WORKING CAPITAL
Working capital, also known as net working capital, is the difference between a company’s current assets, like cash, accounts receivable (customers’ unpaid bills) and inventories of raw materials and finished goods, and current liabilities, like accounts payable.
Working Capital = Current Assets - Current Liabilities
The objective of running any industry is earning profits. An industry will require funds to
acquire “fixed assets” like land, building, plant, machinery, equipments, vehicles, tools etc.,
and also to run the business i.e. its day to day operations.
Funds required for day to-day working will be to finance production and sales. For
production, funds are needed for purchase of raw materials/stores/fuel, for employment of
labour, for power charges etc., for storing finished goods till they are sold out and for
financing the sales by way of sundry debtors/ receivables.
Capital or funds required for an industry can therefore be bifurcated as fixed capital and
working capital. Working capital in this context is the excess of current assets over current
liabilities. Current assets are those assets that in the ordinary course of business will be
converted into cash within a brief period (during the operating cycle of the industry and
normally not exceeding one year) without undergoing diminution in value and without
disrupting the operation. Current liabilities are those liabilities intended at their inception, to
be paid in the ordinary course of business within a reasonably short time (normally within a
year) out of the current assets or the income of the business. The above definition of
working capital, however, takes into account only the funds available to the industry from
long term sources like capital and long term borrowings, after meeting the expenses
towards fixed and other non-current assets. It does not represent the total funds required
by the industry for working capital to sustain its level of operations.
The excess of current assets over current liabilities is treated as net working capital or
liquid surplus and represents that portion of the working capital which has been provided
from the long term source. This can be explained by the following diagram.
Working Capital Assessment :
Concept of Working Capital: Working capital denotes the amount of funds needed for
meeting day-to-day operations of a concern.
This is related to short-term assets and short-term sources of financing. Hence it deals
with both, assets and liabilities
There are two concepts or senses used for working capital.
1. Gross Working Capital: The concept of gross working capital refers to the total
value of current assets. In other words, gross working capital is the total amount
available for financing of current assets. However, it does not reveal the true financial
position of an enterprise. How? A borrowing will increase current assets and, thus, will
increase gross working capital but, at the same time, it will increase current liabilities
also.
As a result, the net working capital will remain the same. This concept is usually
supported by the business community as it raises their assets (current) and is in their
advantage to borrow the funds from external sources such as banks and the financial
institutions.
In this sense, the working capital is a financial concept. As per this concept:
Gross Working Capital = Total Current Assets
2. Net working Capital: The net working capital is an accounting concept which
represents the excess of current assets over current liabilities. Current assets consist of
items such as cash, bank balance, stock, debtors, bills receivables, etc. and current
liabilities include items such as bills payables, creditors, etc. Excess of current assets
over current liabilities, thus, indicates the liquid position of an enterprise.
The ratio of 2:1 between current assets and current liabilities is considered as optimum
or sound. What this ratio implies is that the firm/ enterprise have sufficient liquidity to
meet operating expenses and current liabilities. It is important to mention that net
working capital will not increase with every increase in gross working capital.
Importantly, net working capital will increase only when there is increase in current
assets without corresponding increase in current liabilities.
Working Capital Gap :
Is defined as current assets minus current liabilities excluding bank borrowings. Current
assets will be taken at estimated values or values as per the tendon committee norms,
whichever is lower. Current assets will consist of inventory and receivables, referred as
chargeable current assets (CCA) and other current assets (OCA).
Maximum permissible bank finance (MPBF) in view of the above approach to bank
lending, the Tandon committee suggested the following three methods of determining
the permissible level of bank borrowings:
1. First method:- in the first method, the borrower will contribute 25 per cent of the
working capital gap; the remaining 75 per cent be financed from bank borrowings this
method will give a minimum current ratio of
2. Second method:- in the second method, the borrower will contribute 25 per cent of
the total current assets. The remaining of the working capital gap (the working capital
gap less the borrower‘s contribution) can be bridged from the bank borrowings. This
method will give a current ratio of .
3. Third method:- in the third method, borrower will contribute 100 percent of core
assets, as defined and 25 per cent of the balance of current assets. The remaining of
the working capital gap can be met from the borrowings. This method will further
strengthen the current ratio
Components of Working Capital: Three main components associated with
working capital management:
1. Accounts Receivable
Accounts receivable are revenues due – what is owed to a company by its customers
for sales made. Timely, efficient collection of accounts receivable is essential to a
company's smooth financial operation.
Accounts receivable are listed as assets on a company's balance sheet, but they are
not actually assets until they are collected. A common metric analysts use to assess a
company's handling of accounts receivable is days sales outstanding, which reveals the
average number of days a company takes to collect sales revenues.
2. Accounts Payable
Accounts payable, the money that a company is obligated to pay out over the short
term, is also a key component of working capital management. Companies seek to
strike a balance between maintaining maximum cash flow by delaying payments as long
as is reasonably possible and the need to maintain positive credit ratings while
sustaining good relationships with suppliers and creditors. Ideally, a company's average
time to collect receivables is significantly shorter than its average time to settle
payables.
3. Inventory
Inventory is a company's primary asset that it converts into sales revenues. The rate at
which a company sells and replenishes its inventory is an important measure of its
success.
Investors consider the inventory turnover rate to be an indication of the strength of sales
and as a measure of how efficient the company is in its purchasing and manufacturing
process. Inventory that is too low puts the company in danger of losing out on sales, but
excessively high inventory levels represent wasteful, inefficient use of working capital.
Source of Working Capital:
SPONTANEOUS (URGENT) SOURCES OF WORKING
CAPITAL FINANCE
The word ‗spontaneous‘ itself explains that this source of working capital is readily or
easily available to the business in the normal course of business affairs. The quantum
and terms of this credit depend on the industry norms and the relationship between
buyer and seller. These sources include trade credit allowed by the sundry creditors,
credit from employees, and other trade-related credits. The biggest benefit of
spontaneous sources as working capital is its ‗effortless raising‘ and ‗insignificant cost‘
compared to traditional ways of financing.
List of spontaneous sources of working capital
TRADE CREDIT
SUNDRY CREDITORS
BILLS PAYABLE
NOTES PAYABLE
ACCRUED EXPENSES
The cost factor and the quantum depends a lot on the terms of such credit viz.
maximum credit limit, the period of credit, and discount on cash payment. Each supplier
will have a maximum credit limit defined for the buyer depending on the business
capacity and creditworthiness of the buyer. Similarly, the credit period is defined say 30
days, 45 days etc. Discount on cash payment is allowed to the buyer if the payment
immediately on buying the materials. This percentage of discount is an opportunity cost
for the buyer.
