CORPORATE FINANCE

UNIT – II – SHORT TERM WORKING CAPITAL

Estimating Working Capital Requirement:

The following points highlight the top five methods for estimating working capital
requirements, i.e.,

1. Percentage of Sales Method

2. Regression Analysis Method
3. Cash Forecasting Method
4. Operating Cycle Method
5. Projected Balance Sheet Method.

Method # 1. Percentage of Sales Method:

This method of estimating working capital requirements is based on the assumption that the level of
working capital for any firm is directly related to its sales value. If past experience indicates a stable
relationship between the amount of sales and working capital, then this basis may be used to
determine the requirements of working capital for future period.

Thus, if sales for the year 2007 amounted to Rs 30,00,000 and working capital required was Rs
6,00,000; the requirement of working capital for the year 2008 on an estimated sales of Rs
40,00,000 shall be Rs 8,00,000; i.e. 20% of Rs 40,00,000.

The individual items of current assets and current liabilities can also be estimated on the basis of the
past experience as a percentage of sales. This method is simple to understand and easy to operate but
it cannot be applied in all cases because the direct relationship between sales and working capital may
not be established.
Illustration 1:
The following information has been provided by a company for the year ended
30.6.2008:

Illustration 2:
The following are the extracts from the balance sheet of a company as on 30.6.2008.
Compute the additional working capital required by the company for the year ending
30.6.2009.
Method # 2. Regression Analysis Method (Average Relationship between Sales and
Working Capital):

This method of forecasting working capital requirements is based upon the statistical technique of
estimating or predicting the unknown value of a dependent variable from the known value of an
independent variable. It is the measure of the average relationship between two or more variables,
i.e.; sales and working capital, in terms of the original units of the data.

The relationships between sales and working capital are represented by the equation:

Illustration 3:
The sales and working capital figures of Suvidha Ltd. For a period of 5 years are given
as follows:
Method # 3. Cash Forecasting Method:

This method of estimating working capital requirements involves forecasting of cash receipts and
disbursements during a future period of time. Cash forecast will include all possible sources from
which cash will be received and the channels in which payments are to be made so that a consolidated
cash position is determined.

This method is similar to the preparation of a cash budget. The excess of receipts over payments
represents surplus of cash and the excess of payments over receipts causes deficit of cash or the
amount of working capital required.

Illustration 4:

Texas Manufacturing Company Ltd. is to start production on 1st January, 2009. The prime cost of a
unit is expected to be Rs 40 out of which Rs 16 is for materials and Rs 24 for labour. In addition,
variable expenses per unit are expected to be 7 & Rs 8 and fixed expenses per month Rs 30,000.

Payment for materials is to be made in the month following the purchases. One-third of sales will be
for cash and the rest on credit for settlement in the following month. Expenses are payable in the
month in which they are incurred. The selling price is fixed at Rs 80 per unit.
The numbers of units manufactured and sold are expected to be as under:

Method # 4. Operating Cycle Method:

This method of estimating working capital requirements is based upon the operating cycle concept of
working capital. The cycle starts with the purchase of raw material and other resources and ends with
the realization of cash from the sale of finished goods.

It involves purchase of raw materials and stores, its conversion into stock of finished goods through
work-in-process with progressive increment of labour and service costs, conversion of finished stock
into sales, debtors and receivables, realization of cash and this cycle continues again from cash to
purchase of raw material and so on. The speed/time duration required to complete one cycle
determines the requirement of working capital – longer the period of cycle, larger is the requirement
of working capital and vice-versa.

The requirements of working capital be estimated as follows:

For proper computation of working capital under this method, a detailed analysis is made for each
individual component of working capital.

