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Working Capital
• Working capital typically means the firm’s holding of current or short-term assets such as cash, receivables, inventory and marketable securities.
• Working Capital refers to that part of the firm’s capital, which is required for financing short-term or current assets.
• These items are also referred to as circulating capital.
Working capital: Concept
There are two possible interpretations of working capital concept:
1. Balance sheet concept2. Operating cycle concept
Balance sheet concept: There are two interpretations of working capital under the balance sheet concept.
a. Excess of current assets over current liabilities
b. Gross or total current assets.
Excess of current assets over current liabilities are called the net working capital or net current assets.
Concept of working capital
Operating cycle concept
• A company’s operating cycle typically consists of three primary activities:– Purchasing resources,– Producing the product and– Distributing (selling) the product.
These activities create funds flows that are both unsynchronized and uncertain.
Unsynchronized because cash disbursements usually take place before cash receipts.
Uncertain because future sales and costs cannot be forecasted with complete accuracy.
• The firm has to maintain cash balance to pay the bills as they come due.
• In addition, the company must invest in inventories to fill customer orders promptly.
• And finally, the company invests in accounts receivable to extend credit to customers.
• Operating cycle is equal to the length of inventory and receivable conversion periods.
Operating cycle concept
Operating cycle of a typical company
Payable Deferral period
Inventory conversionperiod
Cash conversioncycle
Operating cycle
Pay forResourcespurchases
Receive CashPurchase
resources
SellProductOn credit
Receivable Conversion period
THE WORKING CAPITAL CYCLE
(OPERATING CYCLE)
Accounts Payable
Cash
RawMaterials
W I P
Finished Goods
Value Addition
AccountsReceivable
SALES
If you Then ......
Collect receivables (debtors) faster
You release cash from the cycle
Collect receivables (debtors) slower
Your receivables soak up cash
Get better credit (in terms of duration or amount) from suppliers
You increase your cash resources
Shift inventory (stocks) faster
You free up cash
Move inventory (stocks) slower
You consume more cash
• Raw material storage peiod: = Average stock of raw material Cost of raw material consumed/365
• WIP holding period: Average WIP inventory/ Cost of production/365• Finished goods storage period: Average stock of finished goods/Cost of goods
sold/365• Inventory conversion period: Avg. inventory/ Cost of sales/365• Receivable conversion period:Accounts receivable/Annual credit sales/365• Payables deferral period: Accounts payable/(Credit purchases)/365
Operating cycle: Inventory conversion period + receivable conversion period.
Cash conversion cycle = operating cycle – payables deferral period.
TYPES OF WORKING CAPITAL
WORKING CAPITAL
BASIS OF CONCEPT
BASIS OF TIME
Gross Working Capital
Net Working Capital
Permanent / Fixed
WC
Temporary / Variable
WC
Regular WC
Reserve WC
Special WC
Seasonal WC
• The size and nature of investment in current assets is a function of different factors such as – Type of products manufactured, – Length of operating cycle, – Sales level, – Inventory policies, – Unexpected demand and – Unanticipated delays in obtaining new inventories, – Credit policies and – Current assets.
Working capital investment
Difference between permanent & temporary working capital
Amount Variable Working Capitalof WorkingCapital
Permanent Working Capital
Time
Variable Working CapitalAmount of WorkingCapital
Permanent Working Capital
Time
Matching approach to asset financing
Fixed Assets
Permanent Current Assets
Total Assets
Fluctuating Current Assets
Time
Rs
Short-termDebt
Long-termDebt +EquityCapital
Conservative approach to asset financing
Fixed Assets
Permanent Current Assets
Total Assets
Fluctuating Current Assets
Time
Rs
Short-termDebt
Long-termDebt +Equity capital
