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UNIT 4 CHAPTER

6 Working Capital

Estimation of
Working
Capital
WorkingCapital Statement

SYNOPSIS

6.1 Introduction
6.2 Definition
6.3 Nature and Types of
Working Capital
6.4 Factors Determing
Working
Requrement
6.5ptimum Working apital
6.6 Need for Adequate
WorkingCapita
Estimation of Working
6.7
Capital
Review Questior
- )
Accounting for Managerial Decision -S.Y, BMS(Sem
224

l6.1 INTRODUCTION
management of various
Management oft Working capital refers to
liabilities. Current Assets includes
components of cuments assets and current
Debtors, Bills Receivables, Prepaid Expenses and Cash and Bank Balance.
Stock. Expenses, Bank Overdraft
Outstanding
Curent Liabilities includes creditors,
among others.
two reasons. Firstly, the
Management of Working Capital is important for Secondly proper
all firms.
existence of working capital is imperative inprofitability of firm.
managerment of wOiking capitalcan maximize the
finance fixed assets. The firm also
Any fim needs long tem finance to
working capital. The fim can maximize
needs short term tinance to finance its
manage working capital of the fim.
proper use of finance if they can properly ideal funds, and on the other hand
Excess working capital implies existence of
smooth running of the business.
shortage of working capital funds can affect gives proper attention to
Therefore it is very essential that financial manager
management of workina.
management of the level of
Managerment of working capital includes the
individual current assetsand current liabilities and management of working
discuss every aspect of
capital as a whole. In next few chapters we shall
here in this chapter we
individual components of currents assets and liabilities,
whole.
shall restrict to management of working capital as a
6.2 DEFINITION
Working in layman's language can be described as funds required for day to
current liabilities.
day running of the business. It is excess of Curent Assets over
6.3NATURE AND TYPES OF WORKING CAPITAL

Working Capital can be classified on the basis


1. Value 2. Time
1. Value
From value the point of view, working capital can be classified as Gross
Working Capital, Net WorkingCapital
Gross Working Capital : Gross working capital refers to fims total
investment in current assets taken together. In short total of current assets of
the firm refers to gross working capital.
For eg the fim has
Stock of Raw Material
7. 5,000
Stock of Work in progress 7. 10,000
Stock of Finished Goods
Debtors 7.20,000
*. 20,000
Prepaid Selling Expenses 7. 1,000
Cash / Bank Balance
the total Current Assets are Z. 10,000
.66,000
Estimation of Working Capital 225

Net Working Capital : Net working Capital means the excess of curent
Assets Over Current Liabilities. Net workingCapital = Curent Assets -- Current
Liabilities. Current liabilities allow the firms to use the funds for the period the
liabilities can be delayed.
Apositive working capital is a good sign for the firm. It is measure of firrns
liquidity. The greater the margin the better for the firm. It indicates that fim is in
the position to pay all its short term obligations.
Net working Capital can further be classified into
i Positive working Capital = Curent Assets > Current Liabilities
11 Zero Working Capital = Current Assets = Current Liabilities
ii. Negative Working capital = Current Assets <Curent Liabilities
2. Time
Working capital can be classified into Permanent working capital and
temporary working capital from time point of view.
Permanent working capital: It is also referred as core working cápital. Its
that s
the minimum thing. It's the least amount of Stock, debtors and cash
needed to be maintained for business operations at any time during the
accounting period. It is kind of fixed working capital. Any shortage in this can
seriously damage firms liquidity.
Temporary Working Capital : It's the working Capital needed over and
above the pemanent working Capital. The need for temporary working capital
fluctuates from time to time according to business activities. The need for working
capital may increase during peak season and may reduce considerably during oft
season. Its directly co-related to production, higher the production, higher the
workingcapital needed and vice versa.
For eg : Sugar industries require higher amount of working capital during
the peak season and lower amount of working capital once the season is over.

