Description
Notes of FM
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CHAPTER: 1– INTRODUCTION TO FINANCIAL MANAGEMENT
SECTION I:- MEANING OF FINANCIAL MANAGEMENT Financial Management is broadly concerned with the mobilization and deployment of funds by a Business organization. For efficient operation of business, it is necessary to obtain and utilize the funds effectively. This job is done by Financial Management. According to Pawan Jhabak, “Finance is simply the art & science of managing money.” Basically therefore financial management centers around fund raising for Business in the most economical way and investing these funds in optimum way so that maximum returns can be obtained for the share holders. Practically all Business decision have financial implication. Hence, financial management is interlinked with all other functions of business. SECTION II:- SCOPE OF FINANCIAL MANAGEMENT
Forecasting Analysis of Economic Trends Analysis of Industries Trends Forecasting Financial requirement Profit planning Scope of Financial Management Financing Coordination Costing & control Acquiring Financial Measuring Funds Adjustment cost of capital Allocation Accounting Preparing of funds cost sheet Investment Budgeting Marginal of funds costing Ensuring availability of funds Reporting Decision making Financial Decision Investment Decision Management of income Dividend decision Meeting contingent liability Others Tax Management Fixed Assets management Inventory / Receivable management Corporate Governance Employment Benefits
Estimating ROI
Financial management is one of the important parts of overall management, which is directly related with various functional departments like personnel, marketing and production. Financial management covers wide area with multidimensional approaches. The following includes important scope of financial management. 1. Financial Management and Economics Economic concepts like micro and macroeconomics are directly applied with the financial management approaches. Investment decisions, micro and macro environmental factors are closely associated with the functions of financial manager. Financial management also uses the economic equations like money value discount factor, economic order quantity etc. Financial economics is one of the emerging area, which provides immense opportunities to finance, and economical areas.
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2. Financial Management and Accounting Accounting records includes the financial information of the business concern. Hence, we can easily understand the relationship between the financial management and accounting. In the olden periods, both financial management and accounting are treated as a same discipline and then it has been merged as Management Accounting because this part is very much helpful to finance manager to take decisions. 3. Financial Management and Mathematics Modern approaches of the financial management applied large number of mathematical and statistical tools and techniques. They are also called as econometrics. Economic order quantity, discount factor, time value of money, present value of money, cost of capital, capital structure theories, dividend theories, ratio analysis and working capital analysis are used as mathematical and statistical tools and techniques in the field of financial management. 4. Financial Management and Production Management Production management is the operational part of the business concern, which helps to multiply the money into profit. Profit of the concern depends upon the production performance. Production performance needs finance, because production department requires raw material, machinery, wages, operating expenses, etc. 5. Financial Management and Marketing Produced goods are sold in the market with innovative and modern approaches. For this, the marketing department needs finance to meet their requirements. The financial manager or finance department is responsible to allocate the adequate finance to the marketing department. 6. Financial Management and Human Resource Financial management is also related with human resource department, which provides manpower to all the functional areas of the management SECTION III:- FUNCTION OF FINANCIAL MANAGEMENT Function / Role of Financial Management / Manager and how have they change in recent years. Ans:Role of financial management / manager Sources / Mobilization of funds Application / deployment of funds (Financial decision ) ( Investment decisions ) 1. Proprietors Funds 1. Fixed Assets Share capital (Capital Budgeting) Reserve & surplus 2. Borrowed Fund 2. Investments (capital structure) (Treasury Management) (cost of capital) 3. Net current Assets (Dividend policy) (Working capital management) The twin aspects procurement & effective utilization of funds are the crucial tasks, which the financial manager faces. The financial manager is required to look into financial implication of
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any decision in a firm. The finance manager has to manage funds in such a way as to make their optimum utilization & to ensure that their procurement is in a manner so that the risk, cost & control considerations are properly balanced under a given situation. Functions of Finance Manager ? Estimating the requirement of fund. ? Decision regarding capital structure. ? Investment decision. ? Dividend decision. ? Working capital management / liquidity function. ? Maintaining financial procedures & system etc 1) Estimating The Requirement Of Funds: In a business the requirements of funds have to be carefully estimated. Certain funds are required for long term purpose i.e. investments in fixed assets etc. certain funds are required for short term purpose i.e. Working Capital. A careful estimation of such funds & the timing of requirement must be made. Forecasting the requirements of funds involves the use of technique of budgetary control. Estimates of requirements of fund can be made only if all physical activities of the organization have been forecasted. 2) Decisions Regarding Capital Structure: Once the requirements of funds have been estimated, decisions regarding various sources form where these funds would be raised have to be taken. Finance manager has to carefully look into existing capital structure and see how the various proposals of raising funds will affect it. He has to maintain a proper balance between long-term funds and short-term funds. Long-term funds raised from outsiders have to be in a certain proportion with the funds procured from the owner. He has to see that capitalization of company is such that company is able to procure funds in future also. All such decisions are ‘financing decisions’. 3) Investment Decision: Funds procured from different sources have to be invested in various kinds of assets. Investments of funds in a project have to be made after careful assessment of the various projects through capital budgeting. A part of long-term funds is also to be kept for financing working capital requirement. The production manager’s &-finance manager keeping in view the requirement of production, future price estimates of raw material & availability of funds would determine inventory policy. 4) Dividend Decision: Finance manager is concerned with the decision to pay or declare dividend. He has to assist management in deciding as to what amount of profit should be retained in business & this depends on whether the company can make a more profitable use of funds. But in practice trend of earning, share market prices; requirement of funds for future growth, cash flow situation, expectation of shareholders has to be kept in mind while deciding dividend. 5) Working Capital Management / Liquidity Function: The financial manager has to properly manage current assets such as cash, inventory and Accounts Receivable. He has to ensure a trade off between liquidity and profitability. He has to ensure efficient utilization of every current assets and also overall working capital involved in current assets. Adequate
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level of current assets is necessary to maintain required level of liquidity of funds. On the other hand if the funds are idle the profitability may be low. Therefore the financial manager has to maintain a proper balance between liquidity and profitability. It includes cash management & receivable management. 6) Maintaining Financial Procedures & Systems: This includes procedures established for the effective execution of the other functions. Budgetary accounting, record keeping and management information system (MIS) & corporate Governance are integral part of any organization. In the last few years, the complexion of the economic and financial environment has altered in many ways. Therefore the role of finance manager has changed from Mobilisation and deployment of funds to profit planning, maximizing shareholder wealth, understanding capital markets and good corporate Governance. These changes have made the job of the finance manager more important, complex and demanding.
Functions of Financial Manager SECTION IV:- OBJECTIVES OF FINANCIAL MANAGEMENT
Discuss wealth maximization and shareholder value maximization as objectives of financial management. Or corporate houses today are increasingly moving towards wealth maximization, comment on this movement. Or the objective of financial management is ‘wealth maximisation & not profit maximisation’. Comment Ans:-
Objectives of Financial Management
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Clear objectives are required for wise decision-making. Objectives provide a framework for optimum financial decision-making. Two of the most widely discussed approaches are: Profit maximization approach Wealth maximization approach Profit Maximization Decision Criteria: Under this approach, actions that increase profits should be undertaken and those that decrease profits are to be avoided. In specific operational terms, the profit maximization criterion implies that the investment, financing and dividend policy decisions of a firm should be oriented towards the maximization of profits. The rationable behind profit maximization as a guide to financial decision making, is due to following reasons. ? Profit is a test of economic efficiency. It provides the yardstick by which economic performance can be judged. ? It leads to efficient allocation of resources tend to be directed to uses, which in terms of profitability are the most desirable. ? It ensures maximum social welfare. This is so because the quest for value drives scarce resources to their most productive uses and their most efficient users. The more effectively resources are deployed, the more robust will be the economic growth and the rate of improvement in the standard of living. The profit maximization criterion however has been questioned and criticized on several grounds. It suffers from the following limitations: ? Profit in absolute terms is not a proper guide to decision making. It has no precise connotation. It can be expressed either on a per share basis or in relation to investment. Also, profit can be long term or short term, before tax or after tax, it may be the return on total capital employed or total assets or shareholders equity and so on. If profit maximization is taken to be the objective which of these variants of profit should a firm try to maximize? Therefore, a loose term like profit cannot from the basis of operational criterion for financial management. ? It leaves considerations of timing and duration undefined. There is no guide for comparing profit now with profit in future or for comparing profit streams of different durations. ? It Ignores Risk Factor. It cannot, for example, discriminate between an investment project, which generates a certain profit of Rs.50 Lakhs and an investment project, which has a variable / uncertain profit outcome of Rs.50 Lakhs. Wealth Maximization Decision Criterion: This is also known as value maximization or net present worth maximization. The focus of financial management is on the value to the owners or suppliers of equity capital. The wealth of the owners is reflected in the market value of the shares. So wealth maximization implies the maximization of the market price of shares. It has been universally accepted as an appropriate operational decision criterion for financial management decisions as it removes the technical limitations, which characterise the earlier profit maximization criterion. Its operational features satisfy all the three requirements of a suitable operational objective of financial courses of action,
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namely exactness, quality of benefits and the time value of money. Maximization of the wealth of shareholders (as reflected in the market value of equity) appears to be the most appropriate goal for financial decision-making. Wider than profit maximization is the principle of corporate governance. The fundamental objective of corporate governance is the “the enhancement of the long -term shareholder value while at the same time protecting the interests of other stakeholders.” As such, this definition emphasizes the need for a company to strike a balance at all times between the need to enhance shareholders” wealth and protecting the interest of other stakeholders in the company such as suppliers, customers, creditors, bankers, employees of the company, government and society at large. If these factors are ignored, a company cannot survive for long. Profit maximization at the cost of social and moral obligations is a short-sighted policy. Hence, it is commonly agreed that the objective of a firm is to maximize its value or wealth. Value is represented by the market price of the company’s common stock. The market price of a firm’s stock represents the judgment of all market participants as to what the value of the particular firm is. The market price serves as a performance index of the firm’s progress; it indicates how well management is doing on behalf of shareholders. An increasingly popular measure of wealth is EVA (Economic Value Added). Economic Value Added (EVA) can be defined as the net operating profit that a company earns above its cost’s of capital. It is a trademark of Stern Stewart & Co. EVA can be calculated as follows:
EVA = Net operating profit after taxes – {Weighted average cost of capital X Cap. invested}
Conceptually, EVA is superior as a measure of value creation because it recognizes the cost of capital and, hence, the riskiness of a firm’s operations. There is a st rong correlation between EVA and the market price of a company’s stock. Maximizing any accounting profit or accounting rate of return as a way of increasing shareholder’s wealth often leads to an undesired outcome. Therefore, wealth maximisation should be the objective of financial management since it: ? Considers risk. ? Uses Cash flows and not profits. ? Considers Time value of money. ? Implies taking care of Interest of both shareholders and other stakeholders (Corporate governance). Describe Agency Problem in Achievement of Objectives of Financial Management Ans:A characteristic feature of corporate enterprise is the separation between ownership and management as a corollary of which the latter enjoys substantial autonomy in regard to the affairs of the firm. With widely diffused ownership, scattered and ill-organised shareholders
