Slm Unit 11 Mbf201

Financial Management Unit 11

Sikkim Manipal University Page No. 232

Unit 11 Working Capital Management

Structure:

11.1 Introduction

Learning Objectives

11.2 Components of Current Assets and Current Liabilities

11.3 Concepts of Working Capital

Gross working capital

Net working capital

11.4 Objective of Working Capital Management

11.5 Need for Working Capital

11.6 Operating Cycle

11.7 Determinants of Working Capital

11.8 Estimation of Working Capital

Estimation of current assets

Estimation of current liabilities

11.9 Summary

11.10 Terminal Questions

11.11 Answers to SAQs and TQs

11.1 Introduction

Working capital is defined as the excess of current assets over current

liabilities and provisions. It is that portion of asset of a business which is

used frequently in current operations and in the operating cycle of the firm.

Inadequacy or mismanagement of working capital is the leading cause of

many business failures. A financial manger, therefore, spends a larger part

of his time in managing working capital. There are two important elements to

be considered under the working capital management:

Decisions on the amount of current assets to be held by a firm for

efficient operations of its business

Decisions on financing working capital requirement

The need for proper management of working capital management is even

more important in the modern era of information technology. In support of

the above argument, let us consider the performance of Dell computers as

reported in one of the recent Fortune articles. A perusal of the article will



give you an insight into how Dell could use the technology for improving the

performance of components of working capital.

Use of internet as a tool for reducing costs of linking manufacturer with

their suppliers and dealers

Outsourcing on operations, if the firms’ competence does not permit the

performance of the operation effectively

Training the employees to accept change

Introducing to internet business

Releasing capital by reduction in investment in inventory for improving

the profitability of operating capital

11.1.1 Learning Objectives

After studying this unit, you should be able to:

Explain the meaning, definition and various concepts of working capital

State the objectives of working capital management

Recognise the importance of working capital management

Estimate the process of working capital

11.2 Components of Current Assets and Current Liabilities

Working capital management is concerned with managing the different

components of current assets and current liabilities.

The following are the components of current assets:

Inventories

Sundry debtors

Bills receivables

Cash and bank balances

Short-term investments

Advances such as advances for purchase of raw materials, components

and consumable stores and pre-paid expenses

The components of current liabilities are:

Sundry creditors

Bills payable

Creditors for out-standing expenses



Provision for tax

Other provisions against the liabilities payable within a period of 12

months

A firm must have adequate working capital, neither excess nor inadequate.

Maintaining adequate working capital is crucial for maintaining the

competitiveness of a firm.

Any lapse of a firm on this account may lead a firm to the state of

insolvency.

Self Assessment Questions

Fill in the blanks:

1. Maintaining adequate working capital at the satisfactory level is very

crucial for ___________ and _______ of a firm.

2. Pre-paid expenses are __________.

3. Provision for tax is____________.

4. A firm must have _________ neither excess nor shortage.

5. List any two components of current assets.

6. List any two components of current liabilities.

11.3 Concepts of Working Capital

The four most important concepts of working capital are (see figure 11.1) –

Gross working capital, Net working capital, Temporary working capital and

Permanent working capital.

Figure 11.1: Concepts of working capital

Gross working capital

Gross Working Capital refers to the amounts invested in various

components of current assets. This concept has the following practical

relevance.



Management of current assets is the crucial aspect of working capital

management

Gross working capital helps in the fixation of various areas of financial

responsibility

Gross working capital is an important component of operating capital.

Therefore, for improving the profitability on its investment a finance

manager of a company must give top priority to efficient management of

current assets

The need to plan and monitor the utilisation of funds of a firm demands

working capital management, as applied to current assets

Net working capital

Net working capital is the excess of current assets over current liabilities and

provisions. Net working capital is positive when current assets exceed

current liabilities and negative when current liabilities exceed current assets.

This concept has the following practical relevance.

Net working capital indicates the ability of the firm to effectively use the

spontaneous finance in managing the firm’s working capital requirements

A firm’s short term solvency is measured through the net working capital

position it commands

Permanent Working Capital

Permanent working capital is the minimum amount of investment required to

be made in current assets at all times to carry on the day to day operation of

firm’s business. This minimum level of current assets has been given the

name of core current assets by the Tandon Committee.

Permanent working capital is also known as fixed working capital.

Temporary Working Capital

Temporary working capital is also known as variable working capital or

fluctuating working capital. The firm’s working capital requirements vary

depending upon the seasonal and cyclical changes in demand for a firm’s

products. The extra working capital required as per the changing production

and sales levels of a firm is known as temporary working capital.




