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UNIT 6: WORKING CAPITAL ANALYSIS

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Structure
6.1 Working Capital: Working Capital Cycle, Factors Effecting Working Capital,
Financing of Working Capital, Computation of Working Capital Requirements

6.1 WORKING CAPITAL: WORKING CAPITAL CYCLE, FACTORS

EFFECTING WORKING CAPITAL, FINANCING OF WORKING CAPITAL,
COMPUTATION OF WORKING CAPITAL REQUIREMENTS

Meaning of Working Capital

Capital required for the business can be of two types:

 Fixed Capital
 Working Capital
Fixed capital is required to create the production facilities through purchase of fixed
assets like Land, Machinery, Building etc. Investment in these assets represents that part
of firm’s capital, which is blocked on permanent or fixed basis and is called fixed capital.
Funds are also needed for short-term purpose for the purchase of Raw material, Payment
of Wages etc. these funds are known as Working Capital.
In simple words, working capital refers to that part of firm’s capital, which is required for
financing short-term assets.

Definitions of Working Capital

Acc. to Shubin
“Working Capital is the amount of funds necessary to cover the cost of operating the
enterprises.”

Acc. to Genestenberg:-
“ Working Capital means current assets of a comp-any that are changed in the ordinary
course of business from one form to another as for e.g. Cash to inventories, inventories to
receivables and receivables to cash”.
 KINDS OF
WORKING
CAPITAL

ON THE BASIS ON THE BASIS

OF CONCEPT OF TIME

GROSS NET WORKING PERMANENT OR TEMPORY AND

WORKING CAPITAL FIXED VARIABLE
CAPITAL WORKING WORKING
CAPITAL CAPITAL
(A) On the basis of concept

(i) Gross working capital concept : According to this concept, working capital
means total of all current assets of business..
Gross working capital = Total current assets.
(ii) Net working capital concept : According to this concept, working capital means
excess of current assets over current liabilities.
Net Working capital = Current Assets – current Liabilities

As per the general practice net working capital is referred to simply as working capital.

(B) On the basis of time

(i) Fixed or permanent working capital : There is always a minimum level of

current assets which is continuously required by the enterprise to carry out normal
business operation. For ex. Every firm has to maintain a minimum level of stock
and cash balance. This minimum level of current assets is called fixed working
capital as this amount is permanently blocked in currant assets
(ii) Temporary or variable working capital. It is that amount of working capital
which is required to meet the seasonal demand and some special needs. Any
amount over and above the permanent level of working capital is called as
Temporary or variable working capital.

OPERATING CYCLE / NEED FOR WORKING CAPIAL

Every business needs some amount of working capital. The need for working capital
arises due to the time gap between the production and realization of cash from sales. Thus
working capital is needed for the following purposes:
1. For the purchase of raw material, components and spares parts.
2. To pay wages and salaries
3. To incur day-to-day expenses.
4. To meet the selling costs s packing, advertising.
5. To provide the credit facilities to the customers.
6. To maintain the inventories of Raw material, work in progress, finished stock
There is an operating cycle involved in the sales and realization of cash. The cycle starts
with the purchase of raw material and ends with the realization of cash from sales of
finished foods. It involves purchase of raw material and stores, it conversion in to stock
of finished goods through work-in- progress, conversion of finished stock in to sales,
debtors and receivables and ultimately in cash and this cycle continues again from cash to
purchase of raw material and so on.

The gross operating cycle of the firm = RMCP +WIPCP + FGCP+RCP

Where, RMCP = Raw material conversion period

WIPCP = Work in progress conversion period
FGCP = Finished goods conversion period
RCP = Receivables conversion period
However a firm may acquire some resources of credit and thus defer payments fro certain
period. In this case
Net operating cycle period = Gross operating cycle period - Payable deferral period.

