WORKING CAPITAL MANAGEMENT – INTRODUCTION

1. INTRODUCTION

In every business an optimum level of Working Capital is to be maintained for the purpose of day to
day remittances. Any Business cannot grow in absence of satisfactory working capital level. In case of
shortage of working capital the business may suffer scarcity of resources. But it should also be kept in
mind that even working capital in excessive quantity, possibly will result into superfluous cost.
Therefore, the management of business firm should goal an optimal level of working capital. Working
capital should be ample enough to carry out the current liabilities but should not be much more than
the genuine requirement. It must be ensured by the firm’s managing people that the return yield
through the funds engrossed in structuring working capital is no less than the return earned from
other investment alternatives. In the circumstances, when the financial resources are insufficient and
as a consequent capital cost is to be enlarged, management of working capital becomes even more
crucial and significant due to its profound influence on liquidity and profitability of the business.

The basic objective of Working Capital Management is to avoid over investment or under investment
in Current Assets, as both the extremes involve adverse consequences. Over investment in Current
Assets may lead to the reduced profitability due to cost of funds. Working capital management is
considered to be one of the most important functions of finance, as a very large amount of funds are
blocked in current assets in practical circumstances. Unless working capital is managed properly, it
may lead to the failure of business. The term ‘Working Capital’ may mean Gross Working Capital or
Net Working Capital. Gross Working Capital means Current Assets. Net Working Capital means Current
Assets less Current Liabilities. Unless otherwise specified, Working Capital means Net Working Capital.
As such, Working Capital Management refers to proper management of Current Assets and Current
Liabilities.

The assets which can be converted in the form of cash or used during the course of normal operations
within a short span of time say one year, without any reduction in value are referred as current assets.
Current assets change the shape very frequently. The current assets ensure smooth and fluent
business operations and are considered to be the life-blood of the business. In case of a manufacturing
organization, current assets may be found in the form of stocks, receivables, cash and bank balances
and sundry loans and advances. The term current liabilities refer to those liabilities which are to be
paid off during the course of business, within a short span of time say one year. They are expected to
be paid out of current assets or the earnings of the business. Current liabilities consist of sundry
creditors, bills payable, bank overdraft or cash credit, outstanding expenses etc.
The objective of Working Capital Management is to ensure Optimum Investment in Current Assets. In
other words, Working Capital Management intends to ensure that the investment in Current Assets is
reduced to the minimum possible extent. However, the normal operations of the organization should
not be affected adversely. If the normal operations of the organization are affected adversely,
reducing the investment in Current Assets is fruitless.

Generally, it will not be possible for any organization to operate without the working capital. Let us
assume that a manufacturing organization commences its business with a certain amount of cash. This
cash will be invested to buy the raw material. The raw material purchased will be processed with the
help of various infrastructural facilities like labor, machinery etc. to convert the same in the form of
finished products. These finished products will be sold in the market on credit basis whereby the
receivables get created. And when receivables make the payment to the organization, cash is
generated again. As such, there is a cycle in which cash available to the organization is converted back
in the form of cash. This cycle is referred to as Working Capital Cycle.

In between each of these stages, there is some time gap involved. The entire requirement of working
capital arises due to this time gap. As this time gap is unavoidable, requirement of working capital is
unavoidable. The finance professional is interested in reducing this time gap to the minimum possible
extent in order to manage the working capital properly. Business can survive even if profits are not
made but it may not survive without proper liquidity. Hence, in order to retain the liquidity state, all
business firms should manage their working capital appropriately.

WORKING CAPITAL MANAGEMENT

Relation between Current assets and current liabilities of a business firm is called management of
working capital. “Working capital management is concerned with the problems that arise in
attempting to manage the current assets and current liabilities and the inter-relationship that exists
between them. There is habitually a distinction made amid the investment decisions concerning
current assets and the financing of working capital.”

Two major aspects of management of working capital are:

(1) To ascertain the current assets
(2) To conclude the method of financing
 1.1 CLASSIFICATION OF WORKING CAPITAL

WORKING CAPITAL

On The Basis of Concepts On The Basis of Time

Gross Working Net Working Permanent / Fixed Temporary /

Capital Capital Working Capital Fluctuating
Working Capital

Initial Working Regular Working

Capital
Capital

Seasonal Working Special Working

Capital Capital
I.On The Basis of Concepts
1) Gross Working Capital
Gross working capital is the amount of funds invested in various components of current assets.
Current assets are those assets which are easily / immediately converted into cash within a short
period of time say, an accounting year. Current assets includes Cash in hand and cash at bank,
Inventories, Bills receivables, Sundry debtors, short term loans and advances.
This concept has the following advantages:- D

 Financial managers are profoundly concerned with the current assets.

