Page 35 - DCOM505_WORKING_CAPITAL_MANAGEMENT

Working Capital Management

Notes Price Level Changes

Changes in the price level also affect the requirements of working capital. Rising prices necessitate
the use of funds for maintaining an existing level of activity. For the same level of current assets,
higher cash outlays are required. The effect of rising prices is that a higher amount of working
capital is needed. However, in the case of companies which can raise their prices proportionately,
there is no serious problem working capital. Moreover, the price rise does not have a uniform
effect on all commodities. It is likely that some firms may not be affected at all. In brief, the
implications of changing price level on working capital position vary from company to company
depending on the nature of its operations, its standing in the market and other relevant
considerations.

Operating Efficiency

The operating of the management is also an important determinant of the level of working
capital. The management can contribute to a sound working capital position through operating
efficiency. Although the management cannot control the rise in prices, it can ensure the efficient
utilisation of resources by eliminating waste, improving coordination, and a fuller utilisation
of existing resources, and so on. Efficiency of operations accelerates the pace of cash cycle and
improves the working capital turnover. It releases the pressure on working capital by improving
profitability and improving the internal generation of funds.
To conclude, the level of working capital is determined by a wide variety of factors which are
partly internal to the firm and partly external (environmental) to it. Efficient working capital
management requires efficient planning and a constant review of the needs for an appropriate
working capital strategy.

2.4.2 Computation of Working Capital

The two components of Working Capital (WC) are Current Assets (CA) and Current Liabilities
(CL). They have a bearing on the cash operating cycle. In order to calculate the working capital
needs, what is required is the holding period of various types of inventories, the credit collection
period and the credit payment period. Working capital also depends on the budgeted level of
activity in terms of production/sales. The calculation of WC is based on the assumption that the
production/sales is carried on evenly throughout the year and all costs accrue similarly. As the
working capital requirements are related to the cost excluding depreciation and not to the sale
price, WC is computed with reference to cash cost. The cash cost approach is comprehensive and
superior to the operating cycle approach based on holding period of debtors and inventories
and payment period of creditors. Some problems have been solved, however, using the operating
cycle approach also.
The steps involved in estimating the different items of CA and CL are as follows:

Estimation of Current Assets

Raw Materials Inventory: The investment in raw materials inventory is estimated on the

Budgeted production Average inventory
(in units) × Cost of raw materials × holding period
per unit
(months/days)

12 months/365 days

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