Fill in the blanks:

7. _______________ refers to the amounts invested in current assets.

8. To _______ and monitor the utilisation of funds of a firm

________________________ is to be given top priority.

9. When current assets exceed current liabilities the net working capital

is _____.

10. Permanent working is called ____ working capital.

11.4 Objective of Working Capital Management

The objective of financial management is maximising the net wealth of the

shareholders. A firm must earn sufficient returns from its operations to

ensure the realisation of this objective. There exists a positive co-relation

between sales and firm’s return on its investment. The amount of earnings

that a firm earns depends upon the volume of sales achieved. There is the

need to ensure adequate investment in current assets, keeping pace with

accelerating sales volume.

Firms make sales on credit. There is always a time gap between sale of

goods on credit and the realisation of earnings of sales from the firm’s

customers. Finance manger of a firm is required to finance the operation

during this time gap.

Therefore, objective of working capital management is to ensure smooth

functioning of the normal business operations of a firm. The firm has to

decide on the amount of working capital to be employed.

The firm may have a conservative policy of holding large quantum of current

assets to ensure larger market share and to prevent the competitors from

snatching any market for their products. However such a policy will affect

the firm’s returns on its investment. The firm will have returns higher than

the required amount of investment in current assets. This excess funds

locked in current assets will reduce the firm’s profitability on operating

capital.



On the other hand a firm may have an aggressive policy of depending on

spontaneous finance to the maximum extent. Credit obtained by a firm from

its suppliers is known as spontaneous finance. Here a firm will try to reduce

its investments in current assets as much as possible but checks that they

are not affecting the firm’s ability to meet working capital needs for sales

growth targets. Such a policy will ensure higher return on its investment as

the firm will not be locking in any excess funds in current assets. However,

any error in forecasting can affect the operations of the firm unfavourably if

the error is fraught with the down side risk. There is also another risk of firm

losing on maintaining its liquidity position.

Objective of working capital management is achieving a trade–off between

liquidity and profitability of operations for the smooth conduct of normal

business operations of the firm.


Fill in the blanks:

11. Objective of working capital management is achieving a trade-off

between _________ and _____________.

12. Credit obtained by a firm from its suppliers is known as _______.

13. An aggressive policy of working capital management means depending

on _________ to the maximum extent.

14. To prevent the competitors from snatching any market for their products

the firm may have ___________ a policy of holding _______ of current

assets.

11.5 Need for Working Capital

The need for working capital arises on account of two reasons:

To finance operations during the time gap between sale of goods on

credit and realisation of money from customers of the firm

To finance investments in current assets for achieving the growth target

in sales

Therefore to finance the operations in operating cycle of a firm, working

capital is required. In the next section, we will know more about the

operating cycle of the firm.




Fill in the blanks:

15. To finance the operations in _______ of a firm working capital is

required.

16. To finance operations during the time gap between _______ and

________ time gap is required.

11.6 Operating Cycle

The time gap between acquisition of resources and collection of cash from

customers is known as the operating cycle

Operating cycle of a firm involves the following elements.

Acquisition of resources from suppliers

Making payments to suppliers

Conversion of raw materials into finished products

Sale of finished products to customers

Collection of cash from customers for the goods sold

The five phases of the operating cycle occur on a continuous basis. There is

no synchronisation between the activities in the operating cycle. Cash

outflows occur before the occurrences of cash inflows in operating cycle.

Cash outflows are certain. However, cash inflows are uncertain because of

uncertainties associated with effecting sales as per the sales forecast and

ultimate timely collection of amount due from the customers to whom the

firm has sold its goods.

Since cash inflows do not match with cash out flows, firm has to invest in

various current assets to ensure smooth conduct of day to day business

operations. Therefore, the firm has to assess the operating cycle time of its

operation for providing adequately for its working capital requirements.

Operating cycle = IC period + RC period

IC period = Inventory conversion period

RC period = Receivables conversion period



Inventory conversion period is the average length of time required to

produce and sell the product.

Receivables conversion period is the average length of time required to

convert the firm’s receivables into cash.

Accounts payables period is also known as payables deferral period.

Accounts payables period = dayperPurchases

CreditorsAverage

(Payables deferral period)

Purchases per day = 365

yearforPurchasesTotal

Cash conversion cycle is the length of time between the firms actual cash

expenditure and its own cash receipt. The cash conversion cycle is the

average length of time a rupee is tied up in current assets.