 Gross working capital provides the correct amount of working capital at the right time.
 It enables a firm to realize the greatest return on its investment.
 It helps in the fixation of various areas of financial responsibility.
 It enables a firm to plan and control funds and to maximize the return on investment.
 2) Net Working Capital

This is the difference between current assets and current liabilities. Current liabilities are those
that are expected to mature within an accounting year and include creditors, bills payable and
outstanding expenses.

Working Capital Management is no doubt significant for all firms, but its significance is enhanced in
cases of small firms. A small firm has more investment in current assets than fixed assets and therefore
current assets should be efficiently managed.

The working capital needs increase as the firm grows. As sales grow, the firm needs to invest more in
debtors and inventories. The finance manager should be aware of such needs and finance them
quickly.

II.On The Basis of Time

1) Permanent / Fixed Working Capital
Permanent or fixed working capital is minimum amount which is required to ensure effective
utilization of fixed facilities and for maintaining the circulation of current assets. Every firm has to
maintain a minimum level of raw material, work- in-process, finished goods and cash balance. This
minimum level of current assts is called permanent or fixed working capital as this part of working is
permanently blocked in current assets. As the business grow the requirements of working capital also
increases due to increase in current assets.

a) Initial working capital

At its inception and during the formative period of its operations a company must have
enough cash fund to meet its obligations. The need for initial working capital is for every
company to consolidate its position.

b) Regular working capital

Regular working capital refers to the minimum amount of liquid capital required to keep up the
circulation of the capital from the cash inventories to accounts receivable and from account
receivables to back again cash. It consists of adequate cash balance on hand and at bank,
adequate stock of raw materials and finished goods and amount of receivables.
 2) Temporary / Fluctuating Working Capital
Temporary / Fluctuating working capital is the working capital needed to meet seasonal as well
as unforeseen requirements. It may be divided into two types.

a) Seasonal Working Capital

There are many lines of business where the volume of operations are different and hence
the amount of working capital vary with the seasons. The capital required to meet the seasonal needs
of the enterprise is known as seasonal Working capital.

b) Special Working Capital

The Capital required to meet any special operations such as experiments with new products or
new techniques of production and making interior advertising campaign etc, are also known as special
Working Capital.
 1.2 WORKING CAPITAL STRUCTURE

It becomes essential to know and understand the current assets components and current liabilities
components to understand working capital management.

Current assets – These are the assets which change their form during working cycle. We can also
define them as those assets which can be converted into cash easily unlike long term assets which
continue in its’ original form for a longer period. They are replaced only after they are fully worn out.
The fixed assets are to be maintained by regular servicing.

1. Cash & Bank Balances- The cash is the most liquid asset. It has direct purchasing power. But no
businessman would like to hold more than minimum necessary cash. It is an asset which does not
appreciate if kept idle. Therefore it is prudent to hold reasonable cash and bank balance for day to
day requirements. The current account balance will appear here.

2. Short term investments- Long term investments are those which cannot be used for day to day
operations such as Gratuity fund, Sinking fund etc. All other temporary or short term investments
which are made with the intention to fetch some extra income and which will mature within
accounting year are short term investments. They are current assets. These investments can be of the
following nature –

i) Government and other trust securities. These types of investments are safe and risk free although
they fetch lesser yield. But they are tradable and can be sold easily without any loss. Therefore such
investments are called current assets.

II) Fixed / Term deposits with banks - After keeping reasonable amount of cash in cash form and in
the current account, surplus is held in term deposit with Banks, the reason being safety and better
returns. Although it is a term deposit which may not mature with accounting year, still it is a practice
to classify it as a current asset because bankers do allow its’ encashment before maturity after
charging some penalty in the form of lesser interest than the contractual interest rate. This also
includes cash margins placed with the bank against LC/ BG facilities.

3. Receivables – These are nothing but outstanding debtors on the date of balance sheet. It is
necessary that these should include debtors arising out of unit’s normal business only. Care also
needs to be taken to ensure that the debtors which are long outstanding say beyond 6 months
are separated and classified under long term or non current assets. Receivables are further
classified as
I) Receivables- (other than Export receivables and deferred receivables) This is the
outstanding amount of local or domestic debtors. It will not include those debtors, which
although are on account of normal business but where long term credit is extended and the
amount is not due on the balance sheet date. Such dues will fall under non current assets.
The amount of bills which are discounted but not due will also be a part of this item. It is
because it’s a contingent liability to the bank or financers if such bills are not realized on due
date.
II) Export Receivables (including bills purchased & discounted)-These are debtors on account
of Exports. They are required to be classified separately because export bills have special
importance and Reserve Bank of India allows banks to extend 100 % finance against export
bills. Therefore the borrower need not provide any margin against this asset. This item can
be removed from the total of current assets while arriving at the margin on current assets.