SHORT TERM SOURCES OF WORKING CAPITAL FINANCE
Short term sources can be further divided into internal and external sources of working
capital finance. The
Short-term Internal Sources
TAX PROVISIONS
DIVIDEND PROVISIONS
Short-term External Sources
Short-term working capital financing from banks such as
BANK OVERDRAFTS,
CASH CREDITS,
TRADE DEPOSITS,
BILLS DISCOUNTING,
SHORT-TERM LOANS OR WORKING CAPITAL LOANS,
INTER-CORPORATE LOANS,
COMMERCIAL PAPER, ETC.
Tax and dividend provisions are current liabilities and cannot be delayed. The fund that
would have been used in paying these provisions act as working capital till the point
these are not paid.
Short-term working capital finance availed from banks and financial institutions are
costly compared to spontaneous and long-term sources in terms of rate of interest but
have a great time flexibility. Due to time flexibility, the finance manager can use the
funds and pay interest on the money which his business utilizes and can pay them
anytime when cash is available. Overall, in comparison to long-term sources where you
have to hold funds even when not required, these facilities prove cheaper.
LONG-TERM SOURCES OF WORKING CAPITAL FINANCING
Long-term sources can also be divided into internal and external sources. Long-term
internal sources of finance are retained profits and provision for depreciation whereas
external sources are Share Capital, long-term loan, and debentures.
Long-term Internal Sources
RETAINED PROFITS
PROVISION FOR DEPRECIATION
Long-term External Sources
SHARE CAPITAL
LONG-TERM LOAN
DEBENTURES
Retained profits and accumulated depreciation are as good as funds available to the
business without any explicit cost. These are the funds completely earned and owned
by the business itself. They are utilized for expansion as well as working capital finance.
Long-term external sources of finance like share capital is a cheaper source of finance
but are not commonly used for working capital finance.
Working capital can be classified as temporary working capital and permanent working
capital. It is advisable to use long-term sources for permanent and short-term sources
for temporary working capital requirements. This will optimize the working capital cost
and enforce good working capital management practices.
Various Methods of Assessment of Working Capital:
• Operating Cycle Method
• Drawing Power Method.
• Turnover Method.
• MPBF method (II method of lending) for limits of Rs 6.00 crores and above
• Cash Budget method - A cash budget is an estimation of the cash inflows and
outflows for a business over a specific period of time, and this budget is used to
assess whether the entity has sufficient cash to operate. Companies use sales
and production forecasts to create a cash budget, along with assumptions about
necessary spending and accounts receivable. If a company does not have
enough liquidity to operate, it must raise more capital by issuing stock or by
taking on debt.
Under this method, monthly cash inflow and outflow statement is prepared and
the highest gap between the two becomes the basis for sanction of credit limit.
Banks make use of cash budget method in case of seasonal industries, software
development, services sector activities including construction activity, etc.
Based on procurement and cash inflow) . It is mainly used for Seasonal
Industries (Sugar/ Rice Mills/Textiles/Tea/Tobacco/Fertilizers) Contractors &
Real Estate Developers , Educational Institutions, etc.
Operating Cycle :
Any manufacturing activity is characterized by a cycle of operations consisting of
purchase of raw materials for cash, converting these into finished goods and realising
cash by sale of these finished goods.
Diagrammatically, the operating cycle is represented as under'
The time that lapses between cash outlay and cash realisation by sale of finished
goods and realisation of sundry debtors is known as the length of the operating cycle.
That is, the operating cycle consists of:
a. Time taken to acquire raw materials and average period for which they are in
store.
b. Conversion process time
c. Average period for which finished goods are in store and
d. Average collection period of receivables (Sundry Debtors)
Operating Cycle is also called the cash-to-cash cycle and indicates how cash is
converted into raw materials, stocks in process, finished goods, bills(receivables) and
finally back to cash. Working capital is the total cash that is circulating in this cycle.
Theref
Traditional Method of Assessment of Working Capital Requirement
The operating cycle concept serves to identify the areas requiring improvement for the
purpose of control and performance review. But, as bankers, we require a more detailed
analysis to assess the various components of working capital requirement viz., finance for
stocks, bills etc.
Bankers provide working capital finance for holding an acceptable level of current assets, viz.
raw materials, stocks-in-process, finished goods and sundry debtors for achieving a
predetermined level of production and sales. Quantification of these funds required to be
blocked in each of these items of current assets at any time will, therefore provide a measure of
the working capital requirement (WCR) of an industry.
Raw Materials: Any industrial unit has to necessarily stock a minimum quantum of
materials used in its production to ensure uninterrupted production. Factors which affect or
influence the funds requirement for holding raw materials are
i. Average consumption of raw materials.
ii. Their availability - locally or from places outside, easy availability / scarcity, number of
sources of supply.
iii. Time taken to procure raw materials (procurement time or lead time)
iv. Imported or indigenous.
v. Minimum quantity supplied by the market (Minimum Order Quantity (MOQ)).
vi. Cost of holding stocks (e.g. insurance, storage, interest)
vii. Criticality of the item.
viii. Transport and other charges (Economic Order Quantity (EOQ)).
ix. Availability on credit or against advance payment in cash
x. Seasonality of the materials.
This raw material requirement is generally expressed as so many months’
requirement (consumption).
Stocks-in-process : Barring a few exceptional types of industries, when the raw materials
get converted into finished products within a few hours, there is normally a time lag or
delay or period of processing only after which the raw materials get converted into finished
product. During this period of processing, the raw materials are being processed and
expenses are being incurred. The period of processing may vary from a few hours to a
number of months and unit will be blocking working funds in the stocks-in-process during
this period. Such funds blocked in SIP depend on:
i. The processing time
ii. Number of products handled at a time in the process
iii. Average quantities of each product, processed at each time. (batch quantity)
iv. The process technology adopted
v. Number of shifts
A rough and ready formula for computing the requirement of funds is to find out the cost of
production for the period of processing. viz. (raw materials consumed per month +
expenses per month) x period of processing in months.
Finished goods: All products manufactured by an industry are not sold immediately. It will
be necessary to stock certain amount of goods pending sale. This stocking depends on:
i. Whether the manufacture is against firm order or against anticipated order
ii. Supply terms
iii. Minimum quantity that can be despatched
iv. Transport availability and transport cost
v. Pre-despatch Inspection
vi. Seasonality of goods
vii. Variation in demand
viii. Peak level/ low level of operations
ix. Marketing arrangement - e.g. direct sale to consumers or through dealers
(wholesalers).
The requirement of funds against finished goods is expressed as so many months’ cost of
production.
Sundry Debtors (Receivables) :
Sales may be effected under three different methods:
a. Against Advance Payment
b. Against Cash
c. On Credit
In the case of (a) no funds are blocked up. Instead it helps in meeting the working capital needs.
