2. • Working capital typically means the firm’s holding of current
or short-term assets such as cash, receivables, inventory and
marketable securities.
• Working Capital refers to that part of the firm’s capital, which
is required for financing short-term or current assets.
• These items are also referred to as circulating capital.
Working capital: Concept
3. There are two possible interpretations of
working capital concept:
1. Balance sheet concept
2. Operating cycle concept
Balance sheet concept: There are two interpretations
of working capital under the balance sheet
concept.
a. Excess of current assets over current liabilities
b. Gross or total current assets.
Excess of current assets over current liabilities are called the net
working capital or net current assets.
Concept of working capital
4. Operating cycle concept
• A company’s operating cycle typically consists of three
primary activities:
– Purchasing resources,
– Producing the product and
– Distributing (selling) the product.
These activities create funds flows that are both unsynchronized
and uncertain.
Unsynchronized because cash disbursements usually take place
before cash receipts.
Uncertain because future sales and costs cannot be forecasted
with complete accuracy.
5. • The firm has to maintain cash balance to pay the
bills as they come due.
• In addition, the company must invest in
inventories to fill customer orders promptly.
• And finally, the company invests in accounts
receivable to extend credit to customers.
• Operating cycle is equal to the length of
inventory and receivable conversion periods.
Operating cycle concept
6. Operating cycle of a typical company
Payable
Deferral period
Inventory conversion
period
Cash conversion
cycle
Operating
cycle
Pay for
Resources
purchases
Receive
CashPurchase
resources
Sell
Product
On credit
Receivable
Conversion period
8. If you Then ......
Collect receivables (debtors)
faster
You release cash from the
cycle
Collect receivables (debtors)
slower
Your receivables soak up
cash
Get better credit (in terms
of duration or amount) from
suppliers
You increase your cash
resources
Shift inventory (stocks)
faster
You free up cash
Move inventory (stocks)
slower
You consume more cash
9. • Raw material storage peiod: = Average stock of raw material
Cost of raw material consumed/365
• WIP holding period: Average WIP inventory/ Cost of production/365
• Finished goods storage period: Average stock of finished goods/Cost of goods
sold/365
• Inventory conversion period: Avg. inventory/ Cost of sales/365
• Receivable conversion period:Accounts receivable/Annual credit sales/365
• Payables deferral period: Accounts payable/(Credit purchases)/365
Operating cycle: Inventory conversion period + receivable
conversion period.
Cash conversion cycle = operating cycle – payables deferral period.
10. TYPES OF WORKING CAPITAL
WORKING CAPITAL
BASIS OF
CONCEPT
BASIS OF
TIME
Gross
Working
Capital
Net
Working
Capital
Permanent
/ Fixed
WC
Temporary
/ Variable
WC
Regular
WC
Reserve
WC
Special
WC
Seasonal
WC
11. • The size and nature of investment in current assets is a
function of different factors such as
– Type of products manufactured,
– Length of operating cycle,
– Sales level,
– Inventory policies,
– Unexpected demand and
– Unanticipated delays in obtaining new inventories,
– Credit policies and
– Current assets.
Working capital investment
12. Difference between permanent & temporary
working capital
Amount Variable Working Capital
of
Working
Capital
Permanent Working Capital
Time
14. Matching approach to asset financing
Fixed Assets
Permanent Current Assets
Total Assets
Fluctuating Current Assets
Time
Rs
Short-term
Debt
Long-term
Debt +
Equity
Capital
15. Conservative approach to asset financing
Fixed Assets
Permanent Current Assets
Total Assets
Fluctuating Current Assets
Time
Rs
Short-term
Debt
Long-term
Debt +
Equity
capital
16. Aggressive approach to asset financing
Fixed Assets
Permanent Current Assets
Total Assets
Fluctuating Current Assets
Time
RS
Short-term
Debt
Long-term
Debt +
Equity
capital
17. FACTORS DETERMINING WORKING CAPITAL
1. Nature of the Industry
2. Demand of Industry
3. Cash requirements
4. Nature of the Business
5. Manufacturing time
6. Volume of Sales
7. Terms of Purchase and Sales
8. Inventory Turnover
9. Business Turnover
10. Business Cycle
11. Current Assets requirements
12. Production Cycle
19. Satyam Ltd profit and loss A/c and balance sheet for the year
ended 31.12.15 are given below. You required to calculate the
working capital requirement under operating cycle method:
Opening stock
Raw material 10,000
WIP 30,000
Finished goods 5,000
Credit purchase 35,000
Manufacturing expn 15,000
Gross profit 55,000
150,000
Administration expn 15,000
Selling &distrbtn expn 10,000
Net profit 30,000
55,000
Credit sales 1,00,000
Closing stock
Raw material 11,000
WIP 30,500
Finished goods 8,500
150,000
Gross profit 55,000
.
