Management of working capital.

1. Management of working capital. • Capital required for a business can be classified under two main categories viz, • (i) Fixed capital and • (ii) Working capital. • Investment in permanent assets, like plant& machinery, building etc. is called fixed capital. • Working capital refers to that part of the firm’s capital which is required for financing short term or current assets such as cash, marketable securities, debtors and inventories.

2. Concept of working capital. • There are two concepts of working capital. • (A) Balance sheet concept. • (B) Operating cycle or circular flow concept. • Balance sheet concept. • (i)Gross working capital -----represents the amount of funds invested in current assets. • Net working capital -----current assets minus current liabilities.

3. Types of working capital: • Permanent working capital. • Temporary or variable working capital. • (i) Permanent working capital represents current assets required on a continuous basis over the entire year. A manufacturing enterprise has to carry irreducible minimum amount of inventories necessary to ensure uninterrupted production and sales. Likewise, some amount of funds remain tied in receivables when the firm sells goods on credit terms. • Some amount of cash has also to be held by the firm so as to exploit business opportunities, meet operational requirements and to provide insurance against business fluctuations.

4. Cont- • Thus, minimum amount of current assets which the firm has to hold for all time to come to carry an operation at any time is termed as permanent working capital. • This type of working capital referred as “core current assets”. • The amount of working capital varies from year to year, depending upon the growth of a company and the stage of the business cycle in which it operates.

5. Characteristics of Permanent working capital. • It is classified on the basis of the time factor. • It constantly changes from one assets to another and continues to remain in the business process. • Its size increase with the growth of business operations.

6. Temporary or variable working capital. • It represents the additional assets which are required at different times during the operating year, additional inventory , extra cash, etc. seasonal working capital is the additional amount of current assets, particularly cash, receivables and inventory which is required during the more active business seasons of the year. • Characteristics :- • It is not always gainfully employed, though it may change from one asset to another. • It is particularly suited to business of a seasonal nature.

7. Working capital cycle. • The duration of time required to complete the following cycle of events in case of a manufacturing firm is called the operating cycle. • (i) conversion of cash into raw material. • (ii) ------------------raw material into w-i-p. • (iii)----------------w-i-p into finished goods. • (iv) ----------------finished goods into debtors & B/R through sales. • (v) --------------debtors and B/R into cash.

8. Cont- • In the case of a ‘Trading firm’, the operating cycle will include the length of time required to convert : • (i) cash into inventories. • (ii) Inventories into accounts receivable. • (iii) Accounts receivable into cash. • In the case of service and financial firms the operating cycle includes the length of time taken for: • (i) Conversion of cash into debtors and • (ii) Conversion of debtors into cash.

9. Management of working capital. • Working capital management is concerned with the problems that arise in attempting to manage the current assets, the current liabilities and the inter-relationship that exist between them. • The basic objective of working capital management is to manage the firm’s current assets and current liabilities in such a way that a satisfactory level of working capital is maintained i.e, it is neither inadequate nor excessive.

10. Cont- • In order to achieve this objective the Finance Manager has to perform basically following two functions: • 1-Estimating the amount of working capital. • 2-Sources from which these funds have to be raised.

11. Factors determining working capital requirement. • Internal factors: • 1-Nature of business. • 2- Size of business. • 3- Firm’s production policy. • 4-Firm’s credit policy. • 5-Access to money market. • 6- Growth and expansion of business. • 7-Profit margin & dividend policy. • 8-Depriciation policy. • 9-Operating efficiency of firm. • 10-Co-ordination of activities in firm.

12. Cont- • External factors: • 1-Business fluctuations. • 2-Technological developments. • 3-Import policy. • 4- Taxation policy. • 5-Trasport and communication policy.

13. Sources of working capital. • Long –term working capital: • 1-Shares. • 2-Debentures. • 3-Publice deposits. • 4-Ploughing back of profits. • 5-Loan from financial Institutions. • Short- term working capital: • 1-Indigenous bankers.2-Trade credit 3-Instalment credit, 4-Advances 5- Accounts payable.6-Accrued expenses,7- Deferred Incomes.8-commercial papers 9- commercial banks etc.

14. Methods of estimating working capital requirements. • Main methods: • (i) Operating cycle method • (ii) Projected Balance sheet method. • Operating cycle method- • Working capital requirement=cost of goods sold* operating cycle (days)/365 or360+Desired cash balance.

15. Question. • Details of X ltd. For the year 2009-10 are given as under: • Cost of goods sold Rs 48,00,000 • Operating cycle 60 days • Minimum desired level of cash balance Rs 75,000.