Aggressive approach to asset financing
Fixed Assets
Permanent Current Assets
Total Assets
Fluctuating Current Assets
Time
RS
Short-termDebt
Long-termDebt +Equity capital
FACTORS DETERMINING WORKING CAPITAL
1. Nature of the Industry2. Demand of Industry3. Cash requirements
4. Nature of the Business5. Manufacturing time
6. Volume of Sales7. Terms of Purchase and Sales
8. Inventory Turnover9. Business Turnover
10. Business Cycle11. Current Assets requirements
12. Production Cycle
Working capital estimation
Satyam Ltd profit and loss A/c and balance sheet for the year ended 31.12.15 are given below. You required to calculate the working capital requirement under operating cycle method:
Opening stockRaw material 10,000WIP
30,000Finished goods 5,000
Credit purchase 35,000Manufacturing expn 15,000Gross profit 55,000
150,000Administration expn 15,000Selling &distrbtn expn 10,000Net profit 30,000
55,000
Credit sales 1,00,000Closing stock
Raw material 11,000
WIP 30,500Finished goods 8,500
150,000Gross profit 55,000
.55,000
LiabilitiesEquities (16,[email protected]) 160,000Net Profit 30,000Creditors 10,000
2,00,000
AssetsFixed Assets1,00,000Debtors 30,500Cash and Bank 19,500Closing stock
Raw material 11,000
WIP 30,500Finished goods 8,500
2,00,000
Opening debtors (excluding profit) and opening creditor were Rs.6,500 and Rs.5,000 respectively
Calculation of operating cycle
Raw material Average raw material /Raw material consumed
per day=10,500/34,000/365 = Work in progressAverage WIP /Total cost of production per day=30,250/48500/365 =
Calculation of operating cycle
Finished goodsAverage stock/ Total cost of goods sold per day=6750/45,000/365 =Debtors Average Debtors/ credit sales per day=18,500/ 100,000/365 =
Calculation of operating cycle
Creditor Average creditor/credit purchases per day=7500/35,000/365Net Operating Cycle isTotal days – Credit allowed by creditors=
Estimation of Net Working capital requirement for Exl Ltd from the data given belowCost of production (per unit) Amount(per unit )Raw materials 100Direct labour 40Overheads 80
220The following are the additional information:Selling price per unit Rs.240Level of activity 1,04,000 units p.aRaw material in stock Average 4 weeksWork In Progress (Assume 100% stage of completion of materials and 50 percent for
labor and overheads) Average 2 weeksFinished goods in stock Average 4 weeksCredit allowed by supplier Average 4 weeksCredit allowed by debtors Average 8 weeks Lag in payment of wages Average 1.50 weeksCash at bank is expected to Rs.25,000. Production is sustained during 52 weeks of year
Statement of Working Capital RequirementParticulars Amount Raw materials 2,000 x 4 x 100 8,00,000
WIP
•Raw materials 2,000 x 2 x 100 4,00,000
•Wages (2,000 x 2 x 40)50% 80,000
•Overheads (2,000 x 2 x 80) 50% 1,60,000 6,40,000
Finished stock 2,000 x 4 x 220 17,60,000
Debtors 2,000 x 8 x 220 35,20,000
Cash 25,000
Total Current Assets 67,45,000Creditors 2,000 x 4 x 100 8,00,000
Outstanding wages 2,000 x 4 x 1.5 1,20,000
Total current liabilities 9,20,000
Net working capital (TCA - TCL) 58,25,000
INVENTORY
MEANING• Held for SALE• Consumed in the PRODUCTION of goods and
services Forms of Inventory for Manufacturing firm.
Raw materials, Work in process, Finished goods and stores & spares.
Inventory Management- objectives
Minimize investments in inventory
Meet the demand for products by efficiently organizing the production & sales operations.
RISK OF HOLDING INVENTORY
• Price decline
• Product Deterioration
• Product Obsolescence
COSTS OF HOLDING INVENTORIES
• Ordering costs
• Inventory Carrying/storage costs
• Opportunity costs of funds blocked
• Shortage
TOOLS & TECHNIQUES OF INVENTORY MANAGEMENT/ CONTROL
• ABC Analysis• Economic Ordering Quantity (EOQ)• Order Point Problem
ABC analysis
• ABC analysis is an inventory categorization method which consists in dividing items into three categories, A, B and C: – A being the most valuable items, – C being the least valuable ones.
• This method aims to draw managers’ attention on the critical few (A-items) and not on the minor many (C-items).