In case of Cash Sales (b) no funds are blocked up and hence there is no need for additional
working capital requirement. It is in the case of (c) credit sales that working funds are required to
meet delays in sales realisation. The entire sales of the industry will not be on cash basis. In fact
a major portion will be on credit. A unit grants trade credit because it expects this investment to
be profitable. It would be in the form of sales expansion and fresh customers or it could be in the
form of retention of existing customers. The extent of credit given by the industry normally
depends upon:
i. Trade Practices
ii. Market conditions
iii. Whether it is a bulk purchase by the buyer.
iv. Seasonality (e.g. rain coats, woolen products).
v. Price advantage.
Even in cases where no credit is extended to buyers, the transit time for the goods to reach the
buyer may take some time and till the cash is received back, the unit will have to be out of
funds. The period from the time of sale to the receipt of funds will have to be reckoned for the
purpose of quantifying the funds blocked in Sundry Debtors. Even through the amount of Sundry
Debtors according to the unit’s books will be on the basis of Sale price, the actual amount
blocked will be only the cost of production of the materials against which credit has been
extended - the difference being the unit’s profit margin - (which the unit does not obviously have
to spend).
The working capital requirement against Sundry Debtors will therefore be computed on the
basis of cost of production (whereas the permissible Bank Finance will be computed on the
basis of sale value since profit margin varies from product to product and buyer to buyer and
cannot be uniformly segregated from the sale value).
The working capital requirement is normally expressed as so many months’ cost of production.
Expenses : It is customary in assessing the working capital requirement of industries, to
provide for one month’s expenses also. A question might be raised as to why expenses
should be taken separately, whereas at every stage the funds required to be blocked had
been taken into account. This amount is provided merely as a cushion, to take care of
temporary bottlenecks and to enable the unit to meet expenses when they fall due.
Normally one month total expenses, direct and indirect, salaries etc. are taken into
account. In cases where the operating cycle is very short say one month or 2 months the
provision for expenses can be reduced. Similarly, where the operating cycle is very long,
say 12 months or more, the provision for expenses may have to be increased, to take care
of contingencies.
While computing the working capital requirements of a unit, it will be necessary to take into
account two other factors, one is the credit received on purchases. Trade Credit is a
normal practice in trading circles. The period of such credit will vary from place to place,
material to material and person to person. The amount of credit received on purchases
reduces the working capital funds required by the unit. Secondly, industries often receive
advance against orders placed for their products.
necessarily give advance to producers e.g. Custom-made machinery. Such funds are used
for the working capital of an industry. It can thus be summarised as follows:
1. Raw Materials Months requirements Rs. A
2. Stocks-in- Process Months (Cost of Rs. B
(for Period of Processing) Production)
3. Finished Goods Months cost of Rs. C
production required
to be stocked
4. Sundry Debtors Months cost of production Rs. D
(outstanding credits)
5. Expenses One month(say) Rs. E
------------------
A+B+C+D+E
-------------------
Less: Credit received on purchases - Rs. F
(Months’ Purchases value)
Advance payment on order received - Rs.G
Working Capital Required (H) = (A+B+C+D+E) - (F+G)
The purpose of assessing the W/C requirement of the industry is to determine how the total
requirements of funds will be met. The two sources for meeting these requirements are the
unit’s long term sources (like capital and long term borrowings) and the short term borrowings
from banks
Drawing Power (DP) Method :
(for units with small limits)
Drawing power is arrived at on the basis of valuation of current assets charged to the
bank in the shape of hypothecation and assignment , after deducting the stipulated
margin
Illustration:
Paid stock – 4 Margin 25% - DP = 3
Semi-finished goods – 4 Margin 50% - DP=2
Finished goods -4 Margin 25% - DP = 3
Book Debts – 4 Margin 50% - DP = 2
Total DP= 10
Turnover Method :
(originally suggested by Nayak Committee for SSI units)
The WC requirements may be worked out on the basis of Naik Committee
recommendations for working capital limit upto Rs.6 crores from the banking system, on
the basis of minimum of 20% of their projected annual turnover for new as well as
existing units, beyond which WC be computed on the basis of WC cycle, after fixing
stipulated margins , on each component of the WC. In case of borrowers desiring
facilities under Naik Committee recommendations and having a WC cycle of more than
3 months in a year, the WC requirements will be funded after assessing his
requirements on the basis of his WC cycle, after fixing proper margins.
Example:
Applicable for limits upto Rs.6 crores
(a) Projected sales = Rs. 10,00,000
(b) Working capital requirements: 25% of projected sales i.e. Rs.2,50,000
(c) Margin (contribution of Owner) : 5% of projected sales i.e. Rs.50,000
(d) Working capital to be funded by bank : Rs.2,00,000
MPBF Method
(Tandon‘s II method of lending)
Tandon Committee also recommended inventory/ receivable norms for 22 major industries.
Approach to lending
Regarding approach to lending, the Committee suggested three methods for assessment of
working capital requirements.
FIRST METHOD
The quantum of bank’s short-term advances will be restricted to 75% of working capital gap
where “working capital gap” is equal to “Current Assets” minus “Current Liabilities Other Than
Bank Borrowings”. Remaining 25% is to be met from long-term sources (Net Working Capital)
SECOND METHOD
Net Working Capital should at least be equal to 25% of total value of acceptable level of current
assets. The remaining 75% should first be financed by Other Current Liabilities (OCL) and the
bank may finance balance of the requirements.
THIRD METHOD
The borrower should provide for entire core current assets and 25% balance current assets from
the Net Working Capital.
To compute the level of working capital requirement of the unit, the analyst has to assess the
level of current assets it has to carry, consistent with its projected level of production and sales.
Inventory and receivables constitute most of the current assets. On the basis of the Committee
report, RBI gave inventory norms and advised the banks to decide the levels of inventory and
receivables taking into account, production, processing cycles and other relevant factors
• Working capital gap : Current assets – current liabilities (other than bank
borrowings)
• Minimum stipulated net working capital= 25% of current assets (excluding
exports receivables)
• Actual projected NWC
Cash budget method::
Assessment of working capital
The assessment of working capital is done through the Projected Balance Sheet
Method (PBS), Cash Budget method or Turnover Method.
Under the PBS method, the fund requirements computed on the basis of borrower’s
projected balance sheet, the funds flow planned for the current/ following year
and examination of the profitability, financial parameters. etc. The key determinants for
the limit can, inter-alia, be the extent of financing support required by the
borrower and the acceptability of the borrower’s overall financial position including
the projected level of liquidity. The projected Bank borrowing thus arrived at, is
termed as ‘Assessed bank Finance’ (ABF). This method is applicable for borrowers
who are engaged in manufacturing, services and trading activities and who require
fund bases working capital (WC) finance of above Rs. 5 crores.
