working capital management
TRANSCRIPT
1
WORKING CAPITAL MANAGEMENT
2
OUTLINE
• Characteristics of Current Assets
• Factors Influencing Working Capital Requirements
• Level of Current Assets
• Current Assets Financing Policy
• Profit Criterion for Current Assets
• Operating Cycle Analysis
• Cash Requirement for Working Capital
3
Concept of WC•Balance sheet concept•Operating cycle concept
Balance sheet concept- two concepts1. Gross CA2. Net working capital or net CA
•Net working capital = Current assets (-) Current liabilitiesICAI has endorsed net CA view while suggesting vertical form of B/S
•B/s concept of WC is not meaning full except as indication of firm’s current solvency in paying creditors •When firm speaks of shortage of WC, it implies scarcity of cash resources
Management of current assets involves management of various items of working capital cycle Cash RM WIP FG Receivables Cash
Operating cycle concept
4
CHARACTERISTICS OF CURRENT ASSETS
• Short life span• Swift transformation into other asset forms
Current Assets Cycle
Accounts receivable
Finished goods
Wages, salaries, factory overheads
Work-in- process
Raw materials
Cash Suppliers
5
Working capitalCurrent assetsInventories
•Raw materials & components•Work-in-process•Finished goods•Others
Trade debtorsLoans & debtorsCash & bank balance
Current liabilitiesSundry creditorsTrade advancesBorrowings (short term)
•Commercial banks•Others
6
FACTORS INFLUENCING WORKING
CAPITAL REQUIREMENTS
• Nature of Business
• Seasonality of Operations
• Production Policy
• Market Conditions
• Conditions of Supply
7
Current Assets (%)
Fixed Assets (T)
Industries
10–20 80–90 Hotels and Restaurants
20–30 70–80 Electricity Generation and Distribution
30–40 60–70 Aluminium, Shipping
40–50 50–60 Iron and Steel, Basic Industrial Chemicals
50–60 40–50 Tea Plantation60–70 30–40 Cotton Textiles, Sugar
70–80 20–30 Edible Oils, Tobacco80–90 10–20 Trading, Construction
Proportions of Current Assets and Fixed Assets
8
Carrying Costs and Shortage Costs
9
WORKING CAPITAL POLICY
Two important issues in working capital policy are:
• What should be the level of investment in current
assets?
• What mix of long-term and short-term financing should
the firm employ to support current assets?
10
LEVEL OF CURRENT ASSETS
Flexible Restrictive (Conservative) (Aggressive)
Policy Policy Liquidity High Low Inventories Large Small Debtors High Low
A flexible policy results in fewer production stoppages, ensures quicker deliveries to customers, and stimulates sales .. but
HIGHER INVESTMENT IN CURRENT ASSETS
A restrictive policy leads to more production stoppages, delayed deliveries to customers, and lost sales … but
LOWER INVESTMENT IN CURRENT ASSETS
11
CAPITAL REQUIREMENTS
AND THEIR FINANCING
Capitalrequirements
Fluctuating current asset requirement
Permanent current asset-requirement
Fixed asset requirement
Time
A
B
C
12
CURRENT ASSETS FINANCING POLICYStrategy A •Long term financing for meeting fixed assets and peak working capital requirements•When working capital requirement is less than peak level, surplus is invested in liquid assets ( cash and marketable securities)•Increased liquidity at cost of profitabilityStrategy B•Long term financing for meeting fixed assets, permanent working capital and a portion of fluctuating working capital requirements•During seasonal upswings short-term financing is used•During seasonal downswings, surplus is invested in liquid assets•Less liquidity as compared to Strategy A but results in more profitabilityStrategy C•This is based on matching principle•Fixed assets and permanent current assets should be supported by long-term sources of finance whereas fluctuating current assets must be supported by short-term sources of finance.•Best option with required liquidity and increased profitability
13
PROFIT CRITERION FOR
WORKING CAPITAL
• Investment in current assets is easily reversible.
• For reversible investments, the criterion of net profit per
period (which here means residual income) is equivalent
to the criterion of net present value
For working of above see next slide
14
P = the initial investment in a current asset, r = the rate of return earned on it, k= the cost of capital.
