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BALAJI INSTITUTE OF
I.T AND MANAGEMENT
KADAPA
FINANCIAL MANAGEMENT (17E00204)
ICET CODE: BIMK 2nd Internal Exam Syllabus
ALSO DOWLOAD AT http://www.bimkadapa.in/materials.html
Name of the Faculty : S.RIYAZ BASHA
Units covered : 2.5 to 5 Units(2nd Internal Syllabus)
E-Mail Id :[email protected]
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(17E00204)FINANCIAL MANAGEMENT
SYLLABUS * Standard Discounting Table and Annuity tables shall
be allowed in the examination
1. The Finance function: Nature and Scope. Importance of Finance
function – The role in
the contemporary scenario – Goals of Finance function; Profit Vs
Wealth maximization .
2. The Investment Decision: Investment decision process –
Project generation, Project
evaluation, Project selection and Project implementation.
Capital Budgeting methods–
Traditional and DCF methods. The NPV Vs IRR Debate.
3. The Financing Decision: Sources of Finance – A brief survey
of financial instruments.
The Capital Structure Decision in practice: EBIT-EPS analysis.
Cost of Capital: The
concept, Measurement of cost of capital – Component Costs and
Weighted Average Cost.
The Dividend Decision: Major forms of Dividends
4. Introduction to Working Capital: Concepts and Characteristics
of Working Capital,
Factors determining the Working Capital, Working Capital
cycle-Management of Current
Assets – Cash, Receivables and Inventory, Financing Current
Assets
5. Corporate Restructures: Corporate Mergers and Acquisitions
and Take-overs-Types of
Mergers, Motives for mergers, Principles of Corporate
Governance.
Textbooks:
Financial management –V.K.Bhalla ,S.Chand
Financial Management, I.M. Pandey, Vikas Publishers. Financial
Management--Text and Problems, MY Khan and PK Jain, Tata McGraw-
Hill
References
Financial Management , Dr.V.R.Palanivelu ,S.Chand
Principles of Corporate Finance, Richard A Brealeyetal., Tata
McGraw Hill.
Fundamentals of Financial Management, Chandra Bose D, PHI
Financial Managemen , William R.Lasheir ,Cengage.
Financial Management – Text and cases, Bringham&Ehrhardt,
Cengage.
Case Studies in Finance, Bruner.R.F, Tata McGraw Hill, New
Delhi.
Financial management , Dr.M.K.Rastogi ,Laxmi Publications
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UNIT-3
THE FINANCING DECISION
3.5 COST OF CAPITAL
The cost of capital is the rate of return the company has to pay
to various suppliers. There is a
variation in the cost of capital due to the fact that different
levels of investment carry different
levels of risk, which is compensated for, by different levels of
return on investment.
There are two main sources of capital for a company viz.
shareholders and lenders. The cost
of equity and cost of debt are the rates of return that need to
be offered to the shareholders
and lenders for supplying capital.
“The cost of capital is the minimum required rate of earnings of
the cut-off rate for capital
expenditures”.
“The cost of capital is the minimum required of return the
hurdle or target rate the cut-off
rateor the financial standard of performance of a project.”
“The project cost of capital is the minimum required rate of
return on funds committed to
theproject which depends on the friskiness of its cash
flows.”
“The firms cost of capital means overall or average required
rate of return on the aggregate of
investment projects”.
3.5.1 SIGNIFICANCE OF THE COST OF CAPITAL:
The determination of the firm’s cost of capital is important
from the point of view of both
capital budgeting as well as capital structure planning
decisions.Cost of capital is a concept of
vital importance in the financial decision making. It is useful
as astandard for
1. Evaluating investment decisions: The primary purpose of
measuring the cost of capital is
its use as a financial standard for evaluating the investment
projects.
a. In NPV method the investment project is accepted it has
positive NPV. The projects
NPV are calculated by discounting its cash flows by the cost of
capital. Positive NPV
makes a net contributing to the wealth of shareholders.
b. If the project has zero NPV it means that its cash flows have
yielded a return just equal
to the cost of capital and acceptance or rejecting of the
project does not affect the
wealth of shareholders.
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c. In the I.R.R. method the investment project is accepted if it
has an internal rate of return
greater than the cost of capital.
d. The cost of capital is the minimum required rate of return on
the investment project that
keeps the present wealth of shareholders unchanged cost of
capital represent a financial
standard for allocation the firm funds supplied by owners and
creditors in the most
efficient manner.
2. Designing Debt Policy: The debt policy of a firm is
significantly influenced by the cost
consideration debt helps to save taxes as interest on debt is a
tax deductible expense. The
interest tax should reduce the overall cost of capital though it
also increases the financial risk
of the firm.
In designing the financing policy the proportioned debt and
equity in the capital structure
thefirms aims at maximizing the firm value by minimizing the
overall cost of capital.
The cost of capital can also useful in deciding about the
methods of financing at a point of
time.
Ex. Cost may be compared in choosing between leasing and
borrowing.
3. Appraising the financial performance of top management: The
cost of capital
framework can be used to evaluate the financial performance of
top management. It involves
a comparison of actual profitability of the investment projects
undertaken by the firm with the
project overall cost of capital and the appraisal of the actual
cost incurred by management in
rising the required funds.The cost of capital also plays a
useful role in a dividend decision
and investment in current assets.
3.6 ELEMENTS OF COST OF CAPITAL (OR) MEASUREMENT OF COST OF
CAPITAL:
The cost of capital consists of the following elements:
1. cost of equity
2. cost of retained earnings
3. cost of preference shares
4. cost of debt
5. weighted average cost of capital
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I.)Cost of equity: the funds required for the project are raised
from equity shareholders. These
funds need not be repayable during the lifetime of the company.
Hence it is a permanent
source of fund. If the business is doing well the ultimate
beneficiaries are the equity
shareholders (ESH). On other hand, if the company comes for
liquidation due to losses, the
ultimate sufferers are also equity shareholders. Sometimes they
may not get their investment
back during the liquidation process. That’s why equity share
capital is also known as ‘risk
capital’.
Profits after tax less dividends paid to preference shareholders
are the funds available
to ESH. These funds have been re-invested in the company and
therefore, these retained
funds should be included in the cost of equity.
Cost of equity may be defined as the minimum rate of return that
a company that must
earn on its equity financed portion so that the market value of
share remain unchanged.
Methods of valuation:
The following methods are used in calculation of cost of
equity.
a) Dividend yield method: This method is based on the assumption
that the market value of
share is directly related to the future dividends on the shares.
Another assumption is that
the future dividend per share is expected to be constant. It
does not allow for any growth
in future dividends. But in reality the shareholders expects the
return from his equity
investment to grow over time.
D1
Thus Ke = -------
PE
Where Ke= Cost of equity
D1 = annual dividend per share
PE = Market price per share
b) Dividends Growth Model: In this method an allowance for
future growth in dividend is
added to the current year dividend. It is recognized that the
current market price of a
share reflects expected future dividends. This model is also
known as Gordon dividend
growth model.
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D1 + g
Ke = ------------
PE
(OR)
Do (1+g)+g
Ke= -----------------
NP
Where Ke= cost of equity
D1 = current dividends per ES
G=growth in expected dividend
PE = Market price per ES
c) Price earning model: It takes into consideration the earnings
per share (EPS) and
market price of share (MPS). It is based on the assumption that
it the earnings are not
disbursed as dividends and kept as retained earnings are not
disbursed earnings will causes
future growth in the earnings of the company as well as an
increase in the market price of
the share. In calculation of equity share capital the EPS is
divided by the current market
price.
E
Thus Ke= ------
M
Where Ke = cost of equity
E = current EPS
M=MPS
d) Capital Asset Pricing Model (CAPM): William F.Sharpe
developed the CAPM. He
emphasized the risk factor in portfolio theory.
