Financial Management - Working Capital Requirement

 

Financial Management

Working Capital Management

(Working Capital Requirement)

 

Part A: Discussion of basic theories, techniques and format for preparing the statement showing working capital requirement

Part B: 6 Illustrations with solutions

Part A

 

Definition

Working capital is that capital which is not fixed and which is required for running the business operations on day to day basis. But practically, working capital may sometimes be negative also when total current liabilities are more than total current assets. It also has a cost like any other capital in the form of interest or opportunity cost. But when an enterprise is having negative working capital it will gain interest for the same from financial management point of view. Technically, working capital may be expressed as follows:

Working Capital =

Current Assets − Current Liabilities

 

Examples of current assets

a)       Inventories (raw materials, work-in-progress, finished goods, stores and spares)

b)       Debtors (net of provision for bad debts)

c)        Marketable securities

d)       Cash at bank

e)        Cash in hand

f)             Short term loans and advances

g)       Bills receivable

h)        Prepaid expenses

i)               Accrued incomes

 

Examples of current liabilities

a)       Creditors

b)       Bills payable

c)        Short term loans and deposits

d)       Outstanding expenses

e)        Unclaimed dividends

f)             Proposed dividends

g)       Provision for tax

h)        Bank overdraft

 

Components of

Working Capital Management

Management of working capital involves managing all the components of current assets and current liabilities individually. For example, as a part of working capital management debtors or receivables are required to be managed in order to ensure collection of these receivables as immediately as possible incurring as less expenses as possible. Similarly, inventories are also required to be managed to ensure primarily that right quality materials are purchased in right quantities at right times at right prices. Again, when creditors are paid off it is required to ensure that they are not paid off before the due dates. If at all they are paid off before the due dates, it is required to ensure that such creditors have allowed certain discounts on such early payments.

 

In view of above, the different components of working capital management may be as follows:

1.           To ascertain the total period of working capital cycle;

2.           To ascertain the total amount of working capital requirement;

3.           Inventory management;

4.           Receivables / Debtors’ management;

5.           Cash management;

6.           Payables / Creditors’ management.

 

WORKING CAPITAL CYCLE PERIOD

Working capital cycle period is the period of time that a business enterprise takes in converting the initial cash investment back to cash. It is the duration of time that starts with the initial cash investment into the business and ends with the realisation of cash from the customers/debtors.

 

Computation of

Working Capital Cycle Period

1	Raw Material Conversion Period (RMCP) =
	(Average stock of raw materials x 365) ÷ (Total consumption of raw materials p.a.)
2	WIP Conversion Period (WIPCP) =
	(Average stock of WIP x 365) ÷ (Total factory cost of production p.a.)
	Note 1: Prime Cost should be taken in place of Factory Cost of Production, if WIP is valued at prime cost. Note 2: Here, Factory Cost of Production means net works cost.
3	Finished Goods Conversion Period (FGCP) =
	(Average stock of finished goods x 365) ÷ (Total cost of sales p.a.)
4	Debt Collection Period (DCP) =
	(Average debtors x 365) ÷ (Total credit sales p.a.)
5	Credit Payment Period (CPP) =
	(Average creditors x 365) ÷ (Total credit purchase p.a.)
6	Wages Payment Period (WPP) =
	(Outstanding wages x 365) ÷ (Total wages p.a.)
7	Working Capital Cycle Period (WCCP) =
	RMCP + WIPCP + FGCP + DCP − CPP − WPP
8	Working Capital Cycle Rotation p.a. (WCCR) =
	365 ÷ WCCP
9	Working Capital Requirement (WCR) =
	(Total cost of sales p.a.) ÷ (WCCR)
	Note: Here WCR has been calculated excluding cash balance

 

WORKING CAPITAL REQUIREMENT

Working capital requirement of a business enterprise can be estimated in any of the following four methods:

1.           Working capital cycle period (WCCP) method;

2.           Two steps method;

3.           Horizontal method; and

4.           Matrix method (also known as columnar method).

 

Here, I will discuss and explain only the Horizontal Method, because this is the most practical, most popular and most widely followed method.

 

Horizontal method

 Click here for "W. C. Requirement - Horizontal Format" in PDF

Important notes in connection with Preparation of Statement showing estimated Working Capital Requirement

 

1. Calculation of work-in-progress:

Calculation of work-in-progress depends upon the degree of completion regarding material, labour and overhead. At any particular point of time, there will be different number of units in different stages of production with different degrees of completion and therefore, valuation of these units is a difficult task. Thus, it is usually assumed that processing is continued evenly throughout the year and accordingly, wages and overheads are also incurred evenly throughout the year. After this assumption is made, valuation of work-in-progress is done taking the values of material, labour and overhead for their respective degrees of completion as given in the problem.

 

Example:      Degree of completion (given):

Material	100%
Labour	80%
Overhead	60%

 

Processing period (given) − 5 weeks. Calculate the cost element wise time lags of work-in-progress.

