WCM Principles SG

8/4/2019 WCM Principles SG

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What is Working Capital?

Working Capital is the investment needed

for carrying out day to day operations of

the business smoothly.

It refers to firms investment in short- term

Assets.


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What are all the components of Current (Short- term)

Assets?

Cash

Short- term Securities

Debtors/ Accounts Receivables

Bills Receivables Inventory

- Raw material

- Work- in Process- Finished Goods

- Stores and spare parts


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What are the components of Current

(Short- term) Liabilities?

Accounts payable/ Creditors

Bills Payable

Short- term borrowings Advances/ Accrued liabilities


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What is Working Capital

Management?

A managerial accounting strategy focusingon maintaining efficient levels of bothcomponents of working capital, current

assets and current liabilities, in respect toeach other.

Working capital management ensures a

company has sufficient cash flow in orderto meet its short-term debt obligations andoperating expenses.


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Difference in the management of fixed assets and

current assets

First, in managing fixed assets, time is a very importantfactor; consequently, discounting and compounding

techniques play a significant role in capital budgeting and a

minor one in the management of current assets. Second, the large holding of current assets, reduces the

overall profitability. Thus, a risk-return trade-off isinvolved in holding current assets.

Third, levels of fixed as well as current assets depend uponexpected sales, but it is only the current assets whichcan be adjusted with sales fluctuations in the short run.

Thus, the firm has a greater degree of flexibility in managing

current assets.

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Concepts of Working Capital

Gross working capital (GWC)

GWC refers to the firms total investment incurrent assets.

GWC focuses on Optimization of total investment in current assetsFinancing of current assets

Also referred as Current Capital or Floating

Capital or Circulating Capital.

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Concepts of Working Capital

Net working capital (NWC)NWC refers to the difference between

current assets and current liabilities.

NWC focuses onLiquidity position of the firm

Judicious mix of short-term and long-tern financing

NWC can be positive or negative.Positive NWC = CA > CL

Negative NWC = CA < CL

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Operating Cycle

Operating cycle is the time duration required to

convert sales, after the conversion of resources

into inventories, into cash.

The operating cycle of a manufacturingcompany involves three phases: Acquisition of resources such as raw material, labour,

power and fuel etc.

Manufacture of the product which includes conversion ofraw material into work-in-progress into finished goods.

Sale of the producteither for cash or on credit. Credit sales

create account receivable for collection.

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Operating Cycle

The length of the operating cycle of a

manufacturing firm is the sum of: Inventory conversion period (ICP).Debtors(receivable) conversion period (DCP).

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Operating cycle of a manufacturing firm


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Gross Operating Cycle (GOC)

The firms gross operating cycle (GOC) can be

determined as inventory conversion period (ICP)

plus debtors conversion period (DCP). Thus,

GOC is given as follows:

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Inventory Conversion Period

Inventory conversion period is the total time

needed for producing and selling the

product. Typically, it includes:Raw material Conversion Period (RMCP)

Work-In-Process Conversion Period (WIPCP)

Finished Goods Conversion Period (FGCP)

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Debtors (receivables) Conversion Period

(DCP)

Debtors Conversion Period (DCP) is theaverage time taken to convert debtors into

cash.

DCP represents the average collection period.It is calculated as follows:

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Creditors (payables) Deferral Period

(CDP)

Creditors (payables) Deferral Period (CDP) isthe average time taken by the firm in paying its

suppliers (creditors).

CDP is given as follows:

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D.D. Manufacturers-Statement of Cost of Sales (Rs. Crores)S.No. Items 20X1 20X2 20x3

1 Opening raw material inventory 5.2 6.8 7.6

2 Purchase of raw material (Credit) 25.6 33.5 45.6

3 Closing raw material inventory 6.8 7.6 9.2

4 Raw material consumed (1+2-3) 24.0 32.7 44.0

5 Wages and Salaries 8.1 11.2 15.3

6 Other Manufacturing expenses 3.2 4.4 5.8

7 Depreciation 1.8 2.0 2.6

8 Total Cost(4+5+6+7) 37.1 50.3 67.7

9 Opening Work- in- process inventory 1.8 2.0 3.1

10 Closing Work- in- process inventory 2.0 3.1 4.6

11 Cost of Production (8+9-10) 36.9 49.2 66.2

12 Opening Finished Goods Inventory 3.2 2.8 3.613 Closing Finished Goods Inventory 2.8 3.6 2.9

14 Cost of Goods Sold (11+12-13) 37.3 48.4 66.9

15 Selling, administrative and other expenses 1.3 1.9 2.1

16 Cost of Sales (14+15) 38.6 50.3 69.0


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D.D. Manufacturers- Sales and Debtors (Rs Crores)

Additional Data

20X1 20X2 20x3

Sales (Credit) 45.9 60.1 82.7

PBIT 7.3 9.8 13.7

Debtors- Opening balance 8.3 10.8 14.9Debtors- Closing balance 10.8 14.9 20.5

Creditors- Opening balance 3.7 4.6 8.0

Creditors- Closing balance 4.6 8.0 12.0

You are required to calculate (i) operating cycle, (ii) net operating

cycle, and (iii) cash conversion cycle for each of the three years.


