MBA Semester-II Financial Management

Working Capital: Planning and Estimation

1. Working Capital: Meaning

 The capital that is required to meet day-to-day requirements of an enterprise is regarded
as ‘Working Capital.
 Putting differently, working capital refers to the capital that is kept in the business to
support the day-to-day business operations.
 Working capital to an enterprise is like the blood to human being. It is needed:
 to hold the stock of raw materials;
 to hold the stock of WIP for process period;
 to hold the stock of finished goods;
 to grant credit to its customers; and
 to hold cash balances to meet different operating expenses.
 It is also known as ‘Circulating Capital/’Revolving Capital’. This is because the capital
employed as working capital constantly changes its form to drive the ‘business wheel’.
 Broadly speaking, funds invested in current assets are continuously recovered through
the realization of cash and again reinvested in current assets. Thus, the amount keeps on
circulating or revolving from cash to current assets and back again to cash.

Cash

Current
Assets

Cash

Fig. 1: Circulating/Revolving Capital

2. Concepts of Working Capital

There are two concepts of working capital:
a) Gross Working Capital
 Gross working capital refers to the firm’s investment in current assets.
 In other words, it represents the aggregate of current assets that are converted, in the
ordinary course of business, into cash within one accounting year.
 Mathematically, Gross Working Capital = Current Assets*
MBA Semester-II Financial Management

Current
Investment

Current Assets
Account
Receivables
Short-tem
Advances

Prepaid Payments

Accrued Income

Cash and cash

equivalents

Fig. 2: Currents Assets

b) Net Working Capital

 Net working capital refers to the excess of current assets over current liabilities.
 In other words, it the difference between current assets and current liabilities.
 It is a qualitative concept that shows liquidity position of a firm.
 Mathematically, Net Working Capital = Current Assets – Current Liabilities*

Short-term
Borrowings
Current Liabilities

Account Playables

Short-tem
Advances
Short-term
Provisions
Outstanding
Expenses
Pre-received
Incomes

Fig. 3: Currents Liabilities

3. Permanent and Temporary Working Capital

a) Permanent Working Capital: It refers to the minimum level of working capital/current
assets that is required by the firm to carry on its business, irrespective of the level of
operations. This working capital is required throughout the year and will generally be
financed through long-term debt and equity.
b) Temporary Working Capital: It refers to the extra working capital/current assets that is
required by the firm to support the changing business activities. This working capital is
MBA Semester-II Financial Management

required over and above permanent working capital in special circumstances and will
generally be financed through short-term debt.

Fig. 4: Permanent and Temporary Working Capital

4. Liquidity-Profitability Relationship
 Liquidity and profitability are competing goals for the finance manager.
 There is an inverse relationship between liquidity and profitability.
 Excessive investment in current assets certainly offer high liquidity to the firm but lowers
profitability. This is because of three reasons: first, excess investment in current assets increase
the cost of holding (e.g., storage cost, insurance, interest, obsolescence, damage, spoilage, theft
etc.); and second, current assets remain idle and earns nothing.
 On the other side of the spectrum, inadequate investment in current assets tend to threaten
solvency of the firm but results in high profit since there are no idle funds.
 Thus, neither excessive investment nor inadequate investment in current assets is desirable. The
financial manager should strike a proper balance between these two conflicting objectives.

5. Can Working Capital be Negative?

 Sometimes the net working capital turn to be negative when current liabilities are
exceeding the current assets.
 The negative working capital position can affect the business operations and thus its
profitability.
 The chronic negative working capital situation might lead to closure of business and the
enterprise is said to be ‘technically insolvent’.
 Other adverse effects include:
 Loss of business opportunities;
 Fixed assets can not be utilized effectively;
 Operating inefficiencies;
 Trade discount and cash discount are lost;
MBA Semester-II Financial Management

 Low employee morale;

 Loss of reputation;
 Stagnant growth;

6. Operating Cycle
 It consists of time-period between the procurement of raw materials and the collection
of cash from receivables.
 In other words, operating/cash conversion cycle refers to the length of time between the
company’s outlay of raw materials, wages, and other expenses and inflow of cash from
sale of goods.
 Operating cycle shows the time elapses/gap between outlay of cash and inflow of cash.
 Shorter the operating cycle, lesser the amount of investment in working capital is
required and vice-versa.
 Thus, it is an indicator of firm’s efficacy in managing its short-term funds and working
capital.
 Firm’s can improve its profitability by reducing operating cycle.
 Proper purchase management, production management, marketing management,
receivables management, and personnel management are desirable in the context.

