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Working Capital Management

It is concerned with the management of the problem of current assets and current liabilities and their interrelationship.

a. Current Assets (CA), are those which are converted into cash within the accounting period or within one year as a result of normal business operations. Example: Cash, Bank, Stock, B/R, Prepaid expenses, etc.

b. Current Liabilities (CL)are those liabilities which are to be paid in the ordinary course of business within one year, out of the current assets or out of the earnings of the company. Example: Creditors, B/P, Bank O/D, Outstanding expenses.

Gross Working Capital= Total Current Assets.

Net Working Capital= CA – CL.

Objectives of Current Assets Management:

1. To maintain the optimum level of CA and reduce the level of current liability. Thereby reducing funds locked up in Working Capital and ensure a healthy return on investment.

2. To ensure that they have a sufficient CA to meet CL.

Characteristics of Current Assets:

1. Short Life Span: It depends on the time taken for the activities the procurement, production, sales and collection.

2. There is a shift transformation for one asset form into another.

Implications of the Above Features:

i. Decisions regarding Working Capital are frequent and repetitive.ii. Time Value of Money is irrelevant in Working Capital Management decisions.

iii. The close interaction between working capital components implies that efficient management of one component cannot be undertaken without affecting another component. Example: to reduce accumulated stocks, the firm may have to offer liberal credit terms to debtors which resulted in increase in debtor balances.

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The Operating Cycle in Working Capital Management:

It begins with the acquisition of raw materials and ends with the collection of receivables.

It can be divided into 4 stages:

1. Raw Materials Storage Period.2. WIP Stage.3. Finished Goods Period.4. Debtors Collection Period.

The duration of the working capital= The Sum of the duration of each of these four stages – Credit period allowed by creditors.

Operating Cycle= RM + WIP + FG + Debtors - Creditors.

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Calculations:

1. Raw Materials Storage Period:

= Average Stock of raw materials

Raw Material Consumed per day

Average Stock of Raw Materials:

= opening stock of raw material + closing stock of raw material

2

Raw Materials consumed per day:

= opening stock of RM+ Purchases – Closing Stock of RM

Number of days in a year (360 days)

2. Work in Progress Stage:

= Average Stock of WIP

Cost of production per day

Average Stock of WIP:

= Opening WIP + Closing WIP

2

Average Cost of Production per Day:

= Opening WIP + Materials Consumed + Labor+ Manufacturing expenses – Closing WIP


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3. Finished Goods Stage:

= Average Stock of Finished Goods

Cost of goods sold per day

Average Stock of Finished Goods:

= Opening Finished Goods + Closing Finished Goods

2

Average Cost of Goods Sold Per Day:

= Opening FG + Cost of Goods produced in the year+ Admin and Selling expenses – Closing FG


4. Debtors Collection Period:

= Average Debtors

Credit sales per day

5. Creditors Payment Period:

= Average Creditors

Credit Purchases per day

1. From the following data calculate the Operating Cycle in days: Rs.

Average Debtors 4, 80,000Raw Materials Consumed 44, 00,000Total Production Cost 100, 00,000Total Cost of Sales 105, 00,000Sales 160, 00,000Average stock of RM 3, 20,000Average Stock of WIP 3, 50,000

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Average Stock of Finished Goods 2, 60,000Creditors Payment Period 16 days.

Solution:



Raw Materials consumed per day

= 3,20,000

44,00,000

365

= 3,20,00012055

= 27 days2. WIP Stage:


Cost of Production per day

= 3,50,000

100,00,000

365

= 3,50,00027397

= 13 days

3. Finished Stock Stage:


Cost of Goods Sold per day

= 2,60,000

105,00,000

365

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= 2,60,00028,767

= 9 daysDebtors Collection Period:

= Average Debtors


= 4,80,000

160,00,000

365

= 4,80,00043836

= 11 days

Operating Cycle= RM + WIP + FG + Debtors - Creditors.

