The schematic diagram of "Flow of Funds within the Firm" ,a circuit through "cash - (through purchases and processing) - Raw materials Work-in- progressEinished goods, i.e. Inventories (in short) (through sales) -Receivables - (through collection) - cash". This is reproduced below in Figure . This is called the operating cash cycle. In the construction industry, "processing" is the construction activity with the needful purchases, "Inventories" include, besides raw materials at site, the progressing work of construction, "sales" is represented by the process of raising bills on the owner by the contractor, "Receivables" are the bills under processing and "Collections" is the stage of partial payment by owner on the bills raised as received by the contractor adding to his "Cash which gets recycled.
 |
| Operating Cash Cycle |
To maximise shareholders' wealth, the firm has to generate profits; extent of profits earned depends upon the magliitude of sales, among other things. However, sales do not instantly convert into cash. The time lag between sale of goods and receipt of cash gives ,rise to the need for (gross) working capital. This working capital, in the form of cash or inventory or receivables, in short as current assets, spans through the several "phases" in the "operating cash cycle" between realisation of cash against goods sold and the repetitions of this cycle.
Because of the unlikely event of completing the sequences in this cycle instantaneously, there arises the need for (and the very existence of) the current assets shown in the boxes (constituting the gross working capital) in Figure. Moreover, even when going through the phases of the operating cash cycle, cash inflows and cash outflows do not match (in quantum), firms have to necessarily keep cash (or short-term liquid assets) to be able to meet their maturing obligations to pay. Likewise, firms must have adequate inventory to keep their production process going decoupled from their material supply sources and also to meet the demands for their products (to complete parts of the construction jobs within the respectively scheduled dates - in the case of the construction industry). If the firms have to be competitive and survive and thrive in their business, they must be willing to sell their goods to customers on credit which necessitates holding of accounts receivable. [In the construction industry, this is unavoidable under the system of tender-based contracting since bills have to be raised after job completion and its inspection by the owner and the bills have to be processed for payment (though only partially in running bills) by the owner,] These operating details necessitate the maintenance of an adequate level of gross working capital for smoothness of operations,
Operating Cycle
In line withathe above discussions, the three phases of the operating (cash) cycle are again described as under.In phase 1, cash gets converted into inventory. This includes purchase of raw materials, conversion of raw materials into WIP (work-in-progress) which end up at varying instants as finished goods and relabelling of the finished goods as stock (or billable quantities of items of work -in construction industry).
In phase 2, inventory is converted into receivables as credit sales are made to customers. (In the construction industry, this phase is gone through by the facts of the contractor raising a bill in the owner and the owner arranging for the processing of the bill.)
In phase 3, receivables are converted into or collected in, cash. This completes the operating cycle.
Permanent and Temporary Working Capital
The operating cycle necessitates the availability of current assets (gross working capital) has been seen in previous Section.The need for the current assets continues beyond one cycle since the firm continues in its business; i.e. a regular supply of WC is a need for continuing business. However, the magnitude of the WC required will not, in general, be constant over time, but will fluctuate. In a growth, or sunrise, industry situation, the need for WC will rise in course of time, even as it fluctuates in cycles over the increasing time horizon. These fluctuations in the timewise need for working capital give rise to two methods of meeting the need by permanent, or fixed, working capital (at the base level), and by temporary, or fluctuating or variable, working capital to meet the needs from time to time over and above the permanent level of working capital.
Changes in Working Capital
The fluctuations in the working capital need as shown in the figures are caused largely by three reasons :
(a) Changes in Sales and Operating Expenses;
(b) Policy changes; and
(c) Changes in technology and methods adopted.
Changes in Sales and Operating Expenses
In a manufacturing industry, engaging in specific prcducts in its business line,Sales and Operating Expenses may change over time due to three reasons :
(a) The change may be under a long-running rrend, e.g., increase of raw material prices, (say. bricks, paints, labour wages); this (except for labour wages) may lead to precautionary overstocking of inventory. This change is largely absorbed by timewise increasing permanent current assets described in next Section .
