7_working capital mgmt

8/3/2019 7_Working Capital Mgmt

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Working Capital Management

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Overview of Working Capital Management

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After Plant & Machinery has been installed and the manufacturing

facility is put in place, the firm would require investment made in

Short-term assets.

Firms may be required to sell finished products/services on credit

leading to Receivables (orDebtors), or maintain stocks of raw

material/finished goods leading to Inventories.

Investments in such short-term assets is called Working Capital.

Working Capital Management: An Overview


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Two Concepts of Working Capital: Gross Working Capital is the aggregate investment in

Current Assets. Focuses attention on (a) Trade-off between excessive and inadequate

Current Assets; (b) Financing of Current Assets.

Net Working Capital is the difference between the CurrentAssets and Current Liabilities of a firm.

Indicates the liquidity position of a firm and the suggests the extent to

which working capital requirements may be financed by long-term

sources.

Current Assets should be sufficiently in excess of the current liabilitiesand form a buffer for maturing obligations within a operating cycle.

Negative NWC means CL > CA, may prove harmful to the firm.

Working Capital Management: An Overview


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Current Assets: Those assets that are either in the form of cashor are expected to be converted into cash in the short term

(usually defined as less than one year).

Inventories (R/M, WIP, FG),

Debtors,

Short Term Investments,

Cash.

Current Liabilities: Those liabilities that are expected to be paid

within a year.

Creditors,

Accrued expenses,

current portion of long-term liabilities.

Working Capital Management


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Sales do not convert into Cash instantaneously as there is anOPERATING CYCLE Duration of time required to convert sales,

after conversion of Raw Material into Finished Goods, into Cash.

Cash

Raw

Material

Work-in-

Progress

Finished

Goods

Debtors

Purchase

Convert

Convert

Sale of

Goods

Realise

OPERATING CYCLE

Why Working Capital is required?


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As Operating Cycle is a continuous process, hence Current Assetsare required continuously but the quantum of Current Assets

required may not remain constant throughout and may vary over

time.

Some part of the Working Capital is required continuously, which

is called FIXED Working Capital represents the MINIMUM levelof Current Assets.

Depending upon changes in production & sales, the need for

Working Capital over and above the Fixed Working Capital may

fluctuate.

Additional working capital required to support the changingproduction & sales level is called VARIABLE or TEMPORARY

Woking Capital.

Fixed & Variable Working Capital


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Fixed & Variable Working Capital (Contd.)

Time

Amo

untofWorkingC

apital

Variable

Current Assets

Fixed Current

Assets

Variable

Current Assets

Fixed Current

Assets

AmountofWorkingCapital

Time


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Approaches to Working Capital Financing

Based on the mix of Short Term(Spontaneous Sources/Current

Liabilities) and Long term sources of financing working Capital,

and the Fixed & Variable Current Assets, there are three

approaches to Working Capital Financing.

Matching Approach

Conservative Approach

Aggressive Approach


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Matching Approach

Expected life of an asset should

match the tenure of the

financing source.

Fixed assets should be

financed by long term sources

while the current assets should

be financed by short term

sources.

Applying to Working Capital

Management, Fixed Current

Assets should be financed by

long-term sources while theVariable Current Assets should

be financed by short-term

sources.

VariableCurrent Assets

Fixed Current

Assets


Time

Long Term

Sources

Short Term

Sources


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Under this approach, morereliance is on long-term

sources

Long term sources are

used to finance Fixed

Assets + Fixed Current

Assets + Part of the

Variable Current Assets.

Lower level of risk of

shortage of funds.

Conservative Approach

Long Term

Sources

VariableCurrent Assets

Fixed Assets


Time

Short Term

Sources


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Aggressive Approach

Under this approach, morereliance is on Short-term

sources of funds to finance

assets.

Part of Fixed Current Assets +

Temporary Current Assets are

financed by short-term

sources.

Variable

Current Assets

Fixed Assets

AmountofWorkingCapit

al

Time

Short Term

Sources


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Ov

erv

iew of Working Capital Management

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Short term vs. Long term

Short-term funds are less costly and more flexible but atthe same time more Risky.

