Lesson 7 Working Captial 205

Lesson 7
Working Capital

LESSON OUTLINE
LEARNING OBJECTIVES
– Meaning, Types, Determinants and
Assessment of W orking Capital Working capital is very important aspect for an
Requirements, organisation. It is called the blood of the
organisation. As without proper blood circulation
– Negative Working Capital in the body, it will face various diseases, similarly
– Operating Cycle Concept and Applications proper circulation of working capital is vital for the
of Quantitative Techniques proper and smooth functioning of an organisation.
Seeing the importance of working capital
– Financing of Working Capital; Banking management, it is very necessary for a corporate
Norms and Macro Aspects professional to know about management of
different constituents of working capital.
– Cash Management, Inventories
Management, Receivables Management The object of the study is to enable the student
to understand:
– Factoring and Forfeiting
– Concept of Working Capital
– Case Studies
– Determinants of Working Capital
– LESSON ROUND UP
– Current Assets and Fixed Assets
– SELF TEST QUESTIONS
Financing
– Operating Circle
– Application of Quantitative Techniques
– Techniques for Allocation and control of
Working Capital
– Financing of Working Capital
– Working Capital Leverage
– Banking Norms and Macro Aspect of
Working Capital Management
– Cash Management
– Inventory Management
– Receivable Management

All companies should focus on the proper management of working capital. Inventory, accounts
receivable, and accounts payable are of specific importance since they can be influenced most
directly by operational management and here starts the role of Management.

205
206 EP-F&SM

MEANING OF WORKING CAPITAL -THE BASIC CONCEPT

The capital which is required to finance current assets is called working capital. It is the capital of a busniess
which is used to carry out day-to-day business operations of a firm.
“Working capital may be defined as all the short term assets used in daily operation”—John. J Harpton.
Current Assets: An asset is classified as current when:
(i) It is expected to be realised or intends to be sold or consumed in normal operating cycle of the entity;
(ii) The asset is held primarily for the purpose of trading;
(iii) It is expected to be realised within twelve months after the reporting period;
(iv) It is non- restricted cash or cash equivalent.
Generally current assets of an entity, for the purpose of working capital management can be grouped into the
following main heads:
(a) Inventory (raw material, work in process and finished goods)
(b) Receivables (trade receivables and bills receivables)
(c) Cash or cash equivalents (short-term marketable securities)
(d) Prepaid expenses.
Current Liabilities: A liability is classified as current when:
(i) It is expected to be settled in normal operating cycle of the entity
(ii) The liability is held primarily for the purpose of trading
(iii) It is expected to be settled within twelve months after the reporting period.
Generally current liabilities of an entity, for the purpose of working capital management can be grouped into the
following main heads:
(a) Payable (trade payables and bills receivables) (b) Outstanding payments (wages & salary etc.)
In general, Working capital management is essentially managing Current Assets, management of working capital
arises as a part of the process of such management.
Short term assets of a firm means cash money, short-term securities, inventory, bill receivable, note receivable,
debtors etc. In operating daily business, fixed assets are also needed in addition to current assets. Though
some fixed assets help on the daily operation of a firm, these can’t be termed as working capital, because these
can’t be converted into cash in the current accounting period. So, the assets which can be converted into raw
material from cash—R/M—Finished Goods—B/R—Cash and helps in operating daily business of the firm, is
called working Capital. Working capital is also called ‘Trading Capital”, Circulating capital/Short term capital /
Short /Current Assets management.
Working capital is defined keeping in view the varying objectives and purposes. To businessmen, working
capital comprises current assets of business whereas to the accountant/creditors/investment analysts working
capital is understood as the difference of current assets and current liabilities. This is also called the Net Working
Capital. There is operative aspects of working capital i.e. current assets (which is known as ‘funds’ also) employed
in the business process from the gross working capital. Current assets comprise: cash, receivables, inventories,
marketable securities held as short-term investment and other items near cash or equivalent to cash. This is
also known as going-concern concept of working capital.
 Lesson 7 Working Captial 207

SIGNIFICANCE OF WORKING CAPITAL

Importance of Adequate Working Capital

Management of working capital is an essential task of the finance manager. He has to ensure that the amount of
working capital available with his concern is neither too large nor too small for its requirements. A large amount
of working capital would mean that the company has idle funds. Since funds have a cost, the company has to
pay huge amount as interest on such funds. If the firm has inadequate working capital, such firm runs the risk of
insolvency. Paucity of working capital may lead to a situation where the firm may not be able to meet its liabilities.
The various studies conducted by the Bureau of Public Enterprises have shown that one of the reasons for the
poor performance of public sector undertakings in our country has been the large amount of funds locked up in
working capital. This results in over capitalization. Over capitalization implies that a company has too large
funds for its requirements, resulting in a low rate of return, a situation which implies a less than optimal use of
resources. A firm, therefore, has to be very careful in estimating its working capital requirements. Maintaining
adequate working capital is not just important in the short-term. Sufficient liquidity must be maintained in order to
ensure the survival of the business in the long- term as well. When businesses make investment decisions they
must not only consider the financial outlay involved with acquiring the new machine or the new building, etc., but
must also take account of the additional current assets that are usually required with any expansion of activity.
For e.g.:-Increased production leads to holding of additional stocks of raw materials and work-in-progress. An
increased sale usually means that the level of debtors will increase. A general increase in the firm’s scale of
operations tends to imply a need for greater levels of working capital. A question then arises what is an optimum
amount of working capital for a firm? We can say that a firm should neither have too high an amount of working
capital nor should the same be too low. It is the job of the finance manager to estimate the requirements of
working capital carefully and determine the optimum level of investment in working capital.

OPTIMUM WORKING CAPITAL

If a company’s current assets do not exceed its current liabilities, then it may run into trouble with creditors that
want their money quickly. Current ratio (current assets/current liabilities) (along with acid test ratio to supplement it)
has traditionally been considered the best indicator of the working capital situation. It is understood that a current
ratio of 2 (two) for a manufacturing firm implies that the firm has an optimum amount of working capital. This is
supplemented by Acid Test Ratio (Quick assets/Current liabilities) which should be at least 1 (one). Thus, it is
considered that there is a comfortable liquidity position if liquid current assets are equal to current liabilities. Bankers,
financial institutions, financial analysts, investors and other people interested in financial statements have, for
years, considered the current ratio at ‘two’ and the acid test ratio at ‘one’ as indicators of a good working capital
situation. As a thumb rule, this may be quite adequate. However, it should be remembered that optimum working
capital can be determined only with reference to the particular circumstances of a specific situation. Thus, in a
company where the inventories are easily saleable and the sundry debtors are as good as liquid cash, the current
ratio may be lower than 2 and yet firm may be sound. In nutshell, a firm should have adequate working capital to
run its business operations. Both excessive as well as inadequate working capital positions are dangerous.

TYPES OF WORKING CAPITAL

The working capital in certain enterprise may be classified into the following kinds.
1. Initial working capital: The capital, which is required at the time of the commencement of business, is called
initial working capital. These are the promotion expenses incurred at the earliest stage of formation of the
enterprise which include the incorporation fees, attorney’s fees, office expenses and other preliminary expenses.
2. Regular working capital: This type of working capital remains always in the enterprise for the successful
operation. It supplies the funds necessary to meet the current working expenses i.e. for purchasing raw material
and supplies, payment of wages, salaries and other sundry expenses.
208 EP-F&SM

3. Fluctuating working capital: This capital is needed to meet the seasonal requirements of the business. It is
used to raise the volume of production by improvement or extension of machinery. It may be secured from any
financial institution which can, of course, be met with short term capital. It is also called variable working capital.
4. Reserve margin working capital: It represents the amount utilized at the time of contingencies. These
unpleasant events may occur at any time in the running life of the business such as inflation, depression, slump,
flood, fire, earthquakes, strike, lay off and unavoidable competition etc. In this case, greater amount of capital is
required for maintenance of the business.
5. Permanent and Temporary Working Capital: The Operating Cycle creates the need for Current Assets
(Working Capital). However, the need does not come to an end once the cycle is completed. It continues to
exist. To explain the continuing need of current assets, a distinction should be drawn between temporary and
permanent working capital.
Business Activity does not come to an end after the realization of cash from customers. For a company, the
process is continuing, and hence, the need for regular supply of working capital. However, the, magnitude of
Working Capital required is not constant but fluctuating. To carry on a business, a certain minimum level of
working capital is necessary on a continuous and uninterrupted basis. For all practical purposes, this requirement
has to be met permanently as with other fixed assets. This requirement is referred to as permanent or fixed
working capital.
Any amount over and above the permanent level of working capital is temporary, fluctuating or variable working
capital. The position of the required working capital is needed to meet fluctuations in demand consequent upon
changes in production and sales as a result of seasonal changes.
Both kinds of working capital are necessary to facilitate the sales proceeds through the Operating Cycle.

Permanent & Temporary Working Capital

Variable Working Capital

Amount
of
Working
Capital
Permanent Working Capital

O Time

6. Long Term working capital: The long-term working capital represents the amount of funds needed to keep
a company running in order to satisfy demand at lowest point. There may be many situations where demand
may fluctuate considerably. It is not possible to retrench the work force or instantly sell all the inventories whenever
demand declines due to temporary reasons. Therefore the value, which represents the long-term working capital,
stays with the business process all the time. It is for all practical purpose known as permanent fixed assets. In
other words, it consists of the minimum current assets to be maintained at all times. The size of the permanent
working capital varies directly with the size of Operation of a firm.
7. Short term working capital: Short-term capital varies directly with the level of activity achieved by a company.
The Volume of Operation decides the quantum of Short-term working capital. It also changes from one form to
 Lesson 7 Working Captial 209

another; from cash to inventory, from inventory to debtors and from debtors back to cash. It may not always be
gainfully employed. Temporary Working capital should be obtained from such sources, which will allow its return
when it is not in use.
8. Gross Working Capital: Gross working capital refers to the firm’s investment in current assets. Current
assets are those assets which can be converted in to cash with in an accounting year and includes cash, short
term securities, debtors bills receivable and stock.
9. Net Working Capital: Net working capital refers to the difference between current asset and Current liabilities.
Current liabilities are those claims of outsiders, which are expected to mature for payment within accounting
year and include creditors, bills payable and outstanding expenses. Net Working capital can be positive or
negative. A positive net working capital will arise when current assets exceed current liabilities.
The Gross working capital concept focuses attention on two aspect of current assets management.
(a) How to optimize investment in current assets?
(b) How should current assets be financed?
Both the question is the most decision making action of the management. It should be given due consideration
before taking decision.
Both Net and Gross working capital is important and they have equal significance from management point of
view.

DETERMINANTS OF WORKING CAPITAL

Working capital management is concerned with:-
(a) Maintaining adequate working capital (management of the level of individual current assets and the
current liabilities) and
(b) Financing of the working capital.
For the point a) above, a Finance Manager needs to plan and compute the working capital requirement for its
business. And once the requirement has been computed, he needs to ensure that it is financed properly. This
whole exercise is nothing but Working Capital Management. Sound financial and statistical techniques, supported
by value judgment should be used to predict the quantum of working capital required at different times. Some of
the factors which need to be considered while planning for working capital requirement are:-
1. Nature of Business: A company’s working capital requirements are directly related to the kind of business it
conducts. A company that sells a service primarily on a cash basis does not have the pressure of keeping
considerable amounts of inventories or of carrying customer’s receivables. On the other hand, a manufacturing
enterprise ordinarily finances its own customers, requires large amounts to pay its own bills, and uses inventories
of direct materials for conversion into end products. These conditions augment the working capital requirements.
2. Degree of Seasonality: Companies that experience strong seasonal movements have special working capital
problems in controlling the internal financial savings that may take place. Aggrevating this difficulty is the fact
that no matter how clearly defined a pattern may be, it is never certain. Unusual circumstances may distort
ordinary relationships. Although seasonality may pull financial manager from the security of fixed programmes
to meet recurring requirements, flexible arrangements are preferable to guard against unforeseen contingencies.
An inability to cope with sharp working capital swings is one of the factors that encourages companies to
undertake diversification programmes.
3. Production Policies: Depending upon the kind of items manufactured, by adjusting its production schedules
a company may be able to offset the effect of seasonal fluctuations upon working capital, at least to some
degree, even without seeking a balancing diversified line. Thus, in one year, in order to avoid burdensome
210 EP-F&SM

inventories, firm may curtail activity when a seasonal upswing normally takes place. As a matter of policy, the
choice will rest on the one hand, and maintaining a steady rate of production and permitting stocks of inventories
to build up during off season periods, on the other. In the first instance, inventories are kept to minimum levels
but the production manager must shoulder the burden of constantly adjusting his working staff; in the second,
the uniform manufacturing rate avoids fluctuations of production schedules, but enlarged inventory stocks create
special risks and costs. Because the purchase of inventories is often financed by suppliers, the mere fact that a
company carries bigger amounts does not necessarily mean that its cash problem is more serious.
4. Growth Stage of Business : As a company expands, it is logical to expect that larger amounts of working
capital will be required to avoid interruptions to the production sequence. Although this is true it is hard to draw
up firm rules for the relationship between the growth in the volume of a company’s business and the growth of its
working capital. A major reason for this is management’s increasing sophistication in handling the current assets,
besides other factors operating simultaneously.
5. Position of the Business Cycle: In addition to the long-term secular trend, the recurring movements of the
business cycle influence working capital changes. As business recedes, companies tend to defer capital
replacement programmes and deflect depreciations to liquid balances rather than fixed assets. Similarly, curtailed
sales reduce amounts receivable and modify inventory purchases, thereby contributing further to the accumulation
of cash balances. Conversely, the sales, capital, and inventory expansions that accompany a boom produce a
greater concentration of credit items in the balance sheet.
The tendency for companies to become cash-poor as the tide of economic prosperity rises and cash-rich as
it runs out is well known economic phenomenon. The pressure on company finances during boom years is
reflected in the business drive for loans and the high interest rate of these years as compared with a reversal
of such conditions during the periods of economic decline. The financial implications of these movements
may be deceptive. A weakening of the cash position in favourable economic environment may suggest the
need or difficulty of raising capital for the further expansion rather than a shortage of funds to take care of
current needs. On the other hand, a strong cash position when the economic outlook is bleak may be the
forerunner of actual financial difficulties. The financial manager must learn to look behind the obvious
significance of the standard test of corporate liquidity interpret their meaning in the light of his knowledge of
the company’s position in the industry, the prospects of new business and the availability of external sources
for supplying additional capital.
6. Competitive Conditions: A corporation that dominates the market may relax its working capital standard
because failing to meet customers requirements promptly does not necessarily lead to a loss of business. When
competition is keen, there is more pressure to stock varied lines of inventory to satisfy customer’s demands and
to grant more generous credit terms, thereby causing an expansion in receivables.
7. Production Collection Time Period: Closely related to a company’s competitive status are the credit terms,
it must grant. These arrangements may be result of tradition, policy within the industry, or even carelessness in
failing to carry out announced principles. And the arrangements, in turn, are part of the overall production
collection time sequence, that is, the time intervening between the actual production of goods and the eventual
collection of receivables, flowing from sales. The length of this period is influenced by various factors.
Purchases may be on a cash basis, but the manufacturing cycle may be prolonged and sales terms generous,
causing a wide gap between cash expenditure and receipt and possibly placing heavy financing pressure on the
firm. The pressure may be eased, despite long manufacturing cycle, if the company can persuade its suppliers
to bear a large part of its financing burden or the manufacturing cycle may be short, and get the pressures heavy
because suppliers do not bear a large part of financial burden. The financing requirements of the company may
always be traceable to the relation between purchasing and sales credit volume and terms of operations.
8. Dividend Policy: A desire to maintain an established dividend policy may affect the volume of working
capital, or changes in working capital may bring about an adjustment of dividend policy. In either event, the
 Lesson 7 Working Captial 211

relationship between dividend policy and working capital is well established, and very few companies ever
declare a dividend without giving consideration to its effect on cash and their needs for cash.
9. Size of Business: The amount needed may be relatively large per unit of output for a small company subject to
higher overhead costs, less favourable buying terms, and higher interest rates. Small though growing companies
tend to be hard pressed in financing their working capital needs because they seldom have access to the open
market as do large established business firms have.
10. Sales Policies: Working capital needs vary on the basis of sales policy of the same industry. A department
store which caters to the “carries trade” by carrying a quality line of merchandise and offering extensive charge
accounts will usually have a slower turnover of assets, a higher margin on sales, and relatively larger accounts
receivable than many of its non-carriage, trade competitors. Another department store which stresses cash and
carry operations will usually have a rapid turnover, a low margin on sales, and small or no accounts receivable.
11. Risk Factor: The greater the uncertainty of receipt and expenditure, more the need for working capital. A
business firm producing an item which sells for a small unit price and which necessitates repeat buying, such as
canned foods or staple dry goods etc., would be subject to less risk than a firm producing a luxury item which
sells for a relatively high price and is purchased once over a period of years, such as furniture, automobiles etc.