(b) Cyclical changes in the economy will lead to ups and downs in business activity and hence in the need for working capital. This may affect both the permanent and the fluctuating components of the working capital.
(c) Seasonality of sales activity also causes changes in the need for working capital, mainly in the level of the temporary working capital.
Construction industry is highly prone to this type of changes, by the very nature of its business. This has been apply discussed in previous unit when dealing with the cash flow from the point of view of the contractor and in the lllustrative Problem.Example. The fundamental difference there, when discussed as "Captim" has been that it represents only one cycle of what is being discussed here since Section . If the same contractor would have taken up several contracts with time lags between them and draws up a composite scheme of working capital needs for all contracts together, he will also face these operating (cash) cycles. The aspects of profitability and risk and their trade-off as functions of the policy adopted by the firm for working capital management. The current assets indicated therein expressed as a fraction of sales volume is called the current asset policy (adopted by the firm). Of course, this will translate as anything between a hedging policy to a totally conservative policy represented respectively by the line through C in Figure 20.1 and the dotted line through D' in Figure . An aggressively hedging policy will be represented by keeping the line through B in Figure (or through B' in Figure) at a quite low position. Whatever conscious decision management takes for its current asset policy will definitely influence the level of working capital needs.As regards construction industry, current assets through inventories expedite the progress of work; but, if as receivables, it affects the progress, the morale and the returns.
Changes in Technology and Methods Adopted
If a new technology with its attendant methods and processes which are more efficient, less time-consuming and cheeper in costing evolves, and is adopted, this not only shortens the duration of the operating cycle but also reduces the working capital. Slip-from shuttering for construction of circular tanks is a very typical example in construction industry.
Determinants of Working Capital
A firm should schedule its operations in-such a way as to need a manageable level of working captial. And, of course, this will vary from time to time depending on the type and rate of implementation of the scheduled activities at any time. In construction practice, this is referred to as resource-based scheduling. The several factors that impinge on the assessment of the quantum of working capital are generally as follows :
Nature of Business
A business enterprise engaged in book publishing has to produce each edition in big lots, distribute them over a wide geographical area and wait for their sales often in batches of small numbers. (It is not denied that there can be other extremes.) Obviously, its working capital need is quite heavy. For a catering industry, raw material stock cannot often be too large, sales are mostly against cash and too fast, the business premises is not spread far and wide. Moreover, much of raw material may have been obtained on credit. Accordingly, its working capital need would, and should, not be high. Within the public sector too, construction organisations and organisations dealing in commodities (construction organisations too deal, in a sense, in commodities - i.e. infrastructure, buildings, etc.) would need a higher level of working capital relative to consultancy and distribution .organisations which should need relatively lower levels of working capital, deal as they do in sale of services rather than commodities.Production Related Factors
Production Cycle
Production cycle refers to the time involved in the manufacture of goods. In construction industry, it may correspondingly refer to the billing intervals in at-site works and to duration of production runs in the manufacture of prefabricated components (when, again, bills can be raised when deliveries would be effected at the worksites ensuing the production). It covers, theoretically, the duration since procurement of raw materials, through the manufacturing (or construction) process till the production of finished goods (and the billing thereupon for the part of the construction since the last billing in construction industry). Shorter the production cycle (or the billing interval),smaller the working capital needed.Technological improvements in the process can expedite the billing cycle and reduce the needed working capital. Credit purchases of materials, securing of advances for machinery, materials, etc. are some practices that can minimise the working capital needed in construction industry.
Production Policy
When demand for products (or for construction-related activity) is seasonal (like in maintenance and facilitation works, e.g. desert cooler, canal linings,etc.), the production policy can be by one of two options : limiting the production (e.g., of lining tiles, etc.) to the periods when goods are (getting) purchased; or continuous (and uniform) production throughout the year to build up stock to meet the peak (i.e. total expected) demand.Understandably, due to rushed production interspersed with having to keep idle manpower and facilities, the former option can be expensive and also requiring spurts of large working capital for concentrated production. On the other hand,the latter option will lead to accumulation of inventory, in turn, locking up the working capital. The firm must decide its own policy or policy-mix to adopt. In case of the former option being adopted, the firm may diversify on its production items enabling it to engage its manpower and facilities additionally productively during the off-season of the primary items of production.Clearly, every industry, with its own specialisations and strengths, must adopt the policy best suited to itself.