 

Solution:

With the above given information, when the working capital requirement is estimated, the material cost will be taken for full 5 weeks, whereas the labour cost will be taken for 4 weeks (80% of the processing period of 5 weeks) and the overhead cost will be taken for 3 weeks (60% of the processing period of 5 weeks) for the valuation of WIP. [If the degree of completion of work-in-progress regarding material, labour and overhead is not given in the problem, it is assumed that raw material has been charged at the start of the production process fully, i.e. 100% complete, whereas conversion cost, i.e. labour cost and overhead cost are taken, on an average, as 50% complete. In other words, if the processing period is given as 2 months, the material cost will be taken for full 2 months, whereas, the labour and overhead costs will be taken for 1 month (50% of the processing period of 2 months) for the valuation of work-in-progress.]

 

2. Treatment of depreciation:

As depreciation charges do not involve any cash outflows, it is not considered in working capital estimation. It is neither included in valuation of WIP nor in valuation of finished goods. If depreciation is included in total overheads, it is to be deducted from the total overheads, and only the cash consuming overheads are to be taken into consideration. However, it is to be kept in mind that the total amount of expected profit will not change for exclusion of depreciation from overheads.

 

3. Treatment of profit:

Inclusion of profit in working capital estimation is a controversial issue. Some experts suggest that profit should not be included in working capital estimation (i.e., debtors should be valued at cost of sales) while some other experts suggest that it should be included (i.e., debtors should be valued at selling price). It means that there is no hard and fast rule regarding inclusion of profit in working capital estimation. This is mainly the managerial policy adopted by the firm whether to include or not to include the profit in working capital estimation i.e., whether to include or not to include the profit in debtors. However, if nothing is mentioned in the problem about whether profit is part of the working capital or not, it should always be assumed that profit is part of the working capital i.e., in other words, it should always be assumed that profit is included in debtors (i.e., debtors should be valued at the selling price).

 

4. Time lag for payment of wages and overheads:

If nothing has been mentioned in the problem about time lag for payments of wages and overheads, it should be assumed that there is no time lag for payments of wages and overheads.

 

5. When total sales include cash sales:

When part of the sales is made in cash, average cost of materials, labour and overhead per period in debtors as well as average profit per period in debtors will be in the proportion of credit sales to total sales.

 

6. Effect of double shift working on working capital requirement:

If a company which is presently running on a single shift working plans to go for double shift, following factors are required to be considered before estimating the working capital requirement under the double shift working:

a)       Production (in units / quantity) p.a. will be doubled due to double shift working.

b)       Requirement of D/materials (in units / quantity) p.a. will be doubled.

c)        Total D/wages cost p.a. will be doubled (assuming that D/wages rate per unit is unchanged).

d)       Total V/OH cost p.a. will be doubled (assuming that V/OH rates p.u. will remain unchanged).

e)        Total fixed overhead cost p.a. will remain unchanged.

f)             Though the production is doubled, the requirement of Direct Materials, Direct Wages and Overheads in WIP will remain unchanged. In other words, WIP (in units / quantity) per period will remain unchanged.

g)       Stock of finished goods (in units / quantity) will be doubled.

h)        Balance of debtors (in terms of units / quantity sold) will be doubled.

i)               Balance of creditors (in terms of units / quantity purchased) will be doubled.

j)               Total W.C. Requirement will increase, but the total W.C. Requirement under double-shift may not be double the requirement as under single shift.

 

Part B

 

Financial Management

Working Capital Requirement

Selected Problems

Illustration: 1

 

A company has prepared its annual budget, relevant details of which are reproduced below:

(a)	Sales Rs 46.80 lakhs (25% of total sales are on cash basis)	78,000 units
(b)	Raw material cost	60% of sales value
(c)	Labour cost	Rs 6 per unit
(d)	Variable overheads	Rs 1 per unit
(e)	Fixed overheads	Rs 5,00,000 (Incl. Rs 1,10,000 as depreciation)
(f)	Budgeted stock levels:
	Raw materials	3 weeks
	Work-in-progress	1 week
	Finished goods	2 weeks
(g)	Debtors are allowed credit for	4 weeks
(h)	Creditors allow credit for	4 weeks
(i)	Lag in payment of wages	2 weeks
(j)	Lag in payment of overheads	2 weeks
(k)	Cash in hand required	Rs 50,000

 

Prepare the Working Capital budget for the year for the company, making whatever assumptions that you may find necessary.

 

Click here for Solution: 1 in PDF 

Illustration: 2

 

A company plans to manufacture and sell 400 units of a domestic appliance per month at a price of Rs 600 each. The ratios of costs to selling price are as follows:

	(% of selling price)
Raw materials	30%
Packing materials	10%
Direct labour	15%
Direct expense	5%

 

Fixed overheads are estimated at Rs 4, 32,000 per annum.

