Meaning, Concept and Policies of Working Capital

Meaning, Concept and Policies of Working Capital

1. 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:

Estimated level of activity: 1,04,000 completed units of production plus 4,000 units of work-in-progress. Based on the above activity, estimated cost per unit is:

Raw materialRs80 per unit

Direct wagesRs 30 per unit

Overhead (exclusive of depreciation)Rs60 per unit

Total costRs 170 per unit

Selling priceRs 200 per unit

Raw materials in stock: average 4 weeks consumption, work-in-progress (assume 50% completion stage in respect of conversion cost) (materials issued at the start of the processing).

Finished goods in stock

8,000 units

Credit allowed by suppliers

Average 4 weeks

Credit allowed to debtors/receivables

Average 8 weeks

Lag in payment of wages

Average 1 weeks

Cash at banks (for smooth operation) is expected to be Rs 25,000.

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

Find out:

(i) the net working capital required;

(ii) the maximum permissible bank finance under first and second method of Financing as per Tandon Committee Norms.

(IPCC, Nov 1998)

Ans: (i) Rs 46,95,990; (ii) Under first method Rs 35,21,993,

Under second method Rs 33,20,125.

2. Q Ltd sells goods at a uniform rate of gross profit of 20% on sales including depreciation as part of cost of production. Its annual figures are as under:

Rs

Sales (At 2 months credit)24,00,000

Materials consumed (Suppliers credit 2 months)6,00,000

Wages paid (Monthly at the beginning of the subsequent month)4,80,000

Manufacturing expenses (Cash expenses are paid one month in arrear)6,00,000

Administration expenses (Cash expenses are paid one month in arrear)1,50,000

Sales promotion expenses (Paid quarterly in advance)75,000 The company keeps one month stock each of raw materials and finished goods. A minimum cash balance of Rs 80,000 is always kept. The company wants to adopt a 10% safety margin in the maintenance of working capital.

The company has no work in progress.

Find out the requirements of working capital of the company on cash cost basis.

(IPCC, May 1999)

Ans: Working capital required Rs 4,44,125.

3. Pollock Co. Pvt. Ltd, which is operating for the last 5 years, has approached Sudershan Industries for grant of credit limit on account of goods bought from the latter, annexing Balance Sheet and Income Statement for the last 2 years as below:

Pollock Co. Pvt. Ltd Balance Sheet

(Rs 000)

CurrentLast

CurrentLast

YearYear

YearYear

Share Capital

Plant & Equipment

Equity (Rs 10)600600 (less Dep.)1,5001,400

Share Premium400400Land750750

Retained Earnings900700

Total Equity1,9001,700Total Fixed Assets2,2502,150

First Mortgage200300Inventories580300

Second Mortgage200Account Receivables350200

Bonds300300Marketable Securities120120

Cash10080

Long-term Liabilities500800Total Current Assets1,150700

Account Payable30060

Notes Payable600220

Secured Liabilities10070

1,000350

Total Current Liabilities3,4002,850

3,4002,850Pollock Co. Pvt. LtdIncome Statement (Rs 000)

Current Year

Last Year

Sales5,980

5,780

Income from Investments206,000205,800

Opening Inventory300

400

Total Mfg. Costs4,200

3,200

Ending Inventory(580)3,920(300)3,300

2,080

2,500

General and Admin. Expenses

950

750

Operating Income

1,130

1,750

Interest Exp.

60

62

Earnings before Taxes

1,070

1,688

Income-tax

480

674

Net Income after Taxes

590

1,014

Dividend declared and paid

250 Sudershan Industries has established the following broad guidelines for granting credit limits to its customers.

(i) Limit credit limit to 10% of net worth and 20% of the net working capital.

(ii) Not to give credit in excess of Rs 1,00,000 to any single customer.

You are required to detail the steps required for establishing credit limits to Pollock Co. Pvt. Ltd. In this case, what you consider to be reasonable credit limit?

(IPCC, May 2000)

Ans: Rs 30,000.00.

