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Contents
Meaning & need for inves/ng in current assets Gross working Capital and Net Working Capital Concept of opera/ng cycle & its rela/on to Working capital Working capital nancing
Introduc;on
Tradi/onally, working capital has been dened as the rms investment in current assets. Current assets are required for day-to-day opera/ons of the rm. The assets keep changing from one form to another from viz. Stocks, Receivables and Cash. Working capital decisions are very important as they aect the liquidity of the business.
Working capital decisions are typically Short-term nancial decisions, i.e., working capital decisions typically aect the cash ows of the rm for a shorter /me frame, extending normally up to a maximum of one year The concepts of risk and 3me value of money are less per0nent to working capital decision-making They are modied from 3me to 3me unlike capital budge/ng decisions, which are one-/me and irreversible Concept of working capital is dynamic as market condi/ons with respect to credit, stocking etc. change more frequently
GWC refers to the rms total investment in current assets Current assets are the assets which can be converted into cash within an accoun/ng year (or opera/ng cycle) and include cash, debtors, (accounts receivable or book debts) bills receivable and stock (inventory). It is termed as managers concept of working capital. It denotes the liquidity posi/on of the rm. Other factors remaining the same, the higher the GWC of a rm, the bePer its liquidity posi/on. Increasing GWC aects protability adversely as more funds get /ed up in current assets that have low/zero yield.
NWC
refers
to
the
dierence
between
current
assets
and
current
liabili/es.
Current
liabili/es
(CL)
are
those
claims
of
outsiders
which
are
expected
to
mature
for
payment
within
an
accoun/ng
year
and
include
creditors
(accounts
payable),
bills
payable,
and
outstanding
expenses.
NWC
can
be
posi/ve
or
nega/ve.
Nature of business
Technology
Opera;ng
Cycle
Opera/ng
cycle
is
the
/me
dura/on
required
to
convert
1. resources
into
inventories
2. inventories
into
sales
(either
cash
or
credit
sales)
3. Credit
sales
into
cash.
The
opera/ng
cycle
of
a
manufacturing
company
involves
following
phases:
1. 2. 3.
Acquisi;on of resources such as raw material, labour, power and fuel etc. Manufacture of the product which includes conversion of raw material into work-in-progress into nished goods. Sale of the product either for cash or on credit. Credit sales create account receivable for collec/on.
Opera;ng
cycle
The
length
of
the
opera/ng
cycle
of
a
manufacturing
rm
is
the
sum
of:
Inventory conversion period (ICP). Debtors (Account receivable) conversion period (DCP).
10
The rms gross opera/ng cycle (GOC) can be determined as inventory conversion period (ICP) plus debtors conversion period (DCP). Thus, GOC is given as follows:
11
Rawmaterial Inventory X 360 RMCP = Rawmaterial consumed Work In process Inventory X 360 WIPCP = Cost of production Finished Goods Inventory X 360 FGCP = Cost of goods sold
12
Debtors conversion period (DCP) is the average /me taken to convert debtors into cash. DCP represents the average collec/on period. It is calculated as follows:
Sundry Debtors X 360 Debtors Conversion Period ( DCP ) = Annual Credit Sales
13
Creditors(payables) deferral period (CDP) is the average /me taken by the rm in paying its suppliers (creditors). CDP is given as follows:
14
Net opera/ng cycle (NOC) is the dierence between gross opera/ng cycle and payables deferral period.
15
16
= 16.76 days
= 10.97 days
17
Industry
Cement
Cement
Auto
Auto
Comp.
Sojware
Comp.
Sojware
Comp.
Sojware
Personal
care
Personal
care
Steel
Steel
DCP (days) 15.35 9.50 14.47 17.32 75.37 73.78 72.15 11.83 2.27 27.98 10.09
ICP (days) 50.65 61.63 36.76 61.93 12.14 0.47 0.00 79.29 23.91 87.80 87.98
CDP (days) 99.39 93.25 70.36 65.41 0.00 34.15 13.97 116.83 88.81 37.23 109.54
CCC or NOC -33.39 -22.12 -19.13 13.84 87.51 40.10 58.18 -25.71 -62.63 78.55 -11.47
18
To es/mate working capital requirements on the basis of average holding period of current assets and rela/ng them to costs based on the companys experience in the previous years. This method is essen/ally based on the opera/ng cycle concept. To es/mate working capital requirements as a ra/o of sales on the assump/on that current assets change with sales. To es/mate working capital requirements as a percentage of xed
Ra3o of sales
investment.
19
Permanent or xed working capital A minimum level of current assets, which is con/nuously required by a rm to carry on its business opera/ons, is referred to as permanent or xed working capital. F l u c t u a ; n g o r v a r i a b l e working capital The extra working capital needed to support the changing produc/on and sales ac/vi/es of the rm is referred to as uctua/ng or variable working capital.
