fm 3 working capital management

8/6/2019 FM 3 Working Capital Management

http://slidepdf.com/reader/full/fm-3-working-capital-management 1/79

Working Capital

ManagementSession 8



What is working capital?

Working capital measures how much in liquid assets acompany has available to build its business. Thenumber can be positive or negative, depending on howmuch debt the company is carrying.

Companies that have a lot of working capital will bemore successful since they can expand and improvetheir operations. Companies with negative workingcapital may lack the funds necessary for growth.

Working capital = Current assets - current liabilities



Purpose of Working Capital

Working capital is required to meet day to dayoperating expenses and for holding stocks of raw materials, spare parts, consumable, wrok in

progress and finished goods.Working capital typically means the firmsholding of current or short term assets such ascash, recievable,inventory and market

securities.These items are also refered as circulatingcapital.



Purpose of Working Capital

To hold the stock of raw materials for such a period so as tofacilitate an uninterrupted supply of raw material to productionprocess.

To hold the stock of work in progress for process peroid

To hold the stock of finished goods for such a peroid so as tomeet the demands of customers on continuous basis andsudden demand from some customer

To grant credit to its customers for marketing and competitivereasons.

To hold cash balances to meet the manufaturing, office andadministraive, selling and distribution exp,taxes etc



Need for Working Capital

It is needed because of the existence of operating cycle

Operating cycle is the duration of time

between acquisition of supplies and thecollection of cash from receivables

Basically, working capital is required to

finance operations during cycle for thebusiness to run smoothly.



Concept of working capital

There are two possible interpretation of working capital :

Balance sheet concept

There are two :Excess of current assets over current liabilities iscalled net working capital

Gross or total current assets

Operating cycle concept



Operating Cycle



Operating cycle

WCC is defined as the time period required for the wholeoperation starting with cash to cash plus (assumes profit). Itexpresses in month days.

Operating cycle - OC is equal to the length of inventory andreceivables conversion period.

OC = R + W + F + D – C

R = Raw material

W = Work in processF = Finished goods waiting period

D = Debtors collection period

C = Creditors payment period.

It helps not only in forecasting working capital requirement but



Calculation of components of operating cycle (in days)

Average raw material Storage period

Average work in progress holding period

Average finished goods storage period

Average Debtors collection period

Average Creditors payment period

Average time lag in payment of expenses

Gross operation cycle

Net operation cycle



Concepts of working capital

Balance sheet concept

Gross Working Capital

It refers to the firm’s investment in current assets. Currentasset refer to the assets which are held for their conversioninto cash within a operating cycle.

Net Working CapitalIt refers to the difference between current assets andcurrent liability.



Gross Working Capital

+

=

+Gross working

capital

Cash

InventoriesRaw Material

Work in

progressFinished goods

Short term marketablesecurities and other

current assets



Gross WC = all current assets

Net WC = current assets – current liabilities

Current assets;Inventories

Raw material

Work in progress

Finished goods

Others

Trade debtors

Loans and advances

Cash in hand and bank

Current liabilities

Sundry creditors

Trade advances



Permanent Working Capital

Temporary Working Capital



Importance or Advantages of

Adequate Working Capital:Helps in arranging loans from banks &others on easy and favourable terms

Enables a concern to avail cash discount

and hence reduce cost.Ensures regular supply of raw material.

Regular payment of salaries, wages and

other day to day comittment.Enables a concern to face business crisis.



Excess or Inadequate WC

Ideal funds.

Loss of return on investment

It may lead to unnecessary purchasing &

accumulation of inventories.

It may implies to defective credit policy or liberal policy



Disadvantages or Dangers of Inadequate WC

A concern which has inadequate WC,cannot pay its short term liabilities in time.

Cannot buy its requirements in bulk & cannot

avail of discounts etc.Create inefficiency

Becomes difficult to use efficiently fixed

assets due to non-availability of liquid funds.