Hence, a Risk-Return trade-off has to be achieved while

deciding the financing mix.


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Overview of Working Capital Management 13

Determinants of Working Capital

Large nu

mber of factors influ

ence the working capital requ

irements.Each factor has different importance which varies over time as

well.

1. Nature & Size of Business: As compared with Total assets,

Trading companies require large investment in working capital

(than investment in Fixed Assets), while Utility companies suchas Power Generation Company, require low levels of working

capital and huge investments in Fixed Assets.

Size (Scale of operations) - Large company would require more

working capital.

2. Manufacturing Cycle: Longer the Manufacturing cycle, largerwill be requirement of working capital.

3. Sales Growth: As sales grow, more working capital would be

required, though a definite relationship is difficult to determine.


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4. Demand Conditions: For seasonal products, as demand varies, so does the

working capital varies.

During Boom periods, as demand picks up, not only the

variable, but the fixed working capital requirements also goes

up.5. Production Policy: Constant Production Policy would lead to

accumulation of inventory in off-season.

Cost of maintaining inventory

Risks- damage; no- off take.

To minimize - firm may choose to vary its production schedules.6. Price Level Changes: Increase in prices, calls for higher

investment in working capital. Though, the impact of increase in

general prices may be different on different companies.



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7.O

perating Efficiency: A firm should make optimumutilisation of its resources at minimum costs. Efficient

utilisations of various factors of production, helps in reducing

the overall quantum of working capital.

8. Credit Policy: Liberal Credit Policy means high debtors,

high collection period, and high bad debts - hence moreworking capital would be required. Therefore, company

should follow a rational credit policy evaluate the credit

worthiness of customers and review them.

9. Availability of Credit from Suppliers: If a firm gets liberal

credit from its suppliers, the requirements of working capitalwould be less. Suppliers credit finances the firms inventory

and reduces the Also, if bank credit is easily available and on

favourable conditions, company would require less working

capital.



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Inventory Management

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Inventory Management 17

Inventory Management

Forms ofInventory Raw materials basic input materials

Work-in-Progress Semi-manufactured goods

Finished Goods Completely manufactured goods,

ready for sale.

Need for holding Inventories:

Transactions motive: To facilitate smooth production &

sales operations

Precautionary motive: To guard against the risk of

unpredictable changes in demand and supply forces Speculative motive:To take advantage of price

fluctuations.


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A firm is faced two conflicting needs:

To maintain large inventory to ensure efficient and smooth

productions and sales which shall tie-up funds in low yielding

assets & excessive carrying costs

To maintain low inventory to reduce costs and maximize

profitability which shall impair smooth production & marketing

functions

Both excessive and inadequate inventory levels are undesirable.

Thus, a trade-off between these two conflicting needs have to

be reached.

Objectives ofInventory Management


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To trade-off the conflicting needs of a firm and to determine theoptimum level of inventory, techniques of Inventory Management

are used.

Economic Order Quantity (EOQ): What should be the size of

the Order placed each time by the firm?

Re-Order Point: When should the firm place the Order for the

inventory?

Inventory Management Techniques


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Economic Order Quantity

Ordering Costs(Requisitioning; Order placing;

Transportation ; Receiving and

Inspecting Costs)

Ordering Costs increases

with the number of Orders

To reduce Ordering Cost,

place lesser no. of orders, but

each order should be of large

quantities.

Carrying Costs(Storage ; Insurance ; Obsolescence

; and Interest on Capital locked-up

in Inventory)

Carrying costs increase with the

inventory size.

To reduce Carrying Costs,

keep minimum inventory by

ordering smaller quantities in

each Order.

These two conflicting objectives are to be resolved

through Economic Order Quantity.