20
Current Assets to Fixed Assets Ra;o Liquidity vs. Protability: RiskReturn Trade-o The Cost Trade-o
Cost Trade-o
21
The
working
capital
nancing
policy
may
have
a
signicant
impact
on
the
protabilityliquidity
posi/on
of
the
rm.
These
policies
could
be
22
Matching Long term nances Poten/al Short term nances Rs. 100 Cr
Aggressive Rs. 85 Cr
Conserva;ve Rs 115 Cr Nil. However, any requirement over and above Rs 115 cr will need short term funding
Rs. 15 Cr
Rs. 30 Cr
23
24
Case
Study
Strong
Cement
Company
Ltd
has
an
installed
capacity
of
producing
1.25
lakh
tons
of
cement
per
annum;
its
present
capacity
u;lisa;on
is
80
per
cent.
The
major
raw
material
to
manufacture
cement
is
limestone
which
is
obtained
from
the
company's
own
mechanised
mine
located
near
the
plant.
The
company
produces
cement
in
200
kg
bags.
From
the
informa;on
given
below,
determine
the
net
working
capital
(NWC)
requirement
of
the
company
for
the
current
year.
Cost
structure
per
bag
of
cement
(es;mated)
Gypsum
Limestone
Coal
Packing
material
Direct
labour
Factory
overheads
(including
deprecia;on
of
Rs
10)
Administra;ve
overheads
Selling
overheads
Total
cost
Prot
margin
Selling
price
Add:
Sale
tax
(10
per
cent
of
selling
price)
Invoice
price
to
consumers
Rs
25
15
30
10
50
30
20
25
205
45
250
25
275
25
Addi;onal informa;on: 1) Desired holding period of raw materials: Gypsum - 3months; Limestone - 1month; Coal - 2.5 months and Packing material - 1.5 months 2) The product is in process for a period of 0.5 month (assume full units of materials, namely gypsum limestone and coal are required in the beginning; other conversion costs are to be taken at 50 per cent). 3) Finished goods are in stock for a period of 1 month before they are sold. 4) Debtors are extended credit for a period 3 months. 5) Average ;me lag in payment of wages is approximately 0.5 month and of overheads, 1 month. 6) Average ;me lag in payment of sales tax is 1.5 months. 7) The credit period extended by various suppliers are: Gypsum - 2 months; Coal - 1 month and Packing material - 0.5 month 1) Minimum desired cash balance is Rs. 25 lakh.
26
SOLUTION Statement showing determina;on of net working capital of Strong Cement Company Ltd Current assets: Minimum desired cash balance Raw materials: Gypsum (5 lakh bags* Rs 25 3/12) Limestone (5 lakh bags* Rs 15 1/12) Coal (5 lakh bags Rs 30 2.5/12) Packing material (5 lakh bags Rs 10 1.5/12) Work-in-process: (5 lakh bags Rs 105 0.5/12) Raw material cost 100 per cent (Rs 25 + Rs 15 + Rs 30) Other conversion costs (Rs 50 + Rs 20 cash factory overheads) 0.5 Finished goods (5 lakh bags Rs 170** 1/12) Debtors (5 lakh bags Rs 220** 3/12) Total Rs 70 35 105 Rs 25,00,000 31,25,000 6,25,000 31,25,000 6,25,000 21,87,500 70,83,333 2,75,00,000 4,67,70,833
27
Current liabili;es: Creditors: Gypsum (5 lakh bags Rs 25 2/12) Coal (5 lakh bags Rs 30 1/12) Packing material (5 lakh bags Rs 10 1/24) Wages (5 lakh bags Rs 50 1/24) Overheads (5 lakh bags Rs 65 1/12) Sales tax (5 lakh bags Rs 25 1.5/12) Total NWC
*1.25 lakh tons 0.8 = 1 lakh ton/200 kgs = 5,00,000 bags **(Total cost, Rs 205 Deprecia;on, Rs 10 selling overheads, Rs 25) ***(Cash cost, Rs 195 + sale tax, Rs 25)
RECEIVABLES MANAGEMENT
29
LEARNING
OBJECTIVES
Establishing a sound credit policy Op/mum credit policy Explain the credit policy variables The nature and costs / benets of factoring
30
INTRODUCTION
Trade credit happens when a rm sells its products or services on credit and does not receive cash immediately
31
Investment in receivables to op;mise returns, which includes volume of credit sales, collec/on period, type of customer
Credit
terms:
Credit
terms
for
specic
customers
Collec/on
eorts:
Process
for
collec/on
Provisioning
policy
for
aged
debts
32
33
Illustration: Delta Company has current sales of Rs 30 Crore (or 3000 lakh). To increase the sales, the company is considering a more liberal credit policy. The current average collection period of the company is 25 days. If the collection period is extended, sales increase in the following manner. The company is selling its product at Credit Increase in Increase in Rs 10 each. Average cost per unit at policy collec;on period sales the current level is Rs 8 and variable X 15 days Rs. 12 lakh cost per unit Rs 6. If the company Y 25 days Rs. 27 lakh required a return of 12 per cent on its investment. Which credit policy is Z 35 days Rs. 47 lakh desirable? Solution: Need to find out a) Incremental investment in Receivables b) Incremental rate of return (contribution / Incremental investment In AR)
Cost calcula3ons: Average cost (Rs) Unit variable cost (Rs) Price (Rs) Total cost of sales (Rs lakh) Total variable cost (Rs lakh) Total xed cost (Rs lakh)
34
Current policy Exis/ng Credit period Add: Change to the exis;ng credit period (days) A. New Credit period (days) B. Annual sales (Rs lakh) C. Inc. sales (Rs lakh), [B - 3,000] D. Inc. contribu;on (Rs lakh), [C x (10-6)/10] E. Cost of sales (Rs lakh), [B/10 x 6 + 600] F. Investment in receivables at cost (Rs lakh), [E/360 x A] G. Inc. receivable invt. at cost (Rs lakh), [F - 167] H. Incremental rate of return (%), [D/G] I. Required rate of return (%) 25 3,000 - - 2,400 167 - - - 25
Policy Z 25 35 60 3,047 47
Conclusion: The revised credit policy would be acceptable if the IRR = or > RRR.
