WC

Components of working capital

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1. INVENTORY MANAGEMENT

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Inventory Liquidity Liquidity lags Creation Storage Sale

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Purpose Behind Maintaining Inventories To avoid lost sales To gain quantity discounts To reduce ordering costs To achieve efficient production run

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Classification Of Inventories

Raw Materials Inventory: Consists of basic inputs that are to be converted into finished goods. Stores and Spares: Accessories to the main products Work-in-process Inventory: Consists of semi-manufactured products Finished Goods Inventory: Consists of completely manufactured products that are ready for sale.5

Costs Associated With Inventories DIRECT COSTS: Material costs Ordering costs: purchase requisition, order, follow up etc Carrying costs: rent of warehouse, insurance, obsolescence etc INDIRECT COSTS Cost funds tied up in inventories Cost of running out of goods

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Objective of Inventory ManagementObjective: To maintain an optimum level of inventory at which the total inventory costs are minimized. It involves trade-off between two conflicting goals: - To maintain a adequate level of inventory for ensuring efficient and smooth production and sales operations. - To maintain a minimum investment in inventories in order to maximize profitability.

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Inventory Management Techniques Economic Order Quantity Reorder Point Subsystem Stock-level Subsystem

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Economic Order Quantity (EOQ)EOQ is the optimal order size that minimizes the total costs (ordering costs + carrying costs) associated with maintaining inventory. EOQ = 2UFPC

where, U is the annual usage Q is the quantity ordered F is the fixed cost per order P is the purchase price per unit C is the carrying costs expressed as a % of purchase price

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ECONOMIC ORDER QUANTITY (EOQ)

Total costs Carrying Costs Costs

Ordering costs

Q*(EOQ)

Order Quantity (Q)10

Example: The annual usage of material for Beta Ltd. is 8,500 units. The carrying cost is 2% of the purchase price. The purchase price is Rs. 85 and the Fixed cost per order is Rs. 550. What quantity should the firm order so that the total costs are minimized?

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Solution: EOQ = =

2UF C

2 v 8500 v 550 85 v 0.02

= 2345.21 i.e. 2345 units approximately.

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Using EOQ approach for making decisions about utilizing discount Notations Q dMinimum quantity to be ordered for utilizing discount : Q* : Economic Order Quantity If Q* > Q, then EOQ is the quantity to be ordered If Q> Q* , then order Q only if the net incremental benefits are positive. Net Incremental benefits = UD + where U is the annual usage; D is the discount offered U U * Q d Q

F

-

Qd D)C Q*PC (P 2 2

F is the cost per order P is the purchase price 13

Example: The supplier of KR Ltd. is offering discount of 2%, if the firm orders 2,800 units. The annual usage of KR Ltd. is 8,000 units and the Fixed cost per order is Rs. 650. The purchase price of each unit is Rs. 90 and the carrying cost per unit is 4% of the inventory. Should the firm accept the cash discount offered by the supplier?

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Solution: EOQ =

2UF C

=

2 v 8000 v 650 0 .04 v 90

= 1,699.60

}

1,700 units.

Net profit if the discount is utilized is computed as: UD + U Q* U v F Q

-

Q (P 2

D)C

Q * PC 2

= 8000 x 1.8 +

8000 8000 2800(90 1.8)0.04 1700 v 90 v 0.04 v 650 - 2 2 1700 2800

= 14,400 + 1201.68 1879.20 = Rs. 13,722.48. Hence, the firm should accept the discount as the incremental profit associated with it is positive.15

Reorder Point SubsystemReorder point: The inventory level at which an order should be placed to replenish the inventory. It depends on: Inventory required during lead time. Minimum level of inventory held to prevent shortage Reorder Point = Normal consumption during lead time + Safety stock Reorder Point = Avg. daily usage rate x lead time(days) + Safety stock Reorder Point = S v L F v S v R v L where, S is the usage in units F is the stock out acceptance factor L is the lead time (days) R is the avg. number of units per order16

STOCK-LEVEL SUBSYSTEMFunctions of a stock-level subsystem: Keeping a record of the existing level of inventory Issuance of goods Maintaining record of the arrival of goods.

