Working Capital Management: Amity Business School

Amity Business School
WORKING CAPITAL MANAGEMENT
Working capital management is concerned with the problems that arise

in managing the current assets (CA), current liabilities (CL) and the interrelationships between them.
Its operational goal is to manage the CA and CL in such a way that a satisfactory/acceptable level of net working capital (NWC) is maintained.
Concepts and Definitions of Working Capital
There are two concepts of working capital: a) Gross Working Capital : The term Gross working Capital refers to the total current assets. b) Net Working Capital: The term net working capital can be defined in two ways: The most common definition of net working capital (NWC) is the difference between current assets and current liabilities; and Net Working Capital (NWC) = Current Assets Current Liabilities Positive NWC = CA > CL Negative NWC = CA < CL Alternate definition of NWC is that portion of current assets which is financed with long-term funds.
DETERMINANTS OF WORKING CAPITAL

General Nature of business Production Cycle Business Cycle Production Policy Credit Policy Growth/ expansion phase Availability of raw material
Profit level
Level of Taxes Dividend Policy Depreciation Policy
Price Level Change

Operating Efficiency
PLANNING OF WORKING CAPITAL- OPERATING CYCLE
The need for working capital (WC) arises from the cash/operating cycle of a firm. Operating Cycle refers to the length of time required to complete the following sequence of events: conversion of cash into inventory, inventory into receivables and receivables into cash. The operating cycle creates the need for working capital and its length in terms of time-span required to complete the cycle is the major determinant of the firms working capital needs.
Contd..
In other words, the term Operating cycle refers to the length of time necessary to complete the following cycle of events: Phase 1 - Conversion of cash into inventory; Phase 2 - Conversion of inventory into receivables; Phase 3 - Conversion of receivables into cash.
Phase 3 Receivables
Cash
Phase 1
Phase 2 Inventory
The length of the operating cycle of a manufacturing firm is the sum of:
Inventory conversion period (ICP). Add: Debtors (receivable) conversion period (DCP). Less: Creditors or payables deferral period (CDP)
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) Debtors conversion period is the time required to collect the outstanding amount from the customers. Creditors or payables deferral period (CDP) is the length of time the firm is able to defer payments on various resource purchases.
KINDS OF WORKING CAPITAL
PERMANENT/ FIXED WORKING CAPITAL
TEMPORARY/ VARIABLE WORKING CAPITAL
Permanent working capital is a certain minimum level of working capital on a continuous and uninterrupted basis.
Temporary (fluctuating/variable) working capital is the working capital needed to meet seasonal as well as unforeseen requirements.
Amount of Working Capital

Temporary Permanent
Time
Permanent and Temporary Working Capital
Amount of Working Capital
Temporary or fluctuating
Permanent Time
Figure 3: Permanent and Temporary Working Capital Expanding firm
Changes in Working Capital
The changes in the level of working capital occur for the following three basic reasons:
- Changes in the level of sales and/or operating expenses, - Policy changes, and - Changes in technology.
WORKING CAPITAL APPROACHES
Theoretically there can be three approaches to working capital financing

a) MATCHING/ HEDGING APPROACH This is the conventional approach to financing. As per this approach, the duration of
requirement of funds should be matched with the duration of

sources of funds. This implies fixed assets and permanent working capital must be financed by long term loans.
CONSERVATIVE APPROACH This approach favours maximum reliance

on long-term sources. This implies that not only fixed assets and its permanent working capital but temporary working capital also is
financed by long term sources. This is a low profitability and high

liquidity approach.
AGGRESSIVE APPROACH Aggressive Approach to working capital

financing favours maximum reliance on short-term sources for working capital financing. In this case, the firm finances a part of its permanent
working capital through short term sources.
Computation of Working Capital
A firm should have adequate WC to support its budgeted level of activity in terms of production/sales. It should have neither more nor less WC than required. While the excessive WC adversely affects its profits, the inadequate WC interrupts its smooth operations. Therefore, its correct computation is an important constituent of efficient WC management. There are two components of WC, namely, CA and CL. Each component is to be separately estimated to determine the correct amount of WC. The relevant factors are -Holding periods of the various types of inventories, - Debtors collection period, - Creditors payment period
Determination of Working Capital
(I) Estimation of Current Asset: Amount (a) Minimum desired cash and bank balances (b) Inventories Raw material Work-in-process Finished Goods (c) Debtors* Total Current Assets (II) Estimation of Current Liabilities: (a) Creditors** (b) Wages (c) Overheads Total Current Liabilities (III)Net Working Capital (I II) Add margin for contingency (IV)Net Working Capital Required *If payment is received in advance, the item would be listed in CL. **If advance payment is to be made to creditors, the item would appear under CA. The same would be the treatment for advance payment of wages and overheads.
Estimation of Current Assets
Raw Materials Inventory :
Budgeted production (in units)
Cost of raw material(s) per unit

