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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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Issues in Working Capital
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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Issues in Working Capital
Management
Current Assets to Fixed Assets Ratio
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Alternative current asset policies
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Issues in Working Capital
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, long- term
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
Estimation of Working Capital : Problem: 4
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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.
Estimation of Working Capital : Problem: 5
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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.
Estimation of Working Capital : Problem: 6
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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.