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ABC SYSTEMUnder this system more control is exercised over items which are more expensive. Inventories are classified into three categories: Category A: Items included in this class are those that require the largest investment. Therefore these items require more rigorous and intensive control. Category B: Items in this group are comparatively less expensive than the items in the group B and require relatively less control. Category C: Items in this group involve relatively small investments although the number of items will be fairly large. Minimum control is required for items in this category.

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Example: A firm has 7 different items in its inventory. The average number of each of these items held, along with their unit costs are listed below. Suggest a break down of the items into A,B and C classifications using the ABC inventory system. Item Number Average number of units inventory Average cost per unit (Rs.)

1 2 3 4 5 6 7

20,000 10,000 32,000 28,000 60,000 30,000 20,000

60.80 102.40 11.00 10.28 3.40 3.00 1.3019

Solution:

Item Units

% of total Unit Cost (Rs.) 10 5 16 14 30 15 10 15 30 55 60.80 102.40 11.00 10.28 3.40 3.00 1.30

Total Cost

% of total costs 70 20

1 2 3 4 5 6 7

20,000 10,000 32,000 28,000 60,000 30,000 20,000

12,16,000 38.00 10,24,000 32.00 3,52,000 11.00 2,88,000 9.00 2,04,000 6.38 90,000 2.80 26,000 0.82

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INVENTORY PRICING TECHNIQUES First In First Out (FIFO) Method Last In First Out (LIFO) Method Weighted Average Cost Method Standard Price Method Replacement/Current Price Method

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Valuation Of Work-in-process And Finished Goods Inventory It depends on: (a) Method used for pricing raw materials: (i.e. FIFO, LIFO , Standard price method, weighted average cost method and replacement method). (b) Method used for apportioning the fixed manufacturing overheads: - Direct costing: Fixed manufacturing overheads are charged directly to income statement and are not reflected in inventory valuation. - Absorption costing: Fixed manufacturing overheads are treated as product costs and are reflected in inventory valuation.22

2. RECEIVABLES MANAGEMENT

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Purpose of Maintaining Receivables Helps the company in increasing sales Leads to increase in profit as credit sales have higher profit margin Helps in maintaining sales in a competitive environment

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Objective of Receivables Management To analyze cost of maintaining receivables To assess probability of the receivables becoming bad debts To assess creditworthiness of the clients before extending credit To perform a cost-benefit analysis before extending credit to the customers

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Costs Associated With Receivables1. Capital costs: Cost of funds locked up in receivables 2. Administrative costs: Costs involved in maintaining records related to receivables 3. Collection costs: Costs associated with collecting the trade debts at the end of the credit period. 4. Default costs: Loss to be borne by the company if the customer defaults.

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Aspects Related to Receivables Management Credit Policy: Aims at maintaining a proper balance between the variables associated with receivables, like credit standard, credit period, cash discount to be offered and collection program Credit Evaluation: Helps in analyzing the creditworthiness of the customer. Credit Granting Decision: Helps in performing a cost-benefit analysis before extending credit to a customer Monitoring Receivables: Aims at reviewing the extent of collections made by the firm.

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CREDIT POLICYVariables associated with credit policy a. Credit standards b. Credit Period c. Cash Discount d. Collection Program

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a. Credit StandardsThey are criteria set by the firm for extending credit to the clients Implications of stringent credit standards Benefits Lower bad debts Lower administrative costs Lower investment in receivables Costs Reduced sales Implications of lenient credit standards Benefits Increased sales Costs Higher bad debts Higher administrative costs Higher investment in receivables29

b. Credit PeriodThe duration for which cash payment for the goods is deferred Implications of increasing credit period Benefits Increase in sales Costs Higher investment in receivables Higher bad debts Implications of reducing the credit period Benefits Lower investment in receivables Lower bad debts Costs Decrease in sales

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Effect of Relaxing / Increasing the Credit PeriodIncremental benefits associated with relaxing credit standards: 1. Increase in contribution = S(1 V) where S is change in sales & V is the variable-cost to sales ratio Incremental costs associated with relaxing credit standards 1. Increase in cost of investing in receivables = k I, where k is the cost of funds and I is the increase in investment S0 S I = 360 (ACP(new) ACP(old)) V 360 ACP(new) Increase in bad debt costs B= bn (S0 + S) b0S0 where bn and b0 are the new and old bad debt loss ratios. S0 is the original sales level Net incremental benefit ( P)= S (1-V) k I - B Decision criterion : Relax credit standards only if P is positive 2.

