final mdp wcm class.ppt

*Prof. S B Mishra KIIT School of Management,Bhubaneswar*Working Capital Management

Prof. S B Mishra KIIT School of Management,Bhubaneswar

LEARNING OBJECTIVES*Prof. S B Mishra KIIT School of Management,Bhubaneswar*Basic Concepts of Working Capital Management.Significance of WCM to the organization and different divisions.Factors Affecting working capital requirementsEstimating Working Capital using Operating Cycle Concepts.Receivables Management.


What do we mean by working capital ?*Prof. S B Mishra KIIT School of Management,Bhubaneswar*


Typical Balance Sheet

AssetsFinancingFixed assetsEquity

Current assetsDebt(financial loans)

Current liabilities


Typical Balance Sheet


Current assets= Gross Working CapitalDebt(financial loans)

Current liabilities


Figure 8.5b Net working capital


Net working capitalDebt

Current assetsCurrent liabilities


Working Capital Concepts*Prof. S B Mishra KIIT School of Management,Bhubaneswar*Net Working CapitalCurrent Assets - Current Liabilities.Gross Working CapitalThe firms investment in current assets.Working Capital ManagementThe administration of the firms current assets and the financing needed to support current assets.


CURRENT ASSETS*Prof. S B Mishra KIIT School of Management,Bhubaneswar*Inventories: Raw Materials , Semi Finished Goods, Finished Goods.Sundry Debtors/ Accounts ReceivableCash and Bank BalanceShort Term Investments.Loans and Receivable including Bills Receivable.Prepaid Expenses Accrued Incomes


Characteristics of Current Assets*Prof. S B Mishra KIIT School of Management,Bhubaneswar*Short Life Span Swift Transformation into other Asset forms.Easily convertible into cash.Nature of repetitive and frequentSubstantial portion of total investmentDepends upon the changes in level of business activitiesIndicator of nature of financial planning.Reveals the credit worthiness of the firmTotal current assets in nothing but gross working capital.


Concepts- CURRENT LIABILITIES*Prof. S B Mishra KIIT School of Management,Bhubaneswar*Sundry Creditors:ProvisionsShort Term Bank Loans.Bank OverdraftsOutstanding Expenses.


Another way to look at it*Prof. S B Mishra KIIT School of Management,Bhubaneswar*


Permanent Working Capital*Prof. S B Mishra KIIT School of Management,Bhubaneswar*The amount of current assets required to meet a firms long-term minimum needs.Permanent current assetsTIMEAMOUNT


Temporary Working Capital*Prof. S B Mishra KIIT School of Management,Bhubaneswar*The amount of current assets that varies with seasonal requirements.Permanent current assetsTIMEAMOUNTTemporary current assets


TYPES OF WORKING CAPITAL

*Prof. S B Mishra KIIT School of Management,Bhubaneswar*WORKING CAPITALBASIS OF CONCEPTBASIS OF TIMEGross Working CapitalNet Working CapitalPermanent / Fixed WCTemporary / Variable WCRegular WCReserve WCSpecial WCSeasonal WC


Now we know*Prof. S B Mishra KIIT School of Management,Bhubaneswar*Gross Working CapitalNet Working capitalPermanent Working capitalTemporary Working capitalCurrent Assets types and their featuresCurrent Liabilities or Sources of Short Term Finance


What do we mean by managing working capital ?*Prof. S B Mishra KIIT School of Management,Bhubaneswar*


WCM includes*Prof. S B Mishra KIIT School of Management,Bhubaneswar*

Decision about the level of investments in each of the current assets.Arranging funds from short term and long term sources for the investments in current assets.


In other words.WCM includes*Prof. S B Mishra KIIT School of Management,Bhubaneswar*Cash Management.Receivables Management.Inventory Mangement.Management of Accounts PayablesManaging other internal but short term sources of finance.Managing Bank financing of WC.


Why WCM is important ?*Prof. S B Mishra KIIT School of Management,Bhubaneswar*


*Prof. S B Mishra KIIT School of Management,Bhubaneswar*Investment in CA represents a substantial portion of total investment.Investment in CA and level of CL have to be geared quickly to changes in sales.