The residual income per year = Pr –PkPr = return for the year
Pk = cost of funds for the year
NPV, assuming investment in current asset continues for n years = –P + Pr (PVIFAk,n) + P(PVIFk,n) (1)
PVIFAk,n = {(1+k)n –1} / (1+k)n k (2)
and PVIFk,n = [1/(1+k)n ] (3)
Putting values from (2) & (3) in (1) NPV = –P + Pr [{(1+k)n –1}/{k(1+k)n}] + P[1/(1+k)n]
= [Pr – Pk) [{(1+k)n –1}/{k(1+k)n] (4)
Thus criterion of residual income per period may be substituted for the criterion of net present value in analysing working capital decisions.
15
OPERATING CYCLE AND CASH CYCLE
Order placed Stock arrives Goods sold Cash received
Inventory period Accounts receivable period
Accounts payable period
Firm receives Cash paid for invoice materials
Operating cycle
Cash cycle Average inventory
Inventory period = Average COGS / 365
Average accounts receivable Accounts receivable period =
Annual sales / 365
Average accounts payable Average payable period =
Average COGS / 365
16
ILLUSTRATION
Financial Information for Horizon Limited
Balance Sheet Data
Profit and Loss Beginning of End of
Account Data 20X0 20X0
Sales 800 Inventory 96 102
Cost of goods 720 Accounts receivable 86 90
Sold Accounts payable 56 60
(96 + 102) / 2
Inventory period = = 50.1 days
720 / 365
17
(86 + 90) / 2Accounts receivable period = = 40.2 days
800 / 365
(56 + 60) / 2Accounts payable period = = 29.4 days
720 / 365 Operating cycle = 50.1 + 40.2 = 90.3 days
Inventory Accounts period receivable
period
Cash cycle = 90.3 - 29.4 = 60.9 days Operating Accounts
cycle payable period
18
CASH REQUIREMENT FOR
WORKING CAPITAL
Step 1 : Estimate the cash cost of various current assets
required by the firm.
Step 2 : Deduct the spontaneous current liabilities from
the cash cost of current assets
19
Step 1 : Estimate cash cost of various current assets required by the firm. The cash cost of a current asset is:•Value of the current asset•Profit element, if any, included in the value
To illustrate, suppose the value of sundry debtors (receivables) is shown to be Rs 10 million on the balance sheet. If the profit margin is 25 percent and the depreciation element in the cost of goods sold corresponding to sundry debtors is Rs 0.5 million, the cash cost of sundry debtors is obtained as follows:Value in the balance sheet Rs 10.0 millionProfit margin Rs 2.5 millionCost of goods sold Rs 7.5 millionDepreciation element Rs 0.5 millionCash cost of sundry debtors Rs 7.0 million
Step 2 : Deduct spontaneous current liabilities from cash cost of current assets A portion of the cash cost of current assets is supported by trade credit and accruals of wages and expenses, which may be referred to as spontaneous current liabilities. The balance left after such deduction has to be arranged from other sources
20
Sales (Two months credit is given) Rs 240 million Material cost (Suppliers give three
months credit)72
Wages (Wages are paid one month in arrears)
48
Manufacturing expenses outstanding at the end of the year (Cash expenses are paid one month in arrears)
4
Administrative and sales expenses (These are paid as incurred)
30
Max Limited sells goods at a profit margin of 25 %, counting depreciation as part of the cost of manufacture.
Its annual figures are as follows:Max Limited keeps two months' stock of raw materials and
one month's stock of finished goods. It wants to maintain a cash balance of Rs 5 million. Estimate the requirement of working capital on cash cost basis, assuming a 10 % safety margin. Ignore work-in-process.
