UNIT III: International Working Capital Management …….Cash Management …….Inventory Management ……..Receivables management

BY: DR. A.K.Singh

Working Capital

• Investment in current assets that are convertible into cash within one accounting year.

• E.g. Cash, Near Cash assets like short-term marketable securities, Bills receivables, Inventories etc.

• Current assets – Circulating assets

• Gross Working Capital- total of current assets

• Net Working Capital- CAs- CLs

Working Capital management

It is nothing but management of

a) Short term liabilities

b) Short term Assets

It should be continously so that for operation which generates cashflows are sufficient to meet the short term obligation and operational expenses.

Working capital

• Working capital manager consumes maximum time of financial manager and it also takes investment in sizeable portion of the total assets portfolio.

• Working capital decides the creditibility and growth of the organisation.

Working capital

• It is based on two classification

a) Value

b) Time

a) Based on value we have two classifications:

• Gross Working Capital

• Net working Capital

WCM

• Based on time:

• Permanent working Capital

• Temporary working Capital

WCM

• Why an organization should have Adequate working capital. • If an organisation has large amount of working capital , it means

they are carrying idle funds but the things is working capital investment is not going to come free because investment in large amount of working capital would require funds that would carry cost in forms of interest payment.It means if you have large amount of working capital , you are going to incur huge cost in interest payments.

• If we have adequate working capital then there is risk of insolvency which means business itself can be closed.

• Important thing is having adequate working capital not only in the short term but also in the long term which is absolutely esssential to ensure the survival of the business during difficult times and growth during good times.

Objectives of Working Capital Management

Size of Current Assets: There must be optimal size of current assets to maintain the trade-offs between liquidity & profitability. If less CAs, will badly affect liquidity, but if more than optimal size, will badly affect profitability.

Financing of Current assets: There should be an optimal mix of long term and short term funds meant for financing current assets.

Problems peculiar to International Working Capital Management

When CAs move borders, many factors influence their value.

• Changes in exchange rate

• Changes in Inflation Rate

• Exchange Control Mechanism

• Political Situation across countries

• Varying interest rate and tax rate amongst countries.

• Complexities in cash positioning and cash mobilisation because intra-firm flow of funds is very common amongst MNCs.

• Wider option for financing of CAs by MNCs- to approach international financial market or domestic firms.

Objectives of international Working Capital Management

• Optimisation of cash holding in different units through smoothening of the cross border cash flows as well as in the firm as a whole

• Minimisation of finance & transaction cost

• Avoidance of foreign exchange losses

• Avoidance of political and economic risk

• Minimisation of tax burden of the firm as a whole

Int Working Capital

• The international manager has to see that the cost of holding CAs is minimum while not compromising liquidity.

• Short term assets are more liquid but also have a higher cost. Therefore there is a conflict between the liquidity and profitability.

IWMC

• Firms views:

1) from the point of view of the whole firm profitability is the major consideration. 2) Even if some affiliate is short of liquidity other units will supply it rather than liquidiate the long term

asset. 3) The working capital policy establishes an optimal link amongst the different units. 4) The focus is on creating and managing regional financial headquaters ,centralised depositories, netting

of payments, intra firms loans and transfer pricing . Affiliates view : From the point of view of the affiliates the international working cap management strategy focuses on : 1 Cash forecasting 2 Leads and lags 3 Local money market dealings 4 local credit practices.

• The two views are optimized in such a manner that the objectives of working capital management are met.

Difference between DWCM and IWCM

• Unlike domestic firms multi national firms are prone to foreign exchange risk involving both inflows and outflows of funds

• They also faced the possibililty of restrictions on cash flows by the host government

• While intra firm fund flows are common amongst multinational enterprises they need to have a more centralised system of cash postioning and cash mobilizations.

• Multi –national manager option do not have a detailed idea about politico-economic conditions.

• Interest rate differentiate and tax differentiate complicate the financing of current assets.

Working Capital mgt of MNCs

Two sides;

One, based on system or firm as a whole. Here profitability of the firm is the prime consideration even if a particular unit has to make sacrifice. Some subsidiaries may generate surplus funds to be used elsewhere in the same firm.

