introductory portion on wc

8/3/2019 Introductory Portion on WC

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**Cash Flows versus Accounting Profits**

Case of Mr. K. Rao: How to go broke while making a profit?On January 1, 2001, Mr. K. Rao of K. Rao & Company had Rs. 27,500, in the following form:

Cash Rs. 10,000; Inventory Rs. 7,500; and Accounts Receivable Rs. 10,000As the year progressed, his company was in fine shape. His company made a popular product, priced

at Rs.10.00 per unitjust what the customers wanted. The production of this unit cost him Rs 7.50 perunit. He made a profit of Rs. 2.50 per unit. His policy was to keep an inventory of one months supply

(30 days supply), make a prompt payment of his suppliers bills and he billed his own customers, 30days net. Sales were right on target, as given below, with the sales manager predicting a steady

increase every month. It felt like his lucky year.

(1) In January, he produced and sold 1,000 units of his product, shipped them to his customers on 30days net terms, collected his dues on the previous balance of Accounts Receivables and made a decent

profit on sales.

(2) In the month of February sales jumped as budgeted to 1,500 units. With a corresponding step-up in

production to maintain his 30 days supply in inventory, he made 2000 units at a cost of Rs.15, 000. Allreceivables from January sales were collected.

(3) March sales were even better, 2000 units. Collections are on time. Production to adhere to hispolicy of 30 days sales in inventory is 2500 units. Profits are increasing satisfactorily, along with the

sales.

(4) In April, sales jumped further by 500 units, to 2,500 units. Rao decides to publicly acknowledgethe sales managers performance. He notes that his customers are also paying in time. Production is

pushed up to 3,000 units now to create further challenge for the marketing team since it sounds soconfident. Rao talks to the travel agency for booking him on a long awaited vacation.

(5) The month of May proves that the marketing teams confidence was well placed. The company is

able to make a sale of 3,000 units. The marketing department makes a recommendation to push theproduction during the month to 3,500 units now. Raos quick calculation tells him that the profit graph

is rising. The travel agency has booked him on a vacation to Ooty for which he packs his bags andleaves.

(6) Hardly three days into his vacation, he suddenly gets a call from his treasurer, Come home. Weneed money to run the operations. Rao cuts his holiday short, returns on May 31, and finds that there

is no money at all in his cash box. His accounts books seem to have caught up with him.

What do you think has happened to his business when everything seemed to be working so well allthese months? Please use this space for your conceptual reasoning.


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Sample Problems on Working capital: Estimating Working Capital Needs

Q.1. You are supplied with the following information for the coming year:Production for the coming year 60,000 unitsFinished Goods in store, 3 monthsRaw materials in store, 2 months consumption

Production process 1 monthCredit allowed by creditors, 2 monthsCredit allowed to Sundry debtors, 3 monthsSelling price per unit, Rs. 50Raw materials, 50 % of the selling priceDirect wages, 10% of the selling priceManufacturing and administrative overheads, 16% of the selling priceSelling overheads, 4% of the selling price

There is a regular production and sales cycle and wages overhead accrue evenly. Wages andoverheads are paid in the next month of accrual. Material is introduced at the beginning of theproduction cycle. Conversion costs (wages, manufacturing costs, overheads) are assumed to beequivalent of 50% to determine WIP; and all sales are credit sales equivalent to the unitsproduced. Determine the working capital requirements of the company for the coming year.

Suggested Solution: (Current Asset holding period Method) In terms of the Amount.

tem Volume per month Holding time Rate in Rs. Amount in Rs.

1. R.M. 5000 units 2 months 25.00 250,000.00

2. W-I-P 5000 units 1 month 31.50 157,500.00

3. F.G. 5000 units 3 months 38.00 570,000.00

4. A/R, 5000 Units 3 months 40,00 600,000.00

5. Total GWC 1,577,500.00

Support from:

1. A/P 5000 units 2 months 25.00 250,000.00

2. Wages 5000 units 1 month 5.00 25,000.00

3. Overheads 5000 Units 1 month 8.00 40,000.00

Total Support 315,000.00NWC (GWC-support)

1,262,500.00

Note: Depreciation has been excluded from the above working. Similarly, the profit margin of Rs. 10/- perunit has been excluded in the working of the blockage of funds in A/R. Thus, it is truly a cash-to-cashcycle.

What are the factors which influence the working capital for a business enterprise? Can you think of thesame?


