Estimating Working Capital

8/4/2019 Estimating Working Capital

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Presents

Eklavya

Subject: Finance Dt. 4/7/06

Chapter 1: Estimating the Working Capital.

Time of the Session: 30 Minutes + 20 Minutes for Practice.

Question: You are required to prepare a statement showing the estimate of workingcapital required to finance the level of activity of 18000 units per year, from the

following information obtained from the books of XYZ ltd.

Sr.No.

Particulars Per unit Cost

12

3

Raw MaterialsDirect Labor

Overheads

123

9

Total cost 24

Profit on Cost price is Rs.6

Hence Selling Price = Rs. 30 ( Cost price + Profit = Selling price).Adjustments:

a) Raw materials are in stock on an average for 2 months.b) Materials are in process on an average for a month.

c) Finished goods are in stock on an average for 2 months.d) Credit allowed by creditors is 2 months.

e) Lag in payment of wages is a month.f) Cash in hand and at bank is expected to be Rs. 7000.

Prepare a Statement showing Estimate of Working Capital.

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Hey guys dont get scared. We will go step by step.

IMAGINE:

You wake up to find the Snoozed Alarm. You rush to College, but

you are late. And there is more to it.

You are quick to realize your Walletlessness. You borrow from a

friend. And then it is back to normal.

You spend as if you are living for the day, and while returning home,

you are again back to Ground Zero (Penniless).

What was the Crux of the problem?

For those people who live by borrowing from other (the so called

Financially Leverage people) there was no problem, but for people

like our Founder, there was.

The answer to the Question is the topic itself.

You failed to estimate. And this failure was not only on

monetary part but it was complimented by you being late, bad

planning.


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The bottom line of the problem accurately was Estimated

Failure. In which case, you are a Damager and not a Manager.

Now lets understand the basics of Working Capital:.

This will include the following things:

1) Meaning

2) The ingredients of working capital.

3) Its effect on the long term policy of the Org.

Meaning:

o That part of Firms capital which is required to hold or operate

firms operations.

o Basically the concept of installment on loan can be understood as

working capital. How we need to pay regular installments so that

we can have access to resources.

o Similarly a firm has to pay for factors of production, to hold on

good. Etc.

o In Accounting sense Working Capital = Current Assets

Current Liabilities.

o Decisions relating to working capital and short term

o These involve managing the relationship between a firm's short-

term assets and its short-term liabilities.


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o The goal of Working capital management is to ensure that

the firm is able to continue its operations and that it has

sufficient cash flow to satisfy both maturing short-term debt

and upcoming operational expenses.

Ingredients or Management of Working Capital

o Management will use a combination of policies and techniques for

the management of working capital.

o These require managing the current assets - generally cash and cash

equivalents, inventories and debtors.

o There are also a variety of short term financing options which are

considered. This includes:

Cash management identify the cash balance which

allows for the business to meet day to day expenses,

but reduces cash holding costs

Inventory management - identify the level of inventory

which allows for uninterrupted production but reduces

the investment in raw materials and hence increases


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cash flow; Techniques Used: Just in Time (JIT) and

Economic order quantity (EOQ).

Debtors management - identify the appropriate credit

policy, i.e. credit terms which will attract customers,

such that any impact on cash flows and the cash

conversion cycle will be offset by increased revenue

and hence Return on Capital (or vice versa); see

Discounts and allowances.

Short term financing - inventory is ideally financed by

credit granted by the supplier; dependent on the cash

conversion cycle, it may be necessary to utilize a bank

loan (or overdraft), or to "convert debtors to cash".

Note:

Cash Conversion Cycle:

The net number of days from the outlay of cash (Purchase) for raw material to receiving

payment from the customer. As a management tool, this metric makes explicit the inter-

relatedness of decisions relating to inventories, accounts receivable and payable, and

cash.


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o Now that was the Conceptual part. But the

Problem is still prevalent.

That is, How to Estimate Working Capital ?

There are 2 ways to solve the sums of Estimation of

Working Capital1. Understanding the Mechanics and then solve

2. Going by a fixed format.

Lets analyze and understand the given sum.

Lets check the information given to us: 1) The Sales or the Turnover of the Firm.