16. Estimation of the amount of different component of working capital. • Inventories: • (i) stock of raw material • budgeted annual units of production*estimated cost of raw material per unit* average holding period in days or month/ no of days or months in a year. • (ii) stock of w.i.p • Budgeted annual units of production*estimated WIP cost per unit* average WIP holding period in days or months/ no of days or months in a year. • (iii) stock of finished goods. • Budgeted annual units of production * estimated cost of production per unit* average holding period in days or months/ no of days or months in a year.

17. Cont- • (iv)Investment in debtors or receivable: • Budgeted units of credit sales* cost of sales per unit* average collection period of receivable in days or months/ no of days or months in a year. • (v) Cash and bank balance • (vi) Prepaid expenses • (vii) Trade creditors. • Budgeted annual units of production* estimated raw material cost per unit* average payment period of creditors in days or months/ no of days or months in a year. • (viii) Creditors for wages and other expenses. • Budgeted annual units of production* estimated labour or overhead cost per unit*average time lag in payment of wages& overhead in days or months/ no of days or months in a year. • (ix) Advanced received.

18. For trading concern : proforma • Statement or working capital requirements. • Current assets: Amount (Rs) • (I) cash • (ii) Debtors • (iii) Stocks • (iv) Advance payments if any • Less : current liablities: • (i) creditors • (ii) Lag in payment of expenses • Working capital(CA-CL) ------------- • Add : provision for contingencies ……………… • Net working capital required ---------------

19. For a manufacturing concern, proforma. • Statement of working capital requirements • Amount(Rs) • Current assets: • (i) Stock of raw material • (ii) Work in progress. • (iii) Stock of finished goods. • (iv) Sundry debtors. • (v) Payment in advance,if any. • (vi) Balance of cash • Less : Current Liabilities: • (i) Creditors • (ii) Lag in payment of expenses. • (iii) Others if any. • Working capital (CA-CL) • Add: provision for contingencies • Net working capital required. ……………………………

20. Approaches to estimation of working capital requirements. • (a) Total approach. • Under this approach, all cost including depreciation and profit margin are included. • Production overhead inclusive of depreciation is considered for calculation of the cost of w.i.p. • In the same manner, cost of goods produced includes depreciation . • Further, the computation of funds invested in debtors is done on the basis of selling price including profit margin.

21. Cont- • (b) Cash cost approach. • Under this approach, the amount of working capital is estimated on the basis of only cash cost incurred. • Depreciation being non-cash is excluded while calculating the cost of w.i.p, cost of goods produced and cost of goods sold. • And debtors are computed on the basis of cash cost of sales excluding profit margin.

22. Question. • Prepare an estimate of working capital requirement from the following information of a trading concern. • (a) Projected annual sales 1,00,000 units. • (b) Selling price Rs.8/-unit • (c ) % of grossprofit on sales 25% • (d) average credit period allowed to customers 8 weeks. • (e) average credit period allowed by suppliers 4 weeks. • (f) average stock holding in terms of sales requirement 12 weeks. • (g) Allow 10% for contingencies.

23. Question. • ABC Ltd. Sells its products on a gross profit of 20% on sales. The following information is extracted from its annual accounts for the year ended 31st March 2010: • Sales (3 months credit) Rs.40,00,000 • Raw materials 12,00,000 • Wages (15 days in arrears) 9,60,000 • Manuf,exp.(1 month in arrears) 12,00,000 • Admin,exp.(1 month in arrears) 4,80,000 • Sales prom.exp(payable half-yearly • In advance) 2,00,000

24. Cont- • The company enjoys one month’s credit from suppliers of raw material and maintains 2 months stock of raw materials and one and half months finished goods. • Cash balance is maintained at Rs 1,00,000 as a precautionary balance. • Assuming a 10% margin, • Find out the working capital requirements of ABC Ltd. Cost of sales for computation of debtors and stock of finished goods may be taken at sales minus gross profit as per rate of gross profit given.

25. Question. • A proforma cost sheet of a company provides the following particulars: • Elements of cost: • material 40% • Direct labour 20% • Overheads 20% • The following further particulars are available: • (a) It is proposed to maintain a level of activity of 2,00,000 units. • (b) Selling price is Rs. 12/-per unit. • (c ) Raw materials are expected to remain in stores for an average period of one month.