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Risk refers to possibility of variation in the expected returns
of the investor’s portfolio risk
consists of both systematic risk and unsystematic risk.
Systematic risk affects the entire stock
market. For example wars, political situation influence the
downward of upward movement
of stock exchange. On the other hand, the unsystematic risk
happens to a company or any
industry due to shortage of raw-materials, technological
changes, change in the preference of
customers etc.,
The CAPM divides the cost of equity into two components, the
near risk-free return available
on investing in govt. bonds and an additional risk premium for
investing in a particular share
or investment. This a additional risk premium comprises the
average return on the overall
market portfolio and the beta (or risk) factor of particular
investment. Putting this all together
the CAPM assess the cost of equity for an investment as
follows:
Ke=Rf + Bi(Rm-Rf)
Where Ke = cost of equity
Rf = risk – free rate of return
Rm = average market return
Bi= risk of the investment.
II) Cost of retained earnings: These are the funds accumulated
over the years. These
retained profits are now distributed to the shareholders, become
the company can use these
funds for further profitable investment opportunities. The cost
of retained earnings is an equal
to the income that they would otherwise obtain by placing these
funds in alternative
investment. It the retained earnings are distributed to the
equity shareholders will attract
personal taxation and therefore, the cost of retained earnings
is calculated as follows:
Kr = Ke (1-T)
Where Kr = cost of retained earnings
Ke = cost of equity
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T= tax rate of individuals
III. Cost of preference shares: the cost of preference share is
the cost of return that must be
earned on preference capital financed investments, to keep
unchanged the earnings available
to equity share holders.
A. Cost of irredeemable preference shares: the cost of
irredeemable preference
share capital is the rate of preference dividend, also called
the coupon rate
dividend by net issue proceeds.
I (1-T)
Kd = -----------
Np
Where Kd= cost of debt
I = annual interest payment
T = tax rate
Np = net proceeds from the issue of debentures, bonds, term
loans etc.
3.7 THE CONCEPT OF AVERAGE VS MARGINAL COST OF CAPITAL
1. Marginal cost of capital:-Current rate of interest on long
term debt or normal rate of
return is treated as firms marginal cost of capital. It is also
termed as explicit cost.
Marginal cost of capital, the weighted average cost of capital
is computed for the sources of
finance already employed by the firm. If the company undertakes
new projects or expansion
schemes. It may be required to compute the cost of raising new
funds and not the historical
costs incurred in the past. The weighted average cost of capital
of the expansion programmes
or new projects is called the marginal cost of capital. Thus,
the weighted average cost of new
or incremental capital is known as marginal cost of capital.
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To finance its new projectors, a company should raise funds
proportionally in accordance
with the optimum capital structure. When a company raises funds
to finance its new projects
in the same proportion as it has for the company as a whole, and
the component costs remain
unchanged, there will be no difference between the average cost
of capital (of the total funds)
and the marginal cost a capital(new funds). But the marginal
cost of capital would rise
whenever any component cost increases. The rationale for using
the marginal cost of capital
as an investment criterion is to maximize the value of equity
shares of the company.
2. Average Cost of Capital:-Average cost of capital is the
weighted average of the costs of
each component of funds used by the firm. The composite cost of
capital is the weights being
the proportion of each source of funds in the capital Structure.
In financial decision making
the term cost of capital is used in this sense. This approach
enables the corporate management
to maximize the profits and wealth of the equity shareholders by
investing funds in projects
earning in excess of the cost of its capital mix.
The following steps are involved in the computation of weighted
average cost of capital:
Calculate the specific costs of various sources of finance, viz
debt, preference equity etc.
Multiply the cost of each source by its proportion in the
capital structure.
Add the weighted costs of all sources of funds to arrive at the
weighted or composite cost of
capital.
3.7.1 WEIGHTED AVERAGE COST OF CAPITAL:
What is weighted average cost of capital? Illustrate your answer
with imaginary figures.
a) Meaning of Weighted Average Cost of Capital: A company has to
employ owner’s funds
as well as creditors funds to finance its projects so as to make
the capital structure of the
company balanced and to increase the return to the shareholders.
The total cost of capital is
the aggregate of costs of specific sources. In financial
decision making, the concept of
composite cost is relevant. The composite cost of capital is the
weighted average of the costs
of various sources of funds, weights being the proportion of
each source of funds in the
capital structure. It should be remembered, that it is weighted
average, and not the simple
average, which is relevant in calculating the overall cost of
capital. The composite cost of all
capital lies between the least and the most expansive funds.
This approach enables the
maximization of corporate profits and the wealth of the equity
shareholders by investing the
funds in a projects earning in excess of the cost of its
capital- mix.
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Weighted average, as the name implies, is an average of the
costs of specific source of capital
employed in a business, properly weighted by the proportion,
they hold in the firm’s capital
structure.
Weighted Average, How to calculate? Though the concept of
weighted average cost of
capital is very simple, yet there are so many problems in the
way of its calculations. Its
computation requires:
i) computation of weights to be assigned to each type funds;
and
ii) assignment of costs to various sources of capital
once these values are known, the calculation of weighted average
cost becomes very simple.
It may be obtained by adding up the products of specific cost of
all types of capital multiplied
by their appropriate weights.
In financial decision making, the cost of capital should be
calculated on after tax basis.
Therefore, the component costs to be used to measure the
weighted cost of capital should be
after tax costs.
Computation of weights: the assignment of weights to specific
sources of funds is a difficult
task. Several approaches are followed in this regard but two of
them are commonly used i.e.,
book-value approach and market value approach. As the cost of
capital is used as a cut- off
rate of investment projects, the market value approach is
considered better because of the
following reasons:
i) it evaluates the profitability as well as the long term
financial position of the firm.
ii) The investors always consider the committing of his funds to
an enterprise and an
adequate return on his investment. In such cases, book values
are of little
significance.
iii) It does not indicate the true economic value of
concern.
iv) It considers price level changes. But as the market value
fluctuates widely and
frequently, the use of book value weights is preferred in
practice because,
v) The firm sets its targets in terms of book value.
vi) It can easily be derived from published accounts and
vii) The investors generally use the debt-equity ratio on the
basis of published figures
to analyze the riskiness of the firms.
Determining the type of capital structure: the next problem in
calculating the weighted
average cost is the selection of capital structure from which
the weights are obtained. There
may be several possibilities i.e,.,
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a) current capital structure either before or after the
projected new financing
b) marginal capital structure i.e, proportion of various types
of capital in total of
additional funds to be raised at certain time and
c) Optimal capital structure. All may agree that firms do seek
optimum capital structure
i.e., the capital structure that minimizes the average cost of
capital.
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3.8 DIVIDEND DECISION
The term dividend refers to that part of profits of a company
which is distributed by the
company among its shareholders after execution of retained
earnings. It is the reward of the
shareholders for investments made by them in the shares for the
company. And In other
words, it is the return that a shareholder gets from the company
out of profit on his
shareholding.
According to the Institute of Chartered Accountant of India, “A
dividend is distribution to
shareholders out of profit or reserves available for this
purpose”.
3.9 MAJOR FORMS OF DIVIDEND/TYPES OF DIVIDEND
Dividends can be classified in various forms. Dividends paid in
the ordinary course of
business are known as profit dividends. While dividends paid out
of capital are known
Liquidation dividends.
Dividends may also be classified on the basis of medium in which
they are paid:
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1. ON THE BASIS OF TYPES OF SHARES:-
i. Equity Dividend: Dividend paid on equity shares called as
equity dividend. Generally
dividend on equity shares is recommended by the Board of
Directors depending upon profit
of the company. Rate of dividend is not fixed. It depends upon
the recommendation of
directors which in turn depends upon the profit and future
requirement of funds of the
company. Because the Directors has freedom regarding quantum and
time of payment of
dividend.
ii. Preference Dividend: Preference dividend is the dividend
paid to preference shareholders.
