Sunday, May 20, 2012

WORKING CAPITAL MANAGEMENT PART 5

Financing of Working Capital
After determining the amount of working capital required, the next step is to arrange funds. Broadly speaking, the working capital finance may be classified between the two categories:
  • Spontaneous sources
  • Negotiable sources
The Spontaneous sources of finance are those which naturally arise in the course of business operation.
For example: Trade credit, credit from employees, credit from suppliers, accrued expenses etc.

Negotiable sources of finance are those which have to be specifically negotiated with lenders
For example: Loan from commercial banks, financial institutions, general public etc. 

Sources of Finance

Inter-corporate Loans and Deposits: organizations having surplus funds invest for short-term period with other organizations. The rate of interest will be higher than the bank rate of interest and depending on financial soundness of the borrower company.

Commercial Paper (CP): This is an instrument that enables highly rated corporate borrowers for a short-term borrowings and provides an additional financial instrument to investors with a freely negotiable interest rate. The maturity period ranges from minimum 7 days to less than 1 year. However this source of borrowing is not available for small businesses.

Funds Generated from Operation: Funds generated from operation increase the working capital amount by equivalent amount. The two main components of funds generated from operation are profit and depreciation.

Public Deposit: Deposit from the public is one of the important source of finance particularly for well established big companies with huge capital base for short and medium term.

Bill Discounting: In the process of bill discounting, the supplier of goods draws a bill of exchange with direction to the buyer to pay a certain amount of money after a certain period, and gets its acceptance from the buyer or drawee of bill. This bill may be further endorsed to bank or other party.

Factoring:  The concept of factoring has already been discussed in part 4.

Working Capital Finance from Banks: Banks in India today constitute the major suppliers of working capital credit to any business activity. Recently, some term lending financial institutions have also announced schemes for working capital financing. The two committees viz., Tandon Committee and Chore Committee have evolved definite guidelines and parameters in working capital financing.

With this we come to conclusion of this series of Working Capital Management. In the five parts I have tried to cover as much as possible about working capital management, but the concept is very large as it is one of the major contributor for profitability and growth of business.


Saturday, May 19, 2012


WORKING CAPITAL MANAGEMENT PART 4

Management of Receivables

A firm needs to offer its goods and services on credit to customers as a business strategy to boost sales. This represents a considerable investment of funds. The basic objective of Receivables management is to optimize the return on investment in this asset. If large amounts are tied up in debtors, there will be chances of bad debts and there will be cost of collection of debts. On the contrary, if the investment is low, the sales may be restricted. Therefore management of debtors is an important issue.

Finance manager can affect the volume of credit sales and collection period and consequently, the investment in receivables through the credit policy. Credit policy is a combination of three components
·        
  • Credit a standard which is the criteria to decide the types of customers to whom goods could be sold on credit.
  • Credit terms specify the duration of credit and terms of payments by customers.
  • Collection efforts determine actual collection period.

Aspects of Management of Debtors

Credit policy
Credit policy is concerned with the profits that could be generated from additional sales that could be generated by extending credit on one hand and cost of carrying those debtors and bad debt losses on other hand. There are various factors which determine credit policy such as effect of credit on sales, credit terms, cash discounts, paying habits of customers etc.

For example, the credit term may be expressed as “2/15 net 40” means that a 2% discount will be granted if the customers pays within 15 days; if he does not avail offer he must make payment within 40 days.

Credit analysis
Finance manager determine as to how risky it is to advance credit to a particular party.

Control of receivable
It involves follow up of debtors and decides about a suitable credit collection policies.
Maintaining receivables comprises of various costs such as collection cost, defaulting cost, and administrative cost record keeping.

Financing Receivable
  • Pledging: firms receivables are used as a security for short term loan as receivables are most liquid assets and this serve as prime collateral for a secured loan. The lender scrutinizes the quality of accounts receivables, selects acceptable accounts, creates a lien on the collateral and fixes a percentage of financing receivables which ranges around 50 to 90%. The major advantage of pledging accounts receivable is the ease and flexibility it provides to the borrower. But the cost of financing is high.

