces the length of time taken for transformation of cash into debtors and from debtors to cash again. 9. Format for Calculation of Net Operating Cycle Raw Material Conversion Period (RMCP) = [Average Raw Material/Total Raw Material] X 365* Work in Progress Conversion Period (WIPCP) = [Average WIP/Total Cost of Production] X 365* Finished Goods Conversion Period (FGCP) = [Average Stock/Total Cost of Production] X 365* Receivable Period (RP) = [Average Debtors/Total Credit Sales] X 365* Deferral Period (DP) = [Average Creditors/Total Credit Purchases] X 365* Total Operating Cycle Period (TOCP) = RMCP + WIPCP + FGCP + RP Net Operating Cycle (NOC) = TOCP DP *In place of 365 days, we can take 360 days in a year. University of Delhi 12

13 10. Determination of Working Capital Requirement: Both permanent working capital and temporary working capital are necessary for every firm which is determined by a wide variety of factor. The following factors are involved to assess the quantum of total working capital requirements: Factors High Level of Working Capital Low or Moderate level of Working capital 1 Nature of Business 2 Operating Cycle In case of industries where adequate amount of cash and inventories have to be maintained. For example in trading industry and financial enterprises. The longer the time span of the production cycle, the greater will be the tied-up funds and therefore, the larger will be the working capital requirements. For For example, a distillery, which has an ageing process, has generally have heavy investment in inventory In case of industries where business is primarily done in cash. For example in case of service industry like hotels, restaurant, eating houses, electricity generation and supply. If the time span of the production cycle is trivial, the less working capital would be desired. For example, a bakery has a very high inventory turnover, and hence working capital is not very large 3 Business Cycle During peal or boom conditions the need for working capital grows to cover the lag between increased sales and receipt of cash. During downswing phase of business cycle, as the sales activity calls, so does the level of inventories and book debts. 4 Credit Policy Relating to Sales and Purchases 5 Market Standing and Goodwill 6 Market Conditions 7 Inflationary Conditions Liberal credit policy and low efforts of debtors follow-up In case of newly established concerns credit sales have to be made but purchases have to be settled in cash In case of fierce competition or buyer s market In case of highly inflationary conditions Strict credit policy and efficient credit collection mechanism In case of reputed and well established firms where there are better and advantageous credit terms with debtors and suppliers In case of seller s market where there is quick disposal of stocks and immediate collection of receivables. For moderate and mild inflationary conditions University of Delhi 13

14 11. Calculation of Working Capital Requirement- Format: Table: Format for the Calculation of Working Capital Requirement Statement of Working Capital Requirement Current Assets (A) Amount (Rs.) Cash Balance XXX Inventories Raw Materials (BP X RMC X AHP/T) XXX Work in Progress (BP X WIPC X AHP/T) XXX Finished Goods (BP X COP X AHP/T) XXX XXX Debtors (BP X *COS or **SP X ACP/T) XXX AAA Current Liabilities (B) Creditors of Raw Materials (BP X RMC X APP/T) XXX Creditors of Wages (BP X W X LIP/T) XXX Creditors of Overheads (BP X O X LIP/T) XXX BBB Net Working Capital(NWC) (C =A-B) XXX Add : Contingencies (% of NWC) XXX Net Working Capital Requirement BP = Budgeted Production per annum RMC = Raw Material Cost per unit WIPC = Work in Progress Cost per unit=(raw Material + 50% of Conversion Cost excluding Depreciation, if completion rate of material and other cost are not given) COP = Cost of Production per unit *COS = Cost of Sales per unit ( In case of Cash Cost Approach) **SP = Sale Price per unit (In case of Total Cost Approach) W = Wages per unit O = Overheads per unit T = Time in Days /Weeks/Months in a Year AHP = Average Holding Period ACP = Average Collection Period APP = Average Payment Period LIP = Lag in Payment # If payment is received in advance, the item would appear under Current Liabilities. ## If any advance payment is to be made to creditors, the item would appear under Current Assets. WCR University of Delhi 14