Factors Determining WorkingCapital

Nature of the businessSize of Business

Manufacturing Cycle / Time

Demand and supply of the product

Volume of sale

Credit policy

Growth and expansion activities

Price level changes

Inventory policy

Dividend policy



Nature of BusinessNature of Business Requirement of WC Reason

Small trading concern or retail shop Small Operating cycle period issmall since-Mostly cash salesCarry small quantitiesof goodsSmall debtors balanceCarry small amount of

cash

Large trading firm Large Operating cycle period issmall since-

Large quantity of stockCarry large amount of cash and debtorsbalance

Manufacturing firm Large Carry large quantity of raw material, work inprogress, finishedgoods, debtors and

cash



Nature of business Requirement of WC Reason

Public utility(electricity generation andsupply, water supply)

Small They have cash salesThey supply servicesand not products

Hotels, Restaurants and

eating houses

Small They mostly have cash

sales and only smallamount of debtorsbalance

Trading firms Large They require largequantities of goods tobe held in stock

They carry largedebtors balance

Financial firms Large They carry largedebtors balance



Factors influencing WorkingCapital

Nature of business

eg: manufacturing, transportation

Technology

Management attitude

Seasonality of operationeg: cold drinks

Production policy

Production of ceiling fan through out the year

Market conditionDepends on competition.

Sale of finished goods and collection of cash

Conditions of supply

Prompt or unpredictable.



Disadvantages of excess Working Capital

Ideal fundsUnnecessary purchasing

Inefficiency in the organisation

Due to low rate of return on investment, market

value of shares may fall.

Disadvantages of short Working Capital

Cant pay off short term liabilities

Difficult for firm to exploit favourable marketconditions

Improper utilisation of fixed assets.

s ma e o u ure ase on



s ma e o u ure ase oncurrent assets and currentliabilties

Step 1:Make the estimates of various current assets as follows:

Stock of = est annual cost of RM to be consumed x avg RM holding period

raw mat. 12 months or 365 days

Stock of = est annual cost of goods to be produced x avg WIP holding period

WIP 12 months or 365 days

Stock of = est annual cost of goods to be produced x avg FG storage period

Fin Goods. 12 months or 365 days

Average = estimated annual cost of credit sales x avg collection period

Trade debtor 12 months or 365 days

Cash and bank balance = minimum as desired by the firm

s ma e o u ure ase on



s ma e o u ure ase oncurrent assets and currentliabilties

Step 2 :Make the estimates of various current Liabilities as follows:

Average = Estimated annual cost of credit purchases x avg credit periodavailed

Trade Creditors 12 months or 365 days

Average Creditors = Expenses for the year x avg time lag in payment

For expenses 12 months or 365 days

Estimate of future WC based on



Estimate of future WC based oncurrent assets and current

liabiltiesStep 3: make estimate of WC by taking outthe difference between the current asset andcurrent liability



RECEIVABLESMANAGEMENT

Session 8



Receivables Management

Receivables management means planning,directing and controlling of receivables. Itanswers the following questions:

To whom credit should be allowedHow much credit should be allowed

How much amount of credit should be alloed



Objective of ReceivablesManagementConsequences of ExcessiveReceivables

Consequences of InadequateReceivables

High opportunity cost of investment inReceivables

Decrease in Sales

High Risk of Bad debts Risk of Loosing Market Share

High Credit Administration Cost

High Risk of Liquidity



What are receivables?Receivables are sales made on credit basis.

Why do we need receivables?

Reach sales potentialCompetition

Understanding Receivables

As a part of the operating cycleTime lag b/w sales and receivables creates

need for working capital

Receivables

Inventory

Cash

OperatingCycle

GRANTING CREDIT



Basic decisions

1. To give credit or not

2. Duration of credit period(selecting the right policy)

Decision based on cost-benefit analysis

Positive net benefit-Credit granted (Highest Net benefit policy chosen)

Negative net benefit- Credit not granted

GRANTING CREDIT

MANAGEMENT

DIFFERENT TYPES OF COSTS ASSOCIATED



COLLECTION COST:

Administrative costs incurred in collecting the accounts receivable.

CAPITAL COST:

Cost incurred for arranging additional funds to support credit sales.

DELINQUENCY COST:

Cost which arises if customers fail to meet their obligations.

DEFAULT COST:

Amounts which have to written off as bad debts.