Significance of WCM*Prof. S B Mishra KIIT School of Management,Bhubaneswar*In a typical manufacturing firm, current assets exceed one-half of total assets.Excessive levels can result in a substandard Return on Investment (ROI).Current liabilities are the principal source of external financing for small firms.Requires continuous, day-to-day managerial supervision.Working capital management affects the companys risk, return, and share price.


Dimensions of WCM*Prof. S B Mishra KIIT School of Management,Bhubaneswar*


3D Nature of Working Capital Management*Prof. S B Mishra KIIT School of Management,Bhubaneswar*Dimension IProfitability, Risk, & LiquidityDimension IIComposition & Level of CADimension IIIComposition & Level of CL


*Prof. S B Mishra KIIT School of Management,Bhubaneswar*Working Capital: trade-offsInventory of raw materialsQuantity discounts (lower unit cost)Risk of inventory shortage (production stop)Inventory of finished goodsRisk of inventory shortage (loss of revenue)Delivery flexibility through high and easily accessible inventory level (larger market share)ReceivablesCredit period as competitive sales argumentTrade payablesCredit versus lower unit price or higher product quality


CHALLENGES in WCM*Prof. S B Mishra KIIT School of Management,Bhubaneswar*WCM encompasses all departments including finance. Cash Management, Management of Receivables and Inventory Management etc. are the responsibilities of finance executives and departmental executives. This division of responsibilities makes a coordinated approach to WCM both necessary and difficult- particularly when managers from different departments are pursuing different goals.The two main aims to be satisfied by the WC Manger are profitability and liquidity. However the two goals of profitability and liquidity frequently conflict with each other .


Three alternative working capital investment policies*Prof. S B Mishra KIIT School of Management,Bhubaneswar* Sales ($)Current Assets ($)Policy CPolicy APolicy B


*Prof. S B Mishra KIIT School of Management,Bhubaneswar*Policy C represents conservative approachPolicy A represents aggressive approach Policy B represents a moderate approach

Optimal level of working capital investment

Risk of long-term versus short-term debt


Working capital requirements is based on what factors?*Prof. S B Mishra KIIT School of Management,Bhubaneswar*


*Prof. S B Mishra KIIT School of Management,Bhubaneswar*

FACTORS DETERMINING WORKING CAPITAL 1. Nature of the Industry 2. Demand of Industry 3. Cash requirements 4. Nature of the Business 5. Manufacturing time 6. Volume of Sales 7. Terms of Purchase and Sales 8. Inventory Turnover 9. Business Turnover 10. Business Cycle 11. Current Assets requirements 12. Production Cycle contd


*Prof. S B Mishra KIIT School of Management,Bhubaneswar*Working Capital Determinants (Contd) 13. Credit control 14. Inflation or Price level changes 15. Profit planning and control 16. Repayment ability 17. Cash reserves 18. Operation efficiency 19. Change in Technology 20. Firms finance and dividend policy 21. Attitude towards Risk


HOW DO WE DETERMINE WORKING CAPITAL NEEDS*Prof. S B Mishra KIIT School of Management,Bhubaneswar*


Different approaches in determination of working capital*Prof. S B Mishra KIIT School of Management,Bhubaneswar*Industry norm approachEconomic modeling approachStrategic choice approach


How to use OPERATING CYCLE Approach to Estimate WC*Prof. S B Mishra KIIT School of Management,Bhubaneswar*


THE WORKING CAPITAL CYCLE (OPERATING CYCLE)Accounts PayableCashRawMaterialsW I PFinished GoodsValue AdditionAccountsReceivableSALES*Prof. S B Mishra KIIT School of Management,Bhubaneswar*


OPERATING CYCLE AND CASH CYCLE

Order placed Stock arrives Goods sold Cash received Inventory period Accounts receivable period Accounts payable period