Components of Operating Cycle:

Gross Operating Cycle = Raw materials storage period ® + WIP holding period (W) +
Finished stock storage period (F) + Receivables collection period allowed (D)

Net Operating Cycle = Raw materials storage period ® + WIP holding period (W) + Finished
stock storage period (F) + Receivables collection period allowed (D) – Credit period allowed
by Supplier ©
MBA Semester-II Financial Management

Where:
Average raw materials∈ stock
Raw Materials Storage Period (in days) =
Average consumption of raw materials /365
Average Stock of WIP
WIP Holding Period (in days) =
Average Cost of Production/365
Average Stock of Finished Goods
Finished Goods Storage Period (in days) =
Average Cost of Sales/365
Average Trade Receivables
Receivables Collection Period (in days) =
Average Credit Sales /365
Average Trade payables
Credit Period allowed by suppliers (in days) =
Average Credit Purchases/365
Illustration 1:
Calculate the operating cycle of Red Sign Ltd. from the following details of its operations:
(₹)
Raw materials consumption per annum 16,84,000
Annual cost of production 28,50,000
Annual cost of sales 30,60,000
Annual sales 39,00,000
Average value of current assets held:
Raw Materials 2,48,000
WIP 1,44,000
Finished Goods 2,44,000
Debtors 5,20,000
Note: 1 year = 365 days

The company gets 30 days credit from its suppliers. All sales made by the firm are on credit
only.
Illustration 2:
The following information is provided by Giant Bull Manufacturing Co. Ltd. for the year
ending 31st March 2022:

Raw materials storage period 55 days

WIP conversion period 18 days
Finished goods storage period 22 days
Debt collection period 45 days
Credit payment period 60 days
Annual operating cost (including ₹ 42,00,000
depreciation of ₹ 4,20,000)
Note: 1 year = 360 days
Required:
(a) Determine Operating cycle period
MBA Semester-II Financial Management

(b) Calculate the number of operating cycles in a year.

© Calculate the amount of working capital requirement for the company on a cash cost basis.
(d) The company is a market leader in its products, there is virtually no competitor in the
market. Based on market research it is planning to discontinue sales on credit and deliver
products based on per-payments. Thereby, it can reduce its working capital requirements
substantially.
What would be the reduction in working capital requirement due to such decision?

Illustration 3:
ABC Ltd. has obtained the following data concerning the average working capital cycle for
other companies in the same industry:

Raw materials turnover 20 days

WIP turnover 15 days
Finished goods stock turnover 40 days
Debt collection period 60 days
Credit payment period 40 days
Note: 1 year = 360 days
Using the following information, you are required to calculate the current working capital
cycle and briefly comment on it:

Sales ₹ 30,00,000
Cost of sales ₹ 21,00,000
Purchases ₹ 6,00,000
Average raw material stock ₹80,000
Average finished goods stock ₹1,80,000
Average WIP stock ₹85,000
Average creditors ₹ 90,000
Average debtors ₹ 3,50,000

Working Capital Estimation:

Step 1: Find out weekly/monthly sales (as the case may be).
Step 2: Prepare a weekly/monthly cost analysis (as the case may be).
Step 3: Forecast Working Capital Requirement
Particulars Avg. Cost (₹) Time lag (In Amount (₹)
(Weekly/Monthly) Months/Weekly)
I. Current Assets:
(a) Inventories:
(i) Raw Materials
(ii) WIP:
MBA Semester-II Financial Management

 Raw Materials
 Labour
 Overhead
(iii) Finished Goods:
 Raw Materials
 Labour
 Overhead
(b) Debtors:
 Raw Materials
 Labour
 Overhead
 Profit
© Cash in hand (if any)
Total Current Assets
II. Current Liabilities:
(a) Outstanding Wages
(b) Outstanding Overhead
© Creditors
Total Current Liabilities
III. Estimated Working
Capital Requirement [I-II]

Illustration 4:
From the following information, prepare a statement showing the Estimated Working Capital
requirements for Prosper Ltd.:
(i) Project Annual Sales – 72,000 units
(ii) Analysis of Sales:
Unit Cost (₹)
Raw Materials 6.00
Direct Labour 4.00
Overhead 3.00
Profit (@ 25% on selling price) 2.00
Unit Selling Price 15.00

(iii) Additional information:

Details Time Lag
Raw Materials in Stock 1 month
Production Process 2 months
Finished Goods in Store 3 months
Credit allowed by Supplier 4 months
Credit allowed to Debtors 2 months
Monthly wages and expenses are paid -
twice on 1st and 16th of each month
MBA Semester-II Financial Management

(iv) Production is carried on evenly throughout the year.

(v) Cash in hand of ₹ 1,00,000 to be kept for future contingencies.
Illustration 5:
Caterpillar Ltd. furnished below its cost and other data:
Unit Cost (₹)
Raw Materials 30.00
Direct Labour 20.00
Overhead (includes depreciation of ₹ ?
5.00 P.U.)
Profit (@ 25% on selling price) ?
Unit Selling Price 100

Additional information:
Details Time Lag
Average Raw Materials:
In Stock 1 month
In WIP ½ month
Credit allowed by Supplier 1 ½ months
Credit allowed to Debtors 3 months
Time lag in payment:
Wages ½ month
Overhead 1 month

Cash is to be kept @ 10% of the net working capital as safety margin and 80% of sales are
credit sales.
Assuming that production is carried on evenly throughout the year, you are required to
determine the Working Capital Requirement of Caterpillar Ltd. to achieve an output level of
6,00,000 units p.a.