CHAPTER TWO

PRINCIPLES OF WORKING CAPITAL MANAGEMENT

Working capital management is concerned with the problems that arise in

attempting to manage the current assets, the current liabilities and the
interrelationship that exists between them. The term Current Assets refer to those
assets which in the ordinary course of business can be, or will be, converted into
cash within one year without undergoing a reduction in value and without disrupting
the operations of the firm. Current Liabilities are those liabilities which are
intended, at their inception, to be paid in the ordinary course of business, within a
year, out of the current assets or earnings of the concern.

Current Assets Current Liabilities

Cash and Bank Balances Short term Borrowings
Marketable Securities Accounts Payables
Accounts Receivables Notes Payables
Notes Receivables Trade Advances
Inventories: RMs, WIP, FGs

In the management of working capital two characteristics of current assets must be

borne in mind: (i) Short life span, and (ii) swift transformation into other asset form.
Current assets have a short life span. Cash balance may be held idle for a week or
two, account receivables may have a life span of 30 to 60 days, and inventories
may be held for 30 to 100 days. The life span of current assets depends upon the
time required in the activities of procurement, production, sales and collection and
degree of coincide (synchronization) among them.

Each current asset is swiftly transformed into another asset forms: cash is used for
acquiring raw material; raw materials are transformed into finished goods ( this
transformation may involve several stages of work-in-progress); finished goods,
generally sold on credit, are converted into accounts receivables; and finally
accounts receivables, on realization generate cash.

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The goal of the working capital management is to manage the firm’s current assets
and liabilities in such a way that a satisfactory level of working capital is
maintained. This is so because if the firm cannot maintain a satisfactory level of
working capital it is likely to become insolvent and may even be forced into
bankruptcy. The current assets should be large enough to cover its current liabilities
in order to ensure a reasonably margin of safety. Each of the current assets must be
managed efficiently in order to maintain the liquidity of the firm while not keeping
too high level of any one of them. Each of the short term sources of financing must
be continuously managed to ensure that they are obtained and used in the best
possible way. The interaction between current assets and current liabilities is,
therefore, the main theme of the theory of working capital management.

2.1 Concepts and Definitions of Working Capital

There are two concepts of working capital: “Gross” and “Net”.

The term Gross Working Capital also referred to as working capital means a
firm’s investment in assets that are expected to be converted to cash within one
year (i.e. current assets).
Gross Working Capital = Total of Current Assets
When a firm is originally established there is a need for two types of investment,
fixed asset investments (land, building, machinery, vehicles, office equipment etc.)
and working capital investment. The working capital investment is meant for
payments for raw material purchases, payment for labor and to meet other
expenditures in an attempt to produce goods (services) for sale.

The term Net Working Capital (NWC) can be defined in two ways (i) the most
common definition of NWC is the difference between current assets and current
liabilities; and (ii) alternative definition of NWC is that portion of current assets
which is financed with long-term funds.
NWC = Current Assets – Current Liabilities

NWC is commonly defined as the difference b/n CA s and CLs. Efficient working
capital requires that firms should operate with some amount of NWC, the exact
amount varying from firm to firm and depending, among other things, on the nature
of industry. The theoretical justification for the use of NWC to measure liquidity is

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based on the basis that the greater the margin by which the current assets cover
the short term obligations, the more is the ability to pay obligations when they
become due for payment. The NWC is necessary because the cash outflows and
inflows do not coincide. In other words, it is the non-synchronous nature of cash
flows that makes NWC necessary. The cash inflows are, however, difficult to predict,
therefore, NWC is necessary. The more predictable the cash inflows are, the less
NWC will be required and vise-versa.

NWC can alternatively be defined as that part of the current assets which are
financed with long-term funds. Since current liabilities represent sources of short
term funds, as long as current assets exceed the current liabilities, the excess must
be finance with long-term funds.

Importance or Advantages of Adequate Working Capital:

Working capital is the life blood and nerve center of a business. Hence, it is very
essential to maintain smooth running of a business. No business can run
successfully without an adequate amount of working capital. The main advantages
of maintaining adequate amount of working capital are as follows:

1) Solvency of the Business: Adequate working capital helps in maintaining

solvency of business by providing uninterrupted flow of production.

2) Goodwill: Sufficient working capital enables a business concern to make prompt

payments and hence helps in creating and maintaining goodwill.

3) Easy Loans: A concern having adequate working capital, high solvency and good
credit standing can arrange loans from banks and others on easy and favorable
terms.

4) Cash Discounts: Adequate working capital also enables a concern to avail cash
discounts on purchases and hence it reduces cost.

5) Regular Supply of Raw Material: Sufficient working capital ensures regular

supply of raw materials and continuous production.

6) Regular payment of salaries, wages and other day to day commitments: A

company which has ample working capital can make regular payment of

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 salaries, wages and other day to day commitments which raises morale of its
employees, increases their efficiency, reduces costs and wastages.

7) Ability to face crisis: Adequate working capital enables a concern to face

business crisis in emergencies such as depression.

8) Quick and regular return on investments: Every investor wants a quick and
regular return on his investments. Sufficiency of working capital enables a
concern to pay quick and regular dividends to investor as there may not be
much pressure to plough back profits which gains the confidence of investors
and creates a favorable market to raise additional funds in future.