INVESTMENT AND FINANCING OF WORKING CAPITAL

Working capital policy is a function of two decisions, first, investment in working capital and the second is
financing of the investment. Investment in working capital is concerned with the level of investment in the current
assets. It gives the answer of ‘How much’ fund to be tied in to achieve the organisation objectives (i.e. Effectiveness
of fund). Financing decision concerned with the arrangement of funds to finance the working capital. It gives the
answer ‘Where from’ fund to be sourced’ at lowest cost as possible (i.e. Economy). Financing decision, we will
discuss this in later part of this chapter.

Investment of working capital

How much to be invested in current assets as working capital is a matter of policy decision by an entity. It has to
be decided in the light of organisational objectives, trade policies and financial (cost-benefit) considerations.
There is not set rules for deciding the level of investment in working capital. Some organisations due to its
peculiarity require more investment than others. For example, an infrastructure development company requires
more investment in its working capital as there may be huge inventory in the form of work in process on the other
hand a company which is engaged in fast food business, comparatively requires less investment. Hence, level
of investment depends on the various factors listed below:
(a) Nature of Industry: Construction companies, breweries etc. requires large investment in working capital
due to long gestation period.
(b) Types of products: Consumer durable has large inventory as compared to perishable products.
(c) Manufacturing Vs Trading Vs Service: A manufacturing entity has to maintain three levels of inventory
i.e. raw material, work-in-process and finished goods whereas a trading and a service entity has to
maintain inventory only in the form of trading stock and consumables respectively.
(d) Volume of sales: Where the sales are high, there is a possibility of high receivables as well.
(e) Credit policy: An entity whose credit policy is liberal has not only high level of receivables but requires
more capital to fund raw material purchases.

Approaches of working capital investment

Based on the organisational policy and risk-return trade off, working capital investment decisions are categorised
into three approaches i.e. aggressive, conservative and moderate.
212 EP-F&SM

(a) Aggressive: Here investment in working capital is kept at minimal investment in current assets which
means the entity does hold lower level of inventory, follow strict credit policy, keeps less cash balance
etc. The advantage of this approach is that lower level of fund is tied in the working capital which results
in lower financial costs but the flip side could be that the organisation could not grow which leads to
lower utilisation of fixed assets and long term debts. In the long run firm stay behind the competitors.
(b) Conservative: In this approach of organisation use to invest high capital in current assets. Organisations
use to keep inventory level higher, follows liberal credit policies, and cash balance as high as to meet
any current liabilities immediately. The advantage of this approach are higher sales volume, increased
demand due to liberal credit policy and increase goodwill among the suppliers due to payment in short
time. The disadvantages are increase cost of capital, higher risk of bad debts, shortage of liquidity in
long run to longer operating cycles.
(c) Moderate: This approach is in between the above two approaches. Under this approach a balance
between the risk and return is maintained to gain more by using the funds in very efficient manner.

Current Assets to Fixed Assets Ratio

The finance manager is required to determine the optimum level of current assets so that the shareholders’
value is maximized. A firm needs fixed and current assets to support a particular level of output. As the firm’s
output and sales increases, the need for current assets also increases. Generally, current assets do not increase
in direct proportion to output; current assets may increase at a decreasing rate with output. As the output
increases, the firm starts using its current asset more efficiently. The level of the current assets can be measured
by creating a relationship between current assets and fixed assets. Dividing current assets by fixed assets gives
current assets/fixed assets ratio. Assuming a constant level of fixed assets, a higher current assets/fixed assets
ratio indicates a conservative current assets policy and a lower current assets/fixed assets ratio means an
aggressive current assets policy assuming all factors to be constant. A conservative policy implies greater
liquidity and lower risk whereas an aggressive policy indicates higher risk and poor liquidity. Moderate current
assets policy will fall in the middle of conservative and aggressive policies. The current assets policy of most of
the firms may fall between these two extreme policies. The following illustration explains the risk-return trade off
of various working capital management policies, viz., conservative, aggressive and moderate.
Example 1
A firm has the following data for the year ending 31st March, 2018:
(`)
Sales (1,00,000 @ ` 20) 20,00,000
Earnings before Interest and Taxes 2,00,000
Fixed Assets 5,00,000
The three possible current assets holdings of the firm are ` 5,00,000, ` 4,00,000 and ` 3,00,000. It is assumed
that fixed assets level is constant and profits do not vary with current assets levels. Show the effect of the three
alternative current assets policies.
SOLUTION
Effect of Alternative Working Capital Policies
 Lesson 7 Working Captial 213

Working Capital Policy Conservative (`) Moderate (`) Aggressive(`)

Sales 20,00,000 20,00,000 20,00,000
Earnings before Interest and Taxes (EBIT) 2,00,000 2,00,000 2,00,000
Current Assets 5,00,000 4,00,000 3,00,000
Fixed Assets 5,00,000 5,00,000 5,00,000
Total Assets 10,00,000 9,00,000 8,00,000
Return on Total Assets (EBIT÷ Total Assets) 20% 22.22% 25%
Current Assets/Fixed Assets 1.00 0.80 0.60
The aforesaid calculation shows that the conservative policy provides greater liquidity (solvency) to the firm, but
lower return on total assets. On the other hand, the aggressive policy gives higher return, but low liquidity and
thus is very risky. The moderate policy generates return higher than Conservative policy but lower than aggressive
policy. This is less risky than aggressive policy but riskier than conservative policy. In determining the optimum
level of current assets, the firm should balance the profitability – solvency tangle by minimizing total costs – Cost
of liquidity and cost of illiquidity.

ESTIMATING WORKING CAPITAL NEEDS

Operating cycle is one of the most reliable methods of Computation of Working Capital. However, other methods
like ratio of sales and ratio of fixed investment may also be used to determine the Working Capital requirements.
These methods are briefly explained as follows:
(i) Current Assets Holding Period: To estimate working capital needs based on the average holding
period of current assets and relating them to costs based on the company’s experience in the previous
year. This method is essentially based on the Operating Cycle Concept.
(ii) Ratio of Sales: To estimate working capital needs as a ratio of sales on the assumption that current
assets change with changes in sales.
(iii) Ratio of Fixed Investments: To estimate Working Capital requirements as a percentage of fixed
investments. A number of factors will, however, be impacting the choice of method of estimating Working
Capital. Factors such as seasonal fluctuations, accurate sales forecast, investment cost and variability
in sales price would generally be considered. The production cycle and credit and collection policies of
the firm will have an impact on Working Capital requirements. Therefore, they should be given due
weightage in projecting Working Capital requirements.

CURRENT ASSETS AND FIXED ASSETS FINANCING

The more of the funds of a business are invested in working capital, lesser is the return in term of profitability and
less amount is available for investing in long-term assets such as plant and machinery, etc. Therefore, the
corporate enterprise has to minimise investment in working capital and to concentrate on investment of resources
in fixed assets. Some economists argue that current assets be financed by current liabilities. But this all depends
upon economic conditions prevailing in the economy at particular time requiring a company to keep business
resources liquid so that business can take immediate advantage of knocking opportunities. In short-run, opportunity
may arise for investment in stocks to make immediate gains due to movement in prices, whereas investment in
plant and machinery may not be possible.
Current assets financing can be viewed from the working capital pool as under:
214 EP-F&SM

(All Current Accounts)

Marketable Securities
~
€
Accounts } Cash } Accounts
Receivables Payables
z

Inventory x
Working Capital Pool
Current assets usually are converted into cash within a current accounting cycle in one year. Cash is used to
purchase raw material etc., i..e. to create inventories. When inventories are sold, it gives rise to accounts
receivables. Collection of receivables brings cash into company and the process forms a circle and goes on as
depicted in figure above:
Thus, the current assets represent cash or near cash necessary to carry on business operations at all times. A
level of current assets is thus maintained throughout the year and this represents permanent working capital.
Additional assets are also required in business at different times during the operating year. Added inventory
must be maintained to support peak selling period when receivables also increase and must be financed. Extra
cash is needed to pay increased obligations due to spurt in activities.
Fixed assets financing is different to current assets financing. In fixed assets investment is made in building,
plant and machinery which remains blocked over a period of time and generates funds through the help of
working capital at a percentage higher than the return on investment in current assets. Working capital financing
or current assets financing is done by raising short-term loans or cash credits limits but fixed assets financing is
done by raising long-term loans or equity.
The working capital leverage and the capital structure leverage are, therefore, two different concepts. Capital
structure leverage is associated with the fixed assets, financing, with an optional mix of owner’s funds and
borrowed funds. Owner’s funds are the internal funds of the company comprised of equity holder’s money in the
shape of equity, retained earnings, depreciation fund and reserves. Borrowed funds are the external sources of
funds raised from banks, financial institutions, issue of debentures, stock and term deposits from public. Financing
of fixed assets with borrowed funds is cheaper than using owner’s funds which increases the earnings per share
and tends to increase the value of owner’s capital in the share market.

OPERATING OR WORKING CAPITAL CYCLE : CONCEPT AND APPLICATION OF QUANTITATIVE

TECHNIQUES
The operating cycle is the length of time between the company’s outlay on raw materials, wages and other
expenditures and the inflow of cash from the sale of the goods. In a manufacturing business, operating cycle
is the average time that raw material remains in stock less the period of credit taken from suppliers, plus the
time taken for producing the goods, plus the time the goods remain in finished inventory, plus the time taken
by customers to pay for the goods. Operating cycle concept is important for management of cash and
management of working capital because the longer the operating cycle the more financial resources the
company needs. Therefore, the management has to remain cautious that the operating cycle should not
become too long.
Most businesses cannot finance the operating cycle (accounts receivable days + inventory days) with accounts
payable financing alone. Consequently, working capital financing is needed. This shortfall is typically covered by
 Lesson 7 Working Captial 215

the net profits generated internally or by externally borrowed funds or by a combination of the two. The duration of
working capital cycle may vary depending on the nature of the business. In the form of an equation, the operating
cycle process can be expressed as follows:
Operating Cycle = R + W + F + D – C
Where,
R = Raw material storage period
W = Work-in-progress holding period
F = Finished goods storage period
D = Receivables (Debtors) collection period.
C = Credit period allowed by suppliers (Creditors).
The stages of operating cycle could be depicted through the following diagram :
CASH
(Ultimate Stage)
Sundry Debtors Raw materials
(Period of Credit (Period of Turnover
Taken by customers) of raw-material
Stage IV Stage I stocks)
Working Capital
Operating Cycle

Finished goods Stage III Stage II Stock-in-process

(Period of Turnover (Period in
of finished goods stock) production)

The above figure would reveal that operating cycle is the time that elapses between the cash outlay and the
cash realisation by the sale of finished goods and realisation of sundry debtors. Thus, cash used in productive
activity, often some time comes back from the operating cycle of the activity. The length of operating cycle of an
enterprise is the sum of these four individual stages i.e. components of time.
The various component operating cycle can be calculated as shown below:

S.No. Name of Working Capital Formula Days

Component

1. Raw materials

Average value of Raw material stock

Period of raw material stock
Consumption of raw material per day

Less: Period of credit granted

by supplier
216 EP-F&SM

Average value of work in progress

2. Period of Production
Average cost of production per day

Average Stock of finished goods

3. Period of turnover of Average cost of goods sold per day
finished goods stock

4. Period of credit taken Average receivable

Average value of credit sales per day
by customers

Total operating cycle period Sum of Sl. Nos. 1, 2, 3, 4

Example No. 2
Calculate the Operating cycle from the following figures related to company ‘X’:
Particulars Average amount Average value
Outstanding per day (340
` days assumed) `
Raw Material inventory 1,80,000
Work-in-progress inventory 96,000
Finished goods inventory 1,20,000
Debtors 1,50,000
Creditors 1,00,000
Purchase of Raw Material 2,500
Cost of Sales 4,000
Sales 5,000
Solution
Calculation of operating cycle
Days
180
, ,000
1. Period of Raw Material Stock 72
2500
100
, ,000
Less: Credit granted by supplier 40 32
2500
96,000
2. Period of Production 24
4,000
120
, ,000
3. Turnover of Finished Goods 30
4000
150
, ,000
4. Credit taken by customers 30
5000
Operating Cycle Period 116

Comments: Operating cycle is long and a number of steps could be taken to shorten this operating cycle.
Debtors could be cut by a quicker collection of accounts.
 Lesson 7 Working Captial 217

Finished goods could be turned over more rapidly, the level of raw material inventory could be reduced or the
production period shortened.
Example No. 3
The following information is available for Swati Ltd.
Amount (` )
Average stock of raw materials and stores 2,00,000
Average work-in-progress inventory 3,00,000
Average finished goods inventory 1,80,000
Average accounts receivable 3,00,000
Average accounts payable 1,80,000
Average raw materials and stores purchased on credit and consumed per day 10,000
Average work-in-progress value of raw materials committed per day 12,500
Average cost of goods sold per day 18,000
Average sales per day 20,000
Calculate the duration of operating cycle.
Solution
Calculation of operating cycle

Period of raw material stage 2,00,000 = 20 days

10,000
Period of work-in-progress stage 3,00,000 = 24 days
12,500
Period of finished goods stage 1,80,000 = 10 days
18,000
Period of Accounts receivable stage 3,00,000 = 15 days
20,000
Period of Accounts payable stage 1,80,000 = 18 days
10,000

Duration of operating cycle = (20 + 24 + 10 + 15) – 18 =51 days

ASSESSMENT OF WORKING CAPITAL

Requirement of working capital over the operating cycle period could be guessed for short-term, medium term
as well as long-term. For short term, working capital is required to support a given level of turnover to pay for the
goods and services before the cash is received from sales to customers. Effort is made that there remains no
idle cash and no shortage of money to erase liquidity within the company’s working process. For this purpose
sales budget could be linked to the expected operating cycle to know working capital requirement for any given
period of time or for each month. Medium term working capital include profit and depreciation provisions. These
funds are retained in business and reduced by expenditure on capital replacements and dividend and tax payment.
By preparing budget the minimum amount required for medium term working capital can be estimated. The
company can work out its working capital needs for different periods through cash budget which is key part of
218 EP-F&SM

working capital planning. To prepare such a budget operating cycle parameters are of great use as estimation of
future sales level, time and amount of funds flowing into business, future expenditure and costs all can be made
with least difficulty to help the main target.
Then, operating cycle help in assessing the needs of working capital accurately by determining the relationship
between debtors and sales, creditors and sales and inventory and sales. Even requirement of extra working
capital can be guessed from such estimate.

WORKING CAPITAL REQUIREMENT ASSESSMENT

Working capital requirement assessment requires :
1. Calculation of average value of Raw Material Inventory, Work in Progress inventory and Finished Goods
inventory
2. Calculation of Trade receivables
3. Calculation of Cash and Cash Convertibles required for normal running of business,
4. Calculation of trade payables.
The formula which is used for assessing the working capital requirement is listed below:
A. Current Assets `
Value of Raw Material Stock XXXX
Value of Work in Progress XXXX
Value of Finished Goods Stock XXXX
Value of Trade Receivables XXXX
Value of Cash Required XXXX
Total of A XXXXX
B. Current Liabilities
Value of Trade Payable XXXX
Value of Bank Overdraft XXXX
Value of Outstanding expenses XXXX
Total of B XXXXX
Working Capital Total of (A)-Total of (B) XXXX

NEGATIVE WORKING CAPITAL

Generally, negative working capital is a sign that the company may be facing bankruptcy or a serious financial
trouble. Under the best circumstances, poor working capital leads to financial pressure on a company, increased
borrowing, and late payments to creditor - all of which result in a lower credit rating. A lower credit rating means
banks charge a higher interest rate, which can cost a corporation a lot of money over time.
In general, companies that have a lot of working capital will be more successful since they can expand and
improve their operations. Companies with negative working capital may lack the funds necessary for growth.
However, some companies can sell their inventory and generate cash so quickly that they actually have a
negative working capital. This is generally true of companies in the restaurant business (McDonald’s had a
negative working capital of $698.5 million between 1999 and 2000). Amazon.com is another example. This
happens because customers pay upfront and so rapidly that the business has no problems raising cash. In
these companies, products are delivered and sold to the customer before the company even pays for them.
 Lesson 7 Working Captial 219

In order to understand how a company can have a negative working capital, let us take an example of Wal-Mart.
Suppose Wal-Mart orders 500,000 copies of a DVD to Warner Brothers and they were supposed to pay within
30 days. What if by the sixth or seventh day, Wal-Mart had already put the DVDs on the shelves of its stores
across the country? By the twentieth day, they may have sold all of the DVDs. Here, Wal-Mart received the
DVDs, shipped them to its stores, and sold them to the customer (making a profit in the process), all before they
had paid Warner Brothers! If Wal-Mart can continue to do this with all of its suppliers, it doesn’t really need to
have enough cash on hand to pay all of its accounts payable. As long as the transactions are timed right, they
can pay each bill as it comes due, maximizing their efficiency.
The bottom line is that a negative working capital can also be a sign of managerial efficiency in a business with
low inventory and accounts receivable (which means they operate on an almost strictly cash basis).
Example No. 4
From the following information, you are required to estimate the net working capital:
Cost per unit (`)
Raw Material 200
Direct Labour 100
Overheads (excluding depreciation) 250
Total Cost 550
Estimated data for the forthcoming period is given as under:
Raw material in stock average 6 weeks
Work-in-progress (assume 50% completion
stage with full material consumption) average 2 weeks
Finished goods in stock average 4 weeks
Credit allowed by suppliers average 4 weeks
Credit allowed to debtors average 6 weeks
Cash at bank is expected to be ` 75,000
Selling price ` 800 per unit
Output 52,000 units per annum
Assume that production is sustained at an even pace during the 52 weeks of the year. All sales are on credit
basis. State any other assumptions that you might have made while computing.
Solution
Computation of Net working Capital
Nature of Asset/Liabilities Basis of Calculation Amount
(`)
A. Current Assets
(i) Raw material stock Average 6 weeks