CASH

RECEIVABLES RAW MATERIAL

CREDIT SALES WORK IN PROCESS

STOCK OF FINISHED GOODS

Diagram : Working capital / Operating Cycle of a manufacturing concern

FACTORS DETERMINING WORKING CAPITAL REQUIREMENTS

The working capital requirement of a concern depends upon a large number of factors,
which are as follow:

1. NATURE OR CHARACTER OF BUSINESS Public utility undertakings like

Electricity, Water supply and Railways need very limited working capital because
they offer cash sales only and supply services not products. On the other hand,
Trading and Financial firms require less investment in fixed assets but have to
investment large amount in current assets like inventories, receivables etc.
2. SIZE OF BUSINESS Greater the size of business unit, generally larger will be the
requirement of working capital. In some case even a smaller concern need more
working capital due to high overhead charges, inefficient use of resources etc.

3. PRODUCTION POLICY The production could be kept either steady by

accumulating inventories during slack periods with a view to meet high demand
during the peak season or the production could be curtailed during the slack season
and increased during peak season. If the policy is to keep the production steady by
accumulating inventories it will require higher working capital.

4. SEASONAL VARIATIONS In certain industries, raw material; is not available

throughout year. They have to buy raw material in bulk during the season to ensure an
uninterrupted flow and process them during the entire year. A huge amount is blocked
in the form of material inventories during such season, which give rise to more
working capital.

5. WORKING CAPITAL CYCLE In manufacturing concern, the working capital

cycle starts with the purchase of raw material and ends with the realization of cash
from the sales of finished products. This cycle involves purchase of raw material and
starts, its conversion into stock of finished goods through work in progress with
progressive increment of labor and service costs, conversion of finished stock into
sales, Debtor and receivables and ultimately realization of cash and this cycle
continues again from cash to purchase of raw material so on.

6. RATE OF STOCK TURNOVER There is high degree of inverse co relationship

between the quantum of working capital and the velocity or speed with which the
sales are effected. A firm with having a high rate of stock turnover will need lower
amount of working capital as compared to the firm having a low rate of turnover.

7. CREDIT POLICY A concern that purchases its requirement on credits and sells its
products / services on cash require lesser amount of working capital. On the other
hand, concern buying its requirement for cash and allow credit to its customers, will
need larger amount of working capital as very huge amount of funds are bound to be
tied up in debtors or bills receivables.

8. BUSINESS CYCLE Business Cycle refers to alternate expansion and contraction in

general business activity. In period of boom i.e. when the business is prosperous,
there is need for larger amount of working capital due to increase in sales, rise in
prices, expansion of business. On the contrary in the times of depression i.e., when
there is down swing of cycle, the business contracts, sales decline, difficulties are
faced in collection from debtors and firms may have a large amount of working
capital lying idle.

9. RATE OF GROWTH OF BUSINESS For the fast growing concern, larger amount
of working capital is required.
IMPORTANCE OR ADVANTAGES OF ADEQUATE OF WORKING CAPITAL

Working capital is the lifeblood and nerve center of a business. No business can run
successfully without and adequate amount of working capital. The main advantage of
maintaining adequate amount of working capital is as follow:

1. Solvency of the business: Adequate amount of working capital helps in

marinating solvency of business by providing uninterrupted flow of production.

2. Goodwill: sufficient amount of working capital enables business concern to make

the prompt payment and helps in creating and marinating goodwill.

3. Easy Loans: a concern having adequate amount of working capital, high

solvency and credit standing can arranges loans from banks.

4. Cash Discounts: Adequate amount of working capital also enables a concern to

avail cash discounts on the purchases and hence it reduces the costs.

5. Exploitation of favorable market condition: Adequate amount of working

capital enables a concern to exploit favorable market conditions such as purchasing
its requirement in bulk when the prices are lower and by holding its inventories for
higher prices.

6. Ability to face the crises: Adequate amount of working capital enables a concern
to face the business crises in emergencies such as depression because during such
periods, generally there is much pressure on working capital.

7. Quick and regular return on investments: Adequate amount of working capital

enables a concern pay quick and regular dividends to its investors as there may not be
much pressure to plough back profits.

