1. Financial management Unit - V Working capital management

2. WORKING CAPITAL MANAGEMENT
Capital required for a business can be classified under two main categories: A. Fixed capital : Capital required for purchase of fixed assets like land,building,plant,machinery,office equipment and furniture is called fixed capital. These assets are purchased for constant use in production and are not intended for re-sale. Working capital : Capital required for purchase of raw materials and for meeting the day to day expenditure on salaries,wages,rent,advertising etc. is called working capital management .

3. Concept of working capital
A.Gross working capital: In a broad sense , the working capital refers to the gross working capital. This represents the amount of funds invested in current assets. Under the gross concept, working capital is equal to total current assets. B.Net working capital : In a narrow sense , working capital refers to net working capital. Working capital refers to networking capital. Net working capital is the excess of current assets over current liabilities. Both gross working capital and net working capital concepts are important aspects of working capital. Gross working capital is suitable to company form of organization where there is divorce between ownership and management and control.

4. But the net working capital concept may be suitable for sole proprietorship or partnership firm. Of the two net working capital ,concept is widely accepted. Types of working capital: Working capital may be classified into two types: a.Permanent or fixed working capital It is the minimum amount of working capital required to ensure effective utilization of fixed assets and support the normal operations of the business.

5. b.Temporary or Variable working capital It is the amount of working capital which is required by the business over and above the permanent working capital. The amount of such working capital keeps on fluctuating from time to time on the basis of business activities. Need or Objects of working capital : The need for working capital arises due to the time gap between purchase of raw materials and production and sales. The time gap is technically termed as ‘ Operating cycle’ of the business .The following stages are usually found in the operating cycle of a manufacturing firm.

7. 1. Conversion of cash into raw ,materials. 2
1.Conversion of cash into raw ,materials. 2.Conversion of raw materials into work-in-progress. 3.Conversion of work-in-progress into finished goods. 4.Coversion of finished goods into debtors through sales. 5.Conversion of debtors into cash WORKING CAPITAL IS NEEDED FOR THE FOLLOWING PURPOSES: 1.To purchase raw materials, spares and component parts. 2.To pay wages and salaries. 3.To incur day to day expenses.. 4.To meet selling costs such as packing, advertising 5.To provide credit facilities to customers 6.To maintain inventories of raw material, work in progress and finished goods.

8. Importance or Advantages of working capital: Working capital is the life blood and nerve center of a business.No business can be run successfully without adequate amount of working capital.The advantages of maintaining adequate working capital are as follows: 1.Continuous production 2.Solvency and good will 3.Easy loans 4.Cash discounts 5.Regular payment expenses 6.Exploiatation of market condition 7.Ability to face crisis 8.High return on investment

9. Dangers of excess working capital
Every business concern should have adequate working capital for its smooth function. It should have neither excess working capital nor shortage of working capital. Both excessive working capital as well as inadequate working capital positions are bad for any business. How ever , out of the two ,inadequate working capital positions inadequacy of working capital is more dangerous for a firm.

10. Disadvantages of excessive working capital
1.Excessive working capital means idle funds which earn no profit for the business. Hence, the business cannot earn a proper rate of return on its investments. 2.Due to low rate of return on investments, the value of shares may also fall 3.Reduntant working capital may lead to unnecessary purchasing and accumulation of inventories. As a result ,chances of theft ,waste and losses will increase. 4.Excessive working capital makes management complication. It leads to overall inefficiency in the organization.

11. Disadvantages of inadequate working capital
1.A concern which has adequate working capital cannot pay its short term liabilities in time. A s a result, it loses its reputation and faces tight credit terms. 2.It cannot buy its requirements in bulk and take advantage of cash discounts. 3.The concern will experience difficulties in meeting its day to day expenses. 4.It becomes difficult to exploit favorable market conditions and undertake profitable projects due to lack of working capital. 5.Due to paucity of working capital, fixed assets are not effectively utilised.Thus the rate of return on investment falls.

12. Factors determining working capital needs
The requirement of working capital depend on the following factors: 1.Nature of business –railways –less:; manufacturing -more 2.Size of business –greater size- more 3.Time consumed in manufacture Seasonal fluctuations –raw material availability- seasonal: bulk purchase; more wc 4.Fluctuations in supply – more wc 5.Speed of turnover-high turnover –low wc 6.Terms of sales- sale on cash-low wc 7.Terms of purchase - sales-purchase on credit –low wc

13. 8.Growth and expansion of business-more wc required- growth increases 9.Price level changes –increase in price-increase in wc 10.Level of taxes- tax increases; wc increases

14. 11. Production policy –wc requirements depend on demand for the product
12.Length of production cycle –longer –more wc
13. Earning capacity and dividend policy –more earning-less wc; more dividend payment-more wc
14. Other factors –operating efficiency, management ability, irregularities to supply, import policy, banking facilities etc.

15. Sources of working capital
The various sources of financing of working capital are as follows:
1.Financing of permanent working capital:
i. Issue of shares:
It is the most important sources for raising permanent or long term capital. According to the companies Act ,a company can issue two types of shares i.e., Equity shares and Preference shares.
2.Issue of debentures: Debenture is a certificate issued by the company under its common seal acknowledging its debt to its holders. A fixed interest will be paid to the debenture holders whether the company makes profit or not.