Cash Conversion Cycle is

CCC = ICP + RCP – PDP

CCC = Cash Conversion Cycle

ICP = Inventory Conversion Period

RCP = Receivables Conversion Period

PDP = Payables deferral period

Receivables conversion period = SalesAnnual

365ceivablesReAccountsAverage

Inventory Conversion period = soldgoodsofCostAnnual

365InventoryAverage



Solved Problem

The following details shown in table 11.1 gives the complete details of

sales and costs of the goods produced by XYZ ltd for the year 31.03.08.

Table 11.1: Sales and costs produced by XYZ ltd.

Sales 80,000 Inventory

Cost of goods 56,000 31.03.07 9,000

31.03.08 12,000

Accounts Receivables

31.03.07 12,000

31.03.08 16,000

Accounts Payable

31.03.07 7,000

31.03.08 10,000

What is the length of the operating cycle?

What is the cash cycle?

Assume 365 days in the year (MBA Adopted)

Answer

Operating Cycle = Inventory Conversion Period + Accounts Receivables

conversion Period

From the above formula we need to first calculate the individual

conversion periods.

Inventory conversion period

36556000

2/)120009000(365

soldgoodsofCostAnnual

InventoryAverage

days4.6856000

36510500

Receivables Conversion Period

= 365SalesAnnual

ceivablesReAccountsAverage

days9.6380000

3652/)1600012000(



The Cash conversion cycle shows the time interval over which additional

non-spontaneous sources of working capital financing must be obtained to

carry out firm’s activities. An increase in the length of operating cycle,

without a corresponding increase in payables deferral period, increases the

cash conversion cycle. Any increase in cash conversion cycle leads to

additional working capital needs of the firm.


Fill in the blanks:

17. The time gap between acquisition of resources from suppliers and

collection of cash from customers is known as ______.

18. ___________ is the average length of time required to produce and

sell the product.

19. __________ is the average length of time required to convert the firms

receivables into cash.

20. _________ conversion cycle is the length of time between firms’ actual

cash expenditure and its own receipt.

Payables Conversion Period

= 365soldgoodsofCostAnnual

PayablesAccountsAverage

56000

3652/)100007000(

days4.5556000

3658500

Operating Cycle = ICP + RCP

= 68.4 + 63.9 = 132.3 days

Cash Conversion cycle= OC – PDP

= 132.3 – 55.4 = 76.9 days



11.7 Determinants of Working Capital

A large number of factors influence working capital needs of a firm. The

basic objective of a firm’s working capital management is to ensure that the

firm has adequate working capital for its operations, neither too much nor

too little. Investing heavily in current assets will drain the firm’s earnings and

inadequate investment in current assets will reduce the firm’s credibility as it

affects the firm’s liquidity. Therefore, the need to strike a balance between

liquidity and profitability cannot be ignored. The following factors determine

a firm’s working capital requirements (see figure 11.2)

Nature of business: Working Capital requirements are basically

influenced by the nature of business of the firm. Trading organisations

are forced to carry large stocks of finished goods, accounts receivables

and accounts payables. Public utilities require lesser investment in

working capital.

Size of business operation: Size is measured in terms of a scales of

operations. A firm with large scale of operation normally requires more

working capital than a firm with a low scale of operation.

Manufacturing cycle: Capital intensive industries with longer

manufacturing process will have higher requirements of working capital

because of the need to run their sophisticated and long production

process.

Figure 11.2: Factors determining working capital



Products policy: Production schedule of a firm influences the

investments in inventories. A firm, exposed to seasonal changes in

demand when following a steady production policy will have to face the

costs and risks associated with inventory accumulation during the off-

season periods. On the other hand a firm with a variable production

policy will be facing different dimensions of management of working

capital. Such a firm has to effectively handle the problem of production

planning and control associated with utilisation of installed plant capacity

under conditions of varying volumes of production of products of

seasonal demand.

Volume of sales: There is a positive direct correlation between the

volume of sales and the size of working capital of a firm.

Term of purchase and sales: A firm which allows liberal credit to its

customers will need more working capital than that of a firm with strict

credit policy. A firm which enjoys liberal credit facilities from its suppliers

requires lower amount of working capital when compared to a firm which

does not have such a facility.

Operating efficiency: The firm with high efficiency in operation can

bring down the total investment in working capital to lower levels. Here

effective utilisation of resources helps the firm in bringing down the

investment in working capital.

Price level changes: Inflation affects the working capital levels in a firm.

