COST-VOLUME-PROFIT ANALYSIS

Financial Management Decisions

Problems

The working capital estimation as per the method of operating cycle, is the most systematic
and logical approach. In this case, the working caital estimation is made on the basis of
analysis of each and every component of the working capital individually. As already dis-
cussed, the working capital, required to sustain the level of planned operations, is deter-
mined by calculating all the individual components of curent assets and current liabilities.
The calculation of net working capital may also be shown as follows ;

Working Capital = Current Assets – Current Liabilitie

= (Raw Materials Stock + Work-in-progress Stock + Finished
Goods Stock + Debtors + Cash Balance) – (Creditors + Outstand-
ing Wages + Outstanding Overheads).
Where,
Raw Materias = Cost (Average) of Materials in Stock.
Work-in-progress Stock = Cost of Materials + Wages +Overhead of Work-in-progress.
Finished Goods Stock = Cost of Materials + Wages +Overhead of Work-in-progress.
Creditors for Material = Cost of Average Outstanding Creditors.
Creditors for Wages = Averages Wages Outstanding.
Creditors for Overhead = Average Overheads Outstanding.
Thus, Working Capital = Cost of Materials in Stores, in Work-in-progress, in Finished
Goods and in Debtors.
Less : Creditors for Materials
Plus : Wages in Work-in-progress, in Finished Goods and in
Debtors.
Less : Creditors for Wages.
Plus : Overheads in Work-in-progress, in Finished Goods and in
Debtors.
Less : Creditors for Overheds.
The work sheet for estimation of working capital requirements under the operating cycle
method may be presented as follows :
Estimation of Working Capital Requirements
1 Current Assets : Amount Amount Amount
Minimum Cash Balance ****
Inventories :
Raw Materials ****
Work-in-progress ****
Finished Goods **** ****

242 Fianancial Management & international finance

 Receivables :
Debtors ****
Bills **** ****
Gross Working Capital (CA) **** ****
II Current Liabilities :
Creditors for Purchases ****
Creditors for Wages ****
Creditors for Overheads **** ****
Total Current Liabilities (CL) **** ****
Excess of CA over CL ****
+ Safety Margin ****
Net Working Capital ****
The following points are also worth noting while estimating the working capital
requirement :
1 Depreciation : An important point worth noting while estimating the working capital
requirement is the depreciation on fixed assets. The depreciation on the fixed assets,
which are used in the production process or other activities, is not considered in work-
ing capital estimation. The depreciation is a non-cash expense and there is no funds
locked up in depreciation as such and therefore, it is ignored. Depreciation is neither
included in valuation of work-in-progress nor in finished goods. The working capital
calculated by ignoring depreciation is known as cash basis working capital. In case, de-
preciation is included in working capital calculations, such estimate is known as total
basis woking capital.
2. Safety Margin : Sometimes, a firm may also like to have a safety margin of working
capital in order to meet andy contingency. The safety margin may be expressed as a %
of total current assets or total current liabilities or net workiong capital. The safety
margin, if required, is incorporated in the working capital estimates to find out the net
working capital required for the firm. There is no hard and fast rule about the quan-
tum of safety margin and depends upon the nature and characteristics of the firm as
well as of its current assets and current liabilities.

Illustration 1.
The cost sheet of POR Ltd. provides the following data :
Cost per unit
Raw materials Rs. 50
Direct Labor 20
Overheads (including depreciation of Rs. 10) 40
Total cost 110
Profits 20
Selling price 130
Average raw material in stock is for one month. Average materials in work-in-progress is for
half month. Credit allowed by suppliers; one month; credit allowed to debtors; one month.
Average time lag in payment of wages; 10 days; average time lag in payment of overheads

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COST-VOLUME-PROFIT ANALYSIS
Financial Management Decisions

30 days. 25% of the sales are on cash basis. Cash balance expected to be Rs. 1,00,000. Fin-
ished goods lie in the warehouse for one month.
You are required to prepare a statement of the working capital needed to finance a level of
the acitivity of 54,000 units of output. Production is carried on evenly throughout the year
and wages and overheads accrue similarly. State your assumptions, if any, clearly.

Solution :
As the annual level of acitivity is given at 54,000 units, it means that the monthly turnover
would be 54,000/12=4,500 units. The working capital requirement for this monthly turn-
over can now be estimated as follows :
Estimation of Working Capital Requirements
1 Current Assets : Amount (Rs.) Amount (Rs.)
Minimum Cash Balance 1,00,000
Inventories :
Raw Materials (4,500×Rs. 50) 2,25,000
Work-in-progress :
Materials (4,500×Rs. 50)/2 1,12,500
Wages 50% of (4,500×Rs. 20)/2 22,500
Overheads 50% of (4,500×Rs. 30)/2 33,750
Finished Goods (4,500×Rs. 100) 4,50,000
Debtors (4,500×Rs. 100×75%) 3,37,500
Gross Working Capital 12,81,250 12,81,250
II Current Liabilities :
Creditors for Materials (4,500×Rs. 50) 2,25,000
Creditors for Wages (4,500×Rs. 20)/3 30,000
Creditors for Overheads (4,500×Rs. 30) 1,35,000
Total Current Liabilities 3,90,000 3,90,000
Net Working Capital 8,91,250
Working Notes :
1. The Overheads of Rs. 40 per unit include a depreciation of Rs. 10 per unit, which is a
non-cash item. This depreciation cost has been ignored for valuation of work-in-progress,
finished goods and debtors. The overhead cost, therefore, has been taken only at Rs. 30
per unit.
2. In the valuation of work-in-progress, the raw materials have been taken at full require-
ments for 15 days; but the wages and overheads have been taken only at 50% on the
assumption that on an average all units in work-in-progress are 50% complete.
3. Since, the wages are paid with a time lag of 10 days, the working capital provided by
wages has been taken by dividing the monthly wages by 3 (assuming a month to con-
sist of 30 days).
Illustration 2.
Grow More Ltd. is presently operating at 60% level, producing 36,000 units per annum. In
view of favourable market conditions, it has been decided that from 1st January 2000, the