  •  Factoring: it is a new concept in financing accounts receivables. This refers to outright sale of accounts receivables to a factor or a financial agency. A factor is firm that acquires the receivables of other firms. The factoring lays down the conditions of the sale in factoring agreement. The factoring agency bears the right of collection and services the accounts for fee. Normally, factoring is a non recourse arrangement which means in the event of default the loss is born by the factor. However in the case of with recourse arrangement such loss is born by the seller. The biggest advantages of factoring are immediate conversion of receivables into cash and it helps company to have liquidity without creating net liability on its financial condition. Some of the commercial banks provide this service.

Tool and Techniques of Receivable Management

Re-engineering Receivable Process: Re-engineering is a fundamental rethinking and redesigning of business processes by incorporating modern business approach. Some of the organizations have achieved real cost savings and performance improvements through re-engineering receivables.
  • Centralization of high nature transactions of accounts receivables and payables is one of the practices for better efficiency.
  • Alternate payment strategies direct transfer of funds from purchasers bank account, collection by third party, lock box processing and payments via internet.
  • Customer orientation: where individual customers or a group of customers have some strategic importance to a firm a case study approach may be followed to develop good customer relationship. A critical study of this group may lead to formation of a strategy for prompt settlement of debt.
Use of Latest Technology such as E-commerce, Automated receivable management system.

Use of financial tools/technique such as Credit rating and decision tree analysis of granting credit.
Example of decision tree analysis: if the chances of recovery are 8 out of 10 then probability of recovery is 0.8 and that of default is 0.2. Suppose cost of goods is Rs 4 lakh and revenue is Rs 7 lakh. Now weighted net benefit should be calculated

= [(700000-400000)*0.8] – [400000*0.2]

= 160000

As there is net benefit hence credit should be granted.

Collection policy: if a firm spends more resources on collection of debts, it is likely to have smaller bad debts. Thus a firm must work out optimum amount that it should spend on collection of debtors. This involves trade off between the levels of expenditure on the one hand and decreases in bad debt losses and investment in debtors on the other hand.

Ageing schedule: When receivables are analysed according to their age, the process is known as preparing ageing schedules of receivables. The computation of average age of debtors is a quick and effective method of comparing liquidity of receivables with the liquidity of receivables in the past and also comparing liquidity of one firm with it competitor. It also helps the firm to predict the collection pattern of receivable in future.

The credit collection procedure must answer the following:
·         How long should a debtor balance be allowed to exist before collection process is started?
·         Should there be collection machinery whereby personal calls by company’s representatives are made?
·         What should be the procedure of follow up with defaulting customers?
·         How reminders are to be sent and how should each successive reminder be drafted?
·         What should be the procedure for dealing with defaulting customers? Is legal action to be instituted?

The fundamental rule of sound receivable management should be to reduce the time lag between the sale and collections, at the same time maintain customer goodwill.

Friday, May 18, 2012

WORKING CAPITAL MANAGEMENT PART 3

Materials constitute a very significant proportion of total cost of finished product in most of the manufacturing industries. A proper control system is necessary to ensure that exact quality of input as required for finished product, the price paid for input should be minimum possible, material should be available in adequate quantity whenever required, there should be no over-stocking, wastage and losses while material is in store and in process should be avoided. 

Requirements of material control
Proper co-ordination of all departments involved viz. finance, purchasing, receiving, inspection, storage accounting and payment.
  1. Purchases are made only after suitable inquiries so that firm gets most favourable deal.
  2. Use of standard forms for placing the order, noting receipt of goods, authorizing issue of material etc.
  3. Preparation of budget concerning material consumption
  4. Storage of all material and supplies at well designated place.
  5. Continuous stock taking to determine value and quantity of each item of material at any time.
  6. Regular reports of materials purchased, issue from stock, inventory balances, obsolete stock, goods returned and spoiled or defective unit.