To maintain the operating efficiency under an inflationary set up, a firm

should examine the maintenance of working capital position under

constant price level. The financial capital maintenance demands a firm

to maintain higher amount of working capital keeping pace with rising

price levels. Under inflationary conditions same levels of inventory will

require increased investment. The ability of a firm to revise its products

prices with rising price levels will decide the additional investment to be

made to maintain the working capital intact.

Business Cycle: During boom, sales rise as business expands.

Depression is marked by a decline in sale. During boom, expansion of

business can be achieved only by augmenting investment in various

assets that constitute working capital of a firm. When there is a decline

in business on account of depression in economy, inventory glut forces



a firm to maintain working capital at a level far in excess of the

requirements under normal conditions.

Processing technology: Longer the manufacturing cycle, the larger is

the investment in working capital. When raw material passes through

several stages in the production, process work in process inventory will

increase correspondingly.

Fluctuations in the supply of raw materials: Companies which use

raw materials available only from one or two sources are forced to

maintain buffer stock of raw materials to meet the requirements of

uncertainty in lead time Such firms normally carry more inventory than it

would have had the materials been available in normal market

conditions.


Fill in the blanks:

21. Capital intensive industries require _________ amount of working

capital.

22. There is a __________ between volume of sales and the size of a

working capital of a firm.

23. Under inflationary conditions same level of inventory will require

__________ investment in working capital.

24. Longer the manufacturing cycle, ________ the investment in working

capital.

11.8 Estimation of Working Capital

The approach to estimate a working capital is based on an operation cycle.

Operation cycle comprises of two important components of working capital

(see figure 11.3) – Current assets and Current liabilities

Figure 11.3: Components of working capital



Estimation of working capital is based on the assumption that production

and sales occur on a continuous basis and all costs occur accordingly.

Estimation of Current Assets

Current assets are estimated based on the following assumptions:

Average investment in raw material is estimated

Average investment in work-in-progress inventory is estimated

Average investment in finished goods inventory is estimated

Average investment in receivables (both in debtors and bills receivables) is

estimated based on credit policy that the firm wishes to pursue

Based on the firm’s attitude towards risk, access to borrowing sources,

past experience and nature of business, firms decide on the policy of

maintaining the minimum cash balances

Estimation of Current Liabilities

Current liabilities are estimated based on the following factors – Trade

creditors, Direct wages and Overheads (see figure 11.4).

Figure 11.4: Estimation of current liabilities

Trade creditors

The average amount of financing available to the firm is estimated based on

the production budget, raw material consumption and the credit period

enjoyed from suppliers.

Direct wages

Estimation is made on total wages, to be paid on average basis, based on

production budget, direct labour cost per unit and average time-lag in

payment of wages.



Overheads

Estimation on an average basis of the outstanding amount to be paid to the

creditors for overhead is estimated based on production budget, overhead

cost per unit and average time-lag in payment of overhead.

Solved Problem

A pro-forma cost sheet of a company provides the following details as

shown in table 11.2.

Table 11.2: Pro-forma sheet

Raw material 52.00

Direct labour 19.50

Overheads 39.00

Total cost 110.50

Profit 19.50

Selling price 130.00

The following additional information is also available:

Average raw material in stock: One month

Average materials in process: Half a month

Credit allowed by Suppliers: One month

Credit allowed to debtors: Two months

Time lag in payment of wages: one and a half weeks

Time lag in payment of overheads: one month

One-fourth of sales on cash basis

Cash balance expected to be maintained is Rs.1,20,000

You are required to prepare a statement showing the working capital

required to finance a level of activity of 70,000 units of output. You may

assume that production is carried on evenly through-out the year and

wages and overheads occur similarly. Assume 360 days in a year (MBA

adapted).

Solution

Estimation of Working Capital

a. Investment in inventory

1. Raw material



33.30333330360

5270000RMCP

360

RMC

2. Work – in process inventory

67.32229115360

5.11070000WIIPCP

360

COP

3. Finished goods inventory

360

305.11070000FGCP

360

COS644583.33

b. Investment in debtors

00.96687560360

5.11052500DCP

360

SalesCreditofCost

c. Cash balance 120000

d. Total current Asset (A + B + C) 2357083.33

e. Current Liabilities

1. Creditors

360

PDPmaterialsrawofPurchase

33.303333360

305270000

2. Wages

67.37916360

105.1970000

3. Overheads

00.227500360

303970000

Total Current Liabilities = 568750.00

Net working Capital (D – F) = 1788958.33



Solved Problem

The following annual figures as shown in table 11.3, are regarding the

sales and production of the company XYZ ltd.