35
Current policy Exis/ng Credit period Add: Change to the exis;ng credit period (days) A. New Credit period (days) B. Annual sales (Rs lakh) C. Inc. sales (Rs lakh), [B - 3,000] D. Inc. contribu;on (Rs lakh), [C x (10-6)/10] E. Cost of sales (Rs lakh), [B/10 x 6 + 600] F. Investment in receivables at cost (Rs lakh), [E/360 x A] G. Inc. receivable invt. at cost (Rs lakh), [F - 167] H. Incremental rate of return (%), [D/G] I. Required rate of return (%) 25 3,000 - - 2,400 167 - - - 25
Conclusion: The revised credit policy would be acceptable if the IRR = or > RRR.
36
Factoring
Factoring can be dened as a contract between the suppliers of goods/services and the Factor. Under this contract the Factor takes over ( or buys) the debtors of the suppliers. The main feature of Factoring are:
37
Bills discoun/ng is a sort of borrowing while factoring is the ecient and specialized management of book debts along with enhancement of the clients liquidity. The client has to undertake the collec/on of book debt. Bill discoun/ng is always with recourse, and as such, the client is not protected from bad-debts. Bills discoun/ng is not a convenient method for companies having large number of buyers with small amounts since it is quite inconvenient to draw a large number of bills.
2.
3.
38
Types
of
Factoring
Full service non-recourse Full service recourse factoring Bulk/agency factoring Non-no/ca/on factoring
39
Benets of Factoring
Factoring provides specialized service in credit management, and thus, helps the rm s management to concentrate on its core competencies viz. manufacturing and marke/ng. Factoring helps the rm to save cost of credit administra/on due to the scale of economics and specializa/on.
CASH MANAGEMENT
41
Contents
42
Cash Management
cash ows into and out of the rm, cash ows within the rm, and Financing decit or inves/ng surplus cash
43
44
Cash Planning
Cash planning is a technique to plan and control the use of cash. Cash Forecas0ng and Budge0ng
Cash budget is the most signicant device to plan for and control cash receipts and payments. Cash forecasts are needed to prepare cash budgets.
45
To determine opera/ng cash requirements To an/cipate short-term nancing To manage investment of surplus cash. The receipt and disbursements method The adjusted net income method
46
It indicates as companys future nancial needs, especially for its working capital requirements. It helps to evaluate proposed capital projects. It pinpoints the cash required to nance these projects as well as the cash to be generated by the company to support them. It helps to improve corporate planning. Long-term cash forecasts compel each division to plan for future and to formulate projects carefully.
47
48
Baumols ModelAssump;ons:
The rm is able to forecast its cash needs with certainty. The rms cash payments occur uniformly over a period of /me. From 1 and 2 therefore, rm knows how much of cash it has to hold at any one point of /me. The opportunity cost of holding cash is known and it does not change over /me. The rm will incur the same transac/on cost whenever it converts securi/es to cash.
49
Baumols Model
The rm incurs a holding cost for keeping the cash balance. It is an opportunity cost; that is, the return foregone on the marketable securi/es. If the opportunity cost is k, then the rms holding cost for maintaining an average cash balance is as follows: Holding cost = k (C / 2) The rm incurs a conversion or transac;on cost whenever it converts its marketable securi/es to cash. Total number of transac/ons during the year will be total funds requirement, T, divided by the cash balance, C, i.e., T/C. The per transac/on cost is assumed to be constant. If per transac/on cost is c, then the total transac/on cost will be:
Transaction cost = c(T / C ) The
total
annual
cost
of
the
demand
for
cash
will
be:
Total cost = k (C / 2) + c(T / C ) The
op/mum
cash
balance,
C*,
is
obtained
when
the
total
cost
is
minimum.