21
Requirement of working capital on cash cost basis is worked out below:A: Current Assets
Item Calculation AmountDebtors (Total cash cost / 12) 2 = (198 2)/12 33.00Raw Material stock (Material cost / 12) 2 = (72 2)/12 12.00Finished goods stock (Cash manufacturing cost / 12) 1 =
(168/12)14.0
Cash balance A predetermined amount 5A: Current Assets 64.0
Item Calculation AmountSundry Creditors (Material cost / 12) 3 = (72 3)/12 18Manufacturing expenses outstanding
One month’s cash manufacturing expenses
4
Wages outstanding (Cash manufacturing cost / 12) 1 = (168/12)
4
B: Current Liabilities 26.0Working capital (A–B) 38.0Add 10 % safety margin 3.8Working capital required 41.8
B. Current Liabilities
22
Rs in million
1. Sales 240
Less: Gross profit (25%) 60
Total manufacturing cost 180
Less: (Materials + Wages) = (72+48) 120
Manufacturing expenses 602. Cash manufacturing expenses (Rs 4 million 12) 48
3. Depreciation: (1–(2) 12
4. Total cash cost
Total manufacturing cost 180
Less: Depreciation 12
Cash manufacturing cost 168
Add Administration and selling expenses 30
Total cash cost 198
23
Requirement of working capital on cash cost basis is worked out below:A: Current Assets
Item Calculation AmountDebtors (Total cash cost / 12) 2 = (198 2)/12 33.00Raw Material stock (Material cost / 12) 2 = (72 2)/12 12.00Finished goods stock (Cash manufacturing cost / 12) 1 =
(168/12)14.0
Cash balance A predetermined amount 5A: Current Assets 64.0
Item Calculation AmountSundry Creditors (Material cost / 12) 3 = (72 3)/12 18Manufacturing expenses outstanding
One month’s cash manufacturing expenses
4
Wages outstanding (Cash manufacturing cost / 12) 1 = (168/12)
4
B: Current Liabilities 26.0Working capital (A–B) 38.0Add 10 % safety margin 3.8Working capital required 41.8
B. Current Liabilities
24
SUMMING UP
• Current assets have a short life span and are swiftly transformed into other asset forms.
• The working capital needs of a firm are influenced by numerous factors : nature of business, seasonality of operations, production policy, market conditions, and supply conditions.
• Determining the optimal level of current assets involves a tradeoff between carrying costs and shortage costs.
• According to the matching principle, the maturity of the sources of finance should match the maturity of assets being financed.
25
• The operating cycle of a firm begins with the acquisition of raw materials and ends with the collection of receivables.
• The cash requirement of working capital is calculated by estimating the cash cost of various current assets required by the firm and deducting the spontaneous current liabilities from the cash cost of current assets.
26
CASH AND LIQUIDITY MANAGEMENT
27
OUTLINE
• Motives for Holding Cash
• Cash Budgeting
• Long-term Cash Forecasting
• Reports for Control
• Cash Collection and Disbursement
• Optimal Cash Balance
• Investment of Surplus Funds
• Cash Management Models
28
MOTIVES FOR HOLDING CASH
Three possible motives for holding cash :
• Transaction motive
• Precautionary motive
• Speculative motive
29
CASH BUDGETThe principal method of cash budgeting is the receipts and disbursements method. Under this method, the cash forecast shows the timing and magnitude of cash receipts and disbursements over the forecast period.
Illustration
The following information about Beta Company is given:
• The estimated sales for the period January 20X1 through June 20X1 are as follows: Rs.100,000 a month from January through March and Rs.120,000 a month from April through June.
• The sales for November and December of the previous year have been Rs.100,000 each.
• Cash and credit sales are expected to be 20 percent and 80 percent respectively.
• The receivables from credit sales are expected to be collected as follows: 50 percent after one month and the balance 50 percent after two months.
• Other anticipated receipts are: Rs.5,000 from the sale of a machine in March and Rs.2000 interest on securities in June.
30
CASH BUDGETING
January February March April May June
1. Sales 100,000 100,000 100,000 120,000 120,000 120,000
2. Credit sales 80,000 80,000 80,000 96,000 96,000 96,000
3. Collection of accounts receivables 80,000 80,000 80,000 80,000 88,000 96,000
4. Cash sales 20,000 20,000 20,000 24,000 24,000 24,000
5. Receipt from machine sale 5,000
6. Interest 2,000 Total cash receipts 100,000 100,000 105,000 104,000 112,000 122,000
(3+4+5+6)
31
CASH BUDGETINGRelevant information for cash payments
Beta Company plans to purchase materials worth Rs.40,000 in January and February and materials worth Rs.48,000 each month from March through June. Payments will be made a month after the purchase
A payment of Rs.40000 will be made in January for purchases in the previous December
Miscellaneous cash purchases of Rs.2000 per month are planned from January through June
Wage payments will be Rs.15000 per month, January through June
Payments for manufacturing expenses will be Rs.20,000 per month and for general administrative expenses will be Rs.10,000 per month, January through June
Dividend payment of Rs.20,000 and a tax payment of Rs.20,000 are planned for June
A machine will be bought in cash for Rs. 50,000 in March
32
CASH BUDGETING
January February March April May June
1. Material purchases 40,000 40,000 48,000 48,000 48,000 48,000 2. Credit material purchases 40,000 40,000 48,000 48,000 48,000 48,000 3. Payment of 40,000 40,000 40,000 48,000 48,000
48,000 accounts payable 4. Miscellaneous 2,000 2,000 2,000 2,000 2,000 2,000 cash purchases 5. Wages 15,000 15,000 15,000 15,000 15,000 15,000 6. Manufacturing exp. 20,000 20,000 20,000 20,000 20,000 20,000 7. General admn. expense 10,000 10,000 10,000 10,000 10,000 10,000 8. Dividend - - - - - 20,000 9. Tax - - - - -
20,00010. Capital - - 50,000 - - - expenditure Total payments 87,000 87,000 137,000 95,000 95,000 135,000 (3+4+5+6+7+8+9+10)
33
CASH BUDGETINGAssuming that the cash balance on 1st January is Rs.22,000 and the minimum cash balancerequired by the firm is Rs.20,000, the summary cash forecast is given below.