The value of each individual item of current assets and current liabilities is determined
on the basis of estimated sales or budgeted production or activity level as follows:

(a) Stock of Raw Material:

The amount of working capital funds to be invested in holding stock of raw material can
be estimated on the basis of budgeted units of production, estimated cost of raw
material per unit and the average duration for which the raw material is held in stock
by using the following formula:

(Note. 360 days in a year may. be assumed in place of 365 to simplify calculations in some cases)
(b) Stock of Work-in-Process:

In manufacturing/processing industries the production is carried on continuous basis. At the end of

the period, some work remains incomplete even though all or some expenses have been incurred, this
work is known as work-in-progress or partly completed or semi-finished goods. The work-in-process
consists of direct material, direct labour and production overheads locked up in these semi-finished
goods.

The amount of funds estimated to be invested in work-in-process may be computed as:

Note:

(i) 360 days a year may be assumed to simplify calculations.

(ii) In the absence of information about stage of completion of WIP with regard to material labour and
overheads, 100% of material cost, and 50% of labour and production overheads cost may be assumed
as the estimated cost of work-in-process.

(iii) In case cash cost approach’ is followed for estimation of working capital, then depreciation should
be excluded from production overheads while calculating cost of work-in-process. However, under the
total approach, depreciation is also included.

(c) Stock of Finished Goods:

The amount of funds to be invested in holding stock of finished goods can be estimated
on the basis of annual budgeted units of production, estimated cost of production per
unit and the average holding period of finished goods stock by using the following
formula:

Note:
(i) Cost of production consist of 100% of material, labour and production overheads costs.

(ii) Under the total cost approach, depreciation is included in the cost of goods produced.
However, depreciation is to be excluded under the cash cost approach.

(d) Investment in Debtors/Receivables. When the sales are made by a firm on cash basis, the amount
is realized immediately and no funds are blocked for after sale period. However, in case of credit sales,
there is a time lag between sales and realization of cash. Thus, funds are to be invested in receivables,
i.e. debtors and bills receivables.

However, actual amount of funds locked up in receivables is only to the extent of cost of sales and not
the actual sales which include profit. It would, therefore, be more appropriate to ascertain the amount
of funds to be invested in debtors/receivables at cost of sales and not the selling price. But in case,
total approach is followed for estimation of working capital then receivables may be computed on the
basis of selling price.

Note:
(i) Cost of sales = Cost of goods produced/sold + Office and administrative overheads + Selling and
distribution overheads

(ii) Selling price per unit should be considered in place of cost of sales per unit in case total approach
is to be followed for estimation of working capital. Under the total approach, all costs including
depreciation and profit margin are included.

(e) Cash and Bank Balance:

Cash is one of the current assets of a business. It is needed at all times to keep the business going. A
business firm has to always keep sufficient cash to meet its obligations. Thus, a minimum desired cash
and bank balance to be maintained by a firm should be considered as an important component of
current assets while estimating the working capital requirements.

(f) Prepaid Expenses:

Some of the expenses like wages, manufacturing overheads, office and administrative expenses and
selling and distribution expenses etc. may have to be paid in advance. Such prepayment of expenses
should also be estimated while computing working capital requirements of a firm.

(g) Trade Creditors:

The term trade creditor refers to the creditors for purchase of raw material, consumables, stores etc.
The suppliers of goods, generally, extend some period of credit in the normal course of business. The
trade credit arrangement of a firm with its suppliers is an important source of short-term finance. It
reduces the amount of net working capital required by a firm.
The amount of funds to be provided by creditors can be estimated as follows:

(h) Creditors for Wages and Other Expenses:

Wages and salaries are usually paid on monthly, fortnightly or weekly basis for the services already
rendered by employees. The longer the payment – period, the greater is the amount of current
liability towards employees or the funds provided by them. In the same manner, other expenses may
also have to be paid after the lag of a certain period. The amount of such accrued or outstanding
expenses reduces the level of net working capital requirements of a firm.

The creditors for wages and other overheads may be computed as follows:

Note:
(i) The creditors for wages and each of the overheads may be calculated separately.

(ii) In case of selling overheads, budgeted annual sales in units should be considered in place of
budgeted production units,

(i) Advanced Received. Sometimes a payment may be received in advance along-with purchase order,
such advances reduce the amount of net working capital required by a firm.

