Lecture notes working Capital Management

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7 Management of Working Capital UNIT – I : MEANING, CONCEPT AND POLICIES OF WORKING CAPITAL Learning Objectives After studying this chapter you will be able to: • Discuss in detail about working capital management, its meanings and its significance to any business/firm. • Understand the concept of operating cycle and the estimation of working capital needs. • Understand the need for a business to invest in current assets. • Know why it is important to manage efficiently the current assets and current liabilities? • Discuss the financing of working capital. Overview This chapter introduces you to the concept of working capital management i.e. management of the capital needed by a firm for its day-to-day activity. Here you also study the management of cash, marketable securities, accounts receivables management, account payable, accruals and different means of short-term financing. Two most important points to remember while studying working capital management are: (a) The optimal level of investment in current assets, and (b) The appropriate mix of short-term and long-term financing used to support this investment in current assets. The chapter also delves upon the different approaches to management of working capital with the objective of maintaining optimum balance of each of the working capital components. Similarly, the different forms of financing which you have gone through in Chapter Five on Types of Financing also have an implication in this chapter. Here the sources of short term financing are re-visited. © The Institute of Chartered Accountants of India7.2 Financial Management 1.1 Introduction Working Capital Management involves managing the balance between firm’s short-term assets and its short-term liabilities. 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. The interaction between current assets and current liabilities is, therefore, the main theme of the theory of working capital management. There are many aspects of working capital management which makes it important function of financial management.  Time: Working capital management requires much of the finance manager’s time.  Investment: Working capital represents a large portion of the total investment in assets.  Credibility: Working capital management has great significance for all firms but it is very critical for small firms.  Growth: The need for working capital is directly related to the firm’s growth. 1.2 Meaning and Concept of Working Capital The concept of working capital can also be explained through two angles. Working Capital Management OR Value Time Gross Working Net Working Permanent Temporary Capital Capital (a) Value : From the value point of view, Working Capital can be defined as Gross Working Capital or Net Working Capital. Gross working capital refers to the firm’s investment in current assets. Current assets are those assets which can be converted into cash within an accounting year. Current Assets include: Stocks of raw materials, Work-in-progress, Finished goods, Trade debtors, Prepayments, Cash balances etc. Net working capital refers to the difference between current assets and current liabilities. Current liabilities are those claims of outsiders which are expected to mature for payment within an accounting year. Current Liabilities include: Trade creditors, Accruals, Taxation payable, Bills Payables, Outstanding expenses, Dividends payable, short term loans. © The Institute of Chartered Accountants of India Management of Working Capital 7.3 A positive working capital means that the company is able to payoff its short-term liabilities. A negative working capital means that the company currently is unable to meet its short-term liabilities. (b) Time: From the point of view of time, the term working capital can be divided into two categories viz., Permanent and temporary. Permanent working capital refers to the hard core 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 refers to that part of total working capital, which is required by a business over and above permanent working capital. It is also called variable working capital. Since the volume of temporary working capital keeps on fluctuating from time to time according to the business activities it may be financed from short-term sources. The following diagrams shows Permanent and Temporary or Fluctuating or variable working capital: Both kinds of working capital i.e. permanent and fluctuating (temporary) are necessary to facilitate production and sales through the operating cycle. 