52,000 ´ 200 ´ 6
12,00,000
52
(ii) Work-in-progress Average 2 weeks
220 EP-F&SM

52,000 ´ 200 ´ 2
(a) Raw Material 4,00,000
52
(b) Direct labour and overhead
52,000 ´ 175 ´ 2
(50% completion stage) 3,50,000
52
(iii) Finished goods stock Average 4 weeks

52,000 ´ 550 ´ 4
22,00,000
52
(iv) Debtors Average 6 weeks

52,000 ´ 800 ´ 6
48,00,000
52
(v) Cash at bank 75,000
Total of A 90,25,000
B. Current Liabilities
(i) Creditors Average 4 weeks

52,000 ´ 200 ´ 4
8,00,000
52
C. Net Working Capital (A-B) 82,25,000
Note: (i) It has been assumed that the material has been introduced at the commencement of the process.
(ii) Lag in payment of overheads is nil.
(iii) There is no depreciation charge.
(iv) Debtors are calculated at selling price.
Example No. 5
Astle Garments Ltd. is a famous manufacturer and exporter of garments to the European countries. The Finance
manager of the company is preparing its working capital forecast for the next year. After carefully screening all the
documents, following information is collected:
Production during the previous year was 15,00,000 units. The same level of activity is intended to be maintained
during the current year. The expected ratios of cost to selling price are:
Raw material 40%
Direct wages 20%
Overheads 20%
The raw materials ordinarily remain in stores for 3 months before production. Every units of production remains in
the process for 2 months and is assumed to be consisting of 100% raw material, wages and overheads. Finished
goods remain in the warehouse for 3 months. Credit allowed by the creditors is 4 months from the date of the
delivery of raw material and credit given to debtors is 3 months from the date of dispatch.
Estimated balance of cash to be held ` 2,00,000
Lag in payment of overhead expenses ½ month
Lag in payment of direct wages expenses ½ month
Selling price is ` 10 per units. Both production and sales are in regular cycle. You are required to make provision of
10% for contingency (except cash). Relevant assumption may be made.
As the Finance Manager of the Company you are required to prepare the forecast statement of estimated working
capital required.
 Lesson 7 Working Captial 221

Solution
Calculation of Profit Margin
Particulars % ` (per unit)
Raw material 40 4
Direct wages 20 2
Overheads 20 2
Total cost 80 8
Add: Profit 20 2
Selling price 100 10
Estimation of Working Capital (`)
Current Assets
Raw materials stock (15,00,000 units × ` 4 × 3/12) 15,00,000
Work-in-progress (15,00,000 units × ` 8 × 2/12) 20,00,000
Finished goods stock (15,00,000 units × ` 8 × 3/12) 30,00,000
Debtors (15,00,000 units × ` 10 × 3/12) 37,50,000
(a) 1,02,50,000
Current Liabilities
Creditors for raw material (15,00,000 units × ` 4 × 4/12) 20,00,000
Wages outstanding (15,00,000 units × ` 2 × 0.5/12) 1,25,000
Outstanding expenses (15,00,000 units × ` 2 × 0.5/12) 1,25,000
(b) 22,50,000
Current assets less (a) – (b) 80,00,000
current liabilities
Add: Contingency (10% of ` 80,00,000) 8,00,000
Add: desired cash balance 2,00,000
Estimated Working capital 90,00,000

Quantitative Techniques for Forecasting Working Capital Needs

A company very often faces fluctuations in business operations which affect the levels of current assets and
liabilities due to cyclical and seasonal fluctuations. Estimation of future needs of working capital becomes difficult
in such situations. But the data collected for past working may establish a trend relationship between the sales
per month or per week and the level of working capital. Linear regression model is used to judge the relationship
of two variables for estimating the working capital needs for the given amount of working capital needs. The
most widely used regression technique employs the method of least squares:
The linear equation technique solve the equation problem as under:
y = a + b (x)
When x = the independent variable i.e. sales
y = the dependent variable i.e. working capital level
a = intercept of the least square line with the vertical axis
222 EP-F&SM

b = the slope of the line. With the help of such model, linear equation could be solved.
Working capital = a + b (prior months sales).
Linear regression can be used in assisting the analyst in making estimates but it must be used with care. A straight
line can be fitted to any data, some additional statistical technique would be needed to see how well the regression
line actually describes the relationship between four variables. In those events where the relationship is not linear,
more sophisticated analytical tools would be needed to express it accurately. The degree of accuracy will depend
upon the skill and expertise of the analyst in using the information and making forecasting.
To forecast the working capital requirement for the next period, the following may also be used:

O. C.
C+ ´C
C.O.G.S
Number of working days in the period

Where, C = Cash balance required

O.C. = Operating cycle
C.O.G.S. = Estimated cost of goods sold.

Financing of Working Capital

Sources of financing of working capital differ as per the classification of working capital into permanent working
capital and variable working capital.
1. Sources of permanent working capital are the following:
(a) Owner’s funds are the main source. Sale of equity stock or preference stock could provide a permanent
working capital to the business with no burden of repayment particularly during short period. These
funds can be retained in the business permanently. Permanent working capital provides more strength
to the business.
(b) Another source of permanent working capital is bond financing but it has a fixed maturity period and
ultimately repayment has to be made. For repayment of this source, company provides sinking funds for
retirement of bonds issued for permanent working capital.
(c) Term loan from banks or financial institutions has the same characteristics as the bond financing of
permanent working capital.
(d) Short-term borrowing is also a source of working capital finance on permanent basis.
2. Source of variable working capital
Working capital required for limited period of time may be secured from temporary sources as discussed below:
(a) Trade Creditors: Trade credit provide a quite effective source of financing variable working capital for
the period falling between the point goods are purchased and the point when payment is made. The
longer this period, the more advantageous it becomes for the firm to avoid efforts of seeking finance for
holding inventories or receivables.
(b) Bank loan: Bank loan is used for variable or temporary working capital. Such loans run from 30 days to
several months with renewals being very common. These loans are granted by bank on the goodwill
and credit worthiness of the borrower, and collateral may include goods, accounts/notes receivable or
Government obligations or other marketable securities, commodities and equipments.
(c) Commercial Paper: It can be defined as a short term money market instrument, issued in the form of
promissory notes for a fixed maturity. It will be totally unsecured and will have a maturity period ranging
from 90 days to 180 days. It will meet the short term finance requirements of the companies and will be
good short term investment for parking temporary surpluses by corporate bodies.
(d) Depreciation as a source of working capital: Increase in working capital results form the difference in
the amount of depreciation allowance deducted from earnings and new investment made in fixed assets.
 Lesson 7 Working Captial 223

Usually, the entire amount deducted towards depreciation on fixed assets is not invested in the acquisition
of fixed assets and is saved and utilised in business as working capital. This is also a temporary source
of working capital so long as the acquisition of fixed asset is deferred.
(e) Tax liabilities: Deferred payment of taxes is also a source of working capital. Taxes are not paid from
day-to-day, but estimated liability for taxes is indicated in Balance Sheet. Besides, business organisations
collect taxes by way of income tax payable on salaries of staff deducted at source, old age retirement
benefits, excise taxes, sales taxes, etc. and retain them for some period in business to be used as
working capital.
(f) Other miscellaneous sources are Dealer Deposits, Customer advances etc.

WORKING CAPITAL – A POLICY DECISION

In formulating a Firm’s Working Capital Policy, an important consideration is the trade-off between profitability
and risk. In other words, the level of a firm’s Net Working Capital (Current Assets – Current Liabilities) has a
bearing on its profitability as well as risk. The term profitability here means profits after expenses. The term risk
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 risk of becoming technically insolvent is measured using net working capital. It is assumed that the greater
the amount of Net Working Capital, the less risky the firm is, and vice-versa. The relationship between liquidity,
Net Working Capital and risk is such that if either net working capital or liquidity increases, the firm’s risk decreases.
What proportion of current assets should be financed by current liabilities and how much by long term sources
will depend, apart from liquidity – profitability trade off, on the risk perception of the management. Two broad
policy alternatives, in this respect, are:
(a) A conservative current Asset financing policy: It relies less on short term bank financing and more
on long term sources.
No doubt it reduces the risk that the firm will be unable to repay its short term debt periodically, but
enhances the cost of financing.
(b) An aggressive current Asset Financing Policy: It relies heavily on short term bank finance and seeks
to reduce dependence on long term financing. It exposes the firm to a higher degree of risk, but reduces
the average cost of financing thereby resulting in higher profits.
The relationship between current assets and sales under different current asset policies is shown in the following
figure:

Y
ive
ss

e
e

at

ive
gr

er

Sales t
Ag

va
od

er
M

s
Con

O X

Investment in Current Assets or Working Capital

224 EP-F&SM

To explain, an aggressive current asset policy aims at minimising the investment in current assets corresponding
to increase in sales thereby exposing the firm to greater risk but at the result of higher expected profitability. On the
other hand conservative policy aims at reducing the risk by having higher investment in current assets and thereby
depressing the expected profitability. In between these two, lies a moderate current asset policy.

Working Capital Leverage

Working capital leverage may refer to the way in which a company’s profitability is affected in part by its working
capital management. Profitability of a business enterprise is affected when working capital is varied relative to
sales but not in the same proportion. If the flow of funds created by the movements of working capital through
the various business processes is interrupted, the turnover of working capital is decreased as is the rate of
return on investment. Working capital management should enhance the productivity of the current assets deployed
in business. This correlates the working capital with Return-on-Investment (ROI). ROI is product of two factors
– assets turnover and profits margin. If either of these ratios can be increased, ROI will be increased to a great
degree. DU Pont Chart illustrates this position as under:

If profit margins is 6% and Asset By increasing profit margin By increasing assets turnover

Turnover is 3 times then ROI would by 1%, ROI increases by 3% by 1, ROI increases by 6%, i.e.

be 18% i.e. 6 + 1 = 7 x 3 = 21% 6% x 4 = 24%

Assets turnover side of ROI computation may also reflect the working capital management.

Current assets reflect the funds position of a company and is known as Gross Working Capital. Working
Capital leverage is nothing but current assets leverage which refers to the asset turnover aspect of ROI.
This reflects company’s degree of efficiency in employing current assets. In other words, the ability of
the company to guarantee large volume of sales with small current asset base is a measure of company’s
operating efficiency. This phenomenon is asset turnover which is a real tool in the hands of finance manager in a
company to monitor the employment of fund on a cumulative basis to result into high degree of working capital
leverage.

Short-term loans or cash credit raised by the company to meet the requirements of working capital i.e. to finance
the current assets, add to the profitability of the company’s turnover of current assets in comparison to the cost
associated in terms of interest charges on such loans. This is the exact measure of working capital leverage.
However, the concept of working capital leverage has not been much in use in academic discussions and its real
importance is also to be understood by the business enterprises. To maximise profits, finance managers unanimously
view the investment in current assets be kept to the minimum and should be financed from the funds such as
current liabilities or low cost funds.

Ways to Improve Working Capital Position

Working capital is a highly effective barometer of a company’s operational and financial efficiency and effectiveness.
The better its condition, the better positioned a company is to focus on developing its core business. By addressing
the drivers of working capital, in fact, a company is sure to reap significant operating cost and customer service
improvement.
Liberating the billions in cash trapped on the balance sheet is easier than one may think. Dell Inc., for instance
lauded for overall strong corporate management and working capital performance builds a computer only when
it has received payment for an order, and doesn’t pay its own suppliers for an agreed-upon period of time
thereafter. As a result, Dell enjoys negative working capital and, the more it grows, the more its suppliers
finance its growth.
 Lesson 7 Working Captial 225

Not all companies can operate like Dell, but most can improve their working capital position by at least 20 percent
over time if they pay attention to the following list of cash management do’s and don’ts:
(1) Get educated. There is more to working capital management than simply forcing debtors to pay as quickly as
possible, delay paying suppliers as long as possible and keep stock levels as lean as possible. A properly conceived
and executed improvement program will certainly focus on optimizing each of these components, but also, it will
deliver additional benefits that extend far beyond operational rewards. All this underscores the need for ambitious
executives to integrate working capital management into their strategic and tactical thinking, rather than view it as
an extraneous added bonus.
(2) Institute dispute management protocols. Consider a case where a company’s working capital is deteriorating
due to an increase in past-due accounts receivable (A/R). A review of the past-due A/R illustrates a high level of
customer disputes, which are taking on average of 30 days to resolve and consuming significant amounts of
sales, order-entry and cash collectors’ time.
By tackling the root cause of the disputes in this case, poor adherence to pricing policies, the company can
eliminate the disputes, thereby improving customer service. Established dispute-management protocols
free up time for sales, order-entry and cash collections’ personnel to be more effective at their designated
roles, and they also will increase productivity, reduce operating costs and potentially boost sales. And finally,
days payable outstanding (DPO) and working capital will improve, as customers won’t have reason to hold
payment.
This example illustrates how working capital is one of the best indicators of underlying inefficiency within an
organization and why it is critical that senior executives remain focused on addressing the primary causes of
working capital excesses to control operating costs and remain competitive.
(3) Facilitate collaborative customer management. One of the most important cash management and
working capital strategies that executives CFOs and treasurers, as well as CEOs can employ is to avoid
thinking linearly and concerning themselves solely with their own company’s needs. If it is feasible to collaborate
with customers to help them plan their inventory requirements more efficiently, it may be possible to match
your production to their consumption, efficiently and cost-effectively, and replicate this collaboration with your
suppliers.
The resulting implications for inventory levels can be massive. By aligning ordering, production and distribution
processes, companies can increase inherent efficiency and achieve direct cost savings almost instantly. At this
point, payment terms can be most effectively negotiated.
(4) Educate personnel, customers and suppliers. A business imperative should be to educate staff to consider
the trade-offs between various working capital assets when negotiating with customers and suppliers. Depending
on the usage pattern of a raw material, there may be more to gain from negotiating consignment stock with a
supplier instead of pushing for extended terms - particularly in cases of long lead-time items or those that
require high minimum-order quantities.
The same can hold true for customers. Would vendor-managed inventory at a customer site provide you the
insight into true usage to better plan your own production? It is important to remember, however, that this is not
the solution for all products, and it should be evaluated on a case-by-case basis.
(5) Agree to formal terms with suppliers and customers and document carefully. This step cannot be stressed
enough. Terms must be kept up to date and communicated to employees throughout the organization, especially
to those involved in the customer-to-cash and purchase-to-pay processes; this includes your sales organization.
Avoid prolific new product introductions without first establishing a clear product-range management strategy.
Whether in the consumer products or aluminium extrusions business, many companies rely heavily on new
products to maintain and grow market share. However, poor product-range management creates inefficiency in
the supply chain, as companies must support old products with inventory and manufacturing capability. This
increases operating costs and exposes the company to obsolete inventory.
226 EP-F&SM

(6) Don’t forget to collect your cash. This may sound obvious, but many businesses fail to implement effective
ongoing collection procedures to prevent excess overdue funds or build-up of old debts. Customers should be
asked if invoices have been received and are clear to pay and, if not, to identify the problems preventing timely
payment. Confirm and reconfirm the credit terms. Often, credit terms get lost in the translation of general payment
terms and what’s on the payables ledger in front of the payables clerk.

(7) Steer clear of arbitrary top-down targets. Many companies, for example, impose a 10 percent reduction
in working capital for each division that fails to take into account the realistic reduction opportunities within
each division. This can result in goals that de-motivate employees by establishing impossible targets, creating
severe unintended consequences. Instead, try to balance top-down with bottom-up intelligence when setting
objectives.

(8) Establish targets that foster desired behaviours. Many companies will incentivise collections staff to minimize
A/R over 60 days outstanding when, in fact, they should reward those who collect A/R within the agreed-upon time
period. After all, what would stop someone from delaying collections activities until after 60 days when they can
expect to be rewarded? Likewise, a purchasing manager may be driven by the purchase price and rewarded for
buying when prices are low, but this provides no incentive to manage lot sizes and order frequency to minimize
inventory.

(9) Do not assume all answers can be found externally. Before approaching existing customers and
suppliers to discuss cash management goals, fully understand your own process gaps so you can credibly
discuss poor payment processes. Approximately 75 percent of the issues that impact cash flow are internally
generated.

(10) Treat suppliers as you would like customers to treat you. Far greater cash flow benefits can be realized
by strategically leveraging your relationship with suppliers and customers. A supplier is more likely to support
you in the case of emergency if you have treated them fairly, and, likewise, a customer will be willing to forgive
a mistake if you have a strong working relationship.