ABC AnalysisCATEGORY NO. OF ITEMS(%) ITEM VALUE(%) MANAGEMENT
CONTROL
A 15 70 (HIGHEST) MAXIMUM
B 30 20(MODERATE) MODERATE
C 55 10(LEAST) MINIMUM
TOTAL 100 100
ExampleABC Analysis
Stock Number Annual Volume Percent of Annual Volume
J24 12,500 46.2R26 9,000 33.3L02 3,200 11.8M12 1,550 5.8P33 620 2.3T72 65 0.2S67 53 0.2Q47 32 0.1V20 30 0.1
Total = 100.0
SolutionABC Groups
Class Items Annual Volume
Percent of Volume
A J24, R26 21,500 79.5
B L02, M12 4,750 17.6
C P33, T72, S67, Q47, V20 800 2.9
S = 100.0
Economic Ordering Quantity (EOQ)
• Level of Inventory at which
• Total Cost* of Inventory is MINIMUM*(Ordering and Carrying Cost)
EOQ MODEL
2AOQ =
SQ = Economic Order Quantity
A = Annual usage/demand
O= Cost of Placing an order
S = Storage cost per unit per order
* Where Storage cost is given in % , it is always calculated by multiplying the % with the purchase price of raw material per unit, i.e Storage cost = % X Purchase price of raw material
BEHAVIOR OF INVENTORY RELATED COSTS
CostsTotal costs
Carrying costs
Ordering costs
Quantity ordered
BEHAVIOUR OF INVENTORY RELATED COSTS
• Total cost of Inventory = Ordering cost + Holding cost
– Ordering cost = Annual Demand*Ordering cost/Q
– Holding cost = Q*Holding cost /2
EOQ- Example• A firm’s annual inventory is 1,600 units. • The cost of placing an order is Rs 50, purchase price of raw
material/unit is Rs.10 and the carrying costs is expected to be 10% per unit p.a.
• Calculate EOQ? A=1600, O= Rs. 50, S= .10 x Rs.10=Rs.1
EOQ = 2 x 1600 x 501
= 400 units
Order Point Problem• The re-order point is that level of inventory when a fresh
order should be placed with suppliers. It is that inventory level which is equal to the consumption during the lead time or procurement time.
• Re-order level = (Daily usage × Lead time) + Safety stock.
• Safety stock is minimum level of inventory that a firm keeps in hand. The firm reorders more inventory if the current inventory falls to safety level.
• Safety Stock = (Maximum Daily Usage − Average Daily Usage) × Lead Time
Example
• ABC Ltd. is engaged in production of tires. It purchases rims from DEL Ltd. an external supplier. DEL Ltd. takes 10 days in manufacturing and delivering an order.
• ABC's requires 10,000 units of rims per year. Its ordering cost is Rs.1,000 per order and its carrying costs are Rs.3 per unit per year.
• The maximum usage per day could be 50 per day. Calculate economic order quantity, total cost of inventory, reorder level and safety stock.
Solution
• EOQ, (Q) = (2*Annual Demand*Ordering Cost Per Unit / Carrying Cost Per Unit)^1/2
• Q = (2*10,000*1,000/3)^1/2 = 2582• Total cost of Inventory = Ordering cost +
Holding cost – Ordering cost = Annual Demand*Ordering cost/Q= 10,000*1,000/2582– Holding cost = Q*Holding cost /2– =
Reorder point
• Safety Stock = (Maximum Daily Usage − Average Daily Usage) × Lead Time
• Reorder Level = Safety Stock + Average Daily Usage × Lead Time
ExampleAssume you have a product with the following parameters:Annual Demand: 360; Holding cost per unit: Rs.1; Cost per order: Rs.100The maximum daily demand is 3 units per day1. What is the EOQ?2. Given the data, and assuming a 300-day work year; how many orders
should be processed per year? What is the expected time between orders?
3. What is the total cost for the inventory policy used ?4. Assume that the demand was actually higher than estimated (i.e., 500 units
instead of 360 units). What will be the actual annual total cost?
Solution
EOQ Demand Order costHolding cost
items 2 2 360 100
172000 268* * * *
N DemandQ
orders per year 360268
134.
T Working daysExpected number of orders
days between orders
300 134 224/ .
• Total cost of Inventory = Ordering cost + Holding cost
• Ordering cost = Annual Demand *Ordering cost/Q = 360* 100/268 = 134
• Holding cost = Q*Holding cost /2 = 268*1/2 =
• Total Cost of inventory =
JUST-IN-TIME (JIT) INVENTORY CONTROL
• The JIT control system implies that the firm should maintain a minimal level of inventory and rely on suppliers to provide parts and components ‘just-in-time’ to meet its assembly requirements.
• JIT also known as Zero Inventory Production Systems(ZIPS), Zero Inventories(ZIN), Materials as Needed(MAN), or Neck of Time(N0T)
Cash Management
Definition
Cash Management refers to management of cash & bank balance and also includes the management of short term deposits.
Motives of cash management
• Transaction motive: Business firm keep cash to meet their demand for cash arising from day to day transactions.
• Precautionary motive: Maintenance of cash balance to act as buffer against unexpected events.
• Speculative motive: Cash balance to take advantage of potential profit making situations that may occur in future.