Availability of Raw Materials
If raw material is not available on a continuous basis, the firm needs to build up its inventory whenever procurement is possible, largely unrelated to the production needs. Inevitably, a high !eve1 of working capital is needed in such situations. Construction industry is often affected for this reason, often on the score of construction steel. Moreover, seasonal availability of raw material will likewise exacerbate the seasonal fluctuations of working capital needs. Changes in Price Levels
Changes in price level affect nearly proportionately the requiremeats of working capital. So too for wage level changes. Construction industry is particularly vulnerable in such situations if it is constrained not to seek revisions of rates for items of work except if the increase in price level exceeds a certain stipulated percentage. Contract clauses often include such constraints.
Operating Eflciency
Management must ensure the efficient utilisation of resources by resource levelling, eliminating waste, and improving coordination. Eliminating wasteincludes non-disruption by employees by resort to go-slows and strikes.Resource levelling also improves employee-utilisation, reduces spurts in resource needs and reduces mechanical (including electrical) breakdowns by avoiding high peaks of power needs. Planning and scheduling the works with telescoping line-of-balance methods on critical path methods for resources and manpower levelling will be highly beneficial in this regard for construction industry. Improving the efficiency of operations by such methods improves profitability without much increase in risk for reason of improved internal generations of funds and/or reduced idling of working capital.
Factors Related to Business Environment
Business Level Fluctuations
If business conditions are not fairly steady but have boom conditions interspersed with declining conditions, going by the general economy, there will be continuous up and down changes in working capital needs, particularly, for the temporary working capital needs. When business activity is in the buoyant condition, working capital needs will increase for two reasons : one, to cover the lag between increased sales and receipt of cash, i.e. by increases in receivables; and, two, to finance the purchase of additional material and additional stock of WIP and finished goods to match the expansion in the demands, i.e. by increase in inventories. Even the fixed assets may have to be increased as plant and machinery. When business activity goes, on the other hand, into depressed conditions, volume of sales declines resulting in reduction in both, viz. in receivables (or book debts) and in inventory. Accordingly, under recessionary conditions, the need for working capital will come down. Thus, business fluctuations affect working capital needs through receivables and inventories.
Growth of the Firm
When a firm grows, it follows logically that the working capital needs will rise,However, the growth of the firm can be postulated on the precedence of need for increased working capital, i.e. increased working capital is a pre-condition for the growth or expansion of the firm. This emphasises the continuous need for advance planning for (and securing of) working capital in increasing quanta for a growing organisation; failing which, in spite of even considerable earnings, the firm may be left with hardly any cash - no matter what the amounts of receivables and inventories are.Credit Policy Section (in the matter of book publishing industry, credit purchases of materials, and lag between increased sales and receipt of cash) has already referred to certain aspects of this factor.The level of working capital needed depends on the credit policy in the matter of sales as well as purchases. Credit terms permitted to its customers by the firm and also credit terms available to the firm from its creditors -both affect the working capital needs, the first through book debts (or receivables) and the second through trade creditors (or bills payable). The higher the book debts, the more the need for working capital. The more liberal the credit terms available to the firm, the lesser the need for working capital. Both these aspects depend on the prevalent trade practices and economic conditions and the level of competition in the market. Factors Relatable to Profit Level
Being an item of appropriation of profits, payment of dividend exhausts cash resources to that extent and also affects (diminishes) working capital available to that extent. Whatever part of the earnings is not distributed as dividends but is retained, would augment the working capital.Whereas investors expect the distribution of dividends, the firm may like to retain the profits to augment its cash resources. The choice on these two courses of action has to be judiciously decided considering all the relevant issues. A method adoptable towards payment of dividend, but without depleting the cash resources of the firm, is to pay through issue of bonus shares.