= 27 + 13 + 9 + 11 – 16 = 44 days.

Operating Cycle = 44 days.

Particulars 1.1.99 31.12.99Stock of Raw Materials 200 210Stock of WIP 45 40Stock of Finished Goods 190 220Debtors 275 300Creditors 190 200

Raw Material Purchased 610Manufacturing expenses 290Depreciation of Factory 45Excise Duty 105Administration and selling expenses 160Sales 1500Assume the year to have 360 days. Calculate Operating Cycle in days.

Solution:

Avg. Stock of Raw Materials: Opening Stock + Closing Stock

2

7

= 200+210

2

= 205

Avg. Stock of WIP: 45+40

2

=42.5

Avg. Stock of Finished Goods: 190+220

2

=205

Avg. Debtors: 275 + 300

2

=287.5

Avg. Creditors: 190+200

2

= 195

Raw Materials consumed per day:

= opening stock of RM+ Purchases – Closing Stock of RM

Number of days in a year(360 days)

= 200 + 310 - 210

360

Average Cost of Production per Day:

= Opening WIP + Materials Consumed + Labor+ Manufacturing expenses – Closing WIP


= 45 + 290 + 45 + 600 - 40

360

8

= 940

360

= 2.61

Average Cost of Goods Sold Per Day:

= Opening FG + Cost of Goods produced in the year+ Admin and Selling expenses – Closing FG


= 190 + 940 + 160 + 105 – 220

360

= 940

360

= 3.26

Credit Sales per day = Sales

360

= 1500

360

= 4.17

Credit Purchases per day = Sales

360

= 610

360

= 1.69



Raw Material Consumed per day

= 205

1.69

9

= 123 days

Work in Progress Stage:


Cost of production per day

= 42.5

2.61

= 16 days

Finished Goods Stage:


Cost of goods sold per day

= 205

3.26

= 63 days

Debtors Collection Period:

= Average Debtors


= 287.5

4.17

= 69 days

Creditors Payment Period:

= Average Creditors

Credit Purchases per day

= 195

1.69

= 115 days.

Operating Cycle = 123+16+63+69-115 = 156 days.

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Factor Affecting Working Capital

1. Nature of Business (Current Assets to Total Assets):a. Public Utilities: These have a low level of working capital. Mostly cash sales of services, not

products. More Fixed assets that Current Assets.b. Trading Concern: High Current Assets.c. Manufacturing Concerns: The WC requirements will fall between the above two

possibilities. There will be variances from industry to industry.d. Construction Companies: These will have high WC.

2. Production Cycle:The time lag between the procurement of raw materials and production of finished goods. The longer the time span the larger WC requirement (eg. Ship building) and vice versa (eg. Bakery).Even within the same industry the production cycle may vary depending on the manufacturing techniques. The Companies manufacturing heavy industries minimize the WC by requiring advance payment by customers against the order.

3. Business Cycle:In boom conditions, business activity expand require more of cash, stock, debtors, etc, i.e, increasing demand. During recession the opposite effect will go into effect.

4. Production Cycle:Firms whose products enjoy seasonal demand will follow any one of the production policy:

a. Production only during the season: Here the operations will be in full capacity to meet demand during the season. During the slack season, the company has to pay the workforce and fixed expenses, even though there is not production. This is an expensive and inconvenient.

b. Adapt a steady production policy throughout the year. This will lead to stock accumulation during the off season and their abrupt sale during the peak period.

c. Produce the main product during the demand season and switch over to other products during off season if possible.

5. Credit Policy:It is the credit terms given to debtors and as well as credit terms received from suppliers liberal credit terms will increase the debtors and hence also the working capital. Where there are liberal credit terms from suppliers reduce the working capital and increase creditors. The credit terms are affected by the trade practices and economic condition. If the competition is acute the company shall abide by competitors.