Optimum Cash Balance
• Baumol’s model• Miller-orr model
Baumol’s model• Suggested by William J. Baumol (1952)• The model attempts to balance the income foregone on cash held by the
firm against the transaction cost of converting cash into marketable securities or vice versa.
• This model can be presented on assumption as follows:– Fixed Cash flow : The Baumol’s model assumes that the firm uses cash
at an already known rate per period and that this rate of use is constant.
– Holding cost: The holding cost is the opportunity cost in terms of interest foregone on investment in cash.
– Transaction cost: whenever cash is invested in marketable securities, there is cost involved like brokerage or commission.
Illustration• The annual cash requirement of A Ltd. is Rs 10 lakhs. The
company has marketable securities in lot sizes of Rs 50,000, Rs 1, 00,000, Rs 2, 00,000, Rs 2, 50,000 and Rs 5, 00,000.
• Cost of conversion of marketable securities per lot is Rs.1,000. The company can earn 5% annual yield on its securities.
• You are required to prepare a table indicating which lot size will have to be sold by the company. Also estimate the economic lot size can be obtained by the Baumol Model.
Baumol model
C= 2A*F/OWhere A= Annual requirement = 10 lakh
F = Fixed conversion charges = 1000O = opportunity 5%
C = 2*10,00,000*1000/0.05 = 2,00,000
Table indicating lot sizeS. No Particulars Situation 1 Situtation2 Situation 3
A Annual cash requirement (Given)
10,00,000 10,00,000 10,00,000
B Lot size of securities (Given) 50,000 1, 00,000 2,00,000
C No. of lot sizes (A/B) 20 10 5
D Average holding OF CASH (B/2) 25,000 50,000 1,00,000
E Opportunity cost of holding cash (D x 0.05)
1250 2500 5000
F Fixed conversion cost (given) 1000 1000 1000
G Total conversion cost (C x F) 20,000 10,000 5,000
H Total cost (E+G) 21,250 12,500 10,000
The above illustration shown that the minimum cost is Rs.10,000 when the lot size is 2,00,000
Miller and Orr model
• Baumol’s model is based on the basic assumption that the size and timing of cash flows are known with certainty. Whereas, in real situation, the cash flows of a firm are neither uniform nor certain.
• M.H. Miller and Daniel Orr (A Model of the Demand for Money) expanded on the Baumol model and developed Stochastic Model for firms with uncertain cash inflows and cash outflows.
The Miller and Orr (MO) model provides two control limits-the upper control limit and the lower control limit along-with a return point as shown in the figure below:
Miller and Orr model• If the cash balance touches the upper control limit (H), marketable
securities are purchased to the extent of (H-Z) to return back to the normal cash balance of Z.
• If the cash balance touches lower control limit (O), the firm will sell the marketable securities to the extent of O-Z to again return to the normal cash balance.
• The spread between the upper and lower cash balance limits (called Z) can be computed using Miller-Orr model as below:
Receivables Management
• Accounts receivables for the selling firm is same as an account payable for the purchaser.
• The purpose of credit analysis is to assess the credit worthiness of potential customers and the corresponding risk of late payments or default.
Receivables Management
• Credit analysis consists of:1. Gathering information about the potential
customer2. Analyzing the information to derive a credit
decision about the payment terms and amount of trade credit granted
Credit agencies provide credit ratings and reports on companies.
STEPS IN CREDIT ANALYSIS
The 5 C’s of Credit Analysis• Character - Reputation, Track Record • Capacity - Ability to repay.• Capital - Financial Position of the co. • Collateral - The type and kind of assets pledged • Conditions - Economic conditions &
competitive factors that may affect the profitability of the customer.
Credit planning
Aspects of credit planning• Credit policy• Credit standards• Credit terms
Credit policy
A company's policy related to trading off the profit on additional sales that arises due to credit sales and the cost of carrying those debtors and probable bad debts.
Credit standards
• The guidelines issued by a company that are used to determine if a potential borrower is creditworthy.
• Credit standards are often created after careful analysis of past borrowers and market conditions, and are designed to limit the risk of a borrower not making credit payments or defaulting on loaned money.
Credit terms
• The terms which indicate when payment is due for sales made on account (or credit). – Credit period– Discount period– Discount rate
• The general credit terms are expressed as 2/10, net 30. This means the amount is due in 30 days; however, if the amount is paid in 10 days a discount of 2% will be permitted.
Calculation of annualized return
• If credit term is expressed as a/b,net c then; • Annualized return = a/(1-a) * 360/(c-b)
Which of the below terms have lower cost to company?
1. 2/10, net 302. 5/10, net 60