Cash budget method is used for assessing working capital finance for seasonal
industries like sugar, tea and construction activity. This method is also used for sanction
of ad-hoc WC limits. In these cases, the required finance is quantified from the
projected cash flows and not from the projected values of current assets and current
liabilities. Other aspects of assessment like examination of funds flow, profitability,
financial parameters, etc, are also carried out
.
Collection of financial data
CMA DATA
Introduction: Credit Monitoring Arrangement (CMA) data is a very important area to understand a person who deals with finance in an organization. This is a critical analysis of current and projected financial statements of a loan applicant by the banker. Data CMA is a systematic analysis of working capital management of the borrower and the purpose of this statement is to ensure the use of long-term and short-term funds have been used . for the particular purpose . In this article I want to discuss the content database CMA CMA Basically contains data that, following the seven states.
1. particular existing and proposed limits: It is the first statement in the CMA data that contains this fund and fund based limits of non-borrower credit limits and their use and history. With the current limitations of funds, which is the limit proposed or the borrower will be mentioned in this statement is a basic document information provided by the borrower, the banker.
2. operating Declaration: This is the second statement provided by the borrower, it indicates that the business plan of the borrower gives the current sales, direct and indirect costs, pre-and after tax, as well as projections of sales, expenses and profit situation for 3-5 years based on the borrower's working capital demand. This statement is a scientific analysis of the capacity of production and financial current and projected income of the borrower.
3. analysis of balance: balance sheet analysis for current and projected statement is the third in the CMA data. This statement gives a detailed analysis of current and non-current assets, fixed assets, cash and bank, the current position and long-term debt of the borrower. Moreover, this declaration indicates the position of the net worth of the borrower for the projected years. budget analysis gives a complete financial situation of the borrower and the generating capacity cash over the planned exercises.
4. Comparative table of current assets and liabilities: . Fourth statement which gives a comparative analysis of current assets and current liabilities of the borrower movement This basically decides the cycle capital of actual work for the projection period and ability of the borrower to meet their working capital needs.
5. Calculate MPBF: This is a very important statement and calculation that indicates the M Aximum P ermissible B ank F inance. This statement, which calculates the borrower working capital GAP and finance eligible in two methods loan, the first method of loan will enable MPBF 75% of the work GAP net capital is Current assets less current liabilities, Second method loan will enable MPBF 75% of current assets less current liabilities. As limit MPBF is the credit component of cash the borrower generally known drawing power (DP Limit). So it is very important statement that decide the borrower `s borrowing limit of the bank.
6. fund cash flow: cash flow analysis statement for the current period and projected is one of the states in the CMA data. fund this position analysis of the borrower's account with reference to the analysis of capital given in the calculations MPBF and projected balance sheets. Objective basis of this statement capture the movement of funds to the borrower for the period.
. 7 Ratio Analysis: This is the last statement that gives the key ratios for the bank on the basis of data from the AMC prepared and presented to the bank financing. Ratios basic gross margin rate net margin, current ratio, limit DP MPBF, net worth, the ratio of the net value of liabilities, the liquidity ratio, inventory turnover, asset turnover, fixed asset turnover, the number of current business assets, working capital turnover, Debt Equity ratio etc.
For working capital assessment, the required financial data are obtained from the borrower
in the following forms:
Form I : Particulars of existing / proposed limits from the banking system
Form II : Operating statement
Form Ill : Analysis of balance sheet
Form IV : Comparative Statement of CA / CL,
Form VI: Funds flows statement.
Form VII: Statement showing the total cost of the project and sources of finance
Information provided in the Forms II, III. IV, and VI serves the detailed financial analysis. In
Form I, in addition to information relating to working capital and term loan borrowings
(existing and proposed) information regarding borrowings from NBFCs, borrowings from
term leading institutions for WC purposes, Inter Corporate Deposits taken, lease finance
availed will also be collected..
Working capital: Numerical
A newly formed company has applied to the Commercial Bank for the first time for financing its
working capital requirements. The following information is available about the projections for
the current year:
Per unit
Elements of cost: (Rs.)
Raw material 40
Direct labour 15
Overhead 30
Total cost 85
Profit 15
Sales 100
Other information:
Raw material in stock : average 4 weeks consumption, Work – in progress (completion stage,
50 per cent), on an average half a month. Finished goods in stock : on an average, one
month.
Credit allowed by suppliers is one month.
Credit allowed to debtors is two months.
Average time lag in payment of wages is 1½ weeks and 4 weeks in overhead expenses.
Cash in hand and at bank is desired to be maintained at Rs. 50,000.
All Sales are on credit basis only.
Required:
(i) Prepare statement showing estimate of working capital needed to finance an activity level
of 96,000 units of production. Assume that production is carried on evenly throughout the
year, and wages and overhead accrue similarly. For the calculation purpose 4 weeks may
be taken as equivalent to a month and 52 weeks in a year.
(ii) From the above information calculate the maximum permissible bank finance by all the
three methods for working capital as per Tondon Committee norms; assume the core
current assets constitute 25% of the current assets.
Answer
Calculation of Working Capital Requirement
(A) Current Assets
Rs.
(i) Stock of material for 4 weeks (96,000 40 4/52) 2,95,385
(ii) Work in progress for ½ month or 2 weeks
Material (96,000 40 2/52) .50 73,846
Labour (96,000 15 2/52) .50 27,692
Overhead (96,000 30 2/52) .50 55,385 1,56,923
(iii) Finished stock (96,000 85 4/52) 6,27,692
(iv) Debtors for 2 months (96,000 85 8/52) 12,55,385
Cash in hand or at bank 50,000
Investment in Current Assets 23,85,385
(B) Current Liabilities
(i) Creditors for one month (96,000 40 4/52) 2,95,385
(ii) Average lag in payment of expenses
Overheads (96,000 30 4/52) 2,21,538
Labour (96,000 15 3/104) 41,538 2,63,076
Current Liabilities 5,58,461
Net working capital (A – B) 18,26,924
Minimum Permissible Bank Finance as per Tandon Committee
Method I : .75 (Current Assets – Current Liabilities)
.75 (23,85,385 – 5,58,461)
.75 (18,26,924) – 5,58,461 = Rs. 13,70,193
Method II : .75 Current Assets – Current Liabilities
.75 23,85,385 – 5,58,461
17,89,039 – 5,58,461 = Rs. 12,30,578
Method III: .75 (Current Assets – CCA) – Current Liabilities
7.3
.75 (23,85,385 – 5,96,346) – 5,58,461
.75 (17,89,039) – 5,58,461
13,41,779 – 5,58,461 = Rs. 7,83,318
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Working capital, also known as net working capital, is the difference between a company’s current assets, like cash, accounts receivable (customers’ unpaid bills) and inventories of raw materials and finished goods, and current liabilities, like accounts payable.