6. Growth and Expansion:Growth and expansion need more working capital. However, the need for working capital will procede expansion. Hence, growing firms will have to continuously plan their working capital needs in advance.

7. Supply Situation of Raw Materials:

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The longer the time for procurement, the longer the inventories and vice versa. Where sources of supplies are few, irregular contract or season, the company has to sustain more production shall compel the purchase of stock, far in excess of current needs.

8. Profit Level:Net profit is the source of working Capital to the extent that profit is eared in cash. Higher profit margins would reduce the Working Capital needs. The profit margin alone isn’t enough, the appropriation out of profit must also be considered.

9. Price Level Changes:Raising prices necessitate more funds for maintaining an existing level of activity. During periods of inflation to maintain the same level of rate (CA), higher cash outlay is required. If however, the company has increased the prices proportionately. There will be no serious working capital problems.

10. Operating Efficiency:By ensuring the efficient utilization of resources, elimination of wastages and improve co-ordination, the working capital requirements can be reduced.

Working Capital Policy

The two important issues are:

a. What should be the ratio of working capital to sales?b. What should be the ratio of short term finance of current assets to long term finance of

current assets?

There are 3 policies namely,

a. Aggressive credit policy;b. Moderate credit policy;c. Conservative/ Liberal credit policy;

Conservative/ Liberal credit policy

Moderate credit policy

Current

Assets Aggressive credit policy

Sales

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Rate of CA to Sales:

There is a relationship between sales growth and current assets. The target sales level can be achieved only if supported by adequate current assets. However, where sales cannot be forecast accurately, the requirement of current assets also cannot be forecast with certainty. In such a situation the firm must maintain the minimum level of CA needed to meet normal sales and provide for some more CA to meet some unusual sales demand. This extra CA to be maintained will be determined by the Working Capital policy.

a. Conservative/ Liberal Credit Policy: It implies that for every increase in sales the increase in Working Capital would be more than proportionately. This policy reduces risk (no sales are lost due to want of stock). But increases the investment in CA thereby reducing profitability.

b. Aggressive Working Capital Policy: It implies the increase in sales does not result in a proportionate decrease in Current Assets. It exposes the firm to the risk of loss of sales due to unavailability of stockbut increases the profitability, by saving on the interest rate due to lesser investment in CA stock.

c. Moderate Credit policy: It implies that an increase in sales is matched by a proportionate increase in Current assets.

Financing Working Capital

There are two types of Working Capital:

i. Permanent Working Capital;ii. Temporary Working Capital(TWC).

Working Capital is required constantly and regularly. However, the magnitude of the W.C needed will not be the same for all times rather it will fluctuate. Thus the W.C. needs are split into:

i. Permanent Working Capital: A minimum level of Current Assets which are held irrespective of the level of activity.

ii. Temporary Working Capital: This is additional working capital required to meet the fluctuations in sales activity.

A part of the Current assets are financed by current liabilities (spontaneous financing).

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For example when creditors offer good on credit the amount of Net working capital to be maintained reduces. There are both long and short term sources of credit, where short term sources are cheaper. There are different approaches to working capital:

1. Matching approach:

The length of finance should match the life of the asset. For example, if additional stocks of Rs. 5,00,000 are required during the peak season of 3 months, then only that much is borrowed and that much stock is maintained. After the peak season when the stocks are all sold the loan can be repaid. However long term loans cannot simply be repaid. This will cause over liquidity and lower profits. However, perfect matching is not always possible.

2. Conservative approach: Here the firm may use long term funds even to finance the Total Working Capital to avoid risks of insolvency. Use of Short term funds may be restricted to a small portion of Temporary working capital.

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In such cases where the funds available are higher than working capital needed, the excess funds should be invested in marketable securities to earn some income. This approach will prove more expensive due to the higher cost of long term vs. short term funds, but reduces the risk involved.