4. Dyer Ltd manufactures a variety of products using a standardized process, which take one month to complete. Each production batch is started at the beginning of a month and is transferred to finished goods at the beginning of the next month. The cost structure, based on current selling price is ;

(%)

(%)

Sales Price

100

Variable Costs

Raw Materials

30

Other Variable Costs

40

Total Variable Costused for

Stock Valuation

70

Contribution

30

Activity levels are constant throughout the year and annual sales, all of which are made on credit areRs 24,00,000. Dyer is now planning to increase sales volume by 50% and unit sales price by 10%; such expansion would not alter the fixed costs of Rs 50,000 per month, which includes monthly depreciation of plant of Rs 10,000. Similarly raw material and other variable costs per unit will not alter as a result of the price rise.

In order to facilitate the envisaged increases several changes would be required in the log run. The relevant changes are:

(i) The average credit period allowed to customers will increase to 70 days;

(ii) Suppliers will continue to be paid on strictly monthly terms;

(iii) Raw material stocks held will continue to be sufficient for one months production;

(iv) Stocks of finished goods held will increase to one months output;

(v) There will be no change in the production period and other variable costs will continue to be paid for in the month of production;

(vi) The current end-of-month working capital position is:

(Rs 000)

Raw Material60

WIP140

Finished Goods70270

Debtors

200

470

Creditors

60

Net Working Capital Excluding Cash

410 Compliance with the long-term changes required by the expansion will be spread over several months. The points concerning the transitional arrangements are:

(i) The cash balance anticipated at the end of May is Rs 80,000.

(ii) Upto and including June all sales will be made on one months credit. From July all sales will be on the transitional credit terms which will mean :

60% of sales will take 2 months credit

40% of sales will take 3 months credit

(iii) Sales price increase will occur with effect from sales in the month of August.

(iv) Production will increase by 50% with effect from the month of July. Raw material purchases made in June will reflect this.

(v) Sales volume will increase by 50% from sales made in October.

Required:

(a) Show the long-term increase in annual profit and long-term working capital requirements as a result of the plans for expansion and a price increase. (Costs of financing the extra working capital requirements may be ignored).

(b) Produce a monthly cash forecast for the period from June to December, the first seven months of the transitional period. Prepare also a working capital position at the end of December.

(c) Using your findings for (a) and (b) above, make brief comments to the management of Dyer Ltd on the major factors concerning the financial aspects of the expansion which should be brought to their attention.

Assume that there are 360 days in a year and each month contains 30 days.

(IPCC, Nov. 2000)

Ans: (a) Increase in Profit Rs 7,20,000. Net working capital requirementRs 12,12,000; (b) Shortage of cash in the month of December is Rs 3,62,000.

5. A company is considering its working capital investment and financial policies for the next year. Estimated fixed assets and current liabilities for the next year are Rs 2.60 crores and Rs 2.34 crore respectively. Estimated Sales and EBIT depend on current assets investment, particularly inventories and book-debts. The Financial Controller of the company is examining the following alternative Working Capital Policies:

(Rs Crores)

Working CapitalInvestment inEstimatedEBIT

PolicyCurrent AssetsSales

Conservative4.5012.301.23

Moderate3.9011.501.15

Aggressive2.6010.001.00

After evaluating the working capital policy, the Financial Controller has advised the adoption of the moderate working capital policy. The company is now examining the use of long-term and short-term borrowings for financings its assets. The company will use Rs 2.50 crores of the equity funds. The corporate tax rate is 35%. The company is considering the following debt alternatives:

(Rs crore)

Financing PolicyShort-term Debt

Long-term

Debt

Conservative0.54

1.12

Moderate1.00

0.66

Aggressive1.50

0.16

Interest rate-Average12%

16%

You are required to calculate the following:

(1) Working Capital Investment for each Policy;

(a)Net Working Capital position

(b)Rate of Return

(c)Current ratio.