244 Fianancial Management & international finance

Company would operate at 90% capacity. The following informations are available :
(i) Existing cost-price structure per unit is given below :
Raw materials Rs. 4.00
Wages 2.00
Overheads (Variable) 2.00
Overheads (Fixed) 1.00
Profits 1.00
(ii) It is expected that the cost of raw material, wages rate expenses and sales per unit
will remain unchanged in 2000.
(iii) Raw materials remain in store for 2 months before these are issued to production.
These units remain in production process for 1 month.
(iv) Finished goods remain in godown for 2 months.
(v) Credit allowed to debtors is 2 months. Credit allowed by creditors is 3 months.
(vi) Lag in wages and overhead payments is 1 months. It may be assumed that wages
and overhead accrue evenly throughout the production cycle.
You are required to :
(a) Prepare profit statement at 90% capacity level; and
(b) Calculate the working requirements on an estimated basis to sustain the increased
production level.
Assumption made if any, ahould be clearly indicated.

Solution :
Statement of Profitability at 90% Capacity
Units (at 90% capacity) 54,000
Sales (54,000×Rs. 10) (A) Rs. 5,40,000
Cost :
Raw materials (54,000×Rs. 4) 2,16,000
Wages (54,000×Rs. 2) 1,08,000
Variable overhead (54,000×Rs. 2) 1,08,000
Fixed overhead (Rs. 1×36,000) 36,000
Total cost (B) 4,68,000
Net Profit (A–B) 72,000
Statement of Working Capital Requirement
A. Current Assets : (Rs.) (Rs.)
Stock of raw materials (2 months×4,500×Rs. 4) 36,000
Work-in-progress :
Materials (1 month×4,500×Rs. 4) 18,000
Wages (1/2 month) 4,500
Overheads (1/2 month) 6,000 28,500
Finished goods (2 month) 78,000
Debtors [2 months × (4,68,000/12)] 78,000
Total Current Assets 2,20,500

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 Financial Management
COST-VOLUME-PROFIT Decisions
ANALYSIS

B. Current Liabilities
Sundry creditors (goods)-3 months 54,000
Outstanding wages (1 month) 9,000
Outstanding overhead (1 month) 12,000
Total Current liabilities 75,000
Working capital requirment 1,45,500
Working Note :
Overhead and Wages — The work in progress period is one month. So, the wages and
overheads included in work-in-progress, are on an average, for half month or 1/24 of a year.
Rs . 1,08,000
Wages = = Rs . 4,500
24
Rs . 1,08,000 − 36,000
Overhead = = Rs . 6,000
24
The valuation of finished goods can also be arrived at as follows :
Number of units = 4,500×2 = 9,000
Variable cost = Rs. 8 per unit
Fixed Cost (Rs. 36,000/12)×2 = Rs. 6,000
Total cost of finished goods (9,000×8) + 6,000= Rs. 78,000
As the decision to increase the operating capacity from 60% to 90% is already taken, it has
been assumed hat the opening balance of raw materials, work in progress and finished goods
have already been brought to the desired level. Consequently, good purchased during the
period will be only for the production requirement and not for increasing the level of stock.
Illustration 3
The management of Royal Industries has called for a statement showing the working capital
to finance a level of acitivity of 1,80,000 units of output for the year. The cost structure for the
company’s product for the above mentioned activity level is detailed below :
Cost per unit
Raw material Rs. 20
Direct labour 5
Overheads (including depreciation of Rs. 5 per unit) 15
40
Profit 10
Selling price 50
Additional information :
(a) Minimum desired cash balance is Rs. 20,000
(b) Raw materials are held in stock, on an average, for two months.
(c) Work-in-progress (assume 50% completion stage) will approximate to half-a-month’s
production.
(d) Finished goods remian in werehouse, on an average, for a month.
(e) Suppliers of materials extend a month’s credit and debtors are provided two month’s
credit; cash sales are 25% of total sale.

246 Fianancial Management & international finance

 (f) There is a time-lag in payment of wages of a month; and half-a-month in the case of
overheads.
From the above facts, you are required to prepare a statment showing working capital re-
quirements.
Solution :
Statement of Total Cost
Raw material (1,80,000×Rs. 20) Rs. 36,00,000
Direct labour (1,80,000×Rs. 5) 9,00,000
Overheads (excluding depreciation) (1,80,000×Rs. 10) 18,00,000
Total Cost 63,00,000
Statement of Working Capital Requirement
1. Current Assets : Amt. (Rs.)
Cash balance 20,000
Raw materials (1/6 of Rs. 36,00,000) 6,00,000
Work-in-progress (Total cost¸24×50%) 1,31,250
Finished goods (Total cost¸12) 5,25,000
Debtors (75%×Rs. 63.00,000)×1/6 7,87,500
Total current assets 20,63,750
2. Current liablities :
Creditors (Rs. 36,00,000)×1/12 3,00,000
Direct labour (Rs. 9,00,000)×1/12 75,000
Overheads (Rs. 18,00,000)×1,24 (excluding dep.) 75,000
Total current liabilities 4,50,000
Net working capital requirement 16,13,750
Note : Depreciation is a non-cash item, therefor, it has been excluded from total cost as
well as working capital provided by overheads. Work-in-progress has been assumed to be
50% complete in respect of materisls as well as labour and overheads expenses.