Working Capital = Current Assets - Current Liabilities
The objective of running any industry is earning profits. An industry will require funds to
acquire “fixed assets” like land, building, plant, machinery, equipments, vehicles, tools etc.,
and also to run the business i.e. its day to day operations.
Funds required for day to-day working will be to finance production and sales. For
production, funds are needed for purchase of raw materials/stores/fuel, for employment of
labour, for power charges etc., for storing finished goods till they are sold out and for
financing the sales by way of sundry debtors/ receivables.
Capital or funds required for an industry can therefore be bifurcated as fixed capital and
working capital. Working capital in this context is the excess of current assets over current
liabilities. Current assets are those assets that in the ordinary course of business will be
converted into cash within a brief period (during the operating cycle of the industry and
normally not exceeding one year) without undergoing diminution in value and without
disrupting the operation. Current liabilities are those liabilities intended at their inception, to
be paid in the ordinary course of business within a reasonably short time (normally within a
year) out of the current assets or the income of the business. The above definition of
working capital, however, takes into account only the funds available to the industry from
long term sources like capital and long term borrowings, after meeting the expenses
towards fixed and other non-current assets. It does not represent the total funds required
by the industry for working capital to sustain its level of operations.
The excess of current assets over current liabilities is treated as net working capital or
liquid surplus and represents that portion of the working capital which has been provided
from the long term source. This can be explained by the following diagram.
Working Capital Assessment :
Concept of Working Capital: Working capital denotes the amount of funds needed for
meeting day-to-day operations of a concern.
This is related to short-term assets and short-term sources of financing. Hence it deals
with both, assets and liabilities
There are two concepts or senses used for working capital.
1. Gross Working Capital: The concept of gross working capital refers to the total
value of current assets. In other words, gross working capital is the total amount
available for financing of current assets. However, it does not reveal the true financial
position of an enterprise. How? A borrowing will increase current assets and, thus, will
increase gross working capital but, at the same time, it will increase current liabilities
also.
As a result, the net working capital will remain the same. This concept is usually
supported by the business community as it raises their assets (current) and is in their
advantage to borrow the funds from external sources such as banks and the financial
institutions.
In this sense, the working capital is a financial concept. As per this concept:
Gross Working Capital = Total Current Assets
2. Net working Capital: The net working capital is an accounting concept which
represents the excess of current assets over current liabilities. Current assets consist of
items such as cash, bank balance, stock, debtors, bills receivables, etc. and current
liabilities include items such as bills payables, creditors, etc. Excess of current assets
over current liabilities, thus, indicates the liquid position of an enterprise.
The ratio of 2:1 between current assets and current liabilities is considered as optimum
or sound. What this ratio implies is that the firm/ enterprise have sufficient liquidity to
meet operating expenses and current liabilities. It is important to mention that net
working capital will not increase with every increase in gross working capital.
Importantly, net working capital will increase only when there is increase in current
assets without corresponding increase in current liabilities.
Working Capital Gap :
Is defined as current assets minus current liabilities excluding bank borrowings. Current
assets will be taken at estimated values or values as per the tendon committee norms,
whichever is lower. Current assets will consist of inventory and receivables, referred as
chargeable current assets (CCA) and other current assets (OCA).
Maximum permissible bank finance (MPBF) in view of the above approach to bank
lending, the Tandon committee suggested the following three methods of determining
the permissible level of bank borrowings:
1. First method:- in the first method, the borrower will contribute 25 per cent of the
working capital gap; the remaining 75 per cent be financed from bank borrowings this
method will give a minimum current ratio of
2. Second method:- in the second method, the borrower will contribute 25 per cent of
the total current assets. The remaining of the working capital gap (the working capital
gap less the borrower‘s contribution) can be bridged from the bank borrowings. This
method will give a current ratio of .
3. Third method:- in the third method, borrower will contribute 100 percent of core
assets, as defined and 25 per cent of the balance of current assets. The remaining of
the working capital gap can be met from the borrowings. This method will further
strengthen the current ratio
Components of Working Capital: Three main components associated with
working capital management:
1. Accounts Receivable
Accounts receivable are revenues due – what is owed to a company by its customers
for sales made. Timely, efficient collection of accounts receivable is essential to a
company's smooth financial operation.
Accounts receivable are listed as assets on a company's balance sheet, but they are
not actually assets until they are collected. A common metric analysts use to assess a
company's handling of accounts receivable is days sales outstanding, which reveals the
average number of days a company takes to collect sales revenues.
2. Accounts Payable
Accounts payable, the money that a company is obligated to pay out over the short
term, is also a key component of working capital management. Companies seek to
strike a balance between maintaining maximum cash flow by delaying payments as long
as is reasonably possible and the need to maintain positive credit ratings while
sustaining good relationships with suppliers and creditors. Ideally, a company's average
time to collect receivables is significantly shorter than its average time to settle
payables.
3. Inventory
Inventory is a company's primary asset that it converts into sales revenues. The rate at
which a company sells and replenishes its inventory is an important measure of its
success.
Investors consider the inventory turnover rate to be an indication of the strength of sales
and as a measure of how efficient the company is in its purchasing and manufacturing
process. Inventory that is too low puts the company in danger of losing out on sales, but
excessively high inventory levels represent wasteful, inefficient use of working capital.
Source of Working Capital:
SPONTANEOUS (URGENT) SOURCES OF WORKING
CAPITAL FINANCE
The word ‗spontaneous‘ itself explains that this source of working capital is readily or
easily available to the business in the normal course of business affairs. The quantum
and terms of this credit depend on the industry norms and the relationship between
buyer and seller. These sources include trade credit allowed by the sundry creditors,
credit from employees, and other trade-related credits. The biggest benefit of
spontaneous sources as working capital is its ‗effortless raising‘ and ‗insignificant cost‘
compared to traditional ways of financing.
List of spontaneous sources of working capital
TRADE CREDIT
SUNDRY CREDITORS
BILLS PAYABLE
NOTES PAYABLE
ACCRUED EXPENSES
The cost factor and the quantum depends a lot on the terms of such credit viz.
maximum credit limit, the period of credit, and discount on cash payment. Each supplier
will have a maximum credit limit defined for the buyer depending on the business
capacity and creditworthiness of the buyer. Similarly, the credit period is defined say 30
days, 45 days etc. Discount on cash payment is allowed to the buyer if the payment
immediately on buying the materials. This percentage of discount is an opportunity cost
for the buyer.
