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Operating Cycle of Business and Financing Working Capital

Operating Cycle of Business and Financing Working Capital. Batch 2013-16 2 nd Semester MMM/MFM SIMSR. Operating Cycle. Source: http://www.cleaningalliance.com/preparecashflow.aspx. Operating Cycle.

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Operating Cycle of Business and Financing Working Capital

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  1. Operating Cycle of Business and Financing Working Capital Batch 2013-16 2nd Semester MMM/MFM SIMSR

  2. Operating Cycle Source: http://www.cleaningalliance.com/preparecashflow.aspx

  3. Operating Cycle • This process indicates the dependence of each stage or component of working capital on its previous stage or component.

  4. Exceptions • Example 1: • In case the manufacturing process may require a raw material which is in short supply, then the company may have to make advance payment in anticipation of the receipt of that raw material. This will cause immediate drain on cash resources in like a situation where credit purchases of raw material can be made.

  5. Exceptions • Example 2: • If there is an excessive accumulation of finished goods inventory the company may have to provide more liberal credit period and / or relax its existing credit standards which will increase sundry debtors.

  6. Operating cycle approach to working capital Management • Working capital cycle is popularly known as operating cycle. • Gross operating cycle period includes: 1) Raw material storage period 2) Conversion period 3) Finished goods storage period 4) Average collection period before getting back cash along with profit

  7. Operating cycle approach to working capital Management • Net operating cycle / Operating Cycle period (NOCP) - when average payment period of the company to its suppliers is deducted from the gross operating cycle period, (i.e. Average payment period) - Its is called as NOCP. • The shorter the duration of the operating cycle , the faster will be the transformation of current assets into cash.

  8. Calculation of the NOCP • Raw material storage period (N1): • 1) Calculate the annual consumption of raw material (RM) as: Opening stock + Purchases – Closing stock 2) Calculate average daily consumption of RM ( for convenience we assume a year consisting of 360 days) as: Step 1 / 360 3) Calculate Average stock of raw material as (Opening stock + Closing stock) / 2 4) N1 = step 3 / step 2 i.e. Avg Stock of RM / Avg Daily consumption of RM

  9. Calculation of the NOCP • Conversion Period (N2): 1) Calculate Annual Cost of production as : Opening stock of WIP + Consumption of RM + Other manufacturing costs ( such as wages & salaries, power & fuel ) + Depreciation – Closing WIP 2) Calculate Average daily COP as : Step 1 / 360 3) Calculate Average stock of WIP as: (Opening WIP + Closing WIP)/ 2 4) Calculate Average conversion Period (N2)as: Step 3 / Step 2 i.e. N2 = Average stock of WIP / Average daily COP

  10. Calculation of the NOCP • Finished Goods storage period (N3): 1) Calculate Annual Cost of sales (COS) as: Opening stock of finished goods + COP+ Excise duty +Selling & distribution costs+ General admin costs+ Financial costs - Closing stock of finished goods 2) Calculate daily COS as: Step 1 / 360 3) Calculate average stock of finished goods as: (Opening stock of FG + Closing stock of FG) / 2 4) Calculate Finished goods storage period (N3) as: Step 3 / Step 2, i.e. (Avg Stock of Finished goods) / Avg daily COS

  11. Calculation of the NOCP • Average collection period (N4): 1) Find annual credit sales of the company 2) Calculate daily credit sales as: Step 1 / 360 3) Calculate Average Debtors as : ( Opening stock of Debtors + Closing stock of Debtors) / 2 4) Calculate Average collection Period (N4)as : Step 3 / Step 2, i.e. Average debtors / Average daily credit sales

  12. Calculation of the NOCP • Average Payment Period (N5) : 1) Find Annual Credit Purchases 2) Calculate average daily credit purchases as: Step 1 / 360 3) Calculate average creditors as: ( Opening stock of creditors +Closing stock of creditors) / 2 4) Calculate Average payment period (N5) as: Step 3 / Step 2 , i.e. Average Creditors / Average daily purchases

  13. Sol to operating cycle for Co. XYZ • Calculation of RM storage period (N1): 1) Annual consumption of raw material= Opening RM – Closing RM +Purchases = 3454.84 +10676.10 – 4095.41 = 10035.53 2) Average daily consumption = 10035.53 / 360 = 27.88 3) Average RM= (3454.84 + 4095.41) / 2 = 3775.13 N1= 3775.13 / 27.88 = 135 days

  14. Sol to operating cycle for Co. XYZ • Average Conversion period ( N2) : 1) Annual COP = Opening stock of WIP + consumption of materials + manufacturing expenses + depreciation – closing WIP = 56.15 + 10035.53 + 1146.76 + 247.72 - 72.50 = 11413.66 2) Average daily COP : 11413.66 /360 = 31.70 3) Average WIP = (56.15 + 72.50) /2 = 64.33 4) N2 = 64.33 / 31.70 = 2 days

  15. Sol to operating cycle for Co. XYZ • Finished Goods storage period (N3) 1) Annual Cost of sales: Opening stock of FG + COP + Selling & Admin exp + Customs & excise duty – closing stock of FG = 637.92 + 11413.66 + 4557.48 + 35025.56 – 1032.74 = 50601.88 2) Avg daily COS = 50601.88 /360 = 140.56 3) Avg Finished goods= (637.92 + 1032.74)= 835.33 4) N3 = 835.33 / 140.56 = 6 days

  16. Sol to operating cycle for Co. XYZ • Average Collection period ( N4) : 1) Annual credit sales = 54210.65 2) Average daily credit sales = 54210.65 / 360 = 150.59 3) Average Debtors = (756.45 +1166.32) /2 = 961.38 4) Average collection period (N4) = 961.38 / 150.59 = 6 days

  17. Sol to operating cycle for Co. XYZ • Average Payment period ( N5) : 1) Annual credit purchases = 10676.10 2) Average daily credit purchases = 10676.10 / 360 = 29.66 3) Average Creditors = (2504.18 +3087.47) /2 = 2795.10 4) Average collection period (N5) = 2795.82 / 29.66 = 94 days

  18. Sol to operating cycle for Co. XYZ • Net Operating Cycle Period ( also called as cash cycle) = N1+N2+N3+N4 – N5 = 135 +2 +6 +6-94 = 55 days 55 days is the time that has elapsed between the purchase of raw Materials and the collection of cash for sales.

  19. Working Capital Financing • Working capital = CA-CL = Net current Assets • Hence it is also called as financing of current assets • As seen earlier. While calculating the operating cycle, a certain minimum level of current assets is to be maintained by a company. • This portion can also be called as PERMANENT OR FIXED COMPONENT OF CURRENT ASSETS Ex ample : Cash, inventory – Required to carry on the operations without any break

  20. Working Capital Financing • Over and above the minimum level, the current asset of a company vary depending upon the level of activity or operation. • Current assets associated with velocity of business activity can be regarded as the “ fluctuating” or “ temporary component” of current assets. Example : This component is likely to be more pronounced in seasonal industries where either the demand for output or its supply is seasonal Like - Woolens

  21. Permanent and Temporary Working Capital Source: http://treasurycafe.blogspot.in/2012/02/working-capital-primer-how-is-it-that.html

  22. Working Capital Financing • Long Term sources of financing Working Capital : Internal accruals, ordinary shares, preference shares, debentures and term loans • The temporary / fluctuating component is financed from short term sources – accounts payable , trade credit, short term bank borrowing , public deposits etc

  23. Reading • “ Financial management “ by Prasanna Chandra, Chapter 26

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