Subject BUSINESS ECONOMICS Paper No and Title 4 ...

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BUSINESS ECONOMICS

PAPER NO. 4 : PRINCIPLES OF BUSINESS FINANCE AND ACCOUNTING

MODULE NO.13: WORKING CAPITAL MANAGEMENT

Subject BUSINESS ECONOMICS

Paper No and Title 4: Principles of Business Finance and Accounting

Module No and Title 13: Working Capital Management

Module Tag BSE_P4_M13

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BUSINESS ECONOMICS



TABLE OF CONTENTS

1. Learning Outcomes

2. Introduction

3. Working Capital

4. Importance of Working Capital

5. Working Capital Cycle

5.1. Simple Weighted Cycle

5.2. Weighted operating Cycle

6. Factors affecting working capital

7. Graded Illustrations

8. Summary

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1. Learning Outcomes

After studying this module, you shall be able to

Know the meaning of Working Capital

Identify the need of working capital

Understand the factors affecting working capital.

Analyze the Working capital cycle.

2. Introduction

Working Capital Management is the functional area of finance which covers all the current

accounts of the firm. It is concerned with management of the levels of individual current assets as

well current liabilities. It refers to the funds invested in current assets which are essential to use

fixed assets profitably. The classification of working capital may be done on the basis of

components of working capital and also on the basis of time factor. Considering components, the

Working capital may be of two types:

Gross Working Capital: The gross working capital refers to investment made in all the

assets taken together. The benefits on account of trade payables are not taken into account.

Net Working Capital: It refers to excess of total current assets over total current liabilities.

The working capital requirement on the basis of time factor involved may be of two types:

Permanent Working Capital: The maximum level of investment in all current assets at

all times is known as the permanent working capital.

Temporary Working Capital: The part of working capital over and above permanent

working capital is called as the temporary working capital. This keeps on fluctuating.

3. Working Capital

Working capital is the amount of investment made by the firm in its current assets to be able to run

the business smoothly. A business does not run by merely investing in large machineries placed in

big buildings. It also needs to invest in raw material which it proposes to process through its

machineries. The output thus produces requires time to be brought to the markets to be sold and

finally the buyer also takes time in making payments. Funds are required till this entire cycle is

complete and since it is ongoing process these funds remain invested in the business till it is a going

concern. A large part of these funds have to be provided by the owner or borrowings from banks

but a small part of it also comes from the credit extended by the suppliers of raw materials or other

components of current liabilities.

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4. Importance of Working Capital

Working capital is a very important aspect in the successful running of the business. State of the

art technology will not be able to produce good financial results if it is not coupled with a proper

working capital management. The funds should be carefully handled in managing the day to day

financial requirements of the firm. Having large funds to provide for all kinds of requirements and

all kinds of emergencies is not a very good idea. A little bit of risk is also necessary in business to

be profitable. A low level of working capital is not a good business proposition either, as this would

mean struggling to meet the day to day expenses and not being able to make payments to the

business creditors on time. Therefore working capital should not be too large, as it implies idle

funds or over capitalization which means low rate of return, nor should it be so less that companies

are unable to meet its liabilities and it runs the risk of solvency. What therefore should be the

optimum working capital and how it is determined is a important question which needs to be well

answered. One of the ways is to calculate the current ratio which is given by current assets / current

liabilities. It is a reflection of working capital management. Current ratio which is ideally 2 and

Acid test ratio which is 1 is generally considered as adequate working capital. However, it may

vary from industry to industry.

5. Working Capital Cycle

Also known as operating cycle it helps in ascertaining the duration for which funds are required for

various stages of the working capital cycle. It refers to the length of time between the firms paying

cash for materials etc., entering into production process/stock and inflow of cash from debtors. This

cycle starts with cash with which the firm buys raw material to process and convert it into finished

stock by bestowing efforts on it.

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The determination of working capital cycle helps in the forecast, control and management of

working capital. Working capital cycle can be calculated in two ways. The first being a simple

operating cycle and the other being weighted operating cycle.

5.1 Simple operating cycle

Simple operating cycle is when we add up the number of days it takes to complete the cycle. For

example:

XYZ Ltd. has obtained the following data concerning the average working capital cycle for

company:

Raw Material stock turnover 20 days

Credit received from suppliers (40 days)

Work-in-Progress turnover 15 days

Finished goods stock turnover 40 days

Debtor’s collection period 60 days

95 days

Thus, in this case the working capital operating cycle is for 95 days.

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5.2 Weighted operating cycle

Weighted operating cycle is an extension of the concept of working capital cycle and helps in

estimation of the amount of funds that are required for various stages of the cycle.

Under this method appropriate weights are attached to the duration of various stages of the

operating cycle and the weighted duration is added to arrive at the weighted operating cycle. The

weights are the ratio of the funds per unit required at each stage; to the selling price per unit. The

weighted operating cycle multiplied by the sales per day gives the working capital requirement. A

certain amount of cash required to be kept may be added to this figure.