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Q.2 The Working Capital: Calculations of the Operating Cycle. (In Number of days)

The data for the year 2005-06 for JKL Company shows the following amount in Lakhs of

Rupees:

Items Opening Balance Closing Balance

1. Raw Materials, Stores and Spares 13,819.36 16,381.642. Work-in-process 224.60 290.00

3. Finished Goods 2,551.68 4,130.964. Accounts Receivables 3,025.80 4,665.28

5. Accounts Payables 10,016.72 12,349.88

6. Purchase of Raw Materials, spares & Stores 42,704.407. Manufacturing Expenses 4,587.04

8. Depreciation 990.889. Customs & Excise Duties 1, 40,102.24

10. Selling, Administration & financial Expenses 18,269.9211. Sales 2, 16,842.60

Calculate and show the computations for the following, assuming 360 days for the year:

(a) Raw Material Storage period,(b) Average Conversion or work-in-process period

(c) Finished Goods storage period(d) Average Collection period

(e) Average payments period(f) The Gross Operating Cycle Period

(g) The Net Operating Cycle period.(h) What would be the impact on the gross operating cycle and net operating cycle if

the management planned to reduce the inventory holding period by 25% acrossthe board?

Q.3 From the following data, compute the operating cycle in days:

Period covered 360 days.Average period of credit allowed by suppliers 16 days

Average debtors outstanding Rs. 480,000Raw material Consumption Rs, 4,400,000

Total Production costs Rs. 10,000,000Total cost of sales Rs. 10,500,000

Sales for the year Rs. 16,000,000Value of the average stock maintained:

Raw material Rs. 320,000Work-in-process Rs. 350,000

Finished Goods Rs. 260,000


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Q.4 Illustrative problem on operating cycle of business and impact on working capitalrequirements (Amount in Lakhs of Rupees):

Item Actual for yr. 2008 Projected for yr. 2009

1. Purchase of Raw material (Credit) 4653 6091

2. Opening Raw Material Inventory 523 827

3. Closing Raw Material Inventory 827 986

4. Raw Material Consumed 4349 5932

5. Direct Labour 368 498

6. Depreciation 82 90

7. Other Manufacturing expenses 553 704

8. Total costs 5352 7224

9. Opening WIP Inventory 185 325

10. Closing WIP Inventory 325 498

11. Costs of Production 5212 7051

12. Opening FG Inventory 317 526

13. Closing FG Inventory 526 995

14. Costs of Goods sold 5003 658215. Selling, Adm. Expenses 304 457

16. Cost of Sales 5307 7039

Sales and Debtors and Creditors

Sales (Credit) 6087 8006

Opening Balance A/R 545 735

Closing Balance A/R 735 1040

Opening Balance A/P 300 454

Closing Balance A/P 454 642

Requirements: (Assume a normal 365-day year for the purpose of calculations).

1. Compute RM Conversion period2. Compute WIP Conversion period

3. Compute FG Conversion period4. Compute Receivables Conversion period

5. Compute Payables Conversion period6. Compute Gross Operating Cycle in days

7. Compute Net Operating Cycle in days


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SolutionsQ.2 Cost sheet for JKL CompanyItem Actual for yr. 2008

1. Purchase of Raw material (Credit) 42704.40

2. +Opening Raw Material Inventory 13819.36

3. -Closing Raw Material Inventory 16381.64

4. =Raw Material Consumed (1+2-3) 40142.12

5. +Direct Labour 00.00

6. +Depreciation 990.88

7. +Other Manufacturing expenses 4587.04

8. =Total costs (4+5+6+7) 45720.04

9.+ Opening WIP Inventory 224.60

10.- Closing WIP Inventory 290.00

11. =Costs of Production(8+9-10) 45654.64

12. +Opening FG Inventory 2551.68

13. +Customs and Excise Duties 140102.24

14.= COGAS (11+12+13) 188308.56

15. -Closing FG Inventory 4130.9616. =COGS (14-15) 184177.60

17. +Selling, Adm. Overhead Expenses 18269.92

18. =Cost of Sales (16+17) 202447.52

Sales and Debtors and Creditors

Sales (Credit) 216842.60

Opening Balance A/R 3025.80

Closing Balance A/R 4665.28

Opening Balance A/P 10016.72

Closing Balance A/P 12349.88


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Q.2. JKL Company Operating Cycle (Rs. Lakhs, except for holding days)Items Data for 2005-2006 No. of Days

