The term working capital refers to the amount of fund required to maintain day-to-day expenditure on operational activities of a business

enterprise. The basic financial formula for calculating working capital is; Working Capital= Current Assets (-) Current Liabilities The estimation of working capital of a firm is a difficult task for the management because of its varying characteristics. It varies across the companies in an industry as well as over the period under consideration for a particular firm. It also varies with the nature and size of the enterprise, level of production, operating cycle, credit policy of the firm and other different macro-economic factors (inflation, fiscal policy, business cycle etc.), availability of raw materials and so on and so forth. WORKING CAPITAL MANAGEMENT INTRODUCTION: Working capital management is a short term financial management. It is concerned with the problems that arise in attempting to manage the current assets, the current liabilities & the relationship that exists between them. The current assets refer to those assets which can be easily converted into cash in normal course of business. The Goal of WCM is to manage the firm s current assets & liabilities, so that a satisfactory level of working capital is maintained. If the firm cannot maintain the satisfactory level of working capital, it is likely to create problems in the liquidity and it may become insolvent. To maintain this margin of safety, current asset should be large enough to cover its current liabilities. Zero Working Capital The usual practice of a firm is to maintain a positive working capital at a level, which ensures better liquidity, good profitability with a reasonable level of risk. The situation of negative working capital is very unusual and mainly linked with financing decision of the firm. But nowadays, the concept of zero working capital is gaining importance in working capital management. It refers to the equality between current assets and current liabilities at all times. To avoid excess investment in current assets, firms try to meet their current liabilities out of the current assets fully matching with the concept. Consequently, smooth and uninterrupted working capital cycle is maintained to create an environment in which firm always try to improve the quality of the current assets at all times for maintaining cent-percent realization of current assets. This zero working capital always brings a fine balance in financial management and brings out the efficient performance of the financial managers.

Zero working capital= CA = CL

Operating Cycle: Operating Cycle approach has been gaining more importance in the present business scenario. Under this concept, the requirements of working capital depend on the operating cycle of a firm and the cost of all operational activities. The Operating Cycle (OC) refers to the period during which investment of one unit of money will remain blocked in the normal course of operation till its recovered out of revenue. It is the average time between the acquisition of materials or services entering the process and the final cash realization from sales. It may be broadly classified into the following four stages: 1. Raw Material Storage Stage 2. Work-in-Progress Stage 3. Finished Goods / Inventory Stage and 4. Receivables Collection Stage. The stages consist of the following: Conversion of cash into raw-materials; Conversion of raw-material into work-in-progress; Conversion of work-in-progress into finished stock; Conversion of finished stock into accounts receivable through sales; and Conversion of accounts receivable into cash

The stage between purchase of raw materials and their payment is known as the creditors payables period. The period between purchase of raw materials and production of finished goods is known as the inventory period. The period between sale of finished goods and the collection of receivables is known as the accounts receivable period. In the form of an equation, the operating cycle process can be expressed as follows:

Operating Cycle = R + W + F + D - C

R = Raw material storage period W = Work in progress holding period F = Finished goods storage period D = Debtors collection period C = Credit payment period

Cash cycle also termed as net operating cycle or cash conversion cycle is interpreted as the number of days between the payment for inputs and getting cash by sales of commodities manufactured from that input. It is the time lag between the payment for raw materials purchases and the collection of cash from sales. The fundamental formula for the calculation of cash conversion cycle is as follows: = = Inventory Period + Accounts Receivable Period Accounts Payable Period Operating Cycle Accounts Payable Period

Some Illustrations depicting calculation of Operating Cycle Operating Cycle for the year 2010 1 RMCP = 59 days 2 WIPCP = 24 days 3 FGCP = 4 days 4 Debtors Conversion Period = 149 days 5 Payable Deferral Period = 132 days. Gross operating Cycle = 59 + 24 + 4 + 149 = 236 days Net Operating Cycle = 236 - 132 = 104 days

Operating Cycle for the year 2011 1 RMCP = 48 days 2 WIPCP = 23 days 3 FGCP = 5 days 4 Debtors Conversion Period = 181 days 5 Payable Deferral Period = 162 days. Gross operating Cycle = 48 + 23 + 5 + 181 = 257 days Net Operating Cycle = 257 - 162 = 95 days

Thus the working capital cycle helps in the forecast, control & management of working capital. It indicates the total time lag & the relative significance of its constituent parts. The duration may vary depending upon the business policies.

The following ratios will help in managing debtors, creditors and inventories 1. Stock Turnover ratio = Cost of goods sold / Average Stock 1. Material Storage Period (M) = Average Stock of raw materials / Daily average consumption OR = [(Opening stock + Closing Stock) /2] / (material consumed for the year / 365) WIP or Conversion Period (W) = Average Stock of WIP / Daily average production cost OR = [(Opening WIP + Closing WIP) /2] / (Total production cost / 365) Finished Goods Storage Period (F) = Average Stock of finished goods / Daily average cost of goods sold OR = [(Opening stock + Closing stock) /2] / (Total cost of goods sold / 365)

Debtors Turnover ratio = [(Debtors+ Bills receivable*365] / Net credit sales Creditors Turnover ratio = [(Creditors + Bills payable)*365] / Credit purchases

Depicts the operating cycle and the cash cycle.

