WORKING CAPITAL

MANAGEMENT
 MEANING
Working Capital refers to that part of the firm’s
capital which is required for financing short-term or
current assets such as cash, marketable securities,
debtors & inventories.

Working Capital is the amount of funds necessary to

cover the cost of operating the enterprise.
 THERE ARE TWO CONCEPT OF
WORKING CAPITAL

GROSS WORKING CAPITAL:-

The gross working capital is the capital invested
in total current assets of the enterprise.

NET WORKING CAPITAL:-

Net working capital is the excess of current
assets over current liabilities. i.e.
Net Working Capital = Current Assets-Current
Liabilities
 CLASSFICATION /KINDS OF
WORKING CAPITAL
Working Capital may be classified in two
ways:
 Kinds of Working Capital

On the basis of concept On the basis of time

Gross Working Capital Net Working Capital

Permanent Temporary
or or
Fixed Working Capital Variable Working Capital

Regular Seasonal Special

Reserve
Working Capital Working Capital Working Capital
Working Capital
 FACTORS DETERMINING THE
WORKING CAPITAL REQUIREMENTS
 Nature of character of Business
 Size of Business/Scale of Operations
 Production Policy
 Manufacturing Process/Length of Production Cycle
 Seasonal Variations
 Working Capital Cycle
 Rate of stock turnover
 Credit Policy
 Business Cycle
 Rate of growth of business
 Earning capacity & Dividend Policy
 Price level changes
 Other factors
 IMPORTANCE OF WORKING
CAPITAL
 Solvency of the Business
 Goodwill
 Easy Loans
 Cash Discounts
 Regular payment of salaries, wages & other day-to-day
commitments
 Regular Supply of raw materials
 Exploitation of favorable market conditions
 Ability to face crisis
 Quick & regular return on investments
 High Morale
FORECAST /ESTIMATE OF WORKING
CAPITAL REQUIREMENTS

 To avoid the shortage of working capital at

once, an estimate of working capital
requirements should be made in advances so
that arrangements can be made to procure
adequate working capital.
FACTORS REQUIRING CONSIDERATION
WHILE ESTIMATING WORKING
CAPITAL

Total costs incurred on material, wages & overheads.

The length of time for which raw materials are to
remain in stress before they are issued for production.
The length of the production cycle or work-in-
process i.e. the time taken for conversion of raw
material into finished goods.
Computation of Working Capital
A firm should have adequate WC to support its budgeted level of activity in
terms of production/sales. It should have neither more nor less WC than
required. While the excessive WC adversely affects its profits, the inadequate
WC interrupts its smooth operations. Therefore, its correct computation is an
important constituent of efficient WC management.
There are two components of WC, namely, CA and CL. Each component is to
be separately estimated to determine the correct amount of WC. The relevant
factors are the holding periods of the various types of inventories, debtors
collection period, creditors payment period, budgeted yearly production/sales,
cost of goods produced, cost of sales, average time-lag in payment of wages
and other overheads, minimum cash balances and so on.
Working capital requirements are to be computed with reference to cash costs
(excluding depreciation) and not the sale price as depreciation is a non-cash
cost and, hence, does not need WC. The investment required to finance
debtors are at cost price. The ‘cash cost approach’ is appropriate to determine
WC requirement of a firm.
Estimation of Current Assets: Raw Materials Inventory  The investment in raw
materials inventory is estimated on the basis of Eq. 1.
Budgeted × Cost of raw material(s) × Average inventory
production (in per unit holding period
units) (months/days)
12 months/365 days

Work-in-Process (W/P) Inventory  The relevant costs to determine work-in-

process inventory are the proportionate share of cost of raw materials and
conversion costs (labour and manufacturing overhead costs excluding
depreciation). In case, full unit of raw material is required in the beginning, the
unit cost of work-in-proess would be higher, that is, cost of full unit + 50 per
cent of conversion cost, compared to the raw material requirement throughout
the production cycle; W/P is normally equivalent to 50 per cent of total cost of
production. Symbolically,
Budgeted production × Estimated work- × Average time span
(in units) in-process cost of work-in-progress
per unit inventory
(months/days)
    12 months/365 days
Finished Goods Inventory
 Working capital required to finance the finished goods inventory is given by
factors summed up in Eq. 3.
Budgeted × Cost of goods produced × Finished goods
production per unit (excluding holding period
(in units)   depreciation) (months/days)
12 months/365 days
Debtors
The WC tied up in debtors should be estimated in relation to total cost price
(excluding depreciation) Symbolically,
Budgeted × Cost of sales per × Average debt
credit sales unit excluding collection period
(in units) depreciation (months/days)
        12 months/365 days
Cash and Bank Balances  
Apart from WC needs for financing inventories and debtors, firms also find it useful
to have some minimum cash balances with them.
Estimation of Current Liabilities  
The working capital needs of business firms are lower to the that extent such needs
are met through the current liabilities (other than bank credit) arising in the ordinary
course of business. The important current liabilities (CL), in this context are, trade-
creditors, wages and overheads:

Trade Creditors
Budgeted yearly × Raw material × Credit period
production cost allowed by creditors
(in units) per unit (months/days)
  12 months/365 days
Note: Proportional adjustment should be made to cash purchases of raw materials.
Direct Wages
Budgeted yearly × Direct labour × Average time-lag in
production cost per unit payment of wages
(in units) (months/days)
  12 months/365 days
The average credit period for the payment of wages approximates to a half-a-
month in the case of monthly wage payment: The first days’ monthly wages are
paid on the 30th day of the month, extending credit for 29 days, the second
day’s wages are, again, paid on the 30th, extending credit for 28 days, and so
on. Average credit period approximates to half-a-month.

Overheads (Other Than Depreciation and Amortisation)

Budgeted yearly × Overhead cost × Average time-lag in
production per unit payment of overheads
(in units) (months/days)
  12 months/365 days
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 computation of working capital is summarised in format 1.
FORMAT 1  Determination of Working Capital
(I) Estimation of Current Asset: Amount
(a) Minimum desired cash and bank balances
(b) Inventories
  Raw material
  Work-in-process
  Finished Goods
(c) Debtors*
Total Current Assets
(II) Estimation of Current Liabilities:
(a) Creditors**
(b) Wages
(c) Overheads
Total Current Liabilities
(III)Net Working Capital (I – II)
Add margin for contingency
(IV)Net Working Capital Required
*If payment is received in advance, the item would be listed in CL.
**If advance payment is to be made to creditors, the item would appear under CA. The
same would be the treatment for advance payment of wages and overheads.
 MANAGEMENT OF WORKING CAPITAL IN INDIA
 Indian corporates seem to have adequate and satisfactory level of working capital as
reflected in their liquidity ratios. The foreign controlled companies are placed in a better
position relative to the domestic companies.
 There are wide inter-industry variations in the liquidity ratios of the corporate enterprises.
With the exception of sugar, all other industry groups have safe and satisfactory liquidity
position.
 The majority of Indian companies maintains relatively lower cash/bank balances.
Marketable securities are yet to emerge as a popular means of cash management. The
excess cash is deployed to retire short-term debt/in short-term bank deposits.
 In spite of the notable decline over the years, inventory consitutes a sizeable part of the
total current assets of the Indian corporates. The most important objective of inventory
management in India is ‘avoid loss of production/sales’. The popular control techniques are
ABC, FSN and SDE and inventory turnover ratio and comparison with competitors are
widely used to assess the performance of inventory management.
 Debtors/receivables also constitute a significant component of current assets. ‘growth in
sales’ is the most important objective of credit policy and the ‘open credit with approval if
exceeds a specified limit’ is the most favoured policy. It is common practice to prepare
‘ageing schedule’ of debtors’ to assess the financial health of the customers before
granting credit and monitoring purposes. To speed up collections, the corporates offer
cash discount. The majority of the companies also charge penal interest.
 Accounts payable and short-term loans/advances are the major components of current
liabilities.
 The ‘length of the operating cycle’ is the most widely use method to determine working
capital need. The working capital financing policy is based on the matching approach. The
majority of the companies have occasionally experienced working capital shortage due
mainly to excess inventory accumulation and poor debt collection.
While 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 per cent to your
computed figure to allow contingencies:
Particulars Amount per unit
Estimated cost per unit of production:
Raw material Rs 80
Direct labour 30
Overheads (exclusive of depreciation, Rs 10 per unit) 60
Total cash cost 170