Table 11.3: Annual figures of XYZ ltd

Sales (at two months credit) Rs. 36,00,000

Materials consumed (suppliers extend two months credit) Rs. 9,00,000

Wages paid (monthly in arrears) Rs. 7,20,000

Manufacturing expenses outstanding at the end of the year(cash expenses are paid one month in arrears)

Rs. 80,000

Total administrative expenses paid, as above Rs. 2,40,000

Sales promotion expenses, paid quarterly in advance Rs.1,20,000

The company sells its products on gross profit of 25% counting

depreciation as part of the cost of production. It keeps one month’s

stock each of raw materials and finished goods, and a cash balance of

Rs.100 000.

Assume a 20 percent safety margin. Calculate the working capital

requirements of the company on cash cost basis.

Solution

The computation of manufacturing expenses is as shown in the table 11.4

Table 11.4: Computation of manufacturing expenses

Sales Rs.36,00,000

Less: gross profit at 25% Rs.9,00,000

Total manufacturing cost Rs.27,00,000

Less: materials Rs.9,00,000

Less: wages Rs.7,20,000

Manufacturing expenses Rs.10,80,000

Cash manufacturing expenses Rs.9,60,000



Depreciation

Total manufacturing expenses – Cash manufacturing expenses

10,80,000 – 9,60,000 = Rs.1,20,000

The total cash cost is determined and shown in the following table 11.5

Table 11.5: Total cash cost

Total manufacturing cost Rs.27,00,000

Less: depreciation Rs.1,20,000

Cash manufacturing cost Rs.25,80,000

Total manufacturing expenses Rs.2,40,000

Sales promotion expenses Rs.1,20,000

Total cash cost Rs.29,40,000

Statement of working capital required:

Current assets:

Raw Materials stock

7500012

19000001

12

CostMaterial

Finished goods stock

Cash manufacturing cost 12

1

2580000 x 12 = 215000

Debtors

Total cash cost of sales x 2 /12

= 2940000 x 2 / 12 = 490000

Sales promotion expenses = 120000 x 1/4= 30,000

Cash required = 100000

Total Assets = 910000

Current Liabilities

Sundry Creditors

15000012

2900002

12

CostMaterial



Wages outstanding = 720000 x 1/12 = 60000

Manufacturing expenses outstanding = 80000

Total administrative expenses:

Outstanding = 240000 / 12 =20000

Total current Liabilities = 310000

Working Capital

A – B = 600000

Add 20% safety margin = 120000

Working Capital required = 720000


Fill in the blanks:

25. ______ is used to estimate working capital requirements of a firm.

26. Operating cycle approach is based on the assumption that production

and sales occur on a ___________.

27. The factors involved in the estimation of the current liabilities are

_____, _________ and _________.

11.9 Summary

All companies are required to maintain a minimum level of current assets at

all point of time. This level is called core or permanent working capital of the

company. Working capital management is concerned with the determination

of optimum level of working capital and its effective utilisation. To assess the

working capital required for a form to conduct its operations smoothly, firms

use operating cycle concept and compute each component of working

capital.

11.10 Terminal Questions

1. Examine the components of working capital.

2. Explain the concepts of working capital

3. What are the objectives of working capital management ?



4. Briefly explain the various elements of operating cycle

11.11 Answers to SAQs and TQs

Answers to Self Assessment Questions

1. Maintaining, Competitiveness.

2. Current assets.

3. Current Liabilities

4. Adequate working capital

5. Inventories

6. Sundry debtors

7. Gross working capital

8. Plan, working capital management as applied.

9. Positive

10. Fixed

11. Liquidity, Profitability.

12. Spontaneous finance.

13. Spontaneous finance.

14. Conservative, Large quantum.

15. Operating cycle

16. Sale of goods on credit, realisation of money from customers.

17. Operating cycle

18. Inventory conversion period

19. Receivables conversion period

20. Cash Conversion cycle

21. Higher

22. Positive direct correlation.

23. Increased

24. Larger

25. Operating cycle

26. Continuous bases

27. Trade creditors, Direct wages and Overheads

Answers to Terminal Questions

1. Refer to 11.2



2. Refer to 11.3

3. Refer to 11.4

4. Refer to 11.6

Slm Unit 11 Mbf201

Documents

sikkim manipal

assessment

payables deferral

adequate working

temporary

rising price

net working

permanent