Working Capital in Financial Management by Debashish Goswami Sir

Working Capital Management plays a vital role in ensuring a business runs smoothly and maintains adequate liquidity. Here, Debashish Goswami Sir focuses on the practical application of core working capital concepts, with special emphasis on numerical problems and calculations that are important for competitive exams. 

It explains how to calculate net working capital, understand the operating cycle, and manage day-to-day funds efficiently. He also covers techniques for inventory optimisation, cash flow management, and evaluating credit policies. By linking theory with problem-solving, it helps students build strong conceptual clarity and exam-ready confidence in Working Capital Management topics.

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Working Capital in Financial Management

Working Capital Management is essential for maintaining smooth business operations and sufficient liquidity. It focuses on effectively managing short-term assets and liabilities to ensure daily expenses are met without disruption. Check below for a detailed explanation of key concepts, practical calculations, and exam-oriented topics such as net working capital, inventory control, cash management, and credit policy evaluation.

1. Calculation of Net Working Capital

Working capital can be understood in two primary ways: Gross and Net.

Comparative Structure: Gross vs. Net Working Capital

• Gross Working Capital: Represents a company's total Current Assets.

• Net Working Capital: Defined as Current Assets minus Current Liabilities. This figure is fundamental for financial planning and estimation.

Components of Current Assets & Liabilities

Current Assets (CA):

• Raw Material (RM): Unprocessed materials.

• Work in Progress (WIP): Partially finished goods.

• Finished Goods (FG): Completed products ready for sale.

• Debtors (Accounts Receivable): Amounts owed by customers for credit sales.

• Cash: Available cash.
  (Memory Tip: To understand the flow of current assets, imagine making food in a kitchen: uncooked flour is Raw Material, kneaded dough is WIP, and the cooked roti is Finished Goods. Debtors represent selling the roti on future payment.)

Current Liabilities (CL):

• Creditors (Accounts Payable): Amounts owed to suppliers for credit purchases.

• Outstanding Wages & Expenses: Incurred but unpaid costs.

Methodology for Calculating Component Values

The value of each working capital component is generally estimated using this formula:

Value = Annual Production Units × Cost per unit × (Holding Period / Total Time Period)

The "Total Time Period" can be 12 months, 52 weeks, or 365 days, based on the problem context.

Key Assumptions on Cost Components (When not specified)

The basis for valuation varies per component. Always follow specific instructions if provided; otherwise, use these standard assumptions:

• Raw Material (RM): Valued at its full purchase price.

• Work in Progress (WIP): 100% Raw Material, 50% Direct Labor, 50% Direct Overheads. (This assumes materials are added at the start, while labor and overheads are incurred evenly.)

• Finished Goods (FG) & Debtors: Valued at the total cost of production (100% RM, 100% DL, 100% OH).

• Creditors: Valued based on the cost of Raw Materials purchased.

• Outstanding Wages: Valued based on the Direct Labor cost.

• Outstanding Overheads: Valued based on the Overhead cost.

Worked Example 1: Net Working Capital Estimation

Problem Data:

• Annual Production: 144,000 units

• Cost Structure: RM ₹80, DL ₹30, OH ₹60 (Total Cost ₹170)

• Holding/Lag Periods: RM (1 month), WIP (0.5 month), FG (1 month), Debtors (2 months), Creditors (1 month), Lag in Wages (1.5 weeks), Lag in Overheads (1 month).

• Sales Policy: 1/4th cash sales. Cash Balance: ₹25,000.

• Assumption: 1 month = 4 weeks; 1 year = 52 weeks.

Solution:

A. Current Assets (CA)

B. Current Liabilities (CL)

C. Net Working Capital (A - B) = ₹6,149,615 - ₹1,675,384 = ₹4,474,231

Concept: Adding a Contingency Margin

A contingency is an extra amount of capital held as a safety buffer for unforeseen expenses.

Total Working Capital = Net Working Capital + Contingency Amount

Worked Example 2: NWC with a Contingency

Problem Data:

• Annual Production: 520,000 units

• Cost Structure: RM ₹1.00, DL ₹0.40, OH ₹0.35 (Total Cost ₹1.75)

• Periods (in days): Debtors (45), Creditors (60), RM (36), FG (15), WIP (18).

• Contingency: 1/3 of Net Working Capital. 1 year = 360 days.

Solution:

A. Net Working Capital (CA - CL)

B. Total Working Capital

2. Preparation of Projected Financial Statements

Some problems extend beyond NWC calculation to include projected financial statements.

1. Trading Account: Determines Gross Profit.

2. Profit & Loss (P&L) Account: Determines Net Profit.

3. Balance Sheet: Shows the projected financial position.

CRUCIAL RULE FOR BALANCE SHEET PREPARATION

For the Balance Sheet, Debtors are calculated using the SELLING PRICE, unlike NWC calculations.