9) Exploitation of Favorable market conditions: Only concerns with adequate

working capital can exploit favorable market conditions such as purchasing its
requirements in bulk when the prices are lower and by holding its inventories for
higher prices.

10) High Morale: Adequacy of working capital creates an environment of security,

confidence, high morale and creates overall efficiency in a business.

The Need or Objects or Working Capital

The need for working capital arises due to time gap between production and
realization of cash from sales. There is an operating cycle involved in sales and
realization of cash. There are time gaps in purchase of raw materials and
production, production and sales, and sales and realization of cash. Thus, working
capital is needed for following purposes.

1. For purchase of raw materials, components and spares.

2. To pay wages and salaries.

3. To incur day-to-day expenses and overhead costs such as fuel, power etc.

4. To meet selling costs as packing, advertisement

5. To provide credit facilities to customers.

6. To maintain inventories of raw materials, work in progress, stores and spares

and finished stock.

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Greater size of business unit large will be requirements of working capital. The
amount of working capital needed goes on increasing with growth and expansion of
business till it attains maturity. At maturity the amount of working capital needed is
called normal working capital.

2.2 operating and cash conversion Cycle

The need for working capital or current assets cannot be overemphasized. Given
the objective of financial decision making which is to maximize the shareholders’
wealth, it is necessary to generate sufficient profits. The extent to which profits can
be earned will naturally depend, among other things, upon the magnitude (size) of
the sales. A successful sales program is, in other words, necessary for earning
profits by any business enterprise. However, sales do not convert into cash
instantly; there is invariably a time-lag b/n the sales of goods and the receipt of
cash. There is, therefore, a need for working capital in the form of CA s to deal with
the problem arising out of the lack of immediate realization of cash against good
sold. Therefore, sufficient working capital is necessary to sustain sales activity.
Technically, this is referred to as the “Operating Cycle”.

The Operating Cycle can be said to be at the heart of the need for working capital.
The continuing flow from cash to suppliers, to inventory, to accounts receivable and
back into cash is what is called the Operating Cycle.
Figure 1- Operating Cycle

Phase - 3
RECEIVABLES

CASH
Phase - 2

INVENTORY
Phase - 1

The Operating cycle consists of three phases. In the phase – 1, cash gets converted
into inventory. This includes purchase of raw materials, conversion of raw material
into WIP, finished goods and finally the transfer of goods to stock at the end of the

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manufacturing process. In the case of trading organizations, this phase is shorter as
there would be no manufacturing activity and cash is directly converted into
inventory. The phase is, of course, totally absent in the case of service
organizations.

In phase – 2 of the cycle the inventory is converted into receivables as credit sales
are made to customers. Firms which do not sell on credit obviously not have phase
– 2 of the operating cycle.

The last, phase, phase – 3, represents the stage of when receivables are collected.
This is phase completes the operating cycle. This, the firm has moved from the cash
to inventory, to receivables and to cash again.

2.3 Characteristics of Working Capital

A) Circulating Capital
Working capital, once invested, is constantly circulating from one component to
other component of working capital. Cash is used to buy RM s, pay labor and
overhead costs. Then the result of production becomes outputs and hence changed
to finished goods inventories. The finished goods will be sold either for cash or on
account. The A/R is then changed back to cash. This circulation goes on until the life
of a project (see figure). Note that the working capital changes with the stage of life
cycle of product or condition of operation. Stable operation necessitates constant
working capital.

The cycle is shown in the following figure.

Figure 2: Working Capital as a Circulating Capital

WIP

Finished goods (or service)

Input (Raw Material)

Cash sales

Sales on account

Cash A/R

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b) Liquidity

Each component of working capital has different degrees of liquidity. Cash is the
most liquid asset. Next is the marketable security (it is sometimes called near cash
asset). A/R is more liquid than inventories in the sense that inventories may first be
converted to receivables before it is converted to cash.

c) Risk

Each component of working capital has its own risk. For example, accounts
receivable may be uncollectible or becomes bad debt. The raw materials may be
damaged, finished goods may be unsalable.

d) Profitability

Generally, excess working capital may reduce profit as the money is tied up in
current assets, entailing high cost (interest or opportunity cost).

Policy A Policy B
Current Assets 2000 1200
Fixed Assets 5000 5000
Total Assets 7000 6200

Current Liabilities 1000 1000

EBIT 2000 2000

Indicators:
Risk (Current ratio) 2.00 1.20
Profitability (EBIT/TA) 0.29 0.32

Policy A with high volume of current asset is less profitable and less risky, while
policy B with low investment in current asset is more profitable but also more risky
since the current assets to current liability ratio is too low leaving the firm with little
safety margin.

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Types of working capital : Permanent and Temporary Working Capital

The operating cycle creates the need for the current assets (working capital).
However, the need does not come to an end after the cycle is completed. It
continues to exist. To explain this continuing need of current assets (working
capital) a distinction should be drawn b/n “Permanent and Temporary WC”.

To carry on business, a certain minimum level of working capital is necessary on a

continuous and uninterrupted basis. For all practical purposes, this requirement has
to be met permanently as with other fixed assets. This requirement is referred to as
“Permanent or Fixed WC”.