DIFFERENT TYPES OF COSTS ASSOCIATED

MANAGEMENT



Credit Trade Policy

Credit gives the customer the opportunity to buy goods and services, and

pay for them at a later date.

Advantages of credit trade

Results in more customers than cash trade.

Can charge more for goods to cover the risk of bad debt.

Gain goodwill and loyalty of customers.

People can buy goods and pay for them at a later date.

Can be used as a promotional tool.

Increase the sales.

Disadvantages of credit trade

Risk of bad debt.

High administration expenses.

People can buy more than they can afford.

More working capital needed.

Risk of Bankruptcy.



The 5 C’s of Credit

Customer Evaluation- The 5 C’s

Character - Reputation, Track Record

Capacity- Ability to repay( earning capacity)

Capital- Financial Position of the co.

Collateral- The type and kind of assets pledged

Conditions- Economic conditions & competitive factors that may affect the

profitability of the customer

To get info on the 5 C’s a firm may rely on:

Financial statement

Bank references

Experience of the firm

Prices and Yields on securities



Obtaining Credit Information

Obtaining Credit Information is the first step in the evaluationprocess

Application Forms

Historical Financial Statements

External Sources



External Sources of Credit

InformationCredit Interchange Bureaus can provide firms with factual dataregarding the credit history.

CIBIL

Direct Credit Information Exchanges provide participants withcredit information

Bank Checking may provide vague credit information (from theapplicant's bank)

FCU check



Analyzing Credit Information

Analyzing Credit Information is the next step in the evaluationprocess

Procedures

Economic Considerations

The Small Business ProblemCredit Scoring is a good (and inexpensive) way for firmsextending credit to a large number of small accounts to addresscredit analysis



Credit Policy- three decisionvariables

Credit Policy

CreditStandards Credit Terms Collection

Efforts



1.Credit Standard

Credit Standards are the minimum requirementsfor extension of credit to a customer

Liberal Credit Standards

Push sales by attracting more customers,

higher incidence of bad debts loss, alarger investment in receivables, higher collection expenses.

Stiff credit standards

Opposite effect



Credit Standard

Standard Effect onsales

Effect onbad debts

Effect on creditadministrationcost

Soft

standards

Increase in

sales

Increase

in Baddebts

Increase in credit

administration cost

Tightstandards Decreasein sales Decreasein Baddebts

Decrease in creditadministration cost



Making The Credit Standard DecisionTwo factors should be considered:

Average collection peroid

Default risk

Character

Capacity

Condition

History of customer

Average collection period Default risk

Good Within credit period 0

Marginal Moderate collection period Moderate

Bad Very large collection period High



Credit Term

Credit Period

It is the length of time for which credit is granted

“net 60”

Cash Discount“2/20 net 60”



Type of term Effect onsales

Effect oninvestmentin accountsreceivables

Effect onbad debts

Effect oncreditadministration cost

Soft Term Increase insales

Increase ininvestmentin accountsreceivables

Increase inbad debts

Increase

Tight Term Decrease insales

Decrease ininvestmentin accountsreceivables

Decrease inbad debts

Decrease



Collection Efforts

Monitoring the state of receivables

Dispatch of letter to customers whose due date is approaching

Telegraphic and telephone advice around due date.

Threat of legal action to overdue accounts.

Legal action against overdue accounts.

A rigorous collection programme

Decreases sales, shorten the average collection period,reduce bad debts %, increase the collection expenses.

A lax collection programme

Opposite influence



Collection Policy

Collection Policy is the set of procedures for collecting a firm's accounts receivable whenthey are due

IntroductionBad debt expenses are a function of both creditpolicy and collection policy

