Define Working capital.

 Working capital (abbreviated WC) is a financial metric which represents operating liquidity available to a business, organization or other entity, including governmental entity. Along with fixed assets such as plant and equipment, working capital is considered a part of operating capital.

 Net working capital is calculated as current assets minus current liabilities. If current assets are less than current liabilities, an entity has a working capital deficiency, also called a deficit working capital.

 Positive working capital is required to ensure that a firm is able to continue its operations and that it has sufficient funds to satisfy both maturing short-term debt and upcoming operational expenses. The management of working capital involves managing inventories, accounts receivable and payable, and cash.

 Q. Discuss about working capital management. Ans.:

 Decisions relating to working capital and short term financing are referred to as working capital management. These involve managing the relationship between a firm's short-term assets and its short-term liabilities. The goal of working capital management is to ensure that the firm is able to continue its operations and that it has sufficient cash flow to satisfy both maturing short-term debt and upcoming^, operational expenses.

Management of working capital:

 The above criteria, management will use a combination of policies and techniques for the management of working capital. The policies aim at managing the current assets (generally cash and cash equivalents, inventories and debtors) and the short term financing, such that cash flows and returns are acceptable;

 Cash management: Identify the cash balance which allows for the business to meet day to day expenses, but reduces cash holding costs.

 Z.Inventory management: Identify the level of inventory which allows for uninterrupted production but reduces the investment in raw materials - and minimizes reordering costs - and hence increases cash flow. Besides this, the lead times in production should be lowered to reduce Work in Process (WIP) and similarly, the Finished Goods should be kept on as low level as possible to avoid over production - see Supply chain management; Just In Time (JIT); Economic order quantity (EOQ); Economic quantity

 3. Debtors management: Identify the appropriate credit policy, i.e. credit terms which will attract customers, such that any impact on cash flows and the cash conversion cycle will be offset by increased revenue and hence Return on Capital (or vice versa); see Discounts and allowances.

 a. Short term financing: Identify the appropriate source of financing, given the cash conversion cycle: the inventory is ideally financed by credit granted by the supplier; however, it may be necessary to utilize a bank loan (or overdraft), or to "convert debtors to cash" through "factoring".

 Q. Explain the differences between variable working capital and permanent working capital.

Ans.:

Working capital is that part of capital invested which is used for running the business such like monev which is used to buy stock, pay expenses and finance credit.

Considering time as the basis of classification, there are two types of worl.~-ig capital:

1) Permanent working capital and

2) Variable working capital

Permanent working capital represents the assets required on continuing basis over the entire year, whereas temporary working capital represents additional assets required at different items during the operation of the year. A firm will finance its

Seasonal and current fluctuations in business operations through short term debt financing. For example, in peak seasons more raw materials to be purchased, more manufacturing expenses to be incurred, more funds will be locked in debtors balances etc. In such times excess requirement of working capital would be financed from short-term financing sources.

The permanent component current assets which are required throughout the year will generally be financed from long-term debt and equity. The minimum level of current assets will be financed by the long-term sources and any fluctuations over the minimum level of current assets will be financed by the short-term financing.

 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.

The difference between variable working capital and permanent working capital is as follows:

I ) Permanent working capital is referred to finance to stock of raw materials, stock of work-in-process, stock of finished goods, debtors balances etc. Variable working capital is used to carry out day to day operations.

2) Permanent working capital consists of stock of raw materials, stock of work-in process, stock of finished goods, debtors' balances, etc. Variable working capital consists of cash, marketable securities, accounts receivable, stock etc.

3) Permanent working capital includes long term financial decisions. Variable working capital includes short term financing decisions.

4) Permanent working capital is mainly required for operational activities. Variable working capital is required for trading activities.