Firm receives Cash paid for invoice materials Operating cycle

Cash cycle

Average inventoryInventory period = Average COGS / 365 Average accounts receivable Accounts receivable period = Annual sales / 365 Average accounts payable Average payable period = Average COGS / 365*Prof. S B Mishra KIIT School of Management,Bhubaneswar*


OC contdOC includes the duration of time required to complete the following sequence of events , in case of a manufacturing firm , is called the operating cycle.Conversion of Cash into Raw Materials.Conversion of Raw Materials into Work in Progress.Conversion of WIP into Finished Goods.Conversion of Finished Goods into Accounts Receivables.Conversion of Accounts Receivables into Cash .*Prof. S B Mishra KIIT School of Management,Bhubaneswar*


Concepts- Dynamic View*Prof. S B Mishra KIIT School of Management,Bhubaneswar*Working Capital Investment =Investment in Raw Material+Investment in Work In Process+Investment in Finished Goods+ Investment in Accounts Receivable+Investment in Minimum Cash Balance-Accounts Payables


Raw MaterialConsumptionPeriod

=Average Raw MaterialInventory(Annual RawMaterialConsumption ) /360=Average WIP Inventory(Cost of Production)/360Work in ProcessConversion Period

FORMULA*Prof. S B Mishra KIIT School of Management,Bhubaneswar*


Finished Goods Conversion Period

=Average Finished GoodsInventory(Cost of Goods sold) /360=Average Sundry Debtors(Credit Sales)/360Debtors ConversionPeriod

FORMULA*Prof. S B Mishra KIIT School of Management,Bhubaneswar*


Creditors Payment Period=Average Creditors(Credit Purchases) /360FORMULA*Prof. S B Mishra KIIT School of Management,Bhubaneswar*


FORMULA contd..*Prof. S B Mishra KIIT School of Management,Bhubaneswar*Annual Consumption of Raw Material=Opening stock of Raw Material + Purchases Closing stock of Raw materialsAnnual Cost of Production = Opening stock of WIP + Annual Consumption of Raw material + Production Cost + Depreciation Closing WIP


*Prof. S B Mishra KIIT School of Management,Bhubaneswar*Cost of Sales= Opening inventory of Finished Goods+ Annual Cost of Production +Sales and Distrn Cost + Excise Duty -Closing stock of Finished Goods


*Prof. S B Mishra KIIT School of Management,Bhubaneswar*COST OF PRODUCTION. (COP)Add Opening Finished Goods InventoryAdd Selling and Distribution OverheadsLess Closing Finished Goods Inventory


PROFORMA - WORKING CAPTIAL ESTIMATES

*Prof. S B Mishra KIIT School of Management,Bhubaneswar*1. TRADING CONCERN

STATEMENT OF WORKING CAPITAL REQUIREMENTS Amount (Rs.)Current Assets(i) Cash ----(ii) Receivables ( For..Months Sales)---- ----(iii) Stocks ( ForMonths Sales)----- ----(iv)Advance Payments if any ----Less : Current Liabilities(i) Creditors (For.. Months Purchases)- ----(ii) Lag in payment of expenses -----_WORKING CAPITAL ( CA CL ) xxxAdd : Provision / Margin for Contingencies -----

NET WORKING CAPITAL REQUIRED XXX


1. MANUFACTURING CONCERN

*Prof. S B Mishra KIIT School of Management,Bhubaneswar*STATEMENT OF WORKING CAPITAL REQUIREMENTSAmount (Rs.)Current Assets(i) Stock of R M( for .months consumption)-----(ii)Work-in-progress (formonths) (a) Raw Materials ----- (b) Direct Labour----- (c) Overheads-----(iii) Stock of Finished Goods ( for months sales) (a) Raw Materials----- (b) Direct Labour----- (c) Overheads-----(iv) Sundry Debtors ( for months sales) (a) Raw Materials----- (b) Direct Labour----- (c) Overheads-----(v) Payments in Advance (if any)-----(iv) Balance of Cash for daily expenses-----(vii)Any other item -----

