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Working
CapitalManagement
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Definition of Working CapitalWorking Capital refers to that part of the
firms 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-term
capital.
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KINDS OF WORKING CAPITAL
WORKINGCAPITAL
BASIS OF
CONCEPT
BASIS OF
TIME
Gross
Working
Capital
Net
Working
Capital
Permanent
/ Fixed
WC
Temporary
/ Variable
WC
Regular
WC
Reserve
WC
Special
WC
Seasonal
WC
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Significance of Gross WC Optimum investment in CA
Investment in CA must be adequate CA investment should notbe inadequate or excessive inadequate WC can disturbproduction and can also threaten the solvency of firm , if it fails
to meet its current obligation excessive investment in CAshould 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 ariseswhich should be invested in Short term securities , they shouldnot be kept idle
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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 andinvestors to judge financial soundness of a
firm
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BALANCE SHEET OF ABC COMPANY AS ON 31-3-2000
Liabilities Rs Assets Rs
Equity Shares 200000 Goodwill 20000
8% Debentures 100000 Land and Building 150000Reserve & Surplus 50000 Plant and Machinery 100000
Sundry Creditors 150000 Inventories
Bills Payable 30000 Finished Goods 60000
Outstanding Expenses 20000 Work in process 40000
Bank Overdraft 50000 Prepaid Expenses 20000
Provision for Taxation 20000 Marketable Securities 60000
Proposed Dividend 30000 Sundry Debtors 90000Bills Receivables 20000
Cash & Bank Balance 90000
TOTAL 650000 TOTAL 650000
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Difference between permanent & temporary workingcapital
Amount Variable Working Capitalof
Working
Capital
Permanent Working Capital
TimePermanent and temporary working capital for Stable firm
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Variable Working Capital
Amount
ofWorking
Capital
Permanent Working Capital
Time
Permanent and temporary working capital for Growing firm
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Operating cycle concept Maximization of share holders 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 notconvert into cash immediately
There is invisible time lap between the sale of good and receipt ofcash
The time taken to convert raw material into cash is known asoperating 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 )
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Operating Cycle in
Manufacturing firmCash
Raw
MaterialsW I P
Finished
Goods
DebtorsSALES
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Operating cycle of NonManufacturing Firm
cash
Receivables
Stock of finished goods
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Formula for calculating Operatingcycle for Manufacturing firmOC = ICP+ARPOC = Operating cycleICP = Inventory Conversion period
ARP = Account Receivable Period
ICP = Average Inventory
Cost of good sold /365ARP = Average Account Receivable
Sales/365
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ABC Company Provide the
following information , Compute
the operating cycle Sales 3000 Lakhs
Inventory Opening Rs 610 Lakhs ;
closing Rs 475 Lakhs
Receivable opening Rs 915 Lakhs;
Closing Rs 975 Lakhs
Cost of Goods Sold Rs 2675 Lakhs
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CASH CONVERSION CYCLE
The amount of time a firms resources are tiedup calculated by subtracting the average
payment period from the operating cycle thetime period between the date a firm pays itssupplier and the date it receives cash from itscustomer
CCC = OCAPPAAI = Average Inventory
Cost of good sold /365
ARP = Average Account ReceivableAnnual Sales/365
APP = Account Payable Period
Cost of good sold /365
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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- APP
OC = AAI+ARP
80+50=130
CCC =130-40 =90 days
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Purchase of Sale of Goods Collection of
Raw Material on Credit Account Receivables
On credit
Average age of Account receivable
Inventory (AII) period (ARP)
Account PayablePeriod (APP)
Payment to
suppliers
Receipt of Invoice Operating Cycle (OC)
Cash Conversion cycle
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Resource flows for a manufacturing firm
FixedAssets
Production
Process
Generates
Inventory
Via Sales Generator
Accounts
receivable
Used in
Accrued Direct
Labour and
materials
Accrued Fixed
Operating
expenses
Cash and
Marketable
Securities
Suppliers
Of Capital
External Financing
Return on Capital
Collection
process
Used to
purchase
Used to
purchase
Used in
Working
Capital
cycle
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Calculate cash conversion cycle Sales Rs 1587.95
Cost of Good sold Rs 1406.27
Inventory opening 195.82, closing 202.29
Account receivables opening 423.03 closing449.46
Account payable opening 140.40, closing168.33
CCC = OCAPP
OC = AAI + ARP
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FORECASTING / ESTIMATION OFWORKING CAPITAL REQUIREMENTSFactors to be considered
Total costs incurred on materials, wages and overheads
The length of time for which raw materials remain in stores
before they are issued to production.
