Working Capital Management

Working Capital Management
Two Types of Capital in a firm

Fixed Capital or the Long Term Capital Working Capital or the Short Term Capital Working Capital Why do companies need them? The aim of the organizations is to Maximize the shareholders wealth The fixed capital is locked up for long term The day to day expenses need to be fulfilled and this is done by the working capital. Thus proper working capital management of the company is of utmost importance
Defining Working Capital Excess of Current Assets over Current Liabilities

What are Current Assets 1. Cash in hand and bank balance 2. Sundry Debtors
Amount that of fund locked with the sundry debtors is calculated on the basis of the credit Sales and the time lag in collecting that fund. Example: Credit sales of the year = Rs 1,20,000 Average credit period enjoyed by the debtors = 2 months Amount of working capital locked (and thus required) = 24,000

3. Advance Payment of Expenses 4. Inventory Inventory can be divided in to following parts
1. Stock of Raw Material ( Here only raw material cost is taken care) Total Raw material required by the firm is Rs 12000 annum Raw material remain in the warehouse( unused) for 3 months , so the working capital requirement = 3/12 X 12000 = RS 3000 Work in progress ( All costs associated with Manufacturing ) 1. Raw Material 2. Wages 3. Overhead and other costs Finished Goods
2.
3.

1. What are Current Liabilities
Sundry Creditors Lags in Payment

Raw Material Wages Rents Salaries etc. Taxation
Net Working Capital Requirement
Currents Assets Current Liabilities

Example: Calculate the average annual working capital requirement for the company. The following estimates are available about the company. Take 10% as contingency
1.
Average amount locked up in 1. Finished Goods = Rs 2500 2. Work in Progress = Rs 2500 3. Average amount locked up in Raw Material = Rs 8000 2. Sales Credit 1. Local Sales ( 2 weeks Credit) = Rs 78,000 2. Outside Sales( 4 weeks) = Rs 3,12,000 3. Time Available for payment 1. For Purchases (4 weeks) = Rs 96,000 2. For Payment of Wages (2 weeks) = Rs 2,60,000

Net Working Capital Req = Currents Assets Current Liabilities 1. Current Assets
Inventory
Stock of Finished Product = Rs 2500 Locked in WIP = Rs 2500 Locked in Stores, Raw Materials etc = Rs 8,000 Total = Rs 13,000
Account Receivable
Sales Credit Local Sales = 2/52 X 78,000 = Rs 3,000 Outside Sales = 6/52 X 3,12,000 = Rs 36000 Total Current Assets = Rs 13,000+ 39,000 = Rs 52,000

1. Current Liabilities
Account Payable
For Purchases = 4/52 X 96,000 = Rs7385 For Wages = 2/52 X 2,60,00 = Rs 10,000 Total = Rs 17385 Net Working Capital = Total Current Assets Total Current Liabilities = 52,000- 17385 = Rs 34,615 Add 10% of the contingency = Rs 3461.5 Total Working Capital Requirement = 34,615+3461.5 = Rs 38076

Example: Calculate the average annual working capital requirement for the company. The following estimates are available about the company. Add 10% as contingency Amount Locked in Stocks
1. 2. 3. Average amount locked up in Finished Goods = Rs 5000 Work in Progress = Rs 4000 Average amount locked up in Raw Material = Rs 4000 Inland Sales ( 6 weeks Credit) = Rs 3,12,000 Outside Sales( 1.5 week credit) = Rs 78,000
1.
2.
Average Credit given

1. 2.
3.
Lag for payment 1. Wages( 1.5 Weeks)

2. 3. 4. 5. 6.
= Rs 2,60,000
Stores, Materials etc. (1.5 months) = Rs 48,000 Rents,Roylaities (6 months) = Rs 10,000 Clerical Staff (0.5 months) = Rs 62,400 Manager (0.5 months) =Rs4800 Miscellaneous expenses (1.5 months) = Rs 48,000

4.
5.
Payment in Advance
1. Sundry Expenses ( paid quarterly in advance) = Rs 8000
Undrawn Profits on the average throughout the year = Rs 11000