Depreciation Policy
Depreciation policy affects the quantum of working capital in several ways.Since charging depreciation does not imply any cash outflow, the effects are only indirect.
(a) The more the depreciation, the lower the profits, hence the lower the tax liability, and hence the more the cash profits.
(b) The more the depreciation, the lower the disposable profits, hence the smaller the dividend payment, and thus more cash is preserved.
(c) If current capital expenditure is less than the depreciation provision, the working capital is increased, thereby reducing the need for short-term borrowing. If, however, current capital expenditure is more than the depreciation provision, either external expenditure must be taken up or dividend payment must be restricted leading to retention of profits thereby firming up the working capital position.It is these three reasons through which depreciation policy influences the availability of working capital.
Computing the Working Capital Needed
The two components of the working capital, viz. current assets and current liabilities have to be computed. The sub-components under each of these is pro-rated according to the holding period (within the whole year).
(a) Under CA, pro-rating is done for raw materials, work-in-progress, finished goods and debtors.
(b) Under CL, pro-rating is done for trade creditors, direct wages and overheads (excluding depreciation and amortisation).
(c) Provision is also made for minimum cash balances.
The net amount as by (a) - (b) + (c) is augmented by a margin for contingencies for (a) - (b); this final amount is the net working capital required. The prdcedure is illustrated through the following examples.
Example
A firm which partially exports its products besides its domestic sales has the profile projections as given in Table 20.1 for the ensuing year in its ongoing business in respect of its inventory holdings, sales (on credit), payments and expenses for wages, overheads, etc., its profit-earning projections and minimum cash balance required by its'bankers on its accounts. With providing 15% extra for unforeseen contingencies, estimate its working capital requirement.
Solution
In Table, stocks and expenses add up to Rs. 61,60,000; and sales total to Rs. 88,00,000. 70% of sales (i.e. less profit of 30%) becomes Rs. 61,60,000 -which checks with the sum of stocks and expenses. With this check having been established, other computations can follow.
Because of the unlikely event of completing the sequences in this cycle instantaneously, there arises the need for (and the very existence of) the current assets shown in the boxes (constituting the gross working capital) in Figure. Moreover, even when going through the phases of the operating cash cycle, cash inflows and cash outflows do not match (in quantum), firms have to necessarily keep cash (or short-term liquid assets) to be able to meet their maturing obligations to pay. Likewise, firms must have adequate inventory to keep their production process going decoupled from their material supply sources and also to meet the demands for their products (to complete parts of the construction jobs within the respectively scheduled dates - in the case of the construction industry). If the firms have to be competitive and survive and thrive in their business, they must be willing to sell their goods to customers on credit which necessitates holding of accounts receivable. [In the construction industry, this is unavoidable under the system of tender-based contracting since bills have to be raised after job completion and its inspection by the owner and the bills have to be processed for payment (though only partially in running bills) by the owner,] These operating details necessitate the maintenance of an adequate level of gross working capital for smoothness of operations,
Operating Cycle
In line withathe above discussions, the three phases of the operating (cash) cycle are again described as under.In phase 1, cash gets converted into inventory. This includes purchase of raw materials, conversion of raw materials into WIP (work-in-progress) which end up at varying instants as finished goods and relabelling of the finished goods as stock (or billable quantities of items of work -in construction industry).
In phase 2, inventory is converted into receivables as credit sales are made to customers. (In the construction industry, this phase is gone through by the facts of the contractor raising a bill in the owner and the owner arranging for the processing of the bill.)
In phase 3, receivables are converted into or collected in, cash. This completes the operating cycle.
Permanent and Temporary Working Capital
The operating cycle necessitates the availability of current assets (gross working capital) has been seen in previous Section.The need for the current assets continues beyond one cycle since the firm continues in its business; i.e. a regular supply of WC is a need for continuing business. However, the magnitude of the WC required will not, in general, be constant over time, but will fluctuate. In a growth, or sunrise, industry situation, the need for WC will rise in course of time, even as it fluctuates in cycles over the increasing time horizon. These fluctuations in the timewise need for working capital give rise to two methods of meeting the need by permanent, or fixed, working capital (at the base level), and by temporary, or fluctuating or variable, working capital to meet the needs from time to time over and above the permanent level of working capital.