The length of the production cycle or WIP, i.e., the time taken
for conversion of RM into FG.
The length of the Sales Cycle during which FG are to be kept
waiting for sales.
The average period of credit allowed to customers.
The amount of cash required to pay day-to-day expenses of the
business.
The amount of cash required for advance payments if any.
The average period of credit to be allowed by suppliers.
Timelag in the payment of wages and other overheads
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PROFORMA - WORKING CAPTIAL ESTIMATES
1.TRADING CONCERN
STATEMENT OF WORKING CAPITAL REQUIREMENTS
Amount (Rs.)
Current Assets(i) Cash ----
(ii) Receivables ( For..Months Sales)---- ----
(iii) Stocks ( ForMonths Sales)----- ----(iv)Advance Payments if any ----
Less : Current Liabilities(i) Creditors (For.. Months Purchases)- ----
(ii) Lag in payment of expenses -----_
WORKING CAPITAL ( CACL ) xxxAdd : Provision / Margin for Contingencies -----
NET WORKING CAPITAL REQUIRED XXX
1 MANUFACTURING CONCERN
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1. MANUFACTURING CONCERN
STATEMENT OF WORKING CAPITAL REQUIREMENTS
Amount (Rs.)
Current Assets
(i) Stock of R M( for .months consumption) -----
(ii)Work-in-progress (formonths)(a) Raw Materials -----
(b) Direct Labour -----
(c) Overheads -----
(iii) Stock of Finished Goods ( for months sales)
(a) Raw Materials -----
(b) Direct Labour -----
(c) Overheads -----
(iv) Sundry Debtors ( for months 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.. Months Purchases) -----
(ii) Lag in payment of expenses -----
(iii) Any other -----
WORKING CAPITAL ( CACL )xxxx
Add : Provision / Margin for Contingencies -----
NET WORKING CAPITAL REQUIRED XXX
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Prepare an estimate of Working capital requirement
from the following information of a trading concern:
Projected annual sales 100000 units
Selling price Rs 8 per unit
% age of Net profit on sales 25%
Average Credit Period allowed to
customer 8 weeks
Average Credit Period allowed by
supplier 4 weeksAverage stock holding in terma of sales
requirement 12 weeks
contingencies 10%
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Points to be remembered whileestimating 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, it may be reduced by the amount of Income tax,
Drawings, Dividend paid etc.
(2) Calculation of WIP depends on the degree of completion as regards
to materials, labour and overheads. However, if nothing is mentioned
in the problem, take 100% of the value as WIP. Because in such a case,
the average period of WIP must have been calculated as equivalent
period of completed units.
(3) Calculation of Stocks of Finished Goods and Debtors should bemade at cost unless otherwise asked in the question.
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Prepare statement of workingcapital requirement, Profit &LossA/C, Balance Sheet Assuming Share Capital 150000
8% Debentures 200000 Fixed asset 130000
Material 40%
Direct lab our 20% Overheads 20%
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The following further particular are available
It is proposed to maintain a level of activity
of 2,00,000 units Selling price is Rs 12/- per unit
Raw Material are expected to remain instores for an average period of one month
Material will be in process , on averagehalf a month
Finished goods are required to be in stockfor an average period of one month
Credit allow to debtors is two month
Credit allow by supplier is one month
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Working Capital Financing Mix
Approaches to Financing
Mix
The Hedging orMatching Approach
The ConservativeApproach
The AggressiveApproach
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Hedging approach to asset financing
Fixed Assets
Permanent Current Assets
Total Assets
Fluctuating Current Assets
Time
Short-term
Debt
Long-term
Debt +
Equity
Capital
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The Hedging approach Hedging approach refers to a process of
matching maturities of debt with the maturities offinancial need . In this approach maturity ofsource of fund should match the nature of assetto be financed
This approach is also known as matchingapproach.
