Page 30 - DCOM505_WORKING_CAPITAL_MANAGEMENT

Unit 2: Planning of Working Capital

Self Assessment Notes
State whether the following statements are true or false:
7. The cash cycle is also called the Cash Conversion Cycle (CCC).
8. Day’s sales outstanding represents payables turnover in days and measures the average
length of time between purchase of goods and payment for them.
9. DPO represents accounts receivable turnover in days and measures the average number of
days from the sale of goods to collection of resulting receivables.

2.4 Estimation of Working Capital Requirements

Working capital plays a very important role in day-to-day working of the business. If mistake
is committed in estimating the working capital, it can create considerable difficulty for the
management. In spite of having enough long-term capital, there are instances when companies
have gone into liquidation due to non-availability of working capital. The finance manager has
to be extra careful while estimating requirement of working capital for various time periods.
Thus the question of estimation of working capital requirement assumes great importance. The
level of activity and the time period of production cycle are important. The credit allowed to
debtors and credit available from creditors have also to be taken into account.

2.4.1 Determinants of Working Capital

A firm should plan its operations in such a way that it should have neither too much nor too
little working capital. The total working capital requirement is determined by a wide variety of
factors. These factors, however, affect different enterprises differently. They also vary from time
to time. In general, the following factors are involved in a proper assessment of the quantum of
working capital required.

General Nature of Business

The working capital requirements of an enterprise are basically related to the conduct of business.
Enterprises fall into some broad categories depending on the nature of their business. For
instance, public utilities have certain features which have a bearing on their working capital
needs. The two relevant features are:
1. The cash nature of business, that is, cash sale, and
2. Sale of service rather than commodities.
In view of these features, they do not maintain big inventories and have, therefore, probably the
least requirement of working capital. At the other extreme are trading and financial enterprises.
The nature of their business is such that they have to maintain a sufficient amount of cash,
inventories and book debts. They have necessarily to invest proportionately large amounts in
working capital. The manufacturing enterprises fall, in a sense, between these two extremes.
The industrial concerns require fairly large amounts of working capital though it varies from
industry to industry depending on their asset structure. The proportion of current assets to total
assets measures the relative requirements of working capital of various industries. Available
data in respect of companies in India confirm the wide variations in the use of working capital
by different enterprises. The percentage of current assets to total assets was found to be the
lowest in hotels, restaurants and eating houses (10–20 per cent range), while in electricity
generation and supply it was in the range of 20–30 per cent. The enterprises in the tobacco,
construction and trading groups had, as is to be expected, the highest component of working
capital (80–90 per cent range). The other industrial groups fall between these limits though there
are very wide inter-industry variations.

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