16. 3.Public deposit:
It is the fixed deposits accepted by the business enterprise directly from the public at a fixed rate of interest.
4.Ploughing back of profits or self-financing :
It means the reinvestment by a concern of its surplus earnings in its business.
5.Loan from financial institutions:
Loan from financial institutions are an important source of meeting fixed capital requirements of company. Interest is charged on such loans at a fixed rate and the loans are repayable in easy installments.

17. ii)Financing of temporary or variable working capital:
A. Internal sources:
a. Depreciation fund :Depreciation reserves provides a good source of funds for working capital.
b.Provision for taxation :The provision for tax is created out of the profits of the company at the end of the financial year but the tax is paid only after the assessment is finalized.
c.Accured expenses: The firm can postpone the payment of expenses for short periods. This Constitute as a source of working capital.

18. B.External sources:
a. Trade credit :Trade credit refers to credit extended by the suppliers of goods in the normal course of the business. The credit worthiness of a firm and the confidence of its suppliers are the main basis of securing trade credit.
b.Commercial papers: A commercial paper is a short-term unsecured promissory note. It is issued by firms which are financially sound and have a high credit rating. The maturity period of commercial paper varies from 91 days to 180 days. It is sold at a discount and redeemed at par. Commercial paper is either sold directly to investors or through banks.

19. Commercial paper is a cheaper source of raising short – term finance as compared to bank credit. However , it cannot be redeemed before the maturity date even though the issuing firm has surplus funds to repay.
c.Bank credit :
Commercial banks are the most important sources of short term working capital. They provide working capital in the form of loans, cash credit or overdrafts and through discounting bills.
d.Advances:
Some business houses get advance s from their customers against orders and this source is a short term finance for them.

20. e .Loans from directors:
An enterprise may also obtain loans from its directors, officers etc.These loans often obtained at a low interest .
f.Instalment credit:
This is the another method by which the assets are purchased and the possession of goods is taken immediately. But the payments are made in instalments over a pre-determined period of time.

21. Problems
1.By determining the amount of current asset and current liabilities 1.From the following balance sheet compute (a)Gross working capital (b)Net working capital Liabilities Rs Assets Rs Share capital 6,00,000 Land & Building 3,00,000 Reserves 1,00,000 Plant & Building 4,00,000 Debentures 3,00,000 Current Liabilities: Current Assets: Bank loan 1,00,000 Cash 60,000 Creditors 60,000 Investment 1,00,000 Bills payable 40,000 Inventory 2,00,000 Debtors 1,40,000 Total 12,00,000 Total 12,00,000

22. Solution:
a. Gross working capital= Current assets
= Cash +Investments+Debtors+Inventory
=60,000+1,00,000+1,40,000+2,00,000
Gross working capital = Rs.5,00,000
(Or)
Total Assets – Fixed assets =Gross working capital
Rs.12,00,000 – Rs.7,00,000 = Rs.5,00,000
(b)Net working capital = Current assets – current liabilities
= Rs.5,00,000 – Rs.2,00,000
Net working capital = Rs.3,00,000

23. PC Ltd. Sells its product on a gross profit of 20% on sales
PC Ltd. Sells its product on a gross profit of 20% on sales. The following information is extracted from its annual accounts for the year ended 31st December 2012.
Particulars
RS.
Sales at 3 months credit
40,00,000
Raw material
12,00,000
Wages paid –avg. time lag 15 days
9,60,000
Manufacturing expenses paid-1 month in arrears
Administrative exp. Paid-1 month in arrears
4,80,000
Sales Promotion exp. –payable half yearly in advance
2,00,000

24. The company enjoy 1 month credit from suppliers of RM and maintains 2 months stock of RM & 1 ½ months finished goods. Cash balance is maintained at Rs.1,00,000 as a precautionary balance. Assuming a 10% margin, Find out the wc requirements .

25. Current Assets
Stock of RM
(12,00,000*2/12)
2,00,000
Stock of Finished goods
(40,00,000*80/100*1,5/12)
4,00,000

26. Statement of Working capital requirements
Current Assets
Stock of RM
(12,00,000*2/12)
2,00,000
Stock of Finished goods
(40,00,000*80/100*1.5/12)
4,00,000
Debtor atcost
(40,00,000*80/100*3/12)
8.00,000
Advance payment of sales promotion
(2,00,000*6/12)
1,00,000
Cash
Total CA
16,00,000

27. Statement of Working capital requirements
Current Liabilities
Creditors
(12,00,000*1/12)
1,00,000
Wages outstanding
(9,60,000*.5/12)
40,000
Manufacturing exp. outstanding
Admin. Exp. outstanding
(4,80,000*1/12)
Total Current liabilities
2,80,000
NWC
13,20,000
Contingencies
1,32,000
WC Required
14,52,000

28. A proforma cost sheet of a company provides the following data:
Cost (per Unit)
Raw Materials
52.0
Direct Labour
19.5
Overheads 39
Total cost(per unit)
110.5
Profit
Selling price
130

29. The following is the additional information available:
Average raw material in stock: one month
Average materials in process : half a month
Credit allowed by suppliers: one month
Credit allowed to debtors: two months
Time lag in payment of wages one & half weeks.
Overheads: one month
One-fourth of sales are on cash basis.
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 output. You may assume that production is carried on evenly throughout the year and wages and overheads accrue similarly.