Order placed

Stock arrives

Inventory Period

Accounts Receivable period

Accounts payable period

Cash Paid for Material Firm receives invoice Operating cycle Cash Cycle

Figure 4.3: Operating cycle

Estimation of Working Capital Requirement The determination of the amount of working capital requirement at a particular level of production is a problem for finance managers. To solve this problem, estimates of future requirements of current assets and cash flows are made. With the help of these cash flows, availability and future requirements of cash for current assets are ascertained to maintain liquidity. Following methods are generally used in estimating working capital for the future period: a) b) c) d) e) Operating Cycle Method Net Current Assets Forecasting Method Projected Balance Sheet Method Adjusted Profit and Loss Method Cash Flow Forecast Method

a) Operating Cycle Method

In this method, total operating expenses for a period are divided by the number of operating cycles in that period to calculate the cash requirement for working capital. Thus, the computation of total operating expenses, operating cycle period and number of operating cycles in the year is essential for estimating the working capital, as discussed below:

1.

Operating Expenses: These expenses include purchase of raw materials, direct labor cost, fuel and power, administrative and selling and distribution expenses for a specific period for which estimates can be obtained from cost records. Depreciation write off of intangible assets, tax and dividend and Capital expenses are not included. Operating Cycle Period: It means the total number of days involved in the different stages of operation starting from the purchase of raw materials till collection of sale proceeds from debtors after adjusting the number of days credit allowed by suppliers. Thus, the operating cycle is the total period involved in different stages of operations;

2.

OC= M + W +F + D - C

Net Current Assets Forecasting Method

This is the most practical method of estimating working capital requirements. Under this method, a working capital forecast is prepared. In preparing this forecast, an estimate of all the current assets is made on a monthly basis. Thus, estimate of stock of raw materials, amount of raw material in process, stock of finished goods and outstanding amount from debtors and other receipts will have to be made. This is followed by an estimate of current liabilities comprising of outstanding payments for material, wages, rent, and administrative and other expenses. The difference between the forecasted amount of current assets and current liabilities gives the networking capital requirements of the firm. To this amount, a percentage would be added by way of provision for contingencies. The resulting figure will be the amount of total estimated working capital required. From this, bank finance is to be subtracted, if available. The remaining balance will be the amount of working capital that is to be managed by the firm. This method is based on cash technique as all transactions are shown on cash cost basis.

Statement showing working Capital Requirements

(A) (i) (ii) Current Assets Stock of Raw Material (for month consumption) (a) Work-in-Process (for months) (b) Direct Labor (c) Overheads Stock of finished Goods (for months sales) Amount . . . . Rs.

(iii)

(a) Raw Material (b) (b) Labor (c) Overheads (iv) Sundry Debtors or Receivables ( for months sales) (a) Raw Material (b) Labor (c) Overheads -------------(v) (vi) Payment in Advance (if any) Balance of Cash (required to meet day-to-day expenses)

(B)

Current Liabilities (i) Creditors (for months purchase of Raw Materials) (ii) Lag in Payment of Expanses (Outstanding expenses months) (iii) Others (if any) Net Working Capital (A) (B) Add: Provision for Contingencies
Total Working Capital Required

--------------------------------------

c)

Projected Balance Sheet Method Under this method, estimates of different assets (excluding cash) and liabilities are made taking into consideration the transactions in the relevant period. Then, a balance sheet is prepared based on these estimates and is called Projected balance sheet. The difference between assets and liabilities of this balance sheet is treated as shortage or surplus cash of that period.

d)

Adjusted Profit and Loss Method In this method, estimated profit based on transactions of the relevant period is calculated. Thereafter, increase or decrease in working capital is computed adjusting the estimated profit by cash inflows and cash outflows. It is similar cash flow statement. A specimen of such a method is given below;

Computation of Working Capital Rs. Net Income Add: (i) Non-cash Items Working Capital Provided Operations ..

Add: (ii) Cash inflow Items Less: Cash Outflow items Net Changes in Working Capital

.. . ..

e)

Cash Forecasting Method In this method, cash receipts and payments estimate is made for a relevant period. The difference of these receipts and payments indicates deficiency or surplus of cash. The management formulates plans to cover the amount of deficit. This method is a form of cash budget.

A short WC cycle suggests a business has good cash flow and allows to quickly obtain cash that can be used for additional purchases or debt repayment. The lower the cash conversion cycle, the more healthy a company generally is. Example, a company that pays contractors in 7 days but takes 30 days to collect payments has 23 days of working capital to fund; having a working capital cycle of 23 days Businesses attempt to shorten the cash conversion cycle by speeding up payments from customers and slowing down payments to suppliers. CCC can even be negative; for instance, if the company has a strong market position and can dictate purchasing terms to suppliers. Amazon.com collects money before it pays for goods. This means they have a negative WC cycle and has more capital available to fund growth.