1.2.1 Importance of Adequate Working Capital: Management of working capital is an essential task of the finance manager. He has to ensure that the amount of working capital available with his concern is neither too large nor too small for its requirements. A large amount of working capital would mean that the company has idle funds. Since funds have a cost, the company has to pay huge amount as interest on such funds. © The Institute of Chartered Accountants of India7.4 Financial Management If the firm has inadequate working capital, such firm runs the risk of insolvency. Paucity of working capital may lead to a situation where the firm may not be able to meet its liabilities The various studies conducted by the Bureau of Public Enterprises have shown that one of the reasons for the poor performance of public sector undertakings in our country has been the large amount of funds locked up in working capital. This results in over capitalization. Over capitalization implies that a company has too large funds for its requirements, resulting in a low rate of return a situation which implies a less than optimal use of resources. A firm has, therefore, to be very careful in estimating its working capital requirements. Maintaining adequate working capital is not just important in the short-term. Sufficient liquidity must be maintained in order to ensure the survival of the business in the long-term as well. When business make investment decisions they must not only consider the financial outlay involved with acquiring the new machine or the new building, etc., but must also take account of the additional current assets that are usually required with any expansion of activity. For e.g.:-  Increased production leads to hold additional stocks of raw materials and work in progress.  An increased sale usually means that the level of debtors will increase.  A general increase in the firm’s scale of operations tends to imply a need for greater levels of working capital. A question then arises what is an optimum amount of working capital for a firm? We can say that a firm should neither have too high an amount of working capital nor should the same be too low. It is the job of the finance manager to estimate the requirements of working capital carefully and determine the optimum level of investment in working capital. 1.2.2 Optimum Working Capital: If a company’s current assets do not exceed its current liabilities, then it may run into trouble with creditors that want their money quickly. Current ratio (current assets/current liabilities) (along with acid test ratio to supplement it) has traditionally been considered the best indicator of the working capital situation. It is understood that a current ratio of 2 (two) for a manufacturing firm implies that the firm has an optimum amount of working capital. This is supplemented by Acid Test Ratio (Quick assets/Current liabilities) which should be at least 1 (one). Thus it is considered that there is a comfortable liquidity position if liquid current assets are equal to current liabilities. Bankers, financial institutions, financial analysts, investors and other people interested in financial statements have, for years, considered the current ratio at, ‘two’ and the acid test ratio at, ‘one’ as indicators of a good working capital situation. As a thumb rule, this may be quite adequate. However, it should be remembered that optimum working capital can be determined only with reference to the particular circumstances of a specific situation. Thus, in a company where the inventories are easily saleable and the sundry debtors are as good as liquid cash, the current ratio may be lower than 2 and yet firm may be sound. © The Institute of Chartered Accountants of India Management of Working Capital 7.5 In nutshell, a firm should have adequate working capital to run its business operations. Both excessive as well as inadequate working capital positions are dangerous. 1.3 Determinants of Working Capital Working capital management is concerned with:- a) Maintaining adequate working capital (management of the level of individual current assets and the current liabilities) AND b) Financing of the working capital. For the point a) above, a Finance Manager needs to plan and compute the working capital requirement for its business. And once the requirement has been computed he needs to ensure that it is financed properly. This whole exercise is nothing but Working Capital Management. Sound financial and statistical techniques, supported by judgment should be used to predict the quantum of working capital required at different times. Some of the items/factors which need to be considered while planning for working capital requirement are:-  Cash – Identify the cash balance which allows for the business to meet day to day expenses, but reduces cash holding costs.  