That said, also realize that each customer is unique. Utilize segmentation tactics to split your customers and
suppliers into similar groups. For customers, segmentation may be based on criteria including, profitability,
sales, A/R size, past-due debt, average order size and frequency. Once segmentation is complete, it is important
to define strategies for each segment based around the segmentation criteria and your strategic goals.

For example, you should minimize the management cost for low-margin customers by changing service levels,
automating interaction, etc. Finally, allocate your resources according to the segmentation, with the aim of
maximizing value.

Control of Working Capital

The direct approach to working capital control is to develop effective policies for the control of each of the
components of working capital. Since deviations occur in actual operations, indirect control techniques are
needed by management to reduce its working capital requirements. Control of cash, receivables and inventories
be maintained in a synchronized way so that a matching balance in all parameters of working capital could be
obtained.

BANKING NORMS AND MACRO ASPECT OF WORKING CAPITAL MANAGEMENT

Banks normally provide working capital finance to hold an acceptable level of current assets viz. raw materials
and stores, stocks in progress, finished goods and sundry debtors for achieving a pre-determined level of
production and sales. The assessment of funds required to be blocked in each of these items of the working
capital required by an industry is discussed as under:
 Lesson 7 Working Captial 227

1. Raw Material: Raw material, of any kind is necessarily required by an industrial unit to continue the
production process. Different raw material could be procured from different sources may be indigenous or
overseas and accordingly different treatment of procurement time is bound to be given. Mode of payment for
the raw material may also be different. Thus, affecting the credit requirements of the client, the funds blocked
up in procurement and stocking of material will have to be taken into consideration. Total materials including
those in transit and for which advance payment is made can normally be expressed in terms of number of
months consumption and requirements of funds can be assessed by multiplying the figure by the amount of
monthly consumption.

2. Work in Process: The time taken by the raw material to be converted into finished product is the period
of material processing and all the expenses of the process are involved in it. Therefore, the assessment of
funds blocked in the process is made by taking into account the raw material consumption during the
processing period and the expenses incurred during such period i.e. the cost of production for the period of
processing.
3. Finished goods in the next stage: The funds blocked in finished goods inventories are assessed by estimating
the manufacturing cost of product.

4. Sundry Debtors: When goods sold is not realised in cash, sundry debtors are generated. The credit period
followed by a particular industrial unit in practice is generally the result of industry practices. Investment in
accounts receivable remains blocked from the time of sale till the time amount is realised from debtors. The
assessment of funds blocked should be on the basis of cost of production of the materials against which bank
extends working capital credit.

5. Expenses: One month’s total expenses, direct or indirect, are provided by way of cushion in assessing the
requirement of funds which may include rent, salaries, etc. depending upon the length of operating cycle.
6. Trade Credit received on purchases reduces working capital funds requirements and has to be taken into
account for correct assessment of funds.

7. Advances received alongwith purchase orders for the products also reduce the funds requirements for
working capital.

Taking into consideration the above parameters of operating cycle, the working capital for a unit can be assessed
as under:

S.No. Component of Working Capital Basis of Calculation `

1. Raw material Month’s consumption 100
2. Stock in process Week’s (cost of production for period of processing) 100
3. Finished goods Month’s cost of production required to be stocked 100
4. Sundry debtors Month’s cost of production 100
5. Expenses One month’s 100
Total 500

Less: Trade credit on month’s purchases ` 100

Less: Advance payment on Orders received ` 100 200

Working Capital required 300

Banks do not provide the entire amount of ` 300 towards working capital. At every stage bank would insist upon
228 EP-F&SM

the borrower’s stake in the form of margin which depends on various factors like saleable quality of product,
durability, price fluctuations, market conditions and business environment, etc. Thus, the bank at every stage
would allow the margin at the pre-determined rate as noted below:

Permissible Limit (`)

Raw material 100
Less: Margin 10% 10 90
Stock in process 100
Less: Margin 40% 40 60
Finished goods 100
Less: Margin 25% 25 75
Sundry Debtors (at sale value) 100
Less: Margin 10% 10 90
Expenses for one month 100
100% Margin 100 –
Total permissible limit 315
Working capital requirement of the unit 500
Permissible limits (Bank loan) 315
Gap (contribution to be provided by Borrower) 185

Before sanctioning the working capital of ` 315, the bank would ensure that borrower is in a position to bring in
margin money of ` 185 by way of excess current assets over current liabilities based on projected balance
sheet.

DIFFERENT COMMITTEE OF RBI FOR WORKING CAPITAL MANAGEMENT

Commercial banks grant working capital advances by way of cash credit limits and are the major suppliers of
working capital to trade and industry. In the past, the practices in commercial banks as revealed by the findings
of different Study Groups appointed by RBI were as follows:

1. Daheja Study Group

The current limit was related to the security offered by the clients of banks without assessing financial position of
the borrower through cash flow analysis. Short-term advances were not utilised for short-term purposes and
defeated their self liquidating objective. In large number of accounts, no credit balance existed nor was the debit
balance fully wiped out over a period of years because withdrawals were more than deposits.
To control the tendency of over-financing and the diversion of the banks funds, Daheja Study Group (National
Credit Council constituted in 1968 under the Chairmanship of V.T. Daheja) made recommendations for the
banking system to finance industry on the basis of a total study of the borrower’s operations rather than on
security considerations. Further, present as well as future cash credit accounts should be distinguished as
between the ‘hard core’ and the ‘short-term components’. The hard core should represent the minimum level of
raw materials, finished goods and stores which the industry required to hold in order to maintain a given level of
production, and the bank finance should be provided on strong financial basis as term loan and be subjected to
regular repayment schedule whereas short-term component of the account would represent the requirement of
funds for temporary purposes i.e. a short term increase in inventories, tax, dividends and bonus payments, etc.
the borrowing being adjsuted in a short period out of sales.
 Lesson 7 Working Captial 229

2. Tandon Committee
Although the above recommendations were implemented but no improvement was noticed in money drain to strong
industrial groups by banks and RBI appointed another study group under the chairmanship of Shri P.L. Tandon in
July, 1974. Tandon committee made certain recommendations inter alia comprising of recommendations on norms
for inventory and receivables for 15 major industries, new approach to bank lending, style of lending credit, information
system and follow up, supervision and control and norms of capital structure. A brief appraisal of the Tandon
committee recommendations would prove more enlightening as given below:
1. Norms for inventory and receivables recommended by Tandon Committee for 15 major industries, cover
about 50 per cent of industrial advances of banks. These norms were arrived at after examining the trends
reflected in the company finance studies conducted by the Reserve Bank of India and detailed discussion with
representatives and experts of the industries concerned.
2. Bank lending: The Committee introduced the concept of working capital gap. This gap arised due to the non-
coverage of the current assets by the current liabilities other than bank borrowings. A certain portion of this gap
will be filled up by the borrower’s own funds and long-term borrowings. The Committee developed three
alternatives for working out the maximum permissible level of bank borrowings:
1. 75% of the working capital gap will be financed by the bank i.e.
Total Current assets
Less: Current Liabilities other than Bank Borrowings
= Working Capital Gap.
Less: 25% of Working Capital gap from long-term sources.
2. Alternatively, the borrower has to provide for a minimum of 25% of the total current assets out of long-
term funds and the bank will provide the balance. The total current liabilities inclusive of bank borrowings
will not exceed 75% of the current assets:
Total Current Assets
Less: 25% of current assets from long-term sources.
Less: Current liabilities other than Bank borrowings
= Maximum Bank Borrowing permissible.
3. The third alternative is also the same as the second one noted above except that it excludes the permanent
portion of current assets from the total current assets to be financed out of the long-term funds, viz.
Total Current assets
Less: Permanent portion of current assets
Real Current Assets
Less: 25% of Real Current Assets
Less: Current liabilities other than Bank Borrowings
= Maximum Bank Borrowing permissible.
Thus, by following the above measures, the excessive borrowings from banks will be gradually eliminated
and the funds could be put to more productive purposes.
The above methods may be reduced to equation as under:
1st Method : PBC = 75/100 x WCG
2nd Method : PBC = TCA – [(25/100 x TCA) + OCL]
3rd Method : PBC = TCA – [CRA + 25/100 (TCA – CRA) + OCL]
Where,
PBC stands for Permissible Bank Credit
230 EP-F&SM

WCG stands for Working Capital Gap

TCA stands for Total Current Assets
OCL stands for Other Current Liabilities
(i.e. Current Liabilities other than Bank Borrowings)
CRA stands for Amount required to finance Core Assets.
3. Style of credit: A change in the style of lending has also been suggested by the Committee so as to bifurcate
the cash credit into a loan account and demand cash credit instead of treating the entire credit limit as cash
credit for a year. This will make the credit less expensive to borrowers. The demand cash credit will meet the
seasonal requirements of industry and will be wiped out automatically at the end of the business cycle. This will
introduce a better financial discipline in the credit system and will generate better financing system in the banking
economy with numerous advantages.
4. Information system: To monitor better credit information system in the banking industry, the committee
suggested for the borrower to submit quarterly statements in the prescribed format about its operations, current
assets and current liabilities and funds flow statements with monthly stock statements and projected balance
sheets and profit and loss account at the end of financial year.
5. Follow up: The Committee also suggested a close follow up for supervision and control of the use of credit by
the banks and change in attitude of the banks from security-oriented lending to production oriented lendings/
credit.
6. Norms of Capital Structure: For examining the capital structure of the company the norms have also been
suggested by the committee for monitoring a better equity : debt relationship.

3. Chore Committee
Reserve Bank of India accepted the above recommendations of the Tandon Committee but found that the gap
between sanctioned cash credit limit and its utilisation has remained unanswered. In this context, RBI appointed
in April 1979 a working group under the Chairmanship of Mr. K.B. Chore to look into this gap between the
sanctioned limits and their utilisation.
The Chore Committee has, inter alia, recommended as follows:
(1) emphasised need for reducing the dependance of large and medium scale units on bank finance for
working capital;
(2) to supplant the cash credit system by loans and bills wherever possible; and
(3) to follow simplified information system but with penalties when such information is not forthcoming
within the specified limit.
Chore Committee also suggested that the banks should adopt henceforth Method II of the lending recommended
by the Tandon Committee so as to enhance the borrowers’ contribution towards working capital. The observance
of these guidelines will ensure a minimum current ratio of 1.33 : 1. Where the borrowers are not in a position to
comply with this, excess borrowings on account of adoption of Method II should be segregated and converted
into a working capital term loan (WCTL). This loan should be made repayable in half-yearly instalments over a
period not exceeding five years. WCTL may carry a rate of interest higher than the rate applicable on the relative
cash credit limit, not exceeding the ceiling with a view to encouraging an early liquidation of WCTL.
It was also suggested that banks should fix separate limits where feasible for peak level and non-peak level
requirements with periods where there is a pronounced seasonal trend. This will not apply to agro-based industries
but also to certain consumer industries like fans, refrigerators, etc. The borrower should be discouraged from
approaching banks frequently for ad hoc limits in excess of the sanctioned limits excepting those special
circumstances when such requests be considered for short duration with 1 per cent additional interest over
 Lesson 7 Working Captial 231

normal rate which could be waived in general cases on merits. Sick units may be allowed general exemptions
from the above requirements. The Committee also favoured encouragement be given to bill finance i.e. bill acceptance
and bill discounting practices involving banks, buyers and sellers. The Committee suggested some modifications
and improvements in the system earlier recommended by the Tandon Committee. The modified system includes
that banks should submit half-yearly statements to RBI above credit limits of borrowers with aggregate working
capital of ` 50 lakhs and above from the banking system.

4. Marathe Committee
In 1982, it was felt that an independent review of the Credit Authorisation Scheme (CAS) which had been in
operation for several years would be useful and accordingly the Reserve Bank of India appointed a Committee
referred as “Marathe Committee” in November 1982 to review the working of the Credit Authorisation Scheme.
The Committee submitted its report in July 1983.
The Marathe Committee which was given terms of reference to examine the Credit Authorisation Scheme from
the point of view of its operational aspects stressed that the ‘CAS is not to be looked upon as a mere regulatory
measure which is confined to large borrowers. The basic purpose of CAS is to ensure orderly credit management
and improve quality of bank lending so that all borrowings, whether large or small, are in conformity with the
policies and priorities laid down by the Central Banking Authority. If the CAS scrutiny has to be limited to a
certain segment of borrowers, it is because of administrative limitations or convenience, and it should not imply
that there are to be different criteria for lending to the borrowers above the cut off point as compared to those
who do not come within the purview of the scheme.

5. Chakraborty Committee
The Reserve Bank of India constituted a committee under the chairmanship of Sukhomoy Chakraborty to review
the working of monetary system in India. The committee examined the matter in details and submitted its report
in April, 1985 with wide ranging suggestions for its improvement. The committee made two major recommendations
which were as under –
i) The observation of the committee was that the delay in making payment by public sector units, some big
private sector units and Government, departments continues unabated. The suggestion of committee in
this regard was that the Government, should take initiative to include a penal interest payment clause in
purchase contracts with suppliers for delayed payments beyond a pre-specified period.
ii) The credit limits to be sanctioned to a borrower should be segregated under three different heads -
Cash credit-I - to cover the supplies to Govt. Cash credit II - to cover special circumstances and
contingencies Normal working capital limit - to cover the balance of the credit facilities.

6. Kannan Committee
With a view to free the banks from rigidities of the Tandon Committee recommendations in the area of Working
Capital Finance and considering the ongoing liberalizations in the financial sector, IBA constituted, following a
meeting of the Chief Executives of Selected public sector banks with the Deputy Governor of Reserve Bank of
India on 31.8.96, a committee on ‘Working Capital Finance’ including Assessment of Maximum Permissible
Bank Finance (MPBF), headed by Mr. K. Kannan, the then Chairman and Managing Director of the Bank of
Baroda.
The Committee examined all the aspects of working capital finance and gave far reaching recommendations on
the modalities of assessment of working capital finance in its report, submitted to IBA on February 25, 1997. It
observed that since commercial banks in India were undergoing a metamorphosis of deregulations and
liberalizations, it was imperative that micro-level credit administration should be handled by each bank individually
with their own risks-perceptions, risks-analysis and risks-forecastings. The final report of the Committee was
submitted to RBI for its consideration in March, 1997. In its final report, the Kannan Committee also pointed that
232 EP-F&SM

alongwith modification of existing systems of working capital assessment and credit monitoring, certain
undermentioned areas also need to be addressed:
(1) Regular interface with the borrower to have a better understanding of (i) his business/activity; and, (ii)
problems/constraints faced by him and the future action plan envisaged;
(2) Periodical obtaining of affidavits from the borrowers, declaring highlights of their assets, liabilities and
operating performance (in lieu of subjecting even the high rated/high valued borrowers to several routine
inspections/ verifications) in order to bestow faith-oriented, rather than ab initio doubt-oriented, approach
in monitoring the credit dispensation.
(3) Periodical exchange of information between/among financing banks/financial institutions to pick-up the
alarm signals at the earliest.
(4) Establishing, within, a time bound programme, a “Credit Information Bureau” to provide updated
information of existing/new borrowers before taking a credit decision. (Modality of Information Bureau in
advanced countries may be taken as a guide for floating an appropriate Credit Information Bureau).
Accordingly, the Kannan Committee recommended that the arithmetical rigidities, imposed by Tandon Committee
(and reinforced by Chore Committee) in the form of MPBF-computation, having so far been in vogue, should be
given a go-by. The committee also recommended for freedoms to each bank in regard to evolving their own
system of working capital finance for a faster credit delivery in order to serve more effectively various segments
of borrowers in the Indian economy.
Concurring with recommendations of the Kannan Committee, Reserve Bank of India (vide circular No. IECD No.
23/08.12.01/96 dated 15.04.1997) advised to all the banks, inter-alia, as under:
It has now been decided that the Reserve Bank of India shall withdraw forthwith the prescription in regard to
assessment o working capital needs based on the concept of maximum permissible bank finance (MPBF)
enunciated by Tandon Working Group. Accordingly, an appropriate system may be evolved by banks for assessing
the working capital needs of borrowers within the prudential guidelines and exposure norms already prescribed.
The turnover method, as already prevalent for small borrowers, may continue to be used as a tool of assessment
for this segment; since major corporates have adopted cash budgeting as a tool of funds management, banks
may follow cash budget system for assessing the working capital finance in respect of large borrowers; there
should also be no objection to the individual banks retaining the concept of the present maximum permissible
bank finance, with necessary modifications or any system.”
Reserve Bank of India further directed that Working capital credit may henceforth be determined by banks
according to their perception of the borrower and the credit needs. Banks should lay down, through their boards
a transparent policy and guidelines for credit dispensation in respect of each broad category of economic activity.