January February March April May June
1. Opening cash balance Rs.22,000
2. Receipts 100,000 100,000 105,000 104,000 112,000 122,000
3. Payments 87,000 87,000 137,000 95,000 95,000 135,000
4. Net cash flow (2 –3) 13,000 13,000 (32,000) 9,000 17,000 (13,000)
5. Cumulative net cash flow 13,000 26,000 (6,000) 3,000 20,000 7,000
6. Opening cash balance + Cumulative net flow (1 + 5) 35,000 48,000 16,000 25,000 42,000 29,000
7. Minimum cash balance required 20,000 20,000 20,000 20,000 20,000 20,000
8. Surplus or deficit in 15,000 28,000 (4,000) 5,000 22,000 9,000 relation to the minimum cash balance required (6 – 7)
34
LONG-TERM CASH FORECASTING
Adjusted net income method is generally used for long-term cash forecasting.
20 X 0 20 X 1 20 X 2 20 X 3 20 X 4Source Net income after taxes Non-cash charges (Depreciation, amortisation, etc.) Increase in borrowings Sale of equity shares Miscellaneous Uses Capital expenditures Increase in current assets Repayment of borrowings Dividend payment MiscellaneousSurplus/ Deficit Opening cash balance Closing cash balance
35
REPORTS FOR CONTROL
• Daily Cash Report
Opening balance
Receipts
Payments
Closing balance
• Daily Treasury Report
Changes in cash, Marketable security, Debtors and
creditors
• Monthly Cash Report
Actual cash receipts and payments
Actuals compared with budgeted figures and variances calculated
36
FLOAT
• The cash balance shown by a firm on its books is called
the book, or ledger balance whereas the balance shown
in its bank account is called the available, or collected,
balance. The difference between the available balance
and the ledger balance is referred to as float.
37
CASH COLLECTION AND DISBURSEMENT
Float = Firm’s available balance (-) Firm’s book balance
• Disbursement float –Created by Cheques issued by firm= Firm’s available balance – Firm's book balance= Rs 40 lacs – Rs 30 lacs ( as cheque of Rs 10 lac issued to a party and not presented by party and debited by bank)
•Collection float – Lead by cheques received by firm= Rs 50 lac ( – ) Rs 65 lac = (–) Rs 15 lac ( cheque received and but so far not credited to It
•Net float = disbursement float + collection float. Positive net float implies that available balance > book balance and vice-versa•Since what matters is the available balance, as a financial manager you should try to maximise the net float. Thus it means that you should strive to speed up collections and delay disbursements.