Illustration 4.
XYZ Ltd. sells its products on a gross profit of 20% of sales. The following information is
extracted from its annual accounts for the year ending 31st March, 2009.
Sales (at 3 months credit) Rs. 40,00,000
Raw material 12,00,000
Wages (15 days in arreas) 9,60,000
Manufacturing and General expenses (one month in arrears) 12,00,000
Administration expenses (one month in arrears) 4,80,000
Sales promotion expenses (payable half yearly in advance) 2,00,000

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Financial Management Decisions

The company enjoys one month’s credit from the suppliers of raw materials and maintains 2
months stock of raw materials and 1½ 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 requirement of XYZ Ltd.
Solution :
Statement of Working Capital Requirement
1. Current Assets : Amt. (Rs.)
Debtors (40,00,000×3/12×80%) 9at cost of goods sold) 8,00,000
Raw maetrial stock (2/12 of 12,00,000) 2,00,000
Finished goods stock (1½ months of cost of production)
(Cost of production being 80% of sales of 40,00,000) 4,00,000
Advance payment of sales promotion 1,00,000
Cash 1,00,000
Total Current assets 16,00,000

2. Current liabilities :
Sundry creditors (1/12 of 12,00,000) 1,00,000
Wages (arrears for 15 days) (1/24 of 9,60,000) 40,000
Manu, and Gen. exp. (arrears for 1 month)(1/12 of 12,00,000) 1,00,000
Administrative exp. (arrears for 1 months) (1/12 of 4,80,000) 40,000
Total Current liabilities 2,80,000
Excess of Current Assets and Current Liabilities 13,20,000
Add 10% margin 1,32,000
Net working capital requirement 14,52,000

Illustration 5.
Hi-tech Ltd. plans to sell 30,000 units next year. The expected cost of goods sold is as fol-
lows :
Rs. (Per Unit)
Raw material 100
Manufacturing expenses 30
Selling, administration and financial expenses 20
Selling price 200
The duration at various stages of the operating cycle is expected to be as follows :
Raw material stage 2 months
Work-in-progress stage 1 month
Finished stage 1/2 month
Debtors stage 1 month

248 Fianancial Management & international finance

Assuming the monthly sales level of 2,500 units, estimate the gross working capital require-
ment is the desired cash balance is 5% of the gross working capital requirement, and work-
in-progress in 25% complete with respect tomanufacturing expenses.

Solution :
Statement of Working Capital Requirement
1. Current Assets : Amt. (Rs.) Amt. (Rs.)
Stock of Raw Material (2,500×2×100) 5,00,000
Work-in-progress :
Raw Materials (2,500×100) 2,50,000
Manufacturing Expenses 25% of (2,500×300) 18,750 2,68,750
Finished Goods :
Raw Materials (2,500×½×30) 1,25,000
Manufacturing Expenses (2,500×½×30) 37,500 1,62,500
Debtors (2,500×150) 3,75,000
13,06,250
Cash Balance (13,06,250×5/95) 68,750
Working Capital Requirement 13,75,000

Note : Selling, administration and financial expenses have not been included in valuation of
closing stock.

Illustration 6.
Calculate the amount of working capital requirement for SRCC Ltd. from the following
information :
Rs. (Per Unit)
Raw materials 160
Direct labour 60
Overheads 120
Total cost 340
Profit 60
Selling price 400

Raw materials are held in stock on an average for one month. Materials are in process on an
average for half-a-month. Finished goods are in stock on an average for one month.
Credit allowed by suppliers is one month and credit allowed to debtors is two months. Time
lag in payment of wages is 1½ weeks. Time lag in payment of overhead expenses is one
month. One fourth of the sales are made on cash basis.
Cash in hand and at the bank is expected to be Rs. 50,000; and expected level of production
amounts to 1,04,000 units for a year of 52 weeks.

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COST-VOLUME-PROFIT ANALYSIS
Financial Management Decisions

You may assume that production is carried on evenly throughout the year and a time period
of four weeks is equivalent to a month.

Solution :
Statement of Working Capital Requirement
1. Current Assets : Amt. (Rs.) Amt. (Rs.)
Cash Balance 50,000
Stock of Raw Materials (2,000×160×4) 12,80,000
Work-in-progress :
Raw Materials (2,000×180×2) 6,40,000
Labour and Overheads (2,000×180×2)×50% 3,60,000 10,00,000
Finished Goods (2,000×340×4) 27,20,000
Debtors (2,000×75%×300×8) 40,80,000
Total Current Assets 91,30,000
2. Current Liabilities :
Creditors (2,000×Rs. 160×4) 12,80,000
Creditors for Wages (2,000×Rs. 160×1½) 1,80,000
Creditors for Overheads (2,000×Rs. 160×4) 9,60,000
Total Current Liabilities 24,20,000
Net Working Capital (CA–CL) 67,10,000

Illustration 7.
X Ltd. sells goods at a gross profit of 20%. It includes depreciation as part of cost of produc-
tion. The following figures for the 12 months ending 31st Dec. 2008 are given to enable you
to ascertain the requirement of working capital of the company on a cash cost basis.
In your working, you are required to assume that :
(i) a sefety margin of 15% will be maintained;
(ii) cash is to be held to the extent of 50% of current liabilities.
(iii) there will be no work-in-progress;
(iv) tax is to be ignored.
Stocks of raw materials and finished goods are kept at one month’s requirements. All work-
ing notes are to form part of your answer.
Sales at 2 months credit Rs. 27,00,000
Materials consumed (suppliers credit if for 2 months) 6,75,000
Total wages (paid at the beginning of the next month) 5,40,000
Manufacturing expenses outstanding at the end of the year 60,000
(These expenses are paid one month in arrears)
Total administrative expenses (paid as above) 1,80,000
Sales promotion expenses paid quarterly and in advance 90,000

