Paper-3 Part-II Financial Management

Chapter-7 Unit-I
By: CA Kapileshwar Bhalla
Working Capital Management involves
managing the balance between firm’s short-
term assets and its short-term liabilities.
From the value point of view:

Gross Working Capital: It refers to the firm’s

investment in current assets.

Net Working Capital: It refers to the difference

between current assets and current liabilities.
From the point of view of time:

Permanent Working Capital: It is that minimum level of

investment in the current assets that is carried by the business
at all times to carry out minimum level of its activities.

Temporary Working Capital: It refers to that part of total

working capital, which is required by a business over and above
permanent working capital.
Nature of Business

Market conditions

Inventory policy

Demand conditions

Operating efficiency

Credit policy

Dividend policy
Working capital management entails the control
and monitoring of all components of working
capital i.e. cash, marketable securities, debtors,
creditors etc.
Finance manager has to pay particular attention
to the levels of current assets and their
financing. To decide the level of financing of
current assets, the risk return trade off must be
taken into account.
The level of current assets can be measured by
creating a relationship between current assets
and fixed assets.
 A conservative policy means lower return and risk while an aggressive
policy produces higher return and risk.

The two important aims of the working capital management are

profitability and solvency.

A liquid firm has less risk of insolvency i.e. it will hardly experience a cash
shortage or a stock out situation. However, there is a cost associated with
maintaining a sound liquidity position.

So, to have a higher profitability the firm may have to sacrifice solvency and
maintain a relatively low level of current assets.
One of the methods for forecasting working capital requirement is based on the
concept of operating cycle. The determination of operating capital cycle helps in
the forecast, control and management of working capital.

The length of operating cycle is the indicator of performance of management.

The net operating cycle represents the time interval for which the firm has to
negotiate for Working Capital from its Bankers. It enables to determine accurately
the amount of working capital needed for the continuous operation of business
activities.

The duration of working capital cycle may vary depending on the nature of the
business.
 In the form of an equation, the operating
cycle process can be expressed as follows:
=R + W + F +D – C
Where,
R= Raw material storage period.
W= Work-in-progress holding period.
F= Finished goods storage period.
D= Debtors collection period.
C= Credit period availed.
} Total cost Basis
} Cash Cost Basis
The following information has been
extracted from the records of a Company:
Product Cost Sheet
Rs./Unit
Raw Materials 45
Direct Labour 20
Overheads 40
Total 105
Profit 15
Selling Price 120
Raw Material are in stock on an average of 2 months.
The materials are in process on an average for 4 weeks. The degree of completion is
50%.
Finished goods stock on an average is for 1 month.

Time lag in payment of wages and overheads is 1 ½ weeks.

Time lag in receipt of proceeds from debtors is 2 months.

Credit allowed by suppliers is 1 month.

20% of the output is sold against cash.

The company expects to keep a cash balance of Rs. 1,00,000.

Take 52 weeks per annum.

The company is poised for the manufacture of 1,44,000 units in the year.
•You are required to prepare a statement showing the working capital requirements of the company.
 Statement showing the Working Capital
Requirement of the Company
[A] Current Assets:
Stock of raw materials 10,80,000
(64,80,000 / 12 months) × 2 months
Work-in-progress 5,81,538
[(1,51,20,000 × 4) / 52 weeks] × 50%
Finished goods 12,60,000
(1,51,20,000 / 12 months) x 1 month
Debtors 23,04,000
(`1,72,80,000 x 80% /12 months) x 2 months
Cash balances 1,00,000
53,25,538
[B] Current Liabilities:
Creditors of raw materials 5,40,000
(64,80,000 / 12 months) x 1month
Creditors for wages & overheads 2,49,231
{86,40,000/52} x 1.5 weeks 7,89,231
Net Working Capital (C.A− C.L) 45,36,307
The following annual figures relate to MNP Limited:
Sales (at 3 months credit) Rs.90,00,000
Materials consumed
(suppliers extend 1 ½ months credit) 22,50,000
Wages paid (one month in arrear) 18,00,000
Manufacturing expenses
outstanding at the end of the year 2,00,000
(Cash expenses are paid one month in arrears)
Total administrative expenses
(Cash expenses are paid one month in arrears) 6,00,000
Sales promotion expenses 12,00,000
(paid quarterly and in advance)
The company sells its products on gross
profit of 25% assuming depreciation as a
part of cost of production.
Its keeps 2 months stock of finished goods
and 1 months stock of raw materials as
inventory.
Its keeps cash balance of Rs. 2,50,000.
Assume a 5% safety margin, work out the
working capital requirements of the
company on cash cost basis. Ignore Work
in progress.
Computation of Total Cash Cost:

Sales 90,00,000
Less: Gross profit 22,50,000
(25% x sales revenue)
Total Manufacturing cost (A) 67,50,000
Less: Material consumed cost 22,50,000
Less: Wages paid 18,75,000 40,50,000
Manufacturing expenses 27,00,000
Less: Cash manufacturing expenses 24,00,000
(2,00,000 x 12)
Depreciation: (B) 3,00,000
Total Manufacturing cost : (C) = (A) – (B) 64,50,000
Add: Administrative expenses 6,00,000
Add: Sales promotion expenses 12,00,000
Total cash cost of manufacturing and sales 82,50,000
Debtors 20,62,500
(Total cash cost × 3/12) or
(82,50,000 × 3/12)
Cash balance 2,50,000
Pre-paid sales promotion expenses 3,00,000
Raw materials stock 1,87,500
(Material consumed / 12) or (`22,50,000 / 12)
Finished goods stock 13,75,000
(Total cash cost x 2/12) or
(82,50,000 x 2/12)

Total Current Assets 41,75,000

Sundry creditors
Material cost 2,81,250
(22,50,000 x 1.5 months / 12 months)
Manufacturing expenses outstanding 2,00,000
Wages outstanding 1,50,000
(18,00,000 × 1/12 months)
Administrative expenses outstanding 50,000
(6,00,000 × 1 month / 12 months)

Total Current Liabilities 6,81,250

= Current Assets – Current Liabilities

= 34,93,750 (On cash cost basis)

Working Capital Cycle indicates the length of
time between a company’s paying for
materials, entering into stock and receiving
the cash from sales of finished goods. It can
be determined by adding the number of days
required for each stage in the cycle.
=R + W + F +D – C
Where,
R= Raw material storage period.
W= Work-in-progress holding period.
F= Finished goods storage period.
D= Debtors collection period.
C= Credit period availed.
Raw material storage period
= Average stock of raw material
Average cost of raw material consumption per
day
Average work - in - progress inventory
Average cost of production per day
 Average stock of finished goods
Average cost of goods sold per day
 Average book debts
Average Credit Sales per day
 Average trade creditors
Average credit purchases per day
 Balance Balance as at
as at 1st April, 31st March,
2009 2010
Raw Material 45,000 65,356
Work-in-progress 35,000 51,300
Finished goods 60,181 70,175
Debtors 1,12,123 1,35,000
Creditors 50,079 70,469
Annual purchases of raw material 4,00,000
(all credit)
Annual cost of production 7,50,000
Annual cost of goods sold 9,15,000
Annual operating cost 9,50,000
Annual sales (all credit) 11,00,000
You may take one year as equal to 365 days.

} Net operating cycle period.

} Number of operating cycles in the year.
} Amount of working capital requirement.
Raw Material Storage Period (R)
= Average Stock of Raw Material
× 365
Annual Consumption of Raw Material
{45,000 + 65,356}/2 × 365
3,79,644
= 53 days.
Annual Consumption of Raw Material
= Opening Stock + Purchases - Closing Stock
= 45,000 + 4,00,000 – 65,356
= 3,79,644
WIP Conversion Period
=Average Stock of WIP × 365
Annual Cost of Production
={35,000 + 51,300}/ 2 × 365
7,50,000
= 21 days
 Average Stock of Finished Goods x 365
Cost of Goods Sold

65,178 × 365
9,15,000
= 26 days.
Average Stock = [60,181 + 70,175] /2
= 65,178
 Average Debtors × 365
Annual Credit Sales

1,23,561.50 × 365
11,00,000
= 41 days
Average debtors = [1,12,123 + 1,35,000]/2
= 1,23,561.50
 Average Creditors × 365
Annual Net Credit Purchases

[50,079 + 70,469] /2× 365

4,00,000
= 55 days
=R+W+F+D-C

= 53 + 21 + 26 + 41 – 55

= 86 days
 365
Operating Cycle Period

365
86
= 4.244
 Annual Operating Cost
Number of Operating Cycles

9,50,000
4.244

= 2, 23,845
An Engineering Company is considering its
working capital investment for the year
2003-04. The estimated fixed assets and
current liabilities for the next year are Rs.
6.63 crore and Rs. 5.967 crore respectively.
The sales and EBIT depend on investment in
its current assets, particularly inventories
and receivables. The Company is examining
the following alternative Working Capital
Policies:
Working Capital Investment in Estimated Sales EBIT
Policy Current Assets (Rs. crore) (Rs. crore)
(Rs. crore)

Conservative 11.475 31.365 3.1365

Moderate 9.945 29.325 2.9325
Aggressive 6.63 25.50 2.55
to calculate the following for each policy:
} Rate of return on total assets.
} Net working Capital position.
} Current Assets to fixed assets ratio.
} Discuss the risk-return trade off each
working capital policy.
{May 2003}
 Working Capital Investment Policy

Conservative Moderate Aggressive

Current assets 11.475 9.945 6.630

Fixed assets 6.630 6.630 6.630
Total assets 18.105 16.575 13.26
Current 5.967 5.967 5.967
liabilities
Estimated sales 31.365 29.325 25.5
Estimated EBIT 3.1365 2.9325 2.55
Current ratio 1.92 1.67 1.11
Rate of return on 17.32 17.69 19.23
total assets
(in percentages)
Net working capital 5.508 3.978 0.663
position (in crores)
Current assets to 1.73 1.50 1
fixed assets ratio
Risk return trade off Min Mod. Max
 What is working Capital

Approaches to calculate working capital

Concept of operating cycle

Practical Illustrations
All the best ……..