caiib caiib- financial management - module –d – working capital & term lending -prof. r.s....

CAIIBCAIIB

• CAIIB- FINANCIAL MANAGEMENT

• - MODULE –D – WORKING CAPITAL & TERM LENDING

• -Prof. R.S. Ullal

• Consultant & Faculty

Module D topicsModule D topics

• Marginal Costing• Capital Budgeting• Cash Budget• Working Capital

COSTINGCOSTING

• Cost accounting system provides information about cost

• Aim : best use of resources and maximization of returns

• cost = amount of expenditure incurred( actual+ notional)

• Purposes +profit from each job/product, division, segment+pricingdecision+control+profit planning +inter firm comparison

Marginal costingMarginal costing

• Marginal costing distinguishes between fixed cost and variable cost

• Marginal cost is nothing but cost of Producing an additional unit

• Marginal cost= variable cost, if such cost does not require creation of additional facilities.

• MC= Direct Material + Direct Labour +Direct expenses

Marginal costing problemsMarginal costing problems

• Sales - variable cost = contribution

• Contribution/ (divided by) sales = C.S. Ratio

• Contribution=Fixed cost (at Break even point)

• Fixed Cost / (divided by) contribution per unit = break even units

Basic formulaBasic formulaSales price (-) variable cost= Sales price (-) variable cost=

contributioncontributionSP less VC = Contributio

n

10 6 = 4

9 6 = 3

8 6 = 2

7 6 = 1

6 6 = 0

5 6 = (1)

4 6 = (2)


• SP = Rs.10, VC =Rs.6 Fixed Cost Rs.60000

Find- Break even point (in Rs. & in units)- C/S ratio- Sales to get profit of Rs.20000


• Sales Rs.100000• Fixed Cost Rs.20000• B.E.Point Rs.80000• What is the profit ?

Management decisions- assessing Management decisions- assessing profitability profitability

CONTRIBUTION/SALES=C.S.RATIOCONTRIBUTION/SALES=C.S.RATIOProduct

sp vc Contribtion

c/s Ratio % ranking

A 20 10 10 10/20

50% 1

B 30 20 10 10/30

33% 2

C 40 30 10 10/40

25% 3

DECISION when limiting DECISION when limiting factorsfactors

SP Rs.14 Rs.11

VC 8 7

ContributionPer unit

6 4

Labour hr. pu 2 1

Contri.per hr 3 4

DECISIONSDECISIONS

• Make or buy decisions• Close department• Accept or reject order• Conversion cost pricing


• cost‑volume‑profit analysis is reliant upon a classification of costs in which fixed and variable costs are separated from one another. Fixed costs are those which are generally time related and are not influenced by the level of activity.

• Variable cost on the other hand are directly related to the level of activity; if activity increases, variable costs will increase and vice‑versa if activity decreases.


• USES OF COST‑VOLUME‑PROFIT ANALYSIS• The ability to analyse and use cost‑volume‑profit

relationship is an important management tool. The knowledge of patterns of cost behaviour offers insights valuable in planning and controlling short and long‑run operations. The example of increasing capacity is a good illustrations of the power of the technique in planning.

• The implications of changes in the level of activity can be measured by flexing a budget using knowledge of cost behaviour, thereby permitting comparison to be made of actual and budgeted perfor mance for any level of activity.


• LIMITATIONS OF COST‑VOLUME-PROFIT ANALYSIS

• A major limitation of conventional CVP analysis that we have already identified is the assumption and use of linear relation ships. Yet another limitation relates to the difficulty of divid ing fixed costs among many products and/or services. Whilst variable costs can usually be identified with production servic es, most fixed cost usually can only be divided by allocation and apportionment methods reliant upon a good deal of judgement. However, perhaps the major limitation of the technique relates to the initial separation of fixed and variable costs.


• ADVANTAGES AND DISADVANTAGES OF MARGINAL COSTING

• ADVANTAGES• 1. More efficient pricing decisions can be

made, since their impact on the contribution margin can be measured.

• 2. Marginal costing can be adapted to all costing system.

• 3. Profit varies in accordance with sales, and is not distorted by changes in stock level.

• 4. It eliminates the confusion and misunderstanding that may occur by the presence of over‑or‑under‑absorbed overhead costs in the profit and loss account.


