What is Working Capital Turnover Ratio

There is direct relation of working capital of company with its sales. We have more control over working capital because we can change current asset or current liability according to our need. But, there is no full control over our sales because external business environment affects our level of sales. Working capital turnover ratio is good tool to take decision to manage sales. It shows the use of working capital for sales. Both high and low working capital turnover ratio is not good. Because low WCTR means low inefficient use of working capital in operation and very high working capital turnover ratio does not show good position of company because its shows company is operating with high short-term debt obligations. Only optimum working capital turnover ratio is the best. Formula of Working capital turnover ratio.

= Cost of sale or sales / average working capital

This ratio also shows the return in volume on our net invested current assets. We can also compare it with Asset turnover ratio which shows the relationship of sales and total assets

= Cost of Sales or Sales / Total Assets

If we write earning asset instead of writing cost of sales or sales, it will be the Earning assets to total assets ratio. It is also better way to check the position of company

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Derivatives

Call Option: - Gives buyer “Right but not the obligation” to buy the share.
Put Option: - Gives buyer “Right but not the obligation” to sell the share

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Capital Budgeting

Process of Capital Budgeting:

• Huge cash outlay.
• Decision taken is irressable.
• Invest in lumsum the receipt is piecemeal
• Wrong decision will affect the very base of the company.

Capital Budgeting Rules:

• Ignore accounting profit and take only cash flows.
• Try only incremental basis ignore Average calculation.
• Consider all incidental effects.
• Ignore sunk cost (ie. Cost remain unaltered for various alternatives available is sunk cost)
• Consider opportunity cost (Opportunity Loss is Opportunity cost)
• Beware of allocated cost – Ignore them
• Depreciation is an important cash flow when taxation is considered. If no taxation, no depreciation.
• Interest should not be considered as part of the cost, in the arrival of cash inflow for investing decision problems. If deducted add back post tax interest.
• Separate investing decision and financing decision.
• Be consistent with inflation rates. All future cash flows is assumed as without inflation. Such cash flows are referred as real cash flows.
• Cash flows under the influence of inflation would be referred to as money cash flows. (Money cash flows (or) Nominal Cash Flows (or) Market cash flows)
• Unless otherwise stated cost of capital is considered after tax basis because cash flows will be considered only on after tax basis. (PV factor is the inverse of compounding factor)
• Equation to find out the PV of an amount if cost of capital and Inflation rate is given
(1 + Money Rate) = (1 + Real Discount rate) * (1 + Inflation Rate)

Method of evaluating Capital Budgeting:

1. Pay back method
2. Annual Rate of Return
3. Discounted cash flow
• Net Present Value (NPV)
• Internal Rate of Return (IRR)
• Profitability Index (PI) (or) Benefit cost Ratio
• Equated Annuity Cost (EAC) (or)
Equated Annuity Benefit (EAB)
• Discounted Pay Back (or) Time adjusted BEP

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Learning Curve

Learning is the process of acquiring skill, Knowledge, and ability by an individual. According to learning curve theory the productivity of the worker increases with increase in experience due to learning effect. The learning theory suggests that the best way to master a task is to “learn by doing”. In other words, as people gain experience with a particular job or project they can produce each unit more efficiently than the preceding one.

The speeding up of a job with repeated performance is known as the learning effect or learning curve effect.

The cumulative average time per unit produced is assumed to fall by a constant percentage every time the total output is doubled. So generally learning effect is found in the multiples of 2. If learning curve effect is asked between two even numbers then Learning curve equation is formed ie. Learning curve effect is expressed mathematically as follows:

Learning curve equation =
Y = a(x) -b Where Y = Average time per unit
a = Total time for first unit
x = Cumulative number of units manufactured
b = the learning curve index

Learning curve index (b) = log (1- % decrease)
Log 2

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Network Analysis

CPM
• Total float = LS – ES (or) LF – EF

• Free float = Total float – Head event slack

• Independent float = Free float – Tail event slack

• In the diagram Es = Lf in the critical path

• Critical path is the longest duration

• To find the minimum time associated cost (i.e. Additional cost incurred per unit of time saved) following formula is used :-
Crash cost per day (or) Activity cost supply
= Crash cost – Normal cost
Normal time – Crash time

• Interfacing float = It is the part of the total float which causes reduction in the float of the succession activities. In other words it is the portion of activity float which cannot be continued without affecting adversely the float of the subsequent activity or activities.

