Q1) Write a note on concept of working capital.         5

A1)

The term Working Capital also called gross working capital refers to the firm‘s aggregate of current assets and current assets are these assets which can be convertible into cash within an accounting period, generally a year. Accounting Standards Board, The Institute of Chartered Accountants of India defines, “Working capital means the funds available for day-to-day operations of an enterprise. It also represents the excess of current assets over current liabilities including short-term loans.”

Working capital has two concepts:

i)    Gross working capital

Gross Working capital refers to the total of the current assets. Gross working capital is more helpful to the management in managing each individual current assets for day-to-day operations.

Ii) Net working capital

Net working capital refers to the excess of the current assets over current liabilities. In the long run, it is the net working capital that is useful for the purpose.

There are two types of working capital-

(a)    Rigid, fixed, regular or permanent working capital

Every business concern has to maintain certain minimum amount of current assets at all times to carry on its activities efficiently and effectively. It is indispensable for any business concern to keep some material as stocks, some in the shape of work-in-progress and some in the form of finished goods. Permanent Working Capital is the irreducible minimum amount of working capital necessary to carry on its activities without any interruptions. It is that minimum amount necessary to outlays its fixed assets effectively.

(b)    Variable, seasonal, temporary or flexible working capital

Temporary working capital is that amount of current assets which is not permanent and fluctuating from time to time depending upon the company‘s requirements and it is generally financed out of short term funds, It may also high due to seasonal character of the industry as such it is also called seasonal working capital.

Q2) Discuss about the factors that determines the planning of working capital of a firm.              8

A2) Planning of Working Capital

There are many factors that determine the size of working capital. Planning of working capital is depend on following factors-

A company‘s working capital requirements depends on the activities it carried on and its size too. For instance, public utility organisation or service organisation where its activities are of mere service nature, does not require high amount of working capital, as it has no need of maintaining any stocks of inventories. In case of trading organisation the magnitude of working capital is high as it requires to maintain certain stocks of goods as also some credit to debtors. Further, if we go to manufacturing organisation the cycle period of working capital is high because the funds are to be invested in each and every type of inventory forms of raw-material, work-in-progress, finished goods as also debtors. Industrial units too require a large amount of working capital.

2.  Production Policies:

These policies will have a great significance in determining the size of the working capital. Where production policies are designed in such a way that uniform production is carried on throughout the accounting period, such concern requires a uniform and lesser amount of working capital. On the other hand, the concerns with production policies according to the needs of the customers will be peak at sometimes and require high amount of working capital. In seasonal industries too, where production policies are laid down tightly in the business season requires a high amount of working capital.

3.  Process of Manufacture:

If the manufacturing process of a particular industry is longer due to its complex nature, more working capital is required to finance that process, because, longer the period of manufacture, the larger the inventory tied up in the process and naturally requires a high amount of working capital.

4.  Growth and Expansion of Business:

A business concern at status requires a uniform amount of working capital as against the concerns which are growing and expanding. It is the tendency of any business organisation to grow further and further till its saturation point, if any. Such growth may be within the existing units by increased activities. Similarly, business concerns will expand their organisation by establishing new units. In both the cases, the need for working capital requirement increases as the organisation increases.

5.  Fluctuations in the Trade Cycle:

Business activities vary according to the general fluctuations in the world. There are four stages in a trade cycle which affects the activities of any business concern. Accordingly, the requirements of working capital are bound to change. When conditions of boom prevail, it is the policy of any prudent management to build or pile up large stock of inventories of various forms to take the advantage of the lower prices. Such fluctuations cause a business concern to demand for more amount of working capital. The other phase of trade cycle i.e., depression i.e., low or absence of business activities cause business concerns to demand for more working capital. In condition of depression, the products produced are not sold due to fall in demand, lack of purchasing power of the people. As a result of which entire production obtained was not sold in the market and high inventories are piled up. Therefore, there arises the need for heavy amount of working capital.

6.  Terms and conditions of Purchases and Sales:

A business concern which allows more credit to its customers and buys its supplies for cash requires more amount of working capital. On the other hand, business concerns which do not allow more credit period to its customers and seek better credit facilities for their supplies naturally require lesser amount of working capital.