Additional information:
Selling price, Rs 200 per unit
Level of activity, 1,04,000 units of production per annum
Raw materials in stock, average 4 weeks
Work in progress (assume 50 per cent completion stage in respect of conversion costs
and 100 per cent completion in respect of materials), 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 1.5 weeks
Cash at bank is expected to be, Rs 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.
Solution
Net working capital estimate of a project
(A) Current assets:
(i) Raw materials in stock, (1,04,000 × Rs 80 × 4/52) Rs 6,40,000
(ii) Work-in-progress
(a) Raw material (1,04,000 × Rs 80 × 2/52) 3,20,000
(b) Direct Labour (1,04,000 × Rs 15 × 2/52) 60,000
(c) Overheads (1,04,000 × Rs 30 × 2/52) 1,20,000
(iii) Finished goods stock: (1,04,000 × Rs 170 × 4/52) 13,60,000
(iv) Debtors: (1,04,000 × Rs 170 × 8/52) 27,20,000
(v) Cash at bank 25,000
Total investment in current assets 52,45,000
(B) Current liabilities:
(i) Creditors, average 4 weeks: (1,04,000 × Rs 80 × 4/52) 6,40,000
(ii) Lag in payment of wages (1,04,000 × Rs 30 × 1.5/52) 90,000
  Total current liabilities 7,30,000
(C) Net working capital: Current assets – Current liabilities 45,15,000
   Add: 10 per cent contingencies 4,51,500
Net working capital required 49,66,500
Working Notes
A full unit of raw material is required at the beginning of the
manufacturing process and, therefore, total cost of the material, that is,
Rs 80 per unit has been taken into consideration, while in the case of
expenses, viz. direct labour and overheads, the unit has been finished
only to the extent of 50 per cent. Accordingly, Rs 15 and Rs 30 have
been charged for direct labour and overheads respectively in valuing
work-in-process.
Strong Cement Company Ltd has an installed capacity of producing 1.25 lakh
tonnes of cement per annum; its present capacity utilisation is 80 per cent.
The major raw material to manufacture cement is limestone which is obtained
from the company's own mechanised mine located near the plant. The
company produces cement in 200 kgs bags. From the information given
below, determine the net working capital (NWC) requirement of the company
for the current year.
Cost structure per bag of cement (estimated)
  Gypsum Rs 25
  Limestone 15
  Coal 30
  Packing material 10
  Direct labour 50
  Factory overheads (including depreciation of Rs 10) 30
  Administrative overheads 20
  Selling overheads 25
Total cost 205
  Profit margin 45
  Selling price 250
    Add: Sale tax (10 per cent of selling price) 25
  Invoice price to consumers 275
Additional information:
1) Desired holding prriod of raw materials: Gypsum, 3 months, Limestone, 1
month, Coal, 2.5 months, and Packing material, 1.5 months
2) The product is in process for a period of 0.5 month (assume full units of
materials, namely gypsum limestone and coal are required in the
beginning; other conversion costs are to be taken at 50 per cent).
3) Finished goods are in stock for a period of 1 month before they are sold.
4) Debtors are extended credit for a period 3 months.
5) Average time lag in payment of wages is approximately 0.5 month and of
overheads, 1 month.
6) Average time lag in payment of sales tax is 1.5 months.
7) The credit period extended by various suppliers are:
Gypsum, 2 months, Coal, 1 month, and Packing
material, 0.5 month.
1) Minimum desired cash balance is Rs 25 lakh.
  You may state your assumptions, if any.
SOLUTION
Statement showing determination of net working capital of Strong Cement
Company Ltd
Current assets:
Minimum desired cash balance Rs 25,00,000
Raw materials:
Gypsum (5 lakh bags1 × Rs 25 × 3/12) 31,25,000
Limestone (5 lakh bags × Rs 15 × 1/12) 6,25,000
Coal (5 lakh bags × Rs 30 × 2.5/12) 31,25,000
Packing material (5 lakh bags × Rs 10 × 1.5/12) 6,25,000
Work-in-process: (5 lakh bags × Rs 115 × 1/24) 23,95,833
— Raw material cost 100 per cent (Rs 25 + Rs 15 + Rs 30) Rs 70
— Other conversion costs (Rs 50 + Rs 20 cash factory
overheads + Rs 20) × 0.5 45
115
Finished goods (5 lakh bags × Rs 170** × 1/12) 70,83,333
Debtors (5 lakh bags × Rs 220** × 3/12) 2,75,00,000
Total 4,69,79,166
Current liabilities:
Creditors:
Gypsum (5 lakh bags × Rs 25 × 2/12) 20,83,333
Coal (5 lakh bags × Rs 30 × 1/12) 12,50,000
Packing material (5 lakh bags × Rs 10 × 1/24) 2,08,333
Wages (5 lakh bags × Rs 50 × 1/24) 10,41,667
Overheads (5 lakh bags × Rs 65 × 1/12) 27,08,333
Sales tax (5 lakh bags × Rs 25 × 1.5/12) 15,62,500
Total
NWC 88,54,166
3,81,25,000
*1.25 lakh tons × 0.8 = 1 lakh ton/200 kgs = 5,00,000 bags
**(Total cost, Rs 205 – Depreciation, Rs 10 – selling overheads, Rs 25)
***(Cash cost, Rs 195 + sale tax, Rs 25)