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hardly exercise any control/influence on management, which may be inclined to act in its own interests rather than those of the owners. However shareholders as owners of the enterprise have the right to change the management. Due to the threat of being dislodged for poor performance, the management would have a natural inclination to achieve a minimum acceptable level of performance, to satisfy the shareholders requirements/goals, while focussing primarily on their own personal goals. Thus in furtherance of their objective of survival, management would aim at satisfying instead of maximising shareholders’ wealth. However, the conflicting goals of management objective of survival and maximizing owners value/wealth can be harmonised by. 1. Incentives To Management: The incentive to management is of various types. Some of them are follows: ? Stock options: Confer on management the right to acquire shares of the enterprise at a special / concessional price. ? Performance shares are given based on the performance of the management. ? Cash bonus-linked to specified performance targets 2. Monitoring of Managers: ? Auditing financial statements and limiting decision making by the management. The audit and control procedures and limiting managerial decisions are intended to ensure that the actions of management sub serve the interests of shareholders. ? Rotation of Audit Partners. SECTION V:- ACCOUNTING PRINCIPLES Even though a financial manager is not an accountant, he must be familiar with various accounting principles (GAAPs) to make good decisions: Monetary Measurement: Accountants do not account for items unless they can be quantified in monetary terms. Items that are not accounted for (unless someone is prepared to pay something for them) include things like market leadership, brand recognition, goodwill etc. Entity: This convention seeks to ensure that private transactions and matters relating to the owners of a business are segregated from transactions that related to the business. Even transactions of owners with business are recorded in books of company. Materiality: The preparation of accounts involves a high degree of judgement. Where decisions are required about the appropriateness of a particular accounting judgement, the “materiality” convention suggests that this should only be an issue if the judgement is “significant” or “material” to a user of the accounts. The concept of “materiality” is an important issue for auditors of financial accounts. Going Concern: Accountants assume, unless there is evidence to the contrary, that a company will continue operations in the foreseeable future. This has important implications for the valuation of assets and liabilities. Consistency: Transactions and valuation methods are treated the same way from year to year, or period to period. Users of accounts can, therefore, make more meaningful comparisons of
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financial performance from year to year. Where accounting policies are changed, companies are required to disclose this fact and explain the impact of any change in notes to Accounts. Prudence / Conservatism: Profits are not recognised until a sale has been completed. In addition, a cautious view is taken for future problems and cost of business (they are “provided for” in the accounts” as soon as their is a reasonable chance that such costs will be incurred in the future. Eg. Depreciation, provision for bad debts) Future probable Loss is to be provided in Current period but future probable Income should not be recorded in current period, according to principle of conservatism. Matching / Accruals: Income should be properly “matched” with the expenses of a given accounting period, to ascertain profitability. It also implies long term asset should be funded through long term source of finance & short term asset through short term sources of finance. (For more details (theory) refer Himalaya Financial Management Pawan Jhabak book)
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CHAPTER: 2– ESTIMATION OF WORKING CAPITAL
WORKING CAPITAL = CURRENT ASSETS – CURRENT LIABILITIES Working capital is defined as the excess of current assets over current liabilities. It identifies the relatively liquid portion of the total capital which constitutes a margin for maturing obligations within the ordinary operating cycle of the business. SECTION I: COMPONENTS OF WORKING CAPITAL CURRENT ASSETS (LOANS AND ADVANCES) SHORT TERM ASSETS These are those real assets which are intended to be disposed off and get it converted into money / money’s worth within a period of 12 months. Examples: ? Closing Stock (RM, WIP, Finished Goods) ? Sundry Debtors ? Bills Receivable ? Cash in Hand and Bank ? Pre-paid Expenses ? Loans Given ? Advance to Suppliers, etc. CURRENT LIABILITIES (AND PROVISIONS) SHORT TERM LIABILITIES These are those outsiders liabilities which are payable within a period of 12 months. Examples: ? Sundry Creditors ? Bills Payable ? O/S Expenses ? Advance from Customers ? Tax Payable ? Bank Overdraft, etc. Working Capital is also known as circulating capital, fluctuating capital and revolving capital. The magnitude and composition of working capital keeps on changing continuously, in the course of business. FORMAT – STATEMENT OF ESTIMATION OF WORKING CAPITAL Particulars a) Current Assets, (Loans & Advances) b) Current Liabilities (& Provisions) Working Capital ( a-b) W.N. Rs. Rs. XXX XXX XXX
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(+) Safety Margin Estimated Working Capital
SECTION II :- WORKING CAPITAL CYCLE Alternatively known as ‘Operating Cycle Concept’ of working capital. This concept is based on the continuity of flow of funds through business operations. This flow of funds is caused by different operational activities during a given period of time. The operational activities of an organization may comprise of : ? Purchase Of Raw Materials ? Conversation Of Raw Materials Into Finished Products ? Sale Of Finished Products and ? Realization Of Accounts Receivable
WORKING CAPITAL CYCLE The time that elapses between the purchase of raw materials and the collection of cash for sales is referred to as the operating cycle, whereas the time length between the payment for the raw material purchases and the collection of cash for sales is referred to as the cash cycle. The operating cycle is the sum of the inventory period and the accounts receivable period, whereas the cash cycle is equal to the operating cycle less the accounts payable period. Material cost is partly covered by trade credit from suppliers and successive operational activities also generate cash flow. If the flow continues without any interruption, operational activities of the company will also continue smoothly. Movement of cash through the above processes is called ‘circular flow of cash’. The period required to complete this flow is called ‘the operating period’ or ‘the operating cycle’. To the estimate the working capital required, the number of operating cycles in a year is to be calculated. This is calculated by dividing the number of days in a year by the length of the cycle. Total operating cost of a year divided by the number of operating cycles in that year is the amount of working capital required. OPERATING CYCLE = R + W + F + D – C
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R = RM Holding Period W = Processing Period F = FG Holding Period D = Debtors Collection Period C = Creditors Payment Period The operating cycle can be shortened by the following means. Raw Materials Procurement One should have a good supply network. This means that he should have a supplier who can provide him with his raw material requirement at the right time, place and in the required quantity at the minimum amount of time. Thus this also implies that he should be in possession of automated machines in case the raw materials are large and bulky. This helps in reducing the time required for transport and movement of the goods from one place to another. Production Process In the production process their should not be any time lag from the time of actually receiving the raw materials and the starting of production process. This means as soon as the materials arrive they should be introduced in the production process. This therefore meant that the company will be following the just in time policy (JIT) which simply means that the requirements of the company will be fulfilled at the time required thus reducing the work in progress and thus increasing the efficiency of the company. Finished Goods The goods once produced should not be held in the company’s possession for a longer duration as the company’s capital would be locked up in these goods. Thus it is essential that the company sell all these finished goods as soon as possible so as to allow the company reacquires its capital employed in the operating cycle. Receipt of Sales The receipts of the money from the debtors as soon as possible so as to regain the money along with the profits. This is how the operating cycle operates along with and how it can be improved so as to enable the company to regain the money invested in the production of the goods. E.g. Tata Motors Ltd. has adopted path breaking steps to reduce its operating cycle in ‘Nano Project’ SECTION III - PROJECTION OF WORKING CAPITAL REQUIREMENTS ? ? ? ? ? ? Determine level of activity Estimate raw materials cost per unit & total Estimate labour and overheads cost per unit & total Estimate work-in-progress period Estimate finished goods period Estimate sundry debtors collection period
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Estimate cash/bank balance Estimate sundry creditors payment period Estimate creditors for expenses Determine safety margin
FACTORS DETERMINING WORKING CAPITAL REQUIREMENTS All firms do not have the same working capital needs. It depends on several factors, which are listed as follows. 1. Nature and size of business:- The working capital requirement of a firm is closely related to the nature of the business. We can say that trading and financial firms have less investment in fixed assets but require a large some of money to be invested in working capital. Also, a firm with a large scale of operation will obviously require more working capital than the smaller firm. 2. Method of Production:- Whether the company follows job, batch or flow production also affect working capital requirement. Also is Production Labour Intensive or Capital Intensive affects working capital requirement. 3. Manufacturing cycle:- It starts with the purchase and use of raw materials and completes with the production of finished goods. Longer the manufacturing cycle larger will be working capital requirement, this is seen mostly in the industrial products. 4. Business cycles:- When there is an upward swing in the economy sales will increase, and also the firm’s investment in inventories and book debts will increase, thus it will increase the working capital requirement of the firm and vice-versa. 5. Production policy:- To maintain an efficient level of production the firms may resort to normal production even during the slack season. These will lead excess production and hence the funds will be blocked in the form of inventories for a long time, hence provisions should be made accordingly. 6. Firm’s credit policy:- If the firm has liberal credit policy, its funds will remain blocked for long time in form of debtors and vice-versa. Normally, industrial goods manufacturing will have a liberal policy whereas dealers of consumer goods will have a tight credit policy. [e.g. L&T vs HUL] 7. Availability of credit:- If the firm gets credit on liberal terms, it will require less working capital since it can always pay its creditors later and vice-versa. 8. Growth and expansion activities:- It is difficult precisely to determine the relationship between volumes of sales and need for working capital. The need for working capital does not follow the growth but precedes it. Hence, if the firm is planning to increase its business activities, it needs to plan its working capital requirements during the growth period. (e.g classic failure - Subhiksha & Success Pantaloons Ltd.
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9. Conditions of supply of raw material and stock policy:- If the supply of raw material is scarce the firm may need more working capital to stock up on the inventory. The decision to follow JIC and JIT is also a factor. 10. Profit margin and profit appropriation:- A high net profit margin contributes towards the working capital and results into lower requirement for working capital (e.g. Infosys Ltd.) Also, tax liability is unavoidable and hence provision for its payment must be in the working capital plan, otherwise it may impose a strain on the working capital. 11. Price level changes:- Changes the price level due to inflation or other reason also affect the requirement of working capital. Rising prices necessitate the use of more funds for maintaining an existing level of activity. Rising prices will require higher level of working capital and vice-versa. 12. Dividend policy:- Also if the firm’s policy is it to retain profits it will increase their funds available for working capital and if they decide to pay their dividends it will weaken their working capital position, as the cash flows out. So dividend policy of the Company is a important factor affecting requirement of working capital. 13. Depreciation policy:- The depreciation of the firm, through the effect on tax liability and retained earnings, has an influence on the working capital. The firm may charge a high rate of depreciation, which will reduce the tax payable. Thus depreciation is an indirect way of retaining profits and preserving the firm’s working capital position. SECTION IV – TYPES / CLASSIFICATION OF WORKING CAPITAL 1. Gross Working Capital and Net Working Capital Gross Working Capital:Gross Working Capital is equal to total current assets only. It is identified with currents assets alone. It is the value of non – fixed assets of an enterprise and includes inventories (raw materials, work-in progress, finished goods, stores and spare), receivables, short term investments, advances to suppliers, loans, short term deposits, sundry deposits with excise and customs, cash and bank balance, prepaid expenses, income receivable, etc. Gross Working Capital indicated the quantum of working capital available to meet current liabilities. Thus, Gross Working Capital = Current Assets Net Working Capital = CA – CL Net Working Capital is the excess of current assets over current liabilities, i.e. current assets less current liabilities. This concept of working capital is widely accepted. This approach, however, does not reflect the exact position of working capital due to the following factors:
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Valuation of inventories include write – offs Debtors include the profit element Debts outstanding for more than a year, likewise debtors which are doubtful or not provided for are included as asset and are also place under the head ‘current assets’ Non - moving and slow moving items of inventories are also included in inventories.
To assess the real strength of working capital position, it is necessary to exclude the non moving and obsolete items from inventories etc. Working Capital thus arrived at is termed as “Tangible Working Capital” 2. Permanent and Temporary Working Capital Considering time as the basis of classification, there are two types of working capital viz, ‘Permanent’ and ‘Temporary’. Permanent working capital represents the assets required on continuing basis over the entire year, whereas temporary working capital represents additional assets required at different times during the operation of the year. A firm will finance its seasonal and current fluctuations in business operations through short term debt financing. For example, in peak seasons more raw materials are to be purchased, more manufacturing expenses are to be incurred, so more funds will be locked in inventory debtors balances etc. In such times excess requirement of working capital would be financed from short-term financing sources. The permanent component of current assets that are required throughout the year will generally be financed from long-term debt and equity. Tandon Committee has referred to this type of working capital as ‘Core Current Assets’. Core Current Assets are those required by the firm to ensure the continuity of operations that represents the minimum levels of various items of current assets viz., stock of raw materials, stock of work-in-progress, stock of finished goods, debtor’s balances, cash and bank etc. This minimum level of current assets will be financed by the longterm sources and short-term financing will finance any fluctuations over the minimum level of current assets. Sometimes core current assets are also referred to as ‘hard core working capital’. The management of working capital is concerned with maximizing the return of shareholders within the accepted risk constraints carried by the participants in the company. Just as excessive long-term debts puts a company at risk, so an excessive quantity of short-term debt also increases the risk to a company by straining its solvency. The suppliers of permanent working capital look for long-term return on funds invested whereas the suppliers of temporary working capital will look for immediate return and the cost of such financing will also be costlier than the cost of permanent funds used for working capital. 3. Core Assets and Non Core Assets Core Assets:- The part of a company's business that is central to its overall strategy and typically generates the bulk of its revenues. In other words, essential asset for a business: an asset without which a business cannot carry on its main activity is Core Asset. 'Item of intrinsic value' Core assets of an organisation comprise those that the organisation is unable to dispense with in order to operate.
