Working Capital Ratios

To calculate the length of working capital cycle there needs to be some ratios that sould find out first these ratios are called working capital ratios.
These ratios are the one that are involved in working capital cycle i:e inventory, WIP, finished goods, receivables, payables. These ratios also helps to appraise the performance of a company in a particular period or compare with previous years. Besides this there are some LIMITATIONS of the ratios as well i:e these are based on historic data do not take account of future, there may be element of inflation that will not be consider, there may be some manipulation in the ratios that distorted the actual results
The some specific ratios that are involved in working capital cycle i:e inventory, WIP, finished goods, receivables, payables are as follows.

Inventory holding days: It is the time b/w inventory purchased and being used in production. Calculated as:

Average inventory held Material usage × 365
To calculate average inventory held:     Opening inventory + Closing inventory ÷ 2
Where material usage is not given purchases or cost of goods sold will be replace by this.

WIP holding days: It is the time in which goods remain in production. Calculated as:

Average WIP ÷ Production cost × 365
To calculate average WIP:                              Opening WIP + Closing WIP
Where Production cost is not given purchases or cost of goods sold will be replace by this.


Finished goods period: It the length of time when goods are completed and ready for sale. Calculated as:
Average finished goods in inventory ÷ Cost of goods sold × 365
Where cost of goods sold is not given purchases will be replace by this.


Receivable days: The spam of time during which the debtors or customers pay. Calculated as:
Average receivables ÷ Credit sales × 365


Payable days: The time in which customers are being paid. Calculated as:
Average payables ÷ Credit purchases × 365
Further there are two more ratios that assists in evaluating performance that are as follows:


Inventory turnover(in times):             Cost ÷ Average inventory held


Working capital turnover: Sales revenue ÷ Net working capital

Description: To calculate the length of working capital cycle there needs to be some ratios that sould find out first these ratios are called working capital ratios.

Accounting Concepts...

While making accounting statements a clear objective is that accounts reflect true and fair view. The true and fair view is applied to ensuring business activites are carring out properly. to ensure this application there are certain concepts and conventions which helps that accounts are maintained accurately. Different accounting concepts are as follows:



The Separate Entity concept: This means that the business is treated as a separate entity.i:e The business transactions are recorded separately and distinct from the personal transactions of the owner. 



Matching concept: Income and expenses are properly matched with a given accounting period i:e to which they relate.


Historical cost concept: According to the historical cost concept assets and liabilities are recorded at their historical cost. Historical cost means the cost that was initially paid for the acquisition of an asset, e.g. cost of an asset.


Going concern concept: An entity is a going concern if it has an intention to cease trading or shut off its operations nor The circumstances that may lead to the shutting off of the entity’s operations.
An entity should prepare its financial statements on going concern basis if it is to continue its operations in the near future.


Prudence concept: The prudence concept reveals that assets and incomes are not overstated, and liabilities and expenses are not understated.


Materiality concept: This implies that an information is material if its omission or misstatement in the financial statements may affect the decisions of the users of the financial statements.


Consistency concept: This means that accounting principles and policies shall be applied on a consistency basis from one period to another period.

DEPRECIATION

It is reduction in the value of fixed asset with the passage of time. As an asset is used, its value decreases which is due to wear and tear of that asset. This amount is charged as an expense and represents the benefit use during the period.Depreciation is a non cash expense. This decrease in value of asset is called depreciable value.


DEPRECIABLE VALUE:
Cost/ revalued amount of asset – residual value


RESIDUAL VALUE:
Scrape value of an asset at the end of its useful life. It is also known as N.R.V. (Net Realizable Value)
DOUBLE ENTRY:
Dr  Depreciation a/c
Cr  Provision for depreciation a/c


METHODS OF DEPRECIATION:
There are two methods of depreciation.
1. Straight Line Method
2. Reducing Balance Method


STRAIGTH LINE METHOD:
This is a method according to which a constant amount of depreciation is charged over the useful life of an asset.
It is calculated as follow:
Annual Charge=Cost – residual value /expected useful life


REDUCING BALANCE METHOD:
This is a method according to which the annual charge decreases over assets useful life there is a percentage given to charge depreciation.
It is calculated as follow:
Net book value = (Cost –Accumulated depreciation) * % of charge

Bad Debts

Accounts receivable that will remain noncollectable  and will be written off are known as irrecoverable or bad debts. They are shown as an expense in trading profit and loss account i:e income statement.


Double entry:


Dr:     Bad debt expense (I/S)


Cr:     Debtors


When a bad debt becomes good i:e the debt is collectd its entry is:


Dr:     Bank/Cash


Cr:     Bad debts recovered a/c


Provision for doubtful debts:


Companies make a provision for bad debts in advance at the year end which they consider will become bad debts in future. Prudence concept also states that provision is to be made for these doubtful debts. The reason for making provision is that the amount of  debtors reported in balance sheet is not overstated.


Double entry:


Dr:     Bad debts (P&L)


Cr:     Provision for bad debts (BS)


When the debt actually becomes bad the entry will be:


Dr:     Provision for bad debts (BS)


Cr:     Debtors a/c

Cash Operating Cycle

Cash operating cycle is the length of time between company’s outflow of material, wages and other expenditure and inflow of  cash from the sales of goods. It reflects a company’s investment in working capital. The faster the cycle, lower is the investment in working capital. The investment increases from raw material to labour, OH, WIP upto final collection of cash from trade receivables.

Calculation of cash operating cycle:

For manufacturing business cash operating cycle is calculated as:

Raw material  period                                                             X

Add: WIP period                                                                          X

Add: Finished good period                                                            X

Add: Receivables collection period                                                X

Less: Payables payment period                                                     (X)

Cash Operating cycle                                                 X

Note: For retail business there is no raw material and WIP  holding period.

The length of cycle depends upon balancing liquidity and profitability. Shortening cash cycle may have an adverse effect on sales because customers buy from that supplier who gives more credit period so there should be an optimum level of cash operating cycle.