Transcript
To maintain adequate capital for operations and paying to creditors and not more
Working Capital
Working capital represents the portion of
in estment that circulates from one form toinvestment that circulates from one form to
another in the ordinary conduct of business.
Two major concept of working capital –
A. Net working capital = CA – CL
B Gross working capital = CAB. Gross working capital = CA
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C t f C t A tComponents of Current Assets In entories Inventories
Raw materials Components Components Work‐in‐Progress Finished Goods, others,
Trade Debtors & receivables Loans & Advances Investments Cash & Bank balances Other debtors
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C t f C t Li bilitiComponents of Current Liabilities
Sundry Creditors Trade Advances Borrowings
From Commercial banks h From others
ProvisionsBill P bl Bills Payable
Outstanding wages, salaries & taxes
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D t i t f ki it lDeterminants of working capitalA Nature of businessA. Nature of business Trading, retail, manufacturing, utilities
B. Sales and demand conditionsB. Sales and demand conditions Growing, seasonal & cyclical
C. Technology and manufacturing policygy g p y Production cycle, steady production policy
D. Market competition Inventory level, credit terms
E. Conditions of the suppliers Seasonal supply, lead time
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Operating cycleOperating cycle
Operating cycle refers to the continuous flow of cash fromOperating cycle refers to the continuous flow of cash fromcash to supplier, to inventory, to A/R and back into cash
InventoryCash InventoryCash
ReceivablesReceivables
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Computing Operating Cycle Operating cycle refers to the time required to convert raw material into cash
OC i i i d d b ll i OC = inventory conversion period + debtor collection period
Cash cycle refers to the length of time period between Cash cycle refers to the length of time period between payment of cash for raw material & collection of cash from debtors CC = OC – Deferred payment period
Conversion period = (average level/usage per i d) Tiperiod)xTime
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IllustrationFrom the following information compute the operatingand cash cycles taking 1 year=365 daysy g y 3 5 yAverage credit period allowed by the suppliers = 16 daysAverage debtors = Rs. 4,80,000Raw material consumed = Rs. 44,00,000Total production costs = Rs. 1,00,00,000Total cost of sales = Rs. 1,05,00,000Sales for the year = Rs. 1,60,00,000Average stock: Raw material ‐ Rs. 3,20,000
W‐I‐P ‐ Rs. 3,50,000Finished goods ‐ Rs. 2,60,000
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Ill t tiIllustrationEstimate the Net Working Capital required from thest ate t e et o g Cap ta equ ed o t egiven data:estimated cost per unit = Raw material Rs. 100
+ Direct Labor Rs. 40+ Overheads Rs. 80
selling price is Rs. 240 per unit. Activity level is 1,04,000units in 52 weeks. Raw material & finished goods stockis a eragel held for 4 eeks Credit allo ed bis averagely held for 4 weeks. Credit allowed bysuppliers is also 4 weeks. Credit allowed to debtors is 8weeks. The lag in payment of wages is 1½ weeks.g p y gAverage Cash balance is Rs. 25,000.
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Motives of holding cashThree possible motives for holding cash1. Transactionmotive1. Transactionmotive Cash required to meet transaction needs
C ll ti f h t f tl Collection of cash not perfectlysynchronised with the disbursement of
hcash Hence cash required as a buffer
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Motives of holding cash2. Precautionarymotives Some uncertainty about the magnitude and
timing of cash inflows from sale of G&S, sale ofassets etc.
Some uncertainty about cash outflows onaccount of purchase and other obligationsT i lf h i i d To protect itself, cash is required
Even for rainy days
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Motives of holding cash3. Speculativemotives To avail of the profit making opportunity from
fluctuations in Commodity prices, Security prices, Interest rates
And forex rates And forex rates
Cash rich organisations better able to utilisethe bargainsthe bargains.