• Steps in proceeding the problem : -

2. First find and fill the ES and LF column from the diagram.

3. Then find LS and EF as follows :-
Ls = Lf – Duration
Ef = Es + Duration

4. Find total float

5. Find free float. Wherever total float column has zero free float column is also taken has zero and remaining elements is filled as said above

6. Find Independent float. Wherever free float column has zero Independent float column is also taken has zero and remaining elements is filled as said above



Notes: -
1. ES = Earliest Start. Indicates earliest time that the given activity can be scheduled
2. EF = Earliest Finish. Time by which the activity can be completed at the earliest.

3. LF = Latest Finish. Latest allowable occurrence time of the head event of the activity.

4. LS = Latest Start.

5. Total duration of the critical path is the maximum time/amount consumed for the activity. This should be crashed with respect to crashing days and crashing cost. This crashing should not change the critical path.

PERT : -

• Expected (or) Average time is found by assigning weights as follows : -
1 for optimistic
4 for Most likely
1 for pessimistic
Average time = 1 optimistic + 4 most likely + 1 pessimistic
6
• Standard Deviation = (Pessimistic time – Optimistic time)
6
• Variance = (Standard Deviation)2

• Probability of completing the project in N days
= Required time(N) (-) Expected time (critical path duration)
Standard Deviation
[Nothing but Z = (X - Mean) / Standard deviation]
= Y (say)
= Find Z(y)
= Probability %
- If required time > Expected time then = 0.5 + Z(Y)
- If required time < Expected time then = 0.5 – Z(Y)

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Turnover Ratios

i) Assets turnover = Sales
Total assets

2) Fixed assets turnover = Sales [Number of times fixed assets has
Fixed assets turned into sales]


3) Working capital turnover = Sales
Working capital

4) Inventory turnover = Cost of goods sold
(for finished goods) Average inventory

5) Debtors turnover (or) Average collection period = Credit sales (in ratio)
Average accounts receivable
(or) = Average accounts receivable * 365 (in days)
Credit sales

6) Creditors turnover (or) Average payment period Credit purchases (in ratio)
Average accounts payable
(or) = Average accounts Payable * 365 (in days)
Credit Purchases

7) Inventory Turnover (for WIP) = Cost of production
Average Inventory (for WIP)

8) Inventory Turnover (for Raw material) = Raw material consumed
Average inventory (for raw material)

10) Inventory Holding Period = 365 .
Inventory turnover ratio

11) Capital Turnover ratio = Cost of sales
Capital employed

Note : -
• Working capital = Current asset – Current liability
= 0.25 * Proprietary ratio
• Accounts Receivable = Debtors + Bills receivable
• Accounts payable = Creditors + Bills Payable

Remarks : -
• If assets turnover ratio is more than 1, then profitability based on capital employed is profitability based on sales.
• Higher inventory turnover is an indicator of efficient inventory movement. It is an indicator of inventory management policies.
• Low inventory holding period lower working capital locking, but too low is not safe.
• Higher the debtors turnover, lower the credit period offered to customers. It is an indicator of credit management policies.
• Higher the creditors turnover, lower the credit period offered by suppliers.

G) Other Ratios: -

1) Operating profit ratio = Net profit ratio + Non operating loss / Sales ratio

2) Gross profit ratio = Operating profit ratio + Indirect expenses ratio

3) Cost of goods sold / Sales ratio = 100% - Gross profit ratio

4) Earnings per share = Net profit after interest and tax
Number of equity shares

5) Price earning ratio = Market price per equity share
Earning per share

6) Pay out ratio = Dividend per equity share * 100
Earning per equity shares

7) Dividend yield ratio = Dividend per share * 100
Market price per share

8) Fixed charges coverage ratio = Net profit before interest and tax
Interest charges