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Example: The existing sales of A Ltd. is Rs. 30 lakh and the company is currently having an average collection period of Net 20 days. The contribution to sales ratio for the company is 30%. It is planning to increase the average collection period to Net 30 days. Though this will increase the sales by Rs. 3 lakh, the bad debt losses which were previously 2% would increase to 5%. If the cost of capital for the company is 10%, determine whether the company should extend the credit period or not?

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3,00,000 (10.7)30,00,000 3,00,000 (30 20) 0.70 v v 30 ) 0.10 ( 360 360

[(0.05 x (30,00,000 + 3,00,000) 0.02 x 30,00,000] = Rs. 25,083.33.

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c. Cash DiscountThe discount on price of the material that is given to the customer if payment is made before the stipulated period Implications of introducing/ increasing cash discount Benefits Additional sales Reduction in amount locked up in receivables Costs Loss due to cash discount offered

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Effect of Increasing the Cash DiscountIncremental benefits associated with increasing cash discount:1. 2. Increase in contribution = S(1-V) Decrease in cost of financing receivables: k I where I is the decreases in investment in receivables = S0 S v CP(new) v ( CP(old) CP(new)) V 360 360

Incremental costs associated with increasing cash discount:1. Increase in cash discount = pn (So + S) dn p0S0d0 where p0 and pn are the proportions of discount sales before and after liberalizing the credit terms. D0 and dn are the old and new discount rates S0 is the original sales level

Cash discount should be given only if incremental benefits are more than incremental costs. 35

Example: R. Ltd is presently having sales of Rs. 15 lakh and is extending credit terms of 2/15 Net 40. Its average collection period is 30 days and 40% of its customers avail the discount facility. In order to encourage quick payment, the company is planning to liberalize its credit terms by increasing the cash discount to 3/15 Net 40. It is assumed that this new policy will increase sales by Rs. 1,00,000 and 60% of the customers will avail the cash discount under the new policy. The companys average collection period is expected to decline to 20 days. If the firms contribution to sales ratio is 40% and the cost of funds for the firm is expected to be 10%, should the firm increase the cash discount or not?

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1,00,000 15,00,000 v (30- 20) 0.60v v 20 ] 1,00,000 (1-0.60) + 0.10 x [ 360 360

[0.60 x(15,00,000 + 1,00,000)x 0.03 ( 0.40 x 15,00,000 x 0.02)] = 40,000 + 3833.33 - 16800 = Rs. 27033.33.

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d. Collection ProgramThe effort and policy followed by the firm in collecting receivables Implications of a stringent collection policy Benefits Lower bad debts Lower average collection period Lower investment in receivables Implications of a lenient collection policy Benefits Increased sales Lower collection expenses

Costs Higher bad debts Costs Might adversely affect company- Higher average collection period customer relationship & reduce Higher investment in receivables sales. Higher collection expenses 38

Example: D Ltd. is not satisfied with its present collection program and is planning to introduce a new collection policy that will help in timely collection of receivables. The current sales level of the company is Rs. 50 lakh and the company is assuming that the level of sales is not likely to get affected by the new policy. The terms and conditions under the existing and new collection policy are given in the following table: Existing Collection Policy Average Collection Period 45 days Bad Debts 5% Collection Expenses Rs. 65,000 New Collection Policy 30 days 3% Rs. 1,96,000

If the cost of funds for the firm is 8%, should the company introduce the new policy or not?39

Incremental benefits: 1. Savings in cost of carrying receivables = Cost of carryingreceivables under the existing collection policy Cost of carrying receivables under the new collection policy

= 50 ,00 ,000 v 45 days x 0.08 - 50 , 00 ,000 v 30 days x 0.08 =16,666.67.360 360

2. Decrease in bad debt losses = New bad debt percentage x totalsales after introduction of the policy Old bad debt percentage x Old level of sales = 0.05 x 50,00,000 0.03 x 50,00,000 = Rs. 1,00,000. Hence, total incremental benefits = 1,00,000 + 16,666.67 = Rs. 1,16,666.67.