2) The Cost Sheet


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Note:

The preparation of Cost Sheet is very important from Exam point of View. Hence,Structure of Cost Sheet is Given below:

Particulars Amount Amount

1) Direct Costs:a. Direct Wages:

b. Direct Labor:c. Raw Materials

d. CarriageInward:

Prime Cost

2) Factory Costs orOverheads Costs:

Factory Cost

3) Office and

Administrative Exp.

Cost of Production:

(+) Opening Stock

Finished goods.

(-) Closing Stock

Cost of Goods Sold:

4) Selling &Distribution Costs:

Cost of Sales:

5) Profit per Unit:

Selling Price per Unit:


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After Understanding the Cost Sheet, lets now make one for the Above problem:

Cost Sheet Of XYZ Ltd for the Period _/_/_

Sr.No.

Particulars Per unit Cost

12

3

Raw MaterialsDirect Labor

Prime Cost

Overheads

123

15

9

Factory cost/Cost of Production/

Cost of Sales

Profit

Selling Price

24

6

30

As there are no Administrative Expenses or Selling or Distribution

Expenses, hence Cost of Production and Cost of Sales Remains Same.

That was About Cost Sheet. Mind You, There will be MoreSums for practice on Cost Sheets as well as Working

Capital.


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Statement of Estimating Working Capital

It is a Compartmental Distribution of all the Costs in an EconomicSense.

For Example,

Imagine You Enter a Restaurant, and there are 10 Seats or

Tables Unoccupied, for Next 10 Minutes.

This Would simply mean that, had there been only ONE Chair, it would

have been Vacant for 100 Minutes. That is what we mean by Calculating

Economically.

2nd

Example:

Imagine 3 People of Same Working Capacity, are Completing a Task.

Now, That would Simply mean Task Will be Completed in 1/3 of the Time

(Approx.) and it would also mean that if the Same Task is given to a person

of Same Working Capacity, then he would take approx. 3 Times the Time

taken by Group to Complete it.

Task To Be Completed = 3 units.

One person Can workout only 1 Unit per Day

Hence He Will Require 3 Days.

But When a Group of 3 do the Task, it would Take them a proper 1 day.


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If you have got the above examples, then Try this Sentence:

Raw Materials are in Store on an Average for 2 Months.

Guys Dont Scratch Your Heads. Mind you, It aint That Simple.

Lets understand it Step by Step:

A firm has daily Requirement for Raw Materials.

Suppose this Requirement is Same/Static For ALL the PERIODS

of Equal Size.

Raw Materials are in Store on an Average For 2 Months

This would Simply mean that Raw Materials At any Point of Time in

the Year Satisfy the Production For Next 2 Months.

That is at the End of Year, there will still be 2 months materials Left.

Or we can say, that, Without Ordering for the Raw Material, I can

Satisfy the Production Cycle For 2 Months. By this statement, we can

again conclude, that whenever we want to make Financial or

Technical Analysis of Raw Materials of the Firm, it would be on the

Scale of 2 Months.

That is once in 2 months, or Thrice in 6 months, or Six times

Annually.

But, but, but, now as i say this, i am remembered by a Fact:


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That is Working Capital Requirement is Forecasted or Calculated on

Monthly Basis. That is 12 Estimates Annually.

And not to Forget, Every Item Which Constitutes the Working

Capital Would Have a Different Period or Cycle of Rotation.

Hence there is a need felt to calculate Working

Capital on Monthly Basis.

Lets make a complete sense of the given Statement:

Raw Materials are in Store on an Average For 2 Months

This as explained earlier, there would be twice the capacity of materials

required by the production department.

But, as also said earlier, the Estimates have to be prepared Monthly.

Hence Simply put Raw Materials are 2 Times the Capacity in any

Given Month.

Hence the Cost of Raw Materials for the Month =

Raw Materials required per Month x 2 x Rate per Unit of Raw

Material.

That is What we mean by Economically Speaking for Standard Units of Time.


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That is Expressing the Variable Time Cycle in to Standard Unit of Time which is One

Month.

Now Consider this:

Finished Goods are in Stock for an Average 2 months.