The preference dividend is paid at pre-determined rate and like
equity shares, dividend on
preference shares is also recommended by the Board of Directors.
As the name suggest
preference dividend gets priority over equity dividend. Equity
dividend is paid only after
payment of shares on preference dividend. The board does not
have power to reduce the rate
of dividend, however they can recommend higher dividend on
preference shares.
2.ON THE BASIS OF MODES OF PAYMENT:-
i. Cash Dividend: A cash dividend is a usual method of paying
dividends. Payment of
dividend in cash results in outflow of funds and reduces the
company’s net worth, though the
shareholders get an opportunity to invest the cash in any manner
they desire. This is why the
ordinary shareholders prefer to receive dividends in cash. But
the firm must have adequate
liquid resources at its disposal or provide for such resources
so that its liquidity position is not
adversely affected on account of cash dividends.
ii. Bonus Share/Stock Dividend: Stock dividend means the issue
of bonus shares to the
existing shareholders. If a company does not have liquid
resources it is better to declare stock
dividend. Stock dividend amounts to capitalization of earnings
and distribution of profits
among the existing. Shareholders without affecting the cash
position of the firm.
iii. Bond Dividend: A Bond dividend promise to pay the
shareholders at a future specific
date. In case a company does not have sufficient funds to pay
dividends in cash, it may issue
notes or bonds for amounts due to the shareholders. The
objective Bond dividend bears
interest and is accepted as collateral security.
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iv. Property Dividend: Property dividends are paid in the form
of some assets other than
cash. They are distributed under exceptional circumstances and
are not popular in India.
v. Composite Dividend: When dividend is paid partly in the form
of cash and partly in other
form, it is called as composite dividend. This is not a new
technique for payment of dividend
it is a combination of earlier discussed techniques.
3. ON THE BASIS OF TIME OF PAYMENT:-
i. Interim Dividend: Generally dividend is declared at the end
of financial year, but
sometime company pays dividend before it declares dividend in
its annual general meeting.
In other words, we can say that it is dividend paid between two
annual general meetings.
Generally it is paid when company’s Board thinks that company
has earned sufficient/huge
profit. In such a case Directors should be very careful because
at the end of year profit may
fall short than what was expected by them.
ii. Regular Dividend: Dividend declared in Annual General
Meeting is called as Regular
dividend. Every year company declares dividend in its Annual
General Meeting.
iii. Special Dividend: A sound dividend policy should be formed
in such a way that rate of
dividend should not be changed frequently year to year. Rate of
dividend should be static.
However, wherever there is any huge/abnormal/extra profit,
company should declare it as
special dividend. So that the shareholders do not expect for the
same in each year, the basic
purpose of this special dividend is to convey the shareholders
that this is a special dividend
and will not be paid every year.
3.9.1 TYPES OF DIVIDEND POLICY
1. Regular Dividend Policy: Payment of dividend at the usual
rate is termed as regular
dividend. The investors such as retired persons, widows and
other economically weaker
person prefer to get regular dividends.
Advantages of Regular Dividend Policy:-
A regular dividend policy offers the following advantages:
i) It establishes a profitable record of the company.
ii) It creates confidence among the shareholders.
iii) It aids in long-term financing and renders financing
easier.
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iv) It stabilizes the market value of shares.
v) The ordinary shareholders view dividends as a source of funds
to meet their day-to-day
living expenses.
vi) If profits are not distributed regularly and are retained,
the shareholders may have to
pay a higher rate of tax in the year when accumulated profits
are distributed.
However, it must be remembered that regular dividends can be
maintained only be
companies of long standing and stable earnings. A company should
establish the regular
dividend at a lower rate as compared to the average earnings of
the company.
2. Stable Dividend Policy: The term ‘stability of dividends’
means consistency or lack of
variability in the stream of dividend payments. In more precise
terms, it means payment of
certain minimum amount of dividend regularly. A stable dividend
policy may be established
in any of the following three forms:
i) Constant Dividend per Share: Some companies follow a policy
of paying fixed
dividend per share irrespective of the level of earnings year
after year. Such firms, usually,
create a ‘Reserve for Dividend Equalization’ to enable them pay
the fixed dividend even in
the year when the earnings are not sufficient or when there are
losses. A policy of constant
dividend per share is most suitable to concerns whose earnings
are expected to remain
stable over a number of years.
ii) Constant Pay-out Ratio: Constant pay-out ratio means payment
of a fixed percentage
of net earnings as dividend every year. The amount of dividend
in such a policy fluctuates
in direct proportion to the earnings of the company. The policy
of constant pay-out is
preferred by the firms because it is related to their ability to
pay dividends.
iii) Stable Rupee Dividend plus Extra Dividend: Some companies
follow a policy of
paying constant low dividend per share plus an extra dividend in
the years of high profits.
Such a policy is most suitable to the firm having fluctuating
Earnings from year to year.
Advantages of Stable Dividend Policy:-
A stable dividend policy is advantageous to both the investors
and the company on
account of
the following:
i. It is sign of continued normal operations of the company.
ii. It stabilizes the market value of shares.
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iii. It creates confidence among the investors
Iv. It meets the requirements of institutional investors who
prefer companies with stable
dividends.
3. Irregular Dividend Policy: Some companies follow regular
dividend payments on
account of the following:
i. Uncertainty of earnings
ii. Unsuccessful business operations
iii. Lack of liquid resources
iv. Fear of adverse effects of regular dividends on the
financial standing of the company
4. No Dividend Policy:A company may follow a policy of paying no
dividends presently
because of its unfavorable working capital position of on
account of requirements of funds of
future expansion and growth.
UNIT-3-AFTER 2.5 UNITS-IMPORTANT QUESTIONS
Briefly explain about Measurement of cost of capital of cost of
capital?
What is Dividend? Elucidate major forms of dividend?
Cost of capital, weighted average cost of capital related
Problems?
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CASE STUDY
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Financial Management M.B.A -II –SEMESTER-R17
UNIT-4 Introduction to Working Capital |BALAJI INST OF I.T AND
MANAGEMENT 1
(17E00204)FINANCIAL MANAGEMENT
Syllabus
* Standard Discounting Table and Annuity tables shall be allowed
in the examination
1. The Finance function: Nature and Scope. Importance of Finance
function – The role in the
contemporary scenario – Goals of Finance function; Profit Vs
Wealth maximization .
2. The Investment Decision: Investment decision process –
Project generation, Project
evaluation, Project selection and Project implementation.
Capital Budgeting methods–
Traditional and DCF methods. The NPV Vs IRR Debate.
3. The Financing Decision: Sources of Finance – A brief survey
of financial instruments. The
Capital Structure Decision in practice: EBIT-EPS analysis. Cost
of Capital: The concept,
Measurement of cost of capital – Component Costs and Weighted
Average Cost. The Dividend
Decision: Major forms of Dividends
4. Introduction to Working Capital: Concepts and Characteristics
of Working Capital, Factors
determining the Working Capital, Working Capital
cycle-Management of Current Assets –
Cash, Receivables and Inventory, Financing Current Assets
5. Corporate Restructures: Corporate Mergers and Acquisitions
and Take-overs-Types of
Mergers, Motives for mergers, Principles of Corporate
Governance.
Textbooks:
Financial management –V.K.Bhalla ,S.Chand
Financial Management, I.M. Pandey, Vikas Publishers. Financial
Management--Text and Problems, MY Khan and PK Jain, Tata McGraw-
Hill
References
Financial Management , Dr.V.R.Palanivelu , S.Chand
Principles of Corporate Finance, Richard A Brealey etal., Tata
McGraw Hill.