250 Fianancial Management & international finance

Solution :
Calculation of Manufacturing Cost–(Cash Cost only)
Materials Consumed Rs. 6,75,000
Wages 5,40,000
Cash manufacturing expenses (Rs. 60,000×12) 7,20,000
A) Cash manufacturing cost 19,35,000
B) Cost of sales (cash cost only)
Cash manufacturing cost (as per ‘A’ above) 19,35,000
Administrative expenses 1,80,000
Sales promotion expenses 90,000
22,05,000
C) Current Liabilities
Creditors for goods (1/6 of materials consumed) 1,12,500
Outstanding wages (1 month) (Rs. 5,40,000/12) 45,000
Cash manufacturing cost (outstanding one month) 60,000
Administrative expenses (outstanding one month) 15,000
2,32,500
D) Current assets
Debtors (at cost of sales) (Rs. 22,05,000/12)×2 3,67,500
Stock of raw materials (Rs. 6,75,000/12) 56,250
Finished stock (1/12 of Rs. 19,35,000) 1,61,250
Cash in hand–50% of current liabilities 1,16,250
Advance payment of expenses (sales promotion) 22,500
Total Current assets 7,23,750
– Current liabilities 2,32,500
Excess of current assets over current liabilities 4,91,250
+ Safety margin 15% 73,687
Working capital on cash cost basis 5,64,937
It may be noted that Gross Profit ratio is given at 20%. So, the cost of production (inclusive of
depreciation is 80%. For Sales of Rs. 27,00,000, the total cost of goods sold comes to Rs.
21,60,000 (i.e., 80% of 27,00,000). But the cash manufacturing cost is only Rs. 19,35,000.
Therefore, depreciation would have been Rs. 2,25,000 (i.e., Rs. 21,60,000–Rs. 19,35,000).
Illustration 8.
A Company has applied a short-term loan to a commercial bank for financing its working
capital requirement. You are asked by the bank to prepare an estimate of the requirement of
the working capital for that company. Add 10% to your estimated figure to cover unforeseen
contingencies. The information about the project Profit and Loss A/c of the company is as
under :
Sales Rs. 21,00,000
Cost of goods sold 15,30,000
Gross Profit 5,70,000

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Financial Management Decisions

Administrative expenses Rs. 1,40,000

Selling expenses 1,30,000 2,70,000
Profit before Tax 3,00,000
Provision for Tax 1,00,000
Cost of goods sold has been derived as follows :
Materials used 8,40,000
Wages and Manufacturing expenses 6,25,000
Depreciation 2,35,000 17,00,000
–Stock of finished goods (10% of total production) 1,70,000
15,30,000
The figure given above relate only to the goods that have been finished and not to W.I.P.
goods which is equal to 15% of the year’s production (in terms of physical units) on an
average, requiring full materials but only 40% of the other expenses. The company believes
in keeping 2 months consumption of material in stock.
All expenses are paid one month in arrears. Suppliers of mateials extend 1½ months credit.
Sales are 20% cash, rest are at 2 months credit. You can make such other assumptions as you
deem necessary for estimating working capital requirement.
Solution :
1. Current Assets :
Stock of Raw Materials (2/12 of 8,40,000) Rs. 1,40,000
Work-in-progress :
Raw maertials (15/100 of 8,40,000) Rs. 1,26,000
Wages and manufacturing (6,25,000×40%×15%) 37,000 1,63,500
Stock finished goods : [10% of (8,40,000+6,25,000)] 1,46,500
Debtors (2 months) :
Cost of goods sold 15,30,000
–Depreciation (2,35,000–23,500) 2,11,500
13,18,500
Adm. Expenses 1,40,000
Selling Expenses 1,30,000
Total Cost 15,88,500
–Cash sales @ 20% 3,17,700
12,70,800
Debtors (2/12 of 12,70,800) 2,11,800
6,61,800
2. Current Liabilities :
Creditors (8,40,000/12×1½) 1,05,000
O/S Wages and Manufacturing exp. (1/12 of 6,25,000) 52,083
O/S Administrative expenses (1/12 of 1,40,000) 11,667
Selling expenses (1/12 of 1,30,000) 10,833 1,79,583

252 Fianancial Management & international finance

 Excess of curent assets over current liabilities 4,82,217
+ 10% for contigencies 48,222
Working capital requirement 5,30,439
Illustration 9
JBC Ltd. sells goods on a gross profit of 25%. Depreciation is considered as a part of cost of
production. The following are the annual figures given to you :
Sales (2 months credit) Rs. 18,00,000
Materials consumed (1 months credit) 4,50,000
Wages paid (1 month lag in payment) 3,60,000
Cash manufacturing expenses (1 month lag in payment 4,80,000
Administrative expenses (1 month lag in payment) 1,20,000
Sales promotion expenses (paid quarterly in advance) 60,000
The company keeps one month’s stock each of raw materials and finished goods. It also
keeps Rs. 1,00,000 in cash. You are required to estimate the working capital requirements of
the company on cash cost basis, assuming 15% safety margin.
Solution :
Statement of Working Capital Requirement
1. Current Assets : Amt. (Rs.)
Cash-in-hand 1,00,000
Debtors (cost of sales i.e. 14,70,000×2/12) 2,45,000
Prepaid Sales Promotion expenses 15,000
Inventories :
Raw Materials (4,50,000/12) 37,500
Finishd goods (12,90,000/12) 1,07,500
Total current assets 5,05,000
2. Current Liabilities :
Sundry creditors (4,50,000/12) 37,500
Outstanding Manufacturing exp. (4,80,000/12) 40,000
Outstanding Administrative exp. (1,20,000/12) 10,000
Outstanding Wages (3,60,000/12) 30,000
Total current liabilities 1,17,500
Excess of CA and CL 3,87,500
+ 15% for contingencies 58,125
Working capital required 4,45,625
Working Notes :
1. Cost Structure Rs.
Sales 18,00,000
– Gross profit 25% on sales 4,50,000
Cost of production 13,50,000
– Cost of materials Rs. 4,50,000
– Wages 3,60,000 8,10,000

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Financial Management Decisions