26. Cont- • (d) Material will be in process, on average half a month and is assumed to be consisting of 100% raw material, 50 % wages and overheads. • (e) Finished goods are required to be in stock for an average period of one month. • (f) Credit period allowed to debtors is two months. • (g) Credit period allowed by suppliers is one month. • You may assume that sales and production follow a consistent pattern. • You are required to prepare a statement of working capital requirements ,a forecast profit & loss account and Balance sheet of the company

27. Cont- • Assuming that- • Share capital Rs 15,00,000 • 8% Debentures 2,00,000 • Fixed assets 13,00,000.

28. Question. • Raju Brothers Pvt, Ltd. Sells goods on a gross profit of 25%. Depreciation is taken into account as a part of cost of production. The following are the annual figures given to you: • Sales (2 months’ credit) Rs.18,00,000 • Material consumed(1month credit) 4,50,000 • Wages (1month lag in payment) 3,60,000 • Cash manfg exp.(1month lag in • Payment) 4,80,000 • Admin.exp.(1month lag in payment) 1,20,000 • Sales prom.(paid quarterly in advance) 60,000 • Income tax payable in 4 installments of which One lies in next year 1,50,000.

29. Cont- • The company keeps one month’s stock each of raw material and finished goods. It also keeps Rs 1,00,000 in cash. • You are required to estimate the working capital requirements of the company on cash cost basis assuming 15% safety margin. Ignore work-in- progress.

30. Question. • A proforma cost sheet of a manufacturing company provides the following particulars: • Elements of cost Rs (per unit) • Raw material 8 • Direct labour 3 • Overheads (excluding dep.) 6 • The following further particulars are available: • Selling price Rs 20 • Level of activity 1,04,000 units of output per annum.

31. Cont- • Raw material in stock on an average 4 weeks • Processing time 2 weeks • Finished goods in store 4 weeks • Credit period: • (a) Customers 8 weeks • (b) Suppliers of materials 4 weeks • Lag in payment: • (a) Wages 1- 1/2weeks • (b) Overhead exp. 2 weeks • 75% of the out put is sold on credit basis. Cash on hand and at bank is expected to be Rs 5,000.

32. Cont- • You are required to prepare a statement in columnar form showing the working capital requirements (a) in total and (b) as regards each constituent part of the same to finance a level of activity of 1,04,000 units of production per annum. • You may assume that all wages and overheads accrue evenly and are completely introduced for half the processing time i,e, 1 week.

33. Financing of working capital by Banks. • To regulate and control bank finance, the Reserve bank of India has been issuing directives and guidelines to the banks from time to time on the recommendation of certain specially constituted committees entrusted with the task of examining various aspects of bank finance to industry. There are important findings and recommendations of the certain committees.

34. Cont- • Committees are follows: • (i) Dehejia committee • (ii) Tandon committee • (iii) Chore committee • (iv) Marathe committee • (v) Charkravarty committee • (vi) Kannan committee report.

35. Banks follows normally the recommendation of Tandon Committee. • Tanon committee: • The committee was the opinion that: • (i) Bank credit is extended on the amount of security available and not according to the level of operations of the customer, • (ii) Bank credit instead of being taken as a supplementary to other sources of finance is treated as the first source of finance.

36. Cont- • The recommendations of the committee regarding lending norms have been suggested under three alternatives. • According to the first method, the borrower will have to contribute a minimum of 25% of the working capital gap from long-term funds i,e. owned funds and term borrowing, this will give a minimum current ratio of 1.17: 1 . • Under the second method the borrower will have to provide a minimum of 25% of the total current assets from long-term funds, this will give a minimum current ratio of 1.33: 1. • In the third method, the borrower’s contribution from long-term funds will be to the extent of the entire core current assets and a minimum of 25% of the balance current assets.

37. Question. • Total current assets required Rs 40,000 • Current liabilities other than bank borrowings • Rs 10,000 • Core current assets Rs 5,000

38. Solution • 1st method • Total current assets required Rs 40,000 • Less : current liabilities Rs 10,000 • Working capital gap 30,000 • Less 25%from long term sources 7,500 • Maximum permissible bank • borrowings 22,500

39. Cont- • 2nd method • Current assets required Rs 40,000 • Less :25% to be provided • from long term funds Rs 10,000 • 30,000 • Less : current liabilities 10,000 • MPBB 20,000

40. Cont- • 3rd method • Current assets Rs 40,000 • Less : core current assets 5,000 • Less :25% to be provided from 35,000 • long term funds 8,750 • 26,250 • Less : current liabilities 10,000 • MPBB 16,250.