Peak

Temporary Working Capital

Fixed Working Capital

In tems of variability the working capital can further be classified into


i. Seasonal Working capital: This is the amount of working capital needed to
meet the seasonal demands.
i. For example: Traderin crackers needs more working capitalin Diwal period
and less working in the remaining period
iii. Special Working Capital: Such working Capital is needed in meet
unforeseen circumstances, like strikes, fire, war, riots etc.
Accounting for ManagerialDecision - S.Y.BMS (Sem-)
226
Peak Working Capital It's the variable working capital needed during the
peak period. If's the maximum working capital needed by the firm during its
course of operations.

REQUIREMENT
64FACTORS DETERMINING WORKING CAPITAL
influenced by
The working capital needs of the firm are determined and
may not
various factors. The tactors affecting the working capital requirement
may vary for same
only vay from industry to industry and firm to firm but also
such factors as they
fim from time to time. One should keep a close watch on
that the need for working
change from time to time and therefore it is necessary timeprocess. Factors
canital is assessed on regular basis and is not taken as one
affecting the working capital requirements are
is closely
1. Nature of Business: Estimation of working capital requirement selling
retail shop
related to the nature of business of the firm. In case of
articles on cash basis, requirement of working capital is fairly small in
huge stock, needs
amount, on the opposite large retail counters, requiring
fairly higher amount of workingcapital.
technological
2. Technology and production process: Innovation and capital. The
advancement have fairly reduced the requirementhigh of working
amount of working
production process which is labor oriented needs
capital oriented, the need tor
capital. However if the production process are
working capital requirement reduces.
up, growth, boom, stable,
Business cycle period: Business cycle, i.e, start
3 amount of working capital.
recession, fall etc all this periods needs different amount of working capital
During periods of boom and expansion, the
requirerHent increases cònsiderably.
deals in products and
Seasonal fluctuations: There are firms which
4. to seasons. Demand for
services where demand fluctuates according
summer seasons, which
product like cold drinks often sees a spike during
will increase the need for working capital.
Inventory: Working capital requirement
largely depends on the amount of
5 process. Quantum of
inventory required to be held ready for production For eg, electricity
inventory is influenced by the nature of business. as the supply
manufacturing company needs huge amount of coal inventory
in time (JIT) and
of Just
is affected by season like rains. The techniques
Economic Order quantity (ECQ) can be handful for the same.
cash holding
6. Cash: It is most liquid component of working capital. But
involves cost. The firm should maintain the cash balance which is optimum
for the smooth running of the business, and also reduces holdingcost.
7. Debtors: The credit period allowed to the debtors, affects the amount of
working capital directly. Higher the credit period, greater the working
capital. Fims are always in a fix with reference to credit period
management, because increase in credit period increases the sales, but on
the other side, increases the risk of bad debts and also quantum of working
capital.
8. Market Competition: Market competitiveness also affects the working
capital requirements. Greater competitiveness induces the fims to extent
227
Estimation of Working Capital
liberal credit tems, discount terms and other freebies, which increases the
working capital requirement of the firms. On the other hand, the industries
which include few firms and are not as competitiveness will have stable
working capital needs.
9. Operational Efficiency: Fims can reduce the amount of working capital
requirements by greater operational efficiency. Cost control is what all firms
are targeling. For rg, promoting paperless environment can reduce wasiages
of stationery, and thereby reduce the needs, of working capital funds.
10. Credit period from Suppliers: The credit period from supplier, reduces
the working capital funds, as inventory can be purchased on credit.

6.5 OPTIMUM WORKING CAPITAL

It found people misreading this word "Optimum". What does this word
mean? People tend to read it as maximum. Optimum neither means maximum
nor does it mean minimum. It means adequate. Working capital as defined is the
sufficient to
excess of curent assets over current liability. If current assets are not
cover curent liability, the firm may run into problems.
The adequacy of working capital is best calculated by curent ratio and
Quick ratio. We have already studied that the standard ratio is 2:1 and Quick
Ratio is 1:1. Following this ratio may ensure smooth running of business. Let us
continue this discussion in the next head.