• 5. The reports based on direct costing are far more effective for management control than those based on absorption costing. First of all, the reports are more directly related to the profit objective or budget for the period. Deviations from standards are more readily apparent and can be corrected more quickly. The variable cost of sales changes in direct proportion with volume. The distorting effect of production on profit is avoided, especially in month following high production when substantial amount of fixed costs are carried in inventory over to next month. A substantial increase in sales in the month after high production under absorption costing will have a significant negative impact on the net operating profit as inventories are liquidated.


• 6. Marginal costing can help to pinpoint responsibility according to organisational lines: individual performance can be evaluated on reliable and appropriate data based on current period activity. Operating reports can be prepared for all segments of the company, with costs separated into fixed and variable and the nature of any variance clearly shown. The responsibility for costs and variances can then be more readily attributed to specific individuals and functions, from top management to down management


• DISADVANTAGES OF MARGINAL COSTING• 1. Difficulty may be experienced in trying to

segregate the fixed and variable elements of overhead costs for the purpose of marginal costing.

• 2. The misuse of marginal costing approaches to pricing decisions may result in setting selling prices that do not allow the full recovery of overhead costs.

• 3. Since production cannot be achieved without incurring fixed costs, such costs are related to production, and total absorprtion costing attempts to make an allowance for this relationship. This avoids the danger inherent in marginal costing of creating the illusion that fixed costs have nothing to do with production.

CAPITAL BUDGETINGCAPITAL BUDGETING

• It involves current outlay of funds in the expectation of a stream of benefits extending far into the futureYear Cash flow

0 (100000)

1 30000

2 40000

3 50000

4 50000


• A capital budgeting decision is one that involves the allocation of funds to projects that will have a life of atleast one year and usually much longer.

• Examples would include the development of a major new product, a plant site location, or an equipment replacement decision.

• Capital budgeting decision must be approached with great care because of the following reasons:

1. Long time period: consequences of capital expenditure extends into the future and will have to be endured for a longer period whether the decision is good or bad.


2. Substantial expenditure: it involves large sums of money and necessitates a careful planning and evaluation.

3. Irreversibility: the decisions are quite often irreversible, because there is little or no second hand market for may types of capital goods.

4. Over and under capacity: an erroneous forecast of asset requirements can result in serious consequences. First the equipment must be modern and secondly it has to be of adequate capacity


• Difficulties• There are three basic reasons why capital

expenditure decisions pose difficulties for the decision maker. These are:

1. Uncertainty: the future business success is today’s investment decision. The future in the real world is never known with certainty.

2. Difficult to measure in quantitative terms: Even if benefits are certain, some might be difficult to measure in quantitative terms.

3. Time Element: the problem of phasing properly the availability of capital assets in order to have them come “on stream” at the correct time.


• Methods of classifying investments• Independent• Dependent• Mutually exclusive • Economically independent and statistically

dependent• Investment may fall into two basic

categories, profit-maintaining and profit-adding when viewed from the perspective of a business, or service maintaining and service-adding when viewed from the perspective of a government or agency.


• Expansion and new product investment

1. Expansion of current production to meet increased demand

2. Expansion of production into fields closely related to current operation – horizontal integration and vertical integration.

3. Expansion of production into new fields not associated with the current operations.

4. Research and development of new products.


• Reasons for using cash flows• Economic value of a proposed investment can be

ascertained by use of cash flows.• Use of cash flows avoids accounting ambiguities• Cash flows approach takes into account the time

value of money• For any investment project generating either

expanded revenues or cost savings for the firm, the appropriate cash flows used in evaluating the project must be incremental cash flow.

• The computation of incremental cash flow should follow the “with and without” principle rather than the “before and after” principle

Types of capital investmentsTypes of capital investments

• New unit• Expansion• Diversification• Replacement• Research & Development

Significance of capital Significance of capital budgetingbudgeting

• Huge outlay• Long term effects• Irreversibility• Problems in measuring future cash

flows

Facets of project analysisFacets of project analysis

• Market analysis• Technical analysis• Financial analysis• Economic analysis• Managerial analysis• Ecological analysis

Financial analysisFinancial analysis

• Cost of project• Means of finance• Cost of capital• Projected profitability• Cash flows of the projects• Project appraisal