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Total Costs(TC) = OrderingCosts + CarryingCost

where,

U=Annual Usage

Q= Quantity OrderedF= Ordering Cost Per Order

P= Price Per Unit

c= Carrying Cost (%)

=

=

No. of

Orders

Average

Inventory+v

Ordering Cost

Per Order vCarrying

Costs

+U FQ

v

Q c P2

v v


Quantity

Total Costs

Ordering Costs

Carrying Costs


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Differentiating w.r.t Q and equating it to zero (for minimization), we get

Given:

Annual Usage (U) = 25,000 Units

Purchase Price (P) = Rs 2,750 per Unit Ordering Cost per order (F) = Rs 550 per Order

Carrying Cost (%) (c) = 25% of Purchase price

EOQ = 2UF/Pc = (2*25000*550)/(2750*25%) = 200 Units

2UFEOQ(Q )

cP

!

2 Annual Usage Ordering CostEOQ(Q )

Carrying Cost(%) Price per Unit

v v

!v


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Assumptions of EOQ: The yearly forecast usage of an item of inventory is

known.

The usage of the item is even and uniform throughout

the period.

Inventory orders can be replenished immediately i.e.

there is no delay in placing and receiving the order.

Ordering and Carrying are the only 2 distinguishable

costs involved.

Cost per Order remains constant irrespective of heOrder size.

Carrying cost is a fixed %age of the Average Inventory

value.

Economic Order Quantity (Contd.)


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To encourage customers to place larger orders,suppliers often offer Quantity Discounts.

Therefore, a Cost-Benefit Analysis has to be made

EOQ Quantity Discounts

Positive Impact Negative Impact

Discount will reduce the

per unit purchase price

By increasing the order

size, the no. of orders

shall reduce which shall

reduce the ordering costs.

As order size increases,

the average inventorysize will also increase,leading to an increase thecarrying costs.


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1.Benefits: Reduction in Purchase Price:= Annual Usage v Discount

(UD)

Reduction in Ordering Costs:

= Decrease in No. ofOrders v Ordering Cost perOrder

Increase in Carrying Costs:

= Increase in Average Inventory v Carrying Cost

EOQ Quantity Discounts (Contd.)

*

1

U UF

Q Q

v

*

1Q (P D)c Q Pc

2 2


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Given: Basic Data as in previous question Discount (D) = Rs 10 per Unit

Order Size to Avail Quantity Discount (Q1)=1,200Units

Impact of Quantity Discounts:

UD = (25,000*10) =2,50,000/-

{U/Q* - U/Q1} F = {25000/200 - 25000/1200}550 =57,292/-

{Q1(P-D)c/2 Q*Pc/2 }=

{1200(2750-10)25%/2 (200*2750*25%/2 }=3,42,250/-

Total Benefit = 2,50,000 + 57,292 - 3,42,250 =(34,958)

As the change in profit is NEGATIVE, hence should NOT go for

the higher order size and avail the quantity discount.

EOQ Quantity Discounts (Contd.)


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Receivables Management

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Receivables Management 28

When goods are sold on credit, finished goods areconverted into Receivables(or Debtors)

Granting of credit and creation of Book debts calls for

blocking of the firms funds.

Duration between the date of sale and the date of

payment has to be financed out of the working capital.

Quantum of a firms investment in debtors depends

upon: Volume of Credit Sales & Collection Period.

Receivables Management

Average

Investment in

Debtors

Daily Credit

Sales

Average

Collection

Periodv=


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Competition: High competition, liberal Credit. Companys bargaining power: Monopoly product,

Brand & financial strengths - lower credit.

Buyers Requirements: e.g. industrial products.

Buyers status: Large Buyers demand better creditterms.

Relationship with dealers- to build long-term

relationship

Marketing tool: esp. when the product is new Industry Practice: past practice; small firms follow

large firms.

Why Firms Sell on Credit?


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While establishing the Credit Policy, the followingvariables are considered:

1. Credit Standards refers to the criteria which a firm

follows in selecting customers for extending credit.

2. Credit Terms are the conditions under which a firm

sells goods on credit.

Credit Period

Cash Discount

3. Collections Efforts are the steps taken by a firm to

ensure timely realisation of receivables.