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Non core-assets:- Assets no longer used in the ordinary business operations of a company. They are likely to be sold in the near future, if the need for cash arise. That part of company’s assets which do not generate significant revenue / profitability, is called non core asset. 4. Negative and Zero working capital Negative working capital : Internet based bookseller Amazon.com manages its cash cycle extremely well. It turns its inventory over 25 times a year, making its inventory period very short. It charges its customer’s credit card when it ships a book and it gets paid by the credit card firm usually in a day. Finally, it takes about 45 days to pay the suppliers. All this means that Amazon.com has a negative cash cycle / working capital i.e. current liabilities are more than Current Assets. Zero Working Capital : Many leading companies seek to have zero (or even negative) working capital. This happens when inventories and receivables are supported by the credit provided by suppliers and the advances given by customers. On average, working capital to sales ratio is about 0.20. Reducing working capital has two financial benefits: (i) every rupee released by reduced working capital makes a one-time contribution to cash flow, and (ii) periodically, the cost of money locked in working capital is saved. Apart from the financial benefits, reducing working capital results into a company to serve its customers quickly, lessens warehousing needs, reduces obsolescence costs, and increases profit etc. (For more details (theory) refer Himalaya Financial Management Pawan Jhabak book) SECTION V – PROBLEMS AND SOLUTIONS Q.1 You are required to prepare a statement showing the working capital required to finance the level of activity of 18,000 units per year from the following information: Per unit Rs. Raw Materials 12 Direct Labour 3 Overheads 9 Total Cost 24 Profit 6 Selling Price 30 a) Raw materials are in stock on an average for two months; b) Materials are in process an average for half a month; c) Finished goods are in stock on an average for two months; d) Credit allowed by creditors is two months of raw materials supplied; e) Credit allowed to debtors is three months; f) Lag in payment of wages is half month; g) Cash on hand and at Bank expected to be Rs.7,000/You are informed that all activities are evenly spread out during the year. Q.1 Solution.
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Statement of estimation of working capital. Particulars I. CURRENT ASSET, L&A ? STOCK ? Raw materials ? Work in progress ? Finished goods ? DEBTORS ? CASH / BANK I]…. II. ? ? CURRENT LIABILITIES & PROVISION :Creditors Outstanding wages II]…. Working Capital (I – II) (+) Safety margin Estimated Working Capital
W.N.
Rs.
Rs.
2. 3. 4. 5.
36000 13500 72000
121500 135000 7000 263500
6. 7.
36000 2250 38250 225250 225250
? W.N. 1) Cost statement for 18000 units (1 year = 12 months) Particulars Raw materials Direct labour Overheads Total cost Profit Selling price ? W.N. 2) Raw materials (2 months) 216000 X 2 = 36000. 12 ? W.N. 3) W.I.P. (0.5 month) Raw material . Direct labour 216000 X 0.5 X 100% = 9000 12 54000 X 0.5 X 50% = 1125 12 162000 X 0.5 X 50% 12 = 3375 13500 Rs. 216000 54000 162000 432000 108000 540000 C.P.U. 12 3 9 24 6 30
Overheads
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Note:In absence of information it is assumed that raw material is 100% and labour & overheads is 50%. ? W.N. 4) Finished goods (2 months) 432000 X 2 = 72000. 12 ? W.N. 5) Debtors (3 months) 540000 X 3 = 135000 12 Note:- Debtors have been valued at sales. Alternatively it can been valued at cost. ? W.N. 6) Creditors (2 months) 216000 X 2 = 36000. 12 W.N. 7) 7) ? W.N. Outstanding wages (0.5 months) 54000 X X 0.5 = 2250. 12 12
Q.2 From the following information prepare a statement showing the working capital required to finance a level of activity of 2,400 units per annum. Production and sales will be uniform throughout the year. a) Selling price Rs.500 per unit. b) Materials constitute 50% of selling price, Wages 15% of selling price and Overheads 25% of selling price. c) Raw materials stock required one month. d) Work in progress to be maintained for one month. Valuation to be made at materials cost plus 50% of wages and overheads. e) Finished Goods stock to be maintained for three months. f) Credit allowed to customers one month and credit allowed by suppliers two months. g) Bank Balance to be maintained Rs.20,000. Q.2) Solution Statement of estimation of working capital Particulars I.] CURRENT ASSET, L&A ? STOCK ? Raw materials ? WIP ? Finished goods ? DEBTORS ? Bank balance I]…. II.] CURRENT LIABILITIES & PROVISIONS :Creditors
W.N.
Rs.
Rs.
2 3 4 5
50000 70000 270000
390000 100000 20000 510000 100000
6
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II]…. :. Working capital (I – II) (+) Safety margin Estimated working capital ? (W.N 1) Cost statement for 200 units (1month) (2400 / 12) Particulars Raw Materials (50%) Labour (15%) Overheads (25%) Total Cost (+) Profit Selling Price ? (W.N 2) Raw materials (1 months) 50000 x 1 = 50000 ? (W.N 3) W.I.P (1 month) Materials 50000 x 1 x 100% Wages 15000 x 1 x 50% Overheads 25000 x 1 x 50% ? (W.N 4) Finished goods (3 months) 90,000 x 3 = 270000 ? (W.N 5) Debtors (1 months) 100000 x 1 = 100000 Note:- Debtors have been valued at sales. Alternatively it can be valued at cost. ? (W.N 6) Creditors (2 months) 50000 x 2 = 100000
Rs. 50000 15000 25000 90000 10000 100000
Rs. 250 75 125 450 50 500
= = =
50000 7500 12500 70000
Q.3 From the following information, prepare a statement showing the working Capital requirements: The Budgeted Profit and Loss Account for the year 2010-2011 is as under: Rs. Sales Less: Materials Labour Expenses 7,20,000 5,40,000 180000 Rs. 1800000
1440000 360000
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Additional Information: a) The production and sales take place evenly throughout the year; b) Raw materials are carried in stock for one month and finished goods for half a month. c) The production cycle takes one month; d) There is a custom in market both for purchases of raw materials and sales of finished goods to give 2 months credit; e) 25% of sales are for cash and balance on credit; f) Cash on hand and at the bank estimated at Rs.25,000/Q.3) Solution Statement of estimation of working capital Particulars I.] CURRENT ASSET, L&A ? STOCK ? Raw materials ? WIP ? Finished goods ? DEBTORS ? CASH / BANK I]…. II.] CURRENT LIABILITIES & PROVISIONS :? Creditors II]…. Working capital (I – II) (+) Safety margin Estimated working capital ? (W.N 1) Raw materials (1 months) 720000 x 1 = 60000 12 ? (W.N 2) W.I.P (1month) Materials 720000 x 1 x 100% = 60,000 12 Labour 540000 x 1 x 50% = 22500 12 Expenses 180000 x 1 x 50% = 7500 12 90000 Note:- In absence of information, materials taken at 100% and labour and expenses at 50% ? (W.N 3) Finished goods (0.5 months) 1440000 x 0.5 = 60000 12
W.N.
Rs.
Rs.
1 2 3 4
60000 90000 60000
210000 225000 25000 460000 120000 120000 340000 340000
5
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? (W.N 4) Debtors (2 months) Credit Sales = 1800000 x 75% = 1350000 :. Debtors = 1350000 x 2 = 225000 12 Note:- Debtors have been valued at sales. Alternatively it can be valued at cost. ? (W.N 5) Creditors (2 months) 720000 x 2 = 12
120000
Q.4 From the following information of X Ltd., prepare a working capital statement for 2010: a) Cost Ratios for 2009: Materials 50% of sales Labour 20% of sales Overheads 10% of sales b) Production in 2009 was 50,000 units, and the same level of activity will be maintained. c) Raw materials are expected to remain in stores for an average period of one month before issued to production. d) Finished goods are to stay in warehouse for two months on an average. e) Raw materials will be in progress for one month on an average. f) Credit allowed by the suppliers will be one month. g) Debtors will be allowed 3 month’s credit from the date of sale of goods. h) Selling price per unit is Rs.50. i) Provide 15% of net current assets for margin of safety. Q.4 Solution Statement of Estimation of Working Capital. Particulars CURRENT ASSET, L&A STOCK ? Raw materials ? WIP ? Finished goods DEBTORS I]…. CURRENT LIABILITIES Creditors Working capital = Net Current Assets (I – II) (+) Safety margin (15% x 1156250) Estimated working capital W.N. Rs. Rs.
III.] ?
? IV.] ?
2 3 4 5
125000 156250 375000
656250 625000 1281250 125000 1156250 173438 1329688
6
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W.N.1) Cost statement for 50,000 units (1 year = 12 month) Particulars Raw Materials (50%) Labour (20%) Overheads (10%) Total Cost (+) Profit Sales ? (W.N 2) Raw materials (1 months) 1500000 x 1 = 125000 12 ? (W.N 3) W.I.P (1 month) Materials 1500000 x 1 x 100% = 12 Wages 500000 x 1 x 50% = 12 Overheads 250000 x 1 x 50% = 12 Rs. 1500000 500000 250000 2250000 250000 2500000 Rs. 25 10 5 45 5 50
125000 20833 10417 ______ 156250
Note: In W.I.P valuation material is taken at 100%, and labour, OHs at 50% ? (W.N 4) Finished goods (2 months) 2250000 x 2 = Rs.375000 12 ? (W.N 5) Debtors (3 months) 2500000 x 3 = Rs.625000 12 Note:- Debtors have been valued at sales. Alternatively it can be valued at cost. ? (W.N 6) Creditors (1 months) 1500000 x 1 = 125000 12 Q.5 The Board of Directors of Century Ltd. request you to prepare a statement showing the requirements of working capital for a forecast level of activity of 52,000 units in the ensuing year (52 weeks) from the following information made available:
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Cost Per Unit 400 150 200 100 850
Additional Information: i) ii) iii) iv) v) vi) vii) viii) ix) x) Selling Price Raw Material in Stock Work-in-progress Finished Goods in Stock Credit allowed to Debtors Credit allowed by Suppliers Cash at bank is expected to be Rs.50,000 All sales are on credit basis. All the activities are evenly spread out during the year. Debtors are to be valued at sales. -Rs.1,000 per unit -Average 4 weeks -Average 4 weeks -Average 4 weeks -Average 8 weeks -Average 4 weeks
Q.5 Solution Statement of Estimation of Working Capital. Particulars I.] CURRENT ASSET, L&A ? STOCK ? Raw materials ? WIP ? Finished goods ? DEBTORS ? Cash at bank I]…. II.] CURRENT LIABILITIES & PROVISIONS :? Creditors II]…. Working capital (I – II) (+) Safety margin Estimated working capital ? (W.N 1) Cost Statement for 1000 units (1 week) (52,000 / 52) Particulars Raw Materials D. Labour Overheads (M) Rs. CPU 400000 400 150000 150 200000 200 W.N. Rs. Rs.