Decision processDecision process

PLANNING PHASE

EVALUATION PHASE

SELECTION PHASE

IMPLEMENTATION PHASE

CONTROL PHASE

AUDITING PHASE

INVESTMENT OPPORTUNITIES

PROPOSALS

ONLINE PROJECTS

PROJECTS

ACCEPTED PROJECTS

PROJECT TERMINATION

PROPOSALSIm

pro

vem

ent

in p

lan

ning

& E

valu

atio

n p

roce

dure

Imp

rove

me

nt in

pla

nni

ng &

Eva

lua

tion

pro

cedu

re

NE

W I

NV

ES

TM

EN

T

OP

PO

RT

UN

ITIE

S

REJECTED

OPPORTUNITIE

S

Rejecte

d

Propo

sa

ls

Reject

ed

proje

ct

s

Methods of capital Methods of capital investment appraisalinvestment appraisal

DISCOUNTING NON-DISCOUNTING

Net present value (NPV) Pay back period

Internal rate of return (IRR)

Accounting rate of return

Profitability Index or Benefit cost ratio

Present value of cash flow Present value of cash flow stream- (cash outlay stream- (cash outlay

Rs.15000)@ 12%Rs.15000)@ 12%Year Cash flow PV factor

@12%PV

1 1000 0.893 893

2 2000 0.799 1594

3 2000 0.712 1424

4 3000 0.636 1908

5 3000 0.567 1701

6 4000 0.507 2028

7 4000 0.452 1808

8 5000 0.404 2020 13376

Present value of cash flow Present value of cash flow stream- (cash outlay stream- (cash outlay

Rs.15000 )@10%Rs.15000 )@10%Year Cash flow PV factor

@10%PV

1 2000 0.909 1818

2 2000 0.826 1652

3 2000 0.751 1502

4 3000 0.683 2049

5 3000 0.621 1863

6 4000 0.564 2256

7 4000 0.513 2052

8 5000 0.466 233015522


• The advantages of IRR over NPV are:• 1. It gives a percentage return which is

easy to understanding at all levels of management.

• 2. The discount rate/required rate of return does not have to be known to calculate IRR. It does have to be decided upon at sometime because IRR must be compared with something. The discussion as to what is an acceptable rate of return can however be left until much later stage. In a NPV calculation the discount rate must be specified prior to any calculation being performed.

• The advantages of NPV over IRR are:• 1. NPV gives an absolute measure of profitability and

hence immediately shows the increase in shareholder’s wealth due to an investment decision.

• 2. NPV gives a clear answer in an accept/reject decision. IRR gives multiple answers.

• 3. NPV always gives the correct ranking for mutually exclusive project while IRR may not.

• 4. NPVs of projects are additive while IRRs are not.• 5. Any changes in discount rates over the life of a

project can more easily be incorporated into the NPV calculation.

• The NPV approach provides as absolute measure that fully represents in value of the company if a particular project is undertaken. The IRR by contrast, provides a percentage figure from which the size of the benefits in terms of wealth creation cannot always be grasped.

The timing of the cash flows is critical for determining the Project's value.below the line for cash investments orabove the line for returns.

Rs.51 Lakh Rs.51 Lakh Rs.61 Lakh

Year 1 Year 2 Year 3Rs.102 lakh

Year 0

Net Present ValueYear Cash Flow Dis. Factor Present

@10% Value

0 -102 1 -1021 51 0.91 46.362 51 0.83 42.153 61 0.75 45.83

NPV 32.34

@27% Value0 -102 1 -1021 51 0.78740 402 51 0.62000 323 61 0.48818 30

NPV 0

The evaluation of any project depends on the magnitude of the cash flows, the timing and the discount rate. The discount rate is highly subjective. The higher the rate , the less a rupee in the future would be worth today. The risk of the project should determine the discount rate.

Internal Rate of Return (IRR) IRR is the rate at which the discounted cash flows in the future equal the value of the investment today. To find the IRR one must try different rates until the NPV equals zero.

Future valueFuture value

• Assume that an investor has $1000 and wishes to know its worth after four years if it grows at 10 percent per year. At the end of the first year, he will have $1000 X 1.10 or 1,100. By the end of the year two, the $1,100 will have grown to $1,210 ($1,100 X 1.10). The four-year pattern is indicated below.