7.  Dividend Policy:

A consistent dividend policy may affect the size of working capital. When some amount of working capital is financed out of the internal generation of funds such affect will be there. The relationship between dividend policy and working, capital is well established and very few companies declare dividend without giving due consideration to its effects on cash and their needs for cash. If the dividend is to be declared in cash, such outflow reduces working capital and therefore, most of the business concerns declare dividend now-a-days in the form of bonus shares as such retain their cash. A shortage of working capital acts as powerful reason for reducing or skipping cash dividend.

8.  Price Level Changes:

The changes in prices make the functions of a finance manager difficult. The anticipations of future price level changes are necessary to avoid their affects on working capital of the firm. Generally, rising price level will require a company to demand for more amount of working capital, because the same level of current assets requires higher amount of working capital due to increased prices.

9.  Operating Efficiency:

The Operating efficiency of a firm relates to its optimum utilisation of resources available whether in any form of factor of production, say, capital, labour, material, machines etc. If a company is able to effectively operate its costs, its operating cycle is accelerated and requires relatively lessor amount of working capital. On the other hand, if a firm is not able to utilise its resources properly will have slow operating cycle and naturally requires higher amount of working capital.

10.   Percentage of Profits and Appropriation out of Profits:

The capacity of all the firms will not be same in generating their profits. It is natural that some firms enjoy a dominant and monopoly positions due to the quality of its products, reputations, goodwill etc. (for example Colgate Tooth Paste, Bata Chapels etc.,)and some companies will not have such position due to poor quality and other inherent hazards. The company policy of retaining or distribution of profits will also affect the working capital. More appropriation out of profits than distribution of profit necessarily reduces the requirements of working capital.

11. Other Factors:

Apart from the above general considerations, there may be some factors responsible for determination of working capital which are inherent to the type of business. Some of such factors may be as follows:

(a) General co-ordination and control of the activities in the organisation.

(b) Absence of specialisation of products and their advantages.

(c) Market facilities.

(d) Means of transport and communication system.

(e) Sector in which the firm works i.e., private or public sector etc.

(f) Government policy as regard to: i) Imports and Exports

(g) Tax considerations.

Q3) Write a note on estimation of working capital requirement of a trading concern.                5

A3) Two components of capital are current assets and current liabilities. Estimation   of the amount of current and current liabilities to maintain a certain level of operation is not an easy task. The lack of working capital disrupts the smooth production process, and excess working capital increases costs. Here we describe the estimation of working capital in case of trading and manufacturing concerns.

The following procedure should be employed to estimate working capital for manufacturing concerns:

(a) Expected production per week or per month.

(b) Determination of costs for each element, namely material, labour and overhead, as well as profit per unit;

(c) Calculation of the amount blocked for each week/month for each element of cost and profit;

(d) Determination of the operating cycle by estimating the raw material retention period. Processing time, storage period of finished products, debt collection period. The period of payment of creditor it takes time lag in pay and overhead payments.

(e) Determining the net block period. This is the period during which each element of the cost remains blocked. For example, if the raw material remains in the store for 2 weeks after purchase, the processing time is 2 weeks, the finished product remains in stock, 3 weeks if the credit period extended to the debtor is extended for 4 weeks, and the payment for the material is made for 2 weeks after purchase, the net block period is as follows:[(2+ 2 + 3 + 4) – (2)] = 9 a few weeks.

(f) Obtain the working capital requirements for each element of the cost by multiplying the net block period calculated in step (e) and the amount blocked for each element of the cost according to step (c).

(g) Get the total amount of working capital, if any, by summing up the costs and all the amounts calculated for each element of the desired cash.

Q4) Write a note on operating cycle.            5

A4) The operating cycle (OC) refers to the amount of days a business must receive inventory, sell inventory, and collect cash from the sale of inventory. This cycle of role decisions is more efficient. The operating cycle is expression is:

Operating cycle=inventory period + accounts receivable period

Where,

The inventory period = the time that the inventory is kept until it's sold.

The assets period = the time it takes to recover cash from the sale of inventory.