4. Inventory- The inventory constitutes the major item of current assets. What level of inventory a
unit should hold depends on various factors.
I) Raw Materials – The value of stock of Raw materials on hand as on balance sheet date. These
should include only those raw materials which are used for manufacturing of the products in which
the unit is engaged. Items of Stores, spares, dies etc although required to be replaced more
frequently and have short life will not be treated as Raw materials and these will be shown
separately.
II) Work –in – Process – The raw materials after it is put into production process and yet to be
converted into finished goods or till it has not taken the form of finished goods are called Work in
Process. It is also called Stock–in–Process. Thus it is neither a Raw Material nor Finished product.
During the course of raw material’s conversion there is lot of value addition such as labour, power
and other raw materials. Therefore as the production process progresses the value of stock in
Process goes up. Such stock is valued as on Balance sheet date and shown as Stock in process. The
valuation will of course be original cost of raw material and also the value of any other material
and services added to it. Proportionate expenses on account of fuel, electricity, labour,
consumables, storage etc will also be added for this valuation. However this item has lesser
realizable value as compared to raw materials and finished goods. This is because it has almost nil
alternative use.
III) Finished goods- Once the finished goods are ready, they under go various formalities such as
packing, billing, payment of excise duty. The goods which are produced on made to order basis
will immediately be converted into debtors or cash. But otherwise it is usual practice to keep some
 stock of finished goods on hand to meet delivery of orders received. Such stock is shown under
this item. (What are the finished goods and what are raw materials will depend on the nature of
the activity. If a unit is a trading unit dealing in auto spares and lubricant then all such item will be
finished goods. But for an auto manufacturer all the parts and lubricants are raw materials.
IV) Other consumable spares - These are those spares which are required for maintenance and
upkeep of machinery to ensure smooth and continuous production process. Units must maintain
adequate stock to avoid breakdown of production process. 8.2.6 Advances to the suppliers of raw
materials and stores / spares, consumable – When advance for acquisition of these items is paid,
then all outstanding amounts on this account will come under this item. These advances are
expected to get adjusted against purchases.

5. Advance payment of taxes- The unit has to pay advance corporate tax and some other taxes in
instalments on the basis of self assessment. The exact amount of taxes payable for particular
financial year / assessment year will be known only after assessment by tax authorities is
complete. Till that time it will be advance tax. In a running unit there will always be some such
advance tax. Such amount in the books is shown under this item.

6. Other current assets- This is the last item under the current assets. It is obvious that the asset or
advance expenditure which is current in nature but not falling under any of the classification under
item 1 to 7 above will fall under this head. It may be pre paid expenses where exact final liability
is not yet decided, short term deposit, advance given to staff which is to be recovered within a
short period of one year. What items in balance sheet will appear here, will depend on correct
analysis of balance sheet.

Current liabilities –Current liabilities are explained as all obligations that are due in near future for
payment. It is necessary to know as to what are the items of current liabilities. These are explained as
below.

1. Bank borrowing- These are all the outstanding balances on account of short term borrowing from
banks/ financial institutions for working capital purposes. It will also include outstanding amount of
Bills purchased / discounted by banks which is a source for working capital finance. All such advances
are payable on demand and not in instalments. However in real practice the fund based facility
extended by bank continues till the unit is running and the working capital limits are normally
enhanced to meet growing requirements of the unit as the sales and production turnover increases.
2. Short term borrowings from others – This item relates to those borrowings which are of short term
nature. By short term what we mean is that such amounts borrowed are to be repaid within a period
of say 12 months or within the accounting year of the firm / company. The amount which is
outstanding as at the year end will appear here.

3. Deposits (Maturing within a year) – It is a common practice to borrow from public, subject to
provisions of various laws in this regard for amount, rate of interest, T.D. S. etc. Even proprietary and
partnership firms borrow long term deposits from friends and relatives. This source is resorted to
mainly because at times it is procedurally simple unlike bank borrowing, wherein strict and rigid
financial discipline is required to be followed like periodical submission of data and statements. Such
deposits are received mainly on account of contacts and goodwill of the owners and trust in the
management. They support the equity or capital. The portion of such deposits which are falling due
for repayment within following 12 months from the date of balance sheet, are treated as current
liability and hence shown here.

4. Sundry creditor (Trade) - A business entity, manufacturer normally enjoys credit from the suppliers
of raw materials as per practice prevailing in the market. It also has creditors for other expenses and
also for supply of fixed assets. So as the name indicates, all such outstanding creditors for trade
purpose (which are due for repayment within one year) will appear under this head

5. Unsecured loans- The outstanding balances of the loans (other than term loans) will appear here.
The basic difference between the short term borrowings from others (item 2 discussed earlier) and
unsecured loans is that although the loans may be of any duration, the short term borrowings are for
a very short period. Moreover in case of unsecured loan, there is some sort of agreement which holds
good in law but in case of short term borrowing no such formal agreement is entered into. Therefore
such loans are more common in case of proprietary / partnership firms. The depositors are secured
creditors but the lenders of these loans are unsecured.