2 3 4 5
1500000 2300000 3000000
6900000 8000000 50000 14950000 1600000 1600000 13350000 13350000
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Factory cost Overheads (S&D) Total Cost (+) Profit Selling Price
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750000 750 100000 100 850000 850 150000 150 1000000 1000
? (W.N 2) Raw materials (4 weeks) 400000 x 4 = 1600000 ? (W.N 3) W.I.P (4 weeks) Materials 400000 x 4 Labour 150000 x 4 OH/s (man) 200000 x 4
= = =
1600000 x 100% 600000 x 50% 5000 x 50%
= 1600000 = 300000 = 400000 = 2300000
Note :- In W.I.P evaluation it is assumed that materials is 100% & labour & OHs is 50% ? (W.N 4) Finished goods (4 weeks) 750000 x 4 = 3000000 Note:- Finished goods are valued on factory cost. ? (W.N 5) Debtors (8 weeks) 1000000 x 8 = 8000000 ? (W.N 6) Creditors (4 weeks) 400000 x 4 = 1600000
Q.6 A proforma cost sheet of a company is as follows: Elements of Costs Raw Material Direct Labour Overheads Total Cost Profit Selling Price The following particulars are available: Raw Materials are in stock on an average for one month. Materials are in process, on an average for half a month. Finished goods are in stock on an average for one month. Per Unit Rs. 80 30 60 170 30 200
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Credit allowed by suppliers is one month. Credit allowed to debtors is two months. Lag in payment of wages is 1 ½ weeks. Lag in payment of overheads is one month. One – fourth of the output is sold against cash. Cash on hand and at bank is to be maintained at 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 the production is carried on evenly throughout the year. Wages and overheads accrue evenly throughout the year and a time period of 4 weeks is equivalent to a month and 52 weeks in year. Q.6) Solution Particulars CURRENT ASSET, L&A STOCK ? Raw materials ? WIP ? Finished goods DEBTORS Cash on hand I]…. CURRENT LIABILITIES & PROVISIONS :Creditors Outstanding wages. Outstanding overheads II]…. Working capital (I – II)… (+) Safety margin Estimated working capital W.N. Rs. Rs.
I.] ?
? ? II.] ? ? ?
2 3 4 5
640000 500000 1360000 2500000 2400000 25000 4925000 640000 90000 480000 1210000 3715000 3715000
6 7 8
? (W.N 1) Cost Statement for 2000 units (1 week) (104000) 52 Particulars Raw Materials D. Labour OHs Total Cost (+) Profit Selling Price Rs. CPU 160000 80 60000 30 120000 60 340000 170 60000 30 400000 200
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? (W.N 2) Raw materials (4 weeks) 160000 x 4 = 640000 ? (W.N 3) W.I.P (2 weeks) Materials 160000 x 2 x 100% Labour 60000 x 2 x 50% Expenses 120000 x 2 x 50%
= = =
320000 60000 120000 500000
Note:- In W.I.P evaluation, materials taken at 100%, labour and O/Hs at 50% ? (W.N 4) Finished goods (4 weeks) 340000 x 4 = 1360000 ? (W.N 5) Debtors (8 weeks) Credit Sales = 400000 x ¾ = 300000 300000 x 8 = 2400000 Note:- Debtors are valued at sales. Alternatively it can be valued at cost. ? (W.N 6) Creditors (4 weeks) 160000 x 4 = 640000 ? (W.N 8) Outstanding Overheads (2 weeks) 120000 x 4 = 480000 ? (W.N 7) Outstanding wages (1.5 weeks) 60000 x 1.5 = 90000
Q.7 From the following data prepare a statement showing working capital requirements for the year, 2010: a) Estimated activity / operations for the year 1,30,000 units (52 weeks) b) Stock of raw materials 2 weeks and material in process for 2 weeks, 50% of wages and overheads are incurred. c) Finished goods 2 weeks storage. d) Creditors 2 weeks. e) Debtors 4 weeks. f) Outstanding wages and overheads 2 weeks each. g) Selling price per unit at Rs.15. h) Analysis of cost per unit is as follows: 1. Raw Material 33 1/3% of sales.
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2. Labour and Overheads in the ratio of 6 : 4 per unit. 3. Profit is at Rs.5 per unit. Assume that operations are evenly spread throughout the year. Q.7 Solution Particulars CURRENT ASSET, L&A STOCK ? Raw materials ? WIP ? Finished goods DEBTORS I]…. CURRENT LIABILITIES & PROVISIONS :Creditors Outstanding wages Outstanding Overheads II]…. Working capital (I – II) (+) Safety margin Estimated working capital W.N. Rs. Rs.
?
? I.] ? ? ?
2 3 4 5
25000 37500 50000
112500 150000 262500 25000 15000 10000 50000 212500 212500
6 7 8
? (W.N 1) Cost Statement for 2500 units (1 week) (130000 / 52) Particulars Raw Materials (15 x 1/3) Labour (6 : 4) Overheads Total Cost (+) Profit Selling Price ? (W.N 2) Raw materials (2 weeks) 12500 x 2 = 25000 ? (W.N 3) W.I.P (2 weeks) Materials 12500 x 2 x 100% Labour 7500 x 2 x 50% Expenses 5000 x 2 x 50%
Rs. 12500 7500 5000 25000 12500 37500
Rs. 5 3 2 10 5 15
= = =
25000 7500 5000 37500
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? (W.N 4) Finished goods (2 weeks) 25000 x 2 = 50000 ? (W.N 5) Debtors (4 weeks) 37500 x 4 = 150000 Note:- Debtors have been valued at sales. Alternatively it can be valued at cost. ? (W.N 6) ? (W.N 8) ? (W.N 7) Creditors (2 weeks) Outstanding Overheads (2 weeks) Outstanding wages (2 weeks) 25000 = 12500 x 2 5000 x 2 = 10000 7500 x 2 = 15000 (Q.8) A Factory produces 96,000 units during the year and sells them for Rs. 50 per unit. Cost structure of a product is as follows: Raw materials 60% Labour 15% Overheads 10% 85% Profit 15% . Selling Price 100% The following additional information is available. 1. The activities of purchasing, producing and selling occur evenly throughout the year. 2. Raw materials equivalent to 1 month’s supply is stored in godown. 3. The producing process takes 1 month. 4. Finished goods equal to three month production are carried in stock. 5. Debtors get 2 months credit. 6. Creditors allow 1 and ½ months credit. 7. Time lag in payment of wages and overheads in ½ month. 8. Cash and Bank Balance is to be maintained at 10% of the working capital. 9. 10% of the sales are made at 10% above the normal selling price. Draw a forecast of working capital requirements of the factory. Q.8 Solution Statement of estimation of working capital. Particulars II.] CURRENT ASSET, L&A ? STOCK ? Raw materials ? WIP ? Finished goods ? DEBTORS I]….
W.N.
Rs.
Rs.
2 3 4 5
240000 290000 102000 1550000 808000 235800
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III.] CURRENT LIABILITIES & PROVISIONS :? Creditors ? Outstanding Labour ? Outstanding Overheads II]…. (I – II) (+) Cash / Bank bal Working Capital
6 7 8
360000 30000 90 x 20000 10x 410000 100x 1948000 216444 2164444
W.N.1) Cost statement for 8000 units (1 month) 96000 12 Particulars Raw Materials (60%) Labour (15%) Overheads (10%) Total Cost (85%) (+) Profit Sales
Rs. CPU 240000 30 60000 7.5 40000 5 340000 42.5 64000 ? 404000 ?
*
10% 800 x (50+5) = 44000 ? (W.N 2) Raw materials (1 month) 240000 x 1 = Rs.240000 ? (W.N 3) W.I.P (1 month) Materials 240000 x 1 x 100% Labour 600000 x 1 x 50% OH/s (man) 400000 x 1 x 50%
+
90% 7200 x 50 = 360000
= = =
240000 30000 20000 290000
Note :- In W.I.P valn, material is taken at 100% and labour, OHs at 50% ? (W.N 4) Finished goods (3 months) 340000 x 3 = 1020000 ? (W.N 5) Debtors (2 months) 404000 x 2 = 808000
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Note :- Debtors have been valued at sales. Alternatively it can be valued at cost. ? (W.N 7) ? (W.N 6) O/s wages (0.5 month) Creditors (1.5 months) 60000 x 0.5 = Rs.30000 240000 x 1.5 = Rs.360000 ? (W.N 8) O/s Overheads (0.5 month) 40000 x 0.5 = Rs.20000
Q.9 Estimate the working capital requirements of a business firm on the basis of the following information: Raw Material Cost Rs.75 per unit Labour Rs.58.5 per unit Overhead Rs.15,00,000 p.a. Output and Sales 10,000 units per month Selling price Rs.150 per unit. Stock to be carried: Raw materials – 2 weeks production. Finished goods – 3 weeks supply. The debtors on an average take 2 ¼ months credit. Raw material is received in uniform deliveries daily and suppliers have to be paid at the end of the month the goods are received. Other trade creditors allow an average of 1½ months credit. Estimate the working capital for the month of March. Assume that a month is a four weeks period. Q.9 Solution Particulars CURRENT ASSET, L&A STOCK a. Raw materials b. Finished goods DEBTORS I]…. CURRENT LIABILITIES & PROVISIONS :Creditors Other trade creditors II]…. Working capital (I – II) (+) Safety margin Estimated working capital W.N. Rs. Rs.
I.] 1.
2. II.] 1. 2.
2 3 4
375000 10,95,000 14,70,000 33,75,000 48,45,000 3,75,000 10,65,000 14,40,000 34,05,000 34,05,000
5 6
? (W.N 1) Cost Statement for 2500 units (1 week) 10000 4 Particulars Rs. CPU
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187500 146250 31,250 3,65,000 10,000 375000
OHS / month = 1500000 12 = Rs.125000 OHS /week = 125000 4 = Rs.31250 ? (W.N 2) Raw materials (2 weeks) 187500 x 2 = 375000
? (W.N 3) Finished goods (3 weeks) 365000 x 3 = 1095000
? (W.N 4) Debtors (9 weeks) 375000 x 9 = 3375000 Note:- Debtors are valued at sales. Alternatively can be valued at cost. ? (W.N 5) ? (W.N 6) Other trade creditors (6 weeks) Creditors end of the month = ½ x 4 = 2 weeks. O/S wages 146250 x 6 = 877500 187500 x 2 = 3,75,000 O/S OHs 31250 x 6 = 187500. 1065000 Q.10 From the following information prepare a statement of Working Capital requirements of Rollover Ltd.: 1. Sales to customers Rs.4,50,000 per annum (at cost plus 50%). 2. Sales to retailers Rs.2,50,000 per annum (at cost plus 25%). 3. Sales to wholesalers Rs.4,80,000 per annum (at cost plus 20%). 4. Total cost of Rs.10 per unit. Raw materials and labour is 50% and 30% of the total cost. 5. Raw materials remain in stores for 2 months. 6. Processing period is one month. 7. Finished goods remain in stores for two months. 8. Sales to customers are on cash basis. Sales to retailers take one month for realisation. Credit allowed to wholesalers two months. 9. Suppliers for raw materials extend one month credit. 10. Minimum cash and bank balance required Rs.25,000. 11. Margin for safety 5%. Q.10 Solution Statement of Estimation of working capital
Particulars
W.N.
Rs.
Rs.
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I.] CURRENT ASSET, L&A ? STOCK a. Raw materials b. WIP c. Finished goods ? DEBTORS a. Retailers b. Wholesalers ? Cash at Bank I]…. II.] CURRENT LIABILITIES & PROVISIONS :1. Creditors II]…. Working capital (I – II)… (+) Safety margin Estimated working capital ? (W.N 1) Cost Statement for 90000 units (1yr = 12 month) Particulars Raw Materials Labour OHs Total Cost (+) Profit Selling Price
2 3 4 5 6
75000 56250 150000 20833 80000
281250
100833 25000 407083 37500 37500 369583 18479 388062
7
Rs. CPU 450000 5 270000 3 180000 2 900000 10 280000 ? 1180000 ?
W.N. 2) Raw materials (2 months) 450000 x 2 = 75000 12 W.N. 3) W.I.P (1 month) Materials 450000 x 1 x 100% 12 Labour 270000 x 1 x 50%
= =
37500 11250
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OHs
12 180000 x 1 x 50% 12
? (W.N 4) Finished goods (2 months) 900000 x 2 = 150000 12 ? (W.N 6) Debtors (Wholesalers) (2 months) 480000 x 2 = 80000 12 Note: Debtors have been valued at sales. Alternatively it can be valued at cost.