Inventory – Identify the level of inventory which allows for uninterrupted production but reduces the investment in raw materials and hence increases cash flow; the techniques like Just in Time (JIT) and Economic order quantity (EOQ) are used for this.  Debtors – 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). The tools like Discounts and allowances are used for this.  Short term financing options – Inventory is ideally financed by credit granted by the supplier; dependent on the cash conversion cycle, it may however, be necessary to utilize a bank loan (or overdraft), or to “convert debtors to cash” through “factoring” in order to finance working capital requirements.  Nature of Business - For e.g. in a business of restaurant, most of the sales are in Cash. Therefore need for working capital is very less.  Market and demand conditions - For e.g. if an item demand far exceeds its production, the working capital requirement would be less as investment in finished good inventory would be very less.  Technology and manufacturing Policies - For e.g. in some businesses the demand for goods is seasonal, in that case a business may follow a policy for steady production through out over the whole year or instead may choose policy of production only during the demand season. © The Institute of Chartered Accountants of India7.6 Financial Management  Operating efficiency – A company can reduce the working capital requirement by eliminating waste, improving coordination etc.  Price Level Changes – For e.g. rising prices necessitate the use of more funds for maintaining an existing level of activity. For the same level of current assets, higher cash outlays are required. Therefore the effect of rising prices is that a higher amount of working capital is required. 1.4 Issues in the Working Capital Management Working capital management entails the control and monitoring of all components of working capital i.e. cash, marketable securities, debtors (receivables) and stocks (inventories) and creditors (payables). Finance manager has to pay particular attention to the levels of current assets and their financing. To decide the levels and financing of current assets, the risk return trade off must be taken into account. 1.4.1 Current Assets to Fixed Assets Ratio The finance manager is required to determine the optimum level of current assets so that the shareholders value is maximized. A firm needs fixed and current assets to support a particular level of output. As the firm’s output and sales increases, the need for current assets also increases. Generally, current assets do not increase in direct proportion to output, current assets may increase at a decreasing rate with output. As the output increases, the firm starts using its current asset more efficiently. The level of the current assets can be measured by creating a relationship between current assets and fixed assets. Dividing current assets by fixed assets gives current assets/fixed assets ratio. Assuming a constant level of fixed assets, a higher current assets/fixed assets ratio indicates a conservative current assets policy and a lower current assets/fixed assets ratio means an aggressive current assets policy assuming all factors to be constant. A conservative policy implies greater liquidity and lower risk whereas an aggressive policy indicates higher risk and poor liquidity. Moderate current assets policy will fall in the middle of conservative and aggressive policies. The current assets policy of most of the firms may fall between these two extreme policies. The following diagram shows alternative current assets policies: © The Institute of Chartered Accountants of India Management of Working Capital 7.7 1.4.2 Liquidity versus Profitability Risk return trade off − A firm may follow a conservative, aggressive or moderate policy as discussed above. However, these policies involve risk, return trade off. 