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Roshankumar S Pimpalkar
roshankumar.2007@rediffmail.com
roshankumar.2007@rediffmail.com
Various combinations of policies and technique are used for working capital
management. The various steps in management of working capital are:
o Cash management- cash level should be maintained at a level so that the
day-to-day expenses can be met and cash holding cost is low.
o Inventory management- maintain quantity of inventory at such level so that
production is not interrupted and at that same time too much money is not
blocked in raw materials.
o Debtors management- an appropriate credit policy should be adopted so that
the credit term which will attract customers, such that the impact on cash
flows and the cash conversion cycle will be offset by increased revenue and
hence return on capital. The tools like discounts and allowances are used for
this.
o Short term financing- inventory is normally financed by credit granted by
suppliers and to finance other components of working capital other sources
are needed such as bank loan ( or overdraft), or to convert debtors to cash
through factoring.
Following are the factors which generally influence the working capital requirements
of the firm:
o
o
o
o
o
o
o
Nature of business
Credit policy of firm
Availability of credit from suppliers
Technology and manufacturing policy
Operating efficiency
Market demand and conditions
Price level changes
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FINISHED GOODS
DEBTORS
CASH
Operating cycle is one of the most useful tools for managing working capital. The
operating cycle analyzes the accounts receivable, inventory and accounts payable
cycle in number of days. Most of the businesses cannot finance the operating cycle
with accounts payable alone so working capital financing is needed. This shortfall is
covered by the net profits generated internally or by externally borrowed funds or by
combination of two.
Each component of working capital has two dimensions i.e. time and money. If the
money moves faster around the cycle or the amount of money tied up is reduced, the
business will generate more cash or it will need to borrow less money to fund
working capital which will ultimately reduce bank interest or the entity will have
additional free money to support additional sales growth or investment. If increased
credit limits can be negotiated from suppliers, entity gets free finance.
Working capital cycle indicates the length of the time between a companys paying
for materials, entering into stock and receiving the cash from sales of finished goods.
It can be determined by adding the number of days required for each stage of cycle.
For example, a company holds raw material on an average of 60 days, it gets credit
from the supplier for 15 days, production process needs 15 days, finished goods are
held for 30 days and 30 days credit is extended to debtors.
Operating cycle = R+W+F+D-C
Where,
R= Raw material storage period
W= Working capital holding period
F= Finished goods storage period
D= Debtors collection period
C= Credit period availed
Operating cycle= 60+15+30+30-15
= 120 days.
Now the above components may be calculated as:
RM storage period = Avg stock of RM / Avg cost of RM consumption per day
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WIP holding period = Avg WIP / Avg cost of production per day
FG storage period = Avg stock of FG / Avg COGS per day
Debtors collection period = Avg book debts / Avg credit sales per day
Credit period availed = avg trade creditor / Avg credit purchases per day
The net operating cycle represents the net time gap between investment of cash and
its recovery of sales revenue. If depreciation is excluded from expenses in the
computation of operating cycle, the net operating cycle also represents the cash
conversion cycle. The net operating cycle represents the time interval for which the
firm has to negotiate for working capital from its Bankers.
Estimation of Working Capital based on current asset and current liabilities
The holding period of various components of operating cycle may either expand or
contract the net operating cycle period. Longer the operating cycle, higher will be the
requirement of working capital and vice-versa.
Estimation of current assets
o Raw materials inventory:
(Estimated production in units * estimated cost of RM p.u. * Avg RM holding
period) / 360 days
o WIP Inventory:
(Estimated production in units * estimated WIP cost p.u. * Avg WIP holding
period) / 360 days
o Finished goods:
(Estimated production in units * Cost of production p.u. excluding
depreciation * Avg FG holding period) / 360 days
o Debtors:
(Estimated credit sales in units * cost of sales p.u. excluding depreciation *
Avg debtors collection period) / 360 days
o Minimum desired Cash and Bank balances to be maintained by the entity
have to be added to current assets for computation of working capital.
Estimation of current liabilities
o Trade creditors:
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