• Debtors (for Balance Sheet) = Annual Credit Sales Units × **Selling Price** × (Credit Period / Total Period)

If a Balance Sheet does not balance, the difference is adjusted as Bank (if assets < liabilities + equity) or Bank Overdraft (if assets > liabilities + equity).

Worked Example 3: Comprehensive Problem with Financial Statements

Problem Data:

• Initial Bal. Sheet: Share Capital (₹2,00,000), 8% Debentures (₹50,000), Fixed Assets (₹1,25,000).

• Production & Sales: 60,000 units. Selling Price: ₹5/unit.

• Cost Structure (% of SP): RM (60% = ₹3), DL (10% = ₹0.50), OH (20% = ₹1).

• Periods (in months): RM (2), WIP (1), FG (3), Creditors (2), Debtors (3).

Solution:

Step 1: Net Working Capital (Calculated based on costs, similar to Ex 1 & 2. Details omitted for brevity).

• Current Assets (CA) = ₹1,83,750

• Current Liabilities (CL) = ₹30,000

• Net Working Capital = ₹1,53,750

Step 2: Trading Account

• Sales (60,000 × ₹5) = ₹3,00,000

• Cost of Goods Sold (RM + DL + OH) = ₹2,70,000

• Gross Profit = ₹30,000

Step 3: P&L Account

• Gross Profit = ₹30,000

• Less: Interest on Debentures (8% of ₹50,000) = ₹4,000

• Net Profit = ₹26,000

Step 4: Projected Balance Sheet

3. Operating Cycle

The Operating Cycle is the time period it takes to convert investment in raw materials back into cash from sales. It measures operational efficiency in days.

Operating Cycle (Days) = (RM Period + WIP Period + FG Period + Debtors Period) - Creditors Period

Calculation of Component Time Periods

If not directly given, these periods can be calculated:

• Raw Material Holding Period (Days) = Average Raw Material Stock / Daily Raw Material Consumption

• Work in Progress Period (Days) = Average WIP Stock / Daily Cost of Production

• Finished Goods Holding Period (Days) = Average Finished Goods Stock / Daily Cost of Sales

• Debtors Collection Period (Days) = Average Debtors / Daily Credit Sales

• Creditors Payment Period (Days) = Average Creditors / Daily Credit Purchase

Worked Example: Calculating the Operating Cycle (Ex 1)

Given Data: Annual Sales ₹1.6 Cr, Annual RM Consumption ₹44 L, Annual Production Cost ₹1 Cr, Annual Cost of Sales ₹1.05 Cr, Avg RM Stock ₹3.2 L, Avg WIP Stock ₹3.5 L, Avg FG Stock ₹2.6 L, Avg Debtors ₹4.8 L, Creditor Days: 16. Year = 365 days.

Calculations:

1. Raw Material Storage Period: (₹3,20,000 / (₹44,00,000 / 365)) ≈ 27 days

2. WIP Conversion Period: (₹3,50,000 / (₹1,00,00,000 / 365)) ≈ 13 days

3. Finished Goods Storage Period: (₹2,60,000 / (₹1,05,00,000 / 365)) ≈ 9 days

4. Debtors Collection Period: (₹4,80,000 / (₹1,60,00,000 / 365)) ≈ 11 days

5. Creditors Payment Period: 16 days (Given)

Net Operating Cycle = (27 + 13 + 9 + 11) - 16 = 44 Days

4. Cash Budget

A cash budget forecasts cash inflows and outflows, crucial for liquidity management.

Format of a Cash Budget

1. Opening Balance: Cash at period start.

2. Add: Receipts: All cash inflows (sales, collections, etc.).

3. Less: Payments: All cash outflows (materials, wages, overheads, etc.).

4. Closing Balance: Net cash position. Closing Balance = Opening Balance + Total Receipts - Total Payments.

• The closing balance of one month becomes the opening balance of the next.

Worked Example: 3-Month Cash Budget (April - June)

Key Timing Rules:

• Materials & Overheads: Paid in the following month.

• Wages: Paid in the same month.

• Sales Collections: 50% in the month due, 50% in the subsequent month.

• Sales Commission (5%): Paid in the following month.

Final Cash Budget (April - June)

(Note: The closing balances in this table have been re-calculated based on the logic provided, and may differ from some original lecture calculations due to corrections.)

5. Inventory Management Formulas

These formulas help set optimal inventory levels.

(Memory Tip: To make a big impact ("Rol"), both the teacher and student perform at their maximum. Minimum people can't make a big impact (Rol) because they're just normal. To reach maximum impact (Rol), add a new order (ROQ) and subtract minimum efforts.)

1. Reorder Level (ROL) = Maximum Consumption × Maximum Reorder Period

2. Minimum Stock Level = ROL – (Normal Consumption × Normal Reorder Period)

3. Maximum Stock Level = ROL + ROQ – (Minimum Consumption × Minimum Reorder Period)

• ROQ (Reorder Quantity) is often EOQ.