Material Procurement Procedure
If a concern can afford, it should have a separate purchase department for all purchases to be made on behalf of all other departments. Purchasing should be centralized i.e. all purchases should be done by purchasing department except for small purchases which may be done by the user's department. The concerned officer in the department keep themselves in constant touch with the markets to have the latest information. The purchase department follows the following steps.
  • Receiving purchase requisitions. It is a form used for making request to the purchasing department to purchase material.
  • Exploring the sources of materials supply and selecting suitable material suppliers. Selection of suppliers is based on various factors such as price, quantity, quality, time of delivery, mode of transportation, terms of payment, reputation of supplier, past records etc.
  • Preparation and execution of purchase order. After identifying the suitable supplier with best quotation the purchase manager issues formal purchase order. Its copies are sent to The supplier, Store department, Receiving department, Accounting department and one copy is held in file.
  • Receipt and inspection of materials to ensure that goods received are of desired quality and quantity. If they are not according to specification then goods are not accepted. After receipt of goods the receiving department prepares Material inward note in quadruplicate. One copy is sent to Purchase department for verifying supplier's bill for payment, other copy is sent to the store, third copy is sent to stores ledger clerk in Cost Department and the last copy is retained for use by receiving department.
  • Checking and passing bills for payment. The invoice received from the supplier is sent to the stores accounting section to check authenticity and mathematical accuracy. The quantity and price are also checked with reference to goods received note and the purchase order respectively. The stores accounting section after checking its accuracy finally certifies and passes the invoice for payment.
Material Issue Procedure
Issue of material must be on the first in first out basis to ensure that the materials which were entered first don't get deteriorated for having been kept for a long period
  • Bill of material also known as Material specification list or simply Material list. Its a schedule of standard quantities of material required for any job or other unit of production. It is prepared by the Engineering or Planning department in a standard form. It is prepared in quadruplicate and sent to Stores department, Cost accounts department, Production control department and Engineering or Planning department.
  • Material requisition note is for issue of materials for use in the factory or in any its department. It is prepared in triplicate and distributed as one copy to Store keeper, one to Cost department and one is for department requiring it.
  • Sometimes any of the department has surplus material which returned to storeroom accompanied by Shop credit note which is prepared in triplicate and distributed as one copy for Store Room, one for Cost department and one for department returning surplus material.
Material Storage
Purchasing material of desired quality is not enough their proper storage is also important. loss due to poor storage is even more than what might arise from purchase of bad quality materials.

Store location should be carefully planned. It should be near to the material department so that transportation charges are minimum. At the same time it should be easily accessible to all other department of the factory.

Inventory Control
Although there are many inventory control methods the two are quite popular- Economic Order Quantity and Just in Time (JIT).

Economic Order Quantity (EOQ)
This method tries to keep ordering cost and carrying cost of inventory at minimum. The formula is

EOQ =  √ (2*A*S)/C

Where
A = Annual usage units
S = Ordering cost per order
C = Carrying cost per unit per annum

Just in Time (JIT)
According to this technique materials are ordered as and when required. So there is no carrying cost as material is delivered directly to production floor. For implementing this system the supplier should be very prompt in delivery and also company's personnel should inspect the quality and quantity of material at the supplier's premises itself.

Review of slow and non-moving items
The expensive slow and non-moving items in the inventory block huge sum of money. For such items no new requisition should be made till the existing stock is exhausted.


Thursday, May 17, 2012

WORKING CAPITAL MANAGEMENT PART-2

In the part 1 of working capital management we tried to understand the concept and importance of working capital management. Now in this part we try to understand how to manage individual components which constitute working capital.

Treasury Management: meaning

Treasury management is defined as 'the complete handling of all financial matters, the generation of external and internal funds for business, the management of currencies and cash flows and the complex, strategies, policies and procedures of corporate finance'. The treasury management deals with working capital which constitute cash management, asset liability mix and Financial risk management which includes forex and interest rate management. The key goal of Treasury management is planning, organizing and controlling cash assets to satisfy the financial objectives of the organization, to maximize the return on available cash, minimize interest cost or mobilize as much cash as possible for corporate ventures.

Functions of Treasury Department:

  1. Cash Management: The efficient collection and payment of cash both inside the organization and to third parties is the function of the treasury department. The treasury may simply advice subsidiaries and divisions on policy matter viz., collection/payment periods, discounts etc. Treasury will normally manage surplus funds in an investment portfolio. Investment policy will consider future needs for liquid funds and acceptable levels of risk as determined by company policy.
  2. Currency Management: The treasury department manages the foreign currency risk exposure of the company. The use of matching receipts and payments in the same currency will save transaction  costs. Treasury might advice on the currency to be used when invoicing overseas sales. Forward contracts can be used to minimize risk.
  3. Funding Management: Treasury department is responsible for planning and sourcing the company's short, medium and long term cash needs.
  4. Banking:  Treasury department carry out negotiations with bankers and act as the initial point of contact with them. Short term finance can come in the form of bank loan or through the sale of commercial paper in the money market.
  5. Corporate Finance:  Treasury department is involved with both acquisition and divestment activities within the group.