Incremental costs:Increase in collection expenses = 1,96,000 65,000 = Rs. 1,31,000.

Net profit = Incremental benefits incremental costs = 1,16,666.67 1,31,000 = Rs. 14,333.33.

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CREDIT EVALUATIONFactors: character, capacity, collateral Techniques / Sources for evaluating creditworthiness Financial statements of the customer Bank references Firms Experience Numerical Credit Scoring Attribute Past payment trend Current ratio Net profit margin Weights 1 2 3 Weighted score 0.4 * 0.40 x 2 = 0.80 0.3 * 0.30 x 3 = 0.90 0.2 0.20 x 2 = 0.40 * Rating index =0.80+0.90+0.40 = 2.1 41

CREDIT GRANTING DECISION Decision-tree ApproachR- C

Customer Pays (p) Offer Credit Customer Defaults (1-p)

Refuse Credit 0

-C

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MONITORING RECEIVABLESTechniques For Monitoring Receivables Days Sales Outstanding : Ageing Schedule: Collection Matrix:

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Days Sales OutstandingIndicates the average number of days sales outstanding at a particular time. ccounts receivable at the time chosen It is computed as: verage daily sales

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Ageing Schedule It reflects the age-wise distribution of accounts receivable at a given time. Example: Following is the ageing schedule for IQ Ltd. which has Rs. 100,000 in receivables: Age of account Amount (in Rs.) 0-10 days 11-60 days 61-80 days Over 80 days 50,000 25,000 20,000 5,000 Total: 100,000 % of total outstanding accounts receivables 50% 25% 20% 5%

If a particular firm has a credit period of 60 days then as per the above ageing schedule, 25% of the firms accounts are yet to be collected.45

Collection MatrixIndicates the extent to which collections associated with the credit sales are made.

Example: Following is the collection matrix for Venus Ltd. % of receivables collected during The month of sales First Month after the sales Second month after the sales January 30% 48% 22% February 40% 35% 25%

In the month of January, 30% of the sales were collected in the same month, 48% were collected in the next month, 22% were collected in march (i.e. the second month after the sales). Similarly, 40% of Februarys sales were collected in that month itself, 35% were collected in march and 25% were collected in the month of April.46

3. CASH MANAGEMENT

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Motives For Holding Cash Transaction motive Precautionary motive Speculative motive

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Objectives of Cash Management To forecast cash inflows and outflows To identify profitable avenues to invest surplus cash To arrange for funds in case of cash deficit

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Cash Forecasting and Budgeting

Cash Budgets: It help in forecasting and summarizing the cash inflows and outflows for a period of time in future. It helps in planning the investment of surplus cash. It helps in adjusting the imbalances between forecasted cash receipts and payments. Frequency

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Cash ReportsUseful in situations in where cash flows do not fluctuate much.

Types of Cash Reports:1. 2. 3. Daily Cash Report Daily Treasury Report Monthly Cash Report

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Example: Expected monthly sales:

Nov 100000 Dec 100000 Jan 100000 Feb 100000 Mar. 120000 Apr. 120000 May 140000 June 140000 Cash and credit sales to be 20 % and 80% resp. Receivable form credit sales: 50% of receivable one month from the date of sales, 50% two months from the date of sale 50,000 expected from the sale of a machine in march and 2000 expected as interest in June52

Expected monthly purchase:

Dec 40000 Jan 40000 Feb 40000 Mar. 45000 Apr. 50000 May 55000 June 55000 Payment for purchases are made a month after the purchase Misc cash purchases of Rs.2500 per month are planned Wage payment, manufacturing exp and general admin exp are expected to be 16,000, 20,000, 10,000 per month resp.

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Factors for Efficient Cash Management Prompt Billing and Mailing Accelerating Cash Collections Controlling disbursement Playing the Float Investment of Surplus Cash

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Forms of Liquidity Cash Balance Cash Credit/ Overdraft Arrangement Marketable Securities Inter Corporate Deposits

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Selecting The Liquidity MixLiquidity Mix: Portfolio of cash and near cash assets Criteria For Selecting a Suitable Liquidity Mix: 1. Uncertainty Surrounding the Cash Flows 2. Managements Attitude Towards Risk 3. Access to Non-Bank Funds 4. Control Over Cash Flows

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END OF THE SESSION

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