? (W.N 5) Debtors (Retailers) (1 month) 250000 x 1 = 20833 12 ? (W.N 7) Creditors (1 month) 450000 x 1 = 37500 12
(For more problems & solutions refer Himalaya Financial Management Pawan Jhabak book)
doc_321388543.pdf
Notes of FM
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CHAPTER: 1– INTRODUCTION TO FINANCIAL MANAGEMENT
SECTION I:- MEANING OF FINANCIAL MANAGEMENT Financial Management is broadly concerned with the mobilization and deployment of funds by a Business organization. For efficient operation of business, it is necessary to obtain and utilize the funds effectively. This job is done by Financial Management. According to Pawan Jhabak, “Finance is simply the art & science of managing money.” Basically therefore financial management centers around fund raising for Business in the most economical way and investing these funds in optimum way so that maximum returns can be obtained for the share holders. Practically all Business decision have financial implication. Hence, financial management is interlinked with all other functions of business. SECTION II:- SCOPE OF FINANCIAL MANAGEMENT
Forecasting Analysis of Economic Trends Analysis of Industries Trends Forecasting Financial requirement Profit planning Scope of Financial Management Financing Coordination Costing & control Acquiring Financial Measuring Funds Adjustment cost of capital Allocation Accounting Preparing of funds cost sheet Investment Budgeting Marginal of funds costing Ensuring availability of funds Reporting Decision making Financial Decision Investment Decision Management of income Dividend decision Meeting contingent liability Others Tax Management Fixed Assets management Inventory / Receivable management Corporate Governance Employment Benefits
Estimating ROI
Financial management is one of the important parts of overall management, which is directly related with various functional departments like personnel, marketing and production. Financial management covers wide area with multidimensional approaches. The following includes important scope of financial management. 1. Financial Management and Economics Economic concepts like micro and macroeconomics are directly applied with the financial management approaches. Investment decisions, micro and macro environmental factors are closely associated with the functions of financial manager. Financial management also uses the economic equations like money value discount factor, economic order quantity etc. Financial economics is one of the emerging area, which provides immense opportunities to finance, and economical areas.
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2. Financial Management and Accounting Accounting records includes the financial information of the business concern. Hence, we can easily understand the relationship between the financial management and accounting. In the olden periods, both financial management and accounting are treated as a same discipline and then it has been merged as Management Accounting because this part is very much helpful to finance manager to take decisions. 3. Financial Management and Mathematics Modern approaches of the financial management applied large number of mathematical and statistical tools and techniques. They are also called as econometrics. Economic order quantity, discount factor, time value of money, present value of money, cost of capital, capital structure theories, dividend theories, ratio analysis and working capital analysis are used as mathematical and statistical tools and techniques in the field of financial management. 4. Financial Management and Production Management Production management is the operational part of the business concern, which helps to multiply the money into profit. Profit of the concern depends upon the production performance. Production performance needs finance, because production department requires raw material, machinery, wages, operating expenses, etc. 5. Financial Management and Marketing Produced goods are sold in the market with innovative and modern approaches. For this, the marketing department needs finance to meet their requirements. The financial manager or finance department is responsible to allocate the adequate finance to the marketing department. 6. Financial Management and Human Resource Financial management is also related with human resource department, which provides manpower to all the functional areas of the management SECTION III:- FUNCTION OF FINANCIAL MANAGEMENT Function / Role of Financial Management / Manager and how have they change in recent years. Ans:Role of financial management / manager Sources / Mobilization of funds Application / deployment of funds (Financial decision ) ( Investment decisions ) 1. Proprietors Funds 1. Fixed Assets Share capital (Capital Budgeting) Reserve & surplus 2. Borrowed Fund 2. Investments (capital structure) (Treasury Management) (cost of capital) 3. Net current Assets (Dividend policy) (Working capital management) The twin aspects procurement & effective utilization of funds are the crucial tasks, which the financial manager faces. The financial manager is required to look into financial implication of
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any decision in a firm. The finance manager has to manage funds in such a way as to make their optimum utilization & to ensure that their procurement is in a manner so that the risk, cost & control considerations are properly balanced under a given situation. Functions of Finance Manager ? Estimating the requirement of fund. ? Decision regarding capital structure. ? Investment decision. ? Dividend decision. ? Working capital management / liquidity function. ? Maintaining financial procedures & system etc 1) Estimating The Requirement Of Funds: In a business the requirements of funds have to be carefully estimated. Certain funds are required for long term purpose i.e. investments in fixed assets etc. certain funds are required for short term purpose i.e. Working Capital. A careful estimation of such funds & the timing of requirement must be made. Forecasting the requirements of funds involves the use of technique of budgetary control. Estimates of requirements of fund can be made only if all physical activities of the organization have been forecasted. 2) Decisions Regarding Capital Structure: Once the requirements of funds have been estimated, decisions regarding various sources form where these funds would be raised have to be taken. Finance manager has to carefully look into existing capital structure and see how the various proposals of raising funds will affect it. He has to maintain a proper balance between long-term funds and short-term funds. Long-term funds raised from outsiders have to be in a certain proportion with the funds procured from the owner. He has to see that capitalization of company is such that company is able to procure funds in future also. All such decisions are ‘financing decisions’. 3) Investment Decision: Funds procured from different sources have to be invested in various kinds of assets. Investments of funds in a project have to be made after careful assessment of the various projects through capital budgeting. A part of long-term funds is also to be kept for financing working capital requirement. The production manager’s &-finance manager keeping in view the requirement of production, future price estimates of raw material & availability of funds would determine inventory policy. 4) Dividend Decision: Finance manager is concerned with the decision to pay or declare dividend. He has to assist management in deciding as to what amount of profit should be retained in business & this depends on whether the company can make a more profitable use of funds. But in practice trend of earning, share market prices; requirement of funds for future growth, cash flow situation, expectation of shareholders has to be kept in mind while deciding dividend. 5) Working Capital Management / Liquidity Function: The financial manager has to properly manage current assets such as cash, inventory and Accounts Receivable. He has to ensure a trade off between liquidity and profitability. He has to ensure efficient utilization of every current assets and also overall working capital involved in current assets. Adequate
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level of current assets is necessary to maintain required level of liquidity of funds. On the other hand if the funds are idle the profitability may be low. Therefore the financial manager has to maintain a proper balance between liquidity and profitability. It includes cash management & receivable management. 6) Maintaining Financial Procedures & Systems: This includes procedures established for the effective execution of the other functions. Budgetary accounting, record keeping and management information system (MIS) & corporate Governance are integral part of any organization. In the last few years, the complexion of the economic and financial environment has altered in many ways. Therefore the role of finance manager has changed from Mobilisation and deployment of funds to profit planning, maximizing shareholder wealth, understanding capital markets and good corporate Governance. These changes have made the job of the finance manager more important, complex and demanding.
Functions of Financial Manager SECTION IV:- OBJECTIVES OF FINANCIAL MANAGEMENT
Discuss wealth maximization and shareholder value maximization as objectives of financial management. Or corporate houses today are increasingly moving towards wealth maximization, comment on this movement. Or the objective of financial management is ‘wealth maximisation & not profit maximisation’. Comment Ans:-
Objectives of Financial Management
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Clear objectives are required for wise decision-making. Objectives provide a framework for optimum financial decision-making. Two of the most widely discussed approaches are: Profit maximization approach Wealth maximization approach Profit Maximization Decision Criteria: Under this approach, actions that increase profits should be undertaken and those that decrease profits are to be avoided. In specific operational terms, the profit maximization criterion implies that the investment, financing and dividend policy decisions of a firm should be oriented towards the maximization of profits. The rationable behind profit maximization as a guide to financial decision making, is due to following reasons. ? Profit is a test of economic efficiency. It provides the yardstick by which economic performance can be judged. ? It leads to efficient allocation of resources tend to be directed to uses, which in terms of profitability are the most desirable. ? It ensures maximum social welfare. This is so because the quest for value drives scarce resources to their most productive uses and their most efficient users. The more effectively resources are deployed, the more robust will be the economic growth and the rate of improvement in the standard of living. The profit maximization criterion however has been questioned and criticized on several grounds. It suffers from the following limitations: ? Profit in absolute terms is not a proper guide to decision making. It has no precise connotation. It can be expressed either on a per share basis or in relation to investment. Also, profit can be long term or short term, before tax or after tax, it may be the return on total capital employed or total assets or shareholders equity and so on. If profit maximization is taken to be the objective which of these variants of profit should a firm try to maximize? Therefore, a loose term like profit cannot from the basis of operational criterion for financial management. ? It leaves considerations of timing and duration undefined. There is no guide for comparing profit now with profit in future or for comparing profit streams of different durations. ? It Ignores Risk Factor. It cannot, for example, discriminate between an investment project, which generates a certain profit of Rs.50 Lakhs and an investment project, which has a variable / uncertain profit outcome of Rs.50 Lakhs. Wealth Maximization Decision Criterion: This is also known as value maximization or net present worth maximization. The focus of financial management is on the value to the owners or suppliers of equity capital. The wealth of the owners is reflected in the market value of the shares. So wealth maximization implies the maximization of the market price of shares. It has been universally accepted as an appropriate operational decision criterion for financial management decisions as it removes the technical limitations, which characterise the earlier profit maximization criterion. Its operational features satisfy all the three requirements of a suitable operational objective of financial courses of action,
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namely exactness, quality of benefits and the time value of money. Maximization of the wealth of shareholders (as reflected in the market value of equity) appears to be the most appropriate goal for financial decision-making. Wider than profit maximization is the principle of corporate governance. The fundamental objective of corporate governance is the “the enhancement of the long -term shareholder value while at the same time protecting the interests of other stakeholders.” As such, this definition emphasizes the need for a company to strike a balance at all times between the need to enhance shareholders” wealth and protecting the interest of other stakeholders in the company such as suppliers, customers, creditors, bankers, employees of the company, government and society at large. If these factors are ignored, a company cannot survive for long. Profit maximization at the cost of social and moral obligations is a short-sighted policy. Hence, it is commonly agreed that the objective of a firm is to maximize its value or wealth. Value is represented by the market price of the company’s common stock. The market price of a firm’s stock represents the judgment of all market participants as to what the value of the particular firm is. The market price serves as a performance index of the firm’s progress; it indicates how well management is doing on behalf of shareholders. An increasingly popular measure of wealth is EVA (Economic Value Added). Economic Value Added (EVA) can be defined as the net operating profit that a company earns above its cost’s of capital. It is a trademark of Stern Stewart & Co. EVA can be calculated as follows:
EVA = Net operating profit after taxes – {Weighted average cost of capital X Cap. invested}
Conceptually, EVA is superior as a measure of value creation because it recognizes the cost of capital and, hence, the riskiness of a firm’s operations. There is a st rong correlation between EVA and the market price of a company’s stock. Maximizing any accounting profit or accounting rate of return as a way of increasing shareholder’s wealth often leads to an undesired outcome. Therefore, wealth maximisation should be the objective of financial management since it: ? Considers risk. ? Uses Cash flows and not profits. ? Considers Time value of money. ? Implies taking care of Interest of both shareholders and other stakeholders (Corporate governance). Describe Agency Problem in Achievement of Objectives of Financial Management Ans:A characteristic feature of corporate enterprise is the separation between ownership and management as a corollary of which the latter enjoys substantial autonomy in regard to the affairs of the firm. With widely diffused ownership, scattered and ill-organised shareholders