OTHER ISSUES INVOLVED IN THE MANAGEMENT OF WORKING CAPITAL

Apart from the discussion of the nature of various components of working capital, we need to consider various
other aspects of this intricate system of financial management. These aspects undertake a finer and more
microscopic analysis of the components in order to strengthen control over the current assets on one hand and
to improve the productivity of working capital on the other. Some of the relevant issues are described as under:

(A) The Concept of Negative Working Capital

Net working capital is the term used to denote the difference of current assets and current liabilities. Traditionally
it has been assumed that the current assets of a firm should be more than adequate to meet the current liabilities.
In other words, the current ratio, i.e. the ratio of current assets to current liabilities should be more than one. The
rationale behind this assumption is that the firm should at all times be in a position to maintain liquidity. By
 Lesson 7 Working Captial 233

definition, current assets are treated as those assets which are capable of quick conversion into cash and secondly,
the time period for conversion into cash is usually small but not more than one year in any case. Carrying the
argument further, one can postulate that the older the current asset gets, the lesser are its chances of easy
conversion into cash. So, in order to maintain the quality of its current assets, the firm seeks to reduce their holding
period. Simultaneously, the firm tries to prolong the time period available for payment of its current liabilities by
building up the level of inventory through trade finance and using bank borrowing against inventory and debtors. The
result of this exercise is that the net working capital of the firm turns negative and its current ratio becomes less
than one.
On the face of, it the concept of negative net working capital appears to be thought with unfavorable consequences
for the firm. In such a situation, if the firm is required to meet its current obligations all at once, it might not have
adequate liquidity available and as a result, it could default on its obligations. This could happen in a situation
where the cash has moved out of the operating cycle to long term uses like creation of fixed assets or towards
non-productive investments in other firms. But if the firm has, as part of its conscious working capital management
policy, kept the level of current assets to the minimum and deployed the surplus cash in non-working capital, yet
liquid investments, then it can afford to function with a net working capital that is negative.
Hence so long as a firm does not default on payment of its current liabilities, the fact that it has a negative net
working capital need not be a cause for concern. This may not always be true as most of the organisatons may
like to see current assets more than current liabilities. Example of such organisations could be banks who
provide short-term credit or suppliers of raw material who sell on credit to firms.

(B) The Myth of Adequate Current Assets

Aligned to the first issue is the myth of adequate current asset. Traditionally, it has been believed that liquidity is
proportional to the level of current assets. A firm having a high current ratio is treated as favorably placed as
regards payment of its current liabilities. This is myth since the holding of current assets is always in proportion
to the turnover. If level of current assets is rising disproportionately to the turnover, then notwithstanding the high
current ratio, the situation has the following implications:
– The age of current assets is increasing which tells upon their quality. As the current assets, particularly
inventory and receivables, get older the chances of their easy and complete conversion into cash recede.
Once this happens, there is every possibility of the operating cycle cracking.
– The firm is paying a huge cost for the higher build up of current assets. This cost consists of
(a) The amount spent towards raw materials and intermediate inputs
(b) The cost incurred towards storing and maintaining the inventory.
(c) The interest cost for obtaining finance against these current assets
(d) The cost of obsolescence associated with holding inventory for longer periods and
(e) The cost of expected default on receivables as reflected in charge to profit and loss account towards
bad debts.

(C) Does the balance sheet give a true picture of current assets?
We have restricted the discussion of current assets to the position obtained as on a particular date. This position
may not be representative of the state of affairs prevailing on a day to day basis throughout the year. In order to
even out the effects of daily variation in the level of current assets, it is advisable to take average of weekly,
monthly or quarterly holding depending upon the nature of the industry and turnover of the assets. The position
at the end of a day is a static position which is not representative of the entire year. By taking period averages
some amount of dynamism is brought into the picture.
234 EP-F&SM

The second point to be noted is that an industry might have seasonal peaks or troughs of working capital requirement.
For example agro based industry like fruit processing unit would need to stock more raw material during the peak
season when the crop has been harvested than during the lean season. In such cases different norms have to be
applied for peak season and non peak season for holding of current assets for judging the reasonability of their
holding.
We find, therefore that the high level of current assets is nothing but a fiction when we seek to realize the current
assets. It may happen that the inventory carried by the firm may consist of obsolete items, packing materials,
finished goods which have been rejected by buyers and items like dies and tools which are more fixed than current
in character. Prudence would advise that the firm should get rid of these current assets as early as possible.
On the other hand, the current liabilities are more ascertainable and less fictions. The payment of these liabilities,
if not possible from the operating cycle, has to be arranged from long term sources of funds which results in a
mismatch that is not conducive to financial health of the firm.

(D) The various forms of cash holding

Cash is considered to be the most liquid of current assets. It is held either as cash balances with the firms or in
bank accounts. There are two ways of holding bank balances – first as current accounts through which the day
to day transactions of the firm are carried out and secondly as fixed deposits in which balances are held for a
specified twice period. Current account balances are most liquid. Fixed account balances are convertible into
cash by adjustment downwards of the rate of interest even before maturity. Hence even fixed deposit balances
should be treated at par as regards liquidity. But there is a catch here. Quite a few fixed deposits are not held
perse, but as margin money deposits for availing the facilities like letters of credit and guarantee from banks. To
the extent of such margin money deposits, the liquidity of bank balances of the firm is impaired.
Cash balances are also held as un availed portion of the working capital facilities granted by the banks. All such
balances earn money for the firm in terms of the interest that is saved on unavailed portion. Yet the money
remains available to the firm almost on call. Such balances are most suitable to a firm for enhancement of
liquidity provided the firm has the policy of availing bank finance for its working capital requirements.
These firms maintain just enough balance in their current accounts and transfer the surplus immediately to the
borrower accounts for saving interest thereon. In most such cases, even the routine transactions are carried out
through the borrowal accounts, thus precluding the need for maintaining current accounts even.
Example No.6
MNO Ltd. has furnished the following cost data relating to the year ending of 31st March, 2017.
` (in Lakhs)
Sales 450
Material consumed 150
Direct wages 30
Factory overheads (100% variable) 60
Office and Administrative overheads (100% variable) 60
Selling overheads 50
The company wants to make a forecast of working capital needed for the next year and anticipates that:
– Sales will go up by 100%,
– Selling expenses will be ` 150 lakhs,
 Lesson 7 Working Captial 235

– Stock holdings for the next year will be-Raw material for two and half months, Work-in-progress for one
month, Finished goods for half month and Book debts for one and half months,
– Lags in payment will be of 3 months for creditors, 1 month for wages and half month for Factory, Office
and Administrative and Selling overheads.
You are required to:
(i) Prepare statement showing working capital requirements for next year, and
(ii) Calculate maximum permissible bank finance as per Tandon Committee guidelines assuming that core
current assets of the firm are estimated to be ` 30 lakhs.
Solution
Working:
Statement showing the projected Cost and Profitability
for the year ending on 31-3-2018
Year ending Increase/ Forecast for Per month
31/3/2017 Decrease the next Year
(` in lakhs) ending 31/3/2018
(` in lakhs)
Sales: 450 +100% 900 75
Direct Materials Consumed 150 +100% 300 25
Direct Wages 30 +100% 60 5
Prime Cost 180 360 30
+ Factory overheads 60 +100% 120 10
Works cost 240 480 40
+ Office & Administrative overheads 60 +100% 120 10
Cost of Production 300 600 50
+ Selling overheads 50 Increase 150 12.50
Total Cost 350 750 62.50
Profit 100 150 12.50

(i) Statement showing Working Capital Requirements of MNO Ltd. for the year 31-3-2018
Amount (` in lakhs)
(A) Current Assets
Raw Material (25 x 2.5 month) 62.50
Work-in-Progress
Raw Material (25 x 1 month) 25.00
Direct Wages (5 x 1 month) 5.00
Factory Overheads (10 x 1 month) 10.00
Finished goods (600 x 0.5/ 12) 25.00
Debtors (900 x 1.5/12) 112.50
Total (A) 240.00
(B) Current Liabilities - Lags in payment:
(i) Creditors (300 x 3/12) 75.00
(ii) Wages (60 x 1/12) 5.00
(iii) Factory overheads (120 x 0.5/12) 5.00
236 EP-F&SM

(iv) Office & Administrative overheads (120 x 0.5/12) 5.00

(v) Selling overhead (150 x 0.5/12) 6.25
Total (B) 96.25
Networking capital (A-B) 143.75
Note: In the above answer while computing Work-in-Progress the degree of completion in respect of Labour and
Overheads components have been assumed at 100%, which can be assumed otherwise also.
(ii) Maximum permissible Bank Finance (MPBF):
First Method ` in lakhs
Total current assets 240
(-) Current Liabilities 96.25
Working Capital gap 143.75
(-) 25% from long term sources (approx.) 35.94
MPBF 107.81
Second Method
Total current assets 240
(-) 25%from long term sources 60
180
(-) Current Liabilities 96.25
MPBF 83.75
Third Method
Total current assets 240
(-) Core Current Assets 30
210
(-) 25% from long term sources 52.5
157.5
(-) Current Liabilities 96.25

MPBF 61.25

CASH MANAGEMENT
By cash management, we mean the management of cash in currency form, bank balances and readily marketable
securities. Cash is the most important component of working capital of a firm. It is also the terminal conversion
point for other constituents. Each firm holds cash to some extent at any point of time. Source of this cash may be
the working capital operating cycle or capital inflows. Similarly the outflow of cash from the cash reservoir of a
firm can be either to the operating cycle or for capital repayment.

Motives for holding cash

At the basic level, a firm like individuals, has three motives for holding cash. These are as under:

(a) Transactional motive

(b) Speculative motive

(c) Contingency motive

 Lesson 7 Working Captial 237

(a) Transactional Motive

This is the most essential motive for holding cash because cash is the medium through which all the transactions
of the firm are carried out. Some examples of transactions of a manufacturing firm are given below:

– Purchase of Capital Goods like plant and machinery

– Purchase of raw material and components

– Payment of rent and wages

– Payment for utilities like water, power and telephone

– Payment for service like freight and courier

These transactions are paid for from the cash pool or cash reservoir which is all the time being supplemented by
inflows. These inflows are of the following kinds:

– Capital inflows from promoters’ capital and borrowed funds

– Sales proceeds of finished goods

– Capital gains from investments

The size of the cash pool depends upon the overall operations of the firm. Ideally, for transaction purposes, the
working capital inflows should be more than the working capital outflows at any point of time. The non-working
capital inflows should be utilized for similar outflows such as purchase of fixed assets together with the surplus
of working capital inflows.

(b) Speculative Motive

Since cash is the most liquid current asset, it has the maximum potential of value addition to a firm’s business.
The value addition can come in two forms. First, as the originating and terminal point of the operating cycle, cash
is invaluable. But cash has an opportunity cost also and if cash is kept idle, it becomes a liability rather than an
asset. Therefore, efficient firms seek to deploy surplus cash in short term investments to get better returns. It is
here that the second form of value addition from cash can be had. Since this deployment of cash needs to be
done skillfully, not all the firms hold cash for speculative motive. Further, the amount of cash held for speculative
motive should not cause any strain upon the operating cycle.

(c) Contingency Motive

This motive of holding cash takes into account the element of uncertainty associated with any form of business.
The uncertainty can result in prolongation of the working capital operating cycle or even its disruption. It is
possible that cost of raw materials or components might go up or the time taken for conversion of raw materials
into finished goods might increase. For such contingencies, some amount of cash is kept by every firm.

Level of cash holding

The level of cash holding of a firm depends upon a number of factors. Prominent among these factors are the
nature of the firms’ business, the extent and reach of the business. The level of cash is measured as a percentage
of turnover of the firm.

1. Nature of the business

If the firm is engaged in cash purchase of raw material from a number of sources, its requirement of cash would
be more than that a firm which buys on credit. Also a firm having cash purchase and cash sale would need to
maintain more cash balance than a firm which buys on credit and sells on credit. A firm buying in cash and
238 EP-F&SM

selling on credit is likely to have strained cash flows. On the other hand, a firm buying on credit and selling in cash
has comfortable cash balances.

2. Extent and reach of the business

A multi location firm having a number of large and small branches has more cash requirement than a single
location firm. Also the problems associated with moving cash between the branches and maintaining liquidity
are much more in a multi location firm.

For illustration, let us assume the amount of cash and bank balances maintained by the firm:

(` in crores)
Firm A Firm B Firm C
2016 2017 2016 2017 2016 2017
Income 3,031.76 3,322.44 10,948.86 11,353.68 1,381.91 1,882.61
Cash and Bank Balances 27.95 27.49 522.08 913.16 315.21 1,089.34
Cash balance as Percentage 0.92 .082 4.77 8.04 22.81 57.86
of Income

Firm A is a large cement manufacturer, Firm B is a FMCG giant and Firm C is a leading software company. Out
of the above three Firms, Firm A has been holding the minimum quantum of cash and bank balances as percentage
of total income while Firm C has the maximum quantum. On the face of it, the first impression that one is likely
to get is that Firm A is the most efficient user of cash and bank balances while Firm C is the most inefficient user.
But that would be a hasty conclusion. We have to move further and probe into the status of cash and bank
balances vis-à-vis other current assets:
Current Assetsincl. Loans Firm A Firm B Firm C
and Advances 2016 2017 2016 2017 2016 2017
Inventories 312.60 30.12 1182.10 1240.03 0 0
Sundry Debtors 247.63 216.50 264.51 424.78 375.22 395.61
Cash and Bank Balances 27.95 27.49 522.08 913.16 151.74 1098.34
Other Current Assets 12.81 6.02 48.53 50.61 0 0
Loans and Advances 306.29 351.42 744.09 798.19 147.68 129.26
Total Current Assets 907.48 901.55 2761.31 3426.77 674.64 1623.1
Cash & Bank Balance as % 3.08 3.05 18.90 26.65 22.49 67.66
of Total current Assets
From the above table, we may note that Firm A holds just around 3% of its current assets as cash balances, i.e.
its operating cycle has an extended and large span requiring conversion into Loans and Advances, Inventories,
Sundry Debtors before re-conversion into cash. Firm B is engaged in manufacture and trading of consumer
non-durables having a relatively shorter operating cycle. As such, holding of cash by this firm as a percentage of
total current assets is larger. Firm C has 22.49% of the current assets in cash and bank balances in 2016 while
the figure has gone up to 67.66% in 2017. The abnormal rise is due to the fact that out of the cash and bank
balances of ` 1098.34 lacs represented unutilised proceeds of the capital issue made by the firm. Ignoring this
figure, the cash and bank balances are ` 666.84 lacs, still 56.43% of the current assets. The implication of this
is that the firm C, being in the services sector as a software exports, has a short operating cycle. The inventory
 Lesson 7 Working Captial 239

holding is nil and current assets and generally held either as cash or receivables. So, the level of cash and bank
balances viewed per se, is no indicator of the efficiency of cash management. We have to analyse the various
components of cash holding to arrive at a more accurate conclusion.

Components of cash and bank balances

Cash and bank balances are held by the firms in three major forms, i.e. cash and cheques in hand, balances
with banks and investment in liquid securities.
1. Cash and Cheques in hand
This is the most liquid and readily accessible component of cash. The cash is held to meet day-to-day payments
of small amounts. It is generated from counter cash receipts of the firm, if any, and from cash withdrawals from
the bank. The volume of cash in hand maintained by the firm again depends upon the nature of operations of the
firm. In case of major portion of the sales being in cash, firm is left with large amounts of cash at the end of the
day which needs to be taken care of safely. This entails security and custody arrangements for the cash before
it is deposited in the bank. Moreover, since receipt and payment of cash is a primary level transaction which is
culminated with the handing over of the cash, special care is required while handling cash.
Cheques in hand are clubbed with cash in a categorization because a cheque is a secondary form of cash and
is equivalent to holding cash. The care and precaution required for holding cheques is much less than required
for cash because almost all the cheques are “account payee cheques” which can be credited to the account of
the firm only. The cheques in hand need to be deposited carefully and expeditiously into the bank in order to get
credit to the correct account well in time. Attention also needs to be paid to those cheques which are dishonoured
at the time of presentation to the payee banks since the drawer of the cheques has to be contacted for obtaining
rectified cheques.
2. Bank Balances
Bank balances represent the amount held with banks in savings, current or deposit accounts. In the case of
firms, balances are not held in savings accounts. A firm has at least one main current account with a bank
through which the transactions are carried out. All the excess cash is deposited into this account together with
the cheques. Payments to employees, creditors and suppliers are made by way of cheques drawn on this
account. Being a current account, no interest is payable to the firm on the balance maintained in this account.
Therefore, the firm seeks to keep just sufficient balance in the current account for meeting immediate payment
liabilities. After accounting for these liabilities, the surplus is transferred either to an interest bearing deposit
account or invested in short term liquid instruments. In case the firm has borrowed funds for working capital, the
surplus cash and cheques are credited to those accounts, thereby reducing the liability of the company.

William J. Baumal Model for Optimal Cash Balance Management

Cash management model of William J. Baumal assumes that the concerned company keeps all its cash on
interest yielding deposits from which it withdraws as and when required. It also assumes that cash usage is
linear over time. The amount of money is withdrawn from deposits in such a way that the cost of withdrawal is
optimally balanced with those of interest foregone by holding cash. The model is almost same as economic
stock order quantity model.