Any amount over and above the permanent level of working capital is “temporary,
fluctuating or variable WC”. This is related to cyclical WC that does not have
long term impact, changing with sales and business cycles. The basic distinction b/n
permanent and temporary WC is illustrated in the figure 1.3.

Figure 1.3 – Permanent and Temporary WC

Y-axis

Amount of
WC Temporary WC

Permanent working capital

0 Time X - axis

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Figure 1.3 shows that the permanent level is fairly constant, while temporary WC is
fluctuating – increasing and decreasing in accordance with seasonal demands. In
the case of an expanding firm, the permanent WC line may not be horizontal. This is
because the demand for permanent current assets might be increase (or
decreasing) to support a rising level of activity. In that case the line would be a
rising one as shown in figure 1.4.

Y – axis Temporary

Amount of WC

WC

Permanent WC

0 Time X -
axis

2.4 Determinants of Working Capital Management

A firm should plan its operations in such a way that it should have neither too much
nor too little working capital. The total working capital requirement is determined by
a wide variety of factors. These factors, however, affect different enterprise
differently.

a) Nature of Business
The working capital requirement of a firm is closely related to the nature of its
business. A service firm, like electricity undertaking or a transport corporation,
which has a short operating cycle and which sells predominantly on cash basis, has
modest (low) working capital requirement. On the other hand, a manufacturing
concern likes a machine tools unit, which has long operating cycle and which sells
largely on credit, has a very substantial working capital requirement.
b) Length of Operating Cycle
The longer the operating cycle the more the working capital requirement will be.
Hence, more working capital is needed:
 The more time the inventories (RMs or FGs) are stocked.

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  The more the manufacturing cycle (i.e. the more the time it takes to convert
the raw materials to final output).
 The more time it takes to collect receivables (liberal credit policy).
c) Seasonality of Operations
Firms which have marked seasonality in their operations usually have highly
fluctuating working capital requirements. To illustrate, consider a firm
manufacturing rain coats. The sale of rain coats reaches a peak during the rainy
season and drops sharply during the winter period, and almost no sales in summer
season. The working capital need of such a firm is likely to increase considerably in
rainy months and decrease significantly during winter period. On the other hand,
afirm manufacturing a product like lamps, which have fairly even sales round the
year, tends to have stable working capital needs.
d) Production Policy
A marked by pronounced seasonal fluctuation in its sales may pursue a production
policy which may reduce the sharp variations in working capital requirements. For
example, a manufacturer of rain coats may maintain a steady production
throughout the year rather than intensify the production activity during the peak
business. Such a production policy may dampen the fluctuations in working capital
requirements.
e) Market Conditions
The degree of competition prevailing in the market place has an important bearing
on working capital needs. When competition is keen, a large inventory of finished
goods is required to promptly serve customers who may not inclined to wait
because other manufacturer are ready to meet their needs. Further,
generous(liberal) credit terms may have to be offered to attract customers in a
highly competitive market. Thus, working capital needs tend to be high because of
greater investment in finished goods inventory and A/R.
f) Conditions of Supply
The inventory of raw material, spare parts, and stores depends on the conditions of
supply. If the supply is prompt and adequate, the firm can manage with small
inventory. However, the supply is unpredictable and scant then the firm, to ensure
continuity of production, would have to acquire stocks as and when they are
available and carry larger inventory on an average. A similar policy may have to

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follow when the raw material is available only seasonally and production operations
are carried out round the year.

g) Credit Policy
The credit policy related to sales and purchases also affect the working capital. The
credit policy influences the requirements of working capital in two ways:
(1) through credit terms granted by the firm to its customers; (2) credit terms
available to the firm from its suppliers. The credit terms granted to customers have
a bearing on the magnitude of working capital by determining the level of
receivables. The credit sales results in higher receivables; higher receivables mean
more working capital. On the other hand, if liberal credit terms are available from
the supplier of goods, the need for working capital is high. The working capital
requirements of a business are thus, affected by the terms of purchase and sale,
and the role given to credit by a company in itsdealing with suppliers and
customers.
h) Inflation
Inflation affects the value of cash and other elements of cash. More WC is required
during high inflation rate affecting price of inputs.

Excess or Inadequate Working Capital

Every business concern should have adequate working capital to run its business operations. It should
have neither excess working capital nor inadequate working capital. Both excess as well as short working
capital positions are bad for any business.

Disadvantages of Excessive Working Capital

1. Excessive working capital means idle funds which earn no profits for business and hence business
cannot earn a proper rate of return.

2. When there is a redundant working capital it may lead to unnecessary purchasing and accumulation
of inventories causing more chances of theft, waste and losses.

3. It may result into overall inefficiency in organization.

4. Due to low rate of return on investments, the value of shares may also fall.

5. The redundant working capital gives rise to speculative transaction.

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6. When there is excessive working capital, relations with banks and other financial institutions may not
be maintained.

Disadvantages of Inadequate working capital

1. A concern which has inadequate working capital cannot pay its short-term liabilities in time. Thus,
it will lose its reputation and shall not be able to get good credit facilities.

2. It cannot buy its requirements in bulk and cannot avail of discounts.

3. It becomes difficult for firm to exploit favourable market conditions and undertake profitable
projects due to lack of working capital.