BUDGETBUDGET

•Quantitative expression of management objective

•Budgets and standards•Budgetary control•Cash budget

PROFIT PLANNINGPROFIT PLANNING

• Budget & budgetary control• Marginal costing• CVP and break even point• Comparative cost analysis• ROCE

PRICING DECISIONSPRICING DECISIONS

• pricing• Full cost pricing• Conversion cost pricing• Marginal cost pricing• Market based


• PRICING AND ITS OBJECTIVES• The objective of pricing in practice will

probably be one of the following:• (a) To ‘skim’ the market (in the case of new

products) by the use of high prices;• (b) To penetrate deeply into the market

(again with new products) at an early stage, before competition produces similar goods;

• (c) To earn a particular rate of return on the funds invested via the generating of revenue; and

• (d) To make a profit on the product range as a whole, which may involve using certain items in the range as loss leaders, and so forth.


• Full cost pricing• The object is to recover all costs

incurred plus a percent age of profit. It is a method best used where the product is clearly differentiated and not in immediate, direct competition. It would not lend itself to situation where price tended to be determined by the market,


• Conversion cost pricing• Conversion cost consists of direct

labour cost and factory overhead, ignoring the cost of the raw material on the grounds that profit should be made within the factory and not upon materials bought from suppliers.


• Marginal cost pricing• Briefly it is that cost which would not be incurred if

the production of the product were discontinued. An important advantage of differential cost of pricing is the flexibility it gives to meet special short‑term circumstances, while accepting that full costs must be recovered in the long term. This is by no means always desirable in the short term. For example, there may be surplus productive capacity in a factory, in which case any opportunity to accept an order which covers differential cost and makes a contribution to fixed cost and profit should be accepted. Any contribution is better than none.


• Market based pricing

• This can be based on the value to a customer of goods or services and involves variable pricing. It also takes account of the price he is able and willing to pay for the goods or services. Businesses using this approach develop special products or services which command premium prices.

• The other market‑based approach is to price on the basis of what competitors are charging.

Operating leverageOperating leverageFinancial leverageFinancial leverage

• OL= amount of fixed cost in a cost structure. Relationship between sales and op. profit

• FL= effect of financing decisions on return to owners. Relationship between operating profit and earning available to equity holders (owners)

Working capitalWorking capital

• Current assets less current liabilities = net working capital or net current assets

• Permanent working capital vs. variable working capital

Working capital cycleWorking capital cycle

• cash> Raw material > Work in progress > finished goods > Sales > Debtors > Cash>

• Operating cycle – it is a length of time between outlay on RM /wages /others AND inflow of cash from the sale of the goods

Matching approach to asset Matching approach to asset

financingfinancing

Fixed Assets

Permanent Current Assets

Total Assets

Fluctuating Current Assets

Time

$

Short-termDebt

Long-termDebt +EquityCapital

THE WORKING CAPITAL THE WORKING CAPITAL CYCLECYCLE

(OPERATING CYCLE)(OPERATING CYCLE)

Accounts Payable

Cash

RawMaterials

W I P

Finished Goods

Value Addition

AccountsReceivable

SALES

• Operating cycle concept• A company’s operating cycle typically

consists of three primary activities:– Purchasing resources,– Producing the product and– Distributing (selling) the product.

These activities create funds flows that are both unsynchronized and uncertain.Unsynchronized because cash disbursements (for example, payments for resource purchases) usually take place before cash receipts (for example collection of receivables).

They are uncertain because future sales and costs, which generate the respective receipts and disbursements, cannot be forecasted with complete accuracy.

Working capital cycleWorking capital cycle


• FACTORS DETERMINING WORKING CAPITALFACTORS DETERMINING WORKING CAPITAL

1. Nature of the Industry1. Nature of the Industry2. Demand of Industry2. Demand of Industry3. Cash requirements3. Cash requirements4. Nature of the Business4. Nature of the Business5. Manufacturing time5. Manufacturing time6. Volume of Sales6. Volume of Sales7. Terms of Purchase and Sales7. Terms of Purchase and Sales8. Inventory Turnover8. Inventory Turnover9. Business Turnover9. Business Turnover10. Business Cycle10. Business Cycle11. Current Assets requirements11. Current Assets requirements12. Production Cycle12. Production Cycle


• Working Capital Determinants (Contd…)Working Capital Determinants (Contd…)