Credit Policy Variables


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Tight Credit Standards: Mostly cash sales andcredit sales to the most reliable and financially strong

customers.

Such policy would result in Lower sales; Low bad-

debts; Low Collection Costs & Profits are forgone onlost sales

Liberal Credit Standards:

Higher sales, higher bad-debts, higher collection

costs.Thus, a trade-off between incremental profits and

incremental costs has to be considered.

Credit Standards


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A firm may typically categorize its customers into:

Good Accounts Financially strong , prompt

payment.

Bad Accounts Financially weak, high risk

customers

Marginal Accounts Customers with moderate

financial health and risk.

Credit Standards (Contd.)


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XYZ Ltd. is contemplating change in the credit standards. Ithas categorised the customers into three categories- A, B, andC .(A being the least risky customers). The company iscurrently selling to A & B category customers but now wants

to sell to category C as well.The potential sales, Average Collection Period & Bad-Debtratio relating to C category are Rs 160 Lacs, 90 days &10% respectively. Variable cost ratio is 75% and Post-tax rate

of return is 15%. Tax rate is 35%. Collection costs would be8% for this category.

Should the firm liberlise the credit standards?



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Particulars Rs Lacs1. Incremental Sales 160.00

2. Incremental Contribution

( Sales*c)=160*25%

40.00

3. Incremental Bad-debts & Collection Costs

( Sales*b+d)=160*(10%+8%)

28.80

4. Incremental OPAT (2-3)*(1-t) 7.28

5. Incremental Investment in Debtors

( Sales/360)*ACP= (160/360) * 90

40.00

6. Marginal Rate of Return( OPAT/( Debtors) = 4/5

18.26%

7. Incremental PAT

( OPATless (r* Debtors)

1.28


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Credit Terms

Credit Terms are the stipulations under which the firmsells on credit to customers. It includes:

(a) Credit Period; &

(b) Cash Discount.

Credit Period: Duration for which the credit is given.

net 40 customer is required to pay the net

amount due within 40 days.


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Hotline Ltd. wants to increase its credit period from net, 30to net 60. This move is expected to push the sales fromRs.395 Lacs to Rs.550 Lacs & ACP from 45 days to 65 days.The companys contribution margin is 20% and collection

costs of 3% of Sales, bad-debt loss of 4% of Sales. If the firmspost-tax rate of return is 18% and tax rate as 35%, should thefirm change its credit terms?

Credit Terms (Contd.)


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Credit Period (Contd.)

Particulars Rs Lacs

1. Incremental Sales ( Sales) 155.00

2. Incremental Contribution

( Sales*c)=155*20%

31.00

3. Incremental Bad-debts & Collection Costs

( Sales*b+d)=155*(4%+3%)

10.85

4. Incremental OPAT (2-3)*(1-t) 13.10


(SalesN/360)*ACPN less (SalesO/360)*ACPO

=(550/360) * 65less

(395/360) * 45

49.93

6. Marginal Rate of Return

( OPAT/( Debtors) = 4/5

26.23%

7. Incremental PAT ( OPATless (r* Debtors) 4.11


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Credit Terms Cash Discounts

As an incentive for customers to pay early. Firms offer adiscount 3/15, net 40 3% discount , if paid within 15

days or pay the full amount in 40 days.


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Phoenix Shoes Ltd. presently sells Rs 242 Lacs worth of goodson net 30, but wants to change to 2/10, net 30. This willreduce ACP from 40 days to 25 days. No change in Sales is

expected due to this move. It is expected that 75% of thecustomers will take advantage of this changed credit terms.

If the firms post-tax rate of return is 16% and tax rate as35%, should the firm change the cash discount?

Cash Discounts(Contd.)


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Cash Discounts (Contd.)