15 12. Approaches to Working Capital Estimation: In estimation of working capital two approaches can be used in practice: (a) Total Approach and (b) Cash Cost Approach Total Approach: In this method of estimation all costs including depreciation and profit margin are included. Unless it is asked specifically, the estimation of working capital under total approach is suggested. Cash Cost Approach: Under this approach, working capital is estimated on the basis of cash cost. Depreciation is excluded from the cost of sales. The profit margin is also not considered while estimation of investment in debtors balances. The estimation of different items of working capital is done under total approach and cash cost approach as follows: Item Total Approach Cash Cost Approach Raw Material Stock Work in- Progress Finished Goods Stock Sundry Debtors Sundry Creditors Solved Problems: Numerical 1: Net purchase cost incurred (after discount) 100% cost of raw materials+ 50% of labour cost+ 50% of production overhead (including depreciation) Cost of production (including depreciation) Selling price (including profit margin) Net purchase cost incurred (after discount) Net purchase cost incurred (after discount) 100% cost of raw materials+ 50% of labour cost+ 50% of production overhead (excluding depreciation) Cost of production (excluding depreciation) Selling price less depreciation and profit margin Net purchase cost incurred (after discount) From the following information, prepare a statement showing working capital requirement using Cash Cost Approach adding 10% for contingencies: Budgeted Production Element of Cost Raw Material Labour Overheads Total Cost Profit Selling Price Time Lag Raw Material holding Period WIP holding Period Finish Goods holding Period Average Collection Period Units per annum Rs. 80 per unit Rs. 30 per unit Rs. 60 per unit Rs. 170 per unit Rs. 30 per unit Rs. 200 per unit 4 weeks 2 weeks 4 weeks 8 weeks University of Delhi 15

16 Average Payment Period Lag in Payment of Wages 4 weeks 1.5 weeks It may be noted that production is carried on evenly during the year and wages and overheads accrue similarly. Expected cash in hand Rs. 25,000. You may state your assumptions, if any. Solution: Statement of Working Capital Requirement Current Assets (A) Amount(Rs.) Cash Balance Inventories Raw Materials ( X 80 X 4) / Work in Progress( X 125 X 2) / Finished Goods( X 170 X 4) / Debtors( X 170 X 8) / Current Liabilities (B) Creditors of Raw Materials( X 80 X 4) / Creditors of Wages( X 30 X 1.5) / Creditors of Overheads Net Working Capital (C =A-B) Add: Contingencies (10%) Working Capital Requirement Note : One Year 52 weeks Cost of Production ( ) Rs. 170 Cost of WIP(80+0.5*30+0.5*60) Rs. 125 Numerical 2: A Ltd. provides the following budget figure for the next year: Budgeted Production Element of Cost Raw Material Labour Overheads(Including Depreciation Rs. 10 per unit) Total Cost Profit Selling Price 2,60,000 Units per annum Rs. 100 per unit Rs. 50 per unit Rs. 40 per unit Rs. 190 per unit Rs. 60 per unit Rs. 250 per unit University of Delhi 16

17 Raw material is in stock, on average for 4 weeks. Materials are in process, on average for 2 weeks. Finished goods are in stock, on average for 6 weeks. Credit allowed by suppliers of raw material is 5 weeks. Credit allowed to customers is 8 weeks. Lag in payment of wages one and half week. Lag in payment of overheads is 1 week. It is necessary to hold in cash of Rs. 50,000. It may be noted that production is carried on evenly during the year and wages and overheads accrue similarly. Prepare a statement showing working capital requirement using Cash Cost Approach adding 5% for contingencies. Solution: Statement of Working Capital Requirement Current Assets (A) Amount(Rs.) Cash Balance Inventories Raw Materials( X100 X 4) / Work in Progress( X140 X 2) / Finished Goods( X180 X 6) / Debtors Current Liabilities (B) Creditors of Raw Materials( X100 X 5) / Creditors of Wages( X50 X1.5) / Creditors of Overheads( X 30 X 1) / Net Working Capital (C =A-B) Add: Contingencies (5%) Working Capital Requirement Note : One Year 52 weeks Cost of Production ( ) Rs. 180 Cost of WIP( *50+0.5*30) Rs. 140 Numerical 3: A Ltd. provides the following budget figure for the next year : Budgeted Production 1,30,000 Units per annum Element of Cost Raw Material Rs. 60 per unit Labour Rs. 25 per unit Overheads Rs. 15 per unit Total Cost Rs. 100 per unit Selling Expenses Rs. 10 per unit University of Delhi 17