The hedging approach suggests that thepermanent working capital requirement should befinanced with fund from long term sources whilethe temporary working capital requirement
should be financed with short term funds.
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Estimated Total Investment in Current Asset of company X for
the year 2000
Month
Investmentin Current Asset
(R's )
Permanent or
FixedInvestments
(R's)
Temporaryor seasonal Invest
(R's)
January 50400 45000 5400
February 50000 45000 5000
March 48700 45000 3700April 48000 45000 3000
May 46000 45000 1000
June 45000 45000 -
July 47500 45000 2500
August 48000 45000 3000September 49500 45000 4500
October 50700 45000 5700
November 52000 45000 7000
December 48500 45000 3500
TOTAL 44300
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Conservative ApproachThis approach suggested that the entire
estimated investments in current asset should befinance from long term source and short termshould be use only for emergency requirement
Distinct features of this approach
Liquidity is greater
Risk is minimized
The cost of financing is relatively more asinterest has to be paid even on seasonalrequirement for the entire period
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Conservative approach to asset financing
Fixed Assets
Permanent Current Assets
Total Assets
Fluctuating Current Assets
Time
Short-term
Debt
Long-term
Debt +
Equity
capital
Trade off between Hedging and
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Trade off between Hedging and
conservative approaches
The hedging approaches implies low cost , highprofit and high risk while the conservativeapproach leads to high cost , low profit , low
risk Both the approaches are the two extremeand neither of them serve the purpose ofefficient working capital management
A trade off between the two will then be anacceptable approach , One way of determiningthe trade off is by finding the AVG of maximumand minimum requirement of current asset or
working capital
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Aggressive approach to asset financing
Fixed Assets
Permanent Current Assets
Total Assets
Fluctuating Current Assets
Time
Short-term
Debt
Long-term
Debt +
Equity
capital
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Aggressive approach
The aggressive approach suggests that the entireestimated requirement of current asset should befinanced from short-term sources and even a
part of fixed asset investment be financed fromshort - term sources
This approach make the finance mix :
More Risky
Less costly
More Profitable
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Prepare a projected balancesheet , profit and loss a/c andthen an estimation of workingcapital .
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 andsales cycle
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Raw Material are kept in stores for an
average period of two month
Finished goods remain in stock for anaverage period of three month
Production during the previous year was180000 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 monthand given by supplier is two month
Selling price is Rs 4 per unit
Calculation of debtors may be made at
selling price
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Management of Working Capital
Working capital in general practice refer to theexcess of CA over CL.
Management of working capital therefore isconcerned with the problems that arise in
attempting to manage the CA, the CL and theinter-relationship that exists between them.
The basic goal of WCM is to manage the CA & CLof a firm in such a way that a satisfactory level of
WC is maintained. Working Capital Management Policies of a firm
have a great effect on its profitability, liquidity andstructural health of the organization
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Working capital management is 3 dimensional inNature
Dimension I
Profitability,
Risk, & Liquidity
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Working Capital Issues
Assumptions
50,000 maximum unitsof production
Continuous production
Three different policies
for current asset levelsare possible
Optimal Amount (Level) of Current Assets
0 25,000 50,000OUTPUT (units)
A
SSETLEVEL
Current Assets
Policy C
Policy A
Policy B
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Impact on Liquidity
Liquidity Analysis
Policy LiquidityA High
B Average
C Low
Greater current asset levelsgenerate more liquidity; allother factors held constant.
Optimal Amount (Level) of Current Assets
0 25,000 50,000OUTPUT (units)
A
SSETLEVEL
Current Assets
Policy C
Policy A
Policy B
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Impact on
Expected Profitability
Return on Investment=
Net ProfitTotal Assets
Let Current Assets = (Cash +
Rec. + Inv.)