The
formula
for
the
op/mum
cash
balance
is
as
follows:
2cT C* = k
50
ABC limited es/mates its total cash requirement as Rs 20 cr. next year. The companys opportunity cost of funds is 16% per annum. The company will have to incur Rs 150 per transac/on when it converts its short-term securi/es to cash. Determine the op/mum cash balance. How much is the total annual cost of the demand for the op/mum cash balance? How many deposits will have to be made during the year? Given, T = total cash requirement for the yr = Rs 20 cr C= cost of conversion = Rs 150 per transac/on k = Holding cost = 16% per annum Therefore, the op/mum cash balance C* =
C* =
C*= C* =
2cT k
2(150)(200000000) 0.16
Total Cost = Rs 97980 made up of a. Cost of conversion = T / C* X c = 20,00,00,000 / 612372 X 150 = Rs. 48990 b. Holding cost = (C* / 2) X k = 612372/2 X 0.16 = Rs 48990
51
two control limitsthe upper control limit and the lower control limit a return point
If the rms cash ows uctuate randomly and hit the upper limit, then it buys sucient marketable securi/es to come back to a normal level of cash balance (the return point). Similarly, when the rms cash ows hit the lower limit, it sells sucient marketable securi/es to bring the cash balance back to the normal level (the return point).
52
Miller-Orr model
53
The
dierence
between
the
upper
limit
and
the
lower
limit
depends
on
the
following
factors:
the transac/on cost (c) the interest rate, (i) the standard devia/on (s) of net cash ows.
The
formula
for
determining
the
distance
between
upper
and
lower
control
limits
(called
Z)
is
as
follows:
1/ 3
(Upper Limit Lower Limit) = (3/4 Transaction Cost Cash Flow Variance/Interest Rate)
Upper Limit = Lower Limit + 3Z Return Point = Lower Limit + Z The net effect is that the firms hold the average the cash balance equal to: Average Cash Balance = Lower Limit + 4/3Z
54
XYZ company has a policy of maintaining a minimum cash balance of Rs 50 lakh. The standard devia/on of the companys daily cash ows is Rs 20 lakh. The annual interest rate is 15 per cent. The transac/on cost of buying and selling securi/es is Rs 150 per transac/on. Determine XYZs upper control limit, return point and average cash balance as per the Miller-Orr model. Solu/on: Upper Control Limit = Lower limit + 3Z Data given Lower limit = Rs 50 lakh 3Z = to be found out Z = dierence (in Rs or $) between upper control limit and lower control limit Formula to nd out Z = (3/ 4 X Transaction Cost X Cash Flow Variance / Interest Rate)1/3 = [3/4 X 150 X 20,00,0002 / (0.15 /365)]1/3 = 10,30,714 Upper limit = 50,00,000+(3 X 10,30,714) = Rs 80,92,141 Return point = Lower limit + z = 50,00,000 + 10,30,714 = Rs 60,30,714 Average cash balance = Lower limit + 4/3 Z = 50,00,000 + (4/3 X 10,30,714) = 63,74,285
55
56
Treasury bills Commercial papers Cer/cates of deposits Bank deposits Inter-corporate deposits Money market mutual funds
57
Appendix
58
59
Clearing
The clearing process refers to the exchange by banks of instruments drawn on them, through a clearinghouse. Instruments like cheques, demand drajs, interest and dividend warrants and refund orders can go through clearing. Documentary bills, or promissory notes do not go through clearing. The clearing process has been highly automated in a number of countries.
60
It gives a complete picture of all the items of expected cash ows. It is a sound tool of managing daily cash opera/ons. Its reliability is reduced because of the uncertainty of cash forecasts. For example, collec/ons may be delayed, or unan/cipated demands may cause large disbursements. It fails to highlight the signicant movements in the working capital items.
61
It highlights the movements in the working capital items, and thus helps to keep a control on a rms working capital. It helps in an/cipa/ng a rms nancial requirements.
It fails to trace cash ows, and therefore, its u/lity in controlling daily cash opera/ons is limited.
62
Controlling Disbursements
63
Controlling Disbursements
Delaying disbursement results in maximum availability of funds. However, the rms that delay in making payments may endanger its credit standing. While, for accelerated collec/ons a decentralized collec/on procedure may be followed, for a proper control of disbursements, a centralized system may be advantageous. Some rms use the technique of playing the oat to maximize the availability of funds. When the rms actual bank balance is greater than the balance shown in the rms books, the dierence is called disbursement or payment oat.