38
Speeding Up CollectionsThe collection time comprises following•Customer mails cheque
Mailing time•Company receives cheque
Processing•Company deposits cheque
Availability delay•Cash available
To speed up collection firms use the following•Customers advised to send cheques to local lock boxes•Customers advised to send cheques to local offices i.e concentration banking• Electronic transfer of funds
Delaying Payments•Make payment when due and not early•Centralise payments•Arrange with suppliers to match payments with receipts
•
39
OPTIMAL CASH BALANCE
•
C*
Costs
Total costs
Opportunity cost
Transaction cost
Cash balance
40
INVESTMENT OF SURPLUS FUNDS
It may be useful to divide a firm’s short-term investment portfolio into three segments:• Ready cash segment
• To augument cash resources of co to meet unanticipated operational needs• This segment needs to be highly liquid
• Controllable cash segment•To meet known outflows like taxes, dividend, interest payments, repayment of borrowings etc•Investment in this segment must match in size and maturity with known outflows
• Free cash segment•Besides the above which represents surplus funds with co which has been invested in short term instruments to generate income without much concern for liquidity or maturity
41
CRITERIA FOR EVALUATING
INVESTMENT OPTIONS
• Safety
• Liquidity
• Yield
• Maturity
42
INVESTMENT OPTIONS
• Fixed deposits with banks
• Treasury bills
• Mutual fund schemes
• Money market schemes
• Commercial paper
• Certificates of deposit
• Inter-corporate deposits
Strategies for managing surplus cash•Do nothing – enhances liquidity at expense of profits
•Make adhoc investments – makes some contribution but not optimal contribution
•Ride the Yield Curve – Buy long term securities if interest expected to fall and vice versa
•Evidence suggests futile to do better than average
•Develop Guidelines reflecting view of mgt towards risk and return like
•Do-not speculate on interest changes
•Hold marketable securities till maturity
•Do-not put more than a % in particular types of securities
•Minimize transaction costs
43
Strategies for managing surplus cash (contd)•Utilize control limits
•Some models define upper and lower limits and when cash reaches upper limit it advocates that a certain amount should be invested in marketable securities and when cash reaches lower limit a certain amount of marketable securities should be liquidated
• Models do not specify which securities to be bought or sold
•Manage with a portfolio objective
•Define the efficient frontier i.e a portfolio where there is no alternative with • same expected return and a lower standard deviation, or •same stan dard deviation and a higher expected return, or •higher expected return and a lower standard deviation.
•Select optimal portfolio which enables investor to achieve highest attainable level of utility
• Portfolio theory does not provide guidance how funds should be switched from cash account to marketable securities
•Follow a mechanical procedure
• Use models that provide rules for switching funds between cash account and marketable securities
•Success of use of model depends on how well the behavior of cash flow of firm conforms to assumptions of model
•In practice mechanical procedures are of limited use44
45
SUMMING UP
• There are three possible motives for holding cash, viz., transaction motive, precautionary motive, and speculative motive.
• The principal method of short-term cash forecasting is the receipts and payment method.
• The method generally used for long-term forecasting is the adjusted income method.
• To enhance the efficiency of cash management collections and disbursements must be properly monitored.
• A variety of options are there for investing surplus funds available for short periods.
• William Baumol has proposed a model which applies the EOQ concept to determine the cash conversion size.
• Expanding on the Baumol model, Miller and Orr consider a stochastic generating process for periodic changes in cash balance.
46
CREDIT MANAGEMENT
47
OUTLINE
• Terms of Payment
• Credit Policy Variables
• Credit Evaluation
• Credit Granting Decision
• Control of Accounts Receivable
• Credit Management in India
48
TERMS OF PAYMENT• Cash Terms• Open Account i.e credit sales
•Credit period•Cash discount•Billing
• Consignment • Bill of Exchange• Letter of Credit
49
CREDIT POLICY VARIABLES
The important dimensions of a firm’s credit policy are:
• Credit standards
• Credit period
• Cash discount
• Collection effort
50
CREDIT STANDARDS
Liberal Stiff
• Sales Higher Lower
• Bad debt loss Higher Lower
• Investment Larger Smaller in receivables
• Collection costs Higher Lower
51
IMPACT ON RESIDUAL INCOME OF RELAXATION
RI = [S(1 – V) - Sbn] (1 – t ) – k I
where RI = change in residual income S = increase in sales V = ratio of variable costs to sales bn = bad debt loss ratio on new sales t = corporate tax rate I = increase in receivables investment k = Post tax cost of capital
52
EXAMPLEPioneer Limited is considering relaxing credit standards.S ( change in sales)= Rs.15 lacs bn = bad debt loss ratio on new sales = 0.10, V = ratio of variable costs to sales = 0.80ACP = Average collection period =40 days, k = Post tax cost of capital =0.10t = corporate tax rate =0.4RI = [15 (1 – 0.80) – 15x 0.10] (1 – 0.4)
15 – 0.10 x x 40 x 0.80
360 = Rs.76,666
53
CREDIT PERIOD
Longer Shorter
• Sales Higher Lower
• Investment in Larger Smaller
receivables
• Bad debts Higher Lower
54
IMPACT ON RESIDUAL
INCOME OF LONGER CREDIT PERIOD
RI = [S(1 – V) - Sbn] (1 – t ) – k I
55
INCREASE IN RECEIVABLES
INVESTMENT
S0 S
I = (ACPn – ACP0) + V (ACPn) 360 360
where: I = increase in receivables investment
ACPn = new average collection period (after lengthening
the credit period)
ACP0 = old average collection period
V = ratio of variable cost to sales
S = increase in sales
56
EXAMPLE
Zenith Limited is considering extending its credit period from 30 to 60 days.