Return on Investment=
Net Profit
Current + Fixed Assets
Optimal Amount (Level) of Current Assets
0 25,000 50,000OUTPUT (units)
A
SSET
LEVEL
Current Assets
Policy C
Policy A
Policy B
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Impact on
Expected Profitability
Profitability Analysis
Policy ProfitabilityA Low
B Average
C High
As current asset levels decline,
total assets will decline and
the ROI will rise.
Optimal Amount (Level) of Current Assets
0 25,000 50,000OUTPUT (units)
A
SSETLEVEL
Current Assets
Policy C
Policy A
Policy B
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Impact on Risk
Decreasing cash reduces thefirms ability to meet its
financial obligations. Morerisk!
Stricter credit policies reducereceivables and possibly losesales and customers. Morerisk!
Lower inventory levelsincrease stockouts and lostsales. More risk!
Optimal Amount (Level) of Current Assets
0 25,000 50,000OUTPUT (units)
A
SSETLEVEL
Current Assets
Policy C
Policy A
Policy B
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Impact on Risk
Risk Analysis
Policy RiskA Low
B Average
C High
Risk increases as the level of
current assets are reduced.
Optimal Amount (Level) of Current Assets
0 25,000 50,000OUTPUT (units)
A
SSETLEVEL
Current Assets
Policy C
Policy A
Policy B
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Summary of the Optimal
Amount of Current Assets
SUMMARYOFOPTIMALCURRENTASSETANALYSIS
Policy Liquidity Profitability Risk
A High Low LowB Average Average Average
C Low High High
1. Profitability varies inversely with liquidity.
2. Profitability moves together with risk.(risk and return go hand in hand!)
Techniques of analysis of working
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Techniques of analysis of working
capital
The analysis of working capital can be conductedthrough a number of devices such as
Ratio analysis
Fund flow analysisWorking capital Budgeting
Ratio analysis : A ratio is a simple arithmetical
expression of the relationship of one number toanother , this technique can be employed formeasuring short term liquidity or working capital
position of a firm.
Th f ll i i b
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The following ratios may be
calculated for this purpose Liquidity Ratioa) 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
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Current ratio may be define as therelationship between CA and CL
This ratio is also known as WCR.
(Working capital ration).
It is helpful to measure shorttermfinancial position or liquidity of a firm
Current ratio: Current assetCurrent liabilities
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CURRENT ASSETS CURRENT LIABILITIESCash in hand
Bills Payable
Cash at bank Sundry Creditors
Sundry DebtorsAccrued or Outstanding
Expenses
Marketable securities(Short term)
Short term loan andadvancesBills Receivable Dividend payable
Inventories of Stock Bank OverdraftWork in progress
Finished goods
Prepaid Expenses
Q i k A id Li id
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Quick or Acid test or Liquid
RatioAn asset is said to be liquid if it can be convert
into cash with in a short period with out loss ofvalue
Inventory cannot be termed to be liquid assetbecause they cannot be convert into cashimmediately
The quick ratio can be calculated
Quick ratio: liquid asset
Current liabilities
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Quick or liquid Current LiabilitiesCash in hand Bills Payable
Cash at bank Sundry Creditors
Sundry DebtorsAccrued or Outstanding
Expenses
Marketable securitiesShort term advances
Temporary Investments Dividend payable
Bank OverdraftIncome tax payable
Convection quick ratio of 1:1 is consider satisfactory
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Cash Position ratio/absolute liquid ratio
Absolute Liquid assets include cash in hand andcash at bank and marketable securities ortemporary investments
The acceptable norms for this ratio is 50% or.05%
Cash ratio: Cash & bank + Shortterm securities
Current liabilities
C l l ll h h i
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Calculate all the three ratioLiabilities Rs Assets Rs
9% preference
share 500000 Goodwill 100000
Equity share
capital 1000000 Land and building 650000
8% debentures 200000 Plant 800000
Long term loan 100000Furniture andfixtures 150000
Bills payable 60000 Bills receivable 70000
Sundry creditors 70000 Sundry debtors 90000
Bank over draft 30000 Bank balance 45000
Outstanding
expenses 5000
short term
investments 25000
Prepaid expenses 5000
Stock 30000
1965000 1965000
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CONCLUSION:
Current ratio of the company is not
satisfactory because the ratio 1:6 is muchbelow then the expected Standards .