Fundamentals of Financial Management, Chandra Bose D, PHI
Financial Managemen , William R.Lasheir ,Cengage.
Financial Management – Text and cases, Bringham & Ehrhardt,
Cengage.
Case Studies in Finance, Bruner.R.F, Tata McGraw Hill, New
Delhi.
Financial management , Dr.M.K.Rastogi ,Laxmi Publications
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UNIT-4
INTRODUCTION TO WORKING CAPITAL
4. INTRODUCTION TO WORKING CAPITAL MANAGEMENT:
Working capital is the life blood of a business. Just as
circulation of blood is essential in the
human body for maintaining life, working capital is very
essential to maintain the smooth
running of a business. No business can run successfully without
an adequate amount of working
capital.
Working capital refers to that part of firm’s capital which is
required for financing short term or
current assets such as cash, marketable securities, debtors, and
inventories. In other words
working capital is the amount of funds necessary to cover the
cost of operating the enterprise.
Meaning: Working capital means the funds (i.e.; capital)
available and used for day to day
operations (i.e.; working) of an enterprise. It consists broadly
of that portion of assets of a
business which are used in or related to its current operations.
It refers to funds which are used
during an accounting period to generate a current income of a
type which is consistent with
major purpose of a firm existence.
Definition:
The following are the some of the definitions given for working
capital by experts in the areas of
finance.
“ the sum of current assets is the working capital of a
business”.-J.S.Mill.
“Working capital has ordinarily been defined as the excess of
current assets over current
liabilities”. – C.W. Gerstenberg.
Definition of Working Capital: “Working Capital sometimes called
as Net Working Capital is
represented by the excess of current assets over the current
liabilities and identified the relatively
liquid portion to total enterprise capital which constitutes a
margin of buffer for maturing
obligations within the ordinary operating cycle of the
business”.
‘Working Capital is a excess of current assets over current
liabilities’.
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1.1 OBJECTIVES & NEED OF WORKING CAPITAL:
To ensure optimum investment in current assets.
To strike balance between the twin objectives of liquidity and
profitability in the use of
funds.
To ensure adequate flow of funds of current operations.
To speed up flow of funds or to minimize the stagnation of
funds.
Businesses with a lot of cash sales and few credit sales should
have minimal trade
debtors. Supermarkets are good examples of such businesses;
Businesses that exist to trade in completed products will only
have finished goods in
stock. Compare this with manufacturers who will also have to
maintain stocks of raw
materials and work-in-progress.
Some finished goods, notably foodstuffs, have to be sold within
a limited period because
of their perishable nature.
Larger companies may be able to use their bargaining strength as
customers to obtain
more favorable, extended credit terms from suppliers. By
contrast, smaller companies,
particularly those that have recently started trading (and do
not have a track record of
credit worthiness) may be required to pay their suppliers
immediately.
Some businesses will receive their monies at certain times of
the year, although they may
incur expenses throughout the year at a fairly consistent level.
This is often known as
“seasonality” of cash flow. For example, travel agents have peak
sales in the weeks
immediately following Christmas.
Working capital needs also fluctuate during the year. The amount
of funds tied up in
working capital would not typically be a constant figure
throughout the year.
Only in the most unusual of businesses would there be a constant
need for working
capital funding. For most businesses there would be weekly
fluctuations.
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4.2 CONCEPTS/TYPES OF WORKING CAPITAL
A)On The Basis of Concept:-On the basis of concept, working
capital is classified as
gross working capital and net working capital. This
classification is important form the point of
view of the financial manager.
i) Gross Working Capital:- The term working capital refers to
the gross working capital and
represents the amount of funds invested in current assets.
GROSS WORKING CAPITAL = TOTAL OF CURRENT ASSETS
ii) Net working Capital:- The term working capital refers to the
net working capital. Net
working capital is the excess of current assets over current
liabilities.
NET WORKING CAPITAL = CURRENT ASSETS - CURRENT LIABILITEIS
Kinds of Working Capital
On The Basis of Concept On The Basis of time
Gross Working
Capital
Net
Working Capital
Permanent or
Fixed working
Capital
Temporary or
Variable Working
Capital
Regular Working
Capital
Reserve
Working Capital
Seasonal Working
Capital
Special Working
Capital
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B)On The Basis of Time:-On the basis of time, working capital
may be classified as
permanent of fixed working capital and temporary or variable
working capital.
i) Permanent or Fixed Working Capital:-Permanent of fixed
working capital is the
minimum amount which is required to ensure effective utilization
of fixed facilities and
for maintaining the circulation of current assets. There is
always a minimum level of
current assets, which is continuously required by the enterprise
to carry out its normal
business operations. For example, every firm has to maintain a
minimum level of raw
materials, work-in-process, finished goods and cash balance.
This minimum level of
current assets is called permanent or fixed working capital as
this part of capital is
permanently blocked in current assets. As the business grows the
requirements of
permanent working capital also increase due to the increase in
current assets. The
permanent working capital can further be classified as regular
working capital and
reserve working capital required ensuring circulation of current
assets from cash to
inventories, from inventories to receivables and form
receivables to cash and so on
a) Regular Working Capital:- this is the amount of working
capital required for
the continuous operations of an enterprise. It refers to the
excess of current assets
over current liabilities. Any organization has to maintain a
minimum stock of
materials. Finished goods and cash to ensure its smooth working
and to meet its
immediate obligations.
b) Reserve Working Capital:- Reserve working capital is the
excess amount over
the requirement for regular working capital which may be
provided for
contingencies that may arise at unstated period such as strikes,
rise in prices,
depression, etc.,
ii) Temporary or variable Working Capital:-Temporary or variable
working capital is the
amount of working capital which is required to meet the seasonal
demands and some special
exigencies. Variable working capital can be further classified
as seasonal working capital and
special working capital.
a) Seasonal Working Capital:- Seasonal working capital is
required to meet the
seasonal needs of the enterprise such as, a textile dealer would
require large
amount of funds a few months before Diwali.
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b) Special Working Capital:- Special working capital is that
part of working
capital which is required to meet special emergency such as
launching or
extensive marketing campaigns for conducting research, etc.
Differences between Temporary and Permanent Working Capital:- In
the following figure
we can see the differences between the Temporary and Permanent
Working capital in case of
two firms like Constant Firm and growing firm.
4.3 COMPONENTS OF WORKING CAPITAL:-
Working Capital will be defined as that excess of current assets
over current liabilities of a firm.
The following are components of working capital which comprise
of current assets and current
liabilities.
Examples of current assets are:
CONSTITUENT OF CURRENT
LIABILITIES
CONSTITUENT OF CURRENT
ASSETS
1. Bills Payable.
2. Sundry Creditor or Accounts Payable.
3. Accrued or Outstanding Expenses.
4. Short term loans and advances.
5. Dividends Payable.
1. Cash in hand and bank balances.
2. Bills Receivables.
3. Sundry Debtors.
4. Short term loans and advances.
5. Inventories of Stock:
Temporary
Permanent
Time
Constant Permanent Capital
Time
Increasing Permanent Capital
Wo
rkin
g C
ap
ital (R
s.)
Wo
rkin
g C
ap
ital (R
s.)
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6. Bank over Draft.
7. Provision for Taxation.
Raw Materials.
Work – in – Process.
Stores and Spares
Finished Goods.
6. Temporary Investment of Surplus funds.
7. Prepaid Expenses, Accrued Income.
4.4 GROSS CAPITAL VS. NET WORKING CAPITAL:
The distinction between gross working capital and net working
capital does not in any
way undermine the relevance of the concepts of either gross or
net working capital. A financial
manager must consider both of them because they provide
different interpretations. The gross
working capital denotes the total working capital or the total
investment in current assets. A
firm should maintain an optimum level of gross working capital.