The inventory period is calculated as follows:

Inventory Period=365/inventory turnover

The formula for inventory turnover is:

Inventory turnover=cost of products sold/average inventory

The assets period is calculated as follows:

Accounts receivable Period= 365 / assets sales

The formula for calculating the turnover of assets is as follows:

Accounts receivable sales = average assets sales of credit assets average assets    sales of credit assets

So the detailed expression for operating cycle is:

Operating cycle=365/(cost of goods sold ⁄average inventory)+365/(credit sale ⁄average accountable receivable)

Q5) What are the reasons of long operating cycle? Suggest some remedies to shorten the operating cycle.           8

A5) The following could be the reasons for longer operating cycle period:

(a) Purchase of materials in excess/short of requirements.

(b) Buying inferior, defective materials.

(c) Failure to get trade discount, cash discount.

(d) Inability to purchase during seasons.

(e) Defective inventory policy.

(f) Use of protracted manufacturing cycle.

(g) Lack of production planning, coordination and control.

(h) Mismatch between production policy and demand.

(i) Use of outdated machinery, technology,

(j) Poor maintenance and upkeep of plant, equipment and infrastructure facilities,

(k) Defective credit policy and slack collection policy.

(l) Inability to get credit from suppliers, employees,

(m) Lack of proper monitoring of external environment etc.

Remedies to reduce the operating cycle-

The purchase manager owes a responsibility in ensuring availability of right type of materials in right quantity of right quality at right price on right time and at right place. These six R’s contribute greatly in the improvement of length of operating cycle. Further, streamlining of credit from supplier and inventory policy also help the management.

Ii. Production Management:

The Production manager affects the length of operating cycle by manag­ing and controlling manufacturing cycle, which is a part of operating cycle and influences directly. Longer the manufacturing cycle, longer will be the operating cycle and higher will be the firm’s working capital requirements.

The following measures may be taken like:

(a) Proper maintenance of plant, machinery and other infrastructure facilities,

(b) Proper planning and coordination at all levels of activity,

(c) Up-gradation of manufacturing system, technology, and

(d) Selection of the shortest manufacturing cycle out of various alternatives etc.

Iii. Marketing Management:

The sale and production policies should be synchronized as far as possible. Lack of matching increases the operating cycle period. Production of qualitative products at lower costs enhances sales of the firm and reduces finished goods storage period. Effective advertisement, sales promotion activities, efficient salesmanship, use of appropriate distribu­tion channel etc., reduce the storage period of the finished products.

Iv. Credit Collection Policies:

Sound credit and collection policies enable the Finance manager in minimizing investment in working capital in the form of book debts. The firm should be discretionary in granting credit terms to its customers. In order to see that the receivable conversion period is not increased, the firm should follow a rationalized credit policy based on the credit standing of customers and other relevant facts. The firm should be prompt in making collections. Slack collection policies will tie-up funds for long period, increasing length of operating cycle.

v. External Environment:

The length of operating cycle is equally influenced by external environment. Abrupt changes in basic conditions would affect the length of operating cycle. Fluctuations in demand, competitors, production and sales policies, government fiscal and monetary policies, changes on import and export front, price fluctuations, etc., should be evaluated carefully by the management to minimize their adverse impact on the length of operating cycle.

Vi. Personnel Management:

The Personnel manager by framing sound recruitment, selection, training, placement, promotion, transfer, wages, incentives and appraisal policies can contrast the length of operating cycle.

Q6) Discuss the nature of working capital.        5

A6) Working capital is works as breath of the company without which an organisation cannot survive. Some of the features of working capital are-

i. Working capital enhances liquidity, solvency, creditworthiness and reputation of the enterprise.

5.  It generates the elements of cost namely: Materials, wages and expenses.

6. It enables the enterprise to avail the cash discount facilities offered by its   suppliers.

Q7) What are the reasons for longer operating cycle? Suggest remedies for longer operating cycle.        8

A7) The following could be the reasons for longer operating cycle period:

(a) Purchase of materials in excess/short of requirements.

(b) Buying inferior, defective materials.

(c) Failure to get trade discount, cash discount.

(d) Inability to purchase during seasons.

(e) Defective inventory policy.