Second, based on specific needs of different affiliates. Here the objective of cash mgt strategy is to focus on its ability to budget and plan for more narrowly conceived objectives.

Why firm holds Cash

Keynes explained 3 motives behind holding of cash:

Transaction motive:

for meeting expenses

Lag between inflow and outflow of cash.

Precautionary motive (for meeting exigencies that may arise)

Speculative motive (unforeseen opportunities arise when it is profitable for firm to invest)

Direction of Flow

Parent to subsidiary: Initial & supplemetary investment in working capital, Transfer Pricing.

Subsidiary to Parent: Dividend payment, Payment for royalty, Technical service fees, Disinvestment by parent company, Interest & Amortization Payment on loans given by parent company, export proceeds.

Among different Subsidiaries: Export proceeds, payment for import or transfer of funds for meeting cash needs.

Int. Working Capital Management

FIRM as Whole: 1. Centralized Depositories 2. Regional Financial Headquarters 3. Netting of Payments 4. Intra-firm Loans 5. Transfer Pricing 6. Dividends and Remittances 7. Re-invoicing centre

Specific needs of unit 1. Cash Forecasting 2. Leads and Lags 3. Local Money

market dealings 4. Local credit

practices

International Working Capital Management

Steps in Cash Management

Assessment of Cash requirements.

Optimisation of cash need through restructuring of inflows and outflows.

Selection of the sources from where cash could be brought in.

Investment of surplus cash into near-cash assets.

Assessment of cash requirement

• Need for cash during a specific period

• Expected amount of cash disbursement vis-à-vis Expected cash inflow

• Cash budget for each subsidiary, cash budget for whole firm by consolidating figures. Consolidation process requires the translation of host country currency into home country currency which is subject to foreign exchange exposure.

Optimisation of cash need through restructuring of inflows and outflows

Accelerating inflows and delaying outflows

Inflows/ Cash collection: In collection of cash, there may be mailing delay or processing delay. The use of telex or cable transfers cuts short the mailing delay. SWIFT has made possible the electronic transfer of funds easy. There are some multinational banks that provide “same-day value” facility. Here through electronic devices, amount deposited in any branch in bank in any country is credited to firm’s account on the same day.

Ctd……

Delaying Outflows: Disbursements are delayed to conserve cash atleast for some time but such delay should not affect creditworthiness. There are also chances of retaliatory measures if disbursements are delayed, so needs extra care. Accelerating cash inflow and decelerating disbursements improve the efficiency of cash management, but involve additional cost. Marginal Return> Marginal cost= technique shd be used.

Selection of Sources

Netting of Intra-firm Payments

o Netting means Payment of net amount.

o Elimination of Counter payments.

o Large volume of intra-firm transactions involve huge amount of cash, transaction cost, inter-currency conversion cost and opportunity cost of float.

o Netting may be bilateral or multi-lateral.

ctd……

Example: NO Netting

B A

C

15

20

12

30 20

6

ctd……

Example: Bilateral Netting

B A

C

5

18

14

ctd……

Example: Multilateral Netting

B A

C

19

4

Selection of Sources Centralised Management of Precautionary Cash Balance.

The larger the precautionary balance, the less is the risk of financial embarrasement and loss of credit standing.

In case a particular unit runs short of precautionary cash balance, the centralized depository comes to the rescue immediately.

Centralized pool represents a pool of funds where the surplus cash of all the units of firm is deposited.The centralized pool may be located either in host country or in home country or in third country depending upon the strength of currency of that country, tax rates, political stability, attitude of host government.

Investment of surplus cash into near-cash assets

Surplus cash over the transaction purposes is held in the form of near-cash assets or short-term marketable securities. Reason being near-cash assets earn something for the firm and are better than holding of idle cash balance.

A centralised pool is formed where the surplus cash of all the units of a firm is deposited. It helps in lowering cost of funds, achieving the economies of the scale, maintaining firm’s global liquidity.

