Question 6
The operating cycle; working capital with a cash margin
18.75 marks
- Time to write
- About 38 minutes
From an older CBCS paper
Question
Question 6 · 18.75 marksWhat is meant by the operating cycle?
From the information below, prepare a statement showing the estimated requirement of working capital:
Projected annual sales 43,200 units
Sales analysis
| Raw materials | ₹ 6 per unit |
| Labour | Rs. 4 per unit |
| Overhead | ₹ 3 per unit |
| Profit | Rs. 2 per unit |
| Selling price | ₹ 15 per unit |
- Further Information:
Raw material held in stock: 1 month
Time in the production process: 2 months
Finished goods held in store: 3 months
Debtors are allowed credit for: 4 months
Suppliers allow credit for: 2 months
The monthly wages and expenses are paid twice, on the 1st and the 16th of every month.
Production goes on evenly over the year, and expenses and wages accrue in the same way.
Cash equal to 10% of the net working capital is to be kept.
Reworded from the university paper: names and figures differ, the task is the same. The original paper belongs to the University of Delhi. See DU's question bank.
Before you write
Read off the question and its marks
Read from the question
- prepare a statementDraw the format first (heading, columns, dates), then fill in the figures from your working.
What the paper leaves open
No mark is printed for the question; the paper asks for any four of six, equal marks. Wages and expenses paid twice a month imply an average lag of half a month; cash at 10% of net working capital is computed on the net working capital before cash. Debtors and finished goods are valued at cost.
Write it in this order
- Read the data; tick every adjustment as you plan it 2 min
- 1 Operating cycle: meaning, components, gross and net cycle 6 marks 11 min
- 2 Basis and work in progress 3 marks 6 min
- 3 Other current assets 4 marks 7 min
- 4 Current liabilities, cash and net working capital 5.8 marks 10 min
- Check: every adjustment used, both sides agree, dates in 2 min
Try it first. About 38 minutes for 18.75 marks. Write it out, then open the solution.
Solution
Hover or tap a marked figure, like 72,000, to see how it is made and where else it appears.
The operating cycle
Meaning. Working capital is needed because there is a time gap between production and the realisation of cash from sales: the firm passes through an operating cycle of buying raw materials, producing, selling and collecting cash. The operating cycle is the time taken to convert cash into raw materials, raw materials into work in progress and finished goods, finished goods into debtors, and debtors back into cash.
1The carpenter's cash becomes a cartload of timber.
Raw material storage periodCash is turned into raw materials.
2Saw and hammer turn the timber into half-made chairs.
Conversion (work-in-progress) periodRaw materials into work-in-progress.
3The finished chairs line the store room, ready.
Finished goods storage periodWork-in-progress into finished goods.
4The chairs go out on credit, and Lakshmi's notebook follows the money home.
Debtors' collection periodFinished goods into debtors and debtors back into cash.
Components (each measured as the average balance divided by the matching flow per day):
- Raw material storage period (R) = average raw material stock ÷ raw material consumed per day;
- Work-in-progress period (W) = average WIP ÷ cost of production per day;
- Finished goods storage period (F) = average finished goods ÷ cost of goods sold per day;
- Debtors' collection period (D) = average debtors ÷ credit sales per day;
- Creditors' payment period (C) = average creditors ÷ credit purchases per day.
Gross and net cycle. Gross operating cycle = R + W + F + D; net operating cycle = R + W + F + D − C, since supplier credit finances part of the cycle. Number of operating cycles in a year = 360 (or 365) ÷ operating cycle; the more cycles, the shorter each cycle and the better for the firm.
Use. The length of the net operating cycle decides how much working capital is needed: the longer the cycle, the more funds are blocked in current assets. Shortening it, by faster production, quicker collection or longer supplier credit, reduces the working capital requirement.
Estimated working capital requirement
Basis (paper note). Monthly output and sales = 43,200 ÷ 12 = 3,600 units. Cost per unit = raw material 6 + labour 4 + overhead 3 = ₹13; finished goods and debtors are valued at cost. Work in progress carries raw material in full and labour and overhead at half, since they accrue evenly. Wages and expenses, paid twice a month, are taken as outstanding for half a month on average. Cash is 10% of the net working capital before cash.
| Element | Working | ₹ |
|---|---|---|
| Raw material (full) | 3,600 × 2 × 6 | 43,200 |
| Labour and overhead (50%) | 3,600 × 2 × 7 × 50% | 25,200 |
| Total | 68,400 |
Statement of working capital requirement
| Particulars | Working | ₹ |
|---|---|---|
| Current assets | ||
| Raw material stock (1 month) | 3,600 × 6 | 21,600 |
| Work in progress (2 months) | as above | 68,400 |
| Finished goods (3 months, at cost) | 3,600 × 3 × 13 | 1,40,400 |
| Debtors (4 months, at cost) | 3,600 × 4 × 13 | 1,87,200 |
| Total current assets | 4,17,600 | |
| Current liabilities | ||
| Creditors (2 months of raw material) | 3,600 × 2 × 6 | 43,200 |
| Wages and overheads outstanding (½ month) | 3,600 × 7 × ½ | 12,600 |
| Total current liabilities | 55,800 | |
| Net working capital before cash | 3,61,800 | |
| Add: cash (10% of net working capital) | 3,61,800 × 10% | 36,180 |
| Net working capital required | 3,97,980 |
Where the 18.75 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | Operating cycle: meaning, components, gross and net cycle | 6 |
| 2 | Basis and work in progress | 3 |
| 3 | Other current assets | 4 |
| 4 | Current liabilities, cash and net working capital | 5.75 |
| Total | 18.75 |
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