Introduction to Working Capital Management:Concept of Working Capital: In a business tow types of capital is generally

required. One is fixed capital which is generally required o purchase fixed

assets, i.e. building, machinery, furniture, equipments etc. Other is working
capital which is required to run day to day operations of a business. This will
be clear to understand if we understand the operation cycle of a business.

Inflow

CASH

BILLS
RECEIVABL
ES

Outflow

MATERIAL
S, WAGES,
OVERHEAD
S

DEBTOR
S
FINISHE
D
PRODUC
TS

SALES

Operating Cycle

In each step of this cycle money is always blocked waiting to be recollected in

the last stage of this cycle. Cash remain invested into various current assets
(i.e. raw-materials, work-in-progress, finished goods, debtors, bills receivables,
etc.) to be converted into cash again. Current assets are needed because sales
do not converted into cash instantaneously. There is always an operation cycle

involved in the conversion of sales into cash. The firm is required to maintain a
reasonable amount of working capital to be invested into current assets for
smooth functioning of the business. However over investment in current assets
will be a loss because it is blocking of money without any return and at the
same time under investment in current assets may hamper the normal business
operation. Hence it is prudent to maintain a optimum level of working capital,
more specifically, a reasonable level of different currents assets which should be
calculated by applying good methods and techniques. Working Capital
Management deals with this area.
Kinds of Working Capital:There are two concepts of working capital. Gross Working Capital and Net
Working Capital
Gross Working Capital: It refers to the firms investment in the current the
current assets. Current assets are the assets which can be converted into
cash within an accounting year or within an operating cycle and includes
accounts receivables or book debt, Bills Receivable, Inventory, Cash & Bank,
etc.

GWC = CA

Net Working capital: It is calculated by deducting Current Liabilities from

Current Assets. Current Liabilities are those liabilities or claims from outsiders
which are expected to mature for payment within a year or within an
operating cycle. Current Liabilities include accounts payable, outstanding
expenses, bank overdraft, cash credit, etc.
NWC = CA CL
Working capital

is also termed as

permanent

working

capital

and

temporary working capital. The minimum level of working capital which is

required continuously by the firm to carry its business operations irrespective of
the volume of business is called permanent working capital. The extra working
capital needed to support the changing production and sales activities is called
fluctuating or temporary working capital.

Factors affecting Working Capital:-

Factors which may affect the requirement of the

working capital in a

business include the following:

a)

the types of goods or services produced or rendered

b)

the length of the operating cycle

c)

the volume of sales

d)

Inventory policies adopted

e)

Credit policy of the firm

f)

Firms capacity to manage current assets efficiently.

g)

technology and manufacturing policy adopted by the firm

Components of Working Capital:a) Currents Assets i.e. inventory (stock of raw-materials,

work-in-progress,

finished goods; stock of spare parts; etc.), debtors, bills receivables, short-term
securities, cash & bank, etc.,
b) Current Liabilities i.e. trade creditors (i.e. creditors for goods & services)
outstanding expenses, bank overdraft, cash credit,
etc.
Sources of Working Capital Finance:a) Long-term Finance: The source of long-term financing include ordinary
share capital, preference share capital, debentures, long term borrowings
from financial institutions, reserve & surplus (i.e. mainly retained earnings),
etc.
b) Short-term Finance: The short-term finance is obtained and supposed to
be repaid back within a period less than one year. It can be a availed from
overdrafts and cash credits from banks & financial institutions, public
deposits, commercial paper, factoring of receivables , loans and advances,
etc.
c) Spontaneous Financing: Spontaneous financing refers to the automatic
sources of short-term funds arising in the normal course of a business. Trade
(suppliers) credit and outstanding expenses are examples of spontaneous
financing. There is no explicit cost of spontaneous financing.