Solution
Current Assets
1. Amount Locked in Stocks Average amount locked up in Finished Goods = Rs 5000 Work in Progress = Rs 4000 Average amount locked up in Raw Material = Rs 4000 Total = Rs 13,000 2. Average Credit given
1. 2. 3. Inland Sales ( 6 weeks Credit) = Rs 36,000 Outside Sales( 1.5 week credit) = Rs 2250 Total = Rs 38250
3.
Advance Payment of Expenses = Rs 2000
Total Current Assets = Rs 13000+38250+2000 = Rs 53250
Current Liabilities
1. Lag for payment 1. Wages( 1.5 Weeks)
2. 3. 4. 5. 6. = Rs 7500 Stores, Materials etc. (1.5 months) = Rs 6000 Rents, Roylaities (6 months) = Rs 5000 Clerical Staff (0.5 months) = Rs 2600 Manager (0.5 months) = Rs 200 Miscellaneous expenses (1.5 months) = Rs 6,000
Total Liabilities = Rs 27300 Net Working Capital = 53250-27300= Rs 25950 Add10% contingency =Rs 2595 Total = RS 28545

Calculating the Working Capital Requirement by Operating cycle approach According to this approach, the requirement of the working capital depends upon the operating cycle of the business What is the operating cycle? The time period between the acquisition of the raw material to the collection of the receivables It is divided in to 4 stages
1. 2. 3. 4. a) b) Raw Material Storage Stage WIP Stage Finished Good Inventory Stage Receivable Collection Stage
In this approach we calculate the time period the money is locked up in stage Calculate the time period for which the money of creditors is locked in by the firm Calculate a-b

Symbolically
O = (R+W+F+D) C
O = Duration of the Operating cycle R = Raw material storage period W= WIP period F= Finished stocked storage period D= Debtors collection period C= Creditors payment period
How to calculate the different periods?

R= Average Stock of Raw Material Average Raw Material consumption per day Average WIP inventory Average cost of production per day Average finished stock Inventory Average cost of good sold per day
W=
F=
D=
Average book debts Average credit sales per day
From the following information extracted from the books of the company xyz compute the operating cycle in days and the amount of working capital required
Period Covered Average Period for creditors allowed Average Total Debtors Outstanding 365 Days 16 days (Rs in 000) 480
Raw Material Consumption

Total Production cost Total cost of sales Sales for the year Value of the average stock maintained Raw Material Work in Progress Finished Goods
4400
10,000 10,500 16,000 (Rs in 000) 320 350 260

R= Average Stock of Raw Material Average Raw Material consumption per day
Average Stock of Raw Material consumption per day = Total consumption/ No of days in operating cycle
= 4400000/365 = 12 000 per day R = 320,000/12000 = 26.6 = 27 days

Average WIP inventory Average cost of production per day Average cost of production = Total COP/ No of days = 10,000,000/365 = RS 27397 per day W = 350,000/27397 = 12.77 days
W=
F = Average finished good in the Inventory/ Avg COG sold per day Avg Cost of good sold = Total cost of good sold/ Total no of days = 10,500,000/365 = RS 28767.12 per day F = 260,000/28767.12 = 9 days

D = Average total outstanding Debt Average Credit sales per day
Average Credit sales per day = Total Credit Sales/no of days = 16,000,000/365 =Rs 43835.6 /day D = 480,000/43835.6 = 10.95 days = 11 days
R+W+F+D = 27+13+9+11 =60 days Average period of credit allowed by creditors = 16 days Operating cycle period = 60-16 = 44 days No of operating cycles per year = 365/44 = 8.30 Working capital Required = Total Operating cost/ NO of Operating cycles 10,500,000/8.30 = Rs 1265,060

Factors affecting the working capital requirement
Production Policies
Labor Intensive vz Automated Small business need more working capital in comparison to the large organization where most of the transaction are in cash Manufacturing needs more WC than services
Nature of business
Length of manufacturing process Credit Policy Seasonal Fluctuations

Working Capital Management

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Working Capital Management

Two Types of Capital in a firm