12 months/365 days
Average inventory holding period (months/days)
Work-in-Process (W/P) Inventory
Estimated workin-process cost per unit 12 months/365 days
Average time span of work-in-progress inventory (months/days)
The relevant costs to determine work-in-process inventory are the proportionate share of cost of raw materials and conversion costs (labour and manufacturing overhead costs excluding depreciation). In case, full unit of raw material is required in the beginning, the unit cost of work-in-progress would be cost of full unit + 50 per cent of conversion cost, compared to the raw material requirement throughout the production cycle; W/P is normally equivalent to 50 per cent of total cost of production.
Finished Goods Inventory
Finished Goods Inventory is calculated as
Cost of goods produced per unit (excluding depreciation) 12 months/365 days
Finished goods holding period (months/days)
Debtors
The WC tied up in debtors can be calculated as:
Budgeted credit sales (in units)
Cost of sales per unit excluding depreciation
Average debt collection period (months/days)
12 months/365 days
Cash and Bank Balances
Apart from WC needs for financing inventories and debtors, firms also
find it useful to have some minimum cash balances with them.
Estimation of Current Liabilities
The estimation of current liabilities can be done as follows:

Trade Creditors
Budgeted yearly production (in units) Raw material cost per unit Credit period allowed by creditors (months/days)
12 months/365 days
Note: Proportional adjustment should be made to cash purchases of raw materials. Direct Wages Budgeted yearly production (in units) Direct labour cost per unit 12 months/365 days Average time-lag in payment of wages (months/days)
Contd..
Overheads (Other Than Depreciation and Amortisation)
Budgeted yearly production (in units)
Overhead cost per unit 12 months/365 days
Average time-lag in payment of overheads (months/days)
The amount of overheads may be separately calculated for different types of overheads. In the case of selling overheads, the relevant item would be sales volume instead of production volume.
ILLUSTRATION
You are supplied with the following information in respect of XYZ Ltd for the ensuing year: Production of the year, 69,000 units Finished goods in store, 3 months Raw material in store, 2 months consumption Production process, 1 month Credit allowed by creditors, 2 months Credit given to debtors, 3 months Selling price per unit, Rs 50 Raw material, 50 per cent of selling price Direct wages, 10 per cent of selling price Manufacturing and administrative overheads, 16 per cent of selling price Selling overheads, 4 per cent of selling price There is a regular production and sales cycle and wages overheads accrue evenly. Wages are paid in the next month of accrual. Material is introduced in the beginning of the production cycle. You are required to ascertain its working capital requirement.
A newly formed company has applied for a loan to a commercial bank for Amity Business School financing its working capital requirements. You are requested by the bank to prepare an estimate of the requirements of the working capital for the company. Add 10% to your estimated figure to cover unforeseen contingencies. The information about projected profit and loss account of this company is as under:
Particulars Sales Cost of Goods Gross profit Administrative expenses Selling expenses Profit before tax Provision for tax Particulars Materials used Wages and manufacturing expenses Depreciation 140000 130000 Amount (Rs) 2100000 1530000 570000
270000 300000 100000 Amount 840000 625000 235000 1700000 170000 1530000
Cost of goods sold has been derived as follows:
Less: stock of finished goods (10% not yet sold)
The figures given above relate only to Amity Business School the goods that have been finished and not to WIP; goods equal to 15% of the years production (in terms of physical units) are in progress on an average, requiring full materials but only 40% of other expenses. The company believes in keeping two months consumption of material of stock; Desired cash balance Rs 40,000. Avg time lag in payment of all expenses is 1 month; suppliers of materials extend 1.5 months credit; sales are 20% cash; rest are 2 months credit; 70 % of the income tax has to be paid in advsance in quarterly instalments. Calculate NWC.
CASE STUDY DISCUSSION

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