Finance Working Capital

Originally Posted by ravichandran44

Hi

Iam Ravichandran doing final year MBA Finance from Madras University. Following are some of the details of Cost, Investment, Profit center.

Cost center

Unit within the organization in which the manager is responsible only for costs. A cost center has no control over sales or over the generating of revenue. An example is the production department of a manufacturing company. The performance of a cost center is measured by comparing actual costs with budgeted costs for a specified period of time.

Revenue center

Unit within an organization that is responsible for generating revenues. A revenue center is a profit center since for all practical purposes there is no revenue center that does not incur some costs during the course of generating revenues. A favorable variance occurs when actual revenue exceeds expected revenue.

Profit center

Responsibility unit that measures the performance of a division, product line, geographic area, or other measurable unit. Divisional profit figures are best obtained by subtracting from revenue only the costs the division manager can control (direct division costs) and eliminating allocated costs common to all divisions (e.g., an allocated share of company image advertising that benefits all divisions but is not controlled by division managers). Profit is a very often used method to evaluate a division's financial success as well as the performance of its manager. In determining divisional profit, a transfer price may have to be derived. The divisional profit center allows for decentralization. as each division is treated as a separate business entity with responsibility for making its own profit.

Responsibility center

Unit in the organization that has control over costs, revenues, or investment funds. For accounting purposes, responsibility centers are classified as cost center , revenue center , profit center , and investment center . A well-designed responsibility accounting system should clearly define responsibility centers in order to collect and report revenue and cost information by areas of responsibility.

Investment center

Responsibility center within an organization that has control over revenue, cost, and investment funds. It is a profit center whose performance is evaluated on the basis of the return earned on invested capital. The corporate headquarters or division in a large decentralized organization would be an example of an investment center. Return On Investment (ROI) and Residual Income (RI) are two key performance measures of an investment center.

WORKING CAPITAL - Meaning of Working Capital

Capital required for a business can be classified under two main categories via,

1. Fixed Capital
2. Working Capital

Every business needs funds for two purposes for its establishment and to carry out its day- to-day operations. Long terms funds are required to create production facilities through purchase of fixed assets such as p&m, land, building, furniture, etc. Investments in these assets represent that part of firm’s capital which is blocked on permanent or fixed basis and is called fixed capital. Funds are also needed for short-term purposes for the purchase of raw material, payment of wages and other day – to- day expenses etc.

These funds are known as working capital. In simple words, working capital refers to that part of the firm’s capital which is required for financing short- term or current assets such as cash, marketable securities, debtors & inventories. Funds, thus, invested in current assts keep revolving fast and are being constantly converted in to cash and this cash flows out again in exchange for other current assets. Hence, it is also known as revolving or circulating capital or short term capital.

CONCEPT OF WORKING CAPITAL

There are two concepts of working capital:

1. Gross working capital
2. Net working capital

The gross working capital is the capital invested in the total current assets of the enterprises current assets are those

Assets which can convert in to cash within a short period normally one accounting year.

CONSTITUENTS OF CURRENT ASSETS

1. Cash in hand and cash at bank
2. Bills receivables
3. Sundry debtors
4. Short term loans and advances.
5. Inventories of stock as:
   • Raw material
   • Work in process
   • Stores and spares
   • Finished goods
6. Temporary investment of surplus funds.
7. Prepaid expenses
8. Accrued incomes.
9. Marketable securities.

In a narrow sense, the term working capital refers to the net working. Net working capital is the excess of current assets over current liability, or, say:

NET WORKING CAPITAL = CURRENT ASSETS – CURRENT LIABILITIES.

Net working capital can be positive or negative. When the current assets exceeds the current liabilities are more than the current assets. Current liabilities are those liabilities, which are intended to be paid in the ordinary course of business within a short period of normally one accounting year out of the current assts or the income business.

CONSTITUENTS OF CURRENT LIABILITIES

1. Accrued or outstanding expenses.
2. Short term loans, advances and deposits.
3. Dividends payable.
4. Bank overdraft.
5. Provision for taxation , if it does not amt. to app. Of profit.
6. Bills payable.
7. Sundry creditors.

The gross working capital concept is financial or going concern concept whereas net working capital is an accounting concept of working capital. Both the concepts have their own merits.

The gross concept is sometimes preferred to the concept of working capital for the following reasons:

1. It enables the enterprise to provide correct amount of working capital at correct time.
2. Every management is more interested in total current assets with which it has to operate then the source from where it is made available.
3. It take into consideration of the fact every increase in the funds of the enterprise would increase its working capital.
4. This concept is also useful in determining the rate of return on investments in working capital. The net working capital concept, however, is also important for following reasons:
   • It is qualitative concept, which indicates the firm’s ability to meet to its operating expenses and short-term liabilities.
   • IT indicates the margin of protection available to the short term creditors.
   • It is an indicator of the financial soundness of enterprises.
   • It suggests the need of financing a part of working capital requirement out of the permanent sources of funds.

Thanks and regards
Ravichandran