Estimating Working Capital

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Eklavya
Subject: Finance Chapter 1: Estimating the Working Capital. Time of the Session: 30 Minutes + 20 Minutes for Practice.
Dt. 4/7/06
Question: You are required to prepare a statement showing the estimate of working capital required to finance the level of activity of 18000 units per year, from the following information obtained from the books of XYZ ltd.
Sr. No. 1 2 3
Particulars Raw Materials Direct Labor Overheads
Per unit Cost 12 3 9
Total cost Profit on Cost price is Rs.6
24
Hence Selling Price = Rs. 30 ( Cost price + Profit = Selling price). Adjustments: a) Raw materials are in stock on an average for 2 months. b) Materials are in process on an average for a month. c) Finished goods are in stock on an average for 2 months. d) Credit allowed by creditors is 2 months. e) Lag in payment of wages is a month. f) Cash in hand and at bank is expected to be Rs. 7000. Prepare a Statement showing Estimate of Working Capital. -----------------------------------------------------------------------------------------------------------Redistributing / Modifying / using this material without permission will result in STRICT legal action. All Content Copyright. ManagementParadise.com
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Hey guys dont get scared. We will go step by step. IMAGINE: You wake up to find the Snoozed Alarm. You rush to College, but you are late. And there is more to it. You are quick to realize your Walletlessness. You borrow from a friend. And then it is back to normal. You spend as if you are living for the day, and while returning home, you are again back to Ground Zero (Penniless).
What was the Crux of the problem? For those people who live by borrowing from other (the so called Financially Leverage people) there was no problem, but for people like our Founder, there was. The answer to the Question is the topic itself. You failed to estimate. And this failure was not only on monetary part but it was complimented by you being late, bad planning.
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The bottom line of the problem accurately was Estimated Failure. In which case, you are a Damager and not a Manager.
Now lets understand the basics of Working Capital:. This will include the following things: 1) Meaning 2) The ingredients of working capital. 3) Its effect on the long term policy of the Org.
Meaning: o That part of Firms capital which is required to hold or operate firms operations. o Basically the concept of installment on loan can be understood as working capital. How we need to pay regular installments so that we can have access to resources. o Similarly a firm has to pay for factors of production, to hold on good. Etc.
In Accounting sense Working Capital = Current Assets Current Liabilities.
o Decisions relating to working capital and short term o These involve managing the relationship between a firm's shortterm assets and its short-term liabilities.
A Management Paradise Initiative!! Pratik@managementparadise.com o The goal of Working capital management is to ensure that the firm is able to continue its operations and that it has sufficient cash flow to satisfy both maturing short-term debt and upcoming operational expenses.
Ingredients or Management of Working Capital
o Management will use a combination of policies and techniques for the management of working capital. o These require managing the current assets - generally cash and cash equivalents, inventories and debtors. o There are also a variety of short term financing options which are considered. This includes:
Cash management identify the cash balance which allows for the business to meet day to day expenses, but reduces cash holding costs
Inventory management - identify the level of inventory which allows for uninterrupted production but reduces the investment in raw materials and hence increases
cash flow; Techniques Used: Just in Time (JIT) and Economic order quantity (EOQ).
Debtors management - identify the appropriate credit policy, i.e. credit terms which will attract customers, such that any impact on cash flows and the cash conversion cycle will be offset by increased revenue and hence Return on Capital (or vice versa); see Discounts and allowances.
Short term financing - inventory is ideally financed by credit granted by the supplier; dependent on the cash conversion cycle, it may be necessary to utilize a bank loan (or overdraft), or to "convert debtors to cash".
Note: Cash Conversion Cycle:

