Related to current assets and current liabilities.

Related to interrelationship exist b/w Current Assets and Current Liabilities

The term Gross Working Capital is also referred to as working capital, means the total current assets.

Current assets – current liabilities

That portion which is financed with long term funds.

CA – CL The excess of CA-CL must be financed

with long term funds.This definition is more useful for the

analysis of the trade -of b/w profitability and risk.

The level of NWC has a bearing on profitability and risk.

Profitability: Used in this context is measured by profits after expenses.

Risk: it is defined as the probability that a firm will become technically insolvent so that it will not be able to meet its obligations when they become due for payment.

The working capital cycle can be defined as:› The period of time which elapses between

the point at which cash begins to be expended on the production of a product and the collection of cash from a customer.

The chain starts with the firm buying raw materials on credit.

• In due course this stock will be used in production, work will be carried out on the stock, and it will become part of the firm’s work in progress (WIP)

• Work will continue on the WIP until it eventually emerges as the finished product

• As production progresses, labor costs and overheads will need to be met

• Of course at some stage trade creditors will need to be paid

• When the finished goods are sold on credit, debtors are increased

• They will eventually pay, so that cash will be injected into the firm

Each of the areas – stocks (raw materials, work in progress and finished goods), trade debtors, cash (positive or negative) and trade creditors – can be viewed as tanks into and from which funds flow.

Working capital is clearly not the only aspect of a business that affects the amount of cash:

• The business will have to make payments to government for taxation

• Fixed assets will be purchased and sold • Lessors of fixed assets will be paid their rent • Shareholders (existing or new) may provide

new funds in the form of cash • Some shares may be redeemed for cash • Dividends may be paid • Long-term loan creditors (existing or new)

may provide loan finance, loans will need to be repaid from time to time, and

• Interest obligations will have to be met by the business.

The working capital cycle measures the amount of time that elapses between the moment when your business begins investing money in a product or service, and the moment the business receives payment for that product or service. This doesn’t necessarily begin when you manufacture a product—businesses often invest money in products when they hire people to produce goods, or when they buy raw materials.

A good working capital cycle balances incoming and outgoing payments to maximize working capital. Simply put, you need to know you can afford to research, produce, and sell your product.

A short working capital cycle suggests a business has good cash flow. For example, a company that pays contractors in 7 days but takes 30 days to collect payments has 23 days of working capital to fund—also known as having a working capital cycle of 23 days. Amazon.com, in contrast, collects money before it pays for goods. This means the company has a negative working capital cycle and has more capital available to fund growth. For a business to grow, it needs access to cash—and being able to free up cash from the working capital cycle is cheaper than other sources of finance, such as loans.

Need of Working Capital: Operating cycle events:

› Conversion of cash into inventory.› Conversion of inventory into receivables.› Conversion of receivables into cash.

THE WORKING CAPITAL THE WORKING CAPITAL CYCLECYCLE

(OPERATING CYCLE)(OPERATING CYCLE)

Accounts Payable

Cash

RawMaterials

W I P

Finished Goods

Value Addition

AccountsReceivable

SALES

The need of WC does not come to end after the cycle is completed.

So it is important to know the difference b/w permanent and temporary working capital.

Amount Variable Working CapitalAmount Variable Working Capitalof of WorkingWorkingCapitalCapital

Permanent Working CapitalPermanent Working Capital

TimeTime

Variable Working CapitalAmount of WorkingCapital

Permanent Working Capital

Time

Fixed Assets

Permanent Current Assets

Total Assets

Fluctuating Current Assets

Time

Fixed Assets

Permanent Current Assets

Total Assets

Fluctuating Current Assets

Time

Short-termDebt

Long-termDebt +EquityCapital

Factors to be consideredFactors to be considered Total costs incurred on Total costs incurred on materials, wages and overheadsmaterials, wages and overheads The The length of timelength of time for which raw materials remain in for which raw materials remain in

stores before they are issued to production.stores before they are issued to production. The length of the production cycle or WIP, i.e., The length of the production cycle or WIP, i.e., the time the time

