Operating Cycle of Business and Financing Working_Capital

8/11/2019 Operating Cycle of Business and Financing Working_Capital

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BATCH 2013-162NDSEMESTER

MMM/MFM

SIMSR

Operating Cycle of Business

and Financing WorkingCapital


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Operating Cycle

This process indicates the dependence of each stageor component of working capital on its previousstage or component.

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Exceptions

Example 1:

In case the manufacturing process may require a raw

material which is in short supply, then the companymay have to make advance payment in anticipationof the receipt of that raw material. This will causeimmediate drain on cash resources in like a situation

where credit purchases of raw material can be made.

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Exceptions

Example 2:

If there is an excessive accumulation of finished

goods inventory the company may have to providemore liberal credit period and / or relax its existingcredit standards which will increase sundry debtors.

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Operating cycle approach to workingcapital Management

Working capital cycle is popularly known asoperating cycle.

Gross operating cycle period includes:

1) Raw material storage period

2) Conversion period

3) Finished goods storage period4) Average collection period before getting back cashalong with profit

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Operating cycle approach to working capitalManagement

Net operating cycle / Operating Cycle period(NOCP)

- when average payment period of the company to its

suppliers is deducted from the gross operating cycleperiod, (i.e. Average payment period) - Its is called asNOCP.

The shorter the duration of the operating cycle , thefaster will be the transformation of current assetsinto cash.

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Calculation of the NOCP

Raw material storage period (N1):

1) Calculate the annual consumption of raw material (RM) as:Opening stock + Purchases Closing stock

2) Calculate average daily consumption of RM ( for convenience weassume a year consisting of 360 days) as:

Step 1 / 360

3) Calculate Average stock of raw material as

(Opening stock + Closing stock) / 2

4) N1= step 3 / step 2 i.e.Avg Stock of RM / Avg Daily consumption of RM

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Finished Goods storage period (N3):

1) Calculate Annual Cost of sales (COS) as:Opening stock of finished goods + COP+ Excise duty +Selling &

distribution costs+ General admin costs+ Financial costs - Closingstock of finished goods

2) Calculate daily COS as:Step 1 / 360

3) Calculate average stock of finished goods as:(Opening stock of FG + Closing stock of FG) / 2

4) Calculate Finished goods storage period (N3) as:Step 3 / Step 2, i.e.

(Avg Stock of Finished goods) / Avg daily COS

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Average collection period (N4):1) Find annual credit sales of the company

2) Calculate daily credit sales as:Step 1 / 360

3) Calculate Average Debtors as :( Opening stock of Debtors + Closing stock of Debtors) / 2

4) Calculate Average collection Period (N4)as :Step 3 / Step 2, i.e.

Average debtors / Average daily credit sales

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Average Payment Period (N5) :1) FindAnnual Credit Purchases

2) Calculate average daily credit purchases as:

Step 1 / 360

3) Calculate average creditors as:

( Opening stock of creditors +Closing stock of creditors) / 2

4) Calculate Average payment period (N5) as:Step 3 / Step 2 , i.e.

Average Creditors / Average daily purchases

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Sol to operating cycle for Co. XYZ

Calculation of RM storage period (N1):

1) Annual consumption of raw material=Opening RM Closing RM +Purchases

= 3454.84 +10676.10 4095.41 = 10035.53

2) Average daily consumption =10035.53 / 360 = 27.88

3) Average RM=(3454.84 + 4095.41) / 2 = 3775.13

N1= 3775.13 / 27.88 = 135 days

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Average Conversion period ( N2) :

1) Annual COP = Opening stock of WIP + consumption of materials +manufacturing expenses + depreciation closing WIP

= 56.15 + 10035.53 + 1146.76 + 247.72 - 72.50 = 11413.66

2) Average daily COP :

11413.66 /360 = 31.70

3) Average WIP =(56.15 + 72.50) /2 = 64.33

4) N2 = 64.33 / 31.70 = 2 days

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Finished Goods storage period (N3)

1) Annual Cost of sales:

Opening stock of FG + COP + Selling & Admin exp + Customs & exciseduty closing stock of FG

= 637.92 + 11413.66 + 4557.48 + 35025.56 1032.74

= 50601.88

2) Avg daily COS

= 50601.88 /360

= 140.56

3) Avg Finished goods=

(637.92 + 1032.74)= 835.33

4) N3 = 835.33 / 140.56 = 6 days 9/2/2014

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Average Collection period ( N4) :

1) Annual credit sales = 54210.65

2) Average daily credit sales = 54210.65 / 360 = 150.59

3) Average Debtors =

(756.45 +1166.32) /2

= 961.38

4)Average collection period (N4) =

961.38 / 150.59 = 6 days

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Average Payment period ( N5) :

1) Annual credit purchases = 10676.10

2) Average daily credit purchases = 10676.10 / 360 = 29.66

3) Average Creditors =

(2504.18 +3087.47) /2

= 2795.10

4)Average collection period (N5) =

2795.82 / 29.66 = 94 days

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Net Operating Cycle Period ( also called as cashcycle) =

N1+N2+N3+N4 N5

= 135 +2 +6 +6-94= 55 days

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55 days is the time that has elapsed between the purchase of raw

Materials and the collection of cash for sales.


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Working Capital Financing

Working capital = CA-CL = Net current Assets

Hence it is also called as financing of current assets

As seen earlier. While calculating the operating cycle,a certain minimum level of current assets is to bemaintained by a company.

This portion can also be called asPERMANENT ORFIXED COMPONENT OF CURRENT ASSETS

Ex ample : Cash, inventory Required to carry on the operationswithout any break

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Over and above the minimum level, the current assetof a company vary depending upon the level ofactivity or operation.

Current assets associated with velocity of businessactivity can be regarded as the fluctuating or temporary component of current assets.

Example : This component is likely to be more pronounced in seasonalindustries where either the demand for output or its supply is seasonalLike - Woolens

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Permanent and Temporary Working Capital

Source: http://treasurycafe.blogspot.in/2012/02/working-capital-primer-how-is-it-that.html

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Long Term sources of financing Working Capital :

Internal accruals, ordinary shares, preference shares,debentures and term loans

The temporary / fluctuating component is financedfrom short term sources accounts payable , tradecredit, short term bank borrowing , public deposits

etc

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Reading

Financial management by Prasanna Chandra,Chapter 26

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Documents

Operating Cycle of Business and Financing Working_Capital