2 ´ Tb
Formula Economic lot size =
I
Where T= Projected cash requirement
b= Conversion cost per lot
I= Interest earned on marketable securities per annum.
240 EP-F&SM

Strategy for effective cash management

The strategy for effective cash management in any firm has a core component of ensuring uninterrupted supply of
cash to the operating cycle. This cash is ideally generated from the cycle itself but under certain circumstances
infusion of cash from outside the cycle also takes place. Examples of such circumstances are:
(a) when the firm has been newly set up and the cycle has yet to commence;
(b) when due to disruption in the cycle, cash gets stuck in other current assets and outside cash infusion in
the form of promoters lenders’ contribution is done.
Essential elements of a successful cash management strategy are:-
– Realistic cash forecasting
– Speeding up collections
– Spreading out payments
(1) Realistic cash forecasting
By realistic cash forecasting we mean that a cash forecast for the entire next year should be prepared at its
commencement. The cash forecast has two parts—one is the forecast of cash flows from the operating cycle
and the second part is the capital flows. The first part originates from the sales forecast for the year while the
second part originates from the capital budget. The surplus of cash generated from the operating cycle in called
the internal accruals of the firm and it is used to fund the capital outlays together with bank borrowings.
For a realistic cash forecast, the sales projections and capital budget have to be drawn up after extensive
deliberations in the management committee of the firm. Such a forecast carries a cushion for normal contingences
like sudden spurt or shrinkage in demand for which mid-term modifications in the forecast are made. Involvement
of operational level people, both from production and sales areas, is essential for a realistic cash forecast.
(2) Speeding up Collections
After the cash forecast has been prepared, the firm should ensure that in day to day operations cash (including
cheques) should be collected speedily. Towards this end, a schedule of receivables should be prepared and
kept updated. Before due date of each payment, the debtor should be reminded for it. When the cheques are
received on due dates, these should be credited to the bank account expeditiously. For a multi-locational firm,
arrangements should be made with the bank for on-line transfer of funds to the main account. Similarly, facilities
like drop boxes can be provided by firms having a large user base whereby customers can drop their payments
in boxes placed at vantage locations.
(3) Spreading out Payments
Simultaneously with speeding up collection, the firm should spread out payments as far as possible. It means
that if credit period is available in some payments, it should be utilized fully. Bunching of payments should be
avoided. For outstation customers, arrangement can be made with the bank for making at par payment.
Example No.7
The annual cash requirement of A Ltd. is ` 10 Lakhs. The company has marketable securities in lot sizes of
` 50,000, ` 1,00,000, ` 2,00,000, ` 2,50,000 and ` 5,00,000. Cost of conversion of marketable securities per lot
is ` 1,000. The company can earn 5% annual yield on its securities.
You are required to prepare a table indicating which lot size will have to be sold by the company.
Also show that the economic lot size can be obtained by the Baumal Model.
 Lesson 7 Working Captial 241

Solution
Table indicating lot size of securities
Total annual cash requirements =T= ` 10,00,000
Lot Size (`) =C 50,000 1,00,000 2,00,000 2,50,000 5,00,000
Number of Lots (T/C) 20 10 5 4 2
Conversion Cost (`)=(T/C) 20,000 10,000 5,000 4,000 2,000
b Where b = cost of
conversion per lot.
Interest charges ` =(C/2)I 1,250 2,500 5,000 6,250 12,500
Total Cost ` = 21,250 12,500 10,000 10,250 14,500
Economic lot size is ` 2,00,000 at which total costs are minimum.
Optimal Cash Balance Management Model of William J. Baumal assumes that the concerned company keeps
all its cash on interest yielding deposits form which it withdraws as and when required. It also assumes that cash
usage is linear over time. The amount of money is withdrawn from deposits in such a way that the cost of
withdrawal are optimally balanced with those of interest foregone by holding cash. The model is almost same as
economic stock order quantity model.

2 ´ Tb
Formula Economic lot size =
I
Where T= Projected cash requirement = ` 10,00,000
b= Conversion cost per lot = ` 1000
I= Interest earned on marketable securities per annum. = 5%
By substituting the figures in the formula

2 ´ 10,00,000 ´ 1000
Economic lot size =
0.05
= ` 2,00,000

INVENTORY MANAGEMENT
Inventory Management is the second important segment of working capital management Inventory is the second
step in the operating cycle wherein cash in converted into various items of the inventory. Inventory has the
following major components:
(a) Raw Material
(b) Work in Process
(c) Finished Goods.
Inventories form a link between production and sale of a product. A manufacturing company must maintain a
certain amount of inventory during production, the inventory known as work in process (WIP). Although other
types of inventory – namely, raw materials and finished goods – are not necessary in the strictest sense, they
allow the company to be flexible. Raw materials inventory gives the firm flexibility in its purchasing. Finished
goods inventory allows the firm flexibility in its production scheduling and in its marketing. Production does not
242 EP-F&SM

need to be geared directly to sales. Large inventories also allow efficient servicing of customer demands. If a
product is temporarily out of stock, present as well as future sales may be lost. Thus, there is an incentive to
maintain large stocks of all three types of inventory.

Benefits versus Costs

The advantages of increased inventories are several. The firm can effect economies of production and purchasing
and can fill orders more quickly. In short, the firm is more flexible. The obvious disadvantages are the total cost
of holding the inventory, including storage and handling costs, and the required return on capital tied up in
inventory. An additional disadvantage is the danger of obsolescence. Because of the benefits, however, the
sales manager and production manager are biased toward relatively large inventories. Moreover, the purchasing
manager often can achieve quantity discounts with large orders, and there may be a bias here as well. It falls on
the financial manager to dampen the temptation for large inventories. This is done by forcing consideration of
the cost of funds necessary to carry inventories as well as perhaps the handling and storage costs.
Inventories should be increased as long as the resulting savings exceed the total cost of estimates of holding
the added inventory. The balance finally reached depends on the estimates of actual savings, the cost of carrying
additional inventory, and the efficiency of inventory control. Obviously, this balance requires coordination of the
production, marketing, and finance areas of the firm in keeping with an overall objective. Our purpose is to
examine various principles of inventory control by which an appropriate balance might be achieved.

Extent and Quantum of Inventory Management

Let us take a look at the extent and quantum of inventory in real life examples taken up for consideration by us
for working capital management.
(` in crores)
Firm A Firm B Firm C
2016 2017 2016 2017 2016 2017
Total Current Assets 907.47 955.73 2,761.30 3610.78 674.64 1,623.21
Inventories 312.8 300.12 1182.10 1424.04 0 0
Sundry Debtors 247.63 216.50 264.51 424.78 375.22 395.61
Cash and Bank Balance 27.95 27.49 522.08 913.16 151.75 1,098.34
Other Current Assets 12.51 60.2 48.53 50.61 0 0
Loans and advances 306.29 351.42 744.08 798.19 147.68 129.26
Inventory as % of Total 34.48 31.40 42.80 39.43 0 0
current assets
Firm A, being in the current manufacturing sector has over 30% of the current assets held in the form of inventories,
while firm B, being in the FMCG manufacturing and trading sector has over 35% of the current assets in the
inventory form. Firm C, in the software export segment has obviously zero inventory holding.

Strategy for Inventory Management

A successful strategy for inventory management has at its core the objective of holding the optimum level of
inventory at the lowest cost.
The cost of holding inventory has the following three elements:
 Lesson 7 Working Captial 243

(i) Carrying Cost

This is the cost of keeping or maintaining the inventory in a usable condition. This includes the storage costs,
i.e. the cost of storing the inventory in rented premises or the opportunity cost of storing in own premises +
the wage cost of personnel assigned to storing and securing it + cost of utilities and insurance + cost of financing.
Inventory carrying cost is directly proportional to the level of inventory assuming that the loading of carrying cost
is done pro rata to the space occupied. Thus if inventory level rises, its carrying cost also rises.
(ii) Ordering Cost
It is the cost associated with placing each individual order for supply of raw materials, stores, packing materials
etc. If these items are procured in small lots, then the ordering cost per unit of inventory would be more and vice
versa.
(iii) Stock-out Cost
It is the cost associated with procuring an inventory item, which has gone out of stock and is needed for immediate
supply. This cost includes the reduction of profit and costs accruing due to disruption in the operating cycle.

How cost of inventory can be lowered:

Cost of inventory can be lowered by–
– Entering into long term arrangements for supply of raw materials at market driven prices.
– Arranging for direct supply of raw material at manufacturing locations.
– Promoting ex-factory sales of the finished goods.
– Availing quantity discounts and spot payment discounts if the carrying cost and financing cost is less
than the discounts.
– Apart from these general steps, a technique called ABC analysis is also used for monitoring inventory costs.

Managing the Inventory Level

1. Economic Order Quantity (EOQ) Model
Inventory level can be managed by adopting the Economic Order Quantity (EOQ) model. This model determines
the order size that will minimize the total inventory cost. According to this model, three parameters are fixed for
each item of the inventory:
(1) Minimum level of that inventory to be kept after accounting for usage rate of that item and time lag in
procuring that item and contingences.
(2) The level at which next order for the item must be placed to avoid possibility of a stock-out.
(3) The quantity of the item for which the re-order must be placed.
In addition to the determination of above parameters, the EOQ model is based on the following assumptions:
– The total usage of that particular item for a given period is known with certainty and the usage rate is
even throughout the period.
– There is no time gap between placing an order and receiving supply.
– The cost per order of an item is constant and the cost of carrying inventory is also fixed and is given as
a percentage of the average value of inventory.
– There are only two costs associated with the inventory and these are the cost of ordering and the cost
of carrying the inventory.
244 EP-F&SM

Given the above assumptions, the optimum or economic order quantity is represented as:

2AO
ECQ
EOQ =
C
Where A = Total annual requirement for the item
O = Ordering cost per order of that item
C = Carrying cost per unit per annum.
2. ABC Analysis
This system is based on the assumption that in view of the scarcity of managerial time and efforts, more attention
should be paid to those items which account for a larger chunk of the value of consumption rather than the
quantity of consumption. Let us take an example of a firm having three major components of raw material:
Component Units Consumed % to total Value per unit Total Value (Lacs) %

A 5000 45.45 1000 50.00 22.93

B 4000 36.36 1200 48.00 22.00

C 2000 18.18 6000 120.00 55.05

11000 100.00 218.00 100.00

Thus, the cost of raw material C which accounts for 55% of the total consumption value should be given priority
over item A although the number of units consumed of the latter is much more than former.
Example No.8
(a) The following details are available in respect of a firm:
(i) Annual requirement of inventory 40,000 units
(ii) Cost per unit (other than carrying and ordering cost) ` 16
(iii) Carrying cost are likely to be 15% per year
(iv) Cost of placing order ` 480 per order.
Determine the economic ordering quantity.
(b) The experience of the firm being out of stock is summarised below:
(1) Stock out (No. of units) No. of times (% Probability)
500 1 (1)
400 2 (2)
250 3 (3)
100 4 (4)
50 10 (10)
0 80 (80)
Figures in brackets indicate percentage of time the firm has been out of stock.
(2) Stock out costs are ` 40 per unit.
 Lesson 7 Working Captial 245

(3) Carrying cost of inventory per unit is ` 20

Determine the optimal level of stock out inventory.
(c) A firm has 5 different levels in its inventory. The relevant details are given. Suggest a breakdown of the
items into A, B and C classifications:
Item No. Avg. No. of units inventory Avg. Cost per unit
1 20,000 ` 60
2 10,000 ` 100
3 32,000 ` 11
4 28,000 ` 10
5 60,000 ` 3.40
Solution
(a) Carrying cost per unit per annum
= cost per unit x carrying cost % p.a.
= ` 16 x 0.15 = ` 2.40
Now from the formula for Economic Order Quantity (EOQ)

2 ´ total consumption p.a. ´ ordering cost per order

=
Carrying cost per unit

2 ´ 40,000 ´ 480
= = 4000 units
2.40
Alternative working:
Ordering size (units) 1,000 2,000 2,500 4,000 5,000 8,000 10,000
No. of orders required 40 20 16 10 8 5 4
Average inventory (units) 500 1,000 1,250 2,000 2,500 4,000 5,000
Total carrying cost of 1,200 2,400 3,000 4,800 6,000 9,600 12,000
Average inventory in `
Total ordering cost = No. 19,200 9,600 7,680 4,800 3,840 2,400 1,920
of orders x Cost of placing
each order
Total cost in ` 20,400 12,000 10,680 9,600 9,840 12,000 13,920
Hence, least cost of ` 9,600 is at the ordering size of 4,000 units.
246 EP-F&SM

(b)
Safety Stock Stock out Probability Expected Total
stock level out (units) cost @ ` 40 of stock stock out expected
(units) per unit ` out at this level stock out cost
(1) (2) (3) (4) (5) (6)
500 0 0 0 0 0
400 100 4000 0.01 40 40
250 250 10,000 0.01 100
150 6000 0.02 120 260
100 400 16,000 0.01 160
300 12,000 0.02 240
150 6,000 0.03 180 840
50 450 18,000 0.01 180
350 14,000 0.02 280
200 8,000 0.03 240
50 2,000 0.04 80 1,620
0 500 20,000 0.01 200
400 16,000 0.02 320
250 10,000 0.03 300
100 4,000 0.04 160
50 2,000 0.10 200 2,800
Safety stock Expected Carrying ` Total safety
level (units) stock out cost at stock cost
costs ` 20 per unit
0 2,800 0 2,800
50 1,620 1,000 2,620
100 840 2,000 2,840
250 260 5,000 5,260
400 40 8,000 8,040
500 0 10,000 10,000
Optimum safety stock where the total cost is the least is at 50 units level.
(c)
Item No. Units % of total Units Unit cost` Total cost` % of total cost
1 20,000 13.3 60.00 12,00,000 39.5]
2 10,000 6.7 100.00 10,00,000 32.9] A
3 32,000 21.3 11.00 3,52,000 11.6]
 Lesson 7 Working Captial 247

4 28,000 18.7 10.00 2,80,000 9.2] B

5 60,000 40.0 3.40 2,04,000 6.8] C
1,50,000 100.0 30,36,000 100.0
Item Nos. I and II being very valuable are to be controlled first though in quantity are hardly 20% of the total,
hence can be classified as A. Next priority is for items 3 and 4, though quantity wise 40% to be classified as B
and last priority item 5 though in quantity bulk but value is less hence to be classified as C.
Example No.9
A publishing house purchases 72,000 rims of a special type paper per annum at cost ` 90 per rim. Ordering cost
per order is ` 500 and the carrying cost is 5 per cent per year of the inventory cost. Normal lead time is 20 days
and safety stock is NIL. Assume 300 working days in a year:
You are required:
(i) Calculate the Economic Order Quantity (E.O.Q).
(ii) Calculate the Reorder Inventory Level.
(iii) If a 1 per cent quantity discount is offered by the supplier for purchases in lots of 18,000 rims or more,
should the publishing house accept the proposal?
Solution

2 AO
(i) EOQ =
C
Where,
A = Annual consumption
O = Ordering cost per order
C = Stock carrying cost per unit per annum

2 ´ 72,000 ´ 500
=
5% of Rs. 90

= 1,60,00,000
= 4,000 Rims.
(ii) Re-order Level = Normal Lead Time ´ Normal Usage
= 20 x 240
= 4,800 Rims.
Note:

Annual usage
Normal Usage =
Normal working days in a year

72,000
= = 240 Rims.
300
248 EP-F&SM

(iii) Evaluation of Quantity Discount Offer:

EOQ Discount Offer
Size of order 4,000 Rims 18,000 Rims
No. of orders in a year 18 4

æ Order size ö
Average inventory ç ÷ 2,000 Rims 9,000 Rims
è 2 ø

Cost: ` `
Ordering Cost @ ` 500 per order 9,000 2,000
Inventory carrying cost
At EOQ – (4,000/2) x ` 4.5 9,000 -
At Discount offer – (18,000/2) x ` 4.455 - 40,095
Purchases Cost
At EOQ – 72,000 x ` 90 64,80,000 -
At discount offer – 72,000 x ` 89.10 ________ 64,15,200
Total Cost 64,98,000 64,57,295
The total cost is less in case of quantity discount offer. Hence, quantity discount offer should be accepted.

