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.

STOCK / INVENTORY

Inventory is a current asset that is held by an entity either to be used in production or to be sold. Inventory that is held at the begining of the financial year is known as opening inventory. The inventory that remains unused or unsold at the end of financial year is known as closing inventory.

There are three forms of inventory.

1. Raw material

2. Work in progress (WIP)

3. Finished goods

Ordering stock

The store manager will decide that an order needs to be placed and the number or the units to order. The amount to be ordered will be determined by the future plans for production and sales.

It is calculated as follow

Ordering stock = required for sales + closing stock – opening stock

Question:

Hussy Ltd makes a product which requires 2 kg of material X. Hussy Ltd always keep closing inventory of 200 kg of material X each month. As the production of last three months were 500 hundred units. Hussy Ltd is planning to increase its sale to 600 hundred units from the present month.

Required:

How many kg of material X should be ordered?

Solution:

Closing stock                200 kg

Opening stock               200 kg

Requirement for sale     600/2= 300 kg

Now put in formula:

Ordering stock = 300+200-200

Ordering stock = 300 kg of material required.

Safety/Buffer Stock

Minimum level of stock required to meet emergencies. Safety stock should be quite enough to cover problems i:e break in supply,shortage of material. In Justin in time(JIT) system the purpose is to eliminate the buffer stock.

Buffer stock=2 x average stock – reorder quantity

Free Stock

Free stock represents what is really available for future use.

The free stock balances give better picture to the manager that how much stock needed for the current situation. So he can take decisions regarding the inventory.

Free stock is calculated as:-

Materials in stock                                      X

Materials on order from suppliers               X

Materials requisitioned, not yet issued       (X)

Free stock balance                                    X

Question: – Mick Ltd, a wholesaler has 8,500 units outstanding for material on existing customers orders; there are 4,000 units in stock. Order from supplier is 5,500.

Required:-

Calculate free stock for Mick Ltd?



Solution:-

Materials in stock                                     4000

Materials on order from suppliers              5500

Materials requisitioned, not yet issued       (8500)

Free stock balance                                    1000

Overheads

Resources consumed or lost in completing a process and which cannot be traced directly to the cost of the product.

Overheads are indirect costs. Overheads are total of:

1)  Indirect materials (e:g nails in a chair, gum used in table )

2)  Indirect labour (e:g supervisor, storekeeper)

3)  Indirect expenses (e:g rent, machine running expense)

Overheads can be categorized into:

Production Overheads
Non-production overheads
Production overheads are those, that are directly related to production e:g machine insurance, machine greases etc.

Non-production overheads are not directly related to production e:g selling and distribution cost, research cost etc.

The production and non-production overheads are further categorized into:

Variable overheads
Fixed overheads
Variable overheads are those indirect cost which varies with the level of output but constant for unit cost e:g salesman commission, electricity charges etc.

Fixed overheads are that cost which remain the same for a given level of output during the period e:g rent and rates, factory managers salary etc.

Cost Volume Profit (CVP) Analysis

It is a method to determine the relationship between change in activity level, total sales revenue, expenses and profit. OR a method that  deals with how profits and costs change with a change in volume.

Objective of CVP analysis:

Establish the financial results when specified level of activity or volume changes. To establish this management need to know

Break-even point
Margin of safety
Break-even point: The level of activity where there is no profit or loss i:e the point at which cost or expenses and revenue are equal.

It can be calculated in units or in value, and can be calculated as follows:

Break-even point (in units) = Fixed cost ÷ Contribution per unit

Contribution per unit = Selling price per unit – Variable cost per unit

Break-even point (in value) = Fixed cost ÷ Contribution to sales ratio

Contribution to sales ratio = Total contribution ÷ Total Sales revenue

Margin of  Safety: It is the difference between budgeted sales volume/revenue and break-even sales volume/revenue. It shows the amount by which actual sales can fall without a loss being incurred.

It can be calculated also in units or in value, and can be calculated as follows:

Margin of safety (in value/units) = Budgeted Sales revenue/unit – Break-even Sales revenue/unit

Margin of Safety (in % value) = Budgeted Sales revenue – Break-even Sales revenue × 100% ÷ Budgeted Sales revenue

Margin of Safety (in % units) = Budgeted Sales units – Break-even Sales units × 100% ÷ Budgeted Sales units

Surplus & Investment of Surplus

Surplus is, when a business have excess of cash inflows over cash outflows because of large amount of cash generated from operations or sale of fixed assets

Business have to invest surplus funds but it should be kept in mind that the surplus is temporary or permanent. Temporary surplus may be invested until it is ensure that it need not be used in current operations. Permanent surplus should be invested. It should be kept in mind that investment should be profitable and secure.

Objectives of investment of surplus:

As they are assets of company so need to be look after like any other assets.

In time of inflation, value of money effectively fall.

There are some factors that should be consider before investment of surplus

Risk
Liquidity
Maturity
Return
Risk: There is a strong link between risk and return the higher the risk the higher the return and vice versa. High risk can lead to permanent losses that can collapse the company. Shares traded in stock market are consider to be most high risk type of investment

Liquidity: It involves the ability to turn investment into cash immediately. There is also a close link between liquidity and return. A less liquid investment generally provide a higher return and a high liquid investment generally provide a lower return. It is important to consider investments liquidity before investing. If the amount and duration of cash surplus are to be change then highly liquid investment should be taken, if not then less liquid investment should be taken.

Maturity: The length and duration of investment. The longer the maturity the higher the return. A company’s investment should be mature so that surplus cash is available when business needs it.

Return: Income generated by an investment, expressed usually as percentage of amount invested. The whole purpose of investment is to receive a return the rate of return is also an important factor when investing cash surpluses.

Types of Investment:

Shares
Bonds
Debenture stocks
Certificates of deposit (CDS)
Gilt-edged securities
Bills of exchange etc…….