Management of Cash

For survival of business it is very necessary that there should be adequate cash. Finance manager has to ensure that all parts of organization have sufficient liquidity on the other hand he has to ensure that there are no idle funds as such funds entail a great deal of cost in terms of interest charges and in terms of opportunity cost.

Lord Keynes outlined three basic needs for cash
  • Transaction needs: Cash is needed to meet day-to-day expenses and to pay other debts.
  • Speculative needs: Cash is needed to take advantage of profitable opportunities.
  • Precautionary needs: Cash may be held to act as for providing safety against unexpected events.
Cash management is concerned with the managing of cash inflows and outflows, cash flows within the firm and cash balances held by the firm at a point of time by financing deficit or investing surplus cash. Company's these days manage it's cash affairs in such a way as to maintain a minimum balance of cash and to invest the surplus immediately in profitable investment opportunities. In order to synchronize the cash receipt and payments the firm has to do cash planning, manage cash flows, maintain optimum cash level and invest the surplus cash.

Cash Planning:
It is technique to plan and control the use of cash. This protects the financial conditions of the firm by developing a projected cash statement from a forecast of expected cash inflows and outflow for a given period. It may be done periodically either on daily, weekly or monthly basis. The very first step in this direction is to estimate the requirement of cash by preparing cash flow statement and cash budget.

Cash Budget:
This is the most significant device to plan for and control cash receipt and payments. This represents cash requirements of business during the budget period. It enables the firm to arrange finances and utilize funds in better ways. However it's less reliable due uncertainty of cash forecasts and also it fails to highlight the significant movements in the working capital items.

These tools help the management to pin point the time of excessive cash or shortage of cash.

Methods of Cash Flow Budgeting
Cash flow budget is detailed budget of income and cash expenditure incorporating both revenue and capital items. Cash budget is concerned with liquidity must reflect changes between opening and closing debtors balances and between opening and closing creditors balances as well as focusing attention on other inflows and outflows of cash. A cash budget can be prepared in the following ways:
  • Receipt and payment method: In this method all the expected receipts and payments for budget period are considered. All the cash inflow and outflow of all functional budgets including capital expenditure budgets are considered. Accruals and adjustments in accounts will not affect the cash flow budget. Anticipated cash inflow is added to opening balance of cash and all cash payments are deducted from this to arrive at the closing balance of cash.
  • Adjusted Income method: In this method the annual cash flows are calculated by adjusting sales revenues and cost figures for delays in receipts and payments and eliminating non-cash items such as depreciation.
  • Adjusted Balance Sheet method: In this method, the budgeted balance sheet is predicted by expressing each type of asset and short-term liabilities as percentage of the expected sales. The profit is also calculated as a  percentage of sales, so that increase in owners equity can be forecasted. Known adjustments, may be made to long-term liabilities and the balance sheet will then show if additional finance is needed.

A firm can conserve cash and reduce its requirements for cash if it can speed up its cash collection which can be done by following methods
Concentration Banking: The company establishes a number of strategic collection centers in different regions instead of a single collection center at the head office. Payments are received these centers and are deposited in respective local banks which in turn transfers all surplus funds to concentration bank of head office. This system reduces the period between the time a consumer mails in his remittances and the time when they become spendable with the company.

Lock Box System: This system eliminates the time between the receipt of remittances by the company and deposited in the bank. Here company rents the local post-office box and authorizes its bank at each of the locations to pick up remittances in the boxes. Customers are billed with instructions to mail their remittances to lock boxes. The bank picks up these cheques in company's account. The company receives a deposit slip and list of all payments together with any other material in the envelope. Here company is free from handling and depositing cheques. The main drawback of this system is its cost. Lock box arrangements are usually not profitable if average remittance is small.

Float
The term float is used to refer to the periods that affect cash as it moves through the different stages of the collection process.

Billing float is the time between the sale and the mailing of the invoice.

Mail float is the time when cheque is being processed by post office, messenger service or other means of delivery.

Cheque processing float is the time required for the seller to sort, record and deposit the cheque after it has been received by company.

Banking processing float is the time from the deposit of the cheque to the crediting of funds in sellers account.

A firm can increase its net float by speeding up collections. It can also increase the net float by delayed disbursement of funds from bank by increasing the mail time. A company may make payment to its outstation suppliers by a cheque and send it through mail. The delay in transit and collection of cheque, will be used to increase the float. The firm should make payments using credit to the fullest extent.