6. Interest and other charges accrued but not due for payment- Interest is required to be paid for
different reasons. In case of short term borrowing or unsecured loans it might have been agreed to
pay interest at agreed rate along with the principal. Such interest although accrued on the principal
up to year end period, it will be paid only along with the principal. Such amount will be shown here.

7. Provision for taxation- Some taxes that have become due but might not have been paid on the date
of final accounts. But a provision has to be made for this unpaid tax liability. The unit normally makes
advance payment of taxes on the stipulated days on the basis of self assessment. While working out
the exact tax liability as on the date of final accounts, it may be observed that some additional tax is
required to be paid and it will be paid only in the next year then a provision is made for this to arrive
at the correct profit. Such provisions appear under this head.

8. Dividend payable - Dividends declared in the previous years may remain unpaid for various reasons.
It can be due to adverse financial position, non availability of current address of the shareholders etc.
Although unpaid this amount is liability and payable as early as possible. Therefore it is a current
liability and classified here.

9. Other statutory liabilities (due within one year)- These are the liabilities which must be paid under
various acts/ laws and falling due for payment within next 12 months. They can be provident fund
dues, E.S.I.C. dues, liabilities under work men compensation act and so on.

10. Instalments of term loans/deferred credits/ debentures/ redeemable preference shares (due
within one year)- All liabilities falling due within a period of next one year has to be considered as
current liability because it will be paid before next year’s profit/loss is arrived at. Therefore it has to
be paid out of this year’s income. The amount taken here is aggregate of all these items falling due
within next year.

After having seen the current assets and current liabilities let us go to some other concepts in the
working capital.

NET WORKING CAPITAL -

Net working capital is provided from long term source which means excess of long term sources over
long term uses. Alternatively it can also be arrived at as a difference between current assets and
current liabilities. We can also call this as owner’s stake or contribution in the working capital. So more
it is, better the unit. In such a situation it can also be said that in case of crisis if the current assets do
not realize the expected value to meet the current liabilities, there is adequate cushion from this
source.

WORKING CAPITAL GAP

The banks when decide to finance for working capital the approach is always need based. They believe
in extending adequate finance. We know the various items of current liabilities other than bank
borrowings are short term sources to meet short uses i.e. current assets. Therefore the uncovered
gap left between Current assets and current liabilities other than bank borrowing is working capital
gap
1.3 THE NEED FOR THE WORKING CAPITAL

Why a business need working capital

Any enterprise whether industrial, trading, or others generate three types of assets to run its business
as a going concern.

1. Fixed assets to carry on the production/ business such as land, building, plant & machinery, furniture
& fixtures etc. For going concern these are of permanent in nature and are not to be sold except in
adverse conditions.

2. Current assets require for day to day working of the business/unit which are floating in nature and
keep changing during the course of business at a rapid pace in comparison to the other assets. These
are short term in nature such as inventory, receivables (outstanding less than six months), loan &
advances, cash & bank balance etc.

3. Non- Current assets which are neither fixed assets not current assets such as Intangible assets, long
term investments, FDR put in bank as margin money, security deposit (rent, government authorities
etc), debtors outstanding more than six months

Further fixed assets are to be financed by owned funds and long term liabilities raised by a concern
while current assets are partly financed long term liabilities and partly by current liabilities and other
short term loans arranged by concern from the bank. Nature of industry decides the requirement of
concern about the investment in current assets. For example big industrial projects may require
substantial investment both in fixed and current assets in comparison to trading unit or service sector.
A trading unit needs to invest a huge amount in stock-in-trade in comparison to fixed asset

The need for working capital arises due to the time gap between production and realization of cash
from sales. Working capital is must for every business for purchasing raw-materials, semi finished
goods, stores & spares etc and the following purposes.

1. To purchase raw materials, spare parts and other component. A manufacturing firm needs
raw-materials and other components parts for the purpose of converting them in to final
products, for this purpose it requires working capital. Trading concern requires less working
capital.

2. To meet over head expenses. Working capital is required to meet recurring over head
expenses such as cost of fuel, power, office expenses and other manufacturing expenses.
3. To hold finished and spare parts etc. Stock represents current asset. A firm that can afford to
maintain stock of required finished goods, work in progress & spares in required quantities
can operate successfully. So for that adequate quantity of working capital is required.
4. To pay selling & distribution expenses.Working capital is required to pay selling & distribution
expenses. It includes cost of packing, commission etc.
1.4 IMPORTANCE OF WORKING CAPITAL

1. Solvency of the business: Adequate working capital helps in maintaining the solvency of the
business by providing uninterrupted of production.