Changes in Working Capital
The fluctuations in the working capital need as shown in the figures are caused largely by three reasons :
(a) Changes in Sales and Operating Expenses;
(b) Policy changes; and
(c) Changes in technology and methods adopted.
Changes in Sales and Operating Expenses
In a manufacturing industry, engaging in specific prcducts in its business line,Sales and Operating Expenses may change over time due to three reasons :
(a) The change may be under a long-running rrend, e.g., increase of raw material prices, (say. bricks, paints, labour wages); this (except for labour wages) may lead to precautionary overstocking of inventory. This change is largely absorbed by timewise increasing permanent current assets described in next Section .
(b) Cyclical changes in the economy will lead to ups and downs in business activity and hence in the need for working capital. This may affect both the permanent and the fluctuating components of the working capital.
(c) Seasonality of sales activity also causes changes in the need for working capital, mainly in the level of the temporary working capital.
Construction industry is highly prone to this type of changes, by the very nature of its business. This has been apply discussed in previous unit when dealing with the cash flow from the point of view of the contractor and in the lllustrative Problem.Example. The fundamental difference there, when discussed as "Captim" has been that it represents only one cycle of what is being discussed here since Section . If the same contractor would have taken up several contracts with time lags between them and draws up a composite scheme of working capital needs for all contracts together, he will also face these operating (cash) cycles. The aspects of profitability and risk and their trade-off as functions of the policy adopted by the firm for working capital management. The current assets indicated therein expressed as a fraction of sales volume is called the current asset policy (adopted by the firm). Of course, this will translate as anything between a hedging policy to a totally conservative policy represented respectively by the line through C in Figure 20.1 and the dotted line through D' in Figure . An aggressively hedging policy will be represented by keeping the line through B in Figure (or through B' in Figure) at a quite low position. Whatever conscious decision management takes for its current asset policy will definitely influence the level of working capital needs.As regards construction industry, current assets through inventories expedite the progress of work; but, if as receivables, it affects the progress, the morale and the returns.
Changes in Technology and Methods Adopted
If a new technology with its attendant methods and processes which are more efficient, less time-consuming and cheeper in costing evolves, and is adopted, this not only shortens the duration of the operating cycle but also reduces the working capital. Slip-from shuttering for construction of circular tanks is a very typical example in construction industry.
Determinants of Working Capital
A firm should schedule its operations in-such a way as to need a manageable level of working captial. And, of course, this will vary from time to time depending on the type and rate of implementation of the scheduled activities at any time. In construction practice, this is referred to as resource-based scheduling. The several factors that impinge on the assessment of the quantum of working capital are generally as follows :
Nature of Business
A business enterprise engaged in book publishing has to produce each edition in big lots, distribute them over a wide geographical area and wait for their sales often in batches of small numbers. (It is not denied that there can be other extremes.) Obviously, its working capital need is quite heavy. For a catering industry, raw material stock cannot often be too large, sales are mostly against cash and too fast, the business premises is not spread far and wide. Moreover, much of raw material may have been obtained on credit. Accordingly, its working capital need would, and should, not be high. Within the public sector too, construction organisations and organisations dealing in commodities (construction organisations too deal, in a sense, in commodities - i.e. infrastructure, buildings, etc.) would need a higher level of working capital relative to consultancy and distribution .organisations which should need relatively lower levels of working capital, deal as they do in sale of services rather than commodities.Production Related Factors
Production Cycle
Production cycle refers to the time involved in the manufacture of goods. In construction industry, it may correspondingly refer to the billing intervals in at-site works and to duration of production runs in the manufacture of prefabricated components (when, again, bills can be raised when deliveries would be effected at the worksites ensuing the production). It covers, theoretically, the duration since procurement of raw materials, through the manufacturing (or construction) process till the production of finished goods (and the billing thereupon for the part of the construction since the last billing in construction industry). Shorter the production cycle (or the billing interval),smaller the working capital needed.Technological improvements in the process can expedite the billing cycle and reduce the needed working capital. Credit purchases of materials, securing of advances for machinery, materials, etc. are some practices that can minimise the working capital needed in construction industry.
