In this article we will discuss about the estimation of working capital need of a company in special situations.
In the seasonal industries, the level of working capital requirement will not be similar all through the year. In times of off-season, the working capital requirement and the levels of investment in current assets and liabilities are very low. During season, the firm’s requirement of working capital is at peak level.
Let us look at the ‘sugar industry’. The crushing season in a year will remain for 5 to 6 months time. During the season the plant is expected to work at full capacity with triple shift working and the requirement of stocks of raw material is very high and resultant increase in stocks of sugar. The requirements for payment of labour, expenses and maintenance is also higher.
There will not be immediate sale of sugar and finished stock inventory would be much higher. After the completion of the crushing season, the plant will be closed and only upkeep and maintenance of plant will be incurred and the level of current assets and current liabilities comes down and the working capital requirement would be very low. For efficient management of working capital, the Finance manager should be able to properly estimate the season and off-season requirements of working capital.
For this he has to take the following precautions:
I. Preparation of projected cash flow statement showing the cash flow for peak season, normal season and offseason requirements.
II. Make proper arrangements with the banks and other sources of finance to meet the short-term needs of season.
III. Make proper arrangement for meeting the contingencies of higher level requirement than the projected levels of requirement.
IV. Proper and careful assessment of working capital requirements for the season and off-season requirement.
V. Care to be taken to reduce the level of investments in current assets after the season is completed.
The Finance Manager of a seasonal industry should be extra cautious while assessment of working capital for the firm.
One of the objectives of working capital management is to determine and maintain the optimum level of investment in current assets for increase of return on capital employed. While determination of working capital requirements, moderate inflation rate can be ignored, but high rates of inflation will be considered otherwise, wrong setting of working capital level will hamper the smooth flow of working and profitability of the concern.
When the inflation rate is high, it will have its direct impact on the requirement of working capital as explained below:
I. Inflation will cause to show the turnover figure at higher level even if there is no increase in the quantity of sales. The higher the sales means the higher levels of balances in receivables.
II. Inflation will result in increase of raw material prices and hike in payment for expenses and as a result, increase in balances of trade creditors and creditors for expenses.
III. Increase in valuation of closing stocks result in showing higher profits but without its realization into cash causing the firm to pay higher tax, dividends and bonus. This will lead the firm in serious problems of funds shortage and firm may unable to meet its short-term and long-term obligations.
IV. Increase in investments in current assets means the increase in requirement of working capital without corresponding increase in sales or profitability of the firm.
Keeping in view of the above, the Finance manager should be very careful about the impact of inflation in assessment of working capital requirements and its management.
If the firm which is presently running in single shift, plans to go for working in double or triple shift the following factors should be considered while assessing the working capital requirements of the firm:
a. Raw Material Stock:
i. Working in double/triple shift means requirement of raw materials will be doubled/ tripled. It increases the safety stock levels, and revision of economic order quantity levels. The need for increased levels of stock simultaneously increase the need for working capital.
ii. Increase in material requirement may call for bulk purchasing and it reduces the cost per unit of raw material consumed.
b. Work-In-Progress Stock:
i. The shift working will not increase the level of work-in-progress stock, since the WIP generated in one shift will be converted into finished units in next shift and so on.
ii. The variable cost per unit will remain same except increase in labour cost due to payment of night shift allowance.
iii. Fixed cost per unit reduces due to dispersion of it over more number of units produced.
iv. The overall investment in WIP stock will remain same even if plant is operating on shift basis.
c. Finished Goods Stock:
i. Due to increase in production, the stock of finished goods will increase and simultaneously the requirement for working capital will also increase.
ii. The variable cost per unit will not change except in case of savings for bulk purchases and extra labour cost for night shift working.
iii. The fixed cost per unit is reduced drastically.
iv. The overall reduction in cost of production may reduce the funds requirement.
d. Sundry Debtors:
i. The increase in demand calls for increase in production, through shift working. The increased operational level increases the credit sales which increases debtors, and require more working capital than before.
ii. The increased production may require to extend liberal credit period than before and may require to offer discounts for sale of additional units.
iii. The increase in debtors balances increases the cost of administration of debtors balances and opportunity cost of funds invested in debtors.
e. Sundry Creditors:
i. The shift working needs for more quantity of raw materials, stores and consumables. The level of trade credit increases, due to bulk purchases, the purchase price and credit period to be renegotiated with the suppliers. The benefit of cash discounts can also be taken to the advantage. The overall cost per unit of raw material consumption may be reduced due to increased purchase of raw materials.
The Finance manager should reassess the working capital requirements if the change is contemplated from single shift operation to double or triple shift.