Factors Requiring Consideration While Estimating Working Capital:

The estimation of working capital requirement is not an easy task and a large number of factors have
to be considered before starting this exercise.
For a manufacturing organisation, the following factors have to be taken into
consideration while making an estimate of working capital requirements:

From the total amount blocked in current assets estimated on the basis of the first seven items given
above, the total of the current liabilities, i.e., the last three items, is deducted to find out the
requirements of working capital.

In case of purely trading concerns, points 1, 2 and 3 would not arise but all other factors from points 4
to 10 are to be taken into consideration. In order to provide for contingencies, some extra amount
generally calculated as a fixed percentage of the working capital may be added as a margin of safety.

Suggested proformas for estimation of working capital requirements are given as

below:

1. For a Trading Concern :

Proforma:
Note:
Profits should be ignored while calculating working capital requirements as funds provided by profits
may or may not be used as working capital.

2. For a Manufacturing Concern:

Notes:

Profits should be generally ignored while calculating working capital requirements for the following
reasons:

(a) Profits may or may not be used as working capital.

(b) Even if profits are to be used for working capital it has to be reduced by the amount of income-tax,
drawings, dividend paid, etc.
3. Columnar Form:

An alternative proforma for estimation of working capital requirements in columnar

form is given below:

Approaches to Estimation of Working Capital Requirements:

While studying the valuation of each individual item of current assets or current
liabilities under the operating cycle method, that there are two approaches which are
followed in the estimation of working capital requirements:

(a) Total Approach:

Under this approach of estimation of working capital requirements, all costs including depreciation
and profit margin are included. Thus, production overhead inclusive of depreciation is considered for
calculation of the cost of work-in-progress. In the same manner, cost of goods produced includes
depreciation. Further, the computation of funds invested in debtors is done on the basis of selling
price including profit margin.

(b) Cash Cost Approach:

Under this approach, the amount of working capital is estimated on the basis of only cash costs
incurred. Thus, depreciation being non-cash is excluded while calculating the cost of work-in-process,
cost of goods produced and cost of goods sold. In the same manner, debtors are computed on the
basis of cash cost of sales excluding profit margin.

Method # 5. Projected Balance Sheet Method:

Under this method, projected balance sheet for future date is prepared by forecasting of assets and
liabilities by following any of the methods stated above. The excess of estimated total current assets
over estimated current liabilities, as shown in the projected balance sheet, is computed to indicate the
estimated amount of working capital required.

Illustration 5:

Prepare an estimate of working capital requirement from the following information of

a trading concern:
Illustration 6:

From the following details you are required to make an assessment of the average
amount of working capital requirement of AB Ltd.:
Illustration 7:

ABC Ltd. sells its products on a gross profit of 20% on sales.

The following information is extracted from its annual accounts for the year ended 31st
March 2008:

The company enjoys one month’s credit from suppliers of raw materials and maintains 2 months
stock of raw materials and one and a half months finished goods. Cash balance is maintained at Rs 1,
00,000 as a precautionary balance. Assuming a 10% margin, find out the working capital
requirements of ABC Ltd. Cost of sales for computation of debtors and stock of finished goods may be
taken at sales minus gross profit as per rate of gross profit given.
Illustration 8:

A proforma cost sheet of a company provides the following particulars:

Elements of Cost:

Material 40%

Direct Labour 20%

Overheads 20%

The following further particulars are available:

(a) It is proposed to maintain a level of activity of 2, 00,000 units.

(b) Selling price is Rs 12/- per unit.

(c) Raw materials are expected to remain in stores for an average period of one month.

(d) Material will be in process, on averages half a month and is assumed to be consisting of 100% raw
material, wages and overheads.

(e) Finished goods are required to be in stock for an average period of one month.

(f) Credit allowed to debtors is two months.

(g) Credit allowed by suppliers is one month.