13. Credit control13. Credit control14. Inflation or Price level changes14. Inflation or Price level changes15. Profit planning and control15. Profit planning and control16. Repayment ability16. Repayment ability17. Cash reserves17. Cash reserves18. Operation efficiency18. Operation efficiency19. Change in Technology19. Change in Technology20. Firm’s finance and dividend policy 20. Firm’s finance and dividend policy 21. Attitude towards Risk21. Attitude towards Risk

TYPES OF WORKING CAPITALTYPES OF WORKING CAPITAL

WORKING CAPITAL

BASIS OF CONCEPT

BASIS OF TIME

Gross Working Capital

Net Working Capital

Permanent / Fixed

WC

Temporary / Variable

WC

Regular WC

Reserve WC

Special WC

Seasonal WC


• Working Capital Levels in Different Industries• A retailing company usually has high levels of

finished goods stock and very low levels of debtors. Most of the retailer’s sales will be for cash, and an independent credit card company or a financial subsidiary of the retail business (which on occasions is not consolidated in the group accounts). The retailing company, however, usually has high levels of creditors. It pays its sup pliers after an agreed period of credit. The levels of working capital required are therefore low:


• Excess of current assets over current liabilities are called the net working capital or net current assets.

• Working capital is really what a part of long term finance is locked in and used for supporting current activities.

• The balance sheet definition of working capital is meaningful only as an indication of the firm’s current solvency in repaying its creditors.

• When firms speak of shortage of working capital they in fact possibly imply scarcity of cash resources.

• In fund flow analysis an increase in working capital, as conventionally defined, represents employment or application of funds.


• In contrast, a manufacturing company will require relatively high levels of working capital with investments in raw materials, work-in-pro gress and finished goods stocks, and with high levels of debtors. The credit terms offered on sales and taken on purchases will be influenced by the normal contractual arrangements in the industry.

Working capitalWorking capital• Debtors Volume of credit sales• Length of credit given• Effective credit control and cash collection• Stocks Lead time & safety level• Variability of demand• Production cycle• No. of product lines• Volume of• – planned output• – actual output• – sales• PayablesVolume of purchases• Length of credit allowed• Length of credit taken – Discounts• Short‑term finance All the above• Other payments/receipts• Availability of credit Interest rates


• Cash Levels• it is necessary to prepare a cash budget where

the minimum balances needed from month to month will be defined.

• business is seasonal, cash shortages may arise in certain periods. Generally it is thought better to keep only sufficient cash to satisfy short‑term needs, and to borrow if longer‑term requirements occur

• The problem, of course, is to balance the cost of this borrowing against any income that might be obtained from investing the cash balances.

• The size of the cash balance that a company might need depends on the availability of other sources of funds at short notice, the credit standing of the company and the control of debtors and creditors


• Debtors• The debtors problem again revolves

around the choice between profitability and liquidity. It might, for instance, be possible to in crease sales by allowing customers more time to pay, but since this policy would reduce the company’s liquid resources it would not necessarily result in higher Profits.

• historical analysis or the use of established credit ratings to classify groups of customers in terms of credit risk


1.1. Establish clear credit practices as a matter Establish clear credit practices as a matter of company policy. of company policy.

2.2. Make sure that these practices are clearly Make sure that these practices are clearly understood by staff, suppliers and understood by staff, suppliers and customers. customers.

3.3. Be professional when accepting new Be professional when accepting new accounts, and especially larger ones. accounts, and especially larger ones.

4.4. Check out each customer thoroughly before Check out each customer thoroughly before you offer credit. Use credit agencies, bank you offer credit. Use credit agencies, bank references, industry sources etc. references, industry sources etc.

5.5. Establish credit limits for each customer... Establish credit limits for each customer... and stick to them. and stick to them.

6.6. Have the right mental attitude to the control Have the right mental attitude to the control of credit and make sure that it gets the of credit and make sure that it gets the priority it deserves. priority it deserves.


• 7. 7. Continuously review these limits when you suspect Continuously review these limits when you suspect tough times are coming or if operating in a volatile tough times are coming or if operating in a volatile sector. sector. 8. Keep very close to your larger customers. 8. Keep very close to your larger customers. 9. Invoice promptly and clearly. 9. Invoice promptly and clearly. 10. Consider charging penalties on overdue accounts. 10. Consider charging penalties on overdue accounts. 11. Consider accepting credit /debit cards as a 11. Consider accepting credit /debit cards as a payment option. payment option. 12. Monitor your debtor balances and ageing 12. Monitor your debtor balances and ageing schedules, and don't let any debts get too large or schedules, and don't let any debts get too large or too old. too old.