Cash Management Models
The models can be put in two categories- inventory type and stochastic model.

William J. Baumol's Economic Order Quantity Model:
According to this model, optimum cash level is that level where the carrying cost and transaction costs are the minimum. This model is used where cash flows are predictable. the formula is

C = { (2U * P) / S }^0.5
Where
C= optimum cash balance
U= Annual ( or monthly) cash disbursement
P= Fixed cost per transaction
S= Opportunity cost of one rupee p.a. ( or p.m.)

Miller-Orr Cash Management Model
According to this model the net cash flow is completely stochastic i.e. random. In this model control limits are set for cash balances. These limits may consist of h as upper limit, z as the return point; and zero as lower limit. When the cash balance reaches the upper limit, the transfer of cash equal to h-z is invested in marketable securities account. When it touches lower limit, a transfer from marketable securities account to cash is made. during the period cash balance stays between high and low limits no transaction of cash and marketable account is made. These limits are set up on the basis of fixed cost associated with the securities transaction, the opportunity cost of holding cash and the degree of likely fluctuation in cash balances. These limits satisfy the demands for cash at the lowest possible total cost. This model is more realistic since it allows variations in cash balance within lower and upper limit.

Wednesday, May 16, 2012


Working Capital Management Part-1

 Working capital is business's life blood. A concern needs funds for its day-to-day working. Adequacy or inadequacy of these funds would determine the efficiency with which the daily business may be carried on. A finance manager has to ensure that the amount of working capital the concern is holding is not too less or too much. Since large working capital indicates idle funds for which the entity has to bear cost to hold such funds and low working capital gives rise to risk of insolvency. The various studies conducted by the Bureau of Public Enterprises have shown that one of the reasons for the poor performance of public sector undertaking in India has been the large amount of funds locked up in working capital. This results in over capitalization. Over capitalization implies that a company has too large funds for its requirements, resulting in low rate of return. Most of the times a company is not perform well despite of the fact that its product has really good demand, just because its working capital management is poor. Maintaining working capital is not just important for short term but it is necessary to ensure long term survival.

There are two concept of working capital- gross and net. Gross working capital refers to firm’s investment in current assets. Net working capital refers to difference between current assets and current liabilities. Current assets are those assets which can be converted into cash within an accounting year. It includes stock of raw material, work-in-progress, finished goods, trade receivables, prepayments, cash balances etc. Current liabilities are those liabilities which mature for payment within an accounting year. It includes trade payables, accruals, tax payable, bills payables, outstanding expenses, dividends payable, short term loans etc. A positive working capital means that the entity is able to pay off its short term liabilities, whereas a negative working capital indicates its inability to pay off its short term liabilities.

The term working capital is divided in two categories viz. Permanent and temporary. Permanent working capital is the hard core working capital. It’s the minimum investment in the current assets that the entity needs to carry out minimum level of activities. Temporary working capital on the other hand is the working capital over and above permanent working capital. It’s also called variable working as its volume keeps changing with change in business activities.

Liquidity Vs Profitability:

Profitability and liquidity are inversely related to each other. A firm with good liquidity has less risk of insolvency, it will hardly experience a cash shortage or a stock out situation, but at the same time the cost of maintaining high liquidity will reduce profits. On the other hand if the firm maintains low level of current assets the risk of insolvency is high but profitability is high due to low cost of maintaining liquidity.

Various combinations of policies and technique are used for working capital management. The various steps in management of working capital are:
  • Cash management- cash level should be maintained at a level so that the day-to-day expenses can be met and cash holding cost is low.
  • Inventory management- maintain quantity of inventory at such level so that production is not interrupted and at that same time too much money is not blocked in raw materials.
  • Debtors management- an appropriate credit policy should be adopted so that the credit term which will attract customers, such that the impact on cash flows and the cash conversion cycle will be offset by increased revenue and hence return on capital. The tools like discounts and allowances are used for this.
  • Short term financing- inventory is normally financed by credit granted by suppliers and to finance other components of working capital other sources are needed such as bank loan ( or overdraft), or to convert debtors to cash through factoring.
Following are the factors which generally influence the working capital requirements of the firm:
  • Nature of business
  • Credit policy of firm
  • Availability of credit from suppliers
  • Technology and manufacturing policy
  • Operating efficiency
  • Market demand and conditions
  • Price level changes
Estimation of Working capital needs:
  • Current assets holding period: working capital needs are estimated based on average holding period of current assets and relating them to costs based on company’s experience in the previous year. This method is based on the Operating cycle concept.
  • Ratio of sales: to estimate working capital needs as a ratio of sales on the assumption that current assets change with change in sales.
  • Ratio of fixed investment: to estimate working capital requirement as a percentage of fixed investment.
Operating Or Working capital cycle