1. Raw Material Conversion Period

(a) Raw Material Consumption 40142.12

(b) Raw Material consumption per day 111.505

(c) Average Raw Material Inventory 15100.50

(d) Raw Material Inventory holding days (c/b) 135.4200

2. Work in Process Conversion period

(a) Cost of production including Depreciation 45654.64

(b) Cost of production per day 126.8184

(c) Average Work-in-process Inventory 257.30

(d) Work-in-Process Inventory holding days 2.0200

3. Finished Goods Conversion period

(a) Cost of Goods Sold including Depreciation 184177.60

(b) Cost of Goods Sold per day 511.6044(c) Average Finished Goods Inventory 3341.32

(d) Finished Goods Inventory holding period 6.5310

4. Collection period

(a) Credit sales (*At Cost of Sales or Sales Price?) 216842.60

(b) Sales per day 602.3405

(c) Average Accounts Receivables 3845.54

(d) Accounts Receivables outstanding days 6.3843

5. Credit Deferral period

(a) Credit purchases 42704.40

(b) Purchases per day 118.6233(c) Average Creditors (A/P) 11183.30

(d) Accounts Payables outstanding days 94.2757

Summary of Operating Cycle CalculationsItem No. of Days

1. Inventory Conversion period (d) of (1+2+3) above 143.9710

2. A/R Conversion period 6.3843

3. Gross Operating Cycle (1+2) 150.3553

4. Payment Deferral period 94.2757

5. Net Operating Cycle (3-4) 56.0796

Note: 1. The above computations have been based on average data for both current assets and

liabilities, and 360 days in a year. Depreciation and Profits are also both included in the working.


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Q.4 (Rs. Lakhs, except for holding days)Items Data for 2008 Data for 2009

1. Raw Material Conversion Period

(a) Raw Material Consumption 4349.00 5932.00

(b) Raw Material consumption per day 11.9150 16.2520

(c) Average Raw Material Inventory 675.00 906.5

(d) Raw Material Inventory holding days 56.65 days 55.78 days

2. Work in Process Conversion period

(a) Cost of production including Depreciation 5212.00 7051.00

(b) Cost of production per day 14.28 19.32

(c) Average Work-in-process Inventory 255.00 411.50

(d) Work-in-Process Inventory holding days 17.86 days 21.30 days

3. Finished Goods Conversion period

(a) Cost of Goods Sold (* or At cost of sales?) 5003.00 6582.00

(b) Cost of Goods Sold per day 13.71 18.03(c) Average Finished Goods Inventory 421.50 760.50

(d) Finished Goods Inventory holding period 30.74 days 42.17 days

4. Collection period

(a) Credit sales (*At Cost of Sales or Sales Price?) 6087.00 8006.00

(b) Sales per day 16.68 21.93

(c) Average Accounts Receivables 640.00 887.50

(d) Accounts Receivables outstanding days 38.37 days 40.47 days

5. Credit Deferral period

(a) Credit purchases 4653.00 6091.00

(b) Purchases per day 12.75 16.69(c) Average Creditors (A/P) 377 548

(d) Accounts Payables outstanding days 29.57 days 34.63 days

Summary of Operating Cycle CalculationsItem No. of Days

1. Inventory Conversion period (d) of (1+2+3) above 105.25 119.25

2. A/R Conversion period 38.37 40.47

3. Gross Operating Cycle (1+2) 143.62 159.72

4. Payment Deferral period 29.57 34.63

5. Net Operating Cycle (3-4) 114.05 125.09

Note: 1. The per-day calculations are based on 365 days in a year.

2. The average figures have been considered in the above working and not the yearend data alone. Depreciation and profits are also included in the working.


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Estimating the Working Capital Needs through other methods:

y Ratio of Sales. (For example, 25%-35% of annual sales)

y Ratio of Fixed Investment (For example, 10%-20% of Fixed capital Investment)

Risk-Return Trade-off in maintaining a particular level of Current Assets:

If the firm maintains excessive levels of current assets, it leads to costs of liquidity or also calledas Carrying costs. These are reduced rates of return, (decline in profitability because funds

remain locked up in inventory or debtors and earn nothing). Starting from a low cost at lowlevels of liquidity, this cost can rise significantly and become very high as liquidity levels

become excessive.

If the firm maintains low levels of current assets or insufficient current assets, then it may lead tocosts of illiquidity or also known as shortage costs. These are increasing stock-outs, inability to

meet supplier or customer demands, loss of business to competitors who may extend more credit,

affecting creditworthiness adversely. These can be very high at the low levels of liquidity.

The firm should try to balance these two costswith opposing characteristics of behavior--- in

such a way that the total costs are minimized. This is the point of optimum level of currentassets.

introductory portion on wc

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