8. Regular supply of raw material: Adequate amount of working capital ensures

regular supply of raw material and continuous production.

FINANCING OF WORKING CAPITAL

A) Financing of permanent/fixed/or Long term working capital

B) Financing of Temporary, variable or short term working capital

A) Financing of permanent/fixed/or Long term working capital

Permanent working capital should be financed in such a manner that the enterprise
may have its uninterrupted use for a sufficient long period. There are five important
sources of long term or permanent capital .
1. Shares
2. Debentures / bonds
3. Public deposits
4. Ploughing back of profits
5. Loans from financial institutions

These long term sources of finance have already been discussed in detail in the first
unit of the book.

B) Financing of Temporary, variable or short term working capital

The main sources of short term working capital are as follows
1) Indigenous Bankers. private money lenders used to be the only source of finance
prior to the establishment of commercial banks. They used to charge very high
rates of interest.
2) Trade credit. Trade credit refers to the credit extended by suppliers of goods in
the normal course of business. The credit worthiness of a firm and the confidence
of its suppliers are the main basis of securing trade credit. The main advantages of
trade credit are:
 It is easy and convenient method of finance.
 It is flexible as the credit increases with the growth of firm
 It is informal and spontaneous source of finance.
3) Installment credit. In this assets are purchased and possession of goods is taken
immediately but payment is made in installment over a predetermined period.
Generally, interest is charged on the unpaid price or it may be adjusted in the
price.
4) Advances. Some business houses get advances from their customers and agents
against orders. Usually the manufacturing concerns having long production cycle
prefer to take advances from their customers.
5) Factoring or Accounts Receivable Credit. A commercial bank may provide
finance by discounting bills or invoices of its customers. Thus, a firm gets
immediate payment for sale made on credit.. a factor I sa financial institution
which offers services related to management and financing of debts arising out of
credit sales.
6) Accrued expenses. Accrued expenses are the expenses which have been incurred
but not yet due and hence not yet paid also. For ex. Wages , salaries, rent, interest,
taxes etc.
7) Deferred Incomes. Deferred incomes are incomes received in advance before
supplying goods or services. However, firms having great demand for its products
and services, and those having good reputation in the market can demand deferred
incomes.
8) Commercial Paper.Commercial paper represents unsecured promissory notes
issued by firms to raise short-term funds. But only large companies enjoying high
credit rating and sound financial health can issue commercial paper to raise short-
term funds. The Reserve Bank of India has laid down a number of conditions to
determine eligibility of a company for the issue of commercial paper. Only a
company which is listed on the. stock exchange, has a net worth of at least Rs. 10
corers and a maximum permissible bank finance of Rs. 25 crores can issue
commercial paper not exceeding 30 per cent of its working capital limit.
The maturity period of commercial paper mostly ranges from 91 to 180 days. It is
sold at a discount from its face value and redeemed at face value on its maturity.
9) Working capital finance by commercial banks. The different forms in which
banks normally provide the finance are as follows:
 a) Loans:

DETERMINING THE WORKING CAPITAL FINANCING MIX

There are two sources of financing working capital requirements: (i) Long-term sources
(ii) short-term sources. Therefore, a question arises as to what portion of working capital
(current assets) should be financed by long-term sources and how much by short-term
sources? There are three basic approaches for determining an appropriate working capital
financing mix.

1. The Hedging or Matching Approach

The term 'hedging' usually refers to two off-selling transactions of a simultaneous but
opposite nature which counterbalance the effect of each other. With reference to
financing mix, the term hedging refers to a process of matching maturities of debt with
the maturities of financial needs. According to this approach, the maturity of sources of
funds should match the nature of assets to be financed. This approach is, therefore, also
known as 'matching approach'. This approach classifies the requirements of total working
capital into two categories:
(i) Permanent or fixed working capital which is the minimum amount required to carry
out the normal business operations. It does not vary over time.
(ii) Temporary or seasonal working capital which is required to meet special exigencies.
It fluctuates over time.
The hedging approach suggests that the permanent working capital requirements should
be financed with funds from long-term sources while the temporary or seasonal working
capital requirements should be financed with short-term funds. The following example
explains this approach.
Estimated total investments in Current Assets of Company X fro the year 2008