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 that is, it will hardly experience a cash shortage or a stock out situation. However, there is a cost associated with maintaining a sound liquidity position. However, to have higher profitability the firm may have to sacrifice solvency and maintain a relatively low level of current assets. This will improve firm’s profitability as fewer funds will be tied up in idle current assets, but its solvency would be threatened and exposed to greater risk of cash shortage and stock outs. The following illustration explains the risk-return trade off of various working capital management policies, viz., conservative, aggressive and moderate. st Illustration 1 : A firm has the following data for the year ending 31 March, 2013: ` Sales (1,00,000 ` 20/-) 20,00,000 Earning before Interest and Taxes 2,00,000 Fixed Assets 5,00,000 The three possible current assets holdings of the firm are ` 5,00,000/-, ` 4,00,000/- and ` 3,00,000. It is assumed that fixed assets level is constant and profits do not vary with current assets levels. The effect of the three alternative current assets policies is as follows: © The Institute of Chartered Accountants of India7.8 Financial Management Effect of Alternative Working Capital Policies (Amount in ` ) Working Capital Policy Conservative Moderate Aggressive Sales 20,00,000 20,00,000 20,00,000 Earnings before Interest and Taxes 2,00,000 2,00,000 2,00,000 (EBIT) Current Assets 5,00,000 4,00,000 3,00,000 Fixed Assets 5,00,000 5,00,000 5,00,000 Total Assets 10,00,000 9,00,000 8,00,000 Return on Total Assets (EBIT/Total 20% 22.22% 25% Assets) Current Assets/Fixed Assets 1.00 0.80 0.60 The aforesaid calculations show that the conservative policy provides greater liquidity (solvency) to the firm, but lower return on total assets. On the other hand, the aggressive policy gives higher return, but low liquidity and thus is very risky. The moderate policy generates return higher than Conservative policy but lower than aggressive policy. This is less risky than Aggressive policy but more risky than conservative policy. In determining the optimum level of current assets, the firm should balance the profitability – Solvency tangle by minimizing total costs. Cost of liquidity and cost of illiquidity. 1.5 Estimating Working Capital Needs Operating cycle is one of the most reliable methods of Computation of Working Capital. However, other methods like ratio of sales and ratio of fixed investment may also be used to determine the Working Capital requirements. These methods are briefly explained as follows: (i) Current assets holding period: To estimate working capital needs based on the average holding period of current assets and relating them to costs based on the company’s experience in the previous year. This method is essentially based on the Operating Cycle Concept. (ii) Ratio of sales: To estimate working capital needs as a ratio of sales on the assumption that current assets change with changes in sales. (iii) Ratio of fixed investments: To estimate Working Capital requirements as a percentage of fixed investments. A number of factors will, however, be impacting the choice of method of estimating Working Capital. Factors such as seasonal fluctuations, accurate sales forecast, investment cost and variability in sales price would generally be considered. The production cycle and credit and © The Institute of Chartered Accountants of India Management of Working Capital 7.9 collection policies of the firm will have an impact on Working Capital requirements. Therefore, they should be given due weightage in projecting Working Capital requirements. 1.6 Operating or Working Capital Cycle A useful tool for managing working capital is the operating cycle. The operating cycle analyzes the accounts receivable, inventory and accounts payable cycles in terms of number of days. For example:  Accounts receivable are analyzed by the average number of days it takes to collect an account.  Inventory is analyzed by the average number of days it takes to turn over the sale of a product (from the point it comes in the store to the point it is converted to cash or an account receivable).  Accounts payable are analyzed by the average number of days it takes to pay a supplier invoice. Operating/Working Capital Cycle Definition 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. For example, a company holds raw materials on an average for 60 days, it gets credit from the supplier for 15 days, production process needs 15 days, finished goods are held for 30 days and 30 days credit is extended to debtors. The total of all these, 120 days, i.e., 60 – 15 + 15 + 30 + 30 days is the total working capital cycle. Working Capital Cycle Cash Raw Material Debtors Labour Overhead Stock WIP Most businesses cannot finance the operating cycle (accounts receivable days + inventory days) with accounts payable financing alone. Consequently, working capital financing is needed. This shortfall is typically covered by the net profits generated internally or by externally borrowed funds or by a combination of the two. © The Institute of Chartered Accountants of India7.10 Financial Management The faster a business expands the more cash it will need for working