4. The rate of return on investments also falls with shortage of working capital.

5. The firm cannot pay day-to-day expenses of its operations and it created inefficiencies, increases
costs and reduces the profits of business.

Management of Working Capital

Working capital refers to excess of current assets over current liabilities.
Management of working capital therefore is concerned with the problems that arise
in attempting to manage current assets, current liabilities and inter relationship that
exists between them. The basic goal of working capital management is to manage
the current assets and current of a firm in such a way that satisfactory level of
working capital is maintained i.e. it is neither inadequate nor excessive. This is so
because both inadequate as well as excessive working capital positions are bad for
any business. Inadequacy of working capital may lead the firm to insolvency and
excessive working capital implies idle funds which earns no profits for the business.
Working capital Management policies of a firm have a great effect on its
profitability, liquidity and structural health of organization. In this context, evolving
capital management is three dimensional in nature.

1. Dimension I is concerned with formulation of policies with regard to profitability,

risk and liquidity.

2. Dimension II is concerned with decisions about composition and level of current

assets.

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3. Dimension III is concerned with decisions about composition and level of current
liabilities.

Principles of Working Capital Management

a) Principle of Risk Variation

b) Principle of Cost of Capital
c) Principle of Equity position
d) Principle of Maturity of Payment

1. Principle of Risk Variation: Risk refers to inability of firm to meet its obligation as
and when they become due for payment. Larger investment in current assets
with less dependence on short-term borrowings increases liquidity reduces risk
and thereby decreases opportunity for gain or loss. On other hand less
investment in current assets with greater dependence on short-term borrowings
increases risk, reduces liquidity and increases profitability.

There is definite direct relationship between degree of risk and profitability. A

conservative management prefers to minimize risk by maintaining higher level
of current assets while liberal management assumes greater risk by reducing
working capital. However, the goal of management should be to establish
suitable trade off between profitability and risk. The various working capital
policies indicating relationship between current assets and sales are depicted
below:-

2. Principle of Cost of Capital: The various sources of raising working capital

finance have different cost of capital and degree of risk involved. Generally,
higher the risk lower is cost and lower the risk higher is the cost. A sound
working capital management should always try to achieve proper balance
between these two.
3. Principle of Equity Position: This principle is concerned with planning the total
investment in current assets. According to this principle, the amount of working
capital invested in each component should be adequately justified by firm’s
equity position. Every rupee invested in current assets should contribute to the

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 net worth of firm. The level of current assets may be measured with help of two
ratios.
(i) Current assets as a percentage of total assets and
(ii) Current assets as a percentage of total sales.

4. Principle of Maturity of Payment: This principle is concerned with planning the

sources of finance for working capital. According to this principle, a firm should
make every effort to relate maturities of payment to its flow of internally
generated funds. Generally, shorter the maturity schedule of current liabilities in
relation to expected cash inflows, the greater inability to meet its obligations in
time.

2.5 Alternative Current Assets Investment Policy

An investment working capital policy decision is concerned with the level of

investment in current assets. Under a relaxed/flexible policy, the investment in
current assets is high. This means that the firm maintains huge balance of cash and
marketable securities, carries large amount of inventories, and grants generous
terms of credit to customers which leads to high level of receivables.

Under a restricted/aggressive policy, the investment in current assets is high.

This means that firm keeps a small balance of cash marketable securities, manages
with small amount of inventories, and offers terms of credit which leads to a low
level of receivables. A restricted currents asset investment policy generally provides
the highest expected return on investment (ROI). But, it entails the greatest risk.
The reverse is true under a relaxed policy.

Moderate policy is a policy that is b/n the relaxed and restricted policy. It falls in
between the two extremes in terms of expected risk and return.

CAs Relaxed

Moderate

Restricted

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 Sales

Fig. 1.5 Alternative current assets investment policies

Determining the optimal level of current assets involves a trade-off between costs
that rise with currents assets and costs that fall with current assets. The former are
referred to as “carrying cost” and later as “shortage costs”.Carrying costs are
mainly in the form of the cost of financing a higher level of current assets. Shortage
costs are mainly in the form of disruption in production schedule, loss of sales, and
loss of customer goodwill.

2.6 Sources of Financing Working Capital

Working capital can be financed from different sources:

a) Spontaneous current liabilities: this source of working capital financing

mainly emanated from operational activities between a credit customer and a
supplier. The customer finances his purchases through a credit that he obtains
from the supplier. Other spontaneous liabilities include accrued wages, accrued
taxes, etc.
b) Short – term financing sources: the sources include bank loans, private
loans, and commercial papers.
c) Long – term loans: this usually involves bank loans on long term basis.
d) Equity Capital: this is usually the major source of initial WC investment. It is
the money put in the firm by the owner or investor.

In assessing the suitability of the above sources one needs to evaluate the risk
and the costs involved, in relation to the returns from each of the sources.
Spontaneous liabilities usually do not involve costs. The short and long term
sources have explicit cost (interest) while equity capital has implicit costs
(opportunity costs).

2.7 Alternative CA Financing Policies/Strategies

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There are three basic option of financing WC, i.e., options of matching-expected
cash inflows from assets with outflows from their respective sources of financing.

a) Perfect Hedge (Maturity matching) Policy

It is a strategy of financing temporary current assets from short term sources and
permanent current assets and fixed assets from long term sources of funds. This
strategy is considered sound because temporary obligations are paid from the sale
of temporary current assets i.e. the temporary obligations are used to finance the
acquisition of current assets (a self-liquidating principle).