55,000
20. Liabilities
Equities (16,000@Rs.10) 160,000
Net Profit 30,000
Creditors 10,000
2,00,000
Assets
Fixed Assets 1,00,000
Debtors 30,500
Cash and Bank 19,500
Closing stock
Raw material 11,000
WIP 30,500
Finished goods 8,500
2,00,000
Opening debtors (excluding profit) and opening creditor were Rs.6,500 and
Rs.5,000 respectively
21. Calculation of operating cycle
Raw material
Average raw material /Raw material consumed
per day
=10,500/34,000/365 =
Work in progress
Average WIP /Total cost of production per day
=30,250/48500/365 =
22. Calculation of operating cycle
Finished goods
Average stock/ Total cost of goods sold per day
=6750/45,000/365 =
Debtors
Average Debtors/ credit sales per day
=18,500/ 100,000/365 =
23. Calculation of operating cycle
Creditor
Average creditor/credit purchases per day
=7500/35,000/365
Net Operating Cycle is
Total days – Credit allowed by creditors
=
24. Estimation of Net Working capital requirement for Exl
Ltd from the data given below
Cost of production (per unit) Amount(per unit )
Raw materials 100
Direct labour 40
Overheads 80
220
The following are the additional information:
Selling price per unit Rs.240
Level of activity 1,04,000 units p.a
Raw material in stock Average 4 weeks
Work In Progress (Assume 100% stage of completion of materials and 50 percent for
labor and overheads) Average 2 weeks
Finished goods in stock Average 4 weeks
Credit allowed by supplier Average 4 weeks
Credit allowed by debtors Average 8 weeks
Lag in payment of wages Average 1.50 weeks
Cash at bank is expected to Rs.25,000. Production is sustained during 52 weeks of year
25. Statement of Working Capital Requirement
Particulars Amount
Raw materials 2,000 x 4 x 100 8,00,000
WIP
•Raw materials 2,000 x 2 x 100 4,00,000
•Wages (2,000 x 2 x 40)50% 80,000
•Overheads (2,000 x 2 x 80) 50% 1,60,000 6,40,000
Finished stock 2,000 x 4 x 220 17,60,000
Debtors 2,000 x 8 x 220 35,20,000
Cash 25,000
Total Current Assets 67,45,000
Creditors 2,000 x 4 x 100 8,00,000
Outstanding wages 2,000 x 4 x 1.5 1,20,000
Total current liabilities 9,20,000
Net working capital (TCA - TCL) 58,25,000
26. INVENTORY
MEANING
• Held for SALE
• Consumed in the PRODUCTION of goods and
services
Forms of Inventory for Manufacturing firm.
Raw materials,
Work in process,
Finished goods and stores & spares.
29. COSTS OF HOLDING INVENTORIES
• Ordering costs
• Inventory Carrying/storage costs
• Opportunity costs of funds blocked
• Shortage
30. TOOLS & TECHNIQUES OF INVENTORY
MANAGEMENT/ CONTROL
• ABC Analysis
• Economic Ordering Quantity (EOQ)
• Order Point Problem
31. ABC analysis
• ABC analysis is an inventory categorization
method which consists in dividing items into
three categories, A, B and C:
– A being the most valuable items,
– C being the least valuable ones.
• This method aims to draw managers’
attention on the critical few (A-items) and not
on the minor many (C-items).
