Financial Management

Working Capital Management

 Working Capital Policy

Important decisions involve

Ω Arranging short-term financing
Ω Negotiating favorable credit terms
Ω Controlling Cash movement
Ω Administering Accounts receivable, and
Ω Monitoring the investment in inventories.
 Constituents of Current Assets and Current
Liabilities
Current Asset
Liabilities
Inventories
Sundry Creditors
TradeRaw
Advances
Materials
payable
and Components
Borrowings
Work-in-process
(short-term)
Commercial
Finished Goods
Banks
Others
Others
Trade Debtors
Provisions
Loans and Advances
Cash and Bank Balances
 Factors Influencing Working Capital
Requirements

a. Nature of business
b. Seasonality of operations
c. Technology and Production policy
d. Credit Policy
e. Conditions of supply
Level of Current Assets
Type of Policy

Conservative
Aggressive Policy
Policy

Huge Cash Limited Cash

Balance balance

Large amount of
Small inventories
inventories

High level of
Stiff credit terms
Debtors
 Carrying costs and Shortage costs

Carrying costs
and Shortage
costs Total Costs

Carrying costs
Shortage costs

CA* Level of Current

Assets (CA)
 Operating Cycle and Cash Cycle

The investment is working capital is influenced by the

following events of the firm:
Ω Purchase of raw materials
Ω Payment for raw materials
Ω Sale of finished goods
Ω Collection of cash for sales
 Operating and Cash Cycle

Order placed Stock arrives Finished goods sold Cash received

Inventory period Accounts receivable period

Accounts
payable period
Firm receives Cash paid for
invoice materials

Operating cycle

Cash cycle
 Operating Cycle and Cash Cycle
Average inventory * 365
Inventory period =
Annual cost of goods sold

Accounts receivable Average accounts receivable * 365

=
period Annual Credit sales

Average accounts payable * 365

Accounts payable period = Annual credit purchases
 Operating Cycle and Cash Cycle
Financial Information for Horizon Limited
Balance Sheet Data

Profit & Loss Beginning of End of

Account Data 20*10 20*10
Sales 800 Inventory 96 102
Cost of goods 720 Accounts 86 90
sold receivable
Accounts 56 60
payable
 Operating Cycle and Cash Cycle
(96+102)/2 * 365
Inventory period =
720
= 50.1 days

Accounts receivable (86+90)/2 * 365

=
period 800
= 40.2 days

(56+60)/2 * 365
Accounts payable period =
720
= 29.4 days
 Operating Cycle and Cash Cycle
Operating cycle = 50.1 + 40.2 = 90.3 days
Inventory Accounts
Period receivable period

Cash cycle = 90.3 - 29.4 = 60.9 days

Operating Accounts
Cycle payable period

Thus, Horizon Ltd takes about two months to collect payment from its
customers from the time it pays for its inventory purchases.
Illustration
The relevant financial information for Xavier Ltd for the year
ended 20x1 is given below.
Profit and Loss Account Data Balance Sheet Data
(Rs. Million) Beginning of End of
20x1 20x1
Sales 80 Inventory 9 12
Cost of goods sold 56 Accounts 12 16
receivable
Accounts 7 10
payable
What is the length of the operating cycle? The cash cycle?
Assume 365 days to a year.
Solution
Average inventory * 365
Inventory period =
Annual cost of goods sold
(9+12)/2 * 365
Inventory period =
56
= 68.4 days

Accounts receivable Average accounts receivable * 365

=
period Annual credit Sales
Accounts Receivable (12+16)/2 * 365
=
period 80
= 63.9 days
Solution
Average accounts payable * 365
Accounts payable
= Average cost of goods sold
period