For eg., a purchase policy of 2/10, n/30 may be matched with a sales policy of
2/10, n/30.

Birr Short- term Financing

Temporary CA s

Permanent CA s Long-term
Financing

Fixed Assets

Time

Fig. 1.7 perfect hedge

b) Conservative Hedge Policy

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This strategy finances all the fixed assets, all permanent current assets and
significant portion of temporary current assets with a long term sources. The short
term source of finance is used to finance just little of temporary CA S. This policy is
conservative because it makes sure that most of its current assets are acquired
from a stable long term source. The advantage is that such long term sources may
be obtained when credit terms are favorable and at times of credit restraint the firm
will have already enough funds and will have less risk. Excess funds at firms may be
invested in marketable securities.

The distinct features of this approach are:

 Liquidity is greater
 Risk is minimized
 The cost of financing is relatively more as interest has to be paid even on
seasonal requirements for entire period.

Birr Temporary CA S Short term

financing

Permanent CA S Long term

financing

Fixed Assets

Time

Trade off between the Hedging and Conservative Approaches

The hedging approach implies low cost, high profit and high risk while the
conservative approach leads to high cost, low profits and low risk. Both the
approaches are the two extremes and neither of them serves the purpose of

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efficient working capital management. A trade off between the two will then be an
acceptable approach. The level of trade off may differ from case to case depending
upon the perception of risk by the persons involved in financial decision making.
However, one way of determining the trade off is by finding the average of
maximum and the minimum requirements of current assets. The average
requirements so calculated may be financed out of long-term funds and excess over
the average from short-term funds.

Hedging Vs Conservative Approach

Hedging Approach Conservative Approach

1. The cost of financing is reduced. 1. The cost of financing is higher
2. The investment in net working 2. Large Investment is blocked in temporary
capital is nil. working capital.
3. Frequent efforts are required to 3. The firm does not face frequent financing
arrange funds. problems.

4. The risk is increased as firm is 4. It is less risky and firm is able to absorb
vulnerable to sudden shocks. shocks.

c) Aggressive Hedge Policy

In aggressive hedge policy, all fixed assets and portion of permanent assets are
financed from long term sources. All temporary current assets and a portion of
permanent current assets are financed from the short term sources. It is a
dangerous strategy in the sense that it may create a problem of liquidity crisis and
sometimes it may lead to a bankruptcy.

Birr Short term

financing
Temporary CA S

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 Permanent CA S Long
termfinancing

Fixed Assets

Time

Which policy is better?

This depends on how individuals view risks in relation to return on equity. Basically,
higher returns involve higher risk or conversely, for taking higher risk, there should
be compensating higher return. In the same manner, lower risks are associated with
lower returns. Relating this to the hedging policy, one should realize that
conservative hedge policy has less risk and less return on equity and aggressive
hedge policy has higher risk and higher return.

The following illustration shows that the risk of conservative policy as measured in
current ratio is less than that of aggressive policy. But, aggressive policy has higher
return on equity.

The Effect of Conservative and Aggressive Financing

Assets Current Assets 1,000

Fixed Assets 1,000
Total Assets 2,000

Financing Options Conservative Aggressive

Short term loan (12%) 200 1000
Long term loan (15%) 900 100
Equity 900 900
Total 2,000 2,000

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Summary of operation:
EBIT 1,000 1,000
less: Interest
Short term (24) (120)
Long term (135) (15)
EBT 841.00 865.00
less: Tax(50%) 420.50 432.50
Net Income 420.50 432.50

Financial Indicators:
Risk: current ratio 5 times 1 times
Return: ROE 46.7% 48.06%

Estimate of Working Capital Requirements

“Working Capital is the life blood and controlling nerve centre of a business.”No
business can be successfully run without an adequate amount of working capital. To
avoid the shortage of working capital at once, an estimate of working capital
requirements should be made in advance so that arrangements can be made to
procure adequate working capital. But estimation of working capital requirements is
not an easy task and large numbers of factors have to be considered before starting
this exercise. There are different approaches available to estimate the working
capital requirements of a firm which are as follows:

(1)Working Capital as a Percentage of Net Sales:This approach to estimate the

working capital requirement is based on the fact that the working capital for any
firm is directly related to the sales volume of that firm. So, the working capital
requirement is expressed as a percentage of expected sales for a particular period.
This approach is based on the assumption that higher the sales level, the greater
would be the need for working capital. There are three steps involved in the
estimation of working capital.

a. To estimate total current assets as a % of estimated net sales.

b. To estimate current liabilities as a % of estimated net sales, and

c. The difference between the two above is the net working capital as a % of net
sales.

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(2) Working Capital as a Percentage of Total Assets or Fixed Asset:

This approach of estimation of working capital requirement is based on the fact that
the total assets of the firm are consisting of fixed assets and current assets. On the
basis of past experience, a relationship between (i) total current assets i.e., gross
working capital; or net working capital i.e. Current assets – Current liabilities; and
(ii) total fixed assets or total assets of the firm is established. The estimation of
working capital therefore, depends upon the estimation of fixed capital which
depends upon the capital budgeting decisions.