2. -: Introduction to Working Capital Management:- Forecast of

Capital for single

shift and double shift:-

Working

Forecasting Of Working Capital:There are mainly four approaches for forecasting working capital needs :

i)

Operating Cycle Method or Current Assets Holding

Period (to estimate working capital requirements on the
basis of average holding period of various components of
current assets and relating them to costs based on the
past experience).

ii)

Ratio of Sales (To estimate working capital requirements

as a ratio of sales on the assumption that currents assets
change with sales).

iii) Ratio of Fixed Investment (To estimate working capital

requirements as a percentage of fixed investments).
iv)

Regression

Analysis

(A

statistical

technique

i.e.

regression analysis is applied for forecasting of working

capital requirements which is a future forecast on the
basis of past results)
Out of the three the widely accepted approach is the first one.
First Stage: Information is collected for
a)

Probable annual production.

b)

Estimate of material, labour and overhead cost per unit

of production.

c)

Time lags in stores, i.e. how raw materials remain in

store before they are issued for production.

d)

Time lag for production process.

e)

Time lag in warehouse i.e. how long goods stay in the

warehouse.

f)

Average credit facilities granted to the customers.

Second Stage: Average estimated production cost per day, week, fortnight,
monthly or as per convenience should be estimated first, then item wise
weekly, fortnightly or monthly cost should be forecast.

Third Stage: Average lag period i.e. average holding period of each working
capital components such as material, labour, overhead at stores, production
process, warehouse, and with debtors should be separately estimated. Item
wise average cost per day, week, fortnight or month (as calculated in the
second stage) should be multiplied by this holding period, and the products
would represent the item-wise working capital requirements for a working
capital cycle.
Fourth Stage: Item wise requirements should be added, and from the total
credits available from the suppliers and the labourers should be deducted.
Sometimes with the figure arrived in this way amount of cash required to
cover immediate contingencies is added.
Whether the profit element should be included in the requirement is a
controversial issue in the context.
Introduction of shift working has some effects on working capital. It brings economies
in the use of fixed capital. Usually additional building infrastructure and plant &
machinery are not necessary to work extra shifts. Production can be enhanced
without additional investments in fixed assets. However this is not true for working
capital. Labourers generally demand higher rate for overtime hours. Extra amount of
inventories is required to be kept. Though fixed overhead cost per unit reduce due to
extra production. Hence for working capital required for double shift will have to
calculated keeping in view in above points.

Prob.:
The management of Rainbow Textiles Ltd has called a statement showing the working
capital needs to finance a level of activity of 1,80,000 units of output for the year.
The cost structure for the companys product for the abovementioned activity level is
detailed below:
Cost per Unit(Rs.)
20

Raw-materials
Direct Labour

Overheads (including depreciation of Rs. 5 per unit)

15
40
Profit

10

Selling Price

50

Additional Information:
a)
Minimum desired cash balance is Rs. 20,000.

b)
c)
d)
e)
f)

Raw-materials are held in stock on an average for 2 months.

Work-in-progress (50% completion stage) will approximate to half months
production.
Finished goods remain in warehouse, on average for a month.
Suppliers of materials extend a months credit and debtors are provided
two months credit; cash sales are 25% of total sales.
There is a time lag in payment of wages of a month and half-a-month in
case of overheads.

Prepare a statement showing working capital needs.

Solution
Working Notes:
Statement of Cost (excluding depreciation) (Total = 1,80,000 units)
Particulars
Per Unit
Raw-material
20.00
Direct Labour
5.00
Overhead (excluding depreciation @ Rs. 5 p.u.)
10.00
35.00
Statement of Working Capital Requirement
Particulars
Holding Period
Current Assets
Raw-materials
2 months
Work-in-progress (50% completion stage)
month
Finished Goods
Debtors ( excluding profit)

1 month
2 months

(Rs.)
Total
36,00,000.00
9,00,000.00
18,00,000.00
63,00,000.00

Cost (p.m.)

Amount (Rs.)