capital and investment. The cheapest and best sources of cash exist as working capital right within business. Good management of working capital will generate cash which will help improve profits and reduce risks. Bear in mind that the cost of providing credit to customers and holding stocks can represent a substantial proportion of a firm’s total profits. Each component of working capital (namely inventory, receivables and payables) has two dimensions ……TIME ………and MONEY, when it comes to managing working capital then time is money. If you can get money to move faster around the cycle (e.g. collect monies due from debtors more quickly) or reduce the amount of money tied up (e.g. reduce inventory levels relative to sales), the business will generate more cash or it will need to borrow less money to fund working capital. Similarly, if you can negotiate improved terms with suppliers e.g. get longer credit or an increased credit limit; you are effectively creating free finance to help fund future sales. If you……………… Then …………………. Collect receivables (debtors) faster You release cash from the cycle Collect receivables (debtors) slower Your receivables soak up cash. Get better credit (in terms of duration or You increase your cash resources. amount) from suppliers. Shift inventory (stocks) faster You free up cash. Move inventory (stocks) slower. You consume more cash. 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: Operating 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. © The Institute of Chartered Accountants of India Management of Working Capital 7.11 The various components of operating cycle may be calculated as shown below: Average stock of raw material (1) Raw material storage period= Average cost of raw material consumptionper day Average work - in - progress inventory (2) Work - in- progress holding period = Average cost of production per day Average stock of finished goods (3) Finished goods storage period= Average cost of goods soldper day Average book debts (4) Debtors collection period= Average Credit Sales per day Average trade creditors (5) Credit period availed= Average credit purchases per day 1.6.1 Working Capital Based on Operating Cycle: One of the methods for forecasting working capital requirement is based on the concept of operating cycle. The calculation of operating cycle and the formula for estimating working capital on its basis has been demonstrated with the help of following illustration: Illustration 2 : From the following information of XYZ Ltd., you are required to calculate : (a) Net operating cycle period. (b) Number of operating cycles in a year. ` (i) Raw material inventory consumed during the year 6,00,000 (ii) Average stock of raw material 50,000 (iii) Work-in-progress inventory 5,00,000 (iv) Average work-in-progress inventory 30,000 (v) Finished goods inventory 8,00,000 (vi) Average finished goods stock held 40,000 (vii) Average collection period from debtors 45 days (viii) Average credit period availed 30 days (ix) No. of days in a year 360 days © The Institute of Chartered Accountants of India7.12 Financial Management Solution Calculation of Net Operating Cycle period of XYZ Ltd. Days Raw material storage period: (a) 30  Average stock of raw material   Average cost of raw materialconsumptionper day  (` 50,000 / 1667) (` 6,00,000 / 360 days) W.I.P. holding period : (b) 22  Average work− in− progress inventory   Average cost of production per day  ` 30,000 / 1,388) (` 5,00,000 / 360 days) Finished goods storage period : (c) 18  Average stock of finished goods   Average cost of goods sold per day  (` 40,000 / 2,222) (` 8,00,000 / 360 days) Debtors collection period: (d) 45 Total operating cycle period: 115 (a) + (b) + (c) + (d) Less: Average credit period availed 30 (i) Net operating cycle period 85 (ii) Number of operating cycles in a year 4.2 (360 days / 85 days) 1.6.2 Estimate of amount of different components of Current Assets and Current The various constituents of current assets and current liabilities have a direct Liabilities: bearing on the computation of working capital and the operating cycle. The holding period of various constituents of Current Assets and Current Liabilities cycle may either contract or expand the net operating cycle period. Shorter the operating cycle period, lower will be the requirement of working capital and vice-versa. © The Institute of Chartered Accountants of India Management of Working Capital 7.13 Estimation of Current Assets The estimates of various components of working capital may be made as follows: (i) Raw materials inventory: The funds to be invested in raw materials inventory may be estimated on the basis of production budget, the estimated cost per unit and average holding period of raw material inventory by using the following formula: Estimatedproduction×Estimated cost of raw material  (in units) per unit Averageraw materialholdingperiod  ×  (inmonths / indays) 12months / 360days    Note: 360 days in a year are generally assumed to facilitate calculation. (ii) Work-in-progress inventory: The funds to be invested in work-in-progress can be estimated by the following formula: Estimatedproduction× Estimated work− in− process  (in units) cost per unit Averageholdingperiodof  ×  W.I.P.