On the other hand Net working
capital means the excess of current assets over current
liabilities.
Gross Working Capital = Total of Current Assets
Net Working Capital = Current Assets – Current Liabilities
4.5. CHARACTERISTICS OF WORKING CAPITAL
The features of working capital distinguishing it from the fixed
capital are as follows:
(1)Short term Needs: Working capital is used to acquire current
assets which get converted into
cash in a short period. In this respect it differs from fixed
capital which represents funds locked
in long term assets. The duration of the working capital depends
on the length of production
process, the time that elapses in the sale and the waiting
period of the cash receipt.
(2) Circular Movement: Working capital is constantly converted
into cash which again turns
into working capital. This process of conversion goes on
continuously. The cash is used to
purchase current assets and when the goods are produced and sold
out; those current assets are
transformed into cash. Thus it moves in a circular away. That is
why working capital is also
described as circulating capital.
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(3) An Element of Permanency: Though working capital is a short
term capital, it is required
always and forever. As stated before, working capital is
necessary to continue the productive
activity of the enterprise. Hence so long as production
continues, the enterprise will constantly
remain in need of working capital. The working capital that is
required permanently is called
permanent or regular working capital.
(4) An Element of Fluctuation: Though the requirement of working
capital is felt permanently,
its requirement fluctuates more widely than that of fixed
capital. The requirement of working
capital varies directly with the level of production. It varies
with the variation of the purchase
and sale policy; price level and the level of demand also. The
portion of working capital that
changes with production, sale, price etc. is called variable
working capital.
(5) Liquidity: Working capital is more liquid than fixed
capital. If need arises, working capital
can be converted into cash within a short period and without
much loss. A company in need of
cash can get it through the conversion of its working capital by
insisting on quick recovery of its
bills receivable and by expediting sales of its product. It is
due to this trait of working capital
that the companies with a larger amount of working capital feel
more secure.'
(6) Less Risky: Funds invested in fixed assets get locked up for
a long period of time and
cannot be recovered easily. There is also a danger of fixed
assets like machinery getting obsolete
due to technological innovations. Hence investment in fixed
capital is comparatively more risky.
As against this, investment in current assets is less risky as
it is a short term investment.
Working capital involves more of physical risk only, and that
too is limited. Working capital
involves financial or economic risk to a much less extent
because the variations of product
prices are less severe generally. Moreover, working capital gets
converted into cash again and
again; therefore, it is free from the risk arising out of
technological changes.
(7) Special Accounting System not needed: Since fixed capital is
invested in long term assets,
it becomes necessary to adopt various systems of estimating
depreciation. On the other hand
working capital is invested in short term assets which last for
one year only. Hence it is not
necessary to adopt special accounting system for them.
4.6. FACTORS DETERMINING WORKING CAPITAL REQUIREMENTS:
1)Nature of Business:- the working capital requirements of a
firm basically depend upon the
nature of its business. Public utility undertakings like
Electricity, Water Supply and Railways
need very limited working capital because they offer cash sales
only and supply services, not
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products and as such no funds are tied up in inventories and
receivables. On the other hand
trading and financial firms require less investment in fixed
assets but have to invest large
amount sin current assets like inventories, receivables and
cash; as such they need large amount
of working capital.
2)Size of Business / Scale of Operations:- the working capital
requirements of a concern are
directly influenced by the size of its business which may be
measured in terms of scale of
operations Greater the size of a business unit, generally larger
will be the requirements of
working capital.
3)Production Policy:- In certain industries the demand is
subject to wide fluctuations due to
seasonal variations. The requirements of working capital, in
such cases, depend upon the
production policy.
4)Manufacturing Process / Length of Production Cycle:- In
manufacturing business, the
requirements of working capital increase in direct proportion to
length of manufacturing process.
Longer the process period of manufacturing, larger is the amount
of working capital required.
5)Seasonal Variations:- In certain industries raw material is
not available throughout the year.
They have to buy raw materials in bulk during the season to
ensure an uninterrupted flow and
process then during the entire year.
6)Working Capital Cycle:- In a manufacturing concern, the
working capital cycle starts with
the purchase of raw material and ends with the realization of
cash from the sale of finished
products. This cycle involves purchase of raw materials and
stores, its conversion into stocks of
finished goods through work-in-progress with progressive
increment of labour and service costs,
conversion of finished stock to sales, debtors and receivables
and ultimately realization or cash
and this cycle continues again from cash to purchase of raw
material and so on. The speed with
which the working capital completes once cycle determines the
requirement of working capital
longer the period of the cycle larger is the requirement of
working capital.
7)Rate of Stock Turnover:- There is a high degree of inverse
co-relationship between the
quantum of working capital and the velocity or speed with which
the sales are affected. A firm
having a high rate of stock turnover will need lower amount of
working capital as compared to a
firm having a low rate of turnover.
8)Credit Policy:- The Credit Policy of a concern in its dealings
with debtors and creditors
influence considerably the requirement6s of working capital a
Concern that purchases its
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requirements on credit and sells its products /services on cash
requires lesser amount of working
capital. On the other hand a concern buying its requirements for
cash and allowing credit to its
customers, shall need larger amount of working capital as very
huge amount of funds are bound
to be blocked up in debtors or bills receivables.
9)Business Cycles:- Business cycle refers to alternate expansion
and contraction in general
business activity. In a period of boom i.e., when the business
is prosperous, there is a need for
larger amount of working capital due to increase in sales, rise
in prices, optimistic expansion of
business, etc. on the contrary in the times of depression i.e.,
when there is a down swing of the
cycle, the business contracts sales decline, difficulties are
faced in collections from debtors and
firms may have a large amount of working capital lying idle.
10)Rate of Growth of Business :- the working capital
requirements of a concern increase with
the growth and expansion of its business activities. Although,
it is difficult to determine the
relationship between the growth in the volume of business and
the growth in the working capital
of a business. Yet it may be concluded that for normal rate of
expansion in the volume of
business, we may have retained profits to provide for more
working capital but in fast growing
concerns, we shall require larger amount of working capital.
11)Earning Capacity and Dividend Policy:- Some firms have more
earning capacity than
others due to quality of their products, monopoly conditions,
etc. such firms with high earning
capacity may generate cash profits form operations and
contribute to their working capital. The
dividend policy of a concern also influences the requirements of
its working capital.
12)Price Level Changes:- Changes in the price level also affect
the working capital
requirements. Some firms may be affected much while some others
may not be affected at all
by the rise in prices.
13)Tax Level:- The first appropriation out of profits is payment
or provision for tax. Taxes
have to be paid in advance on the basis of the profit of the
preceding year. Tax liability is, in a
sense, short term liability payable in cash. An adequate
provision for tax payments is, therefore,
an important aspect of working capital planning. If tax
liability increases, it leads to an increase
in the requirement of working capital and vice versa.
14)Other Factors;-Certain other factors such as operating
efficiency, management ability,
irregularities to supply, import policy, asset structure,
importance of labour, banking facilities,
etc., influence the requirements of working capital.
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4.7 WORKING CAPITAL CYCLE / OPERATING CYCLE
The working capital requirement of a firm depends, to a great
extent upon the operating cycle of
the firm. The duration of time required to complete the sequence
of events right from purchase
of raw material goods for cash to the realization of sales in
cash is called the operating cycle or
working capital cycle. It can be determined by adding the number
of days required for each
stage in the cycle. In case of manufacturing concerns, working
capital is required to cater to the
following needs of business in order:
a)Operating Cycle Manufacturing Firm:-
1. Raw materials are to be purchased for cash.
2. Production process converts raw materials into
work-in-process.