In general, increasing collection expenditures reduce

bad debt



Types Of Collection Techniques

Letters of Reminder

Phone Calls

Personal Visits

Collection Agencies or Attorneys

Legal Action



Factors which influence credit conditions

Nature of the business's activities

Financial position

Product durabilityLength of production process

Competition and competitors' credit conditions

Country's economic positionConditions at financial institutions

Discount for early payment



Effective credit control

Increases sales

Reduces bad debts

Increases profits

Builds customer loyalty

Builds confidence of financial industry

Educating customers for credit history

Sources of information on creditworthiness

Business references

Bank references

credit agenciesChambers of commerce

Employers

Credit application forms



Opportunity Cost & its calculation



Debtors Policy-Total Approach(Proforma)Particular Present

policyProposedpolicy

A. Expected Profit:

1. Credit sales

2. Total Cost VC & FC

3. Bad debts

4. Cash discount

5. Expected profit

6. Less tax

7. Profit after tax

B. Opportunity cost of investments inreceivables locked up in collection period

C. Net Benefits (A-B)



Debtors Policy-IncrementalApproachParticular Pres.policy Pro policy

A. Incremental Expected Profit:1. Incremental Credit sales

2. Incremental Credit Cost( VC & FC)

3. Incremental Bad debts losses

4. Incremental Cash discount

5. Incremental Expected profit

6. Less tax7. Incremental Profit after tax

B.Req return on incremental investments:

1. Cost of credit sales

2. Collection period

3. Investment in recievabless (1 x 2/365)4. Incremental investment in rec.

5. Req rate of return

6. Req rate of return on incremental investment (4 x 5)

C. Incremental Net Benefits (A-B)



Inventory Management

I M




It means planning, organising, directing andcontrolling of inventory.

How much inventory should be ordered at a

particular point of time?It answers:

How much to order

When to place an order

Obj ti f I t



Objective of InventoryManagement

To avoid the situation of excessive andinadequate inventory & to maintain optimumlevel of inventory

Consequences of ExcessiveInventory

Consequences of InadequateInventory

Opportunity cost of funds ties up ininventory

Interruption in production

Excessive carrying costs such asstorage cost, handling cost,insurance etc

Excessive stock out costs

Risk of liquidity

N d f H ldi I t



Need for Holding Inventory

Transaction Motive

Precautionary motive

Speculative motive

T h i f i



Techniques of managinginventory

ABC Analysis

Economic Order Quantity (EOQ)

EOQ



EOQ

It is the order which is placed when the stockreaches re-order level.

EOQ refers to the quantity of inventory, at

which total of ordering and carrying cost isminimum.

The objective of EOQ is to determine thatorder size which is most economical to order

Ordering cost Carrying cost



The term ‘ordering cost’ refers to the costincurred for aquiring inputs. These costincludes:

1. Cost of placing an order

2. Cost of transportation3. Cost of receiving goods4. Cost of inspecting goods

There is inverse relation with orderingcost and ordering size

The term ‘carrying cost’ refers to the costincurred in maintaining a given level of inventory. These cost includes:

1. Cost of storage cost2. Cost of handling material3. Cost of Insurance4. Cost of obsolescence5. Cost of store staff

There is positive relationship betweenorder size and carrying cost

Larger the order size

Lower the orderingcosts because of fewer order

Larger the order size

Higher the carryingcosts because of high average

inventory

Smaller the order size

Higher the orderingcosts because of more order

Smaller the order size

Lower the carryingcosts because of lowaverage inventory

A ti f EOQ



Assumptions of EOQ

Annual usage (consumption) of inventory isknown

Rate of usage is known and constant

Ordering cost are known and constantCarrying cost are known and constant

Zero lead time/ delivery peroid.

F l



Formula

EOQ = AO

CA = annual consumption of Input

O = ordering cost per order C = carrying cost per unit

No. of orders per year = total annual consumption (inunits) / order size

Frequency of orders = 365 days / No. of orders in a year Total annual ordering & carrying cost at EOQ = 2AOC




Session 7

R d Q tit



Re-order Quantity

EOQ

R d L l



Reorder Level

The objective of fixing re order level is todetermine when fresh order should beplaced.

ROL = Maximum rate of consumption X maxre order period

M i l l



Maximum level

It is that level of stock above which the stockin hand should not normally be allowed toexceed.

It is the largest quantity of a particular material which may be held in the store atanytime.