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hardly exercise any control/influence on management, which may be inclined to act in its own interests rather than those of the owners. However shareholders as owners of the enterprise have the right to change the management. Due to the threat of being dislodged for poor performance, the management would have a natural inclination to achieve a minimum acceptable level of performance, to satisfy the shareholders requirements/goals, while focussing primarily on their own personal goals. Thus in furtherance of their objective of survival, management would aim at satisfying instead of maximising shareholders’ wealth. However, the conflicting goals of management objective of survival and maximizing owners value/wealth can be harmonised by. 1. Incentives To Management: The incentive to management is of various types. Some of them are follows: ? Stock options: Confer on management the right to acquire shares of the enterprise at a special / concessional price. ? Performance shares are given based on the performance of the management. ? Cash bonus-linked to specified performance targets 2. Monitoring of Managers: ? Auditing financial statements and limiting decision making by the management. The audit and control procedures and limiting managerial decisions are intended to ensure that the actions of management sub serve the interests of shareholders. ? Rotation of Audit Partners. SECTION V:- ACCOUNTING PRINCIPLES Even though a financial manager is not an accountant, he must be familiar with various accounting principles (GAAPs) to make good decisions: Monetary Measurement: Accountants do not account for items unless they can be quantified in monetary terms. Items that are not accounted for (unless someone is prepared to pay something for them) include things like market leadership, brand recognition, goodwill etc. Entity: This convention seeks to ensure that private transactions and matters relating to the owners of a business are segregated from transactions that related to the business. Even transactions of owners with business are recorded in books of company. Materiality: The preparation of accounts involves a high degree of judgement. Where decisions are required about the appropriateness of a particular accounting judgement, the “materiality” convention suggests that this should only be an issue if the judgement is “significant” or “material” to a user of the accounts. The concept of “materiality” is an important issue for auditors of financial accounts. Going Concern: Accountants assume, unless there is evidence to the contrary, that a company will continue operations in the foreseeable future. This has important implications for the valuation of assets and liabilities. Consistency: Transactions and valuation methods are treated the same way from year to year, or period to period. Users of accounts can, therefore, make more meaningful comparisons of
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financial performance from year to year. Where accounting policies are changed, companies are required to disclose this fact and explain the impact of any change in notes to Accounts. Prudence / Conservatism: Profits are not recognised until a sale has been completed. In addition, a cautious view is taken for future problems and cost of business (they are “provided for” in the accounts” as soon as their is a reasonable chance that such costs will be incurred in the future. Eg. Depreciation, provision for bad debts) Future probable Loss is to be provided in Current period but future probable Income should not be recorded in current period, according to principle of conservatism. Matching / Accruals: Income should be properly “matched” with the expenses of a given accounting period, to ascertain profitability. It also implies long term asset should be funded through long term source of finance & short term asset through short term sources of finance. (For more details (theory) refer Himalaya Financial Management Pawan Jhabak book)
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CHAPTER: 2– ESTIMATION OF WORKING CAPITAL
WORKING CAPITAL = CURRENT ASSETS – CURRENT LIABILITIES Working capital is defined as the excess of current assets over current liabilities. It identifies the relatively liquid portion of the total capital which constitutes a margin for maturing obligations within the ordinary operating cycle of the business. SECTION I: COMPONENTS OF WORKING CAPITAL CURRENT ASSETS (LOANS AND ADVANCES) SHORT TERM ASSETS These are those real assets which are intended to be disposed off and get it converted into money / money’s worth within a period of 12 months. Examples: ? Closing Stock (RM, WIP, Finished Goods) ? Sundry Debtors ? Bills Receivable ? Cash in Hand and Bank ? Pre-paid Expenses ? Loans Given ? Advance to Suppliers, etc. CURRENT LIABILITIES (AND PROVISIONS) SHORT TERM LIABILITIES These are those outsiders liabilities which are payable within a period of 12 months. Examples: ? Sundry Creditors ? Bills Payable ? O/S Expenses ? Advance from Customers ? Tax Payable ? Bank Overdraft, etc. Working Capital is also known as circulating capital, fluctuating capital and revolving capital. The magnitude and composition of working capital keeps on changing continuously, in the course of business. FORMAT – STATEMENT OF ESTIMATION OF WORKING CAPITAL Particulars a) Current Assets, (Loans & Advances) b) Current Liabilities (& Provisions) Working Capital ( a-b) W.N. Rs. Rs. XXX XXX XXX
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(+) Safety Margin Estimated Working Capital
SECTION II :- WORKING CAPITAL CYCLE Alternatively known as ‘Operating Cycle Concept’ of working capital. This concept is based on the continuity of flow of funds through business operations. This flow of funds is caused by different operational activities during a given period of time. The operational activities of an organization may comprise of : ? Purchase Of Raw Materials ? Conversation Of Raw Materials Into Finished Products ? Sale Of Finished Products and ? Realization Of Accounts Receivable
WORKING CAPITAL CYCLE The time that elapses between the purchase of raw materials and the collection of cash for sales is referred to as the operating cycle, whereas the time length between the payment for the raw material purchases and the collection of cash for sales is referred to as the cash cycle. The operating cycle is the sum of the inventory period and the accounts receivable period, whereas the cash cycle is equal to the operating cycle less the accounts payable period. Material cost is partly covered by trade credit from suppliers and successive operational activities also generate cash flow. If the flow continues without any interruption, operational activities of the company will also continue smoothly. Movement of cash through the above processes is called ‘circular flow of cash’. The period required to complete this flow is called ‘the operating period’ or ‘the operating cycle’. To the estimate the working capital required, the number of operating cycles in a year is to be calculated. This is calculated by dividing the number of days in a year by the length of the cycle. Total operating cost of a year divided by the number of operating cycles in that year is the amount of working capital required. OPERATING CYCLE = R + W + F + D – C
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R = RM Holding Period W = Processing Period F = FG Holding Period D = Debtors Collection Period C = Creditors Payment Period The operating cycle can be shortened by the following means. Raw Materials Procurement One should have a good supply network. This means that he should have a supplier who can provide him with his raw material requirement at the right time, place and in the required quantity at the minimum amount of time. Thus this also implies that he should be in possession of automated machines in case the raw materials are large and bulky. This helps in reducing the time required for transport and movement of the goods from one place to another. Production Process In the production process their should not be any time lag from the time of actually receiving the raw materials and the starting of production process. This means as soon as the materials arrive they should be introduced in the production process. This therefore meant that the company will be following the just in time policy (JIT) which simply means that the requirements of the company will be fulfilled at the time required thus reducing the work in progress and thus increasing the efficiency of the company. Finished Goods The goods once produced should not be held in the company’s possession for a longer duration as the company’s capital would be locked up in these goods. Thus it is essential that the company sell all these finished goods as soon as possible so as to allow the company reacquires its capital employed in the operating cycle. Receipt of Sales The receipts of the money from the debtors as soon as possible so as to regain the money along with the profits. This is how the operating cycle operates along with and how it can be improved so as to enable the company to regain the money invested in the production of the goods. E.g. Tata Motors Ltd. has adopted path breaking steps to reduce its operating cycle in ‘Nano Project’ SECTION III - PROJECTION OF WORKING CAPITAL REQUIREMENTS ? ? ? ? ? ? Determine level of activity Estimate raw materials cost per unit & total Estimate labour and overheads cost per unit & total Estimate work-in-progress period Estimate finished goods period Estimate sundry debtors collection period
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Estimate cash/bank balance Estimate sundry creditors payment period Estimate creditors for expenses Determine safety margin
FACTORS DETERMINING WORKING CAPITAL REQUIREMENTS All firms do not have the same working capital needs. It depends on several factors, which are listed as follows. 1. Nature and size of business:- The working capital requirement of a firm is closely related to the nature of the business. We can say that trading and financial firms have less investment in fixed assets but require a large some of money to be invested in working capital. Also, a firm with a large scale of operation will obviously require more working capital than the smaller firm. 2. Method of Production:- Whether the company follows job, batch or flow production also affect working capital requirement. Also is Production Labour Intensive or Capital Intensive affects working capital requirement. 3. Manufacturing cycle:- It starts with the purchase and use of raw materials and completes with the production of finished goods. Longer the manufacturing cycle larger will be working capital requirement, this is seen mostly in the industrial products. 4. Business cycles:- When there is an upward swing in the economy sales will increase, and also the firm’s investment in inventories and book debts will increase, thus it will increase the working capital requirement of the firm and vice-versa. 5. Production policy:- To maintain an efficient level of production the firms may resort to normal production even during the slack season. These will lead excess production and hence the funds will be blocked in the form of inventories for a long time, hence provisions should be made accordingly. 6. Firm’s credit policy:- If the firm has liberal credit policy, its funds will remain blocked for long time in form of debtors and vice-versa. Normally, industrial goods manufacturing will have a liberal policy whereas dealers of consumer goods will have a tight credit policy. [e.g. L&T vs HUL] 7. Availability of credit:- If the firm gets credit on liberal terms, it will require less working capital since it can always pay its creditors later and vice-versa. 8. Growth and expansion activities:- It is difficult precisely to determine the relationship between volumes of sales and need for working capital. The need for working capital does not follow the growth but precedes it. Hence, if the firm is planning to increase its business activities, it needs to plan its working capital requirements during the growth period. (e.g classic failure - Subhiksha & Success Pantaloons Ltd.
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9. Conditions of supply of raw material and stock policy:- If the supply of raw material is scarce the firm may need more working capital to stock up on the inventory. The decision to follow JIC and JIT is also a factor. 10. Profit margin and profit appropriation:- A high net profit margin contributes towards the working capital and results into lower requirement for working capital (e.g. Infosys Ltd.) Also, tax liability is unavoidable and hence provision for its payment must be in the working capital plan, otherwise it may impose a strain on the working capital. 11. Price level changes:- Changes the price level due to inflation or other reason also affect the requirement of working capital. Rising prices necessitate the use of more funds for maintaining an existing level of activity. Rising prices will require higher level of working capital and vice-versa. 12. Dividend policy:- Also if the firm’s policy is it to retain profits it will increase their funds available for working capital and if they decide to pay their dividends it will weaken their working capital position, as the cash flows out. So dividend policy of the Company is a important factor affecting requirement of working capital. 13. Depreciation policy:- The depreciation of the firm, through the effect on tax liability and retained earnings, has an influence on the working capital. The firm may charge a high rate of depreciation, which will reduce the tax payable. Thus depreciation is an indirect way of retaining profits and preserving the firm’s working capital position. SECTION IV – TYPES / CLASSIFICATION OF WORKING CAPITAL 1. Gross Working Capital and Net Working Capital Gross Working Capital:Gross Working Capital is equal to total current assets only. It is identified with currents assets alone. It is the value of non – fixed assets of an enterprise and includes inventories (raw materials, work-in progress, finished goods, stores and spare), receivables, short term investments, advances to suppliers, loans, short term deposits, sundry deposits with excise and customs, cash and bank balance, prepaid expenses, income receivable, etc. Gross Working Capital indicated the quantum of working capital available to meet current liabilities. Thus, Gross Working Capital = Current Assets Net Working Capital = CA – CL Net Working Capital is the excess of current assets over current liabilities, i.e. current assets less current liabilities. This concept of working capital is widely accepted. This approach, however, does not reflect the exact position of working capital due to the following factors:
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Valuation of inventories include write – offs Debtors include the profit element Debts outstanding for more than a year, likewise debtors which are doubtful or not provided for are included as asset and are also place under the head ‘current assets’ Non - moving and slow moving items of inventories are also included in inventories.
To assess the real strength of working capital position, it is necessary to exclude the non moving and obsolete items from inventories etc. Working Capital thus arrived at is termed as “Tangible Working Capital” 2. Permanent and Temporary Working Capital Considering time as the basis of classification, there are two types of working capital viz, ‘Permanent’ and ‘Temporary’. Permanent working capital represents the assets required on continuing basis over the entire year, whereas temporary working capital represents additional assets required at different times during the operation of the year. A firm will finance its seasonal and current fluctuations in business operations through short term debt financing. For example, in peak seasons more raw materials are to be purchased, more manufacturing expenses are to be incurred, so more funds will be locked in inventory debtors balances etc. In such times excess requirement of working capital would be financed from short-term financing sources. The permanent component of current assets that are required throughout the year will generally be financed from long-term debt and equity. Tandon Committee has referred to this type of working capital as ‘Core Current Assets’. Core Current Assets are those required by the firm to ensure the continuity of operations that represents the minimum levels of various items of current assets viz., stock of raw materials, stock of work-in-progress, stock of finished goods, debtor’s balances, cash and bank etc. This minimum level of current assets will be financed by the longterm sources and short-term financing will finance any fluctuations over the minimum level of current assets. Sometimes core current assets are also referred to as ‘hard core working capital’. The management of working capital is concerned with maximizing the return of shareholders within the accepted risk constraints carried by the participants in the company. Just as excessive long-term debts puts a company at risk, so an excessive quantity of short-term debt also increases the risk to a company by straining its solvency. The suppliers of permanent working capital look for long-term return on funds invested whereas the suppliers of temporary working capital will look for immediate return and the cost of such financing will also be costlier than the cost of permanent funds used for working capital. 3. Core Assets and Non Core Assets Core Assets:- The part of a company's business that is central to its overall strategy and typically generates the bulk of its revenues. In other words, essential asset for a business: an asset without which a business cannot carry on its main activity is Core Asset. 'Item of intrinsic value' Core assets of an organisation comprise those that the organisation is unable to dispense with in order to operate.