Manufacturing expenses (Total) 5,40,000

– Cash Manufacturing expenses 4,80,000
Therefore, Depreciation 60,000
2. Total cash cost :
Cost of production 13,50,000
– Depreciation 60,000
+ Administrative expenses 1,20,000
+ Sales promotion expenses 60,000
Total Cash Cost 14,70,000
Illustration 10.
Prepare a working capital forecast from the following information :
Production during the previous year was 10,00,000 units. The same level of activity in is
intended to be maintained during the current year.
The expected ratios of cost to selling price are :
Raw material 40%
Direct Wages 20%
Overheads 20%
The raw materials ordinarily remian in stores for 3 months before production. Every unit of
production remains in the process for 2 months and is assumed to be consisting of 100% raw
material, wages and overheads. Finished goods remain in the warehouse for 3 months. Credit
allowed by creditors is 4 months from the date of the delivery of raw material and credit
given to debtors is 3 months from the date of dispatch.
The estimated balance of cash to be held Rs. 2,00,000
Lag in payment of wates 1/2 month
Lag in payment of expenses 1/2 month
Selling price is Rs. 8 per unit. Both production and sales are in a regular cycle. You are
required to make a provision of 10% for contingency (except cash). Relevant assumptions
may be made.

Solution :
Total Sales = 10,00,000×8=Rs. 80,00,000
Statement of Working Capital Requirement
A. Current Assets : Rs. Rs.
Debtors (80,00,000×80%×3/12) 16,00,000
Finished Goods (80,00,000×80%×3/12) 16,00,000
Work-in-progress (80,00,000×80%×2/12) 10,66,000
Raw Materials (80,00,000×40%×3/12) 8,00,000
Total current assets 50,66,667 50,66,667
B. Current Liabilities :
Creditors (80,00,000×40%×4/12) 10,66,667
Wages (80,00,000×20%×1/24) 66,667
Expenses (80,00,000×20%×1/24) 66,666 12,00,000

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 Excess of CA over CL 38,66,667
+ 10% contingency 3,86,667
42,53,334
Cash 2,00,000
Working Capital Requirement 44,53,334
Illustration 11.
On 1st January, 2000, the Board of Directors of Dowell Co. Ltd. wishes to know the amount
of working capital that will be required to meet the program of acitivity they have planned
for the year. The following informations are available :
i) Issued and paid-up capital Rs. 2,00,000.
ii) 5% Debebtures (secured on assets) Rs. 50,000.
iii) Fixed assets valued at Rs. 1,25,000 on 31.12.2000.
iv) Production during the previous year was 60,000 units. It is planned that the level of
acvitity should be maintained during the present year.
v) The ratios of cost to selling price are—raw materials 60%., direct wages 10%, and
overheads 20%.
vi) Raw materials are expected to remain in stores for an average of two months before
these are issued for production.
vii) Each unit of production is expected to be in process for one month.
viii) Finished goods will stay in warehouse for approximately three months.
ix) Creditors allow credit for 2 months from the date of delivery of raw materials.
x) Credit allowed to debtors is 3 months from the date of dispatch.
xi) Selling price per unit is Rs. 5.
xii) There is a regular production and sales cylce.
Prepare— a) working capital requirement forcast; and
b) an estimated Profit and Loss Account and Balance Sheet at the end of the year.

Solution :
Statement of Working Capital Requirement
A. Current Assets : Amt. (Rs.)
Raw Materials (1,80,000/6) 30,000
Work in progress (1 month) 18,750
Finished goods (3 months) 67,500
Debtors (3 months) (2,70,000/4) 67,500
Total Current Assets 1,83,750
B. Current Liabilities :
Creditors (2 months consumption of RM) 30,000
Net working capital (CA–CL) 1,53,750
Working Notes :
1. Computation of Cost and Sales for 60,000 units :
Sales @ Rs. 5 per unit
Cost of production : 1,80,000

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Financial Management Decisions

Direct Wages @ Rs. 0.50 per unit 30,000

Overheads @ Rs. 100 60,000
Total Cost of Sales 2,70,000
2. Calculation of work in progress (1 month production) :
Raw material (Rs. 1,80,000/12 Rs. 15,000
Direct Wages (Rs. 30,000/12)×50% 1,250
Overheads (Rs. 60,000/12)×50% 2,500
18,750
The direct wages and overheads are assumed to have accrued evently through out the month.
So, only 1/2 month wages and overheads are included work in progress.
Projected Profit and Loss Account for the year ending Decmber 2000.
Sales (60,000×5) Rs. 3,00,000
–Raw material @ 60% Rs. 1,80,000
–Direct Wages @ 10% 30,000
–Overheads @ 20% 60,000 2,70,000
Gross Profit 30,000
–Debenture Interest @ 5% on 50,000 2,500
New Profit 27,500
Projected Balance Sheet as on Dec. 31, 2000
Liabilites Amt. (Rs.) Assets Amt. (Rs.)
Share capital 2,00,000 Fixed assets 1,25,000
Profit and Loss A/c (Bal. Fig.) 8,750 Raw materials 30,000
Profit for the year 1996 27,500 Finished goods 67,500
5% Debentures 50,000 Work-in-progress 18,750
Creditors 30,000 Debtors 75,000
3,16,250 3,16,250
Illustration 12.
Prepare an estimate of net working capital requirement for the WCM Ltd. adding 10% for
contingencies from the information given below :
Estimated cost per unit of production Rs. 170 includes raw materials Rs. 80, direct labour Rs.
30 and overheads (exclusive of depreciation) Rs. 60. Selling price is Rs. 2000 per unit. Level of
activity per annum 1,04,000 units. Raw materials in stock : average 4 weeks; work-in-progress
(assume 50% completion stages) : average 2 weeks; finished goods in stock : average 4 weeks;
credit allowed by suppliers ; average 4 weeks; credit allowed to debtors : average 8 weeks;
lag in payment of wages : average 1.5 weeks, and cash at bank is expected to be Rs. 25,000.
You may assume that production is carried on evenly throughout the year (52 weeks) and
wages and overheads accrue similarly. All sales are on credit basis only. You may state your
assumptions, if any.