Production Policy
When demand for products (or for construction-related activity) is seasonal (like in maintenance and facilitation works, e.g. desert cooler, canal linings,etc.), the production policy can be by one of two options : limiting the production (e.g., of lining tiles, etc.) to the periods when goods are (getting) purchased; or continuous (and uniform) production throughout the year to build up stock to meet the peak (i.e. total expected) demand.Understandably, due to rushed production interspersed with having to keep idle manpower and facilities, the former option can be expensive and also requiring spurts of large working capital for concentrated production. On the other hand,the latter option will lead to accumulation of inventory, in turn, locking up the working capital. The firm must decide its own policy or policy-mix to adopt. In case of the former option being adopted, the firm may diversify on its production items enabling it to engage its manpower and facilities additionally productively during the off-season of the primary items of production.Clearly, every industry, with its own specialisations and strengths, must adopt the policy best suited to itself.
Availability of Raw Materials
If raw material is not available on a continuous basis, the firm needs to build up its inventory whenever procurement is possible, largely unrelated to the production needs. Inevitably, a high !eve1 of working capital is needed in such situations. Construction industry is often affected for this reason, often on the score of construction steel. Moreover, seasonal availability of raw material will likewise exacerbate the seasonal fluctuations of working capital needs. Changes in Price Levels
Changes in price level affect nearly proportionately the requiremeats of working capital. So too for wage level changes. Construction industry is particularly vulnerable in such situations if it is constrained not to seek revisions of rates for items of work except if the increase in price level exceeds a certain stipulated percentage. Contract clauses often include such constraints.
Operating Eflciency
Management must ensure the efficient utilisation of resources by resource levelling, eliminating waste, and improving coordination. Eliminating wasteincludes non-disruption by employees by resort to go-slows and strikes.Resource levelling also improves employee-utilisation, reduces spurts in resource needs and reduces mechanical (including electrical) breakdowns by avoiding high peaks of power needs. Planning and scheduling the works with telescoping line-of-balance methods on critical path methods for resources and manpower levelling will be highly beneficial in this regard for construction industry. Improving the efficiency of operations by such methods improves profitability without much increase in risk for reason of improved internal generations of funds and/or reduced idling of working capital.
Factors Related to Business Environment
Business Level Fluctuations
If business conditions are not fairly steady but have boom conditions interspersed with declining conditions, going by the general economy, there will be continuous up and down changes in working capital needs, particularly, for the temporary working capital needs. When business activity is in the buoyant condition, working capital needs will increase for two reasons : one, to cover the lag between increased sales and receipt of cash, i.e. by increases in receivables; and, two, to finance the purchase of additional material and additional stock of WIP and finished goods to match the expansion in the demands, i.e. by increase in inventories. Even the fixed assets may have to be increased as plant and machinery. When business activity goes, on the other hand, into depressed conditions, volume of sales declines resulting in reduction in both, viz. in receivables (or book debts) and in inventory. Accordingly, under recessionary conditions, the need for working capital will come down. Thus, business fluctuations affect working capital needs through receivables and inventories.
