WORKING CAPITAL ASSESSMENT

What is Working Capital?

Usually, a business concern, to speak more of a manufacturing unit, needs two types of finance. Firstly, it requires capital for the purpose of acquiring fixed and other long-term assets. This type of finance is usually provided by the long-term sources of funds. Secondly, it needs finance for working capital for its current operational purposes i.e., capital required to finance the current assets generated/required for the process of manufacturing and selling is called the Working Capital. The term Working Capital is used as a gross as well as a net concept. Gross Working Capital represents the totality of fluctuating funds invested in all current assets in a business. Whereas Net Working Capital refers to the excess of current assets over current liabilities and indicates the margin or buffer for meeting obligations within the ordinary operating cycle of the business.

Management of Working Capital:

Working capital unless deployed and managed effectively in the business will not yield the desired result. Fixed assets once acquired judiciously, will not bother the management for a certain period, but Working Capital which is the life blood for the current operations of the business needs to be properly assessed, raised and deployed. Working Capital funds are raised from the following two main sources: (a) Funds generated from current operations (b) Short term bank borrowings, trade credit, short term deposits, owners' equity etc. Funds thus raised are usually deployed in various phases of Operating Cycle.

The Operating Cycle

Every on-going business has got its operating cycle. The cycle itself has different successive phases. Let us assume that initially the business has some cash and bank balances. It uses a part of these to acquire raw materials. A part is used to meet the various manufacturing costs. The raw materials are converted into stock-in-process which in turn becomes finished goods. Finished goods get sold and become Accounts Receivables. On realization, the Accounts Receivable turn into cash. The Cycle will repeat itself as the business goes on.

The following are the Working Capital cycles which include operating cycles drawn up for manufacturing concerns and trading concerns respectively:

Factors affecting the Working Capital Requirements :
(1)    Nature of Industry.
(2)    The Operating Cycle.
(3)    The Manufacturing Cycle.
(4)    Vagaries in supply of raw-materials.
(5)    Production policies.
(6)    Shift in demand for products.
(7)    Competitive conditions.
(8)    Growth and expansion programs.
(9)    Operating efficiency.
(10)    Taxation.
(11)    Dividend Policy.
(12)    Depreciation policy.
(13)    Price level changes.

Different Phases of Operating Cycle and their lengths of Period:
The length of the operating cycle of a business is the sum of the lengths of period of different phases of the cycle which can be computed as follows :-

Working Capital Requirements:

From the preceding paragraph, it is possible to compute the working capital requirements first in terms of days and then to convert it into TAKA.
In case of existing units, the first step is to calculate the various components of working capital for the last 3 years interms of days by the method already described, where the past data so permits. After this, the existing situation in physical terms, is to be understood and appreciated. Finally, on the basis of a discussion with the party, the number of days of various components of the working capital he proposes to keep for the coming year is to be  decided. Note that this is not an arithmetical exercise where the past trends, howsoever extrapolated, are simply projected into the future. Frequently the past is a poor guide to the future. No amount of sophisticated analysis of past financing can be substituted for a forecast of what is likely to happen in the future. This is where good bankers are differentiated from bad bankers.
In case of new unit there is no past data to go by. In case there are other units in the same industry, their past components of working capital can be analyzed in terms of days. Where there are no such units or for some reason the other unit's experience is not applicable to the new unit, then the only thing a banker can do is to check the reasonableness of the party's projected holding of the components of working capital. Obviously there is a greater chance of an error here, and for this reason bankers tend to be conservative in financing new units. But being too conservative in financing new units, results in its strangulated growth.
There are two approaches to the next step of converting the working capital in terms of days into TAKA. The approaches differ in only the amount of work to be put in by the borrower and the banker.