It would simply mean that, Finished goods for the Month are Double the

Capacity for that Respective Month.

Cost of Finished Goods: Finished Goods Produced Per Month x 2 x Rate per

Unit.

If you have got this, You have Just Completed A Chapter in Finance.

(Thanks to Eklavya).


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The Technical Aspects of Statement:

As said Earlier, Working Capital is the Difference between Current

Assets and Current Liabilities.

Hence every Statement will have 2 parts to it. That is Current Assets

and Current Liabilities.

A specimen is provided below:

Sr. Particulars Amount Amount (Rs.)

A) Current Assets:i) Stock :

a) Raw Materials:Requirement Per Month x Rate

x Average Time

b) Finished Goods:

Requirement Per Month x Rate x

Average Time

ii) Work in Progress:

a) Requirement Per Month x Rate xAverage Time x 0.5

b) Labor: Requirement Per Month x

Rate x Average Time x 0.5

c) Overheads: Requirement Per

Month x Rate x Average Time x 0.5

iii) Debtors: Sales Per Month x


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Selling Price x Average Time

iv) Advances Given:

v) Cash in Hand & Bank:

Less:

Current Liabilities:

i) Creditors:

a) Raw Materials: Requirement PerMonth x Rate x Average Time Lag.

b) Labor: Requirement Per Month xRate x Average Time Lag.

c) Overheads: Requirement PerMonth x Rate x Average Time Lag.

Net Working Capital Required:

Now as given in the Above Specimen, while Solving

Every sum, we must care of all individual costs, that

including there Periods of Rotation as well as Master

Groups that is Current Assets and Current Liabilities.

Let us Go on the Main Sum provided at the Beginning

of the Document.


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But, but, but

We still have to find out the Production Capacity of thePlant. Without which we will be always dealing with the

Costs per unit. But Estimation of Working Capital is the

Aggregate of all the Costs and that too Monthly.

Given that Production Level of the Firm annually = 18000

Units.

Hence the Monthly Production = 18000\12 = 1500 units.

Books of M/s. XYZ Ltd

Level of Activity: 18000 (Annually)

Therefore, Monthly = 18000/12 = 1500

Estimate of Working Capital Requirement

Sr. Particulars Amount Amount (Rs.)

B) Current Assets:i) Stock :

a) Raw Materials: 1500 x 12 x 2 36000


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b) Finished Goods: 1500 x 24 x 2

ii) Work in Progress:b) Raw Materials: 1500 x 12 x 0.5

c) Labor: 1500 x 3 x 0.5 x 0.5

d) Overheads: 1500 x 9 x 0.5 x

0.5

i) Debtors: 1500 x 30 x 2

ii) Cash in Hand & Bank:

Current Assets Total

Less:

Current Liabilities:i) Creditors:

a) Raw Materials : 1500 x 12 x 2

b) Labor: 1500 x 3 x 0.5

72000

9000

1125

3375

1,35,000

7000

(36,000)

(2,250)

1,08,000

13,500

1,35,000

7,000

2,63,500

(38,250)

Working Capital Required 2, 25, 250

Assumptions Made: (Necessary for every Problem).

1) Both Production and Sales are Evenly Distributed.

2) Raw Materials are issued to Production Right in the

Beginning of the year, whereas wages and overheads areincurred Evenly.

3) Overdraft Sanctioned by Bank is Ignored.


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Notice the Sub-heading of Work-in-Progress. You will notice that

every Sub-Cost is Multiplies by . This is because it is Work-in-

Progress.

This means that we are Assuming, that Goods in Work-in-Progress

are not completely finished nor completely in the Stage of Raw

Materials. That is some work has been done on them, which is why

they are Work-in-Progress.

Hence it is Assumed that they are Partially Completed and to be

Precise are half done.

That makes it for those who have done this sum by understanding

Each and Every Concept.

Now for those people who havent understood the Fundamentals, Just Follow that GivenFormat Blindly and you Will get it right.

For Format See page Number 13.

Sums for Practice will be Posted After Some time, Onceyou Complete the Tutorials of the Chapter, Followed by the

Solution for the Same Tomorrow.


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Estimating Working Capital