SHORT TERM SOURCES OF WORKING CAPITAL FINANCE
Short term sources can be further divided into internal and external sources of working
capital finance. The
Short-term Internal Sources
TAX PROVISIONS
DIVIDEND PROVISIONS
Short-term External Sources
Short-term working capital financing from banks such as
BANK OVERDRAFTS,
CASH CREDITS,
TRADE DEPOSITS,
BILLS DISCOUNTING,
SHORT-TERM LOANS OR WORKING CAPITAL LOANS,
INTER-CORPORATE LOANS,
COMMERCIAL PAPER, ETC.
Tax and dividend provisions are current liabilities and cannot be delayed. The fund that
would have been used in paying these provisions act as working capital till the point
these are not paid.
Short-term working capital finance availed from banks and financial institutions are
costly compared to spontaneous and long-term sources in terms of rate of interest but
have a great time flexibility. Due to time flexibility, the finance manager can use the
funds and pay interest on the money which his business utilizes and can pay them
anytime when cash is available. Overall, in comparison to long-term sources where you
have to hold funds even when not required, these facilities prove cheaper.
LONG-TERM SOURCES OF WORKING CAPITAL FINANCING
Long-term sources can also be divided into internal and external sources. Long-term
internal sources of finance are retained profits and provision for depreciation whereas
external sources are Share Capital, long-term loan, and debentures.
Long-term Internal Sources
RETAINED PROFITS
PROVISION FOR DEPRECIATION
Long-term External Sources
SHARE CAPITAL
LONG-TERM LOAN
DEBENTURES
Retained profits and accumulated depreciation are as good as funds available to the
business without any explicit cost. These are the funds completely earned and owned
by the business itself. They are utilized for expansion as well as working capital finance.
Long-term external sources of finance like share capital is a cheaper source of finance
but are not commonly used for working capital finance.
Working capital can be classified as temporary working capital and permanent working
capital. It is advisable to use long-term sources for permanent and short-term sources
for temporary working capital requirements. This will optimize the working capital cost
and enforce good working capital management practices.
Various Methods of Assessment of Working Capital:
• Operating Cycle Method
• Drawing Power Method.
• Turnover Method.
• MPBF method (II method of lending) for limits of Rs 6.00 crores and above
• Cash Budget method - A cash budget is an estimation of the cash inflows and
outflows for a business over a specific period of time, and this budget is used to
assess whether the entity has sufficient cash to operate. Companies use sales
and production forecasts to create a cash budget, along with assumptions about
necessary spending and accounts receivable. If a company does not have
enough liquidity to operate, it must raise more capital by issuing stock or by
taking on debt.
Under this method, monthly cash inflow and outflow statement is prepared and
the highest gap between the two becomes the basis for sanction of credit limit.
Banks make use of cash budget method in case of seasonal industries, software
development, services sector activities including construction activity, etc.
Based on procurement and cash inflow) . It is mainly used for Seasonal
Industries (Sugar/ Rice Mills/Textiles/Tea/Tobacco/Fertilizers) Contractors &
Real Estate Developers , Educational Institutions, etc.
Operating Cycle :
Any manufacturing activity is characterized by a cycle of operations consisting of
purchase of raw materials for cash, converting these into finished goods and realising
cash by sale of these finished goods.
Diagrammatically, the operating cycle is represented as under'
The time that lapses between cash outlay and cash realisation by sale of finished
goods and realisation of sundry debtors is known as the length of the operating cycle.
That is, the operating cycle consists of:
a. Time taken to acquire raw materials and average period for which they are in
store.
b. Conversion process time
c. Average period for which finished goods are in store and
d. Average collection period of receivables (Sundry Debtors)
Operating Cycle is also called the cash-to-cash cycle and indicates how cash is
converted into raw materials, stocks in process, finished goods, bills(receivables) and
finally back to cash. Working capital is the total cash that is circulating in this cycle.
Theref
Traditional Method of Assessment of Working Capital Requirement
The operating cycle concept serves to identify the areas requiring improvement for the
purpose of control and performance review. But, as bankers, we require a more detailed
analysis to assess the various components of working capital requirement viz., finance for
stocks, bills etc.
Bankers provide working capital finance for holding an acceptable level of current assets, viz.
raw materials, stocks-in-process, finished goods and sundry debtors for achieving a
predetermined level of production and sales. Quantification of these funds required to be
blocked in each of these items of current assets at any time will, therefore provide a measure of
the working capital requirement (WCR) of an industry.
Raw Materials: Any industrial unit has to necessarily stock a minimum quantum of
materials used in its production to ensure uninterrupted production. Factors which affect or
influence the funds requirement for holding raw materials are
i. Average consumption of raw materials.
ii. Their availability - locally or from places outside, easy availability / scarcity, number of
sources of supply.
iii. Time taken to procure raw materials (procurement time or lead time)
iv. Imported or indigenous.
v. Minimum quantity supplied by the market (Minimum Order Quantity (MOQ)).
vi. Cost of holding stocks (e.g. insurance, storage, interest)
vii. Criticality of the item.
viii. Transport and other charges (Economic Order Quantity (EOQ)).
ix. Availability on credit or against advance payment in cash
x. Seasonality of the materials.
This raw material requirement is generally expressed as so many months’
requirement (consumption).
Stocks-in-process : Barring a few exceptional types of industries, when the raw materials
get converted into finished products within a few hours, there is normally a time lag or
delay or period of processing only after which the raw materials get converted into finished
product. During this period of processing, the raw materials are being processed and
expenses are being incurred. The period of processing may vary from a few hours to a
number of months and unit will be blocking working funds in the stocks-in-process during
this period. Such funds blocked in SIP depend on:
i. The processing time
ii. Number of products handled at a time in the process
iii. Average quantities of each product, processed at each time. (batch quantity)
iv. The process technology adopted
v. Number of shifts
A rough and ready formula for computing the requirement of funds is to find out the cost of
production for the period of processing. viz. (raw materials consumed per month +
expenses per month) x period of processing in months.
Finished goods: All products manufactured by an industry are not sold immediately. It will
be necessary to stock certain amount of goods pending sale. This stocking depends on:
i. Whether the manufacture is against firm order or against anticipated order
ii. Supply terms
iii. Minimum quantity that can be despatched
iv. Transport availability and transport cost
v. Pre-despatch Inspection
vi. Seasonality of goods
vii. Variation in demand
viii. Peak level/ low level of operations
ix. Marketing arrangement - e.g. direct sale to consumers or through dealers
(wholesalers).
The requirement of funds against finished goods is expressed as so many months’ cost of
production.
Sundry Debtors (Receivables) :
Sales may be effected under three different methods:
a. Against Advance Payment
b. Against Cash
c. On Credit
In the case of (a) no funds are blocked up. Instead it helps in meeting the working capital needs.