RECEIVABLES MANAGEMENT
Receivables are near the terminating point of the operating cycle. When raw material has been converted into
finished goods, the final product is sold by the firm. Some of the sales are done on spot basis while the remaining
sales are made on credit. The extent of credit sales varies from industry to industry and within an industry.
Period of credit depends upon the position of the firm in the industry. If the firm has a monopoly position, period
of credit would be very low. If the industry consists of a large number of players in keen competition with each
other, the period of credit would tend to be fairly long. Also, during periods of demand recession, even a firm in
monopoly situation might be forced to extend credit in order to promote sales.
Receivables are generally referred to by the name of “Sundry Debtors” in the books of account, Strictly speaking,
Sundry Debtors refer to receivables created in the course of operation of the working capital cycle, i.e. those
persons which owe payment to the firm for goods supplied or services rendered. Thus sundry debtors represent
an intermediate stage between reconversion of finished goods into cash. So long as the sundry debtors persist,
the firm is strained of cash. So, logically the firm seeks to minimize the level of sundry debtors.
The period of credit allowed to debtors also depends upon the industry practice. This period of credit has two
components. First component is a small period of week to ten days which is normally allowed in all industries
and no interest is charged on the amount due. The second component is the larger one, length of which varies
from industry to industry and interest is usually charged for this period. In the alternative, the firm may charge full
invoice value for payment made after the credit period and allow discount for spot payments.
Apart from the Sundry Debtors, cash flow of the firm is also affected by Loans and Advances made to suppliers,
subsidiaries and others. These advances are not exactly working capital advances but nevertheless these are
treated as current assets because these are assumed to be recoverable or converted into inventory, fixed
assets or investments within one year.
Credit policy can have a significant influence on sales. In theory, the firm should lower its quality standard for
accounts accepted as long as the profitability of sales generated exceeds the added costs of the receivables.
What are the costs of relaxing credit standards? Some arise from an enlarged credit department, the clerical
 Lesson 7 Working Captial 249

work of checking additional accounts, and servicing the added volume of receivables. We assume for now that
these costs are deducted from the profitability of additional sales to give a net profitability figure for computational
purpose. An other cost comes from the increased probability of bad-debt losses.

Illustration
To assess the profitability of a more liberal extension of credit, we must know the profitability of additional sales,
the added demand for products arising from the relaxed credit standards, the increased slowness of the average
collection period, and the required return on investment. Suppose a firm’s product sells for ` 10 a unit, of which
`8 represents variable costs before taxes, including credit department costs. The firm is operating at less than
full capacity, and an increase in sales can be accommodated without any increase in fixed costs. Therefore, the
contribution margin of an additional unit of sales is the selling price less variable costs involved in producing the
unit, or `10 – `8 = `2.
At present, annual credit sales are running at a level of `2.4 million, and there is no underlying trend in such
sales. The firm may liberalize credit, which will result in an average collection experience of new customers
of 2 months. Existing customers are not expected to alter their payment habits and continue to pay in 1
month. The relaxation in credit standards is expected to produce a 25 percent increase in sales, to `3
million annually. This `6,00,000 increase represents 60,000 additional units if we assume that the price per
unit stays the same. Finally, assume that the opportunity cost of carrying additional receivables is 20 percent
before taxes.
This information reduces our evaluation to a trade-off between the added profitability on the additional sales and
the opportunity cost of the increased investment in receivables. The increased investment arises solely from
new, slower paying customers; we have assumed existing customers continue to pay in 1 month. With the
additional sales of `6,00,000 and receivable turnover of 6 times a year (12 months divided by the average
collection period of 2 months), the additional receivable are ` 6,00,000 / 6 = ` 1,00,000. For these additional
receivables, the firm invests the variable costs tied up in them. For our example, ` .80 of every Re.1.00 in sales
represents variable costs. Therefore, the added investment in receivables is .80 x `1,00,000 = `80,000. In as
much as the profitability on additional sales, `1,20,000, far exceeds the required return on the additional investment
in receivables, `16,000, the firm would be well advised to relax its credit standards. An optimal credit policy
would involve extending trade credit more liberally until the marginal profitability on additional sales equals the
required return on the additional investment in receivables.
Now, we shall revert back to our sample firms and examine the level of Sundry Debtors and loans and Advances
vis-a-vis the level of operations.

How do firms ensure realisations?

Timely realisation of receivables is an important element of working capital management. Practices in this respect
vary from firm to firm. Most of the firms dissuade credit sales to first time customers and gradually allow credit
after development of relationship. While giving credit, some firms obtain post dated cheques from their clients.
In other cases, firms have special staff earmarked for recovery efforts. The key elements here are the opportunity
cost of funds blocked in receivables and the net expenses of maintaining recovery infrastructure. Expenses of
maintaining recovery infrastructure include the costs associated with recovering the amount from debtors. If the
funds realised from receivables can yield better return than the interest recovered from debtors, then the firm
would be better off by promoting cash sales.

Desirable Level of receivables

Considering the under given situation, let us find out whether there is a desirable level of receivables for a firm
in relation to its turnover:
250 EP-F&SM

` in crores
A B C
2016 2017 2016 2017 2016 2017
1 Sundry Debtors 247.63 216.50 264.51 424.78 470.76 464.10
2 Loans and Advances 306.29 351.42 744.09 798.19 136.91 104.73
3 Sales/Services 3,031.76 3,322.44 10,603.79 10,971.90 1,381.91 1,882.61
4 (1) as % of (3) 8.17 6.52 2.49 3.87 34.08 24.65
5 (2) as % of (3) 10.10 10.57 7.02 7.27 9.91 5.56

Obviously firm B has adopted a tight and conservative policy towards debtors. It is recovering its receivables
quickly. Similarly the outgo on loans and advances is not disproportionate as compared to sales. One reason for
this is that the firm B has undertaken a qualitative analysis of loans and advances and has treated some of these
as doubtful. Such doubtful advances, including loans and advances to subsidiary companies have been charged
to the Profit and Loss Account as part of prudent accounting practice. Similar treatment has been accorded to
sundry debtors as well.
In the case of firm C, the sundry debtors are a fairly high percentage of total sales and rightly so, because the
firm has no inventory and most of the working capital is locked in receivables only. The loans and advances are,
however at around 6-10% of sales.
It is difficult to prescribe a reasonable level for loans and advances for any firm because of the percentage of
sundry debtors to sales varies widely among these firms. In case of firm A sundry debtors are between 6 to 8%
of sales while loans and advances are around 10% of sales. The loans and advances consist of various types of
deposits, pre payments and advances etc. Not all loans and advances are meant to be converted into cash.
That is why loans and advances, although considered as current assets, are not treated part of the working
capital. In fact some of the advances get converted into either capital expenditure or investments. For example
advances for supply of capital goods would ultimately get shaped into fixed assets. Advances towards share
application money or as loans to subsidiary are converted into investments. Similarly, pre-paid taxes & duties
are ultimately treated as expenses. In the case of firm B, the sundry debtors are just around 3-4% of sales while
loans and advances are around 7% of sales.
If a firm is buying raw material or traded goods on credit, then ideally the level of such creditors should be more
than the level of debtors at any point of time. Benchmarking of the receivable level can also be done against
historical industry trends. To guard against the receivables rising beyond tolerable levels, firms usually treat all
advances and debts over six months old as doubtful cases and, if needed, charge such amounts to the profit
and loss account.

FACTORS DETERMINING CREDIT POLICY

The credit policy is an important factor determining both the quantity and the quality of accounts receivables.
Various factors determine the size of the investment a company makes in accounts receivables. They are, for
instance:
(i) The effect of credit on the volume of sales;
(ii) Credit terms;
(iii) Cash discount;
(iv) Policies and practices of the firm for selecting credit customers;
 Lesson 7 Working Captial 251

(v) Paying practices and habits of the customers;

(vi) The firm’s policy and practice of collection; and
(vii) The degree of operating efficiency in the billing, record keeping and adjustment function, other costs
such as interest, collection costs and bad debts etc., would also have an impact on the size of the
investment in receivables.
The rising trend in these costs would depress the size of investment in receivables. The firm may follow a lenient
or a stringent credit policy. The firm which follows a lenient credit policy sells on credit to customers on very
liberal terms and standards. On the contrary a firm following a stringent credit policy sells on credit on a highly
selective basis only to those customers who have proper credit worthiness and who are financially sound. Any
increase in accounts receivables that is, additional extension of trade credit not only results in higher sales but
also requires additional financing to support the increased investment in accounts receivables. The costs of
credit investigations and collection efforts and the chances of bad debts are also increased.

EVALUATION OF CREDIT POLICIES (FORMAT)

Existing Policy Option I Option 2 Option 3
A. Expected Profit:
(a) Credit Sales xxxx xxxx xxxx xxxx
(b) Total Cost other than Bad Debts
(i) Variable Costs xxx xxx xxx xxx
(ii) Fixed Costs xxx xxx xxx xxx
(c) Bad Debts xxx xxx xxx xxx
(d) Cash discount xxx xxx xxx xxx
(e) Expected Net Profit before Tax (a-b-c-d) xxx xxx xxx xxx
(f) Less: Tax xxx xxx xxx xxx
(g) Expected Profit after Tax Xxx xxx xxx xxx
B. Opportunity Cost of Investments in Xxx xxx xxx xxx
Receivables locked up in Collection Period

Net Benefits (A – B) xxx xxx xxx xxx

Here
(i) Total Fixed Cost = [Average Cost per unit – Variable Cost per unit] x No. of units sold on credit under
Present Policy

(ii) Opportunity Cost = Total Cost of Credit Sales × Collection period (Days) x Required Rate of Return
365 (or 360) 100
Example No. 9
Ash Ltd. follows collection policy as detailed below :
(i) 10% of the sales is collected in the same month
(ii) 20% of the sales is collected in the 2nd month
(iii) 40% of the sales is collected in the 3rd month
(iv) 30% of the sales is collected in the 4th month.
Sales of the company for the first three quarters of the year are as follows :
252 EP-F&SM

Month of the Quarter-I Quarter-II Quarter-Ill

Quarter
1 15,000 7,500 22,500
2 15,000 15,000 15,000
3 15,000 22,500 7,500
Total 45,000 45,000 45,000
No. of working days 90 90 90

You are required to work out average age of receivables.

Solution: Calculation of Receivable at the end of 3rd month of quarter
Out of sale 1 2 3 Balance at the end
of Month
1 100 – (10% + 20% + 40%) 30%
2 100 – (10% + 20%) 70%
3 100 – (10%) 90%

Rocoverable at the end of Q-I

Month Amount Recovered Balance Balance

Recoverable Amount
1 15,000 70% 30% 4,500
2 15,000 30% 70% 10,500
3 15,000 10% 90% 13,500
45,000 28,500

Average age of receivables = 28500/45000*90 = 57 days

Rocoverables at the end of Q-II
Month Amount Recovered Balance Balance
Recoverable Amount
1 7,500 70% 30% 2,250
2 15,000 30% 70% 10,500
3 22,500 10% 90% 20,250
45,000 33,000

Average age of receivables = 33000/45000*90 = 66 days

 Lesson 7 Working Captial 253

Recoverables at the end of Q-III

Month Amount Recovered Balance Balance
Recoverable Amount
1 22,500 70% 30% 6,750
2 15,000 30% 70% 10,500
3 7,500 10% 90% 6,750
45,000 24,000
Average age of receivables = 24,000/45,000*90 = 48 days
Recovery speed is lowest in Q-II
Example No.10
XYZ Co. Ltd, manufacturer of electronic gadgets, has an annual sales of ` 50 lakh. It offers 30 days credit on sales.
The fixed costs are ` 5 lakh and the variable costs are 80% of the sales.
The company is considering a change in its credit policy. Based upon its knowledge of market response, it has
estimated likely sales figure against each of the proposed collection period as follows:
Policy Collection period (days) Projected sales (` lakhs)
A 45 56
B 60 60
C 75 62
D 90 63
If the expected rate of return is 20%, which policy should be adopted and why?
Solution:
Evaluation of credit policy (` lakhs)
Current Policy A Policy B Policy C Policy D
policy
Credit period (days) 30 45 60 75 90
Projected sales 50 56 60 62 63
Less: variable cost @ 80% (40) (44.8) (48) (49.6) (50.4)
Contribution 10 11.2 12 12.4 12.6
Less: Fixed cost (5) (5) (5) (5) (5)
Net profit 5 6.2 7 7.4 7.6
Cost of sales (Variable cost + 45 49.8 53 54.6 55.4
Fixed cost)
Investment in debtorsCost of sales × 3.75 6.225 8.833 11.375 13.85
credit period/360 days
Net profit 5 6.2 7 7.4 7.6
Less: cost of funds in debtors balances (0.75) (1.245) (1.767) (2.275) (2.77)
@ 20%
Net return 4.25 4.955 5.233 5.125 4.83
254 EP-F&SM

Analysis: Since the net return is highest for credit policy B, it is suggested to extend the credit policy upto 60 days,
to maximize the company’s profitability.

Control of Bad debts

Control of bad-debts is an important part of controlling the working capital or the current assets of the company.
Credit policy should be followed which may not lead to bad-debts and expedite collections. Periodical checks
should be maintained by classifying debtors as outstandings from 0-30 days, 30-60 days, 60-90 days and 90
and over. Amount due for 60 days or more should be followed seriously and collected.

FACTORING SERVICES
As the accounts receivable amount to the blocking of the firm’s funds, the need for an outlet to impart these
liquidity is obvious. Other than the lag between the date of sale and the date of receipt of dues, collection of
receivables involves a cost of inconvenience associated with tapping every individual debtor. Thus, if the firm
could contract out the collection of accounts receivable it would be saved from many things such as administration
of sales ledger, collection of debt and the management of associated risk of bad-debts etc.
Factoring is a type of financial service which involves an outright sale of the receivables of a firm to a financial
institution called the factor which specialises in the management of trade credit. Under a typical factoring
arrangement, a factor collects the accounts on the due dates, effects payments to the firm on these dates
(irrespective of whether the customers have paid or not) and also assumes the credit risks associated with the
collection of the accounts. As such factoring is nothing but a substitute for in-house management of receivables.
A factor not only enables a firm to get rid of the work involved in handling the credit and collection of receivables,
but also in placing its sales in effect on cash basis.

Definition and functions – Factoring Services

“Factoring may be defined as a relationship between the financial institution or banker (‘factor’) and a business
concern (the ‘supplier’) selling goods or providing services to trade customers (the customer) whereby the
factor purchases book debts with or without recourse (‘with a recourse’ means that in the event of bad debts
factor can approach the ‘supplier’) to the supplier and in relationship thereto controls the credit extended to the
customers and administers the sales ledger of the supplier.”
Though the purchase of book debts is fundamental to the functioning of factoring, there are a number of functions
associated with this unique financial services. A proper appreciation of these functions would enable one to
distinguish it from the other sources of finance against receivables. They are:
– assumption of credit and collection function;
– credit protection;
– encashing of receivables;
– collateral functions such as:
(a) loans on inventory,
(b) loans on fixed assets, other security and on open credit,
(c) advisory services to clients.

Factoring vs. Accounts Receivable Loans

Accounts receivable loan is simply a loan secured by a firm’s accounts receivable by way of hypothecation or
assignment of such receivables with the power to collect the debts under a power of attorney. In case of factoring
 Lesson 7 Working Captial 255

however, there is an outright sale of receivables. Thus, in case of the former, the bank may debit client’s account for
‘handling charges’ if the debt turns out to be bad as against non-recourse factoring.

Factoring vs. Bill Discounting

Under a bill discounting arrangement, the drawer undertakes the responsibility of collecting the bills and remitting
the proceeds to the financing agency, whereas under factoring agreement, the factor collects client’s bills.
Moreover, bill discounting is always with recourse whereas factoring can be either with recourse or without
recourse. The finance house discounting bills does not offer any non-financial services unlike a factor which
finances and manages the receivables of a client.

Mechanics of Factoring
Factoring offers a very flexible mode of cash generation against receivables. Once a line of credit is established,
availability of cash is directly geared to sales so that as sales increase so does the availability of finance. The
dynamics of factoring comprises of the sequence of events outlined in figure.
(1) Seller (client) negotiates with the factor for establishing factoring relationship.
(2) Seller requests credit check on buyer (client).
(3) Factor checks credit credentials and approves buyer. For each approved buyer a credit limit and period
of credit are fixed.
(4) Seller sells goods to buyer.
(5) Seller sends invoice to factor. The invoice is accounted in the buyers account in the factor’s sales ledger.