32. ABC Analysis
CATEGORY NO. OF ITEMS(%) ITEM VALUE(%) MANAGEMENT
CONTROL
A 15 70 (HIGHEST) MAXIMUM
B 30 20(MODERATE) MODERATE
C 55 10(LEAST) MINIMUM
TOTAL 100 100
34. Solution
ABC Groups
Class Items Annual
Volume
Percent of
Volume
A J24, R26 21,500 79.5
B L02, M12 4,750 17.6
C P33, T72, S67, Q47, V20 800 2.9
S = 100.0
35. Economic Ordering Quantity (EOQ)
• Level of Inventory at which
• Total Cost* of Inventory is MINIMUM
*(Ordering and Carrying Cost)
36. EOQ MODEL
2AO
Q =
S
Q = Economic Order Quantity
A = Annual usage/demand
O= Cost of Placing an order
S = Storage cost per unit per order
* Where Storage cost is given in % , it is always calculated by multiplying the %
with the purchase price of raw material per unit, i.e Storage cost = % X Purchase
price of raw material
37. BEHAVIOR OF INVENTORY RELATED COSTS
Costs
Total costs
Carrying costs
Ordering costs
Quantity ordered
38. BEHAVIOUR OF INVENTORY RELATED COSTS
• Total cost of Inventory = Ordering cost +
Holding cost
– Ordering cost = Annual Demand*Ordering cost/Q
– Holding cost = Q*Holding cost /2
39. EOQ- Example
• A firm’s annual inventory is 1,600 units.
• The cost of placing an order is Rs 50, purchase price of raw
material/unit is Rs.10 and the carrying costs is expected to
be 10% per unit p.a.
• Calculate EOQ?
A=1600, O= Rs. 50, S= .10 x Rs.10=Rs.1
EOQ = 2 x 1600 x 50
1
= 400 units
40. Order Point Problem
• The re-order point is that level of inventory when a fresh
order should be placed with suppliers. It is that inventory level
which is equal to the consumption during the lead time or
procurement time.
• Re-order level = (Daily usage × Lead time) + Safety stock.
• Safety stock is minimum level of inventory that a firm keeps in
hand. The firm reorders more inventory if the current
inventory falls to safety level.
• Safety Stock = (Maximum Daily Usage − Average Daily Usage)
× Lead Time
41. Example
• ABC Ltd. is engaged in production of tires. It
purchases rims from DEL Ltd. an external supplier.
DEL Ltd. takes 10 days in manufacturing and
delivering an order.
• ABC's requires 10,000 units of rims per year. Its
ordering cost is Rs.1,000 per order and its carrying
costs are Rs.3 per unit per year.
• The maximum usage per day could be 50 per day.
Calculate economic order quantity, total cost of
inventory, reorder level and safety stock.
43. Reorder point
• Safety Stock = (Maximum Daily Usage −
Average Daily Usage) × Lead Time
• Reorder Level = Safety Stock + Average Daily
Usage × Lead Time
44. Example
Assume you have a product with the following parameters:
Annual Demand: 360; Holding cost per unit: Rs.1; Cost per order: Rs.100
The maximum daily demand is 3 units per day
1. What is the EOQ?
2. Given the data, and assuming a 300-day work year; how many orders
should be processed per year? What is the expected time between
orders?
3. What is the total cost for the inventory policy used ?
4. Assume that the demand was actually higher than estimated (i.e., 500 units
instead of 360 units). What will be the actual annual total cost?
45. Solution
EOQ
Demand Order cost
Holding cost
items
2 2 360 100
1
72000 268
* * * *
N
Demand
Q
orders per year
360
268
134.
T
Working days
Expected number of orders
days between orders 300 134 224/ .
47. JUST-IN-TIME (JIT) INVENTORY CONTROL
• The JIT control system implies that the firm should
maintain a minimal level of inventory and rely on
suppliers to provide parts and components ‘just-in-time’
to meet its assembly requirements.
• JIT also known as Zero Inventory Production Systems(ZIPS),
Zero Inventories(ZIN), Materials as Needed(MAN), or Neck of
Time(N0T)
50. Motives of cash management
• Transaction motive: Business firm keep cash to
meet their demand for cash arising from day to
day transactions.
• Precautionary motive: Maintenance of cash
balance to act as buffer against unexpected
events.
• Speculative motive: Cash balance to take
advantage of potential profit making situations
that may occur in future.
52. Baumol’s model
• Suggested by William J. Baumol (1952)
• The model attempts to balance the income foregone on cash held by the
firm against the transaction cost of converting cash into marketable
securities or vice versa.
• This model can be presented on assumption as follows:
– Fixed Cash flow : The Baumol’s model assumes that the firm uses cash
at an already known rate per period and that this rate of use is
constant.
– Holding cost: The holding cost is the opportunity cost in terms of
interest foregone on investment in cash.
– Transaction cost: whenever cash is invested in marketable securities,
there is cost involved like brokerage or commission.
53.
