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Fm 12

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  • 1. To maintain adequate capital for operations and paying  to creditors and not more
  • 2. Working Capital Working capital represents the portion of investment in estment that circulates from one form to another in the ordinary conduct of business. Two major concept of working capital – A. Net working capital = CA – CL B Gross working capital = CA B. narain@fms.edu
  • 3. C t fC tA tComponents of Current Assets  Inventories In entories  Raw materials  Components  Work‐in‐Progress  Finished Goods, others ,  Trade Debtors & receivables  Loans & Advances  Investments  Cash & Bank balances  Other debtors narain@fms.edu
  • 4. C t fC t Li bilitiComponents of Current Liabilities  Sundry Creditors  Trade Advances  Borrowings  From Commercial banks  From others   h  Provisions  Bill  P bl Bills Payable  Outstanding wages, salaries & taxes narain@fms.edu
  • 5. D t i t f ki it lDeterminants of working capitalA. Nature of businessA  Trading, retail, manufacturing, utilitiesB. Sales and demand conditions  Growing, seasonal & cyclicalC. Technology and manufacturing policy gy gp y  Production cycle, steady production policyD. Market competition  Inventory level, credit termsE. Conditions of the suppliers  Seasonal supply, lead time narain@fms.edu
  • 6. Operating cycle Operating cycleOperating cycle refers to the continuous flow of cash from cash to supplier, to inventory, to A/R and back into cash Cash Inventory Receivables narain@fms.edu
  • 7. Computing Operating Cycle Operating cycle refers to the time required to convert  raw material into cash  OC   i OC = inventory conversion period + debtor collection    i   i d   d b   ll i   period Cash cycle refers to the length of time period between  payment of cash for raw material & collection of cash  from debtors  CC = OC – Deferred payment period Conversion period = (average level/usage per  period)xTime i d) Ti narain@fms.edu
  • 8. IllustrationFrom the following information compute the operating and cash cycles taking 1 y y g year=365 days 3 5 y Average credit period allowed by the suppliers = 16 days Average debtors = Rs. 4,80,000 Raw material consumed = Rs. 44,00,000 Total production costs = Rs. 1,00,00,000 Total cost of sales = Rs. 1,05,00,000 Sales for the year = Rs. 1,60,00,000 Average stock: Raw material ‐ Rs. 3,20,000 W‐I‐P ‐ Rs. 3,50,000 Finished goods ‐ Rs. 2,60,000 narain@fms.edu
  • 9. Ill t tiIllustrationEstimate t e Net Working Cap ta required from t e st ate the et o g Capital equ ed o the given data: estimated cost per unit = Raw material Rs. 100 + Direct Labor Rs. 40 + Overheads Rs. 80 selling price is Rs. 240 per unit. Activity level is 1,04,000 units in 52 weeks. Raw material & finished goods stock is a eragel held for 4 weeks. Credit allo ed b averagely eeks allowed by suppliers is also 4 weeks. Credit allowed to debtors is 8 weeks. The lag in payment of wages is 1½ weeks. g p y g Average Cash balance is Rs. 25,000. narain@fms.edu
  • 10. narain@fms.edu
  • 11. Motives of holding cashThree possible motives for holding cash1. Transaction motive  Cash required to meet transaction needs  C ll ti Collection of cash not perfectly f h t f tl synchronised with the disbursement of cash h  Hence cash required as a buffer narain@fms.edu
  • 12. Motives of holding cash2. Precautionary motives  Some uncertainty about the magnitude and timing of cash inflows from sale of G&S, sale of assets etc.  Some uncertainty about cash outflows on account of purchase and other obligations  T protect i lf cash i required To itself, h is i d  Even for rainy days narain@fms.edu
  • 13. Motives of holding cash3. Speculative motives  To avail of the profit making opportunity from fluctuations in  Commodity prices,  Security prices,  Interest rates  And forex rates  Cash rich organisations better able to utilise the bargains bargains. narain@fms.edu
  • 14. Cash Management Cash serves these functions, as idle resource has an opportunity cost pp y The liquidity provided by cash holding is at the expenses of profits sacrificed by forgoing alternative investment opportunity Cash manager to reconcile – a) Cash disbursement needs b) Minimum commitment in cash b l h balances narain@fms.edu