S = Rs.50 million, S = Rs.5 million, V = 0.85, bn = 0.08, k = 0.10, t = 0.40
RI = [5,000,000 x 0.15 – 5,000,000 x 0.08] (0.6)
– 0.10 (60 – 30) x + 0.85 x 60 x
= [750,000 – 400,000] (0.6) – 0.10 [4,166,667 + 708,333]
= – 277,500
50,000,000360
5,000,000360
57
LIBERALISING THE CASH
DISCOUNT POLICY
RI = [S(1 – V) - DIS] (1 – t ) + k I
DIS = increase in discount cost
58
DECREASING THE RIGOUR
OF COLLECTION PROGRAMME
RI = [S(1 – V) - BD] (1 – t ) – k I
BD = increase in bed debt
59
ERRORS IN CREDIT EVALUATION
In assessing credit risks, two types of errors occur :
Type I error A good customer is misclassified as a
poor credit risk
Type II error A bad customer is misclassified as a good credit risk
60
TRADITIONAL CREDIT ANALYSIS
Five Cs of Credit
Character : The willingness of the customer to honour his obligations
Capacity : The operating cash flows of the customer
Capital : The financial reserves of the customer
Collateral : The security offered by the customer
Conditions : The general economic conditions that affect the customer
To get information on above following may be used:
Financial statements of firms
Bank references
Experience of firm
61
NUMERICAL CREDIT RATING INDEX
Factor Factor Rating Factor weight 5 4 3 2 1 score
Past payment 0.30 1.20 Net profit margin 0.20 0.80 Current ratio 0.20 0.60 Debt-equity ratio 0.10 0.40 Return on equity 0.20 1.00 Rating index 4.00
62
CONTROL OF ACCOUNTS
RECEIVABLES
• Days’ Sales Outstanding = Accounts receivable / average daily sales
• Ageing Schedule= Age group (in days) % of receivables
• Collection Matrix
63
COLLECTION MATRIX
Percentage of Receivables January February March April May June Collected During the Sales Sales Sales Sales Sales Sales Month of sales 13 14 15 12 10 9 First following month 42 35 40 40 36 35 Second following month 33 40 21 24 26 26 Third following month 12 11 24 19 24 25 Fourth following month - - - 5 4 5
64
SUMMING UP
• The important dimensions of a firm’s credit policy are : credit standards, credit period, cash discount, and collection effort
• In general, liberal credit standards tend to push sales up by attracting more customers. However, this is accompanied by a higher incidence of bad debt loss, a larger investment in receivables, and a higher cost of collection. Stiff credit standards have opposite effects.
• Broad approaches are used for credit evaluation are traditional credit analysis and numerical credit scoring.
• The traditional approach to credit analysis calls for assessing a prospective customer in terms of the five Cs of credit, viz. character, capacity, capital, collateral, and conditions.
• Three methods are commonly employed for monitoring accounts receivable : days’ sales outstanding, ageing schedule, and collection matrix.
65
INVENTORY MANAGEMENT
66
OUTLINE
• Need for inventories
• Order quantity – EOQ model
• Order point
• Pricing of raw materials and valuation of stocks
• Monitoring and control of inventories
• Criteria for judging the inventory system
• Inventory management in practice
67
NEED FOR INVENTORIES
• ‘Process or movement’ inventories are required because
it takes time to complete a process/operation and to
move products from one stage to another.
• Organisation inventories are maintained to widen the
latitude in planning and scheduling successive
operations.
68
BEHAVIOUR OF INVENTORY
RELATED COSTS
CostsTotal costs
Carrying costs
Ordering costs
Quantity ordered
69
ORDER QUANTITY – EOQ MODEL
Total cost of ordering and carrying of inventory =
TC = (U/Q)× F + (Q/2) × P × C
Total cost is minimized when
2FUQ =
PC
Q = economic order quantityF = cost per orderU = annual usage/demandF = cost per orderC = percent carrying costP = price per unit
70
ORDER POINT
• If the usage rate of materials and the lead time for
procurement are known with certainty, then the
ordering level would simply be:
Lead time in days for procurement
• When the usage rate and lead time are likely to vary, the
reorder level should be:
Normal consumption + Safety stock
x Average daily usage
Other Factors considered in practice
71
Anticipated scarcity
Expected price change
Obsolescence risk
Government restrictions
Marketing considerations
72
PRICING OF RAW MATERIALS
The important methods of pricing inventories used in
production are:
FIFO (First in First Out) Method The material which is
issued first is priced on the basis of the cost of material
received earliest, so on and so forth.