9) Interest coverage ratio = Earning before interest and tax
Interest charges

10) Fixed dividend coverage ratio = Net profit .
Annual Preference dividend


11) Over all profitability ratio = Operating profit * 100
Capital employed

12) Productivity of assets employed = Net profit .
Total tangible asset

13) Retained earning ratio = Retained earnings * 100
Total earnings

H) General Remarks: -
• Fall in quick ratio when compared with last year or other company is due to huge stock pilling up.
• If current ratio and liquidity ratio increases then the liquidity position of the company has been increased.
• If debt equity ratio increases over a period of time or is greater when comparing two ratios, then the dependence of the company in borrowed funds has increased.
• Direct expenses ratio increases in comparison then the profitability decreases.
• If there is wages / Sales ratio increases, then this is to verified
a) Wage rate
b) Output / Labour rate
• Increment in wage rate may be due to increased rate or fall in labour efficiency.
• Again there are many reasons for fall in labour productivity namely abnormal idle time due to machine failure, power cut etc.
• Reduction in Raw material consumed / sales ratio may be due to reduction in wastage or fall in material price.
• Increase in production expenses ratio may also be due to price raise.
• Stock turnover ratio denotes how many days we are holding stock.
• In stock turnover ratio greater the number of days, the movement of goods will be on the lower side.
• Financial ratios are Current ratio, Quick ratio, Debt equity ratio, Proprietary ratio, Fixed asset ratio.
• Short term solvency ratios are current ratio, Liquidity ratio
• Long term solvency or testing solvency of the company ratios are Debt equity ratio, fixed asset ratio, fixed charges coverage ratio (or) Interest coverage ratio.
• To compute financial position of the business ratios to be calculated are – current ratio, Debt equity ratio, Proprietary ratio, fixed asset ratio.
• Fictitious asset are Preliminary expenses, Discount on issue of shares and debentures, Profit and loss account debit balance.

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Expenses Ratios

a) Direct expenses Ratios : -
i) Raw material consumed * 100
Sales
ii) Wages * 100
Sales
iii) Production Expenses * 100
Sales

b) Indirect expenses Ratios : -
i) Administrative Expenses * 100
Sales
ii) Selling Expenses * 100
Sales
iii) Distribution Expenses * 100
Sales
iv) Finance Charge * 100
Sales

Notes : -
• In the above the term “term” is used for business engaged in sale of goods, for other enterprises the word “revenue” can be used.
• Gross profit = Sales – Cost of goods sold
• Operating profit = Sales – Cost of sales
= Profit after operating expenses but before Interest and tax.
• Operating Expenses = Administration Expenses + Selling and distribution expenses, Interest on short term loans etc.
• Return = Earning before Interest and Tax
= Operating profit
= Net profit + Non operating expenses – Non operating Income
• Capital employed = Share holders fund + Long term borrowings
= Fixed assets + Working capital
• If opening and closing balance is given then average capital employed can be substituted in case of capital employed which is
Opening capital employed + Closing capital employed
2

E) Debt service coverage ratios = Profit available for debt servicing
Loan Installments + Interest

Notes : -
• Profit available for debt servicing = Net profit after tax provision + Depreciation + Other non cash charges + Interest on debt.

Remarks : -
• Higher the debt servicing ratio is an indicator of better credit rating of the company.
• It is an indicator of the ability of a business enterprise to pay off current installments and interest out of profits.

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Profitability Ratio

1) Gross Profit Ratio = Gross Profit * 100
Sales

2) Net Profit Ratio = Net Profit * 100
Sales

3) Operating Profit ratio = Operating profit * 100
Sales

4) Return to shareholders = Net profit after interest and tax
Share holders fund

5) Return on Net Worth = Return on Net worth * 100
Net worth

6) Return on capital employed (or) Return on investment = Return (EBIT)
Capital Employed

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Quick ratio or Acid Test ratio

Quick ratio or Acid Test ratio = Quick Asset
--------------
Quick liability


Notes : -
• Quick Asset = Current Asset – Stock
• Quick Liability = Current liability – Cash credit, Bank borrowings, OD and other Short term Borrowings.
• Secured loan is a current liability and also come under cash credit
• Sundry debtors considered doubtful should not be taken as quick asset.
• Creditors for capital WIP is to be excluded from current liability.
• Current asset can include only marketable securities.
• Loans to employees in asset side are long term in nature and are not part of current assets.
• Provision for gratuity is not a current liability.
• Gratuity fund investment is not a part of marketable securities.
• Trade investments are not part of marketable securities.