3. Aggressive approach:

Here the firm finances the enter TWC and a part of the PWC with Short term funds. This policy will prove cheaper since Short term funds are cheaper than long term funds. At the same time it exposes the firm to greater risk of insolvency if the short term funds are not repaid on time.

To conclude the actual working capital policy followed by the firm will depend upon management attitude towards risks. If they are risk averse they will adopt conservative approach and vice versa.

Problems:

1. The cost sheet of PQR Ltd provides the following data:

Raw Materials Rs.50 per Unit

Labor Rs.20 per Unit

OHS(including depreciation Rs. 10) Rs. 40 per Unit

Profit Rs. 20 per Unit

Selling price Rs. 130 per Unit

1. Raw material is in stock for 1 month.2. WIP for ½ month.3. Finished Goods for 1 month.

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4. Credit allowed by suppliers 1 month.5. Credit allowed to debtors 1 month.6. Average time lag in payment of wages 10 days and payment of OHS 30 days.7. 25% of the sales are for cash. The cash balance of Rs. 1,00,000 is to be maintained.

Ascertain the level of working capital needed to finance level of activity of 54000 units.Production is carried out evenly throughout the year and wages and OHS accrue evenly throughout the year.

Solution:

Estimated production per month= 54000 = 4500 units

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Total Cost Cash Cost

Materials= 4500 * 50 = 2,25,000 2,25,000

Labor = 4500 * 20 = 90,000 90,000

OHS = 4500 * 40 = 1,80,000 1,35,000

110per unit = 4,95,000 4,50,000

Statement of Working Capital requirement:

Particulars Total Cost Rs. Cash Cost Rs.Current AssetsRaw Materials (4500*50*1) 225000 225000Work in ProgressMaterials (4500*50*1* 0.5) 112500Labor (4500*20*1/2* 50/100) 22500OHS (4500*40*1/2*50/100)=45000 and 180000 - (4500*30*1/2*50/100)=33750 - 168750Finished Goods(4500*110*1)=495000 and 495000 - (4500*100*1)=450000 - 450000Debtors: 4500*[50+20+40+20(P)] 438750 - 4500*(110-10)*75/100*1 - 337500Cash 100000 100000Total Current Assets 1438750 1381250Less: Current LiabilitiesCreditors 4500*50*1 225000 225000Outstanding wages 4500*20*10/30 30000 30000Outstanding OHS 4500*40*1 180000 - 4500*30*1 - 135000

435000 3900001003750 891250

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Notes:

1.The total column represents items as they should appear on the Balance sheet.

2. The working capital should be ascertained by cash cost method because depreciation does not cause actual cash outflow.

3. While valuing WIP, material is taken at full value hut wages and OHS are taken at 50%. This based on assumption of uniform production and accrual.

2. A ltd. Produces 120000 units p.a. Its percentage of cost to selling price: Raw materials 60%, Wages 10%, and OHS 20%. Selling price Rs. 5 per unit.

Raw materials in stock for 2 months.

WIP in stock for 1 month.

Finished Goods in stock for 3 months.

Creditors allow 2 months credit and debtors get 3 months credit.

Wages and OHS are paid on the first of each month for the previous month.

Cash in hand Rs. 40000.

Calculate cash cost of Working capital.

Solution:

Production per month= 120000/12= 10000 units per month.

Sales= 10000* 5 = 50000

Raw materials= 50000*60%=30000

Wages= 50000*10%=5000

OHS= 50000*20%=10000

Cost of sales 90%=45000

Statement showing Working Capital Requirement

Particulars Amount Rs.Current AssetsRaw Material 10000*3*2 60000WIP Raw Material 10000*3*1 30000 Wages 10000*.5*1*50/100 2500

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OHS 10000*1*1*50/100 5000 37500Finished Goods 10000*4.5*3 135000Debtors 10000*4.5*3 135000Less: Current LiabilitiesCreditors 10000*3*2 60000Outstanding Wages 10000*.5*1 5000Outstanding OHS 10000*1*1 10000