256 Fianancial Management & international finance

Solution :
Statement of Working Capital Requirement
A. Current Assets : Rs. Rs.
i) Raw materials in stock : (1,04,000×80×4)/52 6,40,000
ii) Work-in-progress :
a) Raw materials (1,04,000×80×2)/52 3,20,000
b) Direct Labour 50% of (1,04,000×30×2)/52 60,000
c) Overheads 50% of (1,04,000×60×2)/52 1,20,000
iii) Finished Good Stock (1,04,000×170×4)/52 13,60,000
iv) Debtors (1,04,000×170×8)/52 27,20,000
v) Cash at Bank 25,000
Total Current Assets 52,45,000
B. Current Liabilities :
i) Creditors (1,04,000×80×4)/52 6,40,000
ii) Wages (Lag-in-payment) : (1,04,000×30×1½)/52 90,000
Total current liabilities : 7,30,000
Net Working Capital (CA–CL) 45,15,000
+ 10% Contingencies 4,51,500
Working Capital Requirement 4,51,500
Assumptions : Net working capital requirement has been estimated on cash cost basis.
Hence, investment in debtor has been computed on cash cost.

Illustration 13.
Gulfam Ltd. is presently operating on single shift basis and has the following cost structure
(per unit) :
Selling Price Rs. 36 Raw Materials Rs. 12
Wages (60% Variable Rs. 10
Overheads (20% Variable) Rs. 10
Rs. 32
For the year ending March, 31, 2000; the sales amounted to Rs. 8,64,000 and the current
asset position on that day was follows :
Raw material Rs. 72,000
Finished Goods 1,44,000
Working in progress (Prime Cost) 44,000
Debtors 2,16,000
At present the company receives a credit of 2 months from the Supplier of raw materials and
Wages & expenses are payable with a time lag of half a month.

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COST-VOLUME-PROFIT ANALYSIS
Financial Management Decisions

In order to meet the extra demand, the company is preparing to work in double shift. The
increase production will enable the firm to get a 10% discount from the supplier of raw
materils. There will not be any change in fixed cost, credit policy etc.
Ascertain the effect on requirement for working capital if the proposal of double shift mate-
rializes.

Solution :
In order to calculate the working capital requiement for double shift operations, the existing
parametres should be ascertained as follows :
Present Position : Sales (Rs. 8,64,000÷36) = 24,000 Units of 2,000 units per month
Debtors : (2,16,000÷8,64,000)×12 = 3 months Outstanding.
Raw Material : (72,000 ÷ 12)=6,000 Units or 3 months requirement.
Work in Process : (44,000 ÷ 22)=2,000 Units or 1 months
Finished Goods : (1,44,000÷32) = 4,500 units or 2.25 months requirement.
New Cost of Raw Material : Rs. 12–10% of 12 = Rs. 10.80

Working Capital Requirement

Single Shift (Present Position) Double Shift (Proposed Position).
Current Assets Amont Current Assets : Amount
Raw Materials (Given) 72,000 Raw Material (4,000×3×10.80) 1,29,600
Work in process (Given) Work in process (4,000×20.80) 83,200
(2000×12) 24,000 Finished Goods (4,000×2.25×30.80) 2,77,200
Finished Goods (Given) 1,44,000 Debtors at cost (4,000×3×30.80) 3,69,600
Debtors at cost (2,000×3×32) 1,92,000
Total Current Assets : 4,52,000 Total Current Assets : 8,59,600
Less Current Liabilities : Less Current Liabilities :
Creditors : (2,000×12×2) 48,000 Creditors (4,000×10.80×2) 86,400
Wages & Expenses
(2,000×20×½) 20,000 Wages & Expenses 40,000
Working Capital Requirement 3,84,000 Working Capital Requirement 7,33,200

So, the Working Capital requirement will increase by (Rs. 7,33,200–3,84,000)=Rs. 3,49,200
due to change from single shift to double shift operations.

258 Fianancial Management & international finance

CASH MANAGEMENT PROBLEMS AND SOLUTIONS

Illustration 1
United Industries Ltd. projects that cash outlays of Rs. 37,50,000 will occur uniformly
throughout the coming year. United plans to meet its cash, requirements by periodically
selling marketable securities from its portfolio. The firm’s marketable securities are invested
to earn 12% and the cost. per transaction of converting securities to cash is Rs. 40.
a. Use the Baumol Model to determine the optimal transaction size of marketable secu-
rities to cash.
b. What will be the company’s average cash balance?
c. How many transfers per year will be required?
d. What will be the total annual cost of maintaining cash balances?

Solution :
______ ____________________
a) Optimal size = “2TA/ I = “(2 X 40 X 375000)/0.12 = 50000
b) average cash balance = Rs25000
c) No of transactions per year =3750000/50000 = 75
d) Total annual cost
Transaction cost 75x40 = 3000
Opportunity cost50000x1/2x12% = 3000
6000

Illustration 2
The Cyberglobe Company has experienced a stochastic demand for its product. With the
result that cash balances fluctuate randomly. The standard deviation of daily net cash flows
is Rs. 1,000, The company wants to impose upper and lower bound control limits for conver-
sion of cash into marketable securities and vice-versa. The current interest rate on market-
able securities is 6%. The fixed cost associated with each transfer is Rs. 1,000 and minimum
cash balance to be maintained is Rs. 10,000.
Compute the upper lower limits.
Solution :
Standard Deviation = 1000
Variance = 1000 x 1000 = 1000000
Interest = 6% / 365 = 0.016%
T = 1000
L = 10000
________ __________________________________
Z = 3" (3TV / 4I) = 3" (3x 1000 x 1000 x 1000) / (4 x 0.016%)
= 3573
Return point = Z + L
3573 + 10000 = 13573
Upper limit = 3R -2L
40719 – 20000 = 20719

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Financial Management Decisions