Weighted Average Cost Method Material issued are
priced at the weighted average cost of materials in stocks
73
TREATMENT OF FIXED MANUFACTURING COSTS
Direct Costing Fixed manufacturing overhead costs are treated as period costs and not product costs. Hence, they are not reflected in inventory valuation and charged directly to income statement.
Absorption Costing Fixed manufacturing costs are treated as product (or inventoriable) costs. Hence valuation of inventory reflects an allocated share of fixed manufacturing overhead costs
Valuation of WIP and FG under Direct costing is lower and higher in absorbtion costing
When inventory level increases, reported profit under direct costing is lower than under absorption costing
74
MONITORING AND CONTROL OF INVENTORIES
ABC Analysis Just-in -Time Inventory Control
CRITERIA FOR JUGGING INVENTORY SYSTEM
Comprehensibility Adoptability Timeliness
75
(ABC ANALYSIS )
GRAPH OF CUMULATIVE PERCENTAGE OF ITEMS AND CUMULATIVE
PERCENTAGE OF USAGE
20
40
60
80
100
25 40 60 80 100Cumulativepercentage of items
Cumulative usage of items (percentage)
A B C
76
JUST-IN-TIME (JIT) INVENTORY CONTROL
• The JIT control system implies that the firm should maintain a minimal level of inventory and rely on suppliers to provide parts and components ‘just-in-time’ to meet its assembly requirements.
• This may be contrasted with the traditional inventory management system which calls for maintaining a healthy level of safety stock to provide a reasonable protection against uncertainties of consumption and supply – the traditional system may be referred to as a “just-in-case” system.
77
PROGRAMME OF INVENTORY MONITORING AND CONTROL
• Exercise of vigilance against imbalances of raw materials and work-in-process which tends to limit the utility of stocks.
• Vigorous efforts to expedite completion of unfinished production jobs to get them into saleable condition.
• Active disposal of goods that are surplus, obsolete, or unusable.
• Shortening of the production cycle.
• Change in design to maximise the use of standard parts and components which are available off-the-shelf.
• Strict adherence to production schedules.
• Special pricing to dispose of unusually slow-moving items.
• Evening out of seasonal sales fluctuations to the extent possible.
78
INVENTORY MANAGEMENT IN INDIA
• The most commonly used tools of inventory management
in India are ABC analysis, FSN (fast moving, slow
moving, and nonmoving analysis), and inventory
turnover analysis.• Inventory levels are high on following pretexts
Purchase Executive penalized for stock outs
Lengthy procedure for imports
It pays to hold inventory due to inflation
Lack of standardization leads to large variety of stores
• Inventory management can be improved by effective computerisation, review of classifications, improved coordination, development of long-term relationships, and disposal of obsolete/surplus inventories, and adoption of challenging norms.
79
SUMMING UP
• Inventories represent a very significant proportion of total assets.
• A distinction may be drawn between ‘process or movement’ inventories and ‘organisation’ inventories.
• According to EOQ model, the optimal order quantity is:
Q =
• The reorder point may be determined by the following formula:Reorder Point = S (L) + S R(L)
• FIFO method and weighted average cost method are commonly used for pricing inventories.
• ABC analysis advocates a selective approach to inventory control.
• The most commonly used tools of inventory management in India are: ABC analysis, FSN analysis and inventory turnover analysis.
2 FUPC
80
WORKING CAPITAL FINANCING
81
OUTLINE
• Accruals
• Trade credit
• Working capital advance by commercial banks
• Regulation of bank finance
• Public deposits
• Inter-corporate deposits
• Short-term loans from financial institutions
• Rights debentures for working capital
• Commercial paper
• Factoring
82
ACCRUALS
• The major accrual items are wages and provisions.
• Accruals vary with the level of activity of the firm.
• While accruals are a welcome source of financing, they
are typically not amenable to control by management.
83
TRADE CREDIT
• Trade credit represents the credit extended by the suppliers of goods and services. It is a spontaneous source of finance.
• The confidence of suppliers is the key to securing trade credit.