In case of Cash Sales (b) no funds are blocked up and hence there is no need for additional
working capital requirement. It is in the case of (c) credit sales that working funds are required to
meet delays in sales realisation. The entire sales of the industry will not be on cash basis. In fact
a major portion will be on credit. A unit grants trade credit because it expects this investment to
be profitable. It would be in the form of sales expansion and fresh customers or it could be in the
form of retention of existing customers. The extent of credit given by the industry normally
depends upon:
i. Trade Practices
ii. Market conditions
iii. Whether it is a bulk purchase by the buyer.
iv. Seasonality (e.g. rain coats, woolen products).
v. Price advantage.
Even in cases where no credit is extended to buyers, the transit time for the goods to reach the
buyer may take some time and till the cash is received back, the unit will have to be out of
funds. The period from the time of sale to the receipt of funds will have to be reckoned for the
purpose of quantifying the funds blocked in Sundry Debtors. Even through the amount of Sundry
Debtors according to the unit’s books will be on the basis of Sale price, the actual amount
blocked will be only the cost of production of the materials against which credit has been
extended - the difference being the unit’s profit margin - (which the unit does not obviously have
to spend).
The working capital requirement against Sundry Debtors will therefore be computed on the
basis of cost of production (whereas the permissible Bank Finance will be computed on the
basis of sale value since profit margin varies from product to product and buyer to buyer and
cannot be uniformly segregated from the sale value).
The working capital requirement is normally expressed as so many months’ cost of production.
Expenses : It is customary in assessing the working capital requirement of industries, to
provide for one month’s expenses also. A question might be raised as to why expenses
should be taken separately, whereas at every stage the funds required to be blocked had
been taken into account. This amount is provided merely as a cushion, to take care of
temporary bottlenecks and to enable the unit to meet expenses when they fall due.
Normally one month total expenses, direct and indirect, salaries etc. are taken into
account. In cases where the operating cycle is very short say one month or 2 months the
provision for expenses can be reduced. Similarly, where the operating cycle is very long,
say 12 months or more, the provision for expenses may have to be increased, to take care
of contingencies.
While computing the working capital requirements of a unit, it will be necessary to take into
account two other factors, one is the credit received on purchases. Trade Credit is a
normal practice in trading circles. The period of such credit will vary from place to place,
material to material and person to person. The amount of credit received on purchases
reduces the working capital funds required by the unit. Secondly, industries often receive
advance against orders placed for their products.
necessarily give advance to producers e.g. Custom-made machinery. Such funds are used
for the working capital of an industry. It can thus be summarised as follows:
1. Raw Materials Months requirements Rs. A
2. Stocks-in- Process Months (Cost of Rs. B
(for Period of Processing) Production)
3. Finished Goods Months cost of Rs. C
production required
to be stocked
4. Sundry Debtors Months cost of production Rs. D
(outstanding credits)
5. Expenses One month(say) Rs. E
------------------
A+B+C+D+E
-------------------
Less: Credit received on purchases - Rs. F
(Months’ Purchases value)
Advance payment on order received - Rs.G
Working Capital Required (H) = (A+B+C+D+E) - (F+G)
The purpose of assessing the W/C requirement of the industry is to determine how the total
requirements of funds will be met. The two sources for meeting these requirements are the
unit’s long term sources (like capital and long term borrowings) and the short term borrowings
from banks
Drawing Power (DP) Method :
(for units with small limits)
Drawing power is arrived at on the basis of valuation of current assets charged to the
bank in the shape of hypothecation and assignment , after deducting the stipulated
margin
Illustration:
Paid stock – 4 Margin 25% - DP = 3
Semi-finished goods – 4 Margin 50% - DP=2
Finished goods -4 Margin 25% - DP = 3
Book Debts – 4 Margin 50% - DP = 2
Total DP= 10
Turnover Method :
(originally suggested by Nayak Committee for SSI units)
The WC requirements may be worked out on the basis of Naik Committee
recommendations for working capital limit upto Rs.6 crores from the banking system, on
the basis of minimum of 20% of their projected annual turnover for new as well as
existing units, beyond which WC be computed on the basis of WC cycle, after fixing
stipulated margins , on each component of the WC. In case of borrowers desiring
facilities under Naik Committee recommendations and having a WC cycle of more than
3 months in a year, the WC requirements will be funded after assessing his
requirements on the basis of his WC cycle, after fixing proper margins.
Example:
Applicable for limits upto Rs.6 crores
(a) Projected sales = Rs. 10,00,000
(b) Working capital requirements: 25% of projected sales i.e. Rs.2,50,000
(c) Margin (contribution of Owner) : 5% of projected sales i.e. Rs.50,000
(d) Working capital to be funded by bank : Rs.2,00,000
MPBF Method
(Tandon‘s II method of lending)
Tandon Committee also recommended inventory/ receivable norms for 22 major industries.
Approach to lending
Regarding approach to lending, the Committee suggested three methods for assessment of
working capital requirements.
FIRST METHOD
The quantum of bank’s short-term advances will be restricted to 75% of working capital gap
where “working capital gap” is equal to “Current Assets” minus “Current Liabilities Other Than
Bank Borrowings”. Remaining 25% is to be met from long-term sources (Net Working Capital)
SECOND METHOD
Net Working Capital should at least be equal to 25% of total value of acceptable level of current
assets. The remaining 75% should first be financed by Other Current Liabilities (OCL) and the
bank may finance balance of the requirements.
THIRD METHOD
The borrower should provide for entire core current assets and 25% balance current assets from
the Net Working Capital.
To compute the level of working capital requirement of the unit, the analyst has to assess the
level of current assets it has to carry, consistent with its projected level of production and sales.
Inventory and receivables constitute most of the current assets. On the basis of the Committee
report, RBI gave inventory norms and advised the banks to decide the levels of inventory and
receivables taking into account, production, processing cycles and other relevant factors
• Working capital gap : Current assets – current liabilities (other than bank
borrowings)
• Minimum stipulated net working capital= 25% of current assets (excluding
exports receivables)
• Actual projected NWC
Cash budget method::
Assessment of working capital
The assessment of working capital is done through the Projected Balance Sheet
Method (PBS), Cash Budget method or Turnover Method.
Under the PBS method, the fund requirements computed on the basis of borrower’s
projected balance sheet, the funds flow planned for the current/ following year
and examination of the profitability, financial parameters. etc. The key determinants for
the limit can, inter-alia, be the extent of financing support required by the
borrower and the acceptability of the borrower’s overall financial position including
the projected level of liquidity. The projected Bank borrowing thus arrived at, is
termed as ‘Assessed bank Finance’ (ABF). This method is applicable for borrowers
who are engaged in manufacturing, services and trading activities and who require
fund bases working capital (WC) finance of above Rs. 5 crores.
