Management Accounting

1. Week two
Working Capital

2. ESTIMATION OR FORECASTING OF WORKING CAPITAL
Forecasting of Working Capital refers to the estimation of Working Capital Requirement for
a certain future period. It is made so as to indicate the amount of Working Capital
required for the future period and the sources from which the required amount of
Working Capital can be financed.
Following factors should be taken into consideration for the estimation of Working Capital
Requirement:
i. Expected annual production quantity.
ii. Cost of raw materials, wages and overheads per unit of the product.
iii. Raw materials holding period in store before use.
iv. Production-processing period.
v. Finished goods storage period before sale.
vi. Credit period allowed to sundry debtors for credit sales.
vii. Credit period received from the sundry creditors against the credit purchases of raw
materials.

3. viii. Lag in the payment of wages and overheads.
ix. Management policy regarding inclusion of profit element into Working Capital blocked in the
amount due from debtors.
x. Amount of cash to be kept in hand for contingencies.
PROCEDURE FOR ESTIMATION/FORECASTING OF WORKING CAPITAL
The following steps are to be followed for the estimation or forecasting of Working Capital
Requirement:
i. Calculation of average production: The average estimated production per period (i.e.,
per day or per week or per month) is to be calculated first.
ii. Calculation of average cost and sales: Secondly, the average cost of each element of
cost as well as the total cost per period is to be calculated—that is, the cost of material, wages
and overhead per day or per week or per month and the total cost per month to be calculated.
The profit per period is to be added to the total cost per period so as to get the sales per
period.

4. iii. Calculation of period of block: The period of block of each element of cost, such as materials, wages
and overheads in the operating cycle, are to be separately calculated, that is, the cost of materials
blocked in the store, in the production process, in the finished goods and in the debtors; wages and
overhead costs blocked in the production process, in the finished goods and in the debtors; and the
profit blocked in the debtors, if the profit element of Working Capital is considered.
iv. Calculation of Working Capital Requirement:
Firstly, the Working Capital Requirement for each element of cost (i.e., for materials, labor and
overheads) is to be separately calculated at Different stages of the operating cycle (i.e., in store,
production process, finished goods and debtors) by multiplying their respective average cost per
period with the period of block at the respective stages of the operating cycle. If any credit period is
allowed by the suppliers of materials and if there is any time lag for the payment of wages and
overheads, then the Working Capital not required for such credit period is to be deducted from the
Working Capital Requirement for materials, wages and overheads, respectively.

5. Finally, the Working Capital Requirements for each element of cost as calculated in the above are
to be added to get the total Working Capital Requirement without any profit. If the profit blocked in
debtors is considered, then the amount of profit blocked per period is to be calculated by
multiplying the amount of profit blocked per period with the credit period allowed to debtors, which
is to be added to the total Working Capital Requirement without any profit as calculated in the
above to get the total Working Capital Requirement with the profit. If any cash balance is required
to be kept in hand, then that amount is to be added to the total Working Capital Requirement with
profit, as calculated in the above to get the ‘Net Working Capital Requirement with profit and cash
balance.’
VALUATION OF STOCK OF WORK-IN-PROGRESS (WIP)
As the degree of completion of the stock of WIP cannot be specifically known, it is valued on the
assumption that it is completed up to 100% of the raw materials, 50% of the wages and 50% the
of overheads. As the stock of WIP as mentioned above, 50% of the amount blocked per period
(i.e., per day or per week or per month) in wages and overheads are to be taken for ascertaining
the Working Capital that is required for wages and overheads, considering the period of block per
period in wages and overheads in full.

6. Alternatively, the periods of block for wages and overheads could be taken at 50% of the normal
period, considering the amount blocked per period in wages and overheads in full. But the Working
Capital required for materials in WIP is to be taken as usual, that is, the full period of block of
materials with the full amount blocked in the materials per period.
CONSTITUENTS OF WORKING CAPITAL
There are two main components of Working Capital. These are—Current Assets, Current
Liabilities.
1. Current Assets: Current Assets are those assets which are convertible into cash within a
period of one year and are required to meet the day-to-day operations of the business.
The value of Current Assets usually does not undergo any change in value during its life
span. Current Assets comprise the following:
● Inventory or Stock
■ Raw Materials
■ Work-in Progress (WIP)
■ Consumable Stores or Spares
■ Finished Goods

7. • Sundry Debtors
 Bills Receivable
 Short-term Loans and Advances
 Marketable Securities (Short-term)
 Cash in Hand
 Cash at Bank
 Prepaid Expenses
 Accrued Income
Current Liabilities: Current Liabilities are those liabilities which are to be settled within a time span of
one year in the normal course of business. Current Liabilities are the short-term obligations, which
are paid off from the Current Assets or from the funds of the business. The following are some of the
items of Current Liabilities:
● Sundry Creditors
● Bills Payable
● Short-term Loans and Advances
● Bank Overdraft
● Proposed Dividend
● Outstanding Expenses
● Provision for Taxation
● Unclaimed Dividend