• The cost of trade credit is:
Discount % 360 x
100 – Discount % Credit period – Discount period
84
WORKING CAPITAL ADVANCE BY
COMMERCIAL BANKS
• Application and processing • Sanction, terms and conditions• Forms of bank finance
• Cash credits/Overdrafts• Loans• Purchase/Discount of Bills• Letter of credit
• Security• Hypothecation• Pledge
• Margin amount
85
MAXIMUM PERMISSIBLE
BANK FINANCE (MPBF)
Tandon Committee had suggested three methods for determining the MPBF
Method 1 : MPBF = 0.75 (CA – CL)
Method 2 : MPBF = 0.75 (CA) – CL
Method 3 : MPBF = 0.75 (CA – CCA) – CL
CA = current assets
CL = non-banking current liabilities
CCA = core current assets
86
PUBLIC DEPOSITS
• These are unsecured deposits from the public.
• Public deposits cannot exceed 25 percent of share capital
and free reserves.
87
INTER-CORPORATE DEPOSITS
• A deposit made by one company with another, normally
for a period up to six months is referred to as an inter-
corporate deposit.
• Inter-corporate deposits are typically unsecured.
• Inter-corporate deposits are usually of three types: call
deposits, three-month deposits, and six-month deposits.
88
SHORT-TERM LOANS
FROM FINANCIAL INSTITUTIONS
• Insurance companies provide short-term loans to
manufacturing companies with an excellent track record.
• Such loans are unsecured and given for a period of 1
year, renewable for two consecutive years.
• A company, to be eligible for such loans, should satisfy
certain conditions relating to dividend payment, debt- equity ratio, current ratio, and interest cover ratio.
89
RIGHTS DEBENTURES
FOR WORKING CAPITAL
• A company can issue “rights” debentures to its shareholders
to augment the long-term source for working capital
requirements
• The key guidelines applicable to “rights” debentures relate to
the quantum of such issues and the debt : equity ratio
90
COMMERCIAL PAPER
• Commercial paper represents short-term unsecured
promissory notes issued by firms which enjoy a fairly
high credit rating.
• Commercial paper is either directly placed with
investors or sold through dealers
• The effective pre-tax cost of commercial paper is:
Face value – Net amount realised 360
Net amount realised Maturity period
91
FACTORING
A factor is a financial institution which offers services relating to management and financing of debt arising from credit sales.
92
ADVANCES IN INVENTORY
MANAGEMENT
• Materials requirements planning
• Just-in-time system
• Electronic data interchange and bar coding
93
MATERIALS REQUIREMENTS PLANNING
Materials requirements planning (MRP) is essentially a
computerised planning and control system for the effective
management of production and inventory in a manufacturing
environment. The objective of the MRP system is to order just the
right parts in the right quantity at the right time.
An MRP system is driven by the master schedule which
specifies the “end items” or output of the production function. The
master schedule is “exploded” into purchase orders for raw
materials and shop orders for scheduling the factory. In the process
of parts explosion, adjustments have to be made for parts which are
already on hand.
94
JUST-IN-TIME (JIT) SYSTEM
Unlike conventional systems where inventory is treated as
an asset, the JIT system views inventory as the “root of all
evil”. In traditional organisations a high level of inventory
is held to cover up the problem areas related to quality,
vendor delivery, machine breakdowns.etc. The JIT
approach is the opposite. The inventory level is lowered to
expose the real organizational problems and attempts are
made to solve the problems at their points of incipience.
95
ELECTRONIC DATA INTERCHANGE
The EDI is a direct computer-to-computer exchange of information normally provided on standard business documents such as purchase orders, invoices, etc. With such a direct communication linkage with a supplier, a buyer can obtain price quotes, determine availability of items in a supplier’s stock, transmit a purchase order, obtain follow-up information, provide the supplier information about changes in purchase requirements caused by schedule revisions, obtain service information, and send letters and memos – all instantly. Without the EDI, such business transactions depend on the exchange of paper documents.
96
BAR CODING
Bar coding identifies products using machine-readable codes. The bar code technology allows faster and more accurate data entry, better document tracking, and reduced inventory cost. Bar codes are printed patterns of lines, spaces, and numerals we see on packaged goods. Bar codes are useful to the manufacturer, as they are to the retailer. The purpose is to keep an accurate, current count of inventory items as they move past a scanner. With the help of bar coding, companies have decreased inventory investment by 10 to 15 percent, reduced clerical errors to almost zero, and increased the ability to give accurate inventory counts and product information to concerned managers.