(months / days)) 12months / 360days    (iii) Finished Goods: The funds to be invested in finished goods inventory can be estimated with the help of following formula: Estimatedproduction×Cost of production(Per unit  (inunits) excludingdepreciation Averageholding periodof finished  ×  goodsinventory (months / days) 12months / 360days    (iv) Debtors: Funds to be invested in trade debtors may be estimated with the help of following formula: Estimated credit sales× Cost of sales(Per unit  Average debtorscollection  ( inunits) excluding depreciation ×  period(months/days) 12months/360days    (v) Minimum desired Cash and Bank balances to be maintained by the firm has to be added in the current assets for the computation of working capital. Estimation of Current Liabilities Current liabilities generally affect computation of working capital. Hence, the amount of working capital is lowered to the extent of current liabilities (other than bank credit) arising in © The Institute of Chartered Accountants of India7.14 Financial Management the normal course of business. The important current liabilities like trade creditors, wages and overheads can be estimated as follows: (i) Trade creditors: Estimated yearly× Raw materialrequirements  Credit period grantedby production (inunits) per unit ×  suppliers(months/days) 12months/360days    (ii) Direct Wages: Estimatedproduction× Direct labour cost  Average time laginpayment  (inunits) per unit x  of wages(months/days) 12months/360days    (iii) Overheads (other than depreciation and amortization): Estimatd yearly× Overheadcost  Average time laginpayment production(inunits) per unit ×  of overheads(months / days) 12months / 360days    Note: 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. The following illustration shows the process of working capital estimation: st Illustration 3 : On 1 January, the Managing Director of Naureen Ltd. wishes to know the amount of working capital that will be required during the year. From the following information prepare the working capital requirements forecast. Production during the previous year was 60,000 units. It is planned that this level of activity would be maintained during the present year. The expected ratios of the cost to selling prices are Raw materials 60%, Direct wages 10% and Overheads 20%. Raw materials are expected to remain in store for an average of 2 months before issue to production. Each unit is expected to be in process for one month, the raw materials being fed into the pipeline immediately and the labour and overhead costs accruing evenly during the month. Finished goods will stay in the warehouse awaiting dispatch to customers for approximately 3 months. Credit allowed by creditors is 2 months from the date of delivery of raw material. Credit allowed to debtors is 3 months from the date of dispatch. Selling price is ` 5 per unit. There is a regular production and sales cycle. st Wages and overheads are paid on the 1 of each month for the previous month. The company normally keeps cash in hand to the extent of ` 20,000. © The Institute of Chartered Accountants of India Management of Working Capital 7.15 Solution Working Notes: 1. Raw material inventory: The cost of materials for the whole year is 60% of the Sales value. 60 Hence it is 60,000 units x ` 5 x =` 1,80,000. The monthly consumption of raw 100 material would be ` 15,000. Raw material requirements would be for two months; hence raw materials in stock would be ` 30,000. 2. Debtors: The average sales would be ` 25,000 p.m. Therefore, a sum of ` 75,000/- would be the amount of sundry debtors. 