Investments in Permanent or Fixed Temporary or Seasonal

Month Current assets Investment investment
(Rs.) (Rs.) (Rs.)
January 50,400 45,000 5,400
February 50,000 45,000 5.000
March 48,700 45,000 3,700
April 48,000 45.000 3,000
May 46,000 45,000 1,000
June 45,000 45.000 -
July 47,500 45,000 2,500
August 48,000 45,000 3,000
September 49,500 45,000 4,500
October 50,700 45,000 5,700
November 52,000 45.000 7,000
December 48,500 45.000 3,500
Total 44,300
According to hedging approach the permanent portion of current assets required (Rs.
45,000) should be financed with long-term sources and temporary or seasonal
 requirements in different months (Rs. 5,400 Rs. 5,000 and so on) should be financed from
short-term sources.
2. The Conservative Approach
This approach suggests that the entire estimated investments in current assets should be
financed from long-term sources and the short-term sources should be used only for
emergency requirements. According to this approach, the entire estimated requirements
of Rs. 52,000 in the month of November (in the above given example) will be financed
from long-term sources. The short-term funds will be used only to meet emergencies. The
distinct features of this approach are:
i. Liquidity is severally greater
ii. Risk is minimized
iii. The cost of financing is relatively more as interest has to be paid even on seasonal
requirements for the entire period

Trade off Between the Hedging and Conservative Approaches

The hedging approach implies low cost, high profit and high risk while the conservative
approach leads to high cost, low profits and low risk. Both the approaches are the two
extremes and neither of them serves' the purpose of efficient working capital
management. A trade off between the two will then be an acceptable approach. The level
of trade off may differ from case to case depending upon the perception of risk by the
persons involved in financial decision-making. However. one way of determining the
trade off is by finding the 'average of maximum and the minimum requirements of
current assets or working capital. The average requirements so calculated may be
financed out of long-term funds and the excess over the average from the short-term
funds. Thus, in the above given example the average requirements of Rs. 48.500.
45,000+52,000
i.e. 2 may be financed from long-term while the excess capital required
during various months from short-term sources.
3. The Aggressive Approach
The aggressive approach suggests that the entire estimated requirements of currents asset
should be financed from .short-term sources and even a part of fixed' assets investments
be financed from short-term sources. This approach makes the finance-mix more risky,
less costly and more profitable.

WORKING CAPITAL ANALYSIS

Working capital is very essential to maintain the smooth running of a business. No

business can run successfully without an adequate amount of working capital. The
concept of working capital has its own importance in a going concern. A going concern,
usually, has a positive balance of working capital, i.e., the excess of current assets over
current liabilities, but sometimes the uses of working capital may be more than the
sources resulting into a negative value of working capital. This negative balance is
generally offset soon by gains in the following periods. A study of changes in the uses
and sources of working capital is necessary to evaluate the efficiency with which the
working capital is employed in a business. This involves the need of ,working capital
analysis.
The analysis of working capital can be conducted through a number of devices, such as :
1. Ratio Analysis
 2. Funds Flow Analysis
3. Budgeting
1. Ratio Analysis. A ratio is a simple arithmetical expression of the relationship of one
number to another. The technique of ratio analysis can be employed for measuring short-
term 'liquidity or working capital position of a firm. The following ratios may be
calculated for this purpose :
i. Current Ratio
ii. Acid Test Ratio
iii. Absolute Liquid Ratio
iv. Receivables Turnover Ratio
v. Payables Turnover Ratio
vi. Working Capital Turnover ratio
vii. Ratio of Current Liabilities to Tangible Net Worth
2. Funds Flow Analysis. Funds flow analysis is a technical device designated to study
the sources from which additional funds were derived and the use to which these sources
were put. It is an effective management tool to study changes in the financial position
(working capital) of a business enterprise between beginning and ending financial
statements dates. The funds flow analysis consists of: (i) preparing schedule of changes
in working capital, and (ii) statement of sources and application of funds.
3. Working Capital Budget. A budget is a financial and/or quantitative expression of
business plans and policies to be pursued in the future period of time. Working capital
budget, as a part of total budgeting process of a business, is prepared estimating future
long-term and short-term working capital needs and the sources to finance them, and then
comparing the budgeted figures with the actual performance for calculating variances, if
any, so that corrective actions may be taken in the future. The objective of a working
capital budget is to ensure availability of funds as and when needed, and to ensure
effective utilisation of these resources. The successful implementation of working capital
budget involves the preparing of separate budgets for various elements of working
capital, such as, cash, inventories and receivables, etc.