RECEIVABLES MANAGEMENT
PROBLEMS AND SOLUTIONS

Illustration 1
The following are the details regarding the operations of a firm during a period of 12 months.
Sales Rs.12,00,000
Selling price per unit Rs.10
Variable cost price per unit Rs. 7
Total cost per unit Rs. 9
Credit period allowed to customers one month. The firm is considering a proposal for a more
liberal extension of credit which will result in in-creasing the average collection period from
one month to two months. This relaxation is expected to increase the sales by 25% from its
existing level.
You are required to advise the firm regarding adoption of the new credit policy, presuming
that the firm’s required return on investment is 25%.
Solution :
Appraisal of Credit policy
Present Proposed Incremental
Credit period (ACP) 1 month 2 months
Sales (units) 120000 150000
Sales @ 10 (in Rs) 1200000 1500000 300000
Total Cost 1080000 1290000 210000
Profit 120000 210000 90000
Investment in receivables 1080000 / 12 = 90000
1290000 / 6 = 215000 125000
Required return on Incremental Investment (125000@ 25%) = 31250
Actual return on Investment = 90000
(or)
(90000 / 125000) x 100 = 72%
Since the Incremental return is greater than required return on Incremental investment ad-
vised to adopt new credit policy
Illustration 2
YASHWANTH Ltd. has received an order from Green Ltd. which insists that the Rs.50,000
of machinery ordered be supplied on 60 days credit. The variable costs of production which
would be incurred by YASHWANTH Ltd. in meeting the order amount to Rs.40,000. Green’s
credit worth whileness is in doubt and the following estimates have been made:
Probability of Green Ltd. paying in full in 60 days 0.6
Probability of Green Ltd. completely defaulting 0.4

260 Fianancial Management & international finance

However, if the order is accepted by YASHWANTH Ltd. and if Green Ltd. does not default,
then there is felt to be a probability of about 0.7 that a further eight identical orders will be
placed by Green Ltd. in exactly 1 year’s time, and further orders in later years may also be
forth coming. Experience has shown that once a firm meets the credit terms on an initial
order, the probability of default in the next year reduces to 0.1. Any work carried out on
Green’s Ltd. order would take place in otherwise idle time and would not encroach upon
YASHWANTH Ltd. other activities. Should Green Ltd. defaults, the legal and other costs of
debt collection would equal any money obtained.
YASHWANTH Ltd. finances all trade credit with readily available overdrafts at a cost of
12% p.a. An appropriate discount rate for long=term decisions is 15%p.a.

Evaluate the proposal if (i) only one order is expected from Green Ltd., and (ii) if further
orders are also expected from it (year may be taken consist-ing of 360 days)

Solution :
YASHWANTH LTD
Evaluation of credit decision
I. If only one order is expected from GREEN Ltd
If Amount received in full in 60 days
Selling price 50000
(-) variable cost 40000
10000
(-) finance cost 800
(40000@12%) x (60 / 360)
Net profit 9200
If GREEN Ltd defaulted

Loss = 50000
Expected return:
If paid in 60 days 9200 x 0.6 5520
If defaulted 50000 x 0.4 (20000)
(14480)

If only one order is received from Green Ltd, it need not be accepted by YASHWANTH Ltd,
Because net receipt is negative

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COST-VOLUME-PROFIT ANALYSIS
Financial Management Decisions

II. If further Orders are expected from GREEN Ltd

Net return from each order (if not defaulted) 9200
For 8 orders 73600
Return expected if defaulted (400000)
Net expected return from further orders
[(73600 x 0.9) + (-400000) x (0.1)] 26240
Pv of expected return from further orders
[26240 x (0.7) x (100 / 115] 15970
Revised value of order [15970 + (-14480)] 1490
Revised value of initial order on the basis of possibility of receiving further orders is Rs1490.
so proposal is to be accepted.
Illustration 3
Trinadh Traders Ltd. currently sells on terms of net 30 days. All the sales are on credit basis
and average collection period is 35 days. Currently, it sells 500,000 units at an average price
of Rs. 50 per unit. The variable cost to sales ratio is 75% and a bad debt to sales ratio is 3%. In
order to expand sales, the management of the company is considering changing the credit
terms from net 30 to 2/10, net 30. Due to the change in policy, sales are expected to go up by
10%, bad debt loss on additional sales will be 5% and bad debt loss on existing sales will
remain unchanged at 3%. 40% of the customers are expected to avail the discount and pay
on the tenth day. The average collection period for the new policy is expected to be 34 day’s:
The company required a return of’20% on its investment in receivables.
You are required to find out the impact of the change in credit policy of the profit of the
company. Ignore taxes.
Solution :
Trinadh Traders
Appraisal of Credit policy:
Present Proposed Gain / (loss)
Credit terms Net30 (2 / 10)Net 30
ACP 35 days 34 days
Discount sales - 40%
Bad debts 3% 3 % + 5%
Sales 500000 550000
Incremental Profit [50000 x 50 x 20%] 625000
Incremental bad debts [50000 x 50 x 5%] (125000)
Discount [550000 x 40% x 50x 2%] (220000)
Investment [500000 x 50 x (35/360)] = 2430555 [500000 x 50 x (37/365)] + [50000 x 50
x 75% x 34/360] = 2538194
107629
Finance cost (107629 x 20%) (21528)
258472

262 Fianancial Management & international finance

By implementing new credit policy, the profit is increased by Rs258472. So the new credit
policy is advised to implement.