2. Goodwill : Sufficient amount of working capital enables a firm to make prompt payments
and makes and maintain the goodwill.

3. Easy loans: Adequate working capital leads to high solvency and credit standing can arrange
loans from banks and other on easy and favorable terms.

4. Cash discounts: Adequate working capital also enables a concern to avail cash discounts on
the purchases and hence reduces cost.

5. Regular Supply of Raw Material: Sufficient working capital ensures regular supply of raw
material and continuous production.

6. Regular payment of salaries, wages and other day to day commitments: It leads to the
satisfaction of the employees and raises the morale of its employees, increases their
efficiency, reduces wastage and costs and enhances production and profits.

7. Exploitation of favorable market conditions: If a firm is having adequate working capital

then it can exploit the favorable market conditions such as purchasing its requirements in
bulk when the prices are lower and holdings its inventories for higher prices.

8. Ability to Face Crises: A concern can face the situation during the depression.

9. Quick and regular return on investments: Sufficient working capital enables a concern to
pay quick and regular of dividends to its investors and gains confidence of the investors and
can raise more funds in future.
 1.5 DETERMINANTS OF WORKING CAPITAL REQUIREMENTS

Papers, with their fixed investment, appear to have the lowest requirement for current assets. This
does not mean that the problem of working capital may be minimized in this field of enterprise, since
ready funds are still essential to cover disbursement for wages, interest on funds debt, purchase of
materials and supplies, etc. indeed, under such conditions the working capital position may become
even more strategic in character because of its relation to, and control of the large amount of fixed
assets. Thus, one of the outstanding problems of paper management in recent years has been the
maintenance of current position sufficiently strong to permit vigorous operations. Public utilities, like
the paper, have a fixed investment which causes the current assets to constitute only a relatively small
percentage of the total assets. There is a difference between operating and holding companies, but
even then the funds required to cover current transactions are minor as compared with those
necessary to finance the long term structure.

Industrial companies, generally, require a large amount of working capital although it various from
business to business of lack of uniformity characterizing each field of enterprise. However, the
underlying determinants of the amounts of fixed capital are required for operation; working assets
may be expected to occupy a smaller niche in the assets structure. For similar reasons, a rapid turnover
of capital will inevitably mean a large proportion of current assets. In the case of industries with fixed
investment, one of the primary uses of working capital is its conversion into operating plant structure.
In turn, it is expected that the income resized form operations will normally replace such defections.
This means that the flow of a portion of working capital is circulating through fixed investment that its
recovery is dependent upon the income realized. Where the current assets are relatively more
important, a rapid sales turnover is usually found. Often, as a case of retail concerns, the specific
working assets constitute the object of sale and recovery is direct and immediate. In manufacturing
enterprises, a large share of working capital management is more likely to become charged in form by
conversion into finished products, but even here, the potentiality of recovery is not delayed as long as
in the case of public utilities and paper companies. The need for working capital varies with changes
in the volume of business. A considerable proportion of current assets is needed permanently as fixed
assets. More than one production cycle may be in process at one and the same time, for business
operations on a continuing basis. Materials are purchase and work is in progress. Finished inventory
is sold. At the same time new receivables accumulate and old ones are converted into cash. Cash is
utilized in the production process
Various factors influence volume and requirement of working capital. Hence determining working
capital does not have a set formula or particular way. The condition and information of company must
be analyzed to conclude the requirement of working capital.

Below are the factors which influence requirement of working capital:

1. Nature of business – Some businesses are such that due to their very nature, their requirement of
fixed capital is more rather than working capital. These businesses may sell services and not the
commodities and that too on cash basis. As such, no funds are blocked in piling the inventories and no
funds are blocked in receivables. For example Public utility services like railways, electricity boards,
and infrastructure oriented projects etc. Their requirement of working capital is less. Whereas if the
organization is a trading organization, the requirement of working capital will be on the higher side,
as huge amount of funds get blocked in mainly two types of current assets, stock and receivables.

2. Size of the Organization – If we talk about undersized scale organizations, because of huge
overheads total, the necessity of working capital gets really high. It is also influenced by high purchase
costs as well as high selling costs. As such, medium sized organizations have an edge over the small
scale organizations. However, if the business grows beyond a certain limit, the requirement of working
capital may be adversely affected by the increasing size.

3. Phase of Trade Cycles – During the inflationary conditions, the working capital requirement will be
on the higher side as the company may like to buy more raw material, may increase the production to
take the advantage of favorable market conditions and due to increased sales more funds are blocked
in stocks and receivables. During the depression, the requirement of working capital will be on the
lower side due to reduced operations but more working capital may be required due to piling up of
inventories and due to nonpayment of dues by customers in time. As such, in both the extreme
situations of trade cycles, requirement of working capital may be high.