DIMENSIONS OF RECEIVABLES MANAGEMENTDIMENSIONS OF RECEIVABLES MANAGEMENT

OPTIMUM LEVEL OF INVESTMENT IN TRADE OPTIMUM LEVEL OF INVESTMENT IN TRADE RECEIVABLESRECEIVABLES

ProfitabilityProfitability

Costs &Costs &Profitability Profitability Optimum LevelOptimum Level

LiquidityLiquidity

StringentStringent LiberalLiberal

Working capital-FACTORINGWorking capital-FACTORING

• FactoringDefinition:• Factoring is defined as ‘a continuing legal

relationship between a financial institution (the factor) and a business concern (the client), selling goods or providing services to trade customers (the customers) on open account basis whereby the Factor purchases the client’s book debts (accounts receivables) either with or without recourse to the client and in relation thereto controls the credit extended to customers and administers the sales ledgers’.


• It is the outright purchase of credit approved accounts receivables with the factor assuming bad debt losses.

• Factoring provides sales accounting service, use of finance and protection against bad debts.

• Factoring is a process of invoice discounting by which a capital market agency purchases all trade debts and offers resources against them.


Debt administration:• The factor manages the sales ledger

of the client company. The client will be saved of the administrative cost of book keeping, invoicing, credit control and debt collection. The factor uses his computer system to render the sales ledger administration services.


• Different kinds of factoring services• Credit Information: Factors provide credit

intelligence to their client and supply periodic information with various customer-wise analysis.

• Credit Protection: Some factors also insure against bad debts and provide without recourse financing.

• Invoice Discounting or Financing : Factors advance 75% to 80% against the invoice of their clients. The clients mark a copy of the invoice to the factors as and when they raise the invoice on their customers.


• Services rendered by factor• Factor evaluated creditworthiness of the customer

(buyer of goods)• Factor fixes limits for the client (seller) which is

an aggregation of the limits fixed for each of the customer (buyer).

• Client sells goods/services.• Client assigns the debt in favour of the factor• Client notifies on the invoice a direction to the

customer to pay the invoice value of the factor.


• Client forwards invoice/copy to factor along with receipted delivery challans.

• Factor provides credit to client to the extent of 80% of the invoice value and also notifies to the customer

• Factor periodically follows with the customer• When the customer pays the amount of the

invoice the balance of 20% of the invoice value is passed to the client recovering necessary interest and other charges.

• If the customer does not pay, the factor takes recourse to the client.

Working capital-FACTORINGWorking capital-FACTORING• Benefits of factoring• The client will be relieved of the work relating to sales

ledger administration and debt collection• The client can therefore concentrate more on planning

production and sales.• The charges paid to a factor which will be marginally high

at 1 to 1.5% than the bank charges will be more than compensated by reductions in administrative expenditure.

• This will also improve the current ratio of the client and consequently his credit rating.

• The subsidiaries of the various banks have been rendering the factoring services.

• The factoring service is more comprehensive in nature than the book debt or receivable financing by the bankers.

Working capital- Working capital- INVENTORY INVENTORY MANAGEMENTMANAGEMENT

• Managing inventory is a juggling act. Managing inventory is a juggling act.

• Excessive stocks can place a heavy burden Excessive stocks can place a heavy burden on the cash resources of a business. on the cash resources of a business.

• Insufficient stocks can result in lost sales, Insufficient stocks can result in lost sales, delays for customers etc. delays for customers etc.