The net number of days from the outlay of cash (Purchase) for raw material to receiving payment from the customer. As a management tool, this metric makes explicit the interrelatedness of decisions relating to inventories, accounts receivable and payable, and cash.
o Now that was the Conceptual part. But the Problem is still prevalent.
That is, How to Estimate Working Capital
There are 2 ways to solve the sums of Estimation of Working Capital 1. Understanding the Mechanics and then solve
2. Going by a fixed format.
Lets analyze and understand the given sum. Lets check the information given to us: 1) The Sales or the Turnover of the Firm. 2) The Cost Sheet
A Management Paradise Initiative!! Pratik@managementparadise.com Note: The preparation of Cost Sheet is very important from Exam point of View. Hence, Structure of Cost Sheet is Given below:
Particulars 1) Direct Costs: a. Direct Wages: b. Direct Labor: c. Raw Materials d. Carriage Inward: Prime Cost 2) Factory Costs or Overheads Costs: Factory Cost 3) Office and Administrative Exp.
Amount
Amount
Cost of Production: (+) Opening Stock Finished goods. (-) Closing Stock Cost of Goods Sold: 4) Selling & Distribution Costs:
Cost of Sales: 5) Profit per Unit:
Selling Price per Unit: Redistributing / Modifying / using this material without permission will result in STRICT legal action. All Content Copyright. ManagementParadise.com
A Management Paradise Initiative!! Pratik@managementparadise.com After Understanding the Cost Sheet, lets now make one for the Above problem: Cost Sheet Of XYZ Ltd for the Period _/_/_ Sr. No. 1 2 3 Particulars Raw Materials Direct Labor Prime Cost Overheads Factory cost/Cost of Production/ Cost of Sales Profit Per unit Cost 12 3 15 9 24
Selling Price
30
As there are no Administrative Expenses or Selling or Distribution Expenses, hence Cost of Production and Cost of Sales Remains Same.
That was About Cost Sheet. Mind You, There will be More Sums for practice on Cost Sheets as well as Working Capital.
Statement of Estimating Working Capital
It is a Compartmental Distribution of all the Costs in an Economic Sense.
For Example, Imagine You Enter a Restaurant, and there are 10 Seats or Tables Unoccupied, for Next 10 Minutes.
This Would simply mean that, had there been only ONE Chair, it would have been Vacant for 100 Minutes. That is what we mean by Calculating
Economically.
2nd Example: Imagine 3 People of Same Working Capacity, are Completing a Task. Now, That would Simply mean Task Will be Completed in 1/3 of the Time (Approx.) and it would also mean that if the Same Task is given to a person of Same Working Capacity, then he would take approx. 3 Times the Time taken by Group to Complete it.
Task To Be Completed = 3 units. One person Can workout only 1 Unit per Day Hence He Will Require 3 Days.
But When a Group of 3 do the Task, it would Take them a proper 1 day.
If you have got the above examples, then Try this Sentence: Raw Materials are in Store on an Average for 2 Months. Guys Dont Scratch Your Heads. Mind you, It aint That Simple.
Lets understand it Step by Step: A firm has daily Requirement for Raw Materials. Suppose this Requirement is Same/Static For ALL the PERIODS of Equal Size.
Raw Materials are in Store on an Average For 2 Months
This would Simply mean that Raw Materials At any Point of Time in the Year Satisfy the Production For Next 2 Months. That is at the End of Year, there will still be 2 months materials Left.
Or we can say, that, Without Ordering for the Raw Material, I can Satisfy the Production Cycle For 2 Months. By this statement, we can again conclude, that whenever we want to make Financial or Technical Analysis of Raw Materials of the Firm, it would be on the Scale of 2 Months. That is once in 2 months, or Thrice in 6 months, or Six times Annually.
But, but, but, now as i say this, i am remembered by a Fact:
That is Working Capital Requirement is Forecasted or Calculated on Monthly Basis. That is 12 Estimates Annually.
And not to Forget, Every Item Which Constitutes the Working Capital Would Have a Different Period or Cycle of Rotation.
Hence there is a need felt to calculate Working Capital on Monthly Basis.

Lets make a complete sense of the given Statement:
Raw Materials are in Store on an Average For 2 Months This as explained earlier, there would be twice the capacity of materials required by the production department.
But, as also said earlier, the Estimates have to be prepared Monthly. Hence Simply put Raw Materials are 2 Times the Capacity in any Given Month.
Hence the Cost of Raw Materials for the Month =
Raw Materials required per Month x 2 x Rate per Unit of Raw Material.
That is What we mean by Economically Speaking for Standard Units of Time. Redistributing / Modifying / using this material without permission will result in STRICT legal action. All Content Copyright. ManagementParadise.com
A Management Paradise Initiative!! Pratik@managementparadise.com That is Expressing the Variable Time Cycle in to Standard Unit of Time which is One Month.
Now Consider this: Finished Goods are in Stock for an Average 2 months. It would simply mean that, Finished goods for the Month are Double the Capacity for that Respective Month.
Cost of Finished Goods: Finished Goods Produced Per Month x 2 x Rate per Unit.
If you have got this, You have Just Completed A Chapter in Finance. (Thanks to Eklavya).
The Technical Aspects of Statement: As said Earlier, Working Capital is the Difference between Current Assets and Current Liabilities. Hence every Statement will have 2 parts to it. That is Current Assets and Current Liabilities. A specimen is provided below:
Sr. Particulars A) Current Assets: i) Stock : a) Raw Materials: Requirement Per Month x Rate x Average Time Amount Amount (Rs.)
b) Finished Goods: Requirement Per Month x Rate x Average Time
ii) Work in Progress: a) Requirement Per Month x Rate x Average Time x 0.5 b) Labor: Requirement Per Month x Rate x Average Time x 0.5
c) Overheads: Requirement Per Month x Rate x Average Time x 0.5
iii)
Debtors: Sales Per Month x
A Management Paradise Initiative!! Pratik@managementparadise.com Selling Price x Average Time iv) Advances Given:
v)
Cash in Hand & Bank:
Less: Current Liabilities: i) Creditors: a) Raw Materials: Requirement Per Month x Rate x Average Time Lag.
b) Labor: Requirement Per Month x Rate x Average Time Lag.
c) Overheads: Requirement Per Month x Rate x Average Time Lag.
Net Working Capital Required:
Now as given in the Above Specimen, while Solving Every sum, we must care of all individual costs, that including there Periods of Rotation as well as Master Groups that is Current Assets and Current Liabilities.
Let us Go on the Main Sum provided at the Beginning of the Document.