Supposing in the above illustration the cost of raw material is Rs. 5 and work in progress is Rs. 7.5

and finished goods cost Rs. 10 and the selling price is Rs.15 then the weights given to raw material

stage would be 0.33, Work in progress would be 0.5 finished good will be 0.66 and debtors would

be 1. Now, weighted operating cycle is given by (D x W) It will be the summation of each

component of working capital.

Raw Material stock turnover 20 days

Credit received from suppliers (40 days)

Work-in-Progress turnover 15 days

Finished goods stock turnover 40 days

Debtor’s collection period 60 days

The Weighted Operating cycle may be calculated in the following manner:

= (0.33 x 20) + (0.5 x 15) + (0.66 x 40) + (1x 60) - (0.33 x 40)

= 6.66 +7.5 + 26.66 + 60 – 13.33

= 87.5 Days.

6. Factors for Working capital

The following factors should be taken into consideration while determining the requirement of

working capital:

1. Production Policies: The need for working capital will vary according to the production plans.

In some cases raw material can be procured in one season and used throughout the year whereas in

other cases production cycle is limited to a part of year and raw material accumulated throughout

the year.

2. Nature of the business: The shorter the manufacturing process the lower is the requirement for

working capital. If the manufacturing process is longer the requirement of working capital will be

higher.

3. Credit Policy: Where liberal credit policy is followed higher working capital is required as large

amount of funds are tied up in sundry debtors.

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Similarly, if a company enjoys good reputation in the market, it can get raw material on credit and

will require less working capital

4. Inventory Policy: If inventory is efficiently managed less working capital is required. However

if inventory is not properly managed, more than required purchases are made, large amount of

working capital will be required. If the raw material is available throughout the year at constant

price, inventory can be planned and less amount of working capital will be required but if supply

in the market is erratic large inventory may have to be purchased at times building up huge piles of

inventory and thereby more working capital.

5. Abnormal Factors: Factors like strikes and lock outs require more working capital. In

recessionary conditions higher amount of finished goods remain in stock. Similarly if there is

inflation in the economy more amount of working capital will be required for maintaining the same

amount of Current Assets.

6. Market Condition: market conditions also play important role in determining the working

capital requirement. If competition is tough the firm will have to give liberal credit to its customers

and therefore investment in debtors will cause an increase in working capital. Stocks of finished

goods must be ready in the stores to be able to serve the customer as and when he demands the

products. The customer will not wait in competitive market and the competitors will not leave any

stone unturned to snatch away the firm’s loyal customers therefore it becomes a necessity to provide

quick services.

7. Conditions of Supply: If supply of raw material etc. is prompt and nearby, small investment in

raw material will be needed. If supply is erratic, availability is for a short period only, then the firm

has to keep large amount of raw material as stock increasing the requirement of working capital.

8. Inventory Policy: Seasonal and cyclical changes in production and sales affect the working

capital requirement.

9. Growth and expansion: With growth and expansion more working capital is required. If a firm

is growing even the permanent working capital will increase with time and will fluctuate.

10. Level of taxes: With higher tax rates and requirement to pay taxes in advance more working

capital is required. If the government demands more taxes or in advance then more funds will be

blocked in running the business and higher working capital will be required.

11. Dividend Policy: Dividend polices also affect working capital requirement.

12. Price Level Changes: If prices are inflationary more and more working capital will be required

but if prices are reducing the investment in working capital will reduce with time as prices go down.

13. Operating Efficiency: A firm which has good operational efficiency can manage effectively

with less working capital where as a poor management will require large working capital.

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7. Working capital Management

It is an attempt to decide the optimum level of the various components of working capital

management in tune with the risk return profile acceptable to the management. It means

1) Determining the need for working capital. \

2) Finding the optimum level of investment in different current assets.

3) Examining the salient points of each element of working capital.

On same level of production, if working capital is more the returns would be less and if working

capital is less the chance of not being able to meet its short term liabilities increases. This is

assuming risk in the business. Thus working capital management is striking a balance between risk

and profitability. Working capital should neither be unnecessarily high and neither low. High

working capital indicates loosing profits by not investing excess capital in other investing

opportunities and low working capital means taking the risk of not meeting business obligations

and risking business reputation or goodwill. However, a surplus is not as bad as deficit. A shortfall

in working capital may wipe out the firm from business.

Another important aspect is to balance different components of working capital. A high current

ratio does not indicate satisfactory working capital if large amount is blocked in inventory or rather

slow moving and obsolete inventory. If debtors are very high and old, it does not reflect good

working capital but poor collection policy. Large amount of idle cash also does not give good

returns.

COMPONENTS OF WORKING CAPITAL:

Working capital management also means managing each component of working capital. Different

components of current assets require fund depending upon the respective operating cycle and the

costs involved. The current liabilities provide financing depending upon the lag in the payment.

The various components of working capital can broadly be classified as

Current assets

- Cash and bank balance

- Inventories

- Inventory of raw material

- Inventory of WIP

- Receivables

Current liabilities

- Creditors for purchases

- Creditors for expenses

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MANAGEMENT OF COMPONENTS OF WORKING CAPITAL

The above components of working capital are required to be managed separately and also

collectively.