(2)Financing for each policy:

(a)Net Working Capital position

(b)Rate of Return on Shareholders equity

(c)Current ratio.

(IPCC, Nov. 2001)

Ans:

Working Capital Policy

ConservativeModerateAggressive

(1)(a)Rs in crores 2.161.560.26

(b)17.3%17.7%19.2%

(c)1.921.671.11

(2)(a)Rs in crores 1.020.560.06

(b)23.6%24%24.4%

(c)1.351.171.02

6. The following information has been extracted from the records of a Company:

Product cost sheetRs/unit

Raw materials45

Direct labour20

Overheads40

Total105

Profit15

Selling price120

Raw materials are in stock on an average of two months.

The materials are in process on an average for 4 weeks. The degree of completion is 50%.

Finished goods stock on an average is for one month.

Time log in payment of wages and overheads is 1 weeks.

Time log in receipt of proceeds from debtors is 2 months.

Credit allowed by suppliers is one month.

20% of the output is sold against cash.

The company expects to keep a Cash balance of Rs 1,00,000.

Take 52 weeks per annum.

The Company is poised for a manufacture of 1,44,000 units in the year.

You are required to prepare a statement showing the Working Capital requirements of the Company.

(IPCC, Nov. 2002)

Hint:

Rs

(a) Total Sales1,72,80,000

(b) Annual Raw Materials Requirements64,80,000

(c) Annual Direct Labour Cost28,80,000

(d) Annual Overhead Costs57,60,000Ans: Net Working Capital: Rs 45,36,307.

7. An engineering company is considering its working capital investment for the year 2003-04. The estimated fixed assets and current liabilities for the next year are Rs 6.3 crores and Rs 5,967 crores respectively. The sales and earnings before interest and taxes (EBIT) depend on investment in its current assets particularly inventory and receivables. The company is examining the following alternative working capital policies:

Working Capital PolicyInvestment in Current AssetsEstimated SalesEBIT

(Rs Crores)(Rs Crores)(Rs Crores)

Conservative 11.47531.3653.1365

Moderate9.94529.3252.9325

Aggressive6.6325.502.55 Your are required to calculate the following for each policy :

(i) Rate of return on total assets.

(ii) Net working capital position.

(iii) Current assets to fixed assets ratio.

(iv) Discuss the risk-return trade-off of each working capital policy.

(IPCC, May 2003)

Ans: Working Capital Investment Policy

(Rs in crores)ConservativeModerate

Aggressive

(i)17.3217.6919.23

(ii)5.5083.9780.663

(iii)1.731.501.00

(iv)The firm can improve profitability by reducing investment in working capital.

8. (a) The following annual figures relate to MNP Limited:

Sales (at three months credit)

Rs 90,00,000

Materials consumed (suppliers extend one and half months credit)

Rs 22,50,000

Wages paid (one month in arrear)

Rs 18,00,000

Manufacturing expenses outstanding at the end of the year

(cash expenses are paid one month in arrear)

Rs 20,00,000

Total Administrative expenses for the year

(cash expenses are paid one month in arrear)

Rs 6,00,000

Sales Promotion expenses for the year (paid quarterly in advance)

Rs 12,00,000

The company sells its products on gross-profit of 25% assuming depreciation as a part of cost of production. It keeps two months stock of finished goods and one months stock of raw materials as inventory. It keeps cash balance of Rs 2,50,000.

Assume a 5% safety margin, work out the working capital requirements of the company on cash cost basis. Ignore work-in-progress.

(IPCC, May 2004)

Ans: Working Capital Requirement (on cash cost basis) is Rs 34,93,750.