54. Illustration
• The annual cash requirement of A Ltd. is Rs 10 lakhs. The
company has marketable securities in lot sizes of Rs 50,000, Rs
1, 00,000, Rs 2, 00,000, Rs 2, 50,000 and Rs 5, 00,000.
• Cost of conversion of marketable securities per lot is Rs.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 estimate the
economic lot size can be obtained by the Baumol Model.
55. Baumol model
C= 2A*F/O
Where A= Annual requirement = 10 lakh
F = Fixed conversion charges = 1000
O = opportunity 5%
C = 2*10,00,000*1000/0.05 = 2,00,000
56. Table indicating lot size
S. No Particulars Situation 1 Situtation2 Situation 3
A Annual cash requirement
(Given)
10,00,000 10,00,000 10,00,000
B Lot size of securities (Given) 50,000 1, 00,000 2,00,000
C No. of lot sizes (A/B) 20 10 5
D Average holding OF CASH (B/2) 25,000 50,000 1,00,000
E Opportunity cost of holding
cash (D x 0.05)
1250 2500 5000
F Fixed conversion cost (given) 1000 1000 1000
G Total conversion cost (C x F) 20,000 10,000 5,000
H Total cost (E+G) 21,250 12,500 10,000
The above illustration shown that the minimum cost is Rs.10,000 when the lot size is 2,00,000
57. Miller and Orr model
• Baumol’s model is based on the basic assumption
that the size and timing of cash flows are known with
certainty. Whereas, in real situation, the cash flows
of a firm are neither uniform nor certain.
• M.H. Miller and Daniel Orr (A Model of the Demand
for Money) expanded on the Baumol model and
developed Stochastic Model for firms with uncertain
cash inflows and cash outflows.
58. The Miller and Orr (MO) model provides two control limits-the
upper control limit and the lower control limit along-with a
return point as shown in the figure below:
59. Miller and Orr model
• If the cash balance touches the upper control limit (H), marketable
securities are purchased to the extent of (H-Z) to return back to the
normal cash balance of Z.
• If the cash balance touches lower control limit (O), the firm will sell the
marketable securities to the extent of O-Z to again return to the normal
cash balance.
• The spread between the upper and lower cash balance limits (called Z) can
be computed using Miller-Orr model as below:
60. Receivables Management
• Accounts receivables for the selling firm is
same as an account payable for the purchaser.
• The purpose of credit analysis is to assess the
credit worthiness of potential customers and
the corresponding risk of late payments or
default.
61. Receivables Management
• Credit analysis consists of:
1. Gathering information about the potential
customer
2. Analyzing the information to derive a credit
decision about the payment terms and amount of
trade credit granted
Credit agencies provide credit ratings and reports on
companies.
62. STEPS IN CREDIT ANALYSIS
The 5 C’s of Credit Analysis
• Character - Reputation, Track Record
• Capacity - Ability to repay.
• Capital - Financial Position of the co.
• Collateral - The type and kind of assets pledged
• Conditions - Economic conditions & competitive
factors that may affect the profitability of the
customer.
64. Credit policy
A company's policy related to trading off the
profit on additional sales that arises due to
credit sales and the cost of carrying those
debtors and probable bad debts.
65. Credit standards
• The guidelines issued by a company that are used to
determine if a potential borrower is creditworthy.
• Credit standards are often created after careful
analysis of past borrowers and market conditions,
and are designed to limit the risk of a borrower not
making credit payments or defaulting on loaned
money.
66. Credit terms
• The terms which indicate when payment is
due for sales made on account (or credit).
– Credit period
– Discount period
– Discount rate
• The general credit terms are expressed as
2/10, net 30. This means the amount is due in
30 days; however, if the amount is paid in 10
days a discount of 2% will be permitted.
67. Calculation of annualized return
• If credit term is expressed as a/b,net c then;
• Annualized return = a/(1-a) * 360/(c-b)
Which of the below terms have lower cost to
company?
1. 2/10, net 30
2. 5/10, net 60
Editor's Notes
Total cost of production: = Opn WIP + Raw material consumed + Manufacturing expn – Cls. WIP
30,000 + (10,000 +35000- 11,000)+ 15,000 – 30,500 = 48,500
Cost of goods sold = Opn Finished Goods + Cost of production – Cls Finished Goods= 5,000 + 48,500 – 8,500 = 45,000
Average Debtors: (6500 + 30,500)/2 = 18,500