Less : Current Liabilities(i) Creditors (For.. Months Purchases)-----(ii) Lag in payment of expenses-----(iii) Any other -----WORKING CAPITAL ( CA CL )xxxxAdd : Provision / Margin for Contingencies-----

NET WORKING CAPITAL REQUIREDXXX


SESSION 2*Prof. S B Mishra KIIT School of Management,Bhubaneswar*


HOW TO MANAGE RECEIVABLES*Prof. S B Mishra KIIT School of Management,Bhubaneswar*


Receivables ( Sundry Debtors ) result from CREDIT SALES. A concern is required to allow credit in order to expand its sales volume. Receivables contribute a significant portion of current assets. But for investment in receivables the firm has to incur certain costs (opportunity cost and time value ) Further, there is a risk of BAD DEBTS also. It is, therefore very necessary to have a proper control and management of receivables.

*Prof. S B Mishra KIIT School of Management,Bhubaneswar*MANAGEMENT OF RECEVABLES


OBJECTIVES

The objective of Receivables Management is to take sound decision as regards to investment in Debtors. In the words of BOLTON S E., the objective of receivables management is

to promote sales and profits until that point is reached where the return on investment in further funding of receivables is less than the cost of funds raised to finance that additional credit*Prof. S B Mishra KIIT School of Management,Bhubaneswar*


DIMENSIONS OF RECEIVABLES MANAGEMENT

*Prof. S B Mishra KIIT School of Management,Bhubaneswar*OPTIMUM LEVEL OF INVESTMENT IN TRADE RECEIVABLES

Profitability

Costs &Profitability Optimum Level

Liquidity

StringentLiberal


TERMS OF PAYMENT Cash Terms Open Account Consignment Bill of Exchange Letter of Credit*Prof. S B Mishra KIIT School of Management,Bhubaneswar*


CREDIT POLICY VARIABLESThe important dimensions of a firms credit policy are: Credit standards Credit period Cash discount Collection effort*Prof. S B Mishra KIIT School of Management,Bhubaneswar*


Cost Benefit Analysis of change in credit policy variables*Prof. S B Mishra KIIT School of Management,Bhubaneswar*


Cost and Benefits associated with changes in Credit Policy*Prof. S B Mishra KIIT School of Management,Bhubaneswar* COSTSIncrease in interest payment on additional investment in receivables.Increase in Discount CostIncrease in Bad Debt Loss BENEFITSIncrease in SalesDecrease in interest payment on LESS investment in receivables.


Rule of Acceptance*Prof. S B Mishra KIIT School of Management,Bhubaneswar*We accept a change in credit policy variable if Benefits are more over cost.

In other words we accept if RESIDUAL INCOME ( Benefits Cost is More)


IMPACT ON RESIDUAL INCOME OF LONGER CREDIT PERIOD

RI = [S(1 V) - Sbn] (1 t ) k I



INCREASE IN RECEIVABLES INVESTMENT

S0 SI = (ACPn ACP0) + V (ACPn) 360 360

where: I = increase in receivables investment ACPn = new average collection period (after lengthening the credit period) ACP0 = old average collection period V = ratio of variable cost to sales S = increase in sales *Prof. S B Mishra KIIT School of Management,Bhubaneswar*


CONTROL OF ACCOUNTS RECEIVABLES Days Sales Outstanding Ageing Schedule Collection Matrix*Prof. S B Mishra KIIT School of Management,Bhubaneswar*


AVERAGE COLLECTION PERIOD AND AGEING SCHEDULE

*Prof. S B Mishra KIIT School of Management,Bhubaneswar*The collection of BOOK DEBTS can be monitored with the use of average collection period and ageing schedule.The ACTUAL AVERAGE COLLECTION PERIOD IS COMPARED WITH THE STANDARD COLLECTION PERIOD to evaluate the efficiency of collection so that necessary corrective action can be initiated and taken.


THE AGEING SCHEDULE HIGHLIGHTS THE DEBTORS ACCORDING TO THE AGE OR LENGTH OF TIME OF THE OUTSTANDING DEBTORS.