Both the above approaches to the estimation of working capital requirement are
simple in approach but difficult in calculation.

(3) Working Capital based on Operating Cycle: In this approach, the working capital
estimate depends upon the operating cycle of the firm. A detailed analysis is made
for each component of working capital and estimation is made for each of these
components. The different components of working capital may be enumerable as
follows:

Current Assets Current Liabilities

Cash and Bank Balance Creditors for Purchases

Inventory of Raw Material Creditors for Expenses

Inventory of Work-in-Progress

Inventory of Finished Goods

For manufacturing organization, the following factors have to be taken into

consideration while making an estimate of working capital requirements.

Factors Requiring Consideration While Estimating Working Capital

1. Total costs incurred on material, wages and overheads

2. The length of time for which raw material are to remain in stores before
they are issued for production.

3. The length of production cycle or work in process i.e. the time taken for

FM II CHAPTER 2 MATERIAL COMPILED BY DD Page 21

 conversion of raw material into finished goods.

4. The length of sales cycle during which finished goods are to be kept waiting
for sales.

5. The average period of credit allowed to customers.

6. The amount of cash required to pay day to day expenses of the business.

7. The average amount of cash required to make advance payments, if any.

8. The average credit period expected to be allowed by suppliers.

9. Time lag in the payment of wages and other expenses.

From the total amount blocked in current assets estimated on the basis of the first
seven items given above, the total of the current liabilities i.e. the last two item, is
deducted to find out the requirements of working capital. In case of purely trading
concern, points 1, 2, 3 would not arise but all other factors from points 4 to 9 are to
be taken into consideration. In order to provide for contingencies, some extras
amount generally calculated as a fixed percentage of the working capital may be
added as margin of safety.

Suggested Pro-forma for estimation of working capital requirements under

operating cycle is given below:

Estimation of Working Capital Requirements

I. Current Assets: Amount Amount Amount

Minimum Cash Balance ****

Inventories:

Raw Materials ****

Work-in-Progress ****

FM II CHAPTER 2 MATERIAL COMPILED BY DD Page 22

 Finished Goods **** ****

Receivables

Debtors ****

Bills **** ****

Gross Working Capital (CA) **** ****

II. Current Liabilities : Amou Amount

nt

Creditors for purchases ****

Creditors for Wages ****

Creditors for Overheads ****

Total Current Liabilities (CL) **** ****

Excess of CA over CL ****

+ Safety Margin ****

Net Working Capital ****

Illustration 1:XYZ Ltd. has obtained the following data concerning the average
working capital cycle for other companies in the same industry:

Raw material stock turnover 20 Days

Credit received 40 Days

Work-in-Progress Turnover 15 Days

Finished goods stock turnover 40 Days

Debtors' collection period 60 Days

95 Days

NB: Use 365 Days in a year.

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Using the following data, calculate the current working capital cycle for XYZ Ltd.
And briefly comment on it.

(Br. in '000)

Sales 3,000

Cost of Production 2,100

Purchase 600

Average raw material stock 80

Average work-in-progress 85

Average finished goods stock 180

Average creditors 90

Average debtors 350

Solution: Operating cycle of XYZ Ltd.

1. Raw material

(Average Raw Material/Total Purchase x 360) = 49 Days

2. Work-in-progress

(Average Work-in-progress/Total cost of goods sold) x 360 = 15 Days

3. Finished Goods

(Average Finished goods/Total cost of goods sold) x 360 = 31 Days

4. Debtors

(Average Debtors/Total Sales) x 360 = 43 Days

5. Creditors

(Average Creditor/Total Purchase) x 360 = 55 Days

Net Operating Cycle = 49 days + 15 days + 31 days + 43 days – 55 days

= 138 Days – 55 Days = 83 Days

FM II CHAPTER 2 MATERIAL COMPILED BY DD Page 24

Comment: For XYZ Ltd., the working capital cycle is below the industry average,
including a lower investment in net current assets. However, the following points
should be noted about the individual elements of working capital.

a. The stock of raw materials is considerably higher than average. So there is a

need for stock control procedure to be reviewed.

b. The value of creditors is also above average; this indicates that XYZ Ltd. is
delaying the payment of creditors beyond the credit period. Although this is an
additional source of finance, it may result in a higher cost of raw materials or
loss of goodwill among the suppliers.

c. The finished goods stock is below average. This may be due to a high demand
for the firm's goods or to efficient stock control. A low finished goods stock can,
however, reduce sales since it can cause delivery delays.

d. Debts are collected more quickly than average. The company might have
employed good credit control procedure or offer cash discounts for early
payments.

