Financial Management & Cost Accounting

Module 6. Working capital management

Lesson 32
WORKING CAPITAL MANAGEMENT, INVENTORY MANAGEMENT

32.1 Working Capital Management

Firms differ in their capacity to generate profit from business operations. Some firms enjoy a dominant position due to quality product or good marketing management or monopoly power in the market and earn a high profit margin. Some other firms may have to operate in an environment of intense competition and may earn low margin of profits. A high net profit margin contributes towards the working capital pool. In fact the net profit is a source of working capital to the extent it has been earned in cash. The profit can be found by adjusting non-cash items, such as depreciation, outstanding expenses, accumulated expenses and losses Witten-off, in the net profit. But, in practice, the net cash inflows from operations cannot be considered as cash available for use at the end of the period. Even as the company's operations are in progress, cash is used up for augmenting stocks book debts or fixed assets. The financial manager must see whether or not the cash generated has been used for rightful purposes. Even if the net profits are earned in cash at the end of the period whole of it is not available for working capital purposes. The contribution towards working capital would be affected by the way in which profits are appropriated. The availability of cash generated from operations, thus depends upon taxation, dividend and retention policy and depreciation policy.

Taxes must be paid out of profits. Tax liability is unavoidable and adequate provision should be made for, it in working capital planning. If the tax liability increases, it will impose an additional strain on working capital. The financial manager must do tax planning in order to avail the benefits of all sorts of, tax concessions and incentives.

The firm's policy to retain or distribute profits' also has a bearing on working capital. Payment of dividend consumes cash resources and thus reduces firm's working capital to that extent. If the profits are retained in the business the firm's working capital position will be strengthened. A number of factors should be evaluated by the financial manager in deciding whether profits will be retained or distributed. A firm may follow the policy of paying a constant amount of dividend every year. In the years the firm makes high profits, its liquidity position will become strong; but in the year it does not earn sufficient profits, the preserved cash resources will be utilized to pay dividends, Sometimes a company wants to pay dividend but at the same time it does not want to drain away its cash resources. The alternative in such a case is to declare bonus shares (stock dividend), out of the past accumulated profits.

The depreciation policy, through its effect on tax liability and retained earnings, has an Influence on working capital. Depreciation is tax deductible. Higher the amount of depreciation lowers the tax liability and more the cash profit. Similarly the amount of net profits will be less if higher depreciation, is charged. If the dividend policy is linked with net profits, the firm can pay less dividend by providing more depreciation. Thus depreciation is an indirect way of retaining profits and preserving the firm's working capital position.

32.2 Estimation of Working Capital

32.3.2 Work-in-progress

The cost of work-in-progress includes raw materials, wages and overheads. In determining the amount of work-in-progress, the time period for which the goods will be in the course of production process is most important. Consider the following example:

Production : 12,000 Units per annum

Elements of cost:

Direct material 50%

Direct labour 40%

Overhead 10%

Each unit costs Rs. 8 and will be in process for one month on an average.

The amount of working capital locked up in work-in-progress will be computed as follows:

Production for one month : 1,000 Units

Cost of Direct Materials : 1.000xRs.4 = 4,000

Direct Labour : 1, 000xRs.3.20 = 3,200

Overhead : 1, 000xRs.0.80 = 800

Total : = 8,000

In case the wages and overheads accrue evenly during the time production is in progress, then the labour and overhead cost will be taken only for half a month instead of for one month, taken above.

32.3.3 Finished goods

The period for which the finished goods have to remain in the warehouse before sales is an important factor for determining the amount locked up in finished goods. Consider the following example:

Units manufactured during the year : 12,000

Cost per unit : Rs. 8

Elements of cost

Direct materials 50%

Direct labour 40%

Overhead 10%

Finished goods are to stay in the warehouse for two months on an average before being sent to the customers.

The working capital requirements for finished goods will be computed as follows:

Rs.

Production for one month : 1,000 Units

Cost of Direct Materials : 2,000x Rs.4 = 8,000

Direct Labour : 2,000x Rs.3.20 = 6,400

Overhead : 2,000x Rs.0.80 = 1,600

Total =16,000

32.4 Sundry Debtors

The amount of funds locked up in Sundry Debtors will be computed on the basis of credit sales and the time-lag in collecting payment.

Consider the following example:

Credit sales for the year : Rs. 1, 20,000

Average credit period enjoyed by the debtors: 2 months

The amount of working capital locked up in Sundry debtors will be computed as follows:

Monthly credit sales : Rs. 10,000

Amount of sundry

Debtors : Rs. 10,000 x 2 months = Rs. 20,000

32.5 Cash and Bank Balance

The amount of money to be kept as cash in hand or cash at bank can be estimated on the basis of past experience. Every businessman knows the amount that he will require for meeting his day-to-day payments.

32.6 Sundry Creditors

The lag in payment to suppliers of raw materials, goods, etc., and the likely credit purchases to be made during the period will help in estimating the amount of creditors. This will be clear with the help of the following example:

Credit purchase per annum: Rs. 24,000

Credit period enjoyed: 1 month

This means on an average Rs. 2,000 will remain outstanding on account of creditors.

32.7 Outstanding Expenses

The time-lag in payment of wages and other expenses will help in estimating the amount of outstanding expenses. For example, if monthly payments for wages and expenses are estimated at Rs. 15.000 and a. time lag of. 15 days in payment is estimated the amount of outstanding expenses on an average will amount to Rs. 7,500.

Having determined the amount of various current assets and current liabilities, the amount of working capital can be calculated by any of the following two methods:

i. By considering the total amount of current assets and current liabilities.

ii. By considering only the cash cost of current assets and current liabilities.

32.8 Illustration of Working Capital

A proforma cost sheet of a company provides the following particulars:

Amount per unit (Rs.)

Elements of cost:

Raw materials 80

Direct labour 30

Overheads 60

Total cost 170

Profit 30

Selling price 200

The following further particulars are available:

Raw materials in stock, on average one month; Materials are in process, on average half a month; Finished goods in stock, on average one month.

Credit allowed by suppliers is one month; credit allowed to debtors is two months; lag in payment of wages is 2 weeks; lag in payment of overhead expenses is one month; one-fourth of the output is sold against cash; cash in hand and at bank is expected to be Rs, 25,000. You are required to prepare a statement showing the working capital needed to finance a level of activity of 1,04,000 units of production.

You may assume that production is carried, on evenly throughout the year and wages and overheads accrue similarly.

SOLUTION

Statement showing Determination of Net Working Capital

Working Notes and Assumptions

i. 26.000 units have been sold for cash. Therefore, credit sales pertain to 78,000 units only.

ii. Year has 52 weeks.

iii. a) Profits may or may not be a source of working capital

b) Profits are to be adjusted for income-tax and dividend payments. For these reasons profits have been ignored

iv. All overheads are assumed to be variable. Presence of depreciation element in overheads will lower the working capital requirement. In the absence of such a figure, an estimate of the amount cannot be made.