Growth of the Firm
When a firm grows, it follows logically that the working capital needs will rise,However, the growth of the firm can be postulated on the precedence of need for increased working capital, i.e. increased working capital is a pre-condition for the growth or expansion of the firm. This emphasises the continuous need for advance planning for (and securing of) working capital in increasing quanta for a growing organisation; failing which, in spite of even considerable earnings, the firm may be left with hardly any cash - no matter what the amounts of receivables and inventories are.Credit Policy Section (in the matter of book publishing industry, credit purchases of materials, and lag between increased sales and receipt of cash) has already referred to certain aspects of this factor.The level of working capital needed depends on the credit policy in the matter of sales as well as purchases. Credit terms permitted to its customers by the firm and also credit terms available to the firm from its creditors -both affect the working capital needs, the first through book debts (or receivables) and the second through trade creditors (or bills payable). The higher the book debts, the more the need for working capital. The more liberal the credit terms available to the firm, the lesser the need for working capital. Both these aspects depend on the prevalent trade practices and economic conditions and the level of competition in the market. Factors Relatable to Profit Level
Being an item of appropriation of profits, payment of dividend exhausts cash resources to that extent and also affects (diminishes) working capital available to that extent. Whatever part of the earnings is not distributed as dividends but is retained, would augment the working capital.Whereas investors expect the distribution of dividends, the firm may like to retain the profits to augment its cash resources. The choice on these two courses of action has to be judiciously decided considering all the relevant issues. A method adoptable towards payment of dividend, but without depleting the cash resources of the firm, is to pay through issue of bonus shares.
Depreciation Policy
Depreciation policy affects the quantum of working capital in several ways.Since charging depreciation does not imply any cash outflow, the effects are only indirect.
(a) The more the depreciation, the lower the profits, hence the lower the tax liability, and hence the more the cash profits.
(b) The more the depreciation, the lower the disposable profits, hence the smaller the dividend payment, and thus more cash is preserved.
(c) If current capital expenditure is less than the depreciation provision, the working capital is increased, thereby reducing the need for short-term borrowing. If, however, current capital expenditure is more than the depreciation provision, either external expenditure must be taken up or dividend payment must be restricted leading to retention of profits thereby firming up the working capital position.It is these three reasons through which depreciation policy influences the availability of working capital.
Computing the Working Capital Needed
The two components of the working capital, viz. current assets and current liabilities have to be computed. The sub-components under each of these is pro-rated according to the holding period (within the whole year).
(a) Under CA, pro-rating is done for raw materials, work-in-progress, finished goods and debtors.
(b) Under CL, pro-rating is done for trade creditors, direct wages and overheads (excluding depreciation and amortisation).
(c) Provision is also made for minimum cash balances.
The net amount as by (a) - (b) + (c) is augmented by a margin for contingencies for (a) - (b); this final amount is the net working capital required. The prdcedure is illustrated through the following examples.
Example
A firm which partially exports its products besides its domestic sales has the profile projections as given in Table 20.1 for the ensuing year in its ongoing business in respect of its inventory holdings, sales (on credit), payments and expenses for wages, overheads, etc., its profit-earning projections and minimum cash balance required by its'bankers on its accounts. With providing 15% extra for unforeseen contingencies, estimate its working capital requirement.
Solution
In Table, stocks and expenses add up to Rs. 61,60,000; and sales total to Rs. 88,00,000. 70% of sales (i.e. less profit of 30%) becomes Rs. 61,60,000 -which checks with the sum of stocks and expenses. With this check having been established, other computations can follow.
Notes
(a) Debtors have been computed as inclusive of profit. Hence, the NWC as at(F) must provide from within it for tax, depreciation and dividend.
(b) The credit collection periods of 2 and 3 months, respectively, must not be relaxed. Administrative efficiency must match.
(c) The firm is considered to be in its on-going business. In the very first-year,besides for permanentlfixed assets, additional funds would also be needed for initial expenses and also to start off with all stock as raw materials, without the benefit by sales revenue too soon.
(d) It is assumed that there are neither business fluctuations nor growth.
(e) Productions should not be delayed or held up. Operating efficiency must match.
(f) There is no impediment in securing raw materials.
(g) Production is taken to be continuous and uniform; so also for the freight, delivery to creditors, realising the receivables, etc.
(h) Having worked with pro-rated values (inclusive of profits) and not strictly following the production schedules, this method of computation is more by conservative approach than by hedging approach.
(i) Comparatively speaking, therefore, what has been discussed for the CAPTIM at the contractor's end in Unit 15 is by hedging approach in as much as periodwise cash outflows and cash inflows and the CAPTIM (as the net difference) were computed, notwithstanding accruals for taxes and withheld arnounts/retentions as receivables.
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