3. Work-in-process in converted into finished goods, during
course of time through
production process.
4. Finished goods are converted into accounts receivable
(debtors and bills receivable)
through sale.
5. Accounting receivable are realized into cash in due course of
time.
Operating Cycle of a Manufacturing concern
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The above operating cycle is repeated –again and again over the
period depending upon
the nature of the business and type of product etc. the duration
of the operating cycle for the
purpose of estimating working capital is equal to the sum of the
duration allowed by the
suppliers.
b) Operating Cycle of Non-Manufacturing Firm:- Non-Manufacturing
firms are wholesalers,
retailers, service firms which do not have manufacturing
process. They will have direct
conversion of cash into finished goods and then into cash. In
other words, they purchase
finished goods from manufacturing firm and sell them either cash
or credit if they sell goods on
credit the process will like in the following figure.
Operating Cycle of a Trading Concern
Finished Goods (1)
Sale
s (2
)
Debtors (3)
Cas
h
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c) Operating Cycle of Service and Finance Firm
Working capital cycle can be expressed as: =R+W+F+D-C where
R = Raw material storage period = Average Stock of raw
materials
Average cost of production per day
W = Work in progress holding period = Average work in progress
inventory
Average cost of production per day.
F = Finished goods storage period =Average stock of finished
goods
Average cost of goods sold per day
D = Debtor collection period = Average Book Debts
Average credit sales per day
C = Credit period availed = Average trade creditors
Average credit purchase per day
Debtors Cash
Operating Cycle of Service and Finance Firm
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4.8. MANAGEMENT OF CURRENT ASSETS
Working capital management involves the management and control
of the gross current assets.
And the current assets mainly comprise cash, sundry debtors
(also known as accounts receivable
(ARs) and bills receivable (BRs)) and inventories. Thus the
working capital management
comprises the management of all those components individuals and
collectively too.
Working capital refers to the excess of current assets over
current liabilities.
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A. CASH MANAGEMENT: identify the cash balance which allows for
the business to
meet day to day expenses but reduces cash holding costs.
B. RECEIVABLES MANAGEMENT: identify the appropriate credit
policy i.e., credit
terms which all attract customers such that any impact on cash
flows and the cash
conversion cycle will be offset by increased revenue and hence
return on capital.
C. INVENTORY MANAGEMENT: identify the level of inventory which
allows for
uninterrupted production but reduces the investment in raw
materials and minimizes re-
ordering costs and hence increases cash flow.
A.CASH MANAGEMENT: Cash is one of the current assets of a
business. It is needed at all
times to keep the business going. A business concern should
always keep sufficient cash for
meeting its obligations. Any shortage of cash will hamper the
operation of a concern and any
excess of it will be unproductive. Cash is the most unproductive
of all the assets. While fixed
assets like capacity cash in hand will not add anything to the
coercer. Cash in a broader sense
includes coins currency notes cheques bank drafts and also
marketable securities and time
deposits with banks.
4.9 FACTORS DETERMINING CASH NEEDS
The amount of cash for transaction requirements is predictable
and depends upon a variety of
factors which are as follows.
1. Credit Position of The Firms: the credit position influences
the amount of cash required in
two distinct ways.
If a firms credit position is sound it is not necessary to carry
a large cash reserve for
emergencies.
Components of working capital management
Management of cash Management of receivables
Management of inventory
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If a firm finance its inventory requirements with trade credit
its cash requirements are
considerably smaller since the firm can synchronize the credit
terms it gives to its
customers with eh terms it receives.
2. Status Of Firm’s Receivable: the amount of time required for
a firm to convert its
receivable into cash also affects the amount of cash needed and
of course, reduces total
working capital employed. In other words the longer the credit
terms the slower the turn
over. When flow out is not synchronized with turn over a firm
must carry amounts of cash
relatively larger than would otherwise be required.
3. Status of Firms Inventory Account: the status of a firms
inventory account also affects the
amount of cash tied up at any one time. For example, if one
business firm carries two
months inventory on hand and another firm carries only one
month’s supply the former has
twice as much investment in inventory and will normally be
called up on to maintain a
larger investment in cash in order to finance its
acquisition.
4. Nature of Business Enterprise: the nature of firms demand
definitely affects the volume of
cash required. For example, a firm whose demand is volatile
needs a relatively larger cash
reserve than one whose demand is stable.
5. Management’s Attitude towards Risk: a more conservative
management will hold a larger
cash reserve than one that is less conservative. The former
usually demands more liquidity
than the latter and consequently does not experience the same
degree of efficiency.
6. Amount of Sales In Relation To Assets: another characteristic
affecting the level of cash is
the amount of sales in relation to assets. Firms with large
sales relative to fixed assets are
required to carry larger cash reserves. This is the result of
having larger sums invested in
inventories and receivable.
7. Cash Inflows and Cash Outflows: every firm has to maintain
cash balance because its
expected inflows and outflows are not always synchronized. The
timings of the cash inflows
may not always match with the timing of the outflows. Therefore
a cash balance is required
to fill up the gap arising out of difference in timings and
quantum of inflows and outflows.
8. Cost of Cash Balance: another factor to be considered while
determining the minimum
cash balance is the cost of maintaining excess cash or of
meeting shortage of cash. There is
always an opportunity cost of maintaining excessive cash
balance. If a firm is maintaining
excess cash then it is missing the opportunities of investing
these funds in a profitable way.
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5.2 OBJECTIVES OF CASH MANAGEMENT
Cash management refers to management of cash balance and the
bank balance including the
short terms deposits. For cash management purposes the term cash
is used in this broader sense,
i.e., it covers cash equivalents and those assets which are
immediately convertible into cash.
Even if a firm is highly profitable its cash inflows may not
exactly match the cash outflows. He
has to manipulate and synchronize the two for the advantage of
the firm by investing excess
cash if any as well as arrangement funds to cover the
deficiency.
1. Meeting the Payment Schedule: in the normal course of
business firms to make
payments of cash on a continuous and regular basis to suppliers
of goods, employees and
so on. At the same time there is a constant inflow of cash
through collections from
debtors. The importance of sufficient cash to meet the payment
schedule can hardly be
over emphasized.
2. Minimizing Funds Committed To Cash Balance: the second
objectives of cash
management are to minimize cash balances. In minimizing the cash
balances two
conflicting aspects have to be reconciled. A high level of cash
balances ensures prompt
payment together with all the advantages. But it also implies
that large funds will remain
idle as cash is a non earning asset and the firm will have to
forego profits. A low level of
cash balances on the other hand may mean failure to meet the
payment schedule. The
aim of cash management should be to have an optimal amount of
cash balances.
5.3 CASH BUDGET
It is an estimate of cash receipts from all sources and cash
payments for all purposes and the net
cash balances during the budget period. It ensures that the
business has adequate cash to meet its
requirements as and when these arise. It indicates cash excesses
and shortfalls so that action may
be taken in advance to invest any surplus cash or to borrow
funds to meet any shortfalls.
According to GUTHMEN AND DOUGAL cash budget is an estimate of
cash receipts and
disbursements for a future period of time.
5.3.1 PURPOSE OF CASH BUDGET
1. Helps in Determining Future Cash Requirements: cash budget
helps in estimating the
future cash requirements. It is estimated how much cash will be
needed for different activities in
a period.
2. Help In Making Plans: cash budget helps in making plans. It
gives reality and possibility on
plans.
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3. Planning Suitable Investment Of Surplus Cash: in cash budget
declared as surplus as per
the cash budget the financial manager will study the amount of
surplus future requirements of
cash and also take into consideration the chance factor.