6.6 NEED FOR ADEQUATE WORKING CAPITAL

One cannot underestimate the need for adequate working capital for the
smooth functioning of the business. Adequate working capital is needed for
affect the
smooth running of business; any shortage in the same can adverselybottom-line
business. On the other hand excess working capital also affect the
(Profitability) of the firm. Prime objective of the financial manager of the firm is to
increase shareholders wealth. This can be done by keeping adequate working
and not
capital needs. Now adequate refer to thèquantum that is not in eXcess
short also.
The excess investment in working capital higher than required results in:
a Large stock of inventory, which may result into damages,
waste, out of
fashion, etc.
due to
b) Higher investment in debtors, which may lead to greater risk
bad debts, and also loss of opportunity cost.
of
Lower amount is invested in Fixed Assets, which leads to reduction
profitability.
Indicates conservative attitude of the management.
On the other hand inadequate working capital situations lead to:
a) Lack of liquidity for smooth running of the business.
b) Underutilization of Assets
c) Frequent breakdown of assets, leading to delay in deliver schedules
and affecting the flow of the orders.
S.Y BMS (Sem - II|)
228 Accounting for Managerial Decision

d) The Growth rate of the firm may be stagnant.


The goodwill of the fim may be adversely affected, as there may
e)
frequent delays in paymentto creditors.
The management of working capital is the responsibility of the entire
the firm
management and financial manager in particular, He should ensure that efficient
build an
maintains optimum working capital. Efforts should be made to
internal control system tor managemeht of working capital.

l6.7 ESTIMATION OF WORKING CAPITAL 1


Statement of Estimationof Working Capital
Particulars W.N Amount(R.) Amount(.)
(A)Current Assets :
Stock-in-trade
Raw material 1 XX
Work-in-Progress XX
XX XX
Finished goods
XX
Debtors / Bills Receivable 4
5 XX
Prepaid Expenses
Cash / Bank Balance XX
XX
CA
(B)Less : Current Liabilities :
Creditors/Bills Payable XX
Outstanding Expenses 7 XX
XX XX
Bank Overdraft
Net Curent Assets XX

Add :Safety Margin/ Contingency XX


Working Capital Estimation XX

Working Note:
W.N Current Assets Formula Amount
/Current
Liabilities
1, Raw Material Raw Material P.A
-xNo. of Months Stock
12/ 52/365 XX
|2. Work in
Progress Raw Material P.A
x Process Period XX
(A+B+C) 12/52/365
|RawMaterial
Labour P.A XX
Process Period 2
12/52/365
Labour/Wages XX
Overhead P.A -x Process Period 1/2
Overheads 12/52/365
Estimation of Working Capital 229

Note : In the absence of information it shall be assumed that


raw, material is fed into pipeline in full and labor and
overhead are completed to 50%
Finishcd Goods Cost of Goods P.A XX
X No. of Months Stock
12/52/365
4. Debtors / Bills Sales P.A
x Period of Credit XX
Reccivable 12/52/365
Note: Debtors can alternatively be calculated at cost.
However in the absence of information it should always be
calculated at sales.
Prepaid Expenses Expenses P.A -x No. of months Prepaid
12/52/365 XX
Advance to Raw Material P.A xMonths Advance
supplier 12/ 52/ 365 XX
7. Creditors Raw Material P.A
-xNo.of months.Credit
12/ 52/ 365 XX
8. Outstanding Expenses P.A x No. of month outstanding
Expenses 12/52/365 XX

SOLVED QUESTIONS
Question:-1
You are required to prepare a statement showing the estimate of working
capital required to finahce the level of activity of 18,000 units per year from the
following infomation, obtained from the Books of Pranav LTD.
Per unit
Particulars
Raw materials 18
Direct Labour 4.5
Overheads 13.5
Total Cost 36
Profit
Selling price 45

(i) Raw materials are in stock on an average for two months.


(ii) Materials are in process on average for half a month.
(iii) Finished Goods are in stock on average for two months.
(iv) Credit allowed by Creditors is two months.
(v) Credit allowed to Debtors is three months.
(vi) Lag in payment of wages is half month.
(vii) Cash on hand and at bank is expected to be 10,500.

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