4. Trading Terms – The terms on which the organization makes the purchases and sales affect the
requirement of working capital in a big way. If the purchases are required to be made on cash basis
and sales are to be made on credit basis to cope with competition existing in the market, it will result
into high requirement of working capital. Whereas, if the purchases can be made on credit basis and
sales can be made on cash basis, it will trim down the prerequisite of working capital, as a part of
working capital requirement can be financed out of credit offered by the suppliers.

5. Length of Production Cycle – The term production cycle refers to the time duration from the stage
raw material is acquired till the stage finished product is manufactured. The principle will be “Longer
the duration of production cycle, higher the requirement of working capital.” In some businesses like
machine tool industry, the time gap between the acquisitions of raw material till the completion of
production is quite high. As such, more amounts are blocked in raw materials or work in progress or
finished goods and even in receivables. Requirement of working capital is always very high in this case.

6. Profitability – High profitability reduces the strain on working capital as the profit to the extent they
are earned in cash can be used for financing the requirement of working capital. However, the profit
which reduces the strain on working capital is the post-tax profit i.e. the profit earned after paying off
the tax liability and Post-dividend profit i.e. the profit remaining in the business after paying the
dividend on the shares.
 1.6 OPERATING CYCLE OF WORKING CAPITAL:

1. Operating Cycle of Manufacturing Firm :-

The working capital cycle reserves to the length of time between the firm paying cash for materials
etc., this working capital also known as operating cycle. Working capital cycle or operating cycle
indicates the length or time between companies paying for materials entering into stock and
receiving the cash from sales of finished goods. The operating cycle (Working Capital) consists of the
following events. Which continues throughout the life of business?

CASH

RAW
DEBTORS MATERIALS

FINISHED STOCK WORK-IN-PROGRESS

 Conversion of cash into raw materials.

 Conversion of raw materials into work in progress.

 Conversion of work in progress into finished stock.

 Conversion of finished stock into accounts receivables(Debtors)through sale and

 Conversion of account receivables into cash

2. Operating Cycle of Non - Manufacturing Firm :-

The non-manufacturing firms, such as whole sellers and retailers, will not have the
manufacturing phase; they will have rather direct conversion of cash into finished stock, into
accounts receivables and then into cash. The operating cycle of a non manufacturing firm is
shown as under.
The non-manufacturing firms, such as whole sellers and retailers, will not have the
manufacturing phase; they will have rather direct conversion of cash into finished stock, into
accounts receivables and then into cash. The operating cycle of a non manufacturing firm is
shown as under

ACCOUNTS RECEIVABLES

CASH STOCK FINISHED GOODS

3. In addition to this, some service and financial concerns may not have any inventory at all. Such
firm have the shortes operating cycle as shown in figure below.

ACCOUNTS

CASH RECEIVABLES
ESTIMATION OF CURRENT ASSETS
1. Raw Material Inventory:
The Investment in Raw Material can be computed with the help of the following formula:-

Budgeted Cost of Raw Average Inventory

Production x Material(s) x Holding Period
( In units ) per unit (months/days)
12 months / 52 weeks / 365days

2. Work-in-progress (W/P) Inventory:

The relevant cost of determine work in process inventory are the proportionate share of cost
of raw material and conversion costs ( labors and Manufacturing over Head cost excluding
depreciation) In case, full until of raw material is required in the beginning the unit cost of work is
process would be higher, i.e., cost of full unit + 50% of conversion cost compared to the raw material
requirement. Throughout the production Cycle, working process is normally equivalent to 50% of total
cost of production. Symbolically,

Budgeted Estimated work- Average Time Span

Production x in-progress cost x of work-in-progress
( In units ) per unit inventory (months/days)
12 months / 52 weeks / 365days

3. Finished Goods Inventory:

Working capital required to finance the finished goods inventory is given by factors summed up
as follows:-

Budgeted Cost of Goods Produced Finished Goods

Production x per unit (excluding x Holding Period
( in units ) depreciation) (months/days)
12 months / 52 weeks / 365days

4. Debtors:
The working capital tied up in debtor should be estimated in relation to total cost price (
excluding depreciation ) symbolically,

Budgeted Cost of Sales per Average Debt

Production x unit excluding x Collection Period

( In units ) depreciation (months/days)

12 months / 52 weeks / 365days
5. Cash and Bank Balances:
Apart from Working Capital needs for Financing Inventories and Debtors, Firms also find it
useful to have such minimum cash Balances with them. It is difficult to lay down the exact procedure
of determining such an amount. This would primarily be based on the motives of holding cash balances
of the business firm, attitude of management towards risk, the access to the borrowing sources in
times of need and past experience.