Cash



Raw material/Labour/Overhead



WIP



Finished goods



Debtors



Cash


Operating cycle is one of the most useful tools for managing working capital. The operating cycle analyzes the accounts receivable, inventory and accounts payable cycle in number of days. Most of the businesses cannot finance the operating cycle with accounts payable alone so working capital financing is needed. This shortfall is covered by the net profits generated internally or by externally borrowed funds or by combination of two.

Each component of working capital has two dimensions i.e. ‘time’ and ‘money’. If the money moves faster around the cycle or the amount of money tied up is reduced, the business will generate more cash or it will need to borrow less money to fund working capital which will ultimately reduce bank interest or the entity will have additional free money to support additional sales growth or investment. If increased credit limits can be negotiated from suppliers, entity gets free finance.

Working capital cycle indicates the length of the time between a company’s paying for materials, entering into stock and receiving the cash from sales of finished goods. It can be determined by adding the number of days required for each stage of cycle. For example, a company holds raw material on an average of 60 days, it gets credit from the supplier for 15 days, production process needs 15 days, finished goods are held for 30 days and 30 days credit is extended to debtors.

Operating cycle = R+W+F+D-C

Where, 

R= Raw material storage period
W= Working capital holding period
F= Finished goods storage period
D= Debtors collection period
C= Credit period availed

Operating cycle= 60+15+30+30-15
                          = 120 days.

Now the above components may be calculated as:

RM storage period = Avg stock of RM / Avg cost of RM consumption per day

WIP holding period = Avg WIP / Avg cost of production per day

FG storage period = Avg stock of FG / Avg COGS per day

Debtors collection period = Avg book debts / Avg credit sales per day

Credit period availed = avg trade creditor / Avg credit purchases per day

The net operating cycle represents the net time gap between investment of cash and its recovery of sales revenue. If depreciation is excluded from expenses in the computation of operating cycle, the net operating cycle also represents the cash conversion cycle. The net operating cycle represents the time interval for which the firm has to negotiate for working capital from its Bankers.

Estimation of Working Capital based on current asset and current liabilities

The holding period of various components of operating cycle may either expand or contract the net operating cycle period. Longer the operating cycle, higher will be the requirement of working capital and vice-versa.

Estimation of current assets
o   Raw materials inventory:

(Estimated production in units * estimated cost of RM p.u. * Avg RM holding period) / 360 days

o   WIP Inventory:

(Estimated production in units * estimated WIP cost p.u. * Avg WIP holding period) / 360 days

o   Finished goods:

(Estimated production in units * Cost of production p.u. excluding depreciation * Avg FG holding period) / 360 days

o   Debtors:

(Estimated credit sales in units * cost of sales p.u. excluding depreciation * Avg debtors collection period) / 360 days

o   Minimum desired Cash and Bank balances to be maintained by the entity have to be added to current assets for computation of working capital.

Estimation of current liabilities

o   Trade creditors:

(Estimated production in units * RM requirements p.u. * credit period granted by suppliers) / 360 days

o   Direct wages:

(Estimated production in units * Direct labour cost p.u. * Avg time lag in payment of wages) / 360 days

o   Overheads (other than depreciation and amortization)

(Estimated production in units * overhead cost p.u. * Avg time lag in payment of overheads) / 360 days

In simple words it’s just the reverse of the process used to determine the operating capital cycle.

Estimation of working capital requirement on cash cost basis

This approach is based on the fact that in case of current assets like debtors and finished goods etc, the exact amount of funds blocked is less than the amount of such current assets. For example, if we have sundry debtors worth Rs 1 lakh and our cost of production is Rs 80000, the actual amount of funds blocked in debtors is Rs 80000 the balance Rs 20000 is profit. Now suppose out of this Rs 80000, Rs 5000 is depreciation then actual funds blocked are Rs 75000. In other word Rs 75000 is the amount needed to finance debtors worth Rs 1 lakh. Thus this approach ignores profit and non cash item while determining working capital requirement.