The simpler approach, the one which will work well with the smaller units, is to ask the borrower to give its projected figure of sales for next one year. This figure given by the borrower needs to be evaluated  against items like its production capacity, past increases in sales, its marketing organization, order book position and future state of the industry and the economy. After evaluation, an acceptable figure of projected annual sales is arrived at. The next step is to calculate the past ratios of the following items : (a) raw material consumption to sales, (b) cost of production to sales, (c) cost of sales to sales. But multiplying the past ratios by the projected annual sales the following projected figures are obtained: (1) Projected raw material consumption (2) Projected manufacturing cost and (3) Projected cost of sales. Dividing these by 360 gives us the daily figures. On multiplication of these daily figures by number of days of future holding of working capital components we get the corresponding amount. Here again, the number of days of future holding is to be determined on the basis of past holding and the existing situation, in consultation with the past, as explained above. It is necessary to sound a note of caution about the projection of past ratios of (a) raw material consumption to sales (b) cost of production to sales (c) cost of sales to sales into the future plans. They will hold good, so long as the party has not switched over to a different product or product-mix or has not changed the technology.

Margin for Working Capital:

The margin for working capital is the balance of net working capital requirements after deducting bank finance. As regards to it, the banker should decide what margin percentage he wants to insist on raw-materials, work in progress, finished goods and receivables. But in our country, varying rates of margin on different individual components of working capital requirement are not widely practiced. So, a flat rate of 25% (say) margin amount can be suggested which has to be provided by the borrower, however the same depends on Banker — Customer relationship.
In the case of new project, it should be ensured that the margin is taken care of by issue of share capital or by long term ldans from financial institutions.

Trading Concern's Assessment:

The assessment of working capital limit for a trading concern is very much simple as compared to an industry. There is no raw-material or work in process to worry about, only stocks of finished goods, receivables and sundry creditors. Very often days of credit received and credit given are approximately the same and therefore, they cancel each other.

FORMAT OF ASSESSMENT OF WORKING CAPITAL REQUIREMENTS AND THE BANK FINANCE CONSIDERED PERMISSIBLE FOR A MANUFACTURING INDUSTRY

                                                                                                                               (Taka in hundreds)
                                                                                                                                   Amount (Tk.)
(a)    Stock of Imported raw materials
for (say) 3 months   
(b)    Stock of Indigenous raw-materials
for (say) 11/2 months   
(c)    Stock of Work-in-process
for (say) 1/2  months   
(d)    Stock of finished goods for
for (say) 11/2 months    
(e)    Stocks of consumable stores and spares
for (say) 2 months   
(0    Amount blocked in Receivables
for (say) 2 months,   

Less:
Credit received on purchase
for (say) 1V2 months   
WORKING CAPITAL REQUIRED

Less:    Margin requirement (say) 25%
BANK FINANCE CONSIDERED PERMISSIBLE


Note: The requirement of non-production expenses have to be met by the sponsors from their own source.

TEXTILE SPINNING INDUSTRY:

01.    Capacity Utilization : 

a)    Existing unit                        : 5% above last year's actual capacity utilization subject to maximum of 75%

b)    New unit                            : 70% of sanctioned/rated capacity whichever is lower

02:    Inventory : 

a)    Imported raw materials      : 90 days (cost at factory site)
b)    Local raw materials           : 30 days (cost of factory site) 3
c)    Work-in-process              : days (at production cost) 10
d)    Finished goods                 : days (at production cost) 90
e)    Stores and spares             : days (cost of factory site)

3.    Receivables                    : 15 days (at production cost)

4.    Cash in hand                   : Cash requirement for other day-to day expenditure (e.g. salary,  

                                                transportation, postage, utilities, etc.) should be arranged by the sponsors.

Format after working capital estimate:

Items                                             Tied-up period                                Working capital  requirement (Tk.)

Raw Materials

a)    Imported                                                                                      90 days

b)   Local                                               30 days

Working-in-process                               03 days

Finished goods                                      10 days

Stores & spares                                    90 days

Receivables                                          15 days

Cash                                                    Lum sum

Note : Margin/Security will be as per Bank Client relationship.