ESTIMATION OF CURRENT LIABILITIES

The Working Capital needs of business firms are lower to the extent that such needs are met through

the Current Liabilities(other than Bank Credit) arising in the ordinary course of business. The Important

Current Liabilities in this context are Trade-Creditors, Wages and Overheads:-

1. Trade Creditors:
The Funding of Working Capital from Trade Creditors can be computed with the help of the
following formula:-

Budgeted Yearly Raw Material Credit Period

Production x Cost x Allowed by creditors
( In units ) per unit (months/days)

12 months / 52 weeks / 365days

Note:- Proportional adjustment should be made to cash purchases of Raw Materials.

2. Direct Wages:
The Funding of Working Capital from Direct Wages can be computed with the help of the

following formula:-

Budgeted Yearly Direct Labor Average Time-lag in

Production x Cost x Payment of wages
( In units ) per unit (months/days)

12 months / 52 weeks / 365dayss

Note:- The average Credit Period for the payment of wages approximates to half-a-month in the case

of monthly wage payment. The first days monthly wages are paid on the 30th of the month, extending

credit for 29 days, the second day’s wages are, again , paid on the 30th day, extending credit for 28

days, and so on. Average credit period approximates to half-a-month.

3. Overheads (other than Depreciation and Amortization):

The Funding of Working Capital from Overheads can be computed with the help of the

following formula:-

Budgeted Yearly Overhead Average Time-lag in

Production x Cost x Payment of overheads

( In units ) per unit (months/days)

12 months / 52 weeks / 365days

Note:- The amount of Overheads may be separately calculated for different types of Overheads. In

the case of Selling Overheads, the relevant item would be sales volume instead of Production Volume.
1.7 FORMAT FOR DETERMINATION OF WORKING CAPITAL:

AMOUNT
SL.NO PARTICULARS

1 ESTIMATION OF CURRENT ASSETS

1) Minimum desired cash and Bank balances. xxx

2) Inventories
Raw material xxx

Work-in-progress xxx

Finished stock xxx

3) Debtors xxx

Total Current Assets

XXX
ESTIMATION OF CURRENT LIABILITIES

1) Creditors xxx

2) Wages xxx

3) Overheads xxx

Total current liabilities

XXX

XXX
2 NET WORKING CAPITAL

(Total Current assets – Total Current liabilities)

XX
Add : Margin for contingency net

Working capital requirement

XXXX
1.8 COMPONENTS OF WORKING CAPITAL

The components of working capital are:

 CASH MANAGEMENT
 RECEIVABLES MANAGEMENT
 INVENTORY MANAGEMENT

 CASH MANAGEMENT:
Cash is the important current asset for the operation of the business. Cash is the Basic input needed
to keep the business running in the continuous basis, it is also the ultimate output expected to be
realized by selling or product manufactured by the firm.

The firm should keep sufficient cash neither more nor less. Cash shortage will disrupt the firm’s
manufacturing operations while excessive cash will simply remain ideal without contributing anything
towards the firm’s profitability. Thus a major function of the financial manager is to maintain a sound
cash position. Cash is the money, which a firm can disburse immediately without any restriction. The
term cash includes coins, currency and cheques held by the firm and balances in its bank account.

NEED FOR HOLDING CASH

The need for holding Cash arises from a variety of reasons which are,

1. Transaction Motive:
A company is always entering into transactions with other entities. While some of these
transactions may not result in an immediate inflow/outflow of cash (E.g. Credit purchases and Sales),
other transactions cause immediate inflows and outflows. So firms keep a certain amount of cash
so as to deal with routine transactions where immediate cash payment is required.

2. Precautionary Motive:
Contingencies have a habit of cropping up when least expected. A sudden fire may break out,
accidents may happen, employees may go on a strike, creditors may present bills earlier than
expected or the debtors may make payments earlier than warranted. The company has to be
prepared to meet these contingencies to minimize the losses. For this purpose companies generally
maintain some amount in the form of Cash.
 3. Speculative Motive:
Firms also maintain cash balances in order to take advantage of opportunities that do not
take place in the course of routine business activities. For example, there may be a sudden decrease
in the price of Raw Materials which is not expected to last long or the firm may want to invest in
securities of other companies when the price is just right. These transactions are purely of speculative
nature for which the firms need cash.

OBJECTIVES OF CASH MANAGEMENT

Primary object of the cash management is to maintain a proper balance between liquidity and
profitability. In order to protect the solvency of the firm and also to maximize the profitability.
Following are some of the objectives of cash management.

1. To meet day to day cash requirements.

2. To provide for unexpected payments.
3. To maximize profits on available investment opportunities.
4. To protect the solvency of the firm and build up image.
5. To minimize operational cost of cash management.
6. To ensure effective utilization of available cash resources.

CASH BUDGETING

Cash budgeting is an important tool for controlling the cash. It is prepared for future period to know
the estimated amount of cash that may be required. Cash budget is a statement of estimated cash
inflows and outflows relating to a future period. It gives information about the amount of cash
expected to be received and the amount of cash expected to be paid out by a firm for a given period.