9. XYZ Co. Ltd is a pipe manufacturing company. Its production cycle indicates that materials, are introduced in the beginning of the production cycle; wage and overhead accrue evenly thorugh out the period of the cycle. Wages are paid in the next month following the month of accrual. Work-in-process includes full units of raw materials used in the beginning of the production process and 50% of wages and overheads are supposed to be conversion costs. Details of production process and the components of working capital are as follows:

Production of pipes

12,00,000 units

Duration of the production cycle

One month

Raw materials inventory held

One month consumption

Finished goods inventory held for

Two months

Credit allowed by creditors

One months

Credit given to debtors

Two months

Cost price of raw materials

Rs 60 per unit

Direct wages

Rs 10 per unit

Overheads

Rs 20 per unit

Selling price of finished pipes

Rs 100 per unitRequired to calculate:

(i) The amount of working capital required for the company.

(ii) Its maximum permissible bank finance under all the three methods of lending norms as suggested by the Tandon Committee, assuming the value of core current assets: Rs 1,00,00,000.

(IPCC, May 2005)

Ans: (i) Net working capital Rs 4,25,00,000; (ii) Maximum possiblebank Finance as per Method I Rs 3,18,75,000, Method II Rs 3,01,25,000and in Method III Rs 2,26,25.000

10. A pro forma cost sheet of a company provides the following particulars :

Amount per unit

Raw materials cost100

Direct labour cost37.50

Overheads cost75

Total cost212.50

Profit37.50

Selling Price2.50 The company keeps raw material in stock, on an average for one month; work-in-progress, on an average for one week; and finished goods in stock, on an average for two weeks.

The Credit allowed by suppliers is three weeks and company allows four weeks credit to its debtors. The lag in payment of wages is one week and lag in payment of overhead expenses is two weeks.

The company sells one-fifth of the output against cash and maintains Cash-in-hand and at bank put together at Rs 37,500.

Required:

Prepare a statement showing estimate of Working Capital needed to finance an activity level of 1,30,000 units of production. Assume that production is carried on evenly throughout the year, and wages and overheads accrue similarly work-in-progress stock is 80% complete in all respects.

(IPCC, Nov. 2006)

Hint: For Calculation puroses, 4 weeks has been considered as equivalent to a month.

Ans: Net working Capital needs Rs 30,06,250.

11. 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:

Elements of cost:Per unit Rs

Raw material40

Direct labour15

Overhead30

Total cost85

Profit15

Sales100

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 in one month.

Credit allowed to debtors is two month.

Average time lag in payment of wages is 1 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 Tandon Committee norms; assume the core current assets constitute 25% of the current assets.

(IPCC, Nov. 2007)

Ans: (i)Net Working Capital = Rs 18,26.924 (ii) Maximum Permissible Bank Finance as per Tandon Committee :

Method I = Rs 13,70,193

Method II = Rs 12,30,578

Method III = Rs 7,83,318.

12. MN Ltd is commencing a new project for manufacture of electric toys. The following cost information has been ascertained for annual production of 60,000 units at full capacity:

RsAmount per unit (Rs)

Raw materials

20

Direct labour

15

Manufacturing overheads :

Variable

15

Fixed

10

25

Selling and Distribution overheads:

Variable

3

Fixed

1

4

Total cost

64

Profit

16

Selling price

80

In the first year of operations expected production and sales are 40,000 units and 35,000 units respectively. To assess the need of Working capital, the following additional information is available:

(i) Stock of Raw materials .. 3 months consumption.

(ii) Credit allowable for debtors .. 1 months.

(iii) Credit allowable by creditors .. 4 months.

(iv) Lag in payment of wages .. 1 month.

(v) Lag in payment of overheads .. month.

(vi) Cash-in-hand and Bank is expected to Rs 60,000.

(vii) Provision for contingencies is required @ 10% of Working capital requirement including that provision.

You are required to prepare a projected statement of Working capital requirement for the first year of operations. Debtors are taken at cost.

(IPCC, May 2000)Hint:

Purchase of Raw Material during the first yearRs

Raw Material consumed during the year8,00,000

Add : Closing Stock of Raw Material (3 months consumption)2,00,000

10,00,000

Less : Opening Stock of Raw MaterialNilPurchases during the year10,00,000Ans : Estimated working Capital Requirement: Rs 4,99,769.