taken for conversion of RM into FG.taken for conversion of RM into FG. The The length of the Sales Cyclelength of the Sales Cycle during which FG are to be during which FG are to be

kept waiting for sales.kept waiting for sales. The average period of The average period of credit allowed to customers.credit allowed to customers. The The amount of cash required to pay day-to-day expenses amount of cash required to pay day-to-day expenses

of the business.of the business. The The amount of cash required for advance payments if any.amount of cash required for advance payments if any. The average period of The average period of credit to be allowed by suppliers.credit to be allowed by suppliers. Time – lag in the payment of wages and other overheadsTime – lag in the payment of wages and other overheads

Components of working capital › Current assets› Current liabilities

Holding period of various inventories The credit collection period and credit

payment period It depends on budgeted level of activity in

terms of production/ sales. WC requirements are related to the cost

excluding depreciation.

The steps involved in estimating the different items of CA and CL under Operating Cycle approach.

Estimation of Current Assets:› Raw Material inventory› Work-in –process inventory› Finish goods inventory› Debtors› Cash and bank balances Estimation of Current liabilities:› Trade creditors› Direct wages› Overheads (other than depreciation and

amortisation)

Estimation of Current Assets:› Raw material inventory: The investment in

raw material inventory is estimated on the basis of under mentioned equation:

Budgeted prod. × Cost of RM × Average inventory

(in units) per unit holding period (months/ days)

12 months/ 365 days

WIP inventory =

Budgeted prod. × Est. WIP cost × Avg. time span of

(in units) per unit WIP inventory (Months/ days)

12 months/365 days

Finished goods inventory:

Budgeted production × Cost of goods produced × Finished goods holding(in units) per unit excluding dep. Period (months/days)

12 months/ 365 days

Debtors:

Budgeted credit sales × cost of sales per unit × Avg. debt

collection (in units) excluding dep. Period

(months/days)

12 months/365 days

Cash and Bank balances:› Motives for holding cash of the business firm› Attitude of management towards risk› The access to the borrowing sources in times of

need and past experience and so on.

Trade creditors:

Budget yearly production × RM cost × Credit period allowed by

(in units) per unit creditors (months/days)

12 months / 365 days

Direct wages:

Budget yearly production × Direct labor cost × Avg. time lag in

(in units) per unit payment of wages (M/D)

12 months/ 365 days

Note: the average credit period for the payment of wages approximated to a half a month in the case of monthly wage payment.

Overheads:

Budget yearly production × Overhead cost × Avg. Time lag in payments

(in units) per unit overheads (M/D)

12 months/ 365 days

(I) Estimation of Current Assets Amount

i. Inventories:a) Raw Materialb) Work -in-processc) Finished goods

ii. Debtorsiii. Minimum desired cash and bank balancesTotal Current Assets

(II) Estimation of Current Liabilitiesi. Creditorsii. Wages iii. OverheadsTotal Current Liabilities

(III) Net working Capital (I-II) Add: Margin of Contingency

IV. Net working Capital Required

Working Capital Policy

Moderate: Match the maturity of the assets with the maturity of the financing.

Aggressive: Use short-term financing to finance permanent assets.

Conservative: Use permanent capital for permanent assets and temporary assets.

Years

$

Perm WC

Fixed Assets

Temp. WC

}S-TLoans

L-T Fin:Stock &Bonds,

Fixed Assets

Years

$

Perm WCL-T Fin:Stock &Bonds

Zero S-Tdebt

1. Cash in hand 2. Cheques in hand3. Bank balances4. Near cash securities:

1. Marketable securities and bank fixed deposits

A. Transactionary Motive:B. Precautionary Motive:C. Speculative Motive:

I. Credit standing of the enterprise.II. Production policy.III. Production process.IV. Terms of purchase and sale.V. Collection policy.VI. Nature of the business.VII.Availability of opportunities.VIII.Economic conditions.IX. Managerial policies.