4. Helps In Cash Control And Liquidity Of The Enterprises: by
preparing cash budget one
can controlled over cash misuse of cash be stopped by preparing
cash budget. It also helps the
liquidity of cash.
PARTICULARS JAN FEB MAR
1. opening cash balance
2. estimated cash receipts
Cash sales
Cash collection from debtors
Interest received from investments
Cash inflow on issue of new securities
Raising of loans
Sales of assets
divided
XXX XXX XXX
3. total receipts available during the month (1+2)
4. estimated cash payments
payment for cash purchases
payment to Sunday creditors for credit purchases
payment for wages and salaries
payments for other administrative expenses
payment in the nature of capital expenditure
loan repayment
dividend payment
payment of interest on loan
5. total cash payments
6. closing cash balance (3-4)
XXX XXX XXX
XXX XXX XXX
XXX XXX XXX
XXX XXX XXX
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EXAMPLES: Prepare a cash budget for the months of June, July,
and august 2014 from the
following information:
opening cash balance in June 7,000
cash sales for June 20,000 July 30,000 and august 40,000
wages payable 6,000 every month
interest receivable 500 n the month of august
Purchase of furniture for 16,000 in July.
Cash purchases for June 10,000 July 9,000 and august 14,000.
Cash budget
(For the period June to August 2014)
Particulars June July August
opening cash balance
add: cash receipts (estimated)
cash sales
interest
7,000
20,000
11,000
30,000
10,000
40,000
500
Total receipts 27,000 41,000 50,500
Less: cash payments (estimated)
Cash purchases
Payment of wages
Purchases of furniture
10,000
6,000
9,000
6,000
16,000
14,000
6,000
Total payment 16,000 31,000 20,000
Closing balance (surplus/deficit)
(total receipts – total payments)
11,000
10,000
30,500
Note: the closing cash balance in June will be the opening cash
balance in July
6. RECEIVABLES MANAGEMENT
Accounts receivables are simply extensions of credit to the
firm’s customers allowing
them a reasonable period of time in which to pay for the goods.
Most firm treat account
receivables as a marketing tool to promote sales and profits.
The receivables constitute a
significant portion of the working capital and are important
elements of it.
The receivables emerge whenever goods are sold on credit and
payments are deferred by
customers. Receivables are a type of loan extended by a seller
to the buyer to facilitate
the purchase process. As against the ordinary type of loan the
trade credit in the form of
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receivable is not a profit making service but an inducement or
facility to the buyer
customer of the firm.
According to HAMPTON receivables are asset accounts representing
amount owned to
firm as a result of sale of goods or service in ordinary course
of business.
According to Bobert N. Anthony accounts receivables are amounts
owed to the business
enterprise, usually by its customers. Sometimes it is broken
down into trade accounts
receivables; the former refers to amounts owed by customers and
the latter refers to
amounts owed by employees and others.
Thus receivables are forms of investment in any enterprise
manufacturing and selling
goods on credit basis large sums of funds are tied up in trade
debtors. Hence a great deal
of careful analysis and proper management is exercised for
effective and efficient
management of receivables to ensure a positive contribution
towards increase in turnover
and profits.
Receivables management is the process of making decisions
relating to investment in
trade debtors. Certain investment in receivables is necessary to
increase the sales and the
profits of a firm. But at the same time investment in this asset
involves cost
considerations also. Further there is always a risk of bad debts
too.
6.1 OBJECTIVES OF RECEIVABLES MANAGEMENT
The objectives of receivables management are to improve sales
eliminate bad debts and reduce
transaction costs incidental to maintenance of accounts and
collection of sale proceeds and
finally enhance profits of the firm. Credit sales help the
organization to make extra profit. It is a
known fact firms charge a higher price when sold on credit
compared to normal price.
1. Book Debts Are Used As A Marketing Tool For Improvement Of
Business: if the firm
wants to expand business it has to necessarily sell on credit.
After a certain level additional sales
do not create additional production costs due to the presence of
fixed costs. So the additional
contribution totally goes towards profit improving the
profitability of the firm.
2. Optimum Level of Investment In Receivables: to support sales
it is necessary for the firm to
make investment in receivables. Investment in receivables
involves costs as funds are tied up in
debtors. Further there is also risk in respect of bad debts too.
On the other hand receivables bring
returns. If so till what level investment is to be made in
receivables? Investment in receivables is
to be made till the incremental costs are less than the
incremental return.
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In the other words the objectives of receivables management is
to promote sales and profits until
that point is reached where the return on investment in further
funding receivables is less than
the cost of funds raised to finance that additional credit.
6.2 FACTORS AFFECTING THE SIZE OF RECEIVABLES
The following factors directly and indirectly affect the size of
receivables.
1. Stability of Sales: in the business of seasonal character
total sales and the credit sales will go
up in the season and therefore volume of receivable will also be
large. On the other hand if a
firm supplies goods on installment basis its balance in
receivables will be high.
2. Size and Policy of Cash Discount: it is also important
variable in deciding the level of
investment in receivables. Cash discount affects the cost of
capital and the investment in
receivables. If cost of capital of the firm is lower in
comparison to the discount to be allowed
investment in receivables will be less. If both are equal it
will not affect the investment at all. If
cost capital is higher than cash discount the investment in
receivables will be larger.
3. Bill Discounting and Endorsement: if firm has any arrangement
with the banks to get the
bills discounted or if they re-endorsed to third parties, the
level of investment in assets will be
automatically low. If bills are honored on due dates the
investment will be larger.
4. Terms Of Sale: a firm may affect its sales either on cash
basis or on credit basis. As a matter
of fact credit is the soul of a business. It also leads to
higher profit level through expansion of
sales. The higher the volume of sales made on credit the higher
will be the volume of receivables
and vice-versa.
5. Volume of Credit Sales: it plays the most important role in
determination of the level of
receivables. As the terms of trade remains more or less similar
to most of the industries. So a
firm dealing with a high level of sales will have large volume
of receivable.
6. Collection Policy: the policy practice and procedure adopted
by a business enterprise in
granting credit deciding as to the amount of credit and the
procedure selected for the collection
of the same also greatly influence the level of receivables of a
concern. The more lenient or
liberal to credit and collection policies the more receivables
are required for the purpose of
investment.
7. Collection Collected: if an enterprise is efficient enough in
encasing the payment attached to
the receivables within the stipulated period granted to the
customer. Then it will opt for keeping
the level of receivable low. Whereas enterprise experiencing
undue delay in collection of
payments will always have to maintain large receivables.
8. Quality of Customer: if a company deals specifically with
financially sound and credit
worthy customers then it would definitely receive all the
payments in due time. As a result the
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firm can comfortably do with a lesser amount of receivables than
in case where a company deals
with customers having financially weaker position.
7. INVENTORY MANAGEMENT
The dictionary meaning of inventory is stock of goods. The word
inventory is understood
differently by various authors. In accounting language it may
mean stock of finished goods only.
In a manufacturing concern it may include raw materials work in
process and stores etc.
INTERNATIONAL ACCOUNTING STANDARD COMMITTEE (I.A.S.C):
defines
inventories as tangible property,
Held for sale in the ordinary course of business
In the process of production for such sale or
To be consumed in the process of production of goods or services
for sale.
According to Bolten S.E., inventory refers to stock pile of
product a firm is offering for sale and
components that make up the product.
7.1 NATURE/ELEMENTS OF INVENTORY
1. Raw Material: It includes direct material used in manufacture
of a product. The purpose of
holding raw material is to ensure uninterrupted production in
the event of delaying delivery. The
amount of raw materials to be kept by a firm depends on various
factors such as speed with
which raw materials are to be ordered and procured and
uncertainty in the supply of these raw
materials.
a. Direct Material: direct material is the primary
classification for raw materials in
manufacturing operations. It is directly related to the final
product. It is only the material
that after manufacturing processes are applied ships out to a
distributor or the final
customer. If e.g., company manufacture hammers then steel would
be its primary direct
material.
b. Indirect Material: indirect material is the class of material
in the manufacturing process
that does not actually ship to the customer as part of the final
product.