But, but, but We still have to find out the Production Capacity of the Plant. Without which we will be always dealing with the Costs per unit. But Estimation of Working Capital is the Aggregate of all the Costs and that too Monthly.
Given that Production Level of the Firm annually = 18000 Units.
Hence the Monthly Production = 18000\12 = 1500 units.
Books of M/s. XYZ Ltd
Level of Activity: 18000 (Annually) Therefore, Monthly = 18000/12 = 1500
Estimate of Working Capital Requirement

Sr. Particulars B) Current Assets: i) Stock : a) Raw Materials: 1500 x 12 x 2 Amount Amount (Rs.)
36000
A Management Paradise Initiative!! Pratik@managementparadise.com b) Finished Goods: 1500 x 24 x 2 ii) Work in Progress: b) Raw Materials: 1500 x 12 x 0.5 c) Labor: 1500 x 3 x 0.5 x 0.5 d) Overheads: 1500 x 9 x 0.5 x 0.5 72000 1,08,000
9000 1125 3375 13,500
i) Debtors: 1500 x 30 x 2 ii) Cash in Hand & Bank: Current Assets Total Less: Current Liabilities: i) Creditors: a) Raw Materials : 1500 x 12 x 2 b) Labor: 1500 x 3 x 0.5
1,35,000 7000
1,35,000 7,000 2,63,500
(36,000) (2,250) (38,250)
Working Capital Required
2, 25, 250
Assumptions Made: (Necessary for every Problem).
1) Both Production and Sales are Evenly Distributed. 2) Raw Materials are issued to Production Right in the Beginning of the year, whereas wages and overheads are incurred Evenly. 3) Overdraft Sanctioned by Bank is Ignored.
Notice the Sub-heading of Work-in-Progress. You will notice that every Sub-Cost is Multiplies by . This is because it is Work-inProgress.
This means that we are Assuming, that Goods in Work-in-Progress are not completely finished nor completely in the Stage of Raw Materials. That is some work has been done on them, which is why they are Work-in-Progress.
Hence it is Assumed that they are Partially Completed and to be Precise are half done.
That makes it for those who have done this sum by understanding Each and Every Concept.
Now for those people who havent understood the Fundamentals, Just Follow that Given Format Blindly and you Will get it right. For Format See page Number 13.
Sums for Practice will be Posted After Some time, Once you Complete the Tutorials of the Chapter, Followed by the Solution for the Same Tomorrow.

Estimating Working Capital

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Estimating Working Capital

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Particulars Raw Materials Direct Labor Overheads

Per unit Cost 12 3 9

Total cost Profit on Cost price is Rs.6

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In Accounting sense Working Capital = Current Assets Current Liabilities.

Ingredients or Management of Working Capital

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Note: Cash Conversion Cycle:

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That is, How to Estimate Working Capital

2. Going by a fixed format.

Cost of Sales: 5) Profit per Unit:

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Statement of Estimating Working Capital

It is a Compartmental Distribution of all the Costs in an Economic Sense.

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Raw Materials are in Store on an Average For 2 Months

But, but, but, now as i say this, i am remembered by a Fact:

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Hence there is a need felt to calculate Working Capital on Monthly Basis.

Hence the Cost of Raw Materials for the Month =

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b) Finished Goods: Requirement Per Month x Rate x Average Time

c) Overheads: Requirement Per Month x Rate x Average Time x 0.5

Debtors: Sales Per Month x

Cash in Hand & Bank:

b) Labor: Requirement Per Month x Rate x Average Time Lag.

c) Overheads: Requirement Per Month x Rate x Average Time Lag.

Net Working Capital Required:

Let us Go on the Main Sum provided at the Beginning of the Document.

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Given that Production Level of the Firm annually = 18000 Units.

Hence the Monthly Production = 18000\12 = 1500 units.

Books of M/s. XYZ Ltd

Level of Activity: 18000 (Annually) Therefore, Monthly = 18000/12 = 1500

Estimate of Working Capital Requirement

9000 1125 3375 13,500

1,35,000 7,000 2,63,500

(36,000) (2,250) (38,250)

Working Capital Required

Assumptions Made: (Necessary for every Problem).

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A Management Paradise Initiative!! Pratik@managementparadise.com

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