8. The difference between the Current Assets and the Current Liabilities is called Net Working Capital. To
arrive at the figure for Net Working Capital, if there are some adjustments then that should be duly
made. For example, the amount of obsolete stock, if any, should be deducted from the inventory item
to arrive at a net figure of inventory. Likewise, if any provision for debtor is there then that should be
taken. Similarly, if some amount is set aside from the cash balance for the redemption of debentures,
preference shares, etc. then that should also be accounted for.
Net Working Capital is the difference between Current Assets and Current Liabilities. It is the excess of
Current Assets over Current Liabilities. It is a narrow concept. The Balance Sheet Approach to Net
Working Capital states Net Working Capital as:
Net Working Capital = Total Current Assets – Total Current Liabilities
Net Working Capital is the qualitative concept of Working Capital.
Net Working Capital indicates the liquidity position of a firm, i.e. its ability to repay short-term debt
obligations or Current Liabilities. Current ratio to measure the liquidity position of a firm is determined
by the following formula:
Current Ratio = Current Assets
Current Liabilities

9. The current ratio is usually taken as 2:1 (It may be noted in this context that this figure varies from industry
to industry). Current ratio indicates the current asset backing for every rupee of Current Liabilities.
Net Working Capital can be positive or negative. Net Working Capital is the excess of Current Assets over
Current Liabilities. If we deduct the amount of total Current Liabilities from the total Current Assets we get
the figure for Net Working Capital.
Symbolically, it is represented as follows:
Net Working Capital = ∑Current Assets – ∑Current Liabilities
If total Current Assets are more than total Current Liabilities, then it is the positive Working Capital. It can
be expressed as follows:
Positive Working Capital: ∑Current Assets > ∑ Current Liabilities
When total Current Assets are less than total Current Liabilities or Current Liabilities are greater than
Current Assets then it is known as negative Working Capital. It can be expressed as:
Negative Working Capital: ∑ Current Assets < ∑ Current Liabilities

10. Net Working Capital measure offers the following advantages:
1. It indicates the liquidity position of the firm.
2. It indicates the ability of a firm to meet its short-term debt obligations.
3. It is the assurance for the creditors regarding their dues.
4. It indicates the viability of a business financially.
Apart from these, there is another concept of ‘Zero Working Capital’. Zero Working Capital arises in situations
where,
∑ Current Assets = ∑ Current Liabilities
Nature of Working Capital Management
Working Capital management is an important aspect of every business. It is essential for
the survival of the business and ensures smooth and uninterrupted operations of a business
without any sort of fund crisis.

11. The nature of Working Capital management has been stated as follows:
1. Management of current assets and liabilities: Working Capital management is concerned with the
management of Current Assets and Current Liabilities. The excess of Current Assets over Current
Liabilities is the Net Working Capital. The Net Working Capital represents the fund of the business.
2. Circulating capital: Working Capital is also known as circulating or revolving capital since it circulates
within the organization in the normal course of business, i.e. say, cash converted into stock, stock to
bills receivable and bills receivable into cash again.
3. Cyclic in nature: Working Capital rotates in the organization in a cyclic manner, e.g. cash as the
component of a current asset. Its outflow occurs with the purchase of raw materials, payment to
labor, meeting expenses, etc. Again when goods produced are sold at credit to the debtors, Cash
Inflow occurs when the cash is realized.
4. Cash inflow and outflow: The inflow of cash—one of the components of Current Assets—replaces the
Cash Outflows, till that investment of cash is to be continued.
5. Increase and decrease of current assets: The increase in investment in Current Assets implies increase
in Working Capital, whereas a decrease in investment in Current Assets implies a decrease in Working
Capital.

12. 6. Forecasting: Working Capital management is concerned with the estimation of Working Capital needs,
management of each component of Current Assets—determining the amount to be invested in Current
Assets, examining each component of Working Capital.
7. Liquidity management: The higher amount of Working Capital leads to a lower Return on Investment,
whereas a lower amount of Working Capital indicates liquidity crisis or fund crunch to repay short-term debt
obligations.
8. Source of finance: Working Capital can be financed from long-term and short-term sources. Permanent
regular Working Capital can be financed by long-term sources, whereas temporary Working Capital can be
financed by short-term sources.
Objectives of Working Capital Management
Working Capital management is concerned with the management of Current Assets and Current Liabilities.
Working Capital management is essential to maintain a satisfactory level of Working Capital in order to avoid a
financial crisis.
Both excess and inadequate Working Capital exert an evil influence on the health of a company. So neither
excess Working Capital nor inadequate Working Capital is desirable. Hence management of Working Capital is
an important aspect. The objectives of Working Capital management are as follows:

13. 1. Management of current assets and liabilities: The prime objective of Working Capital management is the
management of Current Assets and Current Liabilities so that there is neither excess Working Capital nor
inadequate Working Capital, i.e. there is a satisfactory level of Working Capital.
2. Assessing liquidity and profitability: There should be a proper balance between liquidity and profitability
and hence Working Capital management targets at balancing profitability and liquidity by maintaining a
satisfactory level of Working Capital.
3. Proper balance among different components: There should be a proper balance between different
components of Working Capital. For example, if the amount of stock is high it may be the fact that there
exists a huge amount of obsolete stock. The ideal acid test ratio of the firm should be 1:1. Acid test ratio is
measured as:
Current Assets - Stock - Prepaid Expenses
Current Liabilities - Bank Overdraft
4. Maintain optimum cash level: The optimum level of cash balance should be maintained so that there is
neither excessive cash in hand or at bank nor insufficient cash in hand or at bank because excessive cash in
hand or bank indicates the inability of the firm to utilize resources for the profitable and productive purpose,
whereas insufficient cash indicates funds crisis. So management of Working Capital is essential.

14. Examine soundness of company: Working Capital management in an effective and efficient manner ensures
higher profitability, balanced liquidity position and sound health of the company.
EFFECTS OF EXCESSIVE WORKING CAPITAL
Optimum amount of Working Capital should be maintained within the firm, so that there is neither excessive
Working Capital nor inadequate Working Capital. Excessive Working Capital or inadequate Working Capital
both has an evil effect on the growth of a firm.
The evil effects of excessive Working Capital have been discussed below:
1. Excessive Working Capital leads to increase in inventory level due to high production and low
sales leading to daring consequences such as theft, loss, damage and wastage.
2. Increase in idle funds thereby indicates inability in generation of profit by a firm.
3. Huge amount of idle funds indicates incapability of the firm in utilizing resources optimally, i.e.
underutilization of resources of the firm.
4. Excessive Working Capital indicating underutilization of fund may motivate the management of
the firm to involve in speculative activities.
5. Excessive Working Capital may induce a firm to provide credit to debtors liberally. Liberal credit to
the debtors will result in an increase in size of accounts receivable and delay in collection from
debtors.

15. 6. Excessive Working Capital is an indication of the Overcapitalization, i.e. amount of capital more than the
actual requirement.
7. The balance between profitability and liquidity may be distorted due to excessive Working Capital.
8. Excessive Working Capital may make the management inefficient in increasing production capacity and
further expansion of the firm.
All these are the evil effects of excessive Working Capital. Similar to excessive Working Capital, inadequate Working
Capital also have an evil effect on the business.
Effects of inadequate Working Capital have been stated below:
1. Failure to meet short-term obligations due to inadequate funds may lead to loss of reputation, credit
worthiness of the firm.
2. A firm becomes insolvent, i.e. becomes incapable to repay Current Liabilities within stipulated time due to
inadequate Working Capital.
3. Inadequate Working Capital makes a firm incapable to undertake profitable projects.
4. Inadequate Working Capital prevents a firm from earning profit since it cannot undertake its entire operation
plan.
5. Inadequate Working Capital signifies weak liquidity position of the firm, i.e. incapability to meet day-to-day
obligations.

16. FACTORS DETERMINING WORKING CAPITAL REQUIREMENT
The factors determining Working Capital requirement are as follows:
1. Nature of business: Working Capital requirement depends on the nature of the business. For those
organizations providing services, Working Capital requirement is less as compared to manufacturing
organizations. Because requirement of Working Capital is more in case of manufacturing organizations
since they have to maintain a huge stock of raw materials and finished goods.
2. Size of business: Working Capital requirement is comparatively higher for large firms, whereas it is lower
for small-scale business.
3. Business cycle: Working Capital requirement depends on business cycle, i.e. in period of recession the
demand for Working Capital is lower, whereas in boom period the demand for Working Capital is higher
since the volume of production is higher in boom period.
4. Sales volume: For higher sales volume, higher amount of investment in Working Capital is required but
for lower sales volume the amount of investment in Working Capital is lower.

17. 5. Production cycle: If production cycle is longer in that case the amount of Working Capital
requirement is higher as the funds remain blocked for a longer period of time. Production cycle
starts from purchase of raw materials to production of finished goods. Longer the period, higher is
the requirement of Working Capital.
6. Production policy: Depending on the production policy, the requirement of Working Capital varies.
In case of steady production policy, the requirement of Working Capital is higher since production is
to be carried out throughout the year, but in case of seasonal production policy the amount of
Working Capital requirement is low.
7. Credit policy: Credit policy is an important factor determining the requirement of Working Capital. If
the credit policy is stringent, i.e. customers are allowed lower credit period, in that case Working
Capital requirement is lower but in case of liberal credit policy where customers are allowed higher
credit period in that case Working Capital requirement is higher.
8. Operational efficiency: Working Capital requirement depends on operational efficiency of a firm.
Higher the operational efficiency, lower is the pressure on Working Capital.
9. Inventory policy: If amount of funds blocked in inventory is higher, higher will be the requirement of
Working Capital. Whereas if the amount of funds blocked in inventory is lower, lower will be the
requirement of Working Capital.