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Non core-assets:- Assets no longer used in the ordinary business operations of a company. They are likely to be sold in the near future, if the need for cash arise. That part of company’s assets which do not generate significant revenue / profitability, is called non core asset. 4. Negative and Zero working capital Negative working capital : Internet based bookseller Amazon.com manages its cash cycle extremely well. It turns its inventory over 25 times a year, making its inventory period very short. It charges its customer’s credit card when it ships a book and it gets paid by the credit card firm usually in a day. Finally, it takes about 45 days to pay the suppliers. All this means that Amazon.com has a negative cash cycle / working capital i.e. current liabilities are more than Current Assets. Zero Working Capital : Many leading companies seek to have zero (or even negative) working capital. This happens when inventories and receivables are supported by the credit provided by suppliers and the advances given by customers. On average, working capital to sales ratio is about 0.20. Reducing working capital has two financial benefits: (i) every rupee released by reduced working capital makes a one-time contribution to cash flow, and (ii) periodically, the cost of money locked in working capital is saved. Apart from the financial benefits, reducing working capital results into a company to serve its customers quickly, lessens warehousing needs, reduces obsolescence costs, and increases profit etc. (For more details (theory) refer Himalaya Financial Management Pawan Jhabak book) SECTION V – PROBLEMS AND SOLUTIONS Q.1 You are required to prepare a statement showing the working capital required to finance the level of activity of 18,000 units per year from the following information: Per unit Rs. Raw Materials 12 Direct Labour 3 Overheads 9 Total Cost 24 Profit 6 Selling Price 30 a) Raw materials are in stock on an average for two months; b) Materials are in process an average for half a month; c) Finished goods are in stock on an average for two months; d) Credit allowed by creditors is two months of raw materials supplied; e) Credit allowed to debtors is three months; f) Lag in payment of wages is half month; g) Cash on hand and at Bank expected to be Rs.7,000/You are informed that all activities are evenly spread out during the year. Q.1 Solution.
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Statement of estimation of working capital. Particulars I. CURRENT ASSET, L&A ? STOCK ? Raw materials ? Work in progress ? Finished goods ? DEBTORS ? CASH / BANK I]…. II. ? ? CURRENT LIABILITIES & PROVISION :Creditors Outstanding wages II]…. Working Capital (I – II) (+) Safety margin Estimated Working Capital
W.N.
Rs.
Rs.
2. 3. 4. 5.
36000 13500 72000
121500 135000 7000 263500
6. 7.
36000 2250 38250 225250 225250
? W.N. 1) Cost statement for 18000 units (1 year = 12 months) Particulars Raw materials Direct labour Overheads Total cost Profit Selling price ? W.N. 2) Raw materials (2 months) 216000 X 2 = 36000. 12 ? W.N. 3) W.I.P. (0.5 month) Raw material . Direct labour 216000 X 0.5 X 100% = 9000 12 54000 X 0.5 X 50% = 1125 12 162000 X 0.5 X 50% 12 = 3375 13500 Rs. 216000 54000 162000 432000 108000 540000 C.P.U. 12 3 9 24 6 30
Overheads
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Note:In absence of information it is assumed that raw material is 100% and labour & overheads is 50%. ? W.N. 4) Finished goods (2 months) 432000 X 2 = 72000. 12 ? W.N. 5) Debtors (3 months) 540000 X 3 = 135000 12 Note:- Debtors have been valued at sales. Alternatively it can been valued at cost. ? W.N. 6) Creditors (2 months) 216000 X 2 = 36000. 12 W.N. 7) 7) ? W.N. Outstanding wages (0.5 months) 54000 X X 0.5 = 2250. 12 12
Q.2 From the following information prepare a statement showing the working capital required to finance a level of activity of 2,400 units per annum. Production and sales will be uniform throughout the year. a) Selling price Rs.500 per unit. b) Materials constitute 50% of selling price, Wages 15% of selling price and Overheads 25% of selling price. c) Raw materials stock required one month. d) Work in progress to be maintained for one month. Valuation to be made at materials cost plus 50% of wages and overheads. e) Finished Goods stock to be maintained for three months. f) Credit allowed to customers one month and credit allowed by suppliers two months. g) Bank Balance to be maintained Rs.20,000. Q.2) Solution Statement of estimation of working capital Particulars I.] CURRENT ASSET, L&A ? STOCK ? Raw materials ? WIP ? Finished goods ? DEBTORS ? Bank balance I]…. II.] CURRENT LIABILITIES & PROVISIONS :Creditors
W.N.
Rs.
Rs.
2 3 4 5
50000 70000 270000
390000 100000 20000 510000 100000
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II]…. :. Working capital (I – II) (+) Safety margin Estimated working capital ? (W.N 1) Cost statement for 200 units (1month) (2400 / 12) Particulars Raw Materials (50%) Labour (15%) Overheads (25%) Total Cost (+) Profit Selling Price ? (W.N 2) Raw materials (1 months) 50000 x 1 = 50000 ? (W.N 3) W.I.P (1 month) Materials 50000 x 1 x 100% Wages 15000 x 1 x 50% Overheads 25000 x 1 x 50% ? (W.N 4) Finished goods (3 months) 90,000 x 3 = 270000 ? (W.N 5) Debtors (1 months) 100000 x 1 = 100000 Note:- Debtors have been valued at sales. Alternatively it can be valued at cost. ? (W.N 6) Creditors (2 months) 50000 x 2 = 100000
Rs. 50000 15000 25000 90000 10000 100000
Rs. 250 75 125 450 50 500
= = =
50000 7500 12500 70000
Q.3 From the following information, prepare a statement showing the working Capital requirements: The Budgeted Profit and Loss Account for the year 2010-2011 is as under: Rs. Sales Less: Materials Labour Expenses 7,20,000 5,40,000 180000 Rs. 1800000
1440000 360000
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Additional Information: a) The production and sales take place evenly throughout the year; b) Raw materials are carried in stock for one month and finished goods for half a month. c) The production cycle takes one month; d) There is a custom in market both for purchases of raw materials and sales of finished goods to give 2 months credit; e) 25% of sales are for cash and balance on credit; f) Cash on hand and at the bank estimated at Rs.25,000/Q.3) Solution Statement of estimation of working capital Particulars I.] CURRENT ASSET, L&A ? STOCK ? Raw materials ? WIP ? Finished goods ? DEBTORS ? CASH / BANK I]…. II.] CURRENT LIABILITIES & PROVISIONS :? Creditors II]…. Working capital (I – II) (+) Safety margin Estimated working capital ? (W.N 1) Raw materials (1 months) 720000 x 1 = 60000 12 ? (W.N 2) W.I.P (1month) Materials 720000 x 1 x 100% = 60,000 12 Labour 540000 x 1 x 50% = 22500 12 Expenses 180000 x 1 x 50% = 7500 12 90000 Note:- In absence of information, materials taken at 100% and labour and expenses at 50% ? (W.N 3) Finished goods (0.5 months) 1440000 x 0.5 = 60000 12
W.N.
Rs.
Rs.
1 2 3 4
60000 90000 60000
210000 225000 25000 460000 120000 120000 340000 340000
5
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? (W.N 4) Debtors (2 months) Credit Sales = 1800000 x 75% = 1350000 :. Debtors = 1350000 x 2 = 225000 12 Note:- Debtors have been valued at sales. Alternatively it can be valued at cost. ? (W.N 5) Creditors (2 months) 720000 x 2 = 12
120000
Q.4 From the following information of X Ltd., prepare a working capital statement for 2010: a) Cost Ratios for 2009: Materials 50% of sales Labour 20% of sales Overheads 10% of sales b) Production in 2009 was 50,000 units, and the same level of activity will be maintained. c) Raw materials are expected to remain in stores for an average period of one month before issued to production. d) Finished goods are to stay in warehouse for two months on an average. e) Raw materials will be in progress for one month on an average. f) Credit allowed by the suppliers will be one month. g) Debtors will be allowed 3 month’s credit from the date of sale of goods. h) Selling price per unit is Rs.50. i) Provide 15% of net current assets for margin of safety. Q.4 Solution Statement of Estimation of Working Capital. Particulars CURRENT ASSET, L&A STOCK ? Raw materials ? WIP ? Finished goods DEBTORS I]…. CURRENT LIABILITIES Creditors Working capital = Net Current Assets (I – II) (+) Safety margin (15% x 1156250) Estimated working capital W.N. Rs. Rs.
III.] ?
? IV.] ?
2 3 4 5
125000 156250 375000
656250 625000 1281250 125000 1156250 173438 1329688
6
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W.N.1) Cost statement for 50,000 units (1 year = 12 month) Particulars Raw Materials (50%) Labour (20%) Overheads (10%) Total Cost (+) Profit Sales ? (W.N 2) Raw materials (1 months) 1500000 x 1 = 125000 12 ? (W.N 3) W.I.P (1 month) Materials 1500000 x 1 x 100% = 12 Wages 500000 x 1 x 50% = 12 Overheads 250000 x 1 x 50% = 12 Rs. 1500000 500000 250000 2250000 250000 2500000 Rs. 25 10 5 45 5 50
125000 20833 10417 ______ 156250
Note: In W.I.P valuation material is taken at 100%, and labour, OHs at 50% ? (W.N 4) Finished goods (2 months) 2250000 x 2 = Rs.375000 12 ? (W.N 5) Debtors (3 months) 2500000 x 3 = Rs.625000 12 Note:- Debtors have been valued at sales. Alternatively it can be valued at cost. ? (W.N 6) Creditors (1 months) 1500000 x 1 = 125000 12 Q.5 The Board of Directors of Century Ltd. request you to prepare a statement showing the requirements of working capital for a forecast level of activity of 52,000 units in the ensuing year (52 weeks) from the following information made available:
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Raw Material Direct Labour Overheads Manufacturing Overheads Selling and Distribution
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Cost Per Unit 400 150 200 100 850
Additional Information: i) ii) iii) iv) v) vi) vii) viii) ix) x) Selling Price Raw Material in Stock Work-in-progress Finished Goods in Stock Credit allowed to Debtors Credit allowed by Suppliers Cash at bank is expected to be Rs.50,000 All sales are on credit basis. All the activities are evenly spread out during the year. Debtors are to be valued at sales. -Rs.1,000 per unit -Average 4 weeks -Average 4 weeks -Average 4 weeks -Average 8 weeks -Average 4 weeks
Q.5 Solution Statement of Estimation of Working Capital. Particulars I.] CURRENT ASSET, L&A ? STOCK ? Raw materials ? WIP ? Finished goods ? DEBTORS ? Cash at bank I]…. II.] CURRENT LIABILITIES & PROVISIONS :? Creditors II]…. Working capital (I – II) (+) Safety margin Estimated working capital ? (W.N 1) Cost Statement for 1000 units (1 week) (52,000 / 52) Particulars Raw Materials D. Labour Overheads (M) Rs. CPU 400000 400 150000 150 200000 200 W.N. Rs. Rs.