SELLER 4. GOODS BUYER

5. CREDIT CHECK

1. NEGOTIABLE 6. INVOICE NOTICE

2. REQUESTS CREDIT FACTOR OF ASSIGNMENT
3. INVOICE

7. 80% PAYMENT 8. PAYMENT ON DUE

9. BALANCE PAYMENT DATE

Figure: Mechanics of Factoring

Source: Ranjani Chari, 1991, Factoring in India, M.Phil, Dissertation, Delhi University.
(6) Factor sends copy of the invoice to buyer.
(7) Factor advices the amount to which seller is entitled after retaining a margin, say 20%, the residual
amount paid later.
256 EP-F&SM

(8) On expiry of the agreed credit period, buyer makes payment of invoice to the factor.
(9) Factor pays the residual amount to seller.
Types of Factoring: Factoring services may be rendered to cover domestic as well as international sales. The
various services offered by factors for domestic sales are of six types whose essential characteristics are outlined
in Table 1.
Table 1 : Types of Factoring Services

Type of Factoring Type of Functions

Avail- Pro- Credit Sales Collec- Disclo-
ability of tection* Advice Ledger tion sure
Finance against Adminis- Custo-
bad debts tration mers
Full Source(Non-Recourse) Yes Yes Yes Yes Yes Yes
Recourse Factoring Yes ¾ Yes Yes Yes Yes
Agency Factoring Yes Possible ¾ No No Yes
Bulk Factoring Yes Possible ¾ No No Yes
Invoice** Discounting Yes Possible No No No No
Undisclosed Factoring Yes Possible No No No No

* Any form which includes this element may be referred to as ‘non-recourse factoring’
** Also referred to as confidential or non-notification factoring.
Source: Ranjani Chari-opcit. P. 28.
Example No.11
• The turnover of Zenith Ltd. is ` 100 lakh of which 72% is on credit. Debtors are allowed one month to clear
off the dues. A factoring company is willing to advance 80% of the bills raised on credit for a fee of 1% a
month plus a commssion of 5% on the total amount of debts. Zenith Ltd. as a result of this arrangement is
likely to save ` 48,000 annually in management costs and avoid bad debts at 1% on the credit sales.
• A bank has come forward to make an advance equal to 80% of the debts at an annual interest rate of 15%.
However, its processing fee will be at 1% on the debts. Would you accept factoring or the offer from the
bank?
Solution:
Cost of Factoring
Annual Credit Sales = 100 x 72% = ` 72 Lakh
Monthly Credit Sales = 72 Lakh / 12 = ` 6 Lakh
Fee [6,00,000 x 0.80] = 4,80,000
4,80,000 x 0.01 = ` 4,800
Commission [600000 x 0.05] = ` 30,000
= ` 34,800
 Lesson 7 Working Captial 257

Less : Savings in Cost:

Management Cost [48000/12] ` 4,000
Savings in Bad Debts [` 600000 x 0.01] ` 6,000 ` 10,000
Net Cost of Factoring [Per Month] ` 24,800
Cost of Bank Advance
Interest [` 600000 x 0.80 x 0.15 x 1/12] ` 6,000
Processing Fee [` 600000 x 0.01] ` 6,000
Bad Debts [` 600000 x 0.01] ` 6000
Management Cost ` 4,000
Net Cost (Per Month) ` 22,000
Since cost of Bank Finance is les than the cost of factoring, therefore, it is advisable to accept bank offer.

OTHER TECHNIQUES FOR CONTROL OF WORKING CAPITAL

Cash forecast technique can be used for control of funds flowing in and out of business to check surpluses and
shortages. Daily, weekly, monthly, cash flow statements are used to regulate flow of funds and arrange for fund
shortage and invest surplus cash.

1. Fund Flow Statement

Fund flow statements are used to find changes in assets over a period of time showing uses of funds and
sources of funds. Funds flow represent movement of all assets particularly of current assets because movement
in fixed asserts is expected to be small except at times of expansion or diversification.

2. Forfaiting Services
Forfaiting is a form of financing of receivables pertaining to international trade. It denotes the purchase of trade
bills/promissory notes by a bank/financial institution without recourse to the seller. The purchase is in the form of
discounting the documents covering entire risk of non-payment in collection. All risks and collection problems
are fully the responsibility of the purchaser (forfeiter) who pays cash to seller after discounting the bills/notes.
The salient features of forfaiting as a form of export relating financing are as under:
(i) The exporter sells and delivers goods to the importer on deferred payment basis.
(ii) The importer draws a series of promissory notes in favour of the exporter for payment including interest
charge. Alternatively the exporter draws a series of bill which are accepted by the importer.
(iii) The bills/notes are sent to the exporter. The promissory notes/bills are guaranteed by a bank which may
not necessarily be the importer’s bank. The guarantee by the bank is referred to as an Aval, defined as
an endorsement by a bank guaranteeing payment by the importer.
(iv) The exporter enters into a forfaiting agreement with a forfeiter which is usually a reputed bank. The
exporter sells the avalled notes/bills to the bank at a discount without recours and recives the payment.
(v) The forfeiter may hold these notes/bills till maturity for payment by the importers bank.
Forfaiting vs. Export Factoring
Forfaiting is similar to cross border factoring to the extent both have common features of non recourse and
advance payment. But they differ in several important respects:
(a) A forfeiter discounts the entire value of the note/bill but the factor finances between 75-85% and retains
a factor reserve which is paid after maturity.
258 EP-F&SM

(b) The avalling bank which provides an unconditional and irrevocable guarantee is a critical element in the
forfaiting arrangement wheras in a facoring deal, particularly non-recourse type, the export factor bases
his credit decision on the credit standards of the exporter.
(c) Forfaiting is a pure financing arrangement while factoring also includes ledger administration, collection
and so on.
(d) Factoring is essentially a short term financing deal. Forfaiting finances notes/bills arising out of deferred
credit transaction spread over three to five years.
(e) A factor does not guard against exchange rate fluctuations; a forfeiter charges a premium for such risk.

3. Ratio Analysis
Ratio Analysis is normally used for working capital control. The following ratios are commonly used:

Current Assets
1. Current Ratio =
Current Liabilities

Current Assets - Inventories

2. Acid Test Ratio =
Current Liabilities

Cost of goods sold

3. Inventory Turnover =
Average Inventory

Annual Sales
4. Current Assets Turnover =
Current Assets

Sales
5. Receivable Turnover =
Debtors

Total long term debts

6. Debt-equity ratio =
Shareholder funds

Besides above, for managing current assets, it is advisable to calculate the following ratios also:
1. Quantum of shareholders funds invested in current assets.
2. Quantum of shareholders funds and long-term debts invested in current assets.
3. Relationship between the shareholders and long term funds on one hand and the short term funds on
the other pertaining to current assets.

CASE STUDIES
Exercise No. 1 : Calculate cash conversion period from the financial variables given hereunder:
(` in lakh)
Year 2010-2011 Year 2011-12 Year 2012-13
Sales 7,936
Cost of Goods sold 7,036
Inventory 940 936
Bills Receivables 942 962
Bills Payable 608 606
 Lesson 7 Working Captial 259

Solution :
{(940 + 936)/2*365 = 48.7 days
Inventory conversion period:
7,036
B/R conversion period: {942 + 962)/2*365} = 43.8 days
7,936
Payables conversion period: {(608+606)/2*365} = 31.5 days
7036
Cash conversion period: 48.7 + 43.8 – 31.5 = 61 days

Exercise No. 2:Find the average conversion period with the help of the following data:
Gross operating cycle 88 days
Net operating cycle 65 days
Raw material storage period 45 days
Work-in-progress conversion period 4 days
Finished goods storage period 25 days

Solution :
Average conversion period : 88 - (45 + 4 + 25) = 14 days
Exercise No. 3:Calculate the finished goods conversion period if:
(` lakh)
Finished goods opening stock 525
Finished goods closing stock 850
Cost of production 8,000
Administrative expenses 2,250
Excise duty 3,000
Solution :
Average stock of finished goods : ` (525 + 850)/2 = ` 687.5 lakh
Cost of goods sold : ` 525 Lakh + 8,000 Lakh + 2,250 Lakh + 3,000 Lakh – 850 Lakh = ` 12,925 lakh
Daily average = 12,925/365 = ` 35.41 lakh
Finished goods conversion period = 687.5/35.41 = 19.42 days
Exercise No. 4 : Firm uses 1,100 units of a raw material per annum, the price of which is ` 1,500 per unit. The
order cost per order is ` 150 and the carrying cost of the inventory is ` 200 per unit. Find the EOQ and the
number of orders that are to be made during the year.
Solution :
Economic Order Quantity
260 EP-F&SM

= 41
No. of orders during the year = 1,100/41 = 26.8 or 27
Exercise No. 5 : A factory uses 40,000 tonnes of raw material priced at ` 50 per tonne. The holding cost is ` 10
per tonne of inventory. The order cost is ` 200 per order. Find the EOQ. Will this EOQ be maintained if the
supplier introduces 5% discount if the order lot is 2000 tonnes or more?
Solution :

Economic Order Quantity

= 1265
No. of orders = 40,000/1265 = 31.62
Order cost = ` 200 × 31.62 = 6325
Carrying cost = ` 10/2 × 1265 = 6,325
Total cost = ` 6,325 + 6,325 = ` 12,650
EOQ with discount:
No. of orders = 40,000/2000 = 20
Order cost = ` 200 × 20 = ` 4,000
Carrying cost = ` 10/2 × 2,000 = ` 10,000
Price discount = 40000 × 0.05 = ` 2,000
Total cost = 4,000 + 10,000 – 2,000 = ` 12,000
Since total cost without discount > total cost with discount, discount may be availed. In this case, there
will be deviation from the EOQ.

Exercise No. 6 : Find out the average size of receivables if the goods are sold for ` 10,00,000 on a net 60 credit
term with an assumption that 20% of the customers do not pay within the prescribed time. Will there be any
change in the average size if the terms of credit change to 2/10 net 60 with an assumption that 60% of the
customers avail the discount?
Solution
Case I:
Average collection period = 60 + 0.20 × 60 = 72 days
Average size of receivables = ` (10,00,000/360) × 72 = ` 2,00,000
Case II:
Average collection period = (0.6 × 10) + 0.4 (60 + 0.2 × 60)
 Lesson 7 Working Captial 261

= 6 + 28.8 = 35 days
Average size of receivables = ` (10,00,000 / 360) × 35 = ` 97,222.22

Exercise No. 7 : A firm sells 25,000 units at an average price of ` 200 per unit. The variable cost is 80 per cent
of the sale price. The credit term is 1/10 net 30. One-tenth of the customers avail the discount and the average
collection period is 28 days. Administrative cost is ` 20,000. Collection cost/sales and bad debt/sales ratios are
2% each. To increase the level of sales, credit term is changed as 2/10 net 30 as a result of which the sales are
expected to be 50,000 units. The administrative cost, collection cost ratio and bad debt ratio are expected to be
unchanged. The cost of funds is 10%. Tax rate is 30%. Find the net benefit of the changed credit terms.
Solution
Average size of receivables:
Case I : ` (50,00,000 /360) × 28 = ` 3,88,889
Case II : ` (1,00,00,000 /360) × 28 = ` 7,77,778
Financing cost:
Case I: ` 3,88,889 × 0.10 = ` 38,889
Case II: ` 7,77,778 × 0.10 = 77,778
Net Benefit: Amount (`)
Case I Case II
Revenue (sales) 50,00,000 1,00,00,000
Less variable cost (40,00,000) (80,00,000)
Net revenue 10,00,000 20,00,000
Less financing cost (38,889) (77,778)
Less administrative cost (20,000) (20,000)
Less collection cost (1,00,000) (2,00,000)
Less bad debt losses (1,00,000) (2,00,000)
Profit before tax 7,41,111 15,02,222
Less tax @ 30% (2,22,333) (4,50,667)
Net profit after tax 5,18,778 10,51,555

Net benefit of liberal term = ` 10,51,555 – 5,18,778 = ` 5,32,777

Exercise No. 8 : From the following information extracted from the books of a manufacturing company, compute
the operating cycle in days and the amount of working capital required:
Particulars Amount in `
Average Total of Debtors Outstanding 48,000
Raw Material Consumption 4,40,000
Total Production Cost 10,00,000
Total Cost of Sales 10,50,000
Sales for the year 16,00,000
262 EP-F&SM

Value of Average Stock maintained:

Raw Material 32,000
Work-in-progress 35,000
Finished Goods 26,000
Period Covered in days 365
Average period of credit allowed by suppliers in days 16
Solution
Computation of Operating Cycle
(i) Raw material held in stock:

Average stocks of raw material held

Raw material Inventory holding period =
Average raw material consumption per day

32,000 x 365
= = 27 days
4,40,000
Less: Average credit period granted by Suppliers = 16 days
Period for raw material holding = 11 days

(ii)

35,000 x 365
= = 13 days
10,00,000

(iii)

26,000 x 365
= = 9 days
10,50,000

(iv)

48,000 x 365
= = 11 days
16,00,000

Total operating cycle period: (i) + (ii) + (iii) + (iv) = 44 days

Number of Operating cycles in a year = 365/44 = 8.30

= ` 1,26,500 (approx)

Exercise No. 9 : From the following information calculate;

(1) Re-order level
(2) Maximum level
 Lesson 7 Working Captial 263

(3) Minimum level

(4) Average level
Normal usage : 100 units per week
Maximum usage : 150 units per week
Minimum usage : 50 units per week
Re-order quantity (EOQ) 500 : units
Lag in time : 5 to 7 weeks
Solution
(1) Re-order Level
= Maximum consumption × Maximum Re-order period
= 150×7=1050 units
(2) Maximum Level
= Re-order level + Re-order quantity – (Minimum consumption × Minimum delivery period)
= 1050 + 500 – (50 × 5) = 1300 units
(3) Minimum Level
= Re-order level – (Normal consumption × Normal delivery period)
= 1050 – (100 × 6) = 450 units

Maximum Stock Level + Minimum Stock Level

(4) Average Level =
2

= 875 units

Exercise No. 10
A Ltd. has a total sales of ` 3.2 crores and its average collection period is 90 days. The past experience indicates
that bad-debt losses are 1.5% on sales. The expenditure incurred by the firm in administering its receivable
collection efforts are ` 5,00,000. A factor is prepared to buy the firm’s receivables by charging 2% commission.
The factor will pay advance on receivables to the firm at an interest rate of 18% p.a. after withholding 10% as
reserve.
Calculate the effective cost of factoring to the Firm.
Answer `
Average level of Receivables = 3,20,00,000 x 90/360 80,00,000
Factoring commission = 80,00,000 x 2/100 (1,60,000)
Factoring reserve = 80,00,000 x 10/100 (8,00,000)
70,40,000
Factor will deduct his interest @ 18% :-

` 70,40,000 x 18 x 90
Interest = = 3,16,800
100 x 360
Advance to be paid = ` 70,40,000 – ` 3,16,800 = ` 67,23,200
264 EP-F&SM

Annual Cost of Factoring to the Firm: `

Factoring commission (` 1,60,000 x 360/90) 6,40,000
Interest charges (` 3,16,800 x 360/90) 12,67,200
Total 19,07,200
Firm’s Savings on taking Factoring Service: `
Cost of credit administration saved 5,00,000
Cost of Bad Debts (` 3,20,00,000 x 1.5/100) avoided 4,80,000
Total 9,80,000
Net Cost to the firm (` 19,07,200 – ` 9,80,000) 9,27,200

` 9,27,200
Effective rate of interest to the firm = = 13.79%*
` 67,23,200

Note: The number of days in a year have been assumed to be 360 days.

LESSON ROUND-UP

– Gross Working Capital is the total of all current assets. Networking capital is the difference between
current assets and current liabilities.
– Permanent Working Capital is that amount of funds which is required to produce goods and services
necessary to satisfy demand at its lowest point.
– Various factors such as nature of firm’s activities, industrial health of the country, availability of material,
ease or tightness of money markets affect the working capital.
– Factors which influence cash balance include credit position of the company, status of receivables
and inventory accounts, nature of business enterprise and management’s attitude towards risk.
– The amount of time needed for inventories to travel through the various process directly affect the
amount of investment. The investment in inventories is guided by minimization of costs and
management’s ability to predict the forces that may cause disruption in the follow of inventories like
strikes or shifts in demand for the product.
– Factors influencing investment in receivables are mainly the cost and time values of funds.
– The operating cycle is the length of time between the company’s outlay on raw materials, wages and
other expenditures and the inflow of cash from the sale of the goods.
– In deciding company’s working capital policy, an important consideration is trade-off between profitability
and risk.
– Working capital leverage may refer to the way in which a company’s profitability is affected in part by
its working capital management.
– Funds flow represent movement of all assets particularly of current assets because of movement in
fixed assets is expected to be small except at times of expansion or diversification.

– Cash management means management of cash in currency form, bank balance and reality marketable
securities.
 Lesson 7 Working Captial 265

– As John Maynard Keynes put, these are three possible motives for holding cash, such as transaction
motive, precautionary motives and speculative motive.

– Inventory management has at its core the objective of holding the optimum level of inventory at the lowest
cost.

– There are various technical tools used in inventory management such as ABC analysis, Economic Order
Quantity (EOQ) and inventory turnover analysis.

– ABC analysis is based on paid to those item which account for a larger value of consumption rather than
the quantity of consumption.

2AO
– EOQ determines the order size that will minimize the total inventory cost EOQ =
C

– Factoring is a type of financial service which involves an outright sale of the receivables of a firm to a
financial institution called the factor which specializes in the management of trade credit.

SELF-TEST QUESTIONS
(These are meant for re-capitulation only. Answers to these questions are not to be submitted for evaluation)
1. What do you understand by working capital? What are its components?
2. “Working Capital Management is nothing more than deciding about level, structure and financing of
current assets”. Comment.
3. How would you assess the working capital requirements for seasonal industry in which you have been
appointed as Finance Manager? Illustrate your answer with the example.
4. What are the norms for working capital management to be observed in sick industries? How would
you control the liquidity of resources to avoid sickness in industrial unit facing shortage of cash
resources?
5. Write short note on banking norms and macro aspects of working capital management keeping in
view the recommendations of the Tandon Committee and Chore Committee.
6. What is the significance of working capital for a firm?
7. Briefly describe main constituents of working capital?
8. Why does the operating cycle determine the extent of working capital?
9. Describe the principles of effective cash management.
10. What are the main components of inventory?
11. Write short notes on the following:
(i) Working Capital Leverage.
(ii) Financing of working capital.
(iii) Techniques for control of working capital.
266 EP-F&SM