Remarks : -
• Higher the current ratios better the liquidity position.

C) Capital structure ratios : -

1) Debt equity ratio = Debt = External Equity
(or) Leverage ratio Equity Internal Equity
= Long term debt = Share holders fund
Long term fund Long term fund

2) Proprietary ratio = Proprietary fund
Total Assets

3) Total Liability to Net worth ratio = Total Liabilities
Net worth

4) Capital gearing ratio = Preference share capital + Debt
Equity – Preference share capital

Notes : -
• Share holders fund (or) Equity (or) Proprietary fund (or) Owners fund (or) Net worth = Equity share + Preference share + Reserves and surplus – P & L a/c – Preliminary Expenses.
• Debt (or) Long term liability (or) Long term loan fund = Secured loan (excluding cash credit) + unsecured loan + Debentures.
• Total asset = Total assets as per Balance sheet – Preliminary expenses.
• Total liability = Long term liability + Current liability (or) short term liability
• Long term fund = Total asset – Current liability = Share holders fund + long term loan fund.

Remarks : -
• In debt equity ratio higher the debt fund used in capital structure, greater is the risk.
• In debt equity ratio, operates favorable when if rate of interest is lower than the return on capital employed.
• In total liability to Net worth Ratio = Lower the ratio, better is solvency position of business, Higher the ratio lower is its solvency position.
• If debt equity ratio is comparatively higher then the financial strength is better.

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Liquidity Ratio

1) Current ratio = Current asset
------------
Current Liability

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Cash Position Ratio

A) Cash Position Ratio : -

1) Absolute Cash Ratio = Cash Reservoir
Current Liabilities

2) Cash Position to Total asset Ratio = Cash Reservoir * 100
(Measure liquid layer of assets) Total Assets

3) Interval measure = Cash Reservoir
(ability of cash reservoir to meet cash expenses) Average daily cash expenses
( Answer in days)

Notes : -
• Cash Reservoir = Cash in hand + Bank + Marketable Non trade investment at market value.
• Current liabilities = Creditors + Bills Payable + Outstanding Expenses + Provision for tax (Net of advance tax) + Proposed dividend + Other provisions.
• Total assets = Total in asset side – Miscellaneous expenses – Preliminary expenses + Any increase in value of marketable non trading Investments.
• Average cash expenses =Total expenses in debit side of P & L a/c – Non cash item such as depreciation, goodwill, preliminary expenses written off, loss on sale of investments, fixed assets written off + advance tax (Ignore provision for tax) . The net amount is divided by 365 to arrive average expenses.

Remarks : - In Comparison
• When absolute cash ratio is lower then current liability is higher
• When cash position to Total Asset ratio is lower then the total asset is relatively higher.
• When cash interval is lower the company maintain low cash position. It is not good to maintain too low cash position or too high cash position.

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Ratio Analysis

A) Cash Position Ratio : -

1) Absolute Cash Ratio = Cash Reservoir
Current Liabilities

2) Cash Position to Total asset Ratio = Cash Reservoir * 100
(Measure liquid layer of assets) Total Assets

3) Interval measure = Cash Reservoir
(ability of cash reservoir to meet cash expenses) Average daily cash expenses
( Answer in days)

Notes : -
• Cash Reservoir = Cash in hand + Bank + Marketable Non trade investment at market value.
• Current liabilities = Creditors + Bills Payable + Outstanding Expenses + Provision for tax (Net of advance tax) + Proposed dividend + Other provisions.
• Total assets = Total in asset side – Miscellaneous expenses – Preliminary expenses + Any increase in value of marketable non trading Investments.
• Average cash expenses =Total expenses in debit side of P & L a/c – Non cash item such as depreciation, goodwill, preliminary expenses written off, loss on sale of investments, fixed assets written off + advance tax (Ignore provision for tax) . The net amount is divided by 365 to arrive average expenses.

Remarks : - In Comparison
• When absolute cash ratio is lower then current liability is higher
• When cash position to Total Asset ratio is lower then the total asset is relatively higher.
• When cash interval is lower the company maintain low cash position. It is not good to maintain too low cash position or too high cash position.

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