18 Cost of Sales Profit Rs. 110 per unit Rs. 25 per unit Selling Price Rs. 135 per unit Raw material is in stock, on average for 4 weeks. Materials are in process, on average for 2 weeks. Finished goods are in stock, on average for 4 weeks. Credit allowed by suppliers of raw material is 4 weeks. Credit allowed to customers is 8 weeks. Lag in payment of wages one and half week. Lag in payment of overheads is 1 week. It is necessary to hold in cash of Rs. 50,000. It may be noted that production is carried on evenly during the year and wages and overheads accrue similarly. Prepare a statement showing working capital requirement using Cash Cost Approach. Solution: Statement of Working Capital Requirement Current Assets (A) Amount (Rs.) Cash Balance Inventories Raw Materials( X 60 X 4) / Work in Progress( X 80 X 2) / Finished Goods( X 100 X 4) / Debtors( X110 X 8) / Current Liabilities (B) Creditors of Raw Materials( X 60 X 4) / Creditors of Wages( X 25 X 1.5) / Creditors of Overheads( X 15 X 1) / Net Working Capital Requirement (C =A-B) Note : One Year 52 weeks Cost of Production ( ) Rs. 100 Cost of WIP(60+0.5*25+0.5*15) Rs. 80 Cost of Sales(100+10) Numerical 4: Rs.110 A Ltd. provides the following budget figure for the next year: Budgeted Production 13,000 Units per month Element of Cost Raw Material 50% of selling price Labour 30% of selling price Overheads 10% of selling price Selling Price Rs. 120 per unit University of Delhi 18

19 Raw material is in stock, on average for 2 months. Materials are in process, on average for 3 months. Finished goods are in stock, on average 4 months. Credit allowed by suppliers of raw material is 1 month. Credit allowed to customers is 2 month. Lag in payment of wages 1 month. Lag in payment of overheads is 3 week. It is necessary to hold in cash of Rs. 75,000. It may be noted that production is carried on evenly during the year and wages and overheads accrue similarly. Prepare a statement showing working capital requirement using Cash Cost Approach adding 10% for contingencies. Solution: Statement of Working Capital Requirement Current Assets (A) Amount (Rs.) Cash Balance Inventories Raw Materials( X 60 X 2) / Work in Progress( X 84 X 3) / Finished Goods( X 108 X 4) / Debtors Current Liabilities (B) Creditors of Raw Materials( X 60 X 1)/ Creditors of Wages( X 36 X 1)/ Creditors of Overheads( X 12 X 3)/ Net Working Capital (C =A-B) Add: Contingencies Working Capital Requirement Note : One Year 12 mths /52 weeks Cost of Production ( ) Rs. 108 Cost of WIP(60+0.5*36+0.5*12) Rs. 84 Numerical 5: A Ltd. provides the following data: Annual Budgeted Production Element of Cost Raw Material Labour Overheads Selling Price 72,000 Units Rs. 52 per unit Rs per unit Rs. 39 per unit Rs. 130 per unit Raw material is in stock, on average for 30 days. Materials are in process, on average for 15 days. Finished goods are in stock, on average for 30 days. Credit allowed by suppliers University of Delhi 19

20 of raw material is 30 days. Credit allowed to customers is 60 days. Lag in payment of wages 10 days. Lag in payment of overheads is 30 days. It is necessary to hold in cash of Rs. 1,20,000. It may be noted that production is carried on evenly during the year and wages and overheads accrue similarly. One-fourth of sales is on cash basis. Assuming there are 360 days in a year. Prepare a statement showing working capital requirement using Total Cost Approach. Solution 5: Statement of Working Capital Requirement Current Assets (A) Amount(Rs.) Cash Balance Inventories Raw Materials (72000 X52 X 30) / Work in Progress (72000 X81.25 X 15) / Finished Goods (72000 X X 30) / Debtors (72000 X 130 X 60 X 0.75) / Current Liabilities (B) Creditors of Raw Materials (72000 X 52 X 30) / Creditors of Wages (72000 X X 10) / Creditors of Overheads (72000 X 39 X 30) / Net Working Capital Requirement (C =A-B) Note : One Year 360 days Cost of Production ( ) Rs Cost of WIP (52+0.5* *39) Rs Cost of Sales ( ) Rs Selling Price Rs. 130 Numerical 6: A company has prepared its annual budget, relevant details of which are reproduced below: Sales Rs. 46,80,000 25% cash and balance on credit Raw material cost Labour cost Variable overheads Fixed overheads Budgeted Stock Levels Raw materials Work-in-progress : 78,000 units : 60% of sales value : Rs. 6 per unit : Rs. 1 per unit : Rs. 5,00,000 (including Rs. 1,10,000 as depreciation) : 3 weeks : 1 week University of Delhi 20