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Cash Conversion or Net

Operating CycleNet Operating Cycle (NOC) is the difference

between gross operating cycle and payables

deferral period.

Net operating cycle (without taking into consideration of

depreciation and profit element from the profit) is also

referred to as Cash Conversion Cycle.

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BEHAVIOUR OF WORKING CAPITAL

Permanent orfixed working capital

A minimum level of current assets, which iscontinuously required by a firm to carry on itsbusiness operations, is referred to as permanent orfixed working capital.

Fluctuating orvariable working capital

The extra working capital needed to support the

changing production and sales activities of the firm isreferred to as fluctuating or variable working capital.

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Non- Growth, Non- seasonal and Non- cyclical

firms

Time

Workingcapital


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Growing, Non- seasonal and Non- cyclical firms

Time

Working

Capital


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Growing, Seasonal and Non-

cyclical firms

Working capital

Time


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Growing, Seasonal and Cyclical firms

Working

Capital

Time


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Determinants of Working

Capital

1. Nature of business

2. Market and demand

3. Technology and manufacturing policy4. Credit policy

5. Supplies credit

6. Operating efficiency7. Inflation

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Importance of Working capital Management

Time: WCM needs much of financialmanagers time.

Investment: Needs larger portion of the

total investments. Criticality: Generally, WCM is great

significance for all firms, but it is very

critical for small firms. Growth: Directly related to the growth of

the firm.


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Issues in Working Capital

Management

Current Assets to Fixed Assets Ratio

Liquidity vs. Profitability: RiskReturn Trade-

off

The Cost Trade-off

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Management

Current Assets to Fixed Assets Ratio :

Conservative Policy= Higher CA/FA Ratio

Aggressive Policy = Lower CA/FA Ratio

Average (Moderate) Policy= Neither too high ortoo low level of CA/ FA. (say- optimum level)

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Management

Current Assets to Fixed Assets Ratio

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Alternative current asset policies


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Management

The Cost Trade-off

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Cost Trade-off


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Estimating Working capitalCurrent assets holding period To estimate working capital requirements on the basis of

average holding period of current assets and relating them tocosts based on the companys experience in the previousyears. This method is essentially based on the operating

cycle concept.Ratio of sales To estimate working capital requirements as a ratio of sales

on the assumption that current assets change with sales.

Ratio of fixed investment To estimate working capital requirements as a percentage

of fixed investment.

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Working Capital Finance

Policies Long-term: Sources includes share capital,

preference capital, debentures, longterm

borrowings, reserves and surplus.

Short-term: Less than a year- Advances fromBank, other suppliers of short- term finances, public

deposits, commercial paper, factoring of receivables

etc.

Spontaneous:Automatic sources like, tradecredit, outstanding expenses, etc.

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Working Capital Finance

PoliciesMatching Approach or Hedging Approach:Long-term financing will be used to finance fixed assets and

permanent current assets and short- term finance will be

used to finance temporary/ variable/ fluctuating currentassets.

Conservative Approach: Depends more on longterm financing- even temporary current assets are financed

with long-term finances.Aggressive Approach: Uses more of short-term

financing than warranted- part of fixed assets also financed

with short- term finance.

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Matching Approach32

Financing under matching plan


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Conservative Approach33

Conservative financing


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Aggressive Approach34

Aggressive financing

Short term vs Long term Financing:


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Short-term vs. Long-term Financing:

A Risk-Return Trade-off

Cost

Flexibility

Risk

Risk-return trade-off

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Term structure of Interest rates:

Yield Curve

Relationship between maturity of debt and interest rates(Cost).

Higher the maturity period the interest (cost) will be high.

(Liquidity Preference theory:Lenders are risk averse and risk

generally increase with the length of lending time)


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Estimation of Working Capital- Problem 1

X& Co. is desirous to purchase a business and has consulted you, and

the one point on which you are asked to advise them is the average

amount of working capital which will be required in the first years

working.

You are given the following estimates and are instructed to add 10% toyour computed figure to allow contingencies:

Set up you calculations for the average amount of working capital

required.

Estimation of Working Capital- Problem 1 contd


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Estimation of Working Capital Problem 1 contd.