3. Work in process: (Students may give special attention to this point). It is stated that each unit of production is expected to be in process for one month). ` (a) Raw materials in work-in-process (being one 15,000 month’s raw material requirements) (b) Labour costs in work-in-process 1,250 (It is stated that it accrues evenly during the month. Thus, on the first day of each month it would be zero and on the last day of month the work-in-process would include one month’s labour costs. On an average therefore, it would be equivalent to ½ of the month’s labour costs) (c) Overheads _2,500 (For ½ month as explained above) Total work-in- 18,750 process 4. Finished goods inventory: (3 month’s costs of production) 45,000 Raw materials 7,500 Labour 15,000 Overheads 67,500 5. Creditors: Suppliers allow a two months’ credit period. Hence, the average amount of creditors would be ` 30,000 being two months’ purchase of raw materials. 6. Direct Wages payable: The direct wages for the whole year is 60,000 units × ` 5 x 10% = ` 30,000. The monthly direct wages would be ` 2,500 (` 30,000 ÷12). Hence, wages payable would be ` 2,500. © The Institute of Chartered Accountants of India7.16 Financial Management 7. Overheads Payable: The overheads for the whole year is 60,000 units × ` 5 x 20% = ` 60,000. The monthly overheads will be ` 5,000 (` 60,000 ÷ 12). Hence overheads payable would be ` 5,000 p.m. Statement of Working Capital required: ` ` Current Assets Raw materials inventory (Refer to working note 1) 30,000 Debtors (Refer to working note 2) 75,000 Working–in-process (Refer to working note 3) 18,750 Finished goods inventory (Refer to working note 4) 67,500 Cash 20,000 2,11,250 Current Liabilities Creditors (Refer to working note 5) 30,000 Direct wages payable (Refer to working note 6) 2,500 Overheads payable (Refer to working note 7) 5,000 37,500 Estimated working capital requirements 1,73,750 1.6.3 Working capital requirement estimation based on cash cost: We have already seen that working capital is the difference between current assets and current liabilities. To estimate requirements of working capital, we have to forecast the amount required for each item of current assets and current liabilities. In practice another approach may also be useful in estimating working capital requirements. This approach is based on the fact that in the case of current assets, like sundry debtors and finished goods, etc., the exact amount of funds blocked is less than the amount of such current assets. For example:  If we have sundry debtors worth ` 1 lakh and our cost of production is ` 75,000, the actual amount of funds blocked in sundry debtors is ` 75,000 the cost of sundry debtors, the rest (` 25,000) is profit.  Again some of the cost items also are non-cash costs; depreciation is a non-cash cost item. Suppose out of ` 75,000, ` 5,000 is depreciation; then it is obvious that the actual funds blocked in terms of sundry debtors totaling ` 1 lakh is only ` 70,000. In other words, ` 70,000 is the amount of funds required to finance sundry debtors worth ` 1 lakh.  Similarly, in the case of finished goods which are valued at cost, non-cash costs may be © The Institute of Chartered Accountants of India Management of Working Capital 7.17 excluded to work out the amount of funds blocked. Many experts, therefore, calculate the working capital requirements by working out the cash costs of finished goods and sundry debtors. Under this approach, the debtors are calculated not as a percentage of sales value but as a percentage of cash costs. Similarly, finished goods are valued according to cash costs. Illustration 4 : The following annual figures relate to XYZ Co., ` Sales (at two months’ credit) 36,00,000 Materials consumed (suppliers extend two months’ credit) 9,00,000 Wages paid (monthly in arrear) 7,20,000 Manufacturing expenses outstanding at the end of the year 80,000 (Cash expenses are paid one month in arrear) Total administrative expenses, paid as above 2,40,000 Sales promotion expenses, paid quarterly in advance 1,20,000 The company sells its products on gross profit of 25% counting depreciation as part of the cost of production. It keeps one months’ stock each of raw materials and finished goods, and a cash balance of ` 1,00,000. Assuming a 20% safety margin, work out the working capital requirements of the company on cash cost basis. Ignore work-in-process. Solution Statement of Working Capital requirements (cash cost basis) A. Current Asset ` ` . Materials (` 9,00,000 ÷12) 75,000 Finished Goods (` 25,80,000 ÷12) 2,15,000 Debtors (` 29,40,000÷6) 4,90,000 Cash 1,00,000 Prepaid expenses (Sales promotion) (` 1,20,000÷4) 30,000 9,10,000 B. Current Liabilities: Creditors for materials (` 9,00,000÷6) 1,50,000 Wages outstanding (` 7,20,000÷ 12) 60,000 Manufacturing expenses 80,000 Administrative expenses 20,000 3,10,000 (` 2,40,000÷12) Net working capital (A-B) 6,00,000 Add safety margin 20% 1,20,000 Total working capital requirements 7,20,000 © The Institute of Chartered Accountants of India7.18 Financial Management Working Notes: (i) Computation of Annual Cash cost