The following table presents the ageing scheduleAGEING SCHEDULE

Outstanding PeriodO/s Amount of Debtors % of Debtors

0 30 Days 5,00,0005031 40 Days 1,00,0001041 60 Days 2,00,0002061 90 Days 1,00,00010Over 60 Days 1,00,00010Total10,00,000100*Prof. S B Mishra KIIT School of Management,Bhubaneswar*


Have the right mental attitude to the control of credit and make sure that it gets the priority it deserves. Establish clear credit practices as a matter of company policy. Make sure that these practices are clearly understood by staff, suppliers and customers. Be professional when accepting new accounts, and especially larger ones. Check out each customer thoroughly before you offer credit. Use credit agencies, bank references, industry sources etc. Establish credit limits for each customer... and stick to them.

*Prof. S B Mishra KIIT School of Management,Bhubaneswar*Guidelines for Effective Receivables Management


7. Continuously review these limits when you suspect tough times are coming or if operating in a volatile sector. 8. Keep very close to your larger customers. 9. Invoice promptly and clearly. 10. Consider charging penalties on overdue accounts. 11. Consider accepting credit /debit cards as a payment option. 12. Monitor your debtor balances and ageing schedules, and don't let any debts get too large or too old.



WORKING CAPITAL FINANCING*Prof. S B Mishra KIIT School of Management,Bhubaneswar*


ACCRUALS*Prof. S B Mishra KIIT School of Management,Bhubaneswar*The major accrual items are wages and provisions.

Accruals vary with the level of activity of the firm.

While accruals are a welcome source of financing, they are typically not amenable to control by management.


TRADE CREDIT*Prof. S B Mishra KIIT School of Management,Bhubaneswar*Trade credit represents the credit extended by the suppliers of goods and services. It is a spontaneous source of finance.

The confidence of suppliers is the key to securing trade credit.


WORKING CAPITAL ADVANCE BY COMMERCIAL BANKS

Application and processing Sanction, terms and conditions Forms of bank finance Cash credits/Overdrafts Loans Purchase/Discount of Bills Letter of credit Security Hypothecation Pledge Margin amount*Prof. S B Mishra KIIT School of Management,Bhubaneswar*


MAXIMUM PERMISSIBLE BANK FINANCE (MPBF)

Tandon Committee had suggested three methods for determining the MPBFMethod 1 : MPBF = 0.75 (CA CL)Method 2 : MPBF = 0.75 (CA) CLMethod 3 : MPBF = 0.75 (CA CCA) CLCA = current assetsCL = non-banking current liabilitiesCCA = core current assets*Prof. S B Mishra KIIT School of Management,Bhubaneswar*


*Prof. S B Mishra KIIT School of Management,Bhubaneswar*CASH CREDIT / OVERDRAFT A predetermined limit for borrowing is specified by the bank.

The borrower can draw as often as required.

Repayment as and when desired.

Interest is charged on running balance subject to a minimum amount to be paid.


*Prof. S B Mishra KIIT School of Management,Bhubaneswar*LOANSFor the portion of permanent working capital.

Like a term loan .

Interest is payable on the whole portion.

Backed by a demand promissory note.


*Prof. S B Mishra KIIT School of Management,Bhubaneswar*Purchase/ Discount of BillsFor financing sundry creditors.

Against trade bills.

Can be demand or usance bill.


*Prof. S B Mishra KIIT School of Management,Bhubaneswar*Letter of Credit ( LOC)Through this the bank helps the customer to obtain credit from its suppliers.

Through this the bank undertakes the responsibility to honor the obligation of its customer, should the customer fail to do so.

Its a indirect form of financing.


SUMMING UP

Typically, the current assets of the firm are supported by a combination of long-term and short-term sources of financing.

The following sources of finance more or less exclusively support current assets: accruals, trade credit, working capital advance by commercial banks, public deposits, inter-corporate deposits, shot-term loans from financial institutions, rights debentures for working capital,commercial paper, and factoring.*Prof. S B Mishra KIIT School of Management,Bhubaneswar*


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final mdp wcm class.ppt

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