Q. Explain the Factors determininp_ the need for workine capital. Ans.:

The following factors determine the need/requirement for working capital:

     1. Size of business

2. Stage of development

3. Time of production

4. Rate of stock turnover ratio

5. Buying and selling terms

6. Seasonal consumption

7. Seasonal product

8. Profit level

9. Growth and expansion

lo. Production cycle

11. General nature of business

         12. Business cycle

 

Ch.-Working Capital Requirement

 

Problem-1: A newly formed company has applied for a short-term loan to a commercial bank for financing its working capital requirements. You are requested by the bank to prepare an estimate of the requirements of working capital for that company. The information about the company is as under:

 

Estimated cost per unit of production is:

Particulars	Taka
Raw materials	80
Direct labor	30
Overheads (exclusive of depreciation)	60
Total cost = 170

 

Additional information:

Selling price	Tk. 200 per unit
Level of activity	1,04,000 units of production per annum
Raw materials in stock	average 4 weeks
Work in progress (assume gD% completion stage in respect of conversion costs)	average 2 weeks
Finished goods in stock	average 4 weeks
Credit allowed by suppliers	average 4 weeks
Credit allowed by debtors	average 8 weeks
Lag in payment of wages	average 1.50 weeks
Cash at bank expected to be	Tk. 25,000

 

 

 

You may assume that production is carried on evenly throughout the year (52 weeks) and wages and overheads accrue similarly. All sales are on credit basis only.

 

Required: Estimate the net working capital required for the company.

 

Solution:

Estimation of working capital requirements

(A) Investment in Inventory
(i) Investment in Raw materials=RM consumption x RM consumption Period/No. of week (ii) Investment in WIP=Cost of goods sold X WIP consumption Period/No. of week (iii) Investment in Finished goods=Cost of production x FG consumption Period/No. of week	(80X 1,04,OOOX4)/52 (170X 1,04,OOOXO.SX2)/52 (170X 1,04,OOOX4)/52	6,40,000 3,40,000 13,60,000
Total investment in inventory	(i+ii+iii)	23,40.000 27.20,000
(B) Investment in debtors= (Credit sale at costx8)/ No. of week	(170X 1,04,OOOx8)/52
Cash balance required _(C)		25,000
(D) Total investment in current assets (A+Q-+-C)			50,85,000
(E) Current liabilities
(i) Creditors=(Purchase of RMxCP)/No. of week (ii) Deferred wages=Labor costXCP)/No. of week	(80X 1,04,OOOX4)/52 (30x 1,04,OOOX 1.5)/52	6140,000 90,000	7,30,000
(E) Total Current liabilities
(F) Net working capital requirements (D - E)			43,55,000

 

 

Problem-2(Nov' 11): A proforma cost sheet of a company provides the following data:

Fstimated cost per unit of production is:

Costs (per unit)			Taka
Raw materials			52.00
Direct labor			19.50
Overheads			39.00
	Total cost (per unit )		110.50
Profits			19.50
Selling price			130.00

 

The following is the additional information available:

 

Average raw material and finished goods in stock	one month
average material in process	half a month
credit allowed by supplier	one month
credit allowed by debtors	two month
Time lag in payment of wages	one and half week
Overheads	one month
Cash balance is expected	Tk. 1,20,000
One fourth of the sales are on cash basis

 

You are required to prepare a statement showing the working capital needed to finance a level of activity of 70,000 units of output. You may assume that production is carried on evenly throughout the year (52 weeks) and wages and overheads accrue similarly.

Solution:

Estimation of working capital requirements

(A) Investment in Inventory
(i) Investment in Raw materials=RM consumption x RM consumption Period/No. of week (ii) [nvestment in WIP=Cost of goods sold x WIP consumption Period/No. of week (iii) Investment in Finished goods=Cost of production x FG I consumption Period/No. of ~ Week	(52X70,OOOX4)/52 (l 10.50X70,000X2)/52 (1 10.50X70,000X4)/52	2,80,000 2,97,500 5,95,000
~ Total investment in inventory (i+ii+iii) r----                                              --­		1,72,500 10,50,000	I
I (B) Investment in debtors-(Credit sale at                                           ~(130X70,OOOX0.75X8)/52 costx8)/ No. of week
(C) Cash balance required		1,20.000	I, -,
(D) Total investment in current assets (A+B)			23,42,500 i
(F) Current liabilities			I
(i) Creditors=(Purchase of RMxCP)/No. of week (ii) Deferred wages=Labor costxCP)/No. of week tti Deferred overheads	(52X70,OOOX4)/52 (19.5x-,':),000x 1.5)/52 (39X70,OOOX4)/52	2,80,000 39,375 2 ,10,000	5,29,375
(E) Total Current liabilities (i+ii+iii)
(F) Net working capital requirements (D - E)			18,13,125