30. A proforma cost sheet of a company provides the following particulars:
Elements of cost:
Materials 40%
Direct Labor 20%
Overheads 20%
The following further particulars are available:
It is proposed to maintain a level of activity of 2,00,000 units.
Selling price is Rs.12/- per unit.
Raw Material are expected to remain in stores for an average period of one month.

31. 4. Materials will be in process, on averages half a month. 5
4. Materials will be in process, on averages half a month. 5. Finished goods are required to be in stock for an average period of one month. 6. Credit allowed to debtors is two months. 7. Credit allowed by suppliers is one month. 8. Expenses and Overheads are paid 1 month lag.

32. From the following projection of Tall and Short Ltd you are required to workout the working capital required by the company. Annual sales – R6s.7,20,000 Cost of production including depreciation of Rs.60,000 - Rs.6,00,000 Raw materials purchased – Rs.3,52,000 Overheads per month – Rs.15,000 Anticipated opening stock of raw materials – Rs.70,000 Anticipated closing stock of raw materials – Rs.62,500 Inventory norms : 1.Raw materials – 2 months 2.Work in progress – ½ month 3.Finished goods – 1 month 4.Credit allowed to customers – 1 month 5.Credit allowed by suppliers – 15 days 6.Cash balance desired to be maintained – Rs.10,000 7.The company receive an advance of Rs.15,000 on sales orders.

33. Solution:
Working notes:
Calculation of raw materials Consumed :
Opening balance Rs.70,000
+ Purchase Rs.3,52,000
Closing balance - Rs.62,500
Material consumed - Rs.3,60,000
Calculation of stock of finished goods :
Cost of production Rs.6,00,000
- Depreciation Rs.60,000
Cash cost of production Rs.5,40,000

34. 2.Operating cycle method: O = (R+W+F+D) – C Where, O = Duration of operating cycle R =Raw materials average storage period W=Work in progress average process period F=Finished goods average storage period C=Creditors collection period D=Debtors collection period The components of operating cycle may be calculated as follows: R = Average stock of raw materials & storage held Average raw materials & stores consumption per day

35. W = Average work in progress inventory Average cost of production per day F= Average finished stock inventory Average cost of goods sold per day D = Average book debt Average credit sales per day C = Average trade creditors Average credit purchase per day The operating cycle of a firm begins with the acquisition of raw materials and ends with the collection of receivables. It is divided into four types: 1.Raw material and storage 2.Work in progress 3.Finished goods stage and 4.Debtors collection stage

36. From the following particulars, compute (i) Net operating cycle period (ii)number of operating cycles in a year (iii) The amount of working capital. Period covered – 360 days Average period allowed by suppliers – 30 days Average period allowed to debtors – 45 days Raw material consumed during the year – Rs.6,00,000 Average stock of raw materials – Rs.50,000 Work in progress = Rs.5,00,000 Average work in progress inventory= 30,000 Finished goods = Rs.8,00,000 Average finished goods stock held = Rs.40,000 Total cost of sales = Rs.8,40,000

37. Computation of Net operating cycle:
Raw materials held in stock :
Avg.stock of materials Avg.consumption per day – 50,000/ 1667 – 30 days
(6,00,000 / 360 days – 1667)
Work in progress :
Average WIP / Avg.consumption per day ,000/ days
(500000/360 days – 1388)
Finished goods held in stock :
Avg.finished goods/Avg cost of goods sold per day -40,000/2222 –18 days
(8,00,000 / 360 days – 2222)
Credit period to debtors days
115 days
Average credit period allowed by creditors days
Net operating cycle period days

38. ii. No. of operating cycles in a year = 360 / 85 = 4. 2 cycles iii
ii.No.of operating cycles in a year = 360 / 85 = 4.2 cycles iii.Working capital required = Total cost of sales No. of operating cycles in a year = Rs.8,40,000 / 4.2 = Rs.2,00,000

39. Percentage of sales method: In this method the level of working capital is decided on the basis of past experience. 1.The balance sheet of national steel ltd as on is as under: Liabilities Rs Assets Rs Share capital 200 Land and building 60 Reserves & Surplus 160 Plant & machinery 200 Term loans 120 Debtors 220 Sundry creditors 120 Inventories 200 Provision of taxation 60 Cash and bank The company’s turn over for 2004 – 2005 was 1200 lakhs. It anticipates a sales turn over of Rs.1800 lakhs in Estimate the working capital requirement for

40. Statement of working capital requirement for % of sales based on 2004 – 05 (Actuals) (Estimate) Sales Current assets: Debtors Inventories Cash and bank Total (A) Current liabilities: Sundry creditors Provision for Tax Total (B) Working capital (A –B)