21 Finished goods Debtors are allowed credit for Creditors allowed Lag in payment of wages Lag in payment of overheads : 2 weeks : 4 weeks : 4 weeks : 2 weeks : 2 weeks Cash in hand required : Rs. 50,000 Prepare a statement showing working capital requirement using Cash Cost Approach. Solution 6: Statement of Working Capital Requirement Current Assets (A) Amount (Rs.) Cash Balance Inventories Raw Materials (78000 X 36 X 3) / Work in Progress (78000 X 42 X 1) / Finished Goods (78000 X 48 X 2) / Debtors (78000 X 48 X 4 X 0.75) / Current Liabilities (B) Creditors of Raw Materials (78000 X 36 X 4) / Creditors of Wages (78000 X 6 X 2) / Creditors of Overheads (78000 X 6 X 2) / Net Working Capital Requirement (C =A-B) Note : One Year 52 weeks Sale Price per unit (46,80,000 / 78,000) Rs. 60 Raw Material cost per unit (60% of Rs. 60) Rs. 36 Fixed Overheads ( 5,00,000-1,10,000 =3,90,000 / 78,000) Rs. 5 Cost of Production ( ) Rs. 48 Cost of WIP(36+0.5*6+0.5*6) Rs. 42 Cost of Sales(48 + 0) Rs. 48 Numerical 7: Using the following data, calculate working capital cycle for A Ltd. (Rs. in,000) Average Raw Material 190 Average Work in Progress 170 Average Finished Stock 360 Average Debtors 700 University of Delhi 21

22 Average Creditors 150 Total Raw Material 1200 Total Cost of Production 4200 Total Credit Sales 6000 Total Credit Purchases 1200 (Assuming 365 days in a year) Solution 7: Calculation of Net Operating Cycle RMCP = [Average Raw Material/Total Raw Material]*365= 58 days WIPCP = [Average WIP/Total Cost of Production]*365 = 15 days FGCP = [Average Stock/Total Cost of Production]*365 = 31 days RP = [Average Debtors/Total Credit Sales]*365 = 43 days DP = [Average Creditors/Total Credit Purchases]*365 = 46 days Net Operating Cycle (NOC) = RMCP+WIPCP+FGCP+RP - DP = 101 days Numerical 8: Using the following data, calculate working capital cycle for A Ltd. (Rs. in,000) Average Raw Material 3000 Average Work in Progress 2800 Average Finished Stock 8000 Average Debtors Average Creditors 600 Total Raw Material Total Cost of Production Total Credit Sales Total Credit Purchases (Assuming 360 days in a year) Solution 8: Calculation of Net Operating Cycle RMCP = [Average Raw Material/Total Raw Material]*360 WIPCP = [Average WIP/Total Cost of Production]*360 FGCP = [Average Stock/Total Cost of Production]*360 RP = [Average Debtors/Total Credit Sales]*360 DP = [Average Creditors/Total Credit Purchases]*360 NOC = Net Operating Cycle 45 days 11 days 32 days 24 days 7days 105 days University of Delhi 22

23 Summary: Value Addition 7: Quiz Working Capital Management Visit the link below to take a quiz on the concept of working capital management. Source: 10-questions-quiz/ A business enterprise ought to retain a comprehensive and ample working capital situation to run its business operations. The amount of working capital should neither be excessive nor inadequate. Working capital management is concerned with short term financial decisions. A proficient working capital management is indispensable to sustain a balance of liquidity and profitability. In accountancy, working capital generally refers to net working capital, which is difference between current assets and current liabilities. In finance, working capital usually refers to gross working capital which means a firm s investment in total current assets. The amount of current liabilities is not deducted from the total of current assets. This concept is advocated because the management is more concerned with the total current assets as they constitute the total funds available for day- to- day operating purposes than with the sources from which the funds have come. Considering the time or need as the basis of classification, working capital can also be classified into permanent working capital and Temporary / fluctuating working capital. These represent base levels of inventories, receivables, etc., that will always be in hand to carry on the business. Temporary or fluctuating working capital is reliant on the variations in production and sales. Temporary working capital is shaped to meet liquidity necessities that are of a purely ephemeral nature. Management of working capital undertakes paramount significance due to the fact that the working capital decisions have a direct impact on companies risks and returns and in-turn on its share prices. There are three basic approaches to determine an appropriate financing mix : Hedging approach, also called the Matching approach Conservative approach Aggressive approach The factors involved to gauge the quantum of total working capital requirements are: Nature of business, Operating Cycle, Business cycle, Credit policy relating to sales and purchases, Market Standing and goodwill, Market conditions and Inflationary conditions. Glossary: Contribution: It is a difference between Sale Price and Variable Cost. P/V Ratio: Profit Volume Ratio = (Contribution per unit / Sale Price per unit) X 100. Variable Cost Ratio: = (Variable Cost per unit / Sale Price per unit) X 100. Lag in Payment: Delay in payment. University of Delhi 23