Accounts payable (7 + 10)/2 * 365

=
period 56
= 55.4 days

Operating cycle = 68.4 + 63.9 = 132.3 days

Cash operating = Operating cycle – Account payable period

cycle
= 132.3 – 55.4
 Format of Statement of Working Capital Estimation
Particulars Amount (in Rs.) Amount (in Rs.)
A. Estimation of Current Assets:
i) Raw materials XXX
ii) Work-in-process:
Raw Materials XX
Direct labour XX
Overheads XX XXX
iii) Finished goods inventory: XXX
iv) Debtors XXX
v) Cash balance required XXX
Total Current Assets XXX
B. Estimation of Current Liabilities:
i) Creditors: XXX
ii) Expenses:
Overheads XX
Labour XX XXX
Total Current Liabilities XXX
C. Working Capital (A-B) XXX
Add: Contingency (Percentage on working capital) XXX
D. Working Capital Required XXXX
Estimation of working capital (Formulae)

Ω Working capital required is calculated based on the

assumption that the production or sales carries on evenly
throughout the year and all costs accrue similarly.
Estimation of working capital (Formulae)

A. Estimation of Current Assets

a) Investment in Raw Materials Inventory
BP (in units) * RMC per unit * ARM HP (months) / 12
Where BP = Budgeted production in units
RMC = Raw Materials Cost per unit
ARM HP = Avg. Raw Materials Holding Period
Estimation of working capital (Formulae)
A. Estimation of Current Assets
b) Investment in Work-in-progress Inventory:
Work-in-progress cost (permit) is proportionate share of the share
of cost of direct materials and conversion costs. Conversion costs
include raw materials cost, labor and manufacturing overheads
cost excluding depreciation, since it is not out of pocket cost.
Generally raw materials cost is fully considered, if there is no
information about the raw materials requirement. With regard to
the share of labor and overhead cost, it is based on the work
completion stage. For example if the work is completed to the
extent of 50 per cent then only 5o per cent labour cost and
overhead cost is taken into consideration for estimation of work-
in-progress cost. If there is no information about the completion
stage then the opinion is left out to the estimation of working
capital (it is better to consider that work completion stage is 50
per cent).
Estimation of working capital (Formulae)
A. Estimation of Current Assets
b) Investment in Work-in-progress Raw Materials, labour ,
overheads:
BP (in units) * EWIPC per unit * ATSWIP (months) /12
BP = Budgeted production in units
EWIP = Estimated work-in-progress cost per unit
ATSWIP = Avg. Time Span of work-in-progress inventory

c) Investment in Finished Goods Inventory

BP (in units) * CS per unit * FG HP (months) / 12
BP = Budgeted production in units
CS= Cost of Sales
FGHP = Finished Goods Holding Period
 Estimation of working capital (Formulae)
A. Estimation of Current Assets
d) Investment in Debtors
BP (in units) * CS per unit * ADCP (months) / 12
BP = Budgeted production in units
CS = Cost of Sales (Excluding depreciation) per unit
ADCP = Avg. Debt Collection Period

e) Cash and Bank Balance

Maintenance of minimum working capital includes a minimum cash
balance, but it is very difficult to calculate minimum cash balance
required Generally determination of minimizing cash balance would
based on the motives for holding cash of business firm, attitude of
management toward risk, accessibility of the firm to the sources of
finance, when needed and past experience etc. Generally in
examinations the minimum cash balance will be provided.
Estimation of working capital (Formulae)

A. Estimation of Current Liabilities

a) Trade Creditors:
BP (in units) * RMC per unit * CPAS (months) / 12
BP = Budgeted production in units
RMC = Raw material cost per unit
CPAS = Credit Period Allowed by Suppliers
Estimation of working capital (Formulae)

A. Estimation of Current Liabilities

b) Direct Wages
BP (in units) * DWC per unit * LPW (months) / 12
BP = Budgeted production in units
DWC = Direct Wages Cost per unit
LPW = Lag in Payment of Wages
Estimation of working capital (Formulae)

A. Estimation of Current Liabilities

c) Overheads
BP (in units) * OHC per unit * LPOH (months) / 12
BP = Budgeted production in units
OHC = Overhead Cost per unit of production
LPOH – Lag in Payment of overheads