Illustration 2:From the following data, compute the duration of operating cycle for
each of the two years and comment on the increase/decrease:

Year 1 Year 2

Stock:

Raw materials 20,000 27,000

Work-in-progress 14,000 18,000

Finished goods 21,000 24,000

Purchases 96,000 135,000

Cost of goods sold 140,000 180,000

Sales 160,000 200,000

Debtors 32,000 50,000

Creditors 16,000 18,000

Assume 360 Days per year for computational purposes

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Solution:

a) Calculation of Operating Cycle

Year 1 Year 2

1 Raw Material Stock 20/96 x 360 27/135 x 360 = 72

. = 75 Days Days

(Average Raw Material/Total Purchase x 360)

2 Creditors period 16/96 x 360 18/135 x 360 = 48

. = 60 days days

(Average Creditor/Total Purchase) x 360

3 Work-in-progress 14/140 x 360 18/180 x 360 = 36

. = 36 days days

(Average Work-in-progress/Total cost of goods sold) x 360

4 Finished goods 21/140 x 360 24/180 x 360 = 48

. = 54 days days

(Average Finished goods/Total cost of goods sold) x 360

5 Debtors 32/160 x 360 50/200 x 360 = 90

. = 72 days days

(Average Debtors/Total Sales) x 360

Net operating cycle 198

177 days days

This is an increase in length of operating cycle by 21 days i.e., 12% increase

approximately. Reasons for increase are as follows:

Debtors taking longer time to pay (90-72) 18 days

Creditors receiving payment earlier (60-48) 12 days

30 days

- Finished goods turnover lowered (54-48) 6 days

FM II CHAPTER 2 MATERIAL COMPILED BY DD Page 26

-Raw material stock turnover lowered (75-72) 3 days

Increase in Operating Cycle 21 days

Illustration 3: A pro-forma cost sheet of a company provides the following

particulars:

Elements of Cost Amount per unit

Br.

Raw Material 80

Direct Labour 30

Overheads 60

Total Cost 170

Profit 30

Selling Price 200

The following further particulars are available:

Raw materials are in stock on an average for one month. Materials are in process on
an average for half a month. Finished goods are in stock on an average for one
month. Credit allowed by suppliers is one month. Credit allowed to customers is two
months. Lag in payment of wages is 1½ weeks. Lag in payment of overhead
expenses is one month. One-fourth of the output is sold against cash. Cash in hand
and at bank is expected to be Br.25,000.You are required to prepare a statement
showing the working capital needed to finance a level of activity of 104,000 units of
production.

You may assume that production is carried on evenly throughout the year, wages
and overheads accrue similarly and a time period of 4 weeks is equivalent to a
month. Solution:

Statement Showing the Working Capital Needed

Current Assets Br.

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Minimum cash balance 25,000

(i) Stock of raw materials (4 weeks)

1,60,000 x 4 6,40,000

Br.

(ii) Work-in-Process (2 weeks):

Raw materials 1,60,000 x 2 3,20,000

Direct Labour 60,000 x 2 1,20,000

Overheads 120,000 x 2 2,40,000 6,80,000

(iii) Stock of Finished goods (4 weeks):

Raw Materials 160,000 x 4 6,40,000

Direct Labour 60,000 x 4 2,40,000

Overheads 120,000 x 4 4,80,000 13,60,00

0

(iv) Sundry Debtors (8 weeks):

Raw materials 160,000 x 3/4 x 8 9,60,000

Direct Labour 60,000 x 3/4 x 8 3,60,000

Overheads 120,000 x 3/4 x 8 7,20,000 20,40,00

0

47,45,00
0

Less Current Liabilities:

(i) Sundry Creditors (4 weeks)

1,60,000 x 4 6,40,000

FM II CHAPTER 2 MATERIAL COMPILED BY DD Page 28

 (ii) Wages outstanding (1-1/2 weeks): 60,000 x1.5

90,000

(iii) Lag in payment of overheads (4 weeks)

1,20,000 x 4 480,000 1,210,00

0

Net Working Capital Needed 3,535,00

0

Working Notes:

i. It has been assumed that a time period of 4 weeks is equivalent to one month.

ii. It has been assumed that direct labor and overheads are in process, on
average, half a month.

iii. Profit has been ignored and debtors have been taken at cost.

iv. Weekly calculations have been made as follows:

a) Weekly average of raw materials = 104,000 x 80/52 = 160,000

b) Weekly labor cost = 1,04,000 x 30/52 = 60,000

c) Weekly Overheads = 1,04,000 x 60/52 = 120,000

Sources and uses of working capital

The typical sources of working capital are:-

1. Funds from operations (adjusted net income)

 Depreciation /Amortization
 Gain or loss on sale of non current asset
2. Sales of non-current assets

 Sale of long term investments (share, bonds/ debentures etc.)

FM II CHAPTER 2 MATERIAL COMPILED BY DD Page 29

  Sale of tangible fixed assets like land, building, Plant or equipment
 Sale of intangible fixed assets like good will, patents or copyrights
3. Long term financing.

 Long term borrowing (institutional loans, debentures, bonds etc)

 Issuance of equity and preference shares
4. Short term financing such as bank borrowings.