For Example, The gas used to heat the furnaces that melt the
steel in the manufacture of
hammers is an indirect material. Similarly the water that cools
the metal is also an indirect
material
2. Work In Progress: in includes partly finished goods and
materials held between
manufacturing stages. It can also be stated that those raw
materials which are used in production
process but are not finally converted into final product are
work in progress.
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3. Consumable: consumables are products that consumers buy
recurrently i.e., items which get
used up or discarded. For example, consumable office supplies
are such products as paper pens,
file folders post it notes computer disks and toner or ink
cartridges.
4. Finished Goods: the goods ready for sale or distribution
comes under this class. It helps to
reduce the risk associated with stoppage in output on account of
strikes breakdowns shortage of
material etc.
5. Stores And Spares: this category includes those products
which are accessories to the main
products produced for the purpose of sale. For example, stores
and spares items are bolt nuts
clamps, screws, etc.
7.2 FACTORS AFFECTING INVETNORY MANAGEMENT
1. Characteristics of the Manufacturing System: the natures of
the production process the
product design and production planning and plant layout have
significant affect on inventory
policy.
a. Degree Of Specialization And Differentiation Of The Products
At Various Stages: the
degree of changes in the nature of the product from raw material
to final product at various
stages of transformation viz. final assembly and packaging
determines the nature of
inventory control operation, for example, if nature of product
remains more or less same at
various stages of production then economics can be achieved by
keeping the right balance
of stock of semi finished product.
b. Process Capability and Flexibility: process capability is
characterized by processing
time of various operations example; the replenishment lead time
directly influences the
size of inventory. Inventory policy should aim towards balancing
the production flexibility
capability inventory levels and customer service needs.
c. Production Capacity and Storage Facility: the capacity of
production system as well as
the nature of storage facilities considerably affects the
inventory policy of an organization
e.g., capacity for heating oil production in an oil refinery is
governed in part by its
distribution system. Similarly production the cost of facility
is high then it sets a limit on
the storage capacity.
d. Quality Requirements: quality is the performance of the
product as per the commitment
made by producer to the customer. The qualities required for
various factors are quality of
material manpower machine and management. The quality
requirements of material
directly affect the inventory decision.
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e. Nature of the Production System: it is characterized by the
number of manufacturing
stages and the inter relationship between various production
operations e.g, in product line
system inventory control is simpler than in job type system.
2. Amount of Protection against Storages: there is always
variation in demand and supply of
product. The protection against such unpredictable variations
can be done by means of buffer
stocks.
a. Changes In Size And Frequency Of Orders: The amount of
product sold in large number
of orders of small size can be operated with fewer
inventories.
b. Unpredictability Of Sales: if there are too many fluctuations
in demand of product then
these can be held only by flexible and large capacity of
inventory operations.
c. Costs Associated With Failure To Meet Demands: When there is
heavy penalty on any
delay in fulfillment of any order then inventory should be
large.
d. Accuracy Frequency And Detail Of Demand Forecasts:
fluctuations in stock exist when
forecasts are not exact. The responsibility of forecast errors
for inventory needs should be
clearly recognized.
e. Breakdown: protection against breakdown or other
interruptions in production
3. Organizational Factors: there are certain factors which are
related to the policies traditions
and environment of any enterprise.
Labor relation policies of the organization
Amount of capital available for stock
Rate of return on capital available if invested elsewhere.
4. Other Factors: these are related to the overall business
environment of the region viz,
Inflation
Strike situation in communication facilities
Wars or some other natural calamities like famines floods
etc.
7.3 INVENTORY MANAGEMENT TECHNIQUES
Several techniques of inventory management are in use and it
depends on the convenience of the
firm to adopt any of the techniques. What should be stressed
however is the need to cover all
items of inventory and all stages i.e, from the stage of receipt
from suppliers to the stage of their
use. The techniques most commonly used are the following.
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1. ECONOMIC ORDER QUANITY (EOQ): EOQ is a quantity of inventory
which can
reasonably be ordered economically at a time. It is also known
as standard order quantity,
economic lot size, or economical ordering quantity. In
determining this point ordering costs and
carrying costs are taken into consideration. Ordering costs are
basically the cost of getting an
item of inventory and it includes cost of placing an order.
Either of these two costs affects the
profits of the firm adversely and management tries to balance
these two costs.
The balancing or reconciliation point is known as economic order
quantity. The economic order
quantity can also be determined with the help of a graph.
Assuming that inventory is allowed to
fall to zero and then immediately replenished the average
inventory becomes EOQ/2. EOQ
model can be presented as in. it can be seen that ordering cost
of an item is decreasing as the size
the order is increasing. This happens because total number of
orders for a particular item will
decrease resulting in decrease in total order cost. As a result
carrying cost is increasing because
firm keeps more items in stock. The trade off of these two costs
is attained at a level at which
total annual cost is least. At this level order size is
designated as economic order quantity.
Inventory management techniques
Economic order quantity
ABC analysis
Just in time
Reorder levels
VED analysis
Inventory turnover
Inventory control of spares and slow moving items
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The quantity may be calculated with the help of the following
formula
2DA
EOQ =
h
Where, D = annual quantity used (in limits)
A = cost of placing an order (fixed cost)
H = cost of holding one unit
ASSUMING OF EOQ
While calculating EOQ the following assumptions are made,
Supply of goods is satisfactory. The goods can be purchased
whenever these are needed.
The quantity to be purchased by the concern is certain
The prices of goods are stable. It results to establish carrying
costs.
EXAMPLE 6, a company uses annually 12,000 units of raw material
costing 1.25 pr unit.
Placing each order costs 15 and the carrying costs are 15% per
year per unit of the average
inventory. Find the economic order quantity.
SOLUTION: Here
D = 12,000 units
A = 15 per unit
C = 1.25 per unit
Now h = ic = 15% per year per unit of average inventory
= 0.15 x 1.25 = 0.1875
2DA
EOQ =
H
2x12000x15
EOQ = = 1,385 units
0.1875
2. RE-ORDERED LEVEL: this is that level of materials at which a
new order for supply of
materials is to be placed. The concept of re-order point is
basically related with lead time
demand. The problem is that demand can never be accurately
projected over the lead time. This
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point is fixed somewhere in between the maximum and minimum
inventory levels in such a way
that the quantity of materials available between the minimum and
this point may be sufficient to
meet the production requirement upon the time fresh suppliers
are received. This point can be
determined by taking into account the following.
Rate of usage, i.e, average quantity consumed in one unit of
time, i.e, day week etc.
Safety or buffer stock level.
There are a number of methods for demand forecasting. Once we
know the demand in lead time
re-order level can be easily determined mathematically.
3.ABC ANALYSIS:
4. VED analysis: in VED analysis the items are classified on the
basis of their critically to the
production process or other services. In the VED classification
of materials V stands for vital
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items without which the production process would come to a
standstill. The VED analysis is
done mainly in respect of spare parts.
5. JUST IN TIME: just in time production is defined as a
philosophy that focuses attention on
eliminating waste by purchasing or manufacturing just enough of
the right items just in time. It
is a Japanese management philosophy applied in manufacturing
which involves having the r ight
items of the right quality and quantity in the right place and
at the right time.
6. INVENTORY TURNOVER: this ratio is computed by dividing the
cost of goods sold by the
average inventory. This ratio is usually expressed as x number
of tim