2 3 4 5
1500000 2300000 3000000
6900000 8000000 50000 14950000 1600000 1600000 13350000 13350000
6
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Factory cost Overheads (S&D) Total Cost (+) Profit Selling Price
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750000 750 100000 100 850000 850 150000 150 1000000 1000
? (W.N 2) Raw materials (4 weeks) 400000 x 4 = 1600000 ? (W.N 3) W.I.P (4 weeks) Materials 400000 x 4 Labour 150000 x 4 OH/s (man) 200000 x 4
= = =
1600000 x 100% 600000 x 50% 5000 x 50%
= 1600000 = 300000 = 400000 = 2300000
Note :- In W.I.P evaluation it is assumed that materials is 100% & labour & OHs is 50% ? (W.N 4) Finished goods (4 weeks) 750000 x 4 = 3000000 Note:- Finished goods are valued on factory cost. ? (W.N 5) Debtors (8 weeks) 1000000 x 8 = 8000000 ? (W.N 6) Creditors (4 weeks) 400000 x 4 = 1600000
Q.6 A proforma cost sheet of a company is as follows: Elements of Costs Raw Material Direct Labour Overheads Total Cost Profit Selling Price The following particulars are available: Raw Materials are in stock on an average for one month. Materials are in process, on an average for half a month. Finished goods are in stock on an average for one month. Per Unit Rs. 80 30 60 170 30 200
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Credit allowed by suppliers is one month. Credit allowed to debtors is two months. Lag in payment of wages is 1 ½ weeks. Lag in payment of overheads is one month. One – fourth of the output is sold against cash. Cash on hand and at bank is to be maintained at 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 the production is carried on evenly throughout the year. Wages and overheads accrue evenly throughout the year and a time period of 4 weeks is equivalent to a month and 52 weeks in year. Q.6) Solution Particulars CURRENT ASSET, L&A STOCK ? Raw materials ? WIP ? Finished goods DEBTORS Cash on hand I]…. CURRENT LIABILITIES & PROVISIONS :Creditors Outstanding wages. Outstanding overheads II]…. Working capital (I – II)… (+) Safety margin Estimated working capital W.N. Rs. Rs.
I.] ?
? ? II.] ? ? ?
2 3 4 5
640000 500000 1360000 2500000 2400000 25000 4925000 640000 90000 480000 1210000 3715000 3715000
6 7 8
? (W.N 1) Cost Statement for 2000 units (1 week) (104000) 52 Particulars Raw Materials D. Labour OHs Total Cost (+) Profit Selling Price Rs. CPU 160000 80 60000 30 120000 60 340000 170 60000 30 400000 200
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? (W.N 2) Raw materials (4 weeks) 160000 x 4 = 640000 ? (W.N 3) W.I.P (2 weeks) Materials 160000 x 2 x 100% Labour 60000 x 2 x 50% Expenses 120000 x 2 x 50%
= = =
320000 60000 120000 500000
Note:- In W.I.P evaluation, materials taken at 100%, labour and O/Hs at 50% ? (W.N 4) Finished goods (4 weeks) 340000 x 4 = 1360000 ? (W.N 5) Debtors (8 weeks) Credit Sales = 400000 x ¾ = 300000 300000 x 8 = 2400000 Note:- Debtors are valued at sales. Alternatively it can be valued at cost. ? (W.N 6) Creditors (4 weeks) 160000 x 4 = 640000 ? (W.N 8) Outstanding Overheads (2 weeks) 120000 x 4 = 480000 ? (W.N 7) Outstanding wages (1.5 weeks) 60000 x 1.5 = 90000
Q.7 From the following data prepare a statement showing working capital requirements for the year, 2010: a) Estimated activity / operations for the year 1,30,000 units (52 weeks) b) Stock of raw materials 2 weeks and material in process for 2 weeks, 50% of wages and overheads are incurred. c) Finished goods 2 weeks storage. d) Creditors 2 weeks. e) Debtors 4 weeks. f) Outstanding wages and overheads 2 weeks each. g) Selling price per unit at Rs.15. h) Analysis of cost per unit is as follows: 1. Raw Material 33 1/3% of sales.
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2. Labour and Overheads in the ratio of 6 : 4 per unit. 3. Profit is at Rs.5 per unit. Assume that operations are evenly spread throughout the year. Q.7 Solution Particulars CURRENT ASSET, L&A STOCK ? Raw materials ? WIP ? Finished goods DEBTORS I]…. CURRENT LIABILITIES & PROVISIONS :Creditors Outstanding wages Outstanding Overheads II]…. Working capital (I – II) (+) Safety margin Estimated working capital W.N. Rs. Rs.
?
? I.] ? ? ?
2 3 4 5
25000 37500 50000
112500 150000 262500 25000 15000 10000 50000 212500 212500
6 7 8
? (W.N 1) Cost Statement for 2500 units (1 week) (130000 / 52) Particulars Raw Materials (15 x 1/3) Labour (6 : 4) Overheads Total Cost (+) Profit Selling Price ? (W.N 2) Raw materials (2 weeks) 12500 x 2 = 25000 ? (W.N 3) W.I.P (2 weeks) Materials 12500 x 2 x 100% Labour 7500 x 2 x 50% Expenses 5000 x 2 x 50%
Rs. 12500 7500 5000 25000 12500 37500
Rs. 5 3 2 10 5 15
= = =
25000 7500 5000 37500
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? (W.N 4) Finished goods (2 weeks) 25000 x 2 = 50000 ? (W.N 5) Debtors (4 weeks) 37500 x 4 = 150000 Note:- Debtors have been valued at sales. Alternatively it can be valued at cost. ? (W.N 6) ? (W.N 8) ? (W.N 7) Creditors (2 weeks) Outstanding Overheads (2 weeks) Outstanding wages (2 weeks) 25000 = 12500 x 2 5000 x 2 = 10000 7500 x 2 = 15000 (Q.8) A Factory produces 96,000 units during the year and sells them for Rs. 50 per unit. Cost structure of a product is as follows: Raw materials 60% Labour 15% Overheads 10% 85% Profit 15% . Selling Price 100% The following additional information is available. 1. The activities of purchasing, producing and selling occur evenly throughout the year. 2. Raw materials equivalent to 1 month’s supply is stored in godown. 3. The producing process takes 1 month. 4. Finished goods equal to three month production are carried in stock. 5. Debtors get 2 months credit. 6. Creditors allow 1 and ½ months credit. 7. Time lag in payment of wages and overheads in ½ month. 8. Cash and Bank Balance is to be maintained at 10% of the working capital. 9. 10% of the sales are made at 10% above the normal selling price. Draw a forecast of working capital requirements of the factory. Q.8 Solution Statement of estimation of working capital. Particulars II.] CURRENT ASSET, L&A ? STOCK ? Raw materials ? WIP ? Finished goods ? DEBTORS I]….
W.N.
Rs.
Rs.
2 3 4 5
240000 290000 102000 1550000 808000 235800
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III.] CURRENT LIABILITIES & PROVISIONS :? Creditors ? Outstanding Labour ? Outstanding Overheads II]…. (I – II) (+) Cash / Bank bal Working Capital
6 7 8
360000 30000 90 x 20000 10x 410000 100x 1948000 216444 2164444
W.N.1) Cost statement for 8000 units (1 month) 96000 12 Particulars Raw Materials (60%) Labour (15%) Overheads (10%) Total Cost (85%) (+) Profit Sales
Rs. CPU 240000 30 60000 7.5 40000 5 340000 42.5 64000 ? 404000 ?
*
10% 800 x (50+5) = 44000 ? (W.N 2) Raw materials (1 month) 240000 x 1 = Rs.240000 ? (W.N 3) W.I.P (1 month) Materials 240000 x 1 x 100% Labour 600000 x 1 x 50% OH/s (man) 400000 x 1 x 50%
+
90% 7200 x 50 = 360000
= = =
240000 30000 20000 290000
Note :- In W.I.P valn, material is taken at 100% and labour, OHs at 50% ? (W.N 4) Finished goods (3 months) 340000 x 3 = 1020000 ? (W.N 5) Debtors (2 months) 404000 x 2 = 808000
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Note :- Debtors have been valued at sales. Alternatively it can be valued at cost. ? (W.N 7) ? (W.N 6) O/s wages (0.5 month) Creditors (1.5 months) 60000 x 0.5 = Rs.30000 240000 x 1.5 = Rs.360000 ? (W.N 8) O/s Overheads (0.5 month) 40000 x 0.5 = Rs.20000
Q.9 Estimate the working capital requirements of a business firm on the basis of the following information: Raw Material Cost Rs.75 per unit Labour Rs.58.5 per unit Overhead Rs.15,00,000 p.a. Output and Sales 10,000 units per month Selling price Rs.150 per unit. Stock to be carried: Raw materials – 2 weeks production. Finished goods – 3 weeks supply. The debtors on an average take 2 ¼ months credit. Raw material is received in uniform deliveries daily and suppliers have to be paid at the end of the month the goods are received. Other trade creditors allow an average of 1½ months credit. Estimate the working capital for the month of March. Assume that a month is a four weeks period. Q.9 Solution Particulars CURRENT ASSET, L&A STOCK a. Raw materials b. Finished goods DEBTORS I]…. CURRENT LIABILITIES & PROVISIONS :Creditors Other trade creditors II]…. Working capital (I – II) (+) Safety margin Estimated working capital W.N. Rs. Rs.
I.] 1.
2. II.] 1. 2.
2 3 4
375000 10,95,000 14,70,000 33,75,000 48,45,000 3,75,000 10,65,000 14,40,000 34,05,000 34,05,000
5 6
? (W.N 1) Cost Statement for 2500 units (1 week) 10000 4 Particulars Rs. CPU
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Raw Materials D. Labour OHs Total Cost (+) Profit Selling Price
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187500 146250 31,250 3,65,000 10,000 375000
OHS / month = 1500000 12 = Rs.125000 OHS /week = 125000 4 = Rs.31250 ? (W.N 2) Raw materials (2 weeks) 187500 x 2 = 375000
? (W.N 3) Finished goods (3 weeks) 365000 x 3 = 1095000
? (W.N 4) Debtors (9 weeks) 375000 x 9 = 3375000 Note:- Debtors are valued at sales. Alternatively can be valued at cost. ? (W.N 5) ? (W.N 6) Other trade creditors (6 weeks) Creditors end of the month = ½ x 4 = 2 weeks. O/S wages 146250 x 6 = 877500 187500 x 2 = 3,75,000 O/S OHs 31250 x 6 = 187500. 1065000 Q.10 From the following information prepare a statement of Working Capital requirements of Rollover Ltd.: 1. Sales to customers Rs.4,50,000 per annum (at cost plus 50%). 2. Sales to retailers Rs.2,50,000 per annum (at cost plus 25%). 3. Sales to wholesalers Rs.4,80,000 per annum (at cost plus 20%). 4. Total cost of Rs.10 per unit. Raw materials and labour is 50% and 30% of the total cost. 5. Raw materials remain in stores for 2 months. 6. Processing period is one month. 7. Finished goods remain in stores for two months. 8. Sales to customers are on cash basis. Sales to retailers take one month for realisation. Credit allowed to wholesalers two months. 9. Suppliers for raw materials extend one month credit. 10. Minimum cash and bank balance required Rs.25,000. 11. Margin for safety 5%. Q.10 Solution Statement of Estimation of working capital
Particulars
W.N.
Rs.
Rs.
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I.] CURRENT ASSET, L&A ? STOCK a. Raw materials b. WIP c. Finished goods ? DEBTORS a. Retailers b. Wholesalers ? Cash at Bank I]…. II.] CURRENT LIABILITIES & PROVISIONS :1. Creditors II]…. Working capital (I – II)… (+) Safety margin Estimated working capital ? (W.N 1) Cost Statement for 90000 units (1yr = 12 month) Particulars Raw Materials Labour OHs Total Cost (+) Profit Selling Price
2 3 4 5 6
75000 56250 150000 20833 80000
281250
100833 25000 407083 37500 37500 369583 18479 388062
7
Rs. CPU 450000 5 270000 3 180000 2 900000 10 280000 ? 1180000 ?
W.N. 2) Raw materials (2 months) 450000 x 2 = 75000 12 W.N. 3) W.I.P (1 month) Materials 450000 x 1 x 100% 12 Labour 270000 x 1 x 50%
= =
37500 11250
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OHs
12 180000 x 1 x 50% 12
? (W.N 4) Finished goods (2 months) 900000 x 2 = 150000 12 ? (W.N 6) Debtors (Wholesalers) (2 months) 480000 x 2 = 80000 12 Note: Debtors have been valued at sales. Alternatively it can be valued at cost.
? (W.N 5) Debtors (Retailers) (1 month) 250000 x 1 = 20833 12 ? (W.N 7) Creditors (1 month) 450000 x 1 = 37500 12
(For more problems & solutions refer Himalaya Financial Management Pawan Jhabak book)
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