BATCH 2013-16

2
ND
SEMESTER
MMM/MFM
SIMSR

Operating Cycle of Business
and Financing Working
Capital
Operating Cycle
Source: http://www.cleaningalliance.com/preparecashflow.aspx
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Operating Cycle
This process indicates the dependence of each stage
or component of working capital on its previous
stage or component.
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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.
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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.


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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

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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.
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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
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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
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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
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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


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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
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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


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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


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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
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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
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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
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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


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55 days is the time that has elapsed between the purchase of raw
Materials and the collection of cash for sales.
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
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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
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Permanent and Temporary Working Capital
Source: http://treasurycafe.blogspot.in/2012/02/working-capital-primer-how-is-it-that.html
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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

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Reading
Financial management by Prasanna Chandra,
Chapter 26
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