Particulars Rs Lacs

1. Cash Discount

(Sales* % Taking Discount*Discount%)

(242*75%*2%)

3.63

2. Post Tax Cost of Discount(Discount*1-t)

2.36


(SalesN/360)*ACPN less (SalesO/360)*ACPO

= (242/360)*(25-40)

(10.08)

4. Net Change in PAT (SAVINGS Less COSTS)(r* Debtors)less Post Tax Cash Discount

= (16%*10.08)-2.36

(0.75)Savings

Loss


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Collection Efforts

A firms collection programme aimed at timely collection

of receivables.

What the firm should do in case a customer has not paid

up & his credit period is over.

Monitoring the state of receivables;

Despatch of letters to customers whose due date is; polite vs.

strongly worded reminders

Telegraphic / Telephonic advice to the customers around the

due date

Personal visitsThreat of legal action to overdue accounts

Legal action against overdue accounts

Check the customers financial status- if weak, legal action

would only hasten his insolvency.


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Factoring

Factoring involves transfer of the collection of

receivables and the related book-keeping (Sales

Administration functions by a firm (Client) to a financial

intermediary(Factor).

Sometimes the Factor also provides a line of credit

against the receivables of the firm.

Thus, Factoring is the sale of the book-debts by the firm

to a financial intermediary on the understanding that the

factor will pay for the debts as and when they are

realized/collected or on a guaranteed payment date.


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Process of Factoring

Client

(Seller)

Factor

Customer

(Buyer)

1

2b

2a54

63


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Process of Factoring

1. The client makes a Credit Sale to its customer.2a.Client sends the customers account to the Factor.

2b.Client simultaneously informs the customer about hiscontract with the factor.

3. Factor makes part-payment of the credit sales to the client

after adjusting for commission and interest on the advance.4. Factor maintains the Sales Ledger & follows-up for payment

with the customer.

5. Customer remits the amount due to the Factor.

6. Factor makes the final payment to the client , when theamount is collected or on the guaranteed payment date.


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Services provided by Factor

Factor typically provides the following services:

a. Maintenance of Sales Ledger

b. Collection of Receivables

c. Financing of the Client

For services (a) & (b), the factor charges Factor

Commission, which is a % age of the value of receivables

purchased, usually collected up-front.

For service (c), the factor charges Factor Interest for the

duration between the date of advance payment & the date of

collection or the guaranteed payment date.

Factor does not provide 100% finance. It maintains a

margin(Factor Reserve) to provide for contingencies.


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Forms of Factoring

Depending upon the features built into the factoring contract

between the Factor and the client, various types offactoring are as follows:

(a) Recourse Factoring: Factor has recourse to the client in

case of bad-debts.

(b) Non-Recourse Factoring: Factor assumes the credit risk.(c) Advance Factoring: Factor pays 75-80% in advance,

balance upon collection or on the guaranteed payment

date.

(d) Maturity Factoring: Payment on guaranteed paymentdate or on collection.

(e) Full Factoring: Non-Recourse, Advance Factoring.


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Cost Benefit Analysis

Given:Credit Sales 6,000,000 p.a.

Average Collection Period 90 days

Bad debt Loss 1.50%

Collection Costs 120,000 p.a.

Factor Commission 2.25%Factor Interest 18% p.a.

Factor Reserve 15%


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1. Average Investment in Debtors 1,500,000(Daily Credit Sales * ACP)

2. Factor Commission 33,750

(Av. Receivables*Factor Commission)

3. Factor Reserve 225,000

(Av. Receivables*Factor Reserve)

4. Maximum Advance (1-2-3) 1,241,250

5. Factor Interest 55,856

(Max Advance * Factor Interest for Days used)

6. Net Amount Payable (4-5) 1,185,394


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A. Annualized Factoring Costs:

- Factor Commission 135,000

- Factor Interest 223,425

TOTAL FACTORING COSTS 358,425

B. Costs Avoided Due to Factoring:

- Collection Costs 120,000

- Bad Debts 90,000

TOTAL SAVINGS 210,000

C. Net Cost (A-B) 148,425D. Funds Made available by Factoring 1,185,394

E. Effective Cost of Factoring (C/D) 12.52%

Effective Costs

7_working capital mgmt

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