• INVENTORIES INCLUDE INVENTORIES INCLUDE • RAW MATERIALS, WIP & FINISHED RAW MATERIALS, WIP & FINISHED

GOODSGOODS

FACTORS INFLUENCING INVENTORY FACTORS INFLUENCING INVENTORY MANAGEMENTMANAGEMENT

Lead TimeLead Time Cost of Holding InventoryCost of Holding Inventory Material CostsMaterial Costs Ordering CostsOrdering Costs Carrying CostsCarrying Costs Cost of tying-up of FundsCost of tying-up of Funds Cost of Under stockingCost of Under stocking Cost of OverstockingCost of Overstocking


• Cost of Working capital• The other aspect of the working capital problem

concerns obtaining short‑term funds. Every source of finance, including taking credit from suppliers, has a cost; the point is to keep this cost to the minimum. The cost involved in using trade credit might include forfeiting the discount normally given for prompt payment, or loss of goodwill through relying on this strategy to the point of abuse. Some other sources of short‑term funds are bank credit, overdrafts and loans from other institutions. These can be unsecured or secured, with charges made against inventories, specifi c assets or general assets.


• Disadvantages of Redundant or Excess Working Disadvantages of Redundant or Excess Working CapitalCapital

õ Idle funds, non-profitable for business, poor ROIõ Idle funds, non-profitable for business, poor ROIõ Unnecessary purchasing & accumulation of õ Unnecessary purchasing & accumulation of inventories over required level inventories over required level õ Excessive debtors and defective credit policy, õ Excessive debtors and defective credit policy, higher incidence of B/D.higher incidence of B/D.õ Overall inefficiency in the organization.õ Overall inefficiency in the organization.õ When there is excessive working capital, Credit õ When there is excessive working capital, Credit worthiness suffersworthiness suffers õ Due to low rate of return on investments, the õ Due to low rate of return on investments, the market value of shares may fallmarket value of shares may fall


• Disadvantages or Dangers of Inadequate or Short Disadvantages or Dangers of Inadequate or Short Working CapitalWorking Capital

õ Can’t pay off its short-term liabilities in time. õ Can’t pay off its short-term liabilities in time. õ Economies of scale are not possible.õ Economies of scale are not possible.õ Difficult for the firm to exploit favourable market õ Difficult for the firm to exploit favourable market situations situations õ Day-to-day liquidity worsensõ Day-to-day liquidity worsensõ Improper utilization the fixed assets and ROA/ROI õ Improper utilization the fixed assets and ROA/ROI falls sharply falls sharply

Working capital cycleWorking capital cycle• Example: X Company plans to attain a sales of Rs 5 crores. It has the following information

for production and selling activity. It is assumed that the activities are evenly spread through out the year.

• (a) Average time raw materials are kept in store prior to issue for production.2months• (b) Production cycle time or work-in-progress cycle time. 2months• (c) Average time finished stocks are kept in sale in unsold condition 1/2 months• (d) Average credit available from suppliers 1 1/2 months• (e) Average credit allowed to customer 1 1/2 months• (f) Analysis of cost plus profit for above sales:• % Rs. In Crores• Raw Materials 50 2.50• Direct Labour 20 1.00• Overheads 10

0.50• Profit 20 1.00• Total 100 5.00• -----------

Working capital cycleWorking capital cycle• Calculation of Working Capital Requirement:• 1. Total months to be financed to Raw Material

Months• Time in raw material store

2• Working progress cycle 2• Finished goods store 1/2• Credit given to customer 1 1/2 •

6• Less: Credit available from suppliers 1 ½ •

---------------- • Total months to be financed to Raw Materials 4 ½ •

----------------• 2. Total months to be financed to Labour• Production cycle 2 • In Finished stock store ½ • Credit to customer 1

½ • Total Months to be financed

4•

Working capital cycleWorking capital cycle• 3. Total months to be finacned to overhead• Production cycle 2• In finished goods stores ½ • Credit to customer 1 ½ •

-------------• 4• Less: Credit from suppliers

1 ½ •

-------------• Total months to be financed 2 ½ • 4. Maximum working capital required Rs in crores• Raw Materials 4 ½ / 12 × 2.50 0.94• Direct Labour 4 / 12 × 1.00

0.33

• Overheads 2 ½ × 0.50 0.10•

-------• Maximum Working Capital

1.37•

-------

E N DE N D

• THANK YOU VERY MUCH FOR YOUR PATIENCE; I TRUST IT WAS USEFUL.

ANY QUERIES MAY BE ADDRESSED TO

[email protected]

caiib caiib- financial management - module –d – working capital & term lending -prof. r.s....

Documents

variable cost marginal

fixed cost rs

cost aim

additional unit marginal

knowledge of cost behaviour

costing cost accounting

maximization of returns

profit of rs