(f) Use of protracted manufacturing cycle.

(g) Lack of production planning, coordination and control.

(h) Mismatch between production policy and demand.

(i) Use of outdated machinery, technology,

(j) Poor maintenance and upkeep of plant, equipment and infrastructure facilities,

(k) Defective credit policy and slack collection policy.

(l) Inability to get credit from suppliers, employees,

(m) Lack of proper monitoring of external environment etc.

Remedies to reduce the operating cycle

The purchase manager owes a responsibility in ensuring availability of right type of materials in right quantity of right quality at right price on right time and at right place. These six R’s contribute greatly in the improvement of length of operating cycle. Further, streamlining of credit from supplier and inventory policy also help the management.

Ii. Production Management:

The Production manager affects the length of operating cycle by managing and controlling manufacturing cycle, which is a part of operating cycle and influences directly. Longer the manufacturing cycle, longer will be the operating cycle and higher will be the firm’s working capital requirements.

The following measures may be taken like:

(a) Proper maintenance of plant, machinery and other infrastructure facilities,

(b) Proper planning and coordination at all levels of activity,

(c) Up-gradation of manufacturing system, technology, and

(d) Selection of the shortest manufacturing cycle out of various alternatives etc.

Iii. Marketing Management:

The sale and production policies should be synchronized as far as possible. Lack of matching increases the operating cycle period. Production of qualitative products at lower costs enhances sales of the firm and reduces finished goods storage period. Effective advertisement, sales promotion activities, efficient salesmanship, use of appropriate distribu­tion channel etc., reduce the storage period of the finished products.

Iv. Credit Collection Policies:

Sound credit and collection policies enable the Finance manager in minimizing investment in working capital in the form of book debts. The firm should be discretionary in granting credit terms to its customers. In order to see that the receivable conversion period is not increased, the firm should follow a rationalized credit policy based on the credit standing of customers and other relevant facts. The firm should be prompt in making collections. Slack collection policies will tie-up funds for long period, increasing length of operating cycle.

v. External Environment:

The length of operating cycle is equally influenced by external environment. Abrupt changes in basic conditions would affect the length of operating cycle. Fluctuations in demand, competitors, production and sales policies, government fiscal and monetary policies, changes on import and export front, price fluctuations, etc., should be evaluated carefully by the management to minimize their adverse impact on the length of operating cycle.

Vi. Personnel Management:

The Personnel manager by framing sound recruitment, selection, training, placement, promotion, transfer, wages, incentives and appraisal policies can contrast the length of operating cycle.

Q8) Highlight the formula for calculation of operating cycle.       5

A9) The operating cycle is expression is:

Operating cycle=inventory period + accounts receivable period

Where,

The inventory period = the time that the inventory is kept until it's sold.

The assets period = the time it takes to recover cash from the sale of inventory.

The inventory period is calculated as follows:

Inventory Period=365/inventory turnover

The formula for inventory turnover is:

Inventory turnover=cost of products sold/average inventory

The assets period is calculated as follows:

Accounts receivable Period= 365 / assets sales

The formula for calculating the turnover of assets is as follows:

Accounts receivable sales = average assets sales of credit assets average assets    sales of credit assets

So the detailed expression for operating cycle is:

Operating cycle=365/(cost of goods sold ⁄average inventory)+365/(credit sale ⁄average accountable receivable)

Q9) “There are many motivating factors for determination of working capital.”-Justify the statement.         10

A10) There are variations in working capital requirement of working capital of a company. The managers determine the working capital requirements to manage the liquidity and solvency position of the company. There are many factors that determine the size of working capital. Planning of working capital is depend on following factors-

A company‘s working capital requirements depends on the activities it carried on and its size too. For instance, public utility organisation or service organisation where its activities are of mere service nature, does not require high amount of working capital, as it has no need of maintaining any stocks of inventories. In case of trading organisation the magnitude of working capital is high as it requires to maintain certain stocks of goods as also some credit to debtors. Further, if we go to manufacturing organisation the cycle period of working capital is high because the funds are to be invested in each and every type of inventory forms of raw-material, work-in-progress, finished goods as also debtors. Industrial units too require a large amount of working capital.