Cash Management – The efficient collection and payment of cash is the function of the treasury

department. If cash is properly managed an important portion of the working capital will be

managed.

Inventories Management--Inventories are important current assets of the firm. They require

certain investment. The funds of the organization are blocked in inventories. Therefore, losing

interest on this fund becomes the opportunity cost of holding inventories. They should be so

managed that neither large funds are blocked nor there is any risk of being stock out.

Receivables Management--The goods are not always sold on cash, they are also sold on credit.

It takes some time to realize this cash from customers depending upon the credit allowed to them.

Receivables include debtors and bills

Firms offer credit to a customer for a number of reasons, but the ultimate objective is to maximize

the returns on investment in receivables & minimize the risk of bad debts. The financial manager

should follow such policy through which cash resources of the firm can be fully utilized.

Management of receivables creates a trade-off between liquidity and profitability. Thus the ultimate

objective of receivables management is to maximize the sales so as to maximize the profits.

Current liabilities: The time allowed by the suppliers to make payment is current liabilities. Trade

credit should be fully utilized but at the same time cost of trade credit should also be compared.

Creditors for expenses: Creditors for expenses arise when there is delay in making payments to

the workers for their wages and other trade expenses that create outstanding liabilities. This benefit

in lag of payments provide small but meaningful source of working capital.

8. Graded Illustrations

Illustration 13.1

Consider the following information of XYZ Ltd.

Amount (Rs.)

Raw material inventory consumed during the year 6,00,000

Average stock of raw material 50,000

Work-in-progress inventory 5,00,000

Average work-in-progress inventory 30,000

Finished goods inventory 8,00,000

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Average finished goods stock held 40,000

Average collection period from debtors 45 days

Average credit period availed 30 days

No. of days in a year 360 days

You are required to calculate:

(a) Net operating cycle period.

(b) Number of operating cycles in a year.

Solution:

(i) Calculation of Operating Cycle

1. Raw Material Holding Period: Days

Average stock of raw Material X 360 =

50,000 X 360 = 30

Total Raw Material 6,00,000

2. Work-in-progress Conversion Period:

Average stock of Work-in-

progress X 360 =

30,000

X 360 = 22

Total Cost of Production 5,00,000

3. Finished Goods Holding Period:

Average stock of Finished Goods X 360 =

40,000 X 360 = 18

Total Cost of Production 8,00,000

4. Average collection period from debtors (Given in Question) 45

Gross Operating Cycle 115

5. Creditors Payment Period: (Given in Question) (30)

Net Operating Cycle period 85

(ii) No. of operating cycle in a year

= 360/85 = 4.24 cycles in a year.

Illustration 13.2

The following information is available regarding operating cycle for each of the two years in respect

of Vishnu Limited:

Year 1 Year 2

Raw Material stock turnover 27 days 24 days

Work-in-Progress turnover 20 days 25 days

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Finished goods stock turnover 22 days 19 days

Debtor’s collection period 25 days 35 days

Gross Operating Cycle 94 days 103 days

Credit received from suppliers (21 days) (19 days)

Net Operating Cycle 73 days 84 days

Using the above data, answer the following:

a) What is the percentage change in number of operating cycles?

b) What is the percentage increase in length of operating cycle?

c) Explain the reasons for such increase.

Solution:

a) Percentage change in number of operating cycles:

No. of OC (Year 1) = 365/73 = 5 Cycles.

No. of OC (Year 1) = 365/84 = 4.35 Cycles.

Percentage decrease in No. of OC = (5 - 4.35) x 100/5 = 13%

b) Percentage increase in length of operating cycle:

Percentage increase in OC = (84 – 73) x 100/73 = 15.1%

c) Reasons for increase in operating cycle:

Particulars Days

WIP conversion period has increased 5

Debtors taking longer period to pay 10

Creditors demanding the payment early 2

17

Reduction in Raw material storage period (3)

Reduction in Finished Goods storage period (3)

Net increase in Operating Cycle 11

It is important to note that there exists inverse relationship between length and number of operating

cycle.

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8. Summary

Working Capital Management is the functional area of finance which covers all the current

accounts of the firm.

It is concerned with management of the level of individual current assets as well current

liabilities and therefore it is the management of total working capital.

Working capital can be gross working capital and net working capital or Permanent

Working Capital and Temporary Working Capital.

Working capital is a very important aspect in the successful running of the business.

The operating cycle helps in ascertaining the duration for which funds are required for

various stages of the working capital cycle.

When we add up the number of days it takes to complete the cycle, it is called as Simple

operating cycle. When weights are considered it becomes weighted operating cycle.

The Working Capital is affected by various factors like Production Policies, Nature of the

business, , Credit Policy, Inventory Policy, Abnormal Factors, Market Condition,

Conditions of Supply, etc.

Working capital management is striking a balance between risk and profitability.

Working capital should neither be unnecessarily high and neither low.

Working capital management also means managing each component of working capital.

Subject BUSINESS ECONOMICS Paper No and Title 4 ...

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