Uses of working capital

1. Adjusted net loss from operations.

2. Purchase of non-current assets

 Purchase of long term investments like shares, bonds/debentures etc

 Purchase of tangible fixed assets like land, buildings plant, machinery, equipment etc
 Purchase of intangible fixed assets, like good will, patents, copyrights etc.
3. Repayment of long term debt (debentures or bonds) and short-term debt (bank borrowings)

4. Redemption of redeemable preference shares i.e., preference shares payable on maturity.

5. Payment of cash dividend

Statement of changes in working capital

- It helps to identify the amount of changes in working capital

- It shows items of current assets and current liabilities at the beginning and at the end of the accounting
period and the effect of their changes between two periods on the working capital

- There will be a change in working capital if one aspect of a transaction affects current item and the other
aspect fixed item (fixed asset & long term liability)

- There is a direct relations ship between current asset and working capital and there is an inverse relationship
between current liabilities and working capital

Sources and application of funds

Sources Application

1. Fund from operations 1. Losses from operations ( out flow)

2. other income 2. Purchase of fixed asset

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 3. sale of fixed asset 3. Redemption of bond

4. long term borrowings 4. Dividend to share holders

5. Issue of equities for cash

Source- the way how fund is raised

Application – the way in which working capital is used

Funds from operations

The net income/net loss figure as shown in the income statement account doesn’t indicate the amount of
working capital provided by business operation because the revenue and expenses shown don’t run parallel
to the flow of working capital. The income statement contains a variety of write-offs and adjustment, which
don’t involve any corresponding movements with funds. Therefore appropriate adjustments are to be made
to the profit figure. For this purpose:-1. All such expenses that have been deducted from revenue but don’t
reduce working capital has to added back

 Depreciation, amortization of good will, amortization of discount

2. Such items that have been added to revenue but have not contributed to the working capital have to be
deducted

 Revaluation of fixed asset profit

3. All such revenues that aren’t directly cost by business operations should also be deducted and shown
separately in the funds flow statement.

 dividend receivable
 other income (interest receivable on investment

Fund flow statement

A. Net income (loss) as shown by income statement

B. Add: - depreciation expense

Amortization of good will

Amortization of discount on bonds or share

Amortization of losses from previous year

FM II CHAPTER 2 MATERIAL COMPILED BY DD Page 31

 Losses on sale of fixed asset

C. Less: - amortization of premium received on bond

Profit on sale of fixed asset

Profit on revaluation of fixed asset

Other income (dividend, interest received)

Fund from operations = A+ B-C

If calculated from retained earnings take the difference make the above adjustments and then (1) if a transfer to
reserve is there it should be added back (2) payment of dividend should also be added back.

Example 1

Given below is the balance sheet as of December 31 previous year and current year, and a statement of income
& reconciliation of earnings for the given year Electronics Ltd. The only item in the building and equipment
account sold during the year was a special mission that originally cost 15,000; the accumulated depreciation on
this mission at the time of sell was 8,000. The mission was sold for 6,000 and full payment was received in cash.
The company purchase patent of 16,000 during the year besides cash purchase of plant and equipment the
asset of another company were also purchased for 100,000 payable in fully paid share. Assets purchased were
good will 30,000; equipment 70,000.

Balance Sheet

Prev. year Dec. 31 Current year Dec. 31

Cash 74,000 37,000

Account receivable 54,000 47,000

Inventories 312,000 277,000

Land 60,000 60,000

Patents 55,000 65,000

Building & equipment 420,000 550,000

Accumulated deprecation (105,000) (120,000)

Good will 30,000

Total 876,000 950,000

FM II CHAPTER 2 MATERIAL COMPILED BY DD Page 32

Liabilities and Owner’s equity

Notes payable 28,000 8,000

Account payable 58,000 94,000

Estimated income tax 86,000 12,000

Social security tax accrued 3,000 5,000

Debentures 220,000 60,000

Equity Capital 250,000 560,000

Retained Earnings 231,000 211,000

Total 876,000 950,000

Statement of income and reconciliation of earnings for the current year

Net sales 1,970,000

Less: cost of goods sold 1,480,000

Gross profit 490,000

Less: operating expenses (includes deprecation.

on building and equipment) 486,000

Interest on debenture 14,000 500,000

(10,000)

Add: other revenue 7,000

Net loss (3,000)

Add retained earnings (previous year) 231,000

228,000

Less: dividend paid 16,000

Loss on sale of plant assets 1,000 17,000

Retained earnings; Dec. 31 of current year 211,000

FM II CHAPTER 2 MATERIAL COMPILED BY DD Page 33

Required: - prepare fund flow statement

Solution

1. Statement of changes of working capital

Prev. year Current year + -

Current Asset 37,000

Cash 74,000 37,000 7,000

Account receivable 54,000 47,000 35,000

Inventory 312,000 277,000 2,000

Prepaid expense 60,000 4,000

Current liability

Account payable 58,000 94,000 36,000

Est. income tax 86,000 12,000 74,000

Social sec. Tax accrued 3,000 5,000 2,000

Notes payable 28,000 8,000 20,000 _____

Total 621,000 784,000 94,000 119,000

Decrease in working capital 25,000 _______

119,000 119,000

Fund from Operations

Difference in retained earnings (20,000)

Add: deprecation 23,000

Loss on sale 1,000

Patent write off 6,000

Dividend 16,000 46,000

FM II CHAPTER 2 MATERIAL COMPILED BY DD Page 34

 26,000

Less: other income 7,000

19,000

Funds from operations

Funds flow statement

Sources Application

Issue of share for cash 210,000 Purchase of patent 16,000

FFO 19,000 Purchase of equipment 75,000

Sale of equipment 6,000 Repayment of debenture 160,000

Other income 7,000 Payment of dividend 16,000

Decrease in working capital 25,000

267,000 267,000

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