  • 15. Determining cash needsTwo approachesA. Minimum cost cash models 1. Baumol’s model 2. Miller‐Orr’s model 3. Orgler’s modelB. Cash budget g  Statement showing the estimated cash inflows and outflows over the planning horizon p g narain@fms.edu
  • 16. Cash management strategiesStretching accounts payables1. Avoidance of early payments2. Centralised disbursements3. Playing float3 y g a) Cheque kiting b) Paying form a distant bank ) y g c) Scientific cheque encashing analysis4. Accruals narain@fms.edu
  • 17. Cash management strategiesSpeedy collection of account receivables1. Prompt payment by customer’s  Prompt billing2. Early conversion of payments into cash  Centralised  Decentralised – concentration banking,  g, lockbox systemEfficient inventory‐production management  JIT system narain@fms.edu
  • 18. narain@fms.edu
  • 19. Costs in Receivable Management1. Collection cost  Cost of maintaining credit deptt., postage, stationary, etc.2. Capital cost C i l   Amount of interest lost due to capital tied up in  receivables  Which could have been used to pay employees, suppliers3. Delinquency cost q y  Legal charges, prosecution costs4. Default cost  Amount lost as turned bad narain@fms.edu
  • 20. Credit Analysis & Investigation Essential to develop procedures to evaluate credit applications Two basic steps – A. Obtaining credit information B. Analysis of credit information narain@fms.edu
  • 21. Obtaining credit informationInternal sources Various forms filled Trade references furnished Past recordExternal sources Published & unpublished industry information  Financial statements l Bank references C dit b Credit bureaus & other t d references th trade f narain@fms.edu
  • 22. Analysis of credit informationQuantitative analysis : Cross‐section & Temporal Aging schedule Average age of A/C receivables Liquidity, profitability & servicing ratios q yp y gQualitative analysis : Subjective assessment R ti of th applicant Rating f the li t Referenced from banks, other suppliers, etc. narain@fms.edu
  • 23. Terms of PaymentTwo extremes1. Seller may extend credit to buyer till the buyer converts goods bought into cash2. The buyer may pay cash in advance to the seller and finance the entire trade cycleCommon practice Trade cycle financed partly by the seller partly by seller, the buyer and partly by some financial intermediary. y Credit terms like: “2/10, net 30” narain@fms.edu
  • 24. Major terms of payment Cash in advance/delivery etc. Open ongoing account and credit period Cash discount Billi Billing Consignment Draft or Bill of Exchange Letter of credit ette o c ed t narain@fms.edu
  • 25. C dit P li V i blCredit Policy Variables Have bearing on the level of sales, bad debt loss, discount taken by customers and collection expenses. Important decisions –  Credit standards  Credit period  Cash discount  Collection efforts  Monitoring  Reminding  Approaching  Threatening g  Suing narain@fms.edu
  • 26. IllustrationA Co. currently has annual sales of Rs. 5 lakhs & average collection period of 30 days. It is considering a more liberal credit policy. If the credit period is extended, the company expects sales and th dit i d i t d d th t l d bad‐debt losses to increase in the following manner: Credit  Increase in credit  Increase in  Bad‐debt (% of Policy period sales sales) A 10 days Rs. 25,000 1.2 B 15 days 5 y Rs. 35,000 35, 1.5 5 C 30 days Rs. 40,000 1.8 D 42 days Rs. 50,000 2.2The selling price is Rs. 2/‐. At the current level of operation, average cost is Rs. 1.50/‐ and average variable cost is Rs. 1.20/‐. If current bad‐debt loss is 1% of sales and required rate of return is q 20%, which credit policy should be undertaken? (1yr. = 360 days) narain@fms.edu
  • 27. SolutionIncremental expected profit (taking debtors at selling  price) A B C D 5367 5933 1613 -767Incremental expected profit (taking debtors at cost) A B C D 6283 7325 4230 2950 narain@fms.edu
  • 28. A major factor among non‐cash working capital managementA  j  f     h  ki   i l  narain@fms.edu
  • 29. Inventory Management Techniques ABC system  Pareto principle EOQ system  Levels of inventories JIT system  No need to keep the inventory narain@fms.edu
  • 30. narain@fms.edu