Cash budgeting indicates probably cash receipts and cash payments for an under consideration. It is a
statement of budgeted cash receipts and cash payment resulting in either positive or negative cash or
for a week or for a year and so on.
 RECEIVABLES MANAGEMENT:
Receivables or debtors are the one of the most important parts of the current Assets which is created
if the company sells the finished goods to the customer but not receive the cash for the same

immediately. Trade credit arises when a company sales its products or services on credit and does not
receive cash immediately. It is an essential marketing tool, acting as a bridge for the moment of goods
through production and distribution stages to customers.

The receivables include three characteristics

1) It involve element of risk which should be carefully analysis.

2) It is based on economic value. To the buyer, the economic value in goods or services passes
immediately at the time of sale, while seller expects an equivalent value to be received later on.

3) It implies futurity. The cash payment for goods or serves received by the buyer will be made by
him in a future period.

A company gives trade credit to protect its sales from the competitors and to attract the potential
customers to buy its products at favorable terms. Trade credit creates receivables or book debts that
the company is accepted to collect in the near future. The customers from who receivables have to be
collected are called as “Trade Debtors” receivables constitute a substantial position of current assets.

Granting credit and crediting debtors, amounts to the blocking of the company’s funds. The interval
between the date of sale and the date of payment has to be financed out of working capital as
substantial amounts are tied up in trade debtors. It needs careful analysis and proper management.

 INVENTORY MANAGEMENT:
Inventories are goods held for eventual sale by a firm. Inventories are thus one of the major
elements, which help the firm in obtaining the desired level of sales. Inventories includes raw
materials, semi finished goods, finished products.

In company there should be an optimum level of investment for any asset, whether it is plant, cash or
inventories. Again inadequate disrupts production and causes losses in sales. Efficient management
of inventory should ultimately result in wealth maximization of owner’s wealth. It implies that while
the management should try to pursue financial objective of turning inventory as quickly as possible, it
should at the same time ensure sufficient inventories to satisfy production and sales demand.
The main objectives of inventory management are operational and financial.

The operational mean that means that the materials and spares should be available in sufficient
quantity so that work is not disrupted for want of inventory. The financial objective means that
investments in inventories should not remain ideal and minimum working capital should be locked in
it.

The following are the objectives of inventory management:

 To ensure continuous supply of materials, spares and finished goods.

 To avoid both over and under stocking of inventory.
 To maintain investments in inventories at the optimum level as required by the operational and
sale activities.
 To keep material cost under control so that they contribute in reducing cost of production and
overall purchases.
 To minimize losses through deterioration, pilferage, wastages and damages.
 To design proper organization for inventory control so that management. Clear cut account ability
should be fixed at various levels of the organization.
 To ensure perpetual inventory control so that materials shown in stock ledgers should be actually
lying in the stores.
 To ensure right quality of goods at reasonable prices.
 2.WORKING CAPITAL ASSESSMENT
We have seen earlier, what is Working Capital and how it is arrived at. The banker will always sanction
working capital facility based on certain assumption for business process and future prospects. The
finance has to be adequate and should be available well in time. The unit should not suffer on account
of shortage of funds or delay in getting the funds. At the same time if more than necessary or excess
finance is made available, it is likely to be diverted to non-business purposes or this short-term finance
may be diverted to long term uses i.e. for acquisition of fixed assets. If any of this happens, it is likely
to put the unit to financial problem at a later date. Method for assessment of requirement is used
based on size of business and nature of activity.

Therefore, there are various methods for assessment of Working Capital limits. As directed by RBI
each bank may have its own method of assessment of working capital. Each bank is free to devise their
own policy in respect of assessment of working capital finance and such policy should have an approval
of the Board of respective bank. The bank may have different method for different type of borrower
such as Small traders, Manufacturing units, Small & Medium entrepreneurs (SMES), large C& I
borrowers, Service industry etc. The bank may prescribe different methods for the same type of
borrowers but on the basis of turnover or limits.

The various methods commonly used by banks are discussed in the following paragraphs.

PERMISSIBLE LIMIT METHOD

(TRADITIONAL METHOD)

SALES : Rs. 10.00 lacs p.m.

COST OF RAW MATERIALS : Rs. 6.00 lacs p.m. COST OF PRODUCTION : Rs. 8.00 lacs p.m. ASSUME :- (i)
HOLDING LEVELS: Raw Materials Month’s Consumption 1.0 Stocks-in-process Month’s Cost of
Production 0.5 Finished Goods Months’ Cost of Sales 0.5 Receivables Month’s Sales 1.0 Expenses
Month’s Expenses 1.0 Sundry Creditors Month’s Purchases 0.5 LIQUID SURPLUS = C.A. - C.L. = 6.0