2.  Production Policies:

These policies will have a great significance in determining the size of the working capital. Where production policies are designed in such a way that uniform production is carried on throughout the accounting period, such concern requires a uniform and lesser amount of working capital. On the other hand, the concerns with production policies according to the needs of the customers will be peak at sometimes and require high amount of working capital. In seasonal industries too, where production policies are laid down tightly in the business season requires a high amount of working capital.

3.  Process of Manufacture:

If the manufacturing process of a particular industry is longer due to its complex nature, more working capital is required to finance that process, because, longer the period of manufacture, the larger the inventory tied up in the process and naturally requires a high amount of working capital.

4.  Growth and Expansion of Business:

A business concern at status requires a uniform amount of working capital as against the concerns which are growing and expanding. It is the tendency of any business organisation to grow further and further till its saturation point, if any. Such growth may be within the existing units by increased activities. Similarly, business concerns will expand their organisation by establishing new units. In both the cases, the need for working capital requirement increases as the organisation increases.

5.  Fluctuations in the Trade Cycle:

Business activities vary according to the general fluctuations in the world. There are four stages in a trade cycle which affects the activities of any business concern. Accordingly, the requirements of working capital are bound to change. When conditions of boom prevail, it is the policy of any prudent management to build or pile up large stock of inventories of various forms to take the advantage of the lower prices. Such fluctuations cause a business concern to demand for more amount of working capital. The other phase of trade cycle i.e., depression i.e., low or absence of business activities cause business concerns to demand for more working capital. In condition of depression, the products produced are not sold due to fall in demand, lack of purchasing power of the people. As a result of which entire production obtained was not sold in the market and high inventories are piled up. Therefore, there arises the need for heavy amount of working capital.

6.  Terms and conditions of Purchases and Sales:

A business concern which allows more credit to its customers and buys its supplies for cash requires more amount of working capital. On the other hand, business concerns which do not allow more credit period to its customers and seek better credit facilities for their supplies naturally require lesser amount of working capital.

7.  Dividend Policy:

A consistent dividend policy may affect the size of working capital. When some amount of working capital is financed out of the internal generation of funds such affect will be there. The relationship between dividend policy and working, capital is well established and very few companies declare dividend without giving due consideration to its effects on cash and their needs for cash. If the dividend is to be declared in cash, such outflow reduces working capital and therefore, most of the business concerns declare dividend now-a-days in the form of bonus shares as such retain their cash. A shortage of working capital acts as powerful reason for reducing or skipping cash dividend.

8.  Price Level Changes:

The changes in prices make the functions of a finance manager difficult. The anticipations of future price level changes are necessary to avoid their affects on working capital of the firm. Generally, rising price level will require a company to demand for more amount of working capital, because the same level of current assets requires higher amount of working capital due to increased prices.

9.  Operating Efficiency:

The Operating efficiency of a firm relates to its optimum utilisation of resources available whether in any form of factor of production, say, capital, labour, material, machines etc. If a company is able to effectively operate its costs, its operating cycle is accelerated and requires relatively lessor amount of working capital. On the other hand, if a firm is not able to utilise its resources properly will have slow operating cycle and naturally requires higher amount of working capital.

10.   Percentage of Profits and Appropriation out of Profits:

The capacity of all the firms will not be same in generating their profits. It is natural that some firms enjoy a dominant and monopoly positions due to the quality of its products, reputations, goodwill etc. (for example Colgate Tooth Paste, Bata Chapels etc.,)and some companies will not have such position due to poor quality and other inherent hazards. The company policy of retaining or distribution of profits will also affect the working capital. More appropriation out of profits than distribution of profit necessarily reduces the requirements of working capital.

11. Other Factors:

Apart from the above general considerations, there may be some factors responsible for determination of working capital which are inherent to the type of business. Some of such factors may be as follows:

(a) General co-ordination and control of the activities in the organisation.

(b) Absence of specialisation of products and their advantages.

(c) Market facilities.

(d) Means of transport and communication system.

(e) Sector in which the firm works i.e., private or public sector etc.

(f) Government policy as regard to: i) Imports and Exports.

(g) Tax considerations.