of Production ` Material consumed 9,00,000 Wages 7,20,000 Manufacturing expenses (` 80,000 x 12) _9,60,000 Total cash cost of production 25,80,000 (ii) Computation of Annual Cash cost of sales: ` Cash cost of production as in (i) above 25,80,000 Administrative Expenses 2,40,000 Sales promotion expenses _1,20,000 Total cash cost of sales 29,40,000 Illustration 5 : PQ Ltd., a company newly commencing business in 2013 has the under- mentioned projected Profit and Loss Account: ` ` Sales 2,10,000 Cost of goods sold 1,53,000 Gross Profit 57,000 Administrative Expenses 14,000 Selling Expenses 13,000 27,000 Profit before tax 30,000 Provision for taxation 10,000 Profit after tax 20,000 The cost of goods sold has been arrived at as under: Materials used 84,000 Wages and manufacturing Expenses 62,500 Depreciation _23,500 1,70,000 Less: Stock of Finished goods (10% of goods produced not yet sold) __17,000 1,53,000 The figure given above relate only to finished goods and not to work-in-progress. Goods equal to 15% of the year’s production (in terms of physical units) will be in process on the average requiring full materials but only 40% of the other expenses. The company believes in keeping materials equal to two months’ consumption in stock. © The Institute of Chartered Accountants of India Management of Working Capital 7.19 Average time-lag in payment of all expenses is I month. Suppliers of materials will extend 1- 1/2 months credit. Sales will be 20% for cash and the rest at two months’ credit. 70% of the Income tax will be paid in advance in quarterly instalments. The company wishes to keep ` 8,000 in cash. 10% has to be added to the estimated figure for unforeseen contingencies. Prepare an estimate of working capital. Note: All workings should form part of the answer. Solution Net Working Capital Estimate of a Company (A) Current assets: (i) Raw material in stock = (` 84000 × 2/12) ` 14000 (ii) Work-in-progress: (a) Raw material (` 84,000 × 15/100) 12600 (b) Wages and manufacturing expenses = (` 62500 × 0.4 × 15/100) 3750 (iii) Stock of finished goods: ` 17000 – ` 2350 (0.10 × ` 23500, depreciation) 14650 (iv) Debtors (a) Cost of goods sold ` 153,000 Less: Depreciation (` 2,35,000 × 0.9) 21150 131850 (b) Administrative expenses 14000 (c) Selling expenses 13000 Total 15,88,500 Credit sales (4/5 of ` 15,88,500) = ` 12,70,800 (12,70,800 × 2/12) 21180 (v) Cash required 8000 Total investment in current assets 74180 (B) Current liabilities: (i) Average time-lag in payment of expenses: (a) Wages and manufacturing expenses: 62500 (b) Administrative expenses 14000 (c) Selling expenses 13000 89500/12 7458 (ii) Creditors (` 84000 × 3/24) 10500 Total current liabilities 17958 (C) Net working capital: Current assets – Current liabilities (A – B) 56222 Add: 10 per cent contingencies 5622 Net working capital required 61844 © The Institute of Chartered Accountants of India7.20 Financial Management Assumptions and Working Notes (i) Depreciation is not a cash expense and, therefore, excluded from cost of goods sold for the purpose of determining work-in-progress, finished goods and investment in debtors. (ii) Since profit is not taken into consideration in our calculation as a source of working capital, income tax has been excluded as it is to be paid out of profits. Illustration 6 : Shellcal Limited sells goods at a uniform rate of gross profit of 20% on sales including depreciation as part of cost of production. Its annual figures are as under: (` ) Sales (At 2 months’ credit) 24,00,000 Materials consumed (Suppliers credit 2 months) 6,00,000 Wages paid (Monthly at the beginning of the subsequent month) 4,80,000 Manufacturing expenses (Cash expenses are paid – one month in arrear) 6,00,000 Administration expenses (Cash expenses are paid – one month in arrear) 1,50,000 Sales promotion expenses (Paid quarterly in advance) 75,000 The company keeps one month stock each of raw materials and finished goods. A minimum cash balance of ` 80,000 is always kept. The company wants to adopt a 10% safety margin in the maintenance of working capital. The company has no work-in-progress. Find out the requirements of working capital of the company on cash cost basis. Solution 1. Total Manufacturing expenses (` ) Sales 24,00,000 Less: Gross profit 20% 4,80,000 Manufacturing cost 19,20,000 Less: Material 6,00,000 Wages 4,80,000 10,80,000 Manufacturing expenses 8,40,000 2. Cash manufacturing expenses 6,00,000 3. Depreciation (` 8,40,000 – ` 6,00,000) 2,40,000 4. Cost of Sales (Cash Expenses) (` ) Manufacturing Cost 19,20,000 © The Institute of Chartered Accountants of India

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