Particulars Period Figures for the year (Rs)

Average amount backed up for stocks:

- Stocks of finished product 5000

- Stocks of stores, materials etc 8000

Average Credit Given:

- Inland sales 6 weeks credit 3,12,000

- Export sales 1 weeks credit 78,000

Lag in payment of wages and otheroutgoings:

- Wages 1 weeks 260000

- Stocks, materials, etc. 1 weeks 48000

- Rent, royalties, etc. 6 months 10000

- Clerical staff month 62000

- Manager month 4800

- Miscellaneous expense 1 months 48000

Payment in Advance:

Estimation of Working Capital- Problem :2


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Estimation of Working Capital Problem :2

From the following information prepare a statement showing the

estimated working capital needs, in total and for each constituent.

It is estimated that (a) Raw materials will be carried in stock for twoweeks and finished goods for three weeks (b) Factory processing

will take four weeks ( c) Suppliers will give four weeks credit and

customers will require seven weeks credit. It may be assumed that

the production and overhead arises evenly throughout the year.

Budgeted sales Rs. 52,00,000

Analysis per unit of sales Rs.

Raw Materials 25

Direct labour 45

Overheads 20

Cost of sales 90

Profit 10

Sales price per unit 100


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Estimation of Working Capital : Problem: 3

A Proforma cost sheet of a company provides the following particulars:

The following further particulars are available:

(a) Raw material in stock, on an average one month ; materials in process, on average

half a month; finished goods in stock, on an average one month.

(b) Credit allowed by suppliers is one month; credit allowed to debtors is two months; lagin payment of wages is one and a half weeks; lag in payment of overhead expenses is

one month; one fourth of the out put is sold against cash; cash in hand and at bank is

expected to be Rs. 25,000.

You are required to prepare a statement showing working capital needed to finance a level

of activity of 1,04,000 units of production. You may assume that production is carried

on evenly throughout the year, and wages and overheads accrue similarly.

Amount per unit Rs.

Raw material 80

Direct labour 30

Overheads 60

Total cost 170

Profit 30

Selling price 200



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gWhile preparing a project report on behalf of a client you have collected the

following facts. Estimate the net working capital required for that project. Add

10% to your computed figure to allow for contingencies.Particulars Amount / Unit Rs.

Estimated cost per unit of productionis:

Raw material 42.40

Direct labour 15.90

Overheads (excluding depreciation) 31.80

Total cost 90.10

Additional Information:

Selling Price per unit 106.00

Level of Activity- production per annum 1,00,000 units

Raw material in stock Average 4 weeks

W I P (assume 50% completion stage Average 2 weeks

Finished goods in stock Average 4 weeks

Credit allowed by suppliers Average 4 weeks

Credit allowed to debtors Average 8 weeks

Lag in payment of wages Average 1 weeks

Cash at bank is expected to be Rs. 1,25,000

You may assume that

production is carried on

evenly throughout the year

(52 weeks) and wages and

overheads accrue similarly.

All sales are on credit basis

only.



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A firm is engaged in large- scale manufacturing company. From the

following information you are required to forecast their working capital

requirements, projected monthly sales of 32000 units are at Rs. 10 per

unit. The expected ratio of cost to selling price are the following:

Raw materials 40% and labour 30%.

Budgeted overheads Rs. 16000 per week.

Stock will include raw materials for Rs. 96000 and 16000 units of finished

goods.

Material will stay in process for 2 weeks.

Credit allowed to debtors is 5 weeks.

Credit allowed by creditors is 1 month.

Lag in payment of overheads is 2 weeks.

Wages will be paid at the beginning of the week following the week ofwork.

Cash in hand is expected to be 10% of net working capital.

Assume the production is carried on evenly throughout the year and

overheads accrue similarly and a time period of 4 weeks to equivalent to

a month.



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Estimation of Working Capital : Problem: 6A client of yours, Care Ltd., is about to commence a new business and finance has been

provided in respect of fixed assets. They have, however, asked you to advice on the

additional amount, which they should make available for the working capital.

They provided you with the following estimate for their first year and they inform you that

they have arranged an overdraft limit with their banker for Rs. 150000.Particulars Averageperiod ofcredit

Estimate forthe first year(Rs.)

Purchase of material 6 weeks 2600000

Wages weeks 1950000

Overheads:

Rent 6 months 100000

Directors and Managers salary 1 month 360000

Traveler's commission 2 weeks 455000

Other overheads 3 months 600000Sales:

Cash 1400000

Credit 7 weeks 6500000

Sales were made at

an even rate for the

year. You are

required to preparefrom the above

figures and

information, a table

for submission to

your client, giving

an estimate of theaverage amount of

working capital

which are provided.

Documents

WCM Principles SG