Acid test ratio on the other hand is morethan the normal standard of 1:1
Absolute ratio is slightly low because it is
0.42 where as the accepted standard is 0.5 In this company need to improve its short
term financial position
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Inventory turnover ratio
Inventory turn over ratio = Cost of good soldAverage Inventory at cost
Generally , the cost of good sold may not be known
from the published financials , in suchcircumstances
Inventory turn over ratio = Net Sales
Average Inventory at costInventory turn over ratio = Cost of good sold
Average Inventory at selling price
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Inventory conversion period
Inventory conversion period = Days in a yearInventory 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
Opening Stock Rs 25000
Closing Stock Rs 35000
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Debtor/Receivable turnover ratio/Debtor velocityDebtor(Receivable) = Net credit Annual sales
Average Trade debtorsTrade debtors = Sundry debtor + Bill Receivable and
account receivable s
Average Trade Debtors = Opening Trade debtor +
Closing Trade Debtor /2Note : Debtor should always be taken at gross value , Noprovision for doubtful debt be deducted from them but whenthe information about opening and closing balance of trade
debtor and credit sales is not available , then the debtorsturnover ratio calculated by dividing the total sales by thebalance of debtors(inclusive of Bills receivables) given
Debtors turn over Ratio = Total sales
Debtors
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Average Collection Period
The average collection period represent theaverage number of days for which a firm has towait before its receivable are converted into cash
Average Collection period =
Average Trade Debtors (Drs + B/R)
Sales per day
Sales Per day = Net Sales
No of working days
O
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Or
Average collection period =Average trade debtors
Net SalesNo of working days
If the period is in months:
Average collection period =No of working daysDebtors turnover ratio
The two basis component of the ratio are debtors
and sales per day
Creditor/Payable turnover ratio
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Creditor/Payable turnover ratio
The analysis for credit turnover is basically the same
as of debtors turnover ratio except that in place oftrade debtor, the trade creditor are taken and inplace of sales , average daily purchase are taken as
the other component of the ratio.Creditors turnover ratio
= Net credit annual purchase
Average Trade creditors
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Average Payment period Ratio
= Average Trade Creditors( Creditors+ Billspayable)/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.
Average Payment Period = No of working days /Credit turnover Ratio.
W rkin pit l t rn r r ti
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Working capital turnover ratioWorking capital of a concern is directly related to
sales and current asset like debtors , billsreceivable , cash , stock etc .
Working capital turnover ratio = Cost of Sales /
Average working capitalAverage working capital = Opening working
capital + Closing Working capital/2
** If cost of sales is not given , then the figure ofsale can be used . O n the other hand if openingworking capital is not disclosed then working
capital at the end of the year will be used.
The following information is given about M/s S.P
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g gLtd 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 theopening stock
Opening Creditors = Rs 20000
Closing Creditors = Rs 30000Trade debtor at the end = Rs 60000
Net Working Capital = Rs 50000
FIND OUT
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FIND OUT
Average Stock
Purchases
Credit turnover ratio
Average Payment PeriodAverage Collection Period
Working Capital turnover ratio
F nd flo n l sis F d fl l i i
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Fund flow analysis : Fund flow analysis is atechnical device designated to study the sources
from which additional fund were derived andthe use to which these sources were put . It is aneffective management tool to study change inthe financial position of business
The fund flow analysis consists of
Preparing schedule of change in working capital
Statement of sources and application of funds
Working capital Budgeting : Working
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Working capital Budgeting : Working
capital budget as a part of total
budgeting process of a business , isprepared estimating future long term
and short term working capital need
and the sources of finance them .
The objective of a working capital
budget is to ensure availability of fundas and when needed and to ensure
effective utilization of these resources .