ESTIMATION OF WORKING CAPITAL REQUIREMENTS:

Factors requiring consideration while estimating working capital

1 Total costs incurred on material, wages and overheads.

2 The length of the time for which materials are to remain in stores before they
are issued for production.
3 The length of the production cycle or work in progress.
4 The length of the sales cycle during which finished goods are to be kept
waiting for sales.
5 The average period of credit allowed to customers.
6 The amount of cash required to pay day to day expenses of the business.
7 The average amount of cash required to make the payments.
8 The average credit period expected to be allowed by suppliers.
9 Time lag in the payment of wages and other expenses.

Illustration: You are required to prepare a statement showing the working capital
required to finance the level of activity of 18,000 units per year from the following
information:-
Particulars Rs.
Raw material Per Unit 12
Direct labour Per Unit 3
Overheads Per Unit 9
Total cost Per Unit 24
Profit Per Unit 6
Selling price Per Unit 30

Additional Information:
1. Raw material are in stock on an average for 2 months.
2. Materials are in process on an average for half-a- month.
3. Finished goods are in stock on an average for two months.
4. Credit allowed by creditors is two months in respect of raw materials supplied.
5. Credit allowed to debtors is three months.
6. Lag in payment of wages is half month.
7. Cash on hand and at bank is expected to be Rs. 7,000.
8. You are informed that all activities are evenly spread out during the year.
Solution:
Estimation of Working Capital:
Current Assets: Rs.
1. Stock-in-Trade
a. Raw materials 18,000 x 12 x 2 = 36,000
12
b. Work in progress 18000 x 18 x ½ = 13,500
12
c. Finished goods 18,000 x 24 x 2 = 72,000
12
1,21,500

2. Sundry debtors 18,000 x 30 x 3 = 1,35,000

12
3. Cash on hand and at bank 18,000 x 30 x 3 = 7,000
12 2,63,500
Less: Current liabilities:
4. Sundry creditors 18,000 x 12 x 3 = 36,000
12
5. Wages 18,000 x 3 x ½ = 2250
12
Estimated Working Capital Requirement 2,25,250

Working Notes:
(1) Cost of each unit of Work in process Rs.
Raw materials 12
Labour (50% of Rs. 3) 1.50
Overhead(50% of Rs. 9) 4.50
Total 18
Illustration: Runwall Ltd. had an annual sales of 50,000 units at Rs.100per unit. The
company works for 50 weeks in the year. Cost details of the Company are as given
below:
Particulars Rs.
Raw material Per Unit 30
Labour Per Unit 10
Overheads Per Unit 20
Total cost Per Unit 60
Profit Per Unit 40
Selling price Per Unit 100

Additional Information:
1. The Company has the practice of storing raw materials for 4weeks requirements.
2. The wages and other expenses are paid after a lag of 2 weeks.
3. Further the debtors enjoy a credit of 10 weeks and Company gets a credit of 4 weeks
from suppliers.
4. The processing time is 2 weeks and finished goods inventory is maintained for 4
weeks.
From the above information prepare a working capital estimate, allowing for a 15%
Contingency.
Solution:
Estimation working Capital:.
Current Assets: Rs.
1. Stock-in-Trade
a. Raw materials 50,000 x 30 x 4 = 1,20,000
50
b. Work in progress 50,000 x 45 x 2 = 90,000
50
c. Finished goods 50,000 x 60 x 4 = 2,40,000
50
4,50,000