You may assume that sales and production follow a consistent pattern.
You are required to prepare a statement of working capital requirements, a forecast
Profit and Loss Account and Balance Sheet of the company assuming that:
Working capital Approaches by Commercial Banks:

A) Matching or hedging approach: This approach matches assets and liabilities to maturities.
Basically, a company uses long term sources to finance fixed assets and permanent current assets and
short term financing to finance temporary current assets.

Example: A fixed asset which is expected to provide cash flow for 5 years should be financed by
approx 5 years long-term debts. Assuming the company needs to have additional inventories for 2
months, it will then seek short term 2 months bank credit to match it.

B) Conservative approach: it is conservative because the company prefers to have more cash on
hand. That is why, fixed and part of current assets are financed by long-term or permanent funds. As
permanent or long-term sources are more expensive, this leads to “lower risk lower return”.

C) Aggressive approach: The Company wants to take high risk where short term funds are used to
a very high degree to finance current and even fixed assets.

Components associated with WCM:

Often the interrelationships among the working capital components create real challenges for the
financial managers. Inventory is purchased from suppliers, sale of which generates accounts
receivable and collected in cash from customers to pay off those suppliers. Working capital has to be
managed because the firm cannot always control how quickly the customers will buy, and once they
have made purchases, exactly when they will pay. That is why; controlling the “cash-to-cash” cycle is
paramount.

The different components of working capital management of any organization are:

• Cash and Cash equivalents

• Inventory
• Debtors / accounts receivables
• Creditors / accounts payable

A) Cash and Cash equivalents:

One of the most important working capital components to be managed by all organizations is cash
and cash equivalents. Cash management helps in determining the optimal size of the firm’s liquid
asset balance. It indicates the appropriate types and amounts of short-term investments along with
efficient ways of controlling collection and payout of cash. Good cash management implies the co-
relation between maintaining adequate liquidity with minimum cash in bank. All companies strongly
emphasize cash management as it is the key to maintain the firm’s credit rating, minimize interest
cost and avoid insolvency.
B) Management of inventories:

Inventories include raw material, WIP (work in progress) and finished goods. Where excessive stocks
can place a heavy burden on the cash resources of a business, insufficient stocks can result in reduced
sales, delays for customers etc. Inventory management involves the control of assets that are
produced to be sold in the normal course of business.

For better stock/inventory control:

 Regularly review the effectiveness of existing purchase and inventory systems

 Keep a track of stocks for all major items of inventory
 Slow moving stock needs to be disposed as it becomes difficult to sell if kept for long
 Outsourcing should also be a part of the strategy where part of the production can be done
through another manufacturer
 A close check needs to be kept on the security procedures as well

C) Management of receivables:

Receivables contribute to a significant portion of the current assets. For investments into receivables,
there are certain costs (opportunity cost and time value) that any company has to bear, alongwith the
risk of bad debts associated to it. It is, therefore necessary to have proper control and management of
receivables which helps in taking sound investment decisions in debtors. Thereby, for effective
receivables management one needs to have control of the credits and make sure clear credit practices
are a part of the company policy, which is adopted by all others associated with the organization. One
has to be vigilant enough when accepting new accounts, especially larger ones. Thereby, the principle
lies in establishing appropriate credit limits for every customer and stick to them.

Effectively managing accounts receivables:

 Process and maintain records efficiently by regularly coordinating and communicating with
credit managers’ and treasury in-charges
 Prepare performance measurement reports
 Control accuracy and security of accounts receivable records.
 Captive finance subsidiary can be used to centralize accounts receivable functions and provide
financing for company’s sales

D) Management of accounts payable:

Creditors are a vital part of effective cash management and have to be managed carefully to enhance
the cash position of the business. One has to keep in mind that purchasing initiates cash outflows and
an undefined purchasing function can create liquidity problems for the company. The trade credit
terms are to be defined by companies as they vary across industries and also among companies.
COMMERCIAL PAPER
Commercial paper, or CP, is a short-term debt instrument issued by companies to raise funds
generally for a time period up to one year. It is an unsecured money market instrument issued in the
form of a promissory note and was introduced in India in 1990.