4. Average Stock Level = (Minimum Level + Maximum Level) / 2

Worked Example: Inventory Levels (Components X & Y)

Given Data:

• Normal Usage: 300 units/week; Min Usage: 150 units/week; Max Usage: 450 units/week

• ROQ: X = 2,000 units; Y = 4,000 units

• Reorder Period: X = 4-6 weeks; Y = 2-4 weeks

Calculations for Component X:

• ROL = 450 × 6 = 2,700 units

• Min Level = 2,700 – (300 × 5) = 1,200 units

• Max Level = 2,700 + 2,000 – (150 × 4) = 4,100 units

• Avg Level = (1,200 + 4,100) / 2 = 2,650 units

Calculations for Component Y:

• ROL = 450 × 4 = 1,800 units

• Min Level = 1,800 – (300 × 3) = 900 units

• Max Level = 1,800 + 4,000 – (150 × 2) = 5,500 units

• Avg Level = (900 + 5,500) / 2 = 3,200 units

6. Economic Order Quantity (EOQ)

EOQ is the optimal order size that minimizes total inventory costs (ordering and carrying costs).

EOQ = √ [ (2 × A × O) / C ]

Where:

• A = Annual Demand (consumption)

• O = Ordering Cost per order

• C = Carrying Cost per unit per year
  (Important Note: Carrying Cost is often a percentage of the purchase price, so it changes if the purchase price changes.)

Worked Example: EOQ Calculation

Given Data: Annual Consumption (A): 10,000 units, Ordering Cost (O): ₹25, Purchase Price: ₹2, Storage (Carrying) Cost: 4% of purchase price.

Calculation:

1. Carrying Cost (C): 4% of ₹2 = ₹0.08 per unit per year

2. EOQ = √ [ (2 × 10,000 × 25) / 0.08 ] = √6,250,000 = 2,500 units

3. Number of Orders per Year: 10,000 / 2,500 = 4 orders

Evaluating Credit Policy Proposals

This evaluates if more lenient credit terms are financially beneficial, balancing increased sales against higher bad debts and opportunity costs.

Analytical Framework:

1. Incremental Profit: Additional profit from increased sales.

2. Incremental Bad Debt: Additional losses from non-payment.

3. Opportunity Cost: Return lost on funds tied up in receivables. Opportunity Cost = Total Cost × Required Rate of Return × (Credit Period / Total Period)

4. Net Benefit: Profit – Bad Debt – Opportunity Cost

Worked Example: Comparing Credit Policies

Given Data:

• Existing Policy: 1 month credit. Sales 10,000 units @ ₹300. VC ₹200. FC ₹3L. Bad Debt 1%.

• Proposal 1: 2 months credit. Sales +15%. Bad Debt 3%.

• Proposal 2: 3 months credit. Sales +30%. Bad Debt 5%. FC +₹50k (as sales >25%).

• Required Rate of Return: 20%.

Analysis Table:

Conclusion: Proposal 1 has the highest Net Benefit (₹6,59,833) and should be adopted.

Calculation of Current Assets and Liabilities from Aggregate Data

This method prorates total annual figures over specific time periods.

Value = Total Annual Amount × (Given Time Period / Total Annual Period)

• Total annual period: 52 weeks or 12 months.

• Payment lags create liabilities.

• Advance payments create current assets.

Example:

• Material Costs (annual ₹62,400, 6 weeks credit): ₹62,400 × (6/52) = ₹7,200

• Advance Payment (annual ₹1,600, quarterly in advance): ₹1,600 × (3/12) = ₹400 (Asset)

Problem: Economic Order Quantity (EOQ) with Discount Analysis

This problem involves calculating EOQ and comparing total costs with discount proposals.

Given Data: Purchase Price (P): ₹200, Ordering Cost (O): ₹100, Annual Carrying Cost: 10% of P. Annual Demand (A): 4,000 units.

1. Calculate EOQ:

• Carrying Cost (C): 10% of ₹200 = ₹20.

• EOQ = √(2 × 4,000 × 100 / 20) = 200 units

2. Calculate Total Cost at EOQ:

• Purchase Cost: 4,000 × ₹200 = ₹800,000

• Ordering Cost: (4,000/200) × ₹100 = ₹2,000

• Carrying Cost: (200/2) × ₹20 = ₹2,000

• Total Cost at EOQ = ₹804,000

Comparative Analysis of Discount Proposals:

Conclusion: The 5% discount for a single order of 4,000 units yields the lowest total annual cost (₹798,100), making it the most advantageous option. (Note: Carrying cost is recalculated based on the discounted purchase price.)

Lecture Summary & Exam Topic Prioritization

This lecture covered crucial working capital concepts and problem-solving techniques.

• A Category (Essential): Net Working Capital, Reorder Level (ROL), and related inventory levels.

• B Category (Important): Proposal Decision problems, Economic Order Quantity (EOQ).

• C Category (Lower Priority): Capital Budgeting, Balance Sheet Method (as it has appeared previously).