2. Sundry debtors 50,000 x 100 x 10 = 10,00,000

50
14,50,000
Less: Current liabilities:
3. Sundry creditors 50,000 x 30 x 4 = 1,20,000
50

4. Wages 50,000 x 10 x 2 = 20,000

50
5. Overhead 50,000 x 20 x 2 = 40,000
50
12,70,000
Add: 10 % for contingencies 1,27,000
Estimated Working Capital Requirement 13,97,000

Working Notes:
(1) Cost of each unit of Work in process Rs.
Raw materials 30
Labour (50% of Rs. 10) 5
Overhead(50% of Rs. 20) 10
Total 45

Illustration: From the following particulars, you are required to prepare a statement of
working capital requirements:
Estimates for the next year: Rs.
Raw Material cost 31,20,000
Wages 18,72000
Overhead( including depreciation Rs. 1,20,000) 7,44,000
57,36,000
Profit 12,64,000
Selling Price 70,00,000

Additional Information:

1. Inventory norms:
a. Raw material 2months
b. Work in progress 3 weeks
c. Finished goods 1 month
2. 50% of the sales is on credit and 2 weeks credit is normal.
3. The company enjoys 4 weeks credit facilities on 30 % of the purchases.
4. Lag in payment of overheads is one month.
5. Wages are paid at the end of the month.
6. Cash is to be held to the extent of 50% of the current liabilities.
Solution:
Estimation working Capital:.
Current Assets: Rs.
1. Stock-in-Trade
a. Raw materials 31,20,000 x 2 = 5,20,000
12
b. Work in progress 43,68,000 x 3 = 5,52,000
52
c. Finished goods
(31,20,000+18,72000+7,44,000)
-Depreciation 1,20,000 = 56,16,000 x 1 = 4,68,000
12
2. Sundry debtors 56,16,000 x 50 x 2 = 1,08,000
100 52
3. Cash in hand 2,02,000 x 50 = 1,01,000
100
14,49,000
Less: Current liabilities:
4. Sundry creditors 31,20,000 x 30 x 4 = 72,000
100 52
5.Wages 18,72,000 x 1 = 20,000
24
6.Overhead 6,24,000 x 1 = 52,000 2,02,000
12
Estimated working capital Requirement 12,47,000

Illustration: From the following information, you are required to estimate the net
working capital.
Particulars Rs.
Raw material Per Unit 400
Labour Per Unit 150
Overheads Per Unit 300
Total cost Per Unit 850

Additional information:
1. Selling Price Rs. 1000 per unit
2. Output 52000 units per annum
3. Raw material in stock Average 4 weeks
4. Work in progress (Assume 50% of stage with full material consumption) Average
2weeks
5. Credit allowed by the Suppliers Average 4 weeks
6. Credit allowed to debtors Average 8 weeks
7. Cash at bank expected to be Rs. 50,000
Assume that production is sustained at an even pace during the 52 weeks of the year. All
sales are on credit basis. State any other assumptions that you might have make while
computing.
Solution
Statement of Working Capital Estimation
Current Assets:

1. Stock-in-Trade
a. Raw materials 52,000 x 400 x 4 = 16,00,000
52
b. Work in progress 52,000 x 625 x 2 = 12,50,000
52
c. Finished goods 52,000 x 850 x 4 = 34,00,000
52
12
2. Sundry debtors 52,000 x 850 x 8 = 68,00,000
52
3. Cash at bank = 50,000
1,31,00,000
Less: Current liabilities:
4. Sundry creditors 52,000 x 400 x 4 = 16,00,000
52
Net working capital 1,51,00,000