24 Exercises: A. Objective Type Questions 1. Fill in the blanks Working Capital Management i. Gross working capital refers to company investment in. ii. Net working capital refers to excess of current assets over. iii. iv. Management of working capital implies trade-off between. Operating cycle is a technique of management. v. Permanent working capital includes minimum level of. [Ans. (i) current assets, (ii) current liabilities,(iii) liquidity and profitability, (iv)working capital, (v) current assets ] 2. State True or False i. Working capital management refers to the management of all assets. ii. iii. iv. Management of working capital deals with short-term liquidity. Operating cycle is the duration of time taken to convert cash into cash. Net operating cycle is equal to TOCP - DP. v. Reducing credit period to debtors will increase working capital needs of a company. vi. vii. Liquidity and profitability are directly related. Hedging approach of financing working capital uses higher long-term funds. [Ans. (i) F,(ii) T,(iii) T,(iv) T,(v) F,(vi) F (vii) T ] B. Short Answer Type Questions: 1. What do you mean by gross and net concept of working capital? 2. Explain operating and cash cycle. 3. Differentiate the working capital requirement based on cash cost basis and total cost basis. 4. How the value of work-in-progress can be estimated? 5. Write a note on Aggressive Approach of working capital. C. Long Answer Type Questions: 1. What do you mean by working capital management? What are the elements of working capital management? 2. Define working capital. Differentiate between permanent and temporary working capital. 3. Discuss the various sources of working capital finance. 4. What do you mean by inadequate working capital? What are its consequences? 5. Explain the factors considered while determining the need for working capital. 6. Differentiate between Conservative Approach and Hedging Approach of working capital. University of Delhi 24

25 D. Numerical Questions: Question 1: From the following information, prepare a statement showing working capital requirement using Cash Cost Approach adding 10% for contingencies: Budgeted Production Element of Cost Raw Material Labour Overheads Total Cost Profit Selling Price Time Lag Raw Material holding Period WIP holding Period Finish Goods holding Period Average Collection Period Average Payment Period Lag in Payment of Wages Units per annum Rs. 100 per unit Rs. 30 per unit Rs. 50 per unit Rs. 180 per unit Rs. 70 per unit Rs. 250 per unit 3 Weeks 2 Weeks 4 Weeks 6 Weeks 5 Weeks 2 Weeks It may be noted that production is carried on evenly during the year and wages and overheads accrue similarly. Expected cash in hand Rs. 2,50,000. You may state your assumptions, if any. (Ans. Rs. 2,02,95,000) Question 2: A Ltd. provides the following budget figure for the next year: Budgeted Production Element of Cost 39,000 Units per annum Raw Material Rs.120 per unit Labour Rs. 60 per unit Overheads(Including Depreciation Rs.10 per unit) Rs. 50 per unit Total Cost Rs.230 per unit Profit Rs. 70 per unit Selling Price Rs.300 per unit Raw material in stock, on average 4 weeks. Material are in process, on average 2 weeks. Finished goods are in stock, on average 4 weeks. Credit allowed by suppliers of raw material is 4 weeks. Credit allowed to customers is 8 weeks. Lag in payment of wages one and half week. Lag in payment of overheads is 1 week. It is necessary to hold in cash of Rs. 50,000. It may be noted that production is carried on evenly during the year and wages and overheads accrue similarly. Prepare a statement showing working capital requirement using Cash Cost Approach adding 10% for contingencies. (Ans. Rs. 24,06,250) University of Delhi 25