 

The following norms are maintained for inventory management:

Raw materials	30 days
Packing materials	15 days
Finished goods	200 units
Work-in-progress	7 days

 

Other particulars are given below:

a)       Credit sales represent 80% of total sales and the dealers enjoy 30 working days credit. Balance 20% is cash sales.

b)       Creditors allow 21 working days credit for payment.

c)        Lag in payment of overheads and expenses are 15 working days.

d)       Cash requirements to be 12% of net working capital.

e)        Working days in a year are taken as 300 for budgeting purpose.

 

Prepare a Working Capital Requirement forecast for the budget year.

 

 Click here for Solution: 2 in PDF

 

Illustration: 3

 

A Company provided the following data:

	Cost per unit (Rs)
Raw materials	52.00
Direct labour	19.50
Overheads	39.00
Total Cost	110.50
Profit	19.50
Selling Price	130.00

 

The following additional information is available:

(a)  Average raw materials in stock: one month.

(b)  Average materials in process: half-a-month.

(c)  Average finished goods in stock: one month.

(d)  Credit allowed by suppliers: one month.

(e)  Credit allowed to debtors: two months.

(f)        Time lag in payment of wages: one and a half weeks.

(g)  Overheads: one month.

(h)   One-fourth of sales are on cash basis.

(i)         Cash balance is expected to be Rs 1, 20,000.

 

You are required to prepare a statement showing the Working Capital needed to finance a level of activity of 70,000 units of annual output. The production is carried throughout the year on even basis and wages and overheads accrue similarly. (Calculations should be made on the basis of 30 days a month and 52 weeks a year).

 

Click here for Solution: 3 in PDF

 

Illustration: 4

(a) From the following details prepare an estimate of the requirement of Working Capital:

Production	60,000 units
Selling price p.u.	Rs 5
Raw material	60% of selling price
Direct wages	10% of selling price
Overheads	20% of selling price
Materials in hand	2 months requirement
Production Time	1 month
Finished goods in Stores	3 months
Credit for Material	2 months
Credit allowed to Customers	3 months
Average Cash Balance	Rs 20,000

 

Wages and overheads are paid at the beginning of the month following. In production all the required materials are charged in the initial stage and wages and overheads accrue evenly.

 

(b) What is the effect of Double Shift Working on the requirement of Working capital?

 

Click here for Solution: 4 (a) in PDF 

Click here for Solution: 4 (b) in PDF

Illustration: 5

Solaris Ltd. sells goods in domestic market at a gross profit of 25%. Its estimates for next year are as follows:

 

                                              (Rs in lakhs)

Sales – Home At 1 month’s credit	1,200
Sales – Exports At 3 months’ credit, [Selling price 10% below home price]	540
Materials used (Suppliers extend 2 months’ credit)	450
Wages, paid ½ month in arrears	360
Manufacturing expenses, paid 1 month in arrears	540
Administrative expenses, paid 1 month in arrears	120
Sales promotion expenses (payable quarterly – in advance)	60

 

The company keeps 1 month’s stock of each of raw materials and finished goods and believes in keeping Rs 20 lakh as cash. Assuming a 15% safety margin, ascertain the estimated Working Capital Requirement of the company (ignore work -in-process).

 

Click here for Solution: 5 in PDF 

Illustration: 6

Camellia Industries Ltd. is desirous of assessing its Working Capital Requirements for the next year. The finance manager has collected the following information for the purpose.

Estimated cost per unit of Finished Product:	Rs
Raw materials	90
Direct labour	50
Manufacturing and Administrative Overhead (Excluding depreciation)	40
Depreciation	20
Selling overheads	30
Total Cost	230

 

The product is sold at Rs 300 per unit.

 

Additional information:

           1.            Budgeted level of activity is 1, 20,000 units of output for the next year.

           2.            Raw material cost consists of the following:

a.         Pig iron Rs 65 per unit

b.         Ferro alloys Rs 15 per unit

c.         Cast iron borings Rs 10 per unit

           3.            Raw materials are purchased from different suppliers, extending different credit period as follows:

a.         Pig iron 2 months

b.         Ferro alloys ½ month

c.         Cast iron borings 1 month

           4.            Product is in process for a period of ½ month. Production process requires full unit (100%) of pig iron and ferroalloys in the beginning of production. Cast iron boring is required only to the extent of 50% in the beginning and the remaining is needed at a uniform rate during the process. Direct labour and other overheads accrue similarly at a uniform rate throughout the production process.

           5.            Past trends indicate that the pig iron is required to be stored for 2 months and other materials for 1 month.

           6.            Finished goods are in stock for a period of 1 month.

           7.            It is estimated that one-fourth of total sales are on cash basis and the remaining sales are on credit. The past experience of the firm has been to collect the credit sales in 2 months.

           8.            Average time-lag in payment of all overheads is 1 month and ½ month in the case of direct labour.

           9.            Desired cash balance is to be maintained at Rs 10 lakh.

 

You are required to determine the amount of Net Working Capital Requirement of the firm. State your assumptions, if any.

Click here for Solution: 6 in PDF