Objective is to avoid the cost of over stocking – cost of storage, insurance,risk etc



The level is fixed after considering followingfactors:Re order level & quantity

Min. rate of consumption & reorder peroid

Availability of working capital & storage spaceExtra cost of storage and insurance

Price fluctuation

Risk of deterioration

Max level = Re-order level + Re-order quantity – (minimum consumption x min re-order period)

Minimum level



Minimum level

It is the lowest quantity of a particular material which must be held in the store atall time.

The objective of fixing the min. level is toavoid the costs of under stockingsuch as-cost of stoppage of production, cost of idlelabour , cost of idle plant & machinery.



The level is fixed after considering followingfactors:

Re-order level

Normal rate of consumption

Normal Re-order peroid

Formula:

Min level = Re-order Level – (Normal

consumption x normal re-order period)

Average Stock Level



Average Stock Level

Formula:

Avg stock level = Max level + Min level

2

Danger level



Danger levelIt is the level at which normal issues of the

raw material inventory are stopped andemergency issues are only made on specialrequisition approved by the authority

The level is fixed after considering following

factors:Average consumption

Max re-order period for emergency purchases

Formula=Average consumption x max re-order peroidfor emergency purchases

ABC Analysis



ABC Analysis

ABC analysis is a system of inventorycontrol.

It exercises discriminating control over

different items of stores classified on thebasis of the investment involved.

Working of ABC Analysis

Catego Composition Degree of control



Working of ABC Analysisry

A It consist of those items which require largeinvestments ( say about 70% of total value of stores) but constitute a small percentage (say10%) of total items of stores

High degree of control isexercised by use of varioustechniques such as fixingstock level like max level,min level, reorder level.

B It consist of those items which require relativelymoderate investments ( say about 20% of totalvalue of stores) but constitute relativelymoderate percentage (say 20%) of total items of stores

Moderate degree of controlis exercised. Order areplaced on a periodic reviewbasis

C It consist of those items which require small

investments ( say about 10% of total value of stores) but constitute a large percentage (say70%) of total items of stores

Lower degree of control is

exercised. Order of largesize are placed either after 6 months or once in a year to minimize ordering costsand to take advantage of bulk purchase



Techniques for Managing InventoryThe ABC System

The ABC System is a technique that divides inventory into threecategories of descending importance based on the dollar investmentin each category

Group % of Items % of Investment Degree of Control

A 20 70-80 TightB 30 10-20 Average

C 50 <10 Loose

'A' group items are controlled on a daily basis; 'B' group items arecontrolled on a periodic (e.g. weekly) basis; 'C' group items are oftencontrolled by a red-line method under which a reorder is placed when a

redline drawn inside an inventory bin is exposed

ABC Analysis



ABC Analysis

Advantages of ABC Analysis



Advantages of ABC Analysis

It ensures effective control on costly items,which requires large investment (A)

It saves time and cost by exercising

economic systems of control over low valueitems (C)

It ensures optimum investment in inventoryconsidering the operational requirements

and financial resources with use of EOQ

It ensures minimum total cost




Inventory is necessary to permit the production-saleprocess to operate with a minimum of disturbance

Inventory may represent as much as 42% of atypical manufacturing firm's current assets and

about 18% of its total assets

Inventory is commonly under the control of theproduction/operations manager, but the financialmanager generally acts as a “watchdog” and

advisor in matters concerning inventory



Inventory Fundamentals

Types of Inventory include:Raw materials used in the manufacture of finished products

Work-in-process which consists of items in production

Finished goods which are produced but not yet sold

Differing Viewpoints About Inventory Level

Financial Manager: low levels to minimize costMarketing Manager: high levels to minimize stockouts and maximizecustomer service

Manufacturing Manager: high levels to ensure timely and low-costproduction

Purchasing Manager: high levels (of raw materials) to secure low cost per

unit and ensure ready availability



The Relationship Between InventoryAnd A/cs Receivable

Inventory often becomes an account receivablebefore it becomes spendable cash.

A decision to extend credit to a customer mayincrease sales, which will in turn be supported by

higher levels of inventory and accounts receivable

Generally the cost of carrying accounts receivableis less than the cost of carrying inventory sincephysical handling, storage, and insurance costs are

reduced

fm 3 working capital management

Documents