Cash budget method is used for assessing working capital finance for seasonal
industries like sugar, tea and construction activity. This method is also used for sanction
of ad-hoc WC limits. In these cases, the required finance is quantified from the
projected cash flows and not from the projected values of current assets and current
liabilities. Other aspects of assessment like examination of funds flow, profitability,
financial parameters, etc, are also carried out
.
Collection of financial data
CMA DATA
Introduction: Credit Monitoring Arrangement (CMA) data is a very important area to understand a person who deals with finance in an organization. This is a critical analysis of current and projected financial statements of a loan applicant by the banker. Data CMA is a systematic analysis of working capital management of the borrower and the purpose of this statement is to ensure the use of long-term and short-term funds have been used . for the particular purpose . In this article I want to discuss the content database CMA CMA Basically contains data that, following the seven states.
1. particular existing and proposed limits: It is the first statement in the CMA data that contains this fund and fund based limits of non-borrower credit limits and their use and history. With the current limitations of funds, which is the limit proposed or the borrower will be mentioned in this statement is a basic document information provided by the borrower, the banker.
2. operating Declaration: This is the second statement provided by the borrower, it indicates that the business plan of the borrower gives the current sales, direct and indirect costs, pre-and after tax, as well as projections of sales, expenses and profit situation for 3-5 years based on the borrower's working capital demand. This statement is a scientific analysis of the capacity of production and financial current and projected income of the borrower.
3. analysis of balance: balance sheet analysis for current and projected statement is the third in the CMA data. This statement gives a detailed analysis of current and non-current assets, fixed assets, cash and bank, the current position and long-term debt of the borrower. Moreover, this declaration indicates the position of the net worth of the borrower for the projected years. budget analysis gives a complete financial situation of the borrower and the generating capacity cash over the planned exercises.
4. Comparative table of current assets and liabilities: . Fourth statement which gives a comparative analysis of current assets and current liabilities of the borrower movement This basically decides the cycle capital of actual work for the projection period and ability of the borrower to meet their working capital needs.
5. Calculate MPBF: This is a very important statement and calculation that indicates the M Aximum P ermissible B ank F inance. This statement, which calculates the borrower working capital GAP and finance eligible in two methods loan, the first method of loan will enable MPBF 75% of the work GAP net capital is Current assets less current liabilities, Second method loan will enable MPBF 75% of current assets less current liabilities. As limit MPBF is the credit component of cash the borrower generally known drawing power (DP Limit). So it is very important statement that decide the borrower `s borrowing limit of the bank.
6. fund cash flow: cash flow analysis statement for the current period and projected is one of the states in the CMA data. fund this position analysis of the borrower's account with reference to the analysis of capital given in the calculations MPBF and projected balance sheets. Objective basis of this statement capture the movement of funds to the borrower for the period.
. 7 Ratio Analysis: This is the last statement that gives the key ratios for the bank on the basis of data from the AMC prepared and presented to the bank financing. Ratios basic gross margin rate net margin, current ratio, limit DP MPBF, net worth, the ratio of the net value of liabilities, the liquidity ratio, inventory turnover, asset turnover, fixed asset turnover, the number of current business assets, working capital turnover, Debt Equity ratio etc.
For working capital assessment, the required financial data are obtained from the borrower
in the following forms:
Form I : Particulars of existing / proposed limits from the banking system
Form II : Operating statement
Form Ill : Analysis of balance sheet
Form IV : Comparative Statement of CA / CL,
Form VI: Funds flows statement.
Form VII: Statement showing the total cost of the project and sources of finance
Information provided in the Forms II, III. IV, and VI serves the detailed financial analysis. In
Form I, in addition to information relating to working capital and term loan borrowings
(existing and proposed) information regarding borrowings from NBFCs, borrowings from
term leading institutions for WC purposes, Inter Corporate Deposits taken, lease finance
availed will also be collected..
Working capital: Numerical
A newly formed company has applied to the Commercial Bank for the first time for financing its
working capital requirements. The following information is available about the projections for
the current year:
Per unit
Elements of cost: (Rs.)
Raw material 40
Direct labour 15
Overhead 30
Total cost 85
Profit 15
Sales 100
Other information:
Raw material in stock : average 4 weeks consumption, Work – in progress (completion stage,
50 per cent), on an average half a month. Finished goods in stock : on an average, one
month.
Credit allowed by suppliers is one month.
Credit allowed to debtors is two months.
Average time lag in payment of wages is 1½ weeks and 4 weeks in overhead expenses.
Cash in hand and at bank is desired to be maintained at Rs. 50,000.
All Sales are on credit basis only.
Required:
(i) Prepare statement showing estimate of working capital needed to finance an activity level
of 96,000 units of production. Assume that production is carried on evenly throughout the
year, and wages and overhead accrue similarly. For the calculation purpose 4 weeks may
be taken as equivalent to a month and 52 weeks in a year.
(ii) From the above information calculate the maximum permissible bank finance by all the
three methods for working capital as per Tondon Committee norms; assume the core
current assets constitute 25% of the current assets.
Answer
Calculation of Working Capital Requirement
(A) Current Assets
Rs.
(i) Stock of material for 4 weeks (96,000 40 4/52) 2,95,385
(ii) Work in progress for ½ month or 2 weeks
Material (96,000 40 2/52) .50 73,846
Labour (96,000 15 2/52) .50 27,692
Overhead (96,000 30 2/52) .50 55,385 1,56,923
(iii) Finished stock (96,000 85 4/52) 6,27,692
(iv) Debtors for 2 months (96,000 85 8/52) 12,55,385
Cash in hand or at bank 50,000
Investment in Current Assets 23,85,385
(B) Current Liabilities
(i) Creditors for one month (96,000 40 4/52) 2,95,385
(ii) Average lag in payment of expenses
Overheads (96,000 30 4/52) 2,21,538
Labour (96,000 15 3/104) 41,538 2,63,076
Current Liabilities 5,58,461
Net working capital (A – B) 18,26,924
Minimum Permissible Bank Finance as per Tandon Committee
Method I : .75 (Current Assets – Current Liabilities)
.75 (23,85,385 – 5,58,461)
.75 (18,26,924) – 5,58,461 = Rs. 13,70,193
Method II : .75 Current Assets – Current Liabilities
.75 23,85,385 – 5,58,461
17,89,039 – 5,58,461 = Rs. 12,30,578
Method III: .75 (Current Assets – CCA) – Current Liabilities
7.3
.75 (23,85,385 – 5,96,346) – 5,58,461
.75 (17,89,039) – 5,58,461
13,41,779 – 5,58,461 = Rs. 7,83,318
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