26 Question 3: A Ltd. provides the following budget figure for the next year: Budgeted Production 3,90,000 Units per annum Element of Cost Raw Material Rs. 80 per unit Labour Rs. 40 per unit Overheads Rs. 30 per unit Total Cost Rs. 150 per unit Selling Expenses Rs. 5 per unit Cost of Sales Rs. 155 per unit Profit Rs. 25 per unit Selling Price Rs. 180 per unit Raw material in stock, on average 4 weeks. Material are in process, on average 2 weeks. Finished goods are in stock, on average 4 weeks. Credit allowed by suppliers of raw material is 4 weeks. Credit allowed to customers is 8 weeks. Lag in payment of wages one and half week. Lag in payment of overheads is 1 week. It is necessary to hold in cash of Rs. 50,000. It may be noted that production is carried on evenly during the year and wages and overheads accrue similarly. Prepare a statement showing working capital requirement using Cash Cost Approach adding 5% for contingencies. (Ans. Rs. 1.56,45,000) Question 4: A Ltd. provides the following budget figure for the next year: Budgeted Production 15,000 Units per month Element of Cost Raw Material Labour Overheads 50% of selling price 30% of selling price 10% of selling price Selling Price Rs. 200 per unit Raw material in stock, on average 2 months. Material are in process, on average 3 months. Finished goods are in stock, on average 4 months. Credit allowed by suppliers of raw material is 1 month. Credit allowed to customers is 2 month. Lag in payment of wages 1 month. Lag in payment of overheads is 3 week. It is necessary to hold in cash of Rs. 75,000. It may be noted that production is carried on evenly during the year and wages and overheads accrue similarly. Prepare a statement showing working capital requirement using Cash Cost Approach adding 10% for contingencies. (Ans. Rs. 2,52.45,000) University of Delhi 26

27 Question 5: A Ltd. provides the following data: Annual Budgeted Production 1,08,000 Units Element of Cost Raw Material Rs. 26 per unit Labour Rs per unit Overheads Rs per unit Selling Price Rs. 150 per unit Raw material in stock, on average 30 days. Material are in process, on average 15 days. Finished goods are in stock, on average 30 days. Credit allowed by suppliers of raw material is 30 days. Credit allowed to customers is 60 days. Lag in payment of wages 21 days. Lag in payment of overheads is 30 days. It is necessary to hold in cash of Rs. 1,20,000. It may be noted that production is carried on evenly during the year and wages and overheads accrue similarly. One-fourth of sales on cash basis. Assuming 360 days in a year. Prepare a statement showing working capital requirement using Total Cost Approach. (Ans. Rs. 28,50,600) Question 6: A company has prepared its annual budget, relevant details of which are reproduced below: Sales Rs. 1,09,20,000 25% cash and balance on credit Raw material cost Labour cost Variable overheads Fixed overheads Budgeted stock levels Raw materials Work-in-progress Finished goods Debtors are allowed credit for Creditors allowed Lag in payment of wages Lag in payment of overheads : 1,56,000 units :40% of sales value :Rs. 10 per unit :Rs. 5 per unit :Rs. 5,00,000 (including Rs. 32,000 as depreciation) : 3 weeks : 1 week : 2 weeks : 4 weeks : 4 weeks : 2 weeks : 2 weeks Cash in hand required : Rs. 50,000 Prepare a statement showing working capital requirement using Cash Cost Approach. (Ans. Rs. 6.59,000) University of Delhi 27

28 Question 7: Using the following data, calculate working capital cycle for A Ltd. (Rs. in,000) Average Raw Material 300 Average Work in Progress 240 Average Finished Stock 400 Average Debtors 900 Average Creditors 250 Total Raw Material 1500 Total Cost of Production 5600 Total Credit Sales 7000 Total Credit Purchases 1800 (Assuming 365 days in a year) (Ans. 111 days) Question 8: Using the following data, calculate working capital cycle for A Ltd. (Rs. in,000) Average Raw Material 2000 Average Work in Progress 3000 Average Finished Stock 7000 Average Debtors Average Creditors 6600 Total Raw Material Total Cost of Production Total Credit Sales Total Credit Purchases (Assuming 360 days in a year) (Ans. 96 days) University of Delhi 28

29 References: Working Capital Management 1. Work Cited and Suggested Readings: Khan, M.Y., & Jain, P.K. (2011). Financial Management Text, Problems and Cases (6thed.):TMH Chandra, Prasanna(2008). Financial Management- Theory and Practice (7thed.): TMH Pandey, I.M.,(2010) Financial Management, Vikas Publications Van Horne, James C., John Wachowicz, Fundamentals of Financial Management, Pearson Education. Ross, Stephen A., Westerfield, Randolph and Jeffery Jaffe, Corporate Finance, TMH. Srivastava, Rajiv, and Anil Mishra, Financial Management, Oxford University Press, UK. Singh,Preeti, Financial Management, Ane Books Pvt. Ltd. Brealey, Richard a., &Stewart C.Myers, Corporate Finance, Capital Investment and Valuation, McGraw Hill. 2. Web Links: Visit the URL to gain an insight into the strategies of working capital management. 3. Video Links: Visit the URL to watch the video to understand the concept of operating cycle in financial management. University of Delhi 29