18. 10. Level of competition in market: Working Capital requirement depends on level of competition in the
market. If there is cut-throat competition in the market of the product manufactured by the company
then the company needs to make his credit policy liberal, i.e. may have to allow higher credit period to
debtors to retain customers. In addition, this company may also have to maintain high level of inventory
to satisfy the customers’ demand at right time to restrain them from moving to other competitors. For
this reason they need to maintain high level of inventory and funds remain block in receivables for a
longer period of time owing to liberal credit policy. Hence the Working Capital requirement is very high
in case of high level of competition.
11. Operating or Working Capital cycle: Longer the Working Capital or Operating Cycle, higher will be the
requirement of Working Capital. Working Capital cycle starts from procurement of raw materials and
ends at cash realization. The longer the time taken to complete one cycle, higher will be the Working
Capital requirement.
12. Raw materials availability: If raw materials are available throughout the year smoothly then there is no
requirement to maintain huge inventory. Hence the Working Capital requirement is less, since huge
inventory level implies unnecessary blockage of Working Capital.

19. 13.Growth and expansion of firm in future: If a firm wants to expand its business then additional Working
Capital is required. If a firm plans for further expansion in future in that case the Working Capital
requirement will be higher compared to a firm which does not want to expand its business in future.
14.Changes in price level: Price level is also another determinant of Working Capital requirement. If price
increases then it will lead to an increase in Working Capital requirement to maintain the same level of
operation.
15.Profit level: Profit earned by a firm is an important internal source of funds. Profit can be invested in the
business provided it is adequate. Profit meets the Working Capital requirement to the extent it is earned in
cash. Cash profit is the profit earned before depreciation and amortization.
16.Tax level: Working Capital requirement depends on level of tax imposed by the government. Higher the tax
rate higher will be the requirement of Working Capital and vice versa.
17.Dividend policy: Dividend policy of a firm is also an important determinant of Working Capital requirement.
Higher the amount of dividend paid in cash higher will be the requirement of Working Capital and lower the
amount of dividend paid lower will be the Working Capital requirement.

20. 18. Cash reserve for contingencies: Some amount of cash reserve should be maintained to handle the
situation arising due to sudden unpredictable events. Higher the amount of cash reserve maintained
higher will be the requirement of Working Capital.
19. Depreciation policy: If higher amount of depreciation is charged then it would lead to reduction
in profit level, lower the profit lower will be the tax liability and large amount can be retained.
Due to low profit firm will pay less dividend and large amount can be retained. Higher the
amount of retained earning, stronger will be the position of Working Capital.
20. Stable political condition: If a state is politically stable in that case a firm can expands its
business easily and can undertake new ventures easily, in that situation the requirement of
Working Capital is high.

21. CONCEPT OF OPERATING CYCLE
Operating Cycle refers to the time period required for conversion of cash back into cash again. Operating
Cycle is also known as Working Capital cycle. It is an important determinant of Working Capital
requirement. Operating Cycle starts from purchase of raw material and ends in cash realization from sales.
The first stage of Operating Cycle is
procurement of raw materials by cash. Raw materials can be procured on credit also but cash is required for
labor and overhead expenses to carry out production process. Raw materials procured in combination
with labor and overhead are converted into finished goods; this process of conversion of raw materials into
finished goods is known as production. Raw materials are converted into finished goods by adding some
values to it. These finished goods are sold in the market either for cash or credit. For credit sales, cash is
realized from debtors after the expiry of credit period allowed to debtors by the company. So the time
taken to complete one cycle from procurement of raw materials in cash till realization of cash from sales is
known as Operating Cycle or Working Capital cycle.

22. Stages in Operating Cycle
Operating Cycle (Figure 5.2) constitutes the steps mentioned as follows:
1. Procurement of raw materials.
2. Conversion of raw materials in work-in-progress.
3. Conversion of work-in-progress into finished goods.
4. Sale of finished goods
● For cash sales (Operating Cycle ends)
● For credit sales
5. Conversion of receivables into cash or realization of debtors into cash.
Cash cycle refers to the time period between the payment of cash for purchase of raw materials and
collection of cash from sales, i.e. the total Operating Cycle minus the lag in accounts payable/payment made
to suppliers of raw materials. Cash cycle is also known as Net Operating Cycle. Operating Cycle is also known
as Gross Operating Cycle which refers to the total time length from purchase of raw materials till collection
of cash through sales.