3,00,000.00
2,62,500.00
(63,00,000 X
50% X 1/12)
5,25,000.00
3,93,750.00
(63,00,000 X
75% x 1/12)

6,00,000.00
1,31,250.00

Cash Requirements

5,25,000.00
7,87,500.00
20,000.00
20,63,750.00

(A)
Current Liabilities
Creditors
Direct Labour
Overheads

1 month
1 month
month
(B)

Working Capital Requirement (C =A B)

3,00,000.00
75,000.00
1,50,000.00

3,00,000.00
75,000.00
75,000.00
4,50,000.00
16,13,750.00

3. -: Inventory Management:Need to hold

Inventory:

Component of inventories are (i) Raw-materials (ii) Work-in-progress (i.e. semifinished products) (iii) Finished Goods (iv) Supplies, stores & spares. There are
three general motives for holding inventories:

Transaction Motive

(the need to maintain sufficient inventories for

smooth production and sales operation)

Precautionary Motive (the need for holding inventories to guard against

the risk of unpredictable changes in demand and
supply forces and other factors)

Speculative Motive

(the motive for taking the advantage of price

fluctuations)
Objectives

of

Inventory Management:

The objectives of inventory management are:

a)

Ensuring a continuous supply of raw-materials to ensure uninterrupted

production.

b)

Maintaining sufficient stocks of raw-materials to safeguard against

short supply and change in price.

c)

Maintaining sufficient finished goods inventory for smooth sales

operation and efficient customer service.

d)

Minimising the inventory carrying cost an time.

e)

Controlling investment in inventories and to keep a optimum level of it

so that money does not remain blocked unnecessarily.

Economic Order Quantity (EOQ):

Economic order quantity is a quantity of materials to be ordered which
minimizes the total cost associated with inventory. These costs include:
(i)

Cost of purchase (bulk discounts for bulk purchases also taken into
consideration)

(ii)

Annual Usage or Consumption

(iii)

Cost of Order (i.e. administrating cost associated with each order

placed)

(iv)

Cost of Carrying (i.e. inventory holding cost e.g. storage cost,

insurance cost, handing cost, staffing cost, opportunity cost of money
blocked in inventory, obsolescence and pilferage & damage cost and
other administration cost associated with inventory holding)

The lower will be the total order cost per annum (higher the quantity will be
ordered per order, number of total order per annum will decrease), higher will
be the inventory carrying cost per annum (because higher the quantity will be
ordered per order, average inventory holding will be higher). On the contrary,
the higher will be the total order cost per annum, lower will be the inventory
carrying cost per annum. To solve this dilemma, the EOQ model is resorted to.
Optimum or Economic Order Quantity (EOQ) =

2AO/Ci,

where

= Annual Consumption,

= Purchase Cost per unit,

= Order Cost (per order),

i = Inventory Carrying Cost.

Total Cost = Purchase Cost + Ordering Cost + Inventory Carrying Cost

=

C X A + (A / EOQ) X O + (EOQ X C)/2

As purchase cost does not change irrespective of quantity ordered, for

management decision making it is not taken into account and hence total cost
is:
Total Cost = Ordering Cost + Inventory Carrying Cost
=

(A / EOQ) X O + (EOQ X C)/2

Quantity Discount: Sometimes quantity discount is received on bulk orders. If

we purchase at EOQ, we may not avail this discount. Under this situation to
ascertain net return on discount availing is calculate by:
Discount Receivable + Savings in Ordering Cost (bulk order will result in
less no of order per year) Increase in Inventory Carrying Cost (due to
bulk order purchase).
Discount Saving = Discount Tate X Purchase Price X Annual Consumption
Savings in Ordering Cost = O(A/EOQ A/Q*)
Increase in Inventory Carrying Cost =
ordered at bulk

Ci(Q*/2

EOQ/2),

Q* = Quantity

If the net return on discount availing is positive we should go for bulk

purchasing, if it is zero or negative we should stick to EOQ ordering.