Corporates which enjoy a high rating can diversify their sources of shortterm borrowings using CPs.
Investors get an additional instrument. It is typically issued by large banks or corporations to cover
short-term receivables and meet short-term receivables and meet short-term financial obligations,
such as funding for a new project.

CPs have a minimum maturity of seven days and a maximum of up to one year from the date of issue.
However, the maturity date of the instrument typically should not go beyond the date up to which the
credit rating of the issuer is valid. They can be issued in denominations of ₹ 5 lakh or multiples
thereof.

Individuals, banking companies, other corporate bodies (registered or incorporated in India) and
unincorporated bodies, non-resident Indians and foreign institutional investors etc can invest in CPs.

However, investment by FIIs would be within the limits set for them by Securities and Exchange
Board of India from time to time.

Merits of Commercial Paper

 Technically, it provides more funds compared to other sources. The cost of commercial paper
to the issuing firm is lower than the cost of commercial bank loans.
 It is in freely transferable nature, therefore it has high liquidity also a wide range of maturity
provide more flexibility.
 A commercial paper is highly secure and does not contain any restrictive condition.
 Companies can save their extra funds on commercial paper and also earn some good return on
the same.
 Commercial papers produce a continuing source of funds. This is because their maturity can be
tailored to suit the needs of issuing firm. Again, commercial paper that matures can be repaid
by selling the new commercial paper.

Limitations of Commercial Paper

 Only financially secure and highly rated organizations can raise money through commercial
papers. New and moderately rated organizations are not in a position to raise funds by this
method.
 The amount of money that we can raise through commercial paper is limited to the deductible
liquidity available with the suppliers of funds at a particular time.
 Commercial paper is an odd method of financing. As such if a firm is not in a position to
redeem its paper due to financial difficulties, extending the duration of commercial paper is
not possible.
PUBLIC DEPOSITS:

Definition

Public deposits refer to the unsecured deposits invited by companies from the public mainly to
finance working capital needs. A company wishing to invite public deposits makes an advertisement
in the newspapers.

Any member of the public can fill up the prescribed form and deposit the money with the company.
The company in return issues a deposit receipt. This receipt is an acknowledgement of debt by the
company. The terms and conditions of the deposit are printed on the back of the receipt. The rate of
interest on public deposits depends on the period of deposit and reputation of the company.

A company can invite public deposits for a period of six months to three years. Therefore, public
deposits are primarily a source of short-term finance. However, the deposits can be renewed from
time-to-time. Renewal facility enables companies to use public deposits as medium-term finance.

Public deposits of a company cannot exceed 25 per cent of its share capital and free reserves. As these
deposits are unsecured, the company having public deposits is required to set aside 10 per cent of
deposits maturing by the end of the year. The amount so set aside can be used only for paying such
deposits.

Thus, public deposits refer to the deposits received by a company from the public as unsecured debt.
Companies prefer public deposits because these deposits are cheaper than bank loans. The public
prefers to deposit money with well-established companies because the rate of interest on public
deposits is higher than on bank deposits. Now public sector companies also invite public deposits.
Public deposits have become a popular source of industrial finance in India.

Merits of Public Deposits:

1. Simplicity:

Public deposits are a very convenient source of business finance. No cumbersome legal formalities are
involved. The company raising deposits has to simply give an advertisement and issue a receipt to
each depositor.

2. Economy:

Interest paid on public deposits is lower than that paid on debentures and bank loans. Moreover, no
underwriting commission, brokerage, etc. has to be paid. Interest paid on public deposits is tax
deductible which reduces tax liability. Therefore, public deposits are a cheaper source of finance.