Surplus cash to be invested only to the extent where the sum of transaction cost and opportunity cost is equal.

Receivables Management

Credit sales lead to emergence of account receivables.

Two Points to be noted:

Cost of credit sale < Benefit of credit sale

Whether intra-firm sale or inter-firm sale

Cost and benefit of Receivables

Benefit- Increased sales. Becoz customers get more time to pay for the goods. Costs- o Financing Cost (interest on funds tagged with

sales) o Administrative Cost (Cost of maintaining records) o Collection cost o Bad Debts o Foreign Exchange Loss (if exchange rate changes

during the period of credit)

Managing Accounts Receivable • Appropriate policy is that the firm extends credit only upto the

point where marginal profits on its increased sales are equal to the marginal cost of receivables.

• Size of credit sale< optimal size= Benefits will be less than maximum.

• Size of credit sale> optimal size= Costs will turn higher to slash or reduce the benefit.

• Liberal terms raise benefits as well as costs.

• Stringent terms lower both the benefit & cost.

• In order to assess the optimal term of credit, firm prepares performa income statement assuming a particular size of sales and the size of different costs and arrives at net profit. The term representing the maximum net profit is the optimal term of credit.

Credit Policy: Intra-firm /Inter-firm Sales

Intra Firm Sales

Focus not on quantum of credit sale or timing of payment but on global allocation of firm’s resources.

Early payment or late payment does not matter because seller and purchaser represent the same firm. A particular unit may delay payment if it is short of cash and the other unit may pay quickly if it has surplus cash.

Game of intra-firm allocation of resources.

Ctd….

• If a unit of firm is located in weak-currency country, it is asked to make a quick payment so that the cost of receivables borne by firm as a whole may not be large.

• Example; Suppose credit period is 120 days. The financing cost is 1% per month. Importer’s currency is to depreciate by 2% during four month period.

Additional cost of receivables to exporter’s currency= (1-0.04) (0.98)= 0.0588 = 5.9%

Credit Policy: Intra-firm /Inter-firm Sales

Inter- Firm Sales

Sale to an outside firm

Issues- currency in which transaction should be denominated & Terms of Payment

Currency Denomination: Exporter likes to denominate the transaction in a strong currency while the importer likes to get it denominated in weak currency. However exporter may be ready to invoice the transaction in the weak currency even for a long period of credit if it has debt in that currency because no loss on account of exchange rate changes.

Ctd….

Terms of Payment: • Exporter does not provide for a longer period of

credit and tries to get export proceeds as early as possible if transaction is invoiced in weak currency.

• However, sometimes credit terms may be liberal if exporter is able to borrow from bank on basis of bills receivable and not on the basis of actual inventory. And sometimes the market competition forces the exporter to finance importer’s inventory.

Inventory Management

Inventory Management in MNC/ Domestic Firm: o Inventory- biggest share in Current assets o Least liquid, needs sufficient care o Some additional points to be noted in MNC in addition

to domestic firm: • MNC has to maintain inventory simulaneously in

different countries • Longer transit time • Lengthy custom procedures • Political risk • Exchange rate risk

1. MNCs deviate from EOQ

• EOQ is the optimal size of inventory that a firm orders at a particular point of time.

• EOQ is quantity of order where the sum of ordering and carrying cost of inventory is minimum.

• Trade off between carrying cost and ordering cost.

• MNCs don’t follow above norm strictly, they deviate from EOQ and keep an inventory order more than EOQ that is called stockpiling. This is done to take care of political disturbances, currency depreciation etc. However stockpiling cannot be done indefinitely because it will increase carrying cost.

2. MNCs shift Reorder Point

• In domestic firms, inventory is reordered when the existing stock comes down to sum of safety level of stock (in no. of days) and lead time (time between making an order and arrival of goods)

• Suppose, the existing stock based on present usage can last for 30 days and firm maintains the safety level of stock for 5 days and lead time is 6 days. Here domestic firm will place the order for the next lot only after 19 days of arrival of existing stock.

• MNCs deviate because lead time is larger as different units are located far off in different parts of globe and many custom formalities are involved.