Working Capital and Current Assets Management

Given:

• Annual sales = Rs. 8,00,000
• Inventory turnover ratio = 8 times
• Receivable collection period = 24 days
• Payable deferral period = 18 days
• Working days in a year = 340 days

a) Inventory Conversion Period

$\text{Inventory Conversion Period} = \frac{340 \text{ days}}{\text{Inventory Turnover Ratio}}$

$= \frac{340}{8} = \boxed{42.5 \text{ days}}$

b) Cash Conversion Cycle

$\text{Cash Conversion Cycle} = \text{Inventory Conversion Period} + \text{Receivable Collection Period} - \text{Payable Deferral Period}$

$= 42.5 + 24 - 18 = \boxed{48.5 \text{ days}}$

Interpretation: The company takes 42.5 days to convert inventory into sales and 24 days to collect cash from debtors, while it enjoys 18 days of credit from suppliers. Net cash is tied up for 48.5 days, so the firm must arrange financing for this period.

Given: Receivable collection period (RCP) = 39 days, payable deferral period (PDP) = 30 days, inventory turnover ratio = 5 times, 365 days in a year.

(a) Inventory Conversion Period (ICP)

$ICP = \frac{365}{\text{Inventory turnover ratio}} = \frac{365}{5} = 73 \text{ days}$

(b) Cash Conversion Cycle (CCC)

$CCC = ICP + RCP - PDP = 73 + 39 - 30 = 82 \text{ days}$

The firm's cash is tied up in operations for 82 days, so it must finance this period.

Given: Annual sales = Rs 12,00,000; inventory turnover ratio = 10 times; receivable collection period = 28 days; payable deferral period = 21 days; 350 working days in a year.

(a) Inventory conversion period

$\text{Inventory conversion period} = \frac{350}{10} = 35 \text{ days}$

(b) Cash conversion cycle

$CCC = \text{Inventory conversion period} + \text{Receivable collection period} - \text{Payable deferral period}$

$CCC = 35 + 28 - 21 = 42 \text{ days}$

(c) Working capital requirement

Sales per day:

$\frac{12{,}00{,}000}{350} = \text{Rs } 3{,}428.57$

Check: $3{,}428.57 \times 42 = \text{Rs } 1{,}44{,}000$.

Answer: Inventory conversion period = 35 days; cash conversion cycle = 42 days; working capital requirement = Rs 1,44,000.

Two determinants of working capital:

1. Nature of business – A trading concern needs less working capital than a manufacturing concern, which must hold large stocks of raw materials and finished goods.
2. Scale of operation – A business operating on a large scale requires more working capital than one operating on a small scale.

Gross concept of working capital refers to the total amount of current assets of a business, i.e. the sum of cash, marketable securities, debtors, bills receivable, inventory and prepaid expenses, without deducting current liabilities. It shows the total funds invested in current assets and is also called gross working capital (GWC).

$\text{Gross Working Capital} = \text{Total Current Assets}$

Working capital is the capital needed to run the day-to-day operations of a business. Gross working capital is the total of current assets; net working capital is current assets minus current liabilities. It is used for buying raw materials, paying wages and expenses, and financing credit sales.

Types of working capital

Working capital is classified in two ways.

A. On the basis of concept

1. Gross working capital: Total investment in current assets such as cash, receivables, inventory and prepaid expenses.
2. Net working capital: Current assets less current liabilities. Example: current assets Rs 5,00,000 and current liabilities Rs 3,00,000 give net working capital of Rs 2,00,000.

B. On the basis of time

1. Permanent (fixed) working capital: The minimum level of current assets always needed to carry on operations, even in the slowest season. Example: the minimum stock of raw materials and cash a factory must always hold.
2. Temporary (variable) working capital: The extra working capital needed due to seasonal or special demands, above the permanent level. Example: extra stock and cash a sweets shop needs before Dashain and Tihar.

Permanent working capital is best financed from long-term sources, while temporary working capital is financed from short-term sources such as bank overdraft.

(i) Cash conversion cycle

$CCC = \text{Inventory period} + \text{Receivable period} - \text{Payable period} = 50 + 40 - 30 = 60 \text{ days}$

So the firm's cash is tied up in operations for 60 days.

(ii) Account receivable amount

$\text{Receivable} = \frac{\text{Annual credit sales}}{360}\times\text{Receivable period} = \frac{9{,}00{,}000}{360}\times 40 = 2{,}500 \times 40 = \text{Rs } 1{,}00{,}000$

Receivable (accounts receivable or trade debtors) is the amount a firm is to receive from customers to whom goods or services have been sold on credit. It is a current asset and represents money tied up in credit sales.

Elements affecting the level of receivables

1. Volume of credit sales: The higher the proportion of credit sales, the larger the receivables.
2. Credit policy: A liberal policy (relaxed standards, longer credit) increases receivables; a strict policy reduces them.
3. Credit period and cash discount: A longer credit period raises receivables, while an attractive cash discount encourages early payment and lowers them.
4. Collection policy and efficiency: Prompt follow-up, reminders and legal action reduce the collection period; weak collection increases receivables and bad debts.
5. Nature of business and competition: In competitive industries, firms offer longer credit to attract customers, and seasonal sales change receivables over the year.
6. Terms of trade and customer standing: Credit standing of customers and their payment habits determine how quickly dues are paid.
7. Firm's own financial position: A firm with cash shortage will try to collect faster and limit credit.

Working notes

• Cash sales = 20% of the month's sales; credit sales = 80%, collected in the next month.
• Purchases are paid in the next month. Wages and other expenses are paid in the same month.

Collections

Cash budget (Rs)

The firm has a surplus in all three months and no short-term borrowing is needed; the surplus cash of about Rs 5,61,000 by Asar could be invested temporarily.

Carrying cost per unit = $10\% \times 40 =$ Rs 4 per kg per year.

(i) Economic order quantity

$EOQ = \sqrt{\frac{2AO}{C}} = \sqrt{\frac{2 \times 1{,}60{,}000 \times 200}{4}} = \sqrt{1{,}60{,}00{,}000} = 4{,}000 \text{ kg}$

(ii) Optimum number of orders

$\text{Number of orders} = \frac{\text{Annual requirement}}{EOQ} = \frac{1{,}60{,}000}{4{,}000} = 40 \text{ orders per year}$