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Cash ManagementCash serves these functions, as idle resourcehas an opportunity costpp y
The liquidity provided by cash holding is atthe expenses of profits sacrificed by forgoingthe expenses of profits sacrificed by forgoingalternative investment opportunity
Cash manager to reconcile –Cash manager to reconcile –a) Cash disbursement needs
h b lb) Minimum commitment in cash balancesnarain@fms.edu
Determining cash needsTwo approachesA. Minimum cost cash models1. Baumol’s model2. Miller‐Orr’s model3. Orgler’s model
B. Cash budgetg Statement showing the estimated cash inflows
and outflows over the planning horizonp g
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Cash management strategiesStretching accounts payables1. Avoidance of early payments2. Centralised disbursements3. Playing float3 y ga) Cheque kitingb) Paying form a distant bank) y gc) Scientific cheque encashing analysis
4. Accruals4. Accruals
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Cash management strategiesSpeedy collection of account receivables1. Prompt payment by customer’s Prompt billing
2. Early conversion of payments into cash Centralised Decentralised – concentration banking, g,
lockbox systemEfficient inventory‐production management JIT system
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narain@fms.edu
Costs in Receivable Management1. Collection cost Cost of maintaining credit deptt., postage, stationary, etc.C i l 2. Capital cost
Amount of interest lost due to capital tied up in receivablesreceivables
Which could have been used to pay employees, suppliers3. Delinquency costq y Legal charges, prosecution costs
4. Default cost Amount lost as turned bad
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Credit Analysis & InvestigationEssential to develop procedures toevaluate credit applicationsevaluate credit applicationsTwo basic steps –A. Obtaining credit informationB. Analysis of credit informationB. Analysis of credit information
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Obtaining credit informationInternal sources Various forms filled Trade references furnished Past recordExternal sources Published & unpublished industry information
l Financial statements Bank referencesC dit b & th t d f Credit bureaus & other trade references
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Analysis of credit informationQuantitative analysis : Cross‐section & Temporal Aging schedule Average age of A/C receivables Liquidity, profitability & servicing ratiosq y p y g
Qualitative analysis : Subjective assessment
R ti f th li t Rating of the applicant Referenced from banks, other suppliers, etc.
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Terms of PaymentTwo extremesTwo extremes1. Seller may extend credit to buyer till the buyer
converts goods bought into cashconverts goods bought into cash2. The buyer may pay cash in advance to the seller
and finance the entire trade cycleand finance the entire trade cycleCommon practice Trade cycle financed partly by the seller partly by Trade cycle financed partly by the seller, partly by
the buyer and partly by some financialintermediary.y
Credit terms like: “2/10, net 30”narain@fms.edu
Major terms of paymentCash in advance/delivery etc.Open ongoing account and credit periodOpen ongoing account and credit periodCash discountBilliBillingConsignmentDraft or Bill of ExchangeLetter of creditette o c ed t
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C dit P li V i blCredit Policy Variables Have bearing on the level of sales, bad debt loss,Have bearing on the level of sales, bad debt loss,discount taken by customers and collection expenses.
Important decisions – Credit standards Credit period Cash discount Cash discount Collection efforts
Monitoring Reminding Approaching Threateningg Suing
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IllustrationA Co. currently has annual sales of Rs. 5 lakhs & average collectionperiod of 30 days. It is considering a more liberal credit policy. Ifth dit i d i t d d th t l dthe credit period is extended, the company expects sales andbad‐debt losses to increase in the following manner:
Credit Increase in credit Increase in Bad‐debt (% ofPolicy period sales sales)
A 10 days Rs. 25,000 1.2B 15 days Rs. 35,000 1.55 y 35, 5C 30 days Rs. 40,000 1.8D 42 days Rs. 50,000 2.2
The selling price is Rs. 2/‐. At the current level of operation,average cost is Rs. 1.50/‐ and average variable cost is Rs. 1.20/‐. Ifcurrent bad‐debt loss is 1% of sales and required rate of return isq20%, which credit policy should be undertaken? (1yr. = 360 days)
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SolutionIncremental expected profit (taking debtors at selling price)
A B C D5367 5933 1613 -767
Incremental expected profit (taking debtors at cost)
A B C D6283 7325 4230 2950
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A j f h ki i l A major factor among non‐cash working capital management
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Inventory Management TechniquesABC systemPareto principlePareto principle
EOQ systemLevels of inventories
JIT systemJIT systemNo need to keep the inventory
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narain@fms.edu
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