Illustration 4
A small firm has a total sales of Rs. 100 lakhs, of which 80% is on credit. It is offering a
discount-credit terms of 2/40 Net 30. Of the total, 50% of customers avail of discount and
the balance pay in 120 days. The past experience indicates that bad debt losses are around
1% of credit sales. The firm spends about Rs. 1,20,000 per annum to administer its credit
sales. These are avoidable as a factor is prepared to buy the firm’s receivables. He will
charge 2% commission. He will also pay advance against receivables to the firm at an inter-
est rate of 18% after withholding 10% as reserve. Answer the following:

a) What is the total credit sales?

b) What is the average collection period?
c) What is the average receivables?
d) What is the factoring commission payable per annum?
e) What is the disbursable amount to the firm by the factor?
f) What is the total interest chargeable by the factor?
g) What is the cost of factoring?
h) Should the firm avail factoring services?
Solution :
a) Total credit sales (100lakhs x 80%) 8000000
b) Average collection period [(40x 0.5 ) + (120 x 0.5)] 80 days
c) Average debtors (80lakhs x 80 / 360 ) 1777778
d) Factoring commission (80lakhs x 2%) 160000
e) Disbursable amount
Average receivables 1777778
(-) Factor reserve @10% 177778
1600000
(-) Commission (1777778 x 2%) 35554
–––––––––––
1564446
f) Total interest
Interest for 80 days [1564446 x18% x (80 / 360)] 62578
Interest per year [62578 x (360 / 80)] 281600

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COST-VOLUME-PROFIT ANALYSIS
Financial Management Decisions

g) Effective cost of factoring

Commission 160000
Interest 281600
441600
(-) savings in
Bad debt 80000
Admin cost 120000
Effective cost 241600

Effective cost of factoring (241600 / 1564446) x 100 = 15.4 %

h) If the firm obtain funds less than 15.4% interest rate, then firm need not accept factoring
services. Otherwise advised to accept factoring.

Illustration 5
BP Factors, offers recourse factoring on the following terms:
Facility Recourse Factoring
I Discount charge (payable up-front) 18% p.a.
II Reserve 21%
III Commission 2.5%
The Finance Manager of Aiswarya Garments Ltd Ltd, a dealer in home furnishings has
approached BP Factors to factor its receivables. After intricate analysis of the sales docu-
ments of Aiswarya Garments Ltd ltd, BP Factors offered a guaranteed payment period of 45
days.
Aiswarya Garments Ltd self on terms 210 net 45. On an average 50% of the customers pay
on the 10th day and avail the discount. Again, on an average the remaining customers pay 80
days after the invoice date. The bad debts and losses amount to 1% of the sales invoices. The
sales personnel are responsible for following up collections and by and large the Aiswarya
Garments Ltd can increase its annual sales by Rs. 25 lakhs if the sales people are relieved
from collection jobs. The gross margin on sales is 28% and the estimated sales turnover for
the following year without considering the increase in sales is Rs.300 lakhs. By offloading
sales ledger administration and credit monitoring, Aiswarya Garments Ltd can save overheads
to the extent of Rs. 1.50 lakhs per annum. Currently, Aiswarya Garments Ltd is financing its
investments through a mix of bank finance and long-term funds in the ratio of 3:2. The
effective rate on bank finance is 17% and the pre-tax cost of long-term funds is 21%.
You are required to:
a) Perform cost-benefit analysis of recourse factoring and advise Aiswarya Garments Ltd
whether to accept the factoring proposal or not.
b) Find out the maximum rate of factoring commission Aiswarya Garments Ltd can pay if
it wishes to relieve the cost of bad debts and be indifferent between recourse and non-
recourse factoring.

264 Fianancial Management & international finance

Solution :
Aiswarya Garments Ltd.
a) Cost of in house administration of receivables (p.a)
Total sales 30000000
Average collection period
[ ( 10x 0.5)+(80x0.5)] 45 days
Average receivables
30000000 x 45/ 360 3750000
Ko =17% x (3/5) + 21 x (2 / 5) 18.6%
Costs ;
Bad debts @ 1% on sales 300000
Cash discount 150lakhs @2% 300000
Sales administration 150000
Finance cost (on sales) 697500 (37.5lakhs x 18.67 %)
Contribution lost 700000 (2500000 x 28%)
Cost of factoring:
Commission (32500000 x 2.5 %) 812500
Discount (32500000 x 79 % x 18 % x 45 / 360) 577690
Cost of long term funds (32500000 x 21 % x 21% x 45 / 360) = 179160
1569250
Benefits of recourse factoring:
Cash discount 300000
Sales admin expense 150000
Contribution lost 700000
Finance cost 697500
1847500
Since cost of factoring is less than benefits advised to accept factoring.
b) Maximum commission to be paid to relieve the bad debts = 812500+ 300000 = 1112500
Rate of commission(1112500 / 32500000 x 100) = 3.42 %
(or)
( 812000+325000 / 3250000 x 100 ) = 3.5 %

Illustration 6
The turnover of Modern Ltd. Is Rs. 60 lakhs of which 80% is on credit. Debtors are allowed
on month to clear off the dues. A factor is willing to advance 90% of the bills raised on credit
for a fee of 2% a month plus a commission of 4% on the total amount of debts. Modern Ltd.
As a result of this arrangement is likely to save Rs. 21,600 annually in management costs and
avoid bad debts at 1% on the credit sales.

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COST-VOLUME-PROFIT ANALYSIS
Financial Management Decisions

A scheduled bank has come forward to make an advance equal to 90% of the debts at an
interest rate of 18% p.a. However its processing fee will be at 2% on the debts. Would you
accept factoring or the offer from the bank?
Solution :
Factoring vs. Bill Discounting:
Alternative 1: Factoring:
Calculation of Effective Cost of Factoring:
Sale for the year 6000000
Credit sales 4800000
Receivables = (4800000 / 12) x 1 month = 400000
Cost of factoring: (Per month)
Fee (interest) 400000 x 90 % x 2% = 7200
Commission 400000 x 4% = 16000
Cost per month 23200
Savings:
Management cost (21600 / 12) (1800)
Bad debts (400000 x 1%) (4000)

17400

Alternative 2: Bill Discounting:

Cost of Bill Discounting
Average debtors – 400000p.m
Processing Fee 8000
(400000 x 2 %)
Interest / Discount 5400
[400000@90% x 18% x (1 /12)]
Loss due to bad debts p.m 4000
Administration cost 1800

19200
Company may Opt Factoring but not Bill discounting.

266 Fianancial Management & international finance