75000Net Working Capital 332000

3.A Ltd is currently operating at 60% capacity and producing 36000 units p.a. In the next year it plans to produce 54000 units operate at 90% capacity. The present cost price structure per unit is: Raw materials Rs.4; Wages Rs. 2; Variable OHS Rs. 2; Fixed OHS Rupee 1 and selling price Rs.10.

i. Raw material will remain in storage in stores for 2 months.ii. WIP for 1 months

iii. Finished Goods for 2 months.iv. Debtors allowed credit for 2 months and creditors allowed 3 months credit.v. Lag in payment of wages and overheads= 1 month.

Ascertain the profit at 90% capacity level and the working capital necessary to sustain this production, assuming that the cash balance of 5% of the gross working capital is required. Calculate cash cost of working capital.

Solution:

Estimated production for next year= 36000*90/60= 54000 units p.a

Production p.m= 54000/12=4500 units.

Ascertainment of Cash profit at 90% capacity:

Sales 54000*10 540000

Less:Variable Cost (4+2+2)*54000 432000

Contribution= 108000

Less: Fixed Expenses 36000*1 36000

72000

Statement Showing Working requirement:

Particulars Amount Rs.Current Assets

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Raw Material 4500*4*2 36000WIP Raw Material 4500*4*1 18000 Wages 4500*2*1*50/100 4500 VariableOHS 4500*2*1*50/100 4500 Fixed OHS 36000*1/12*1*50/100 1500 28500Finished Goods: Variable Cost 4500*8*2 72000Finished Goods: Fixed Cost 36000*1/12*1*2 6000 78000Debtors (Cash CostOnly) Variable Cost 4500*8*2 72000 Fixed Cost 36000*1/12*1*2 6000 78000Gross Working Capital 220500Cash Balance: 220500*5/95 11605

TOTAL 232105Less: Current LiabilitiesCreditors 4500*4*3 54000Outstanding Wages 4500*2*1 9000Outstanding OHS (4500*2*1=9000) + (36000*1/12*1*1month=3000) 12000

75000Net Working Capital 157105

4.A ltd sells its product at a gross profit of 20%on sales. The following data relates to the year ended 31.3.98:

Rs.

Sales at (3months credit) 4000000

Raw Material 1 month credit 1200000

Wages Paid 15 days arrears 960000

Manufacturing expenses I month arrear 1200000

Administration expenses paid I month arrear 480000

Sales promotion expenses paid half yearly in advance 200000

The company maintains 2 months stock of Raw materials, 1.5 months stock of finished goods, and a cash balance of Rs. 1,00,000. Assuming a 10% margin is required calculate the level of working capital.

Solution:

Cost of Goods Sold= Sales – Gross profit.

= 4000000 – 20% of 4000000 = 3200000.

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Cost of goods sold according to problem data:

Raw materials 1200000

Wages 960000

Manufacturing Expenses 1200000

3360000

Depreciation must be 3360000-3200000= 160000.

Cost of sales:

Cost of Goods Sold =3200000

Administration expenses =480000

Sales promotion expenses = 200000

3880000

Statement showing cash cost of working capital requirement:

Particulars Amount Rs.Current AssetsRaw Material 1200000*1/12*2 200000Finished Goods 3880000*1/12*1.5 485000Debtors 3880000*1/12*3 970000Cash 100000Prepaid Sales Promotion expenses 200000*1/12*6 100000

Gross Working Capital 1855000Less: Current LiabilitiesCreditors 1200000*1/12*1 100000Outstanding wages 960000*1/12*1/2 40000Outstanding Manufacturing Expenses 1200000*1/12*1 100000Outstanding Administration Expenses 480000*1/12/*1 40000

TOTAL 280000Net Working Capital 1575000

Add: 10% safety margin 157500Working capital requirements 1732500

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