3. No Charge on Assets:

Public deposits are unsecured and, therefore, do not create any charge or mortgage on the company’s
assets. The company can raise loans in future against the security of its assets.
4. Flexibility:

Public deposits can be raised during the season to buy raw materials in bulk and for other short-term
needs. They can be returned when the need is over. Therefore, public deposits introduce flexibility in
the company’s financial structure.

5. Trading on Equity:

Interest on public deposits is paid at a fixed rate. This enables a company to declare higher rates of
dividend to equity shareholders during periods of good earnings.

6. No Dilution of Control:

There is no dilution of shareholders’ control because the depositors have no voting rights.

7. Wide Contacts:

Public deposits enable a company to build up contacts with a wider public. These contacts prove
helpful in the sale of shares and debentures in future.

Demerits of Public Deposits:

1. Uncertainty:

Public deposits are an uncertain and unreliable source of finance. The depositors may not respond
when economic conditions are uncertain. Moreover, they may withdraw their deposits whenever they
feel shaky about the financial health of the company.

Depositors are entitled to withdraw their deposits at any time after giving prior notice to the
company. During times of financial tightness or distress the depositors may get panicky and wish to
withdraw their deposits.

Moreover, if a large number of depositors simultaneously withdraw their deposits during slump, the
company may find it difficult to repay a huge sum at once. Therefore, public deposits are described as
‘fair weather friends’.

2. Limited Funds:

A limited amount of funds can be raised through public deposits due to legal restrictions.

3. Temporary Finance:

The maturity period of public deposits is short. The company cannot depend upon public deposits for
meeting long-term financial needs.

4. Speculation:

As public deposits can be raised easily and quickly, a company may be tempted to raise more funds
than it can profitably use. It may keep idle money to meet future contingencies. The management of
the company may indulge in over-trading and speculation which exercise harmful effects on the
business.

5. Hindrance to Growth of Capital Market:

Public deposits hamper the growth of a healthy capital market in the country. Widespread use of
public deposits creates a shortage of industrial securities.

6. Limited Appeal:

Public deposits do not appeal as a mode of investment to bold investors who want capital gains.
Conservative investors may also not like these deposits in the absence of proper security.

7. Unsuitable for New Concerns:

New companies lacking in sound credit standing cannot depend upon public deposits. Investors do
not like to deposit money with such companies.

INTERCORPORATE INVESTMENT

Intercorporate investment occurs when a company makes an investment in another company. It

could be through the purchase of shares of a publicly traded company on a public exchange, or a
privately negotiated deal for a share of a company that is not publicly traded. The investment may
also involve buying the debt of another company, publicly traded or otherwise.

Intercorporate investments fall into one of three categories which affect the accounting treatment of
the investment: minority passive (less than 20% ownership), minority active (20%-50% ownership)
and controlling interest (over 50%). The companies can also opt to call it a joint venture where
decisions are made together.

For minority active and joint venture investments, the equity method of accounting is used. For a
controlling interest, the consolidation method is used. When a minority passive interest is taken, the
investment is not treated much differently than other securities owned by the company for investment
purposes.

The security can be designated as held to maturity (bonds), held for trading (bonds and stocks),
available for sale (bonds and stocks) or held on the balance sheet at its designated fair value as a long-
term asset.

Accounting for Intercorporate Investments

Unless it is a minority passive interest, intercorporate investments are accounted for differently than
other investments by a company. Investments a company makes where they have significant control
over the actions and future direction of another company utilize methods of accounting that require
the acquiring company to take on some of the target company's financial weight.
In the equity method of accounting, which is used for joint venture or a minority active interest, the
initial investment in the target company is recorded on the balance sheet and goodwill must be
recognized. Earnings of the target company are added to the balance sheet of the acquirer per the
proportion of ownership of the acquirer. Dividends are recorded on the income statement.

For the acquisition method of accounting, the companies' assets, liabilities, revenues and expenses are
combined on the financial statement of the acquirer, and an account for minority interest is created to
represent the acquirer's non-controlling interest in the target.