Prof S N Rao 1

Working Capital Policy

Prof S N Rao 2

Working Capital Policy

Concepts of Working CapitalCharacteristics of current assetsFactors influencing Working Capital requirementLevel of current assetsCurrent asset financing policyOperating cycle analysisCash requirement for working capital

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Concepts of Working CapitalGross Working CapitalNet Working Capital

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Proportions of CAs &FAsCAs FAs Industry10-20 80-90 Hotels & Service Ind20-30 70-80 Electricity generation & distribution30-40 60-70 Aluminum, Shipping40-50 50-60 Iron and Steel, Chemicals50-60 40-50 Tea plantation60-70 30-40 Cotton textiles & Sugar70-80 20-30 Food Processing, Tobacco80-90 10-20 Trading & construction

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Characteristics of CAsShort life span & swift transformationCash: 7-10 daysDebtors: 30-60 days Inventories: 2-60 days

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Current Asset Cycle

CashRaw material

Work in process

Finished goods

Debtors

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Implications for WC MgtWorking capital decisions are repetitive and frequentThere is close interaction among working capital components

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Factors influencing WC requirements

Nature of businessSeasonality of operationsProduction policy/strategyMarket conditionsConditions of supply

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Working Capital Policy Decision

Current Asset PolicyWhat should be the level of current

assets in relation to sales (CA/Sales)?Current Asset Financing PolicyWhat should be the level of short-term

financing in relation to long-term financing? (ST loans/LT loans OR ST loans/NCA )

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Types of WC PolicyAggressive ORRestrictive Working Capital Policy

ModerateWorking Capital Policy

ModerateWorking Capital Policy

Conservative OR FlexibleWorking Capital Policy

Level of Current Assets (CA/Sales)

Level of Short Term Financing

(ST/LT)

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Optimal Level of CAs

costs

Level of Current Assets

Total costsCarrying costs

Shortage costs

CA*

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Financing of CAs

Time

FA requirement

Permanent CA

Fluctuating CA

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Matching PrincipleMaturity of the sources of financing should match the maturity of the assets being financedFixed assets and permanent current assets should be financed by long-term sources of financeFluctuating current assets should be financed by short-term sources of finance

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Operating Cycle and Cash Cycle

Order placed Stocks arrive

Inventory period A/R period

A/P periodCash paid for material

Operating cycle periodCash cycle period

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Operating Cycle for AL2002 2003 2004 2005

Avg Inventory 557 503 459 538COGS/Day 5.36 5.69 7.84 9.68Inventory period 104 88 59 56

Avg Debtors 580 506 462 432Net Sales/Day 6.37 7.55 9.42 11.64

Debtors period 91 67 49 37

Operating cycle period 195 155 108 93

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Operating Cycle for AL2002 2003 2004 2005

Avg Creditors 314 326 390 549

COGS-Emp cost 1698 1779 2545 3169

(COGS-Emp C)/day 4.65 4.87 6.97 8.68

Creditors period 68 67 56 63Operating cycle period 195 155 108 93Cash cycle period 127 88 52 30

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Estimation of Cash WC Requirement

Estimate the cash cost of various current assets required by the firmDeduct the spontaneous current liabilities from the sum of cash cost of current assetsThe difference, plus margin of safety, is Cash Working Capital required

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Working Capital Requirement on Cash Basis-Example

Sales (credit period: 2months) Rs.240 m

Materials (Credit period: 2 months) Rs.72 m

Wages (paid monthly in arrear) Rs.48 m

Mfg exp outstanding at the end of year(cash expenses,paid one month in arrear)

Rs.4

Total administrative exp,paid as incurred Rs.30

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Working Capital Requirement on Cash Basis

The company sells its products on gross profit of 25%, counting depreciation as part of the COPIt keeps two months stock of Rmonemonths stock of FG, and cash balance of Rs.5 mAssuming 10% safety margin, work out the WC requirements on cash basis (ignore WIP)

Prof S N Rao

Cash Management

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Prof S N Rao

Cash ManagementShort-term cash forecasting (Cash Budgeting)Reports for ControlFactors for efficient cash managementInvestment of surplus funds

(treasury Mgt)

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Prof S N Rao

Short-term Cash ForecastingHelpful in

Estimating cash requirements/surplusPlanning short-term financing/investmentsScheduling payments in connection with capital expenditure projectsPlanning purchases of materialsDeveloping credit policies

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Prof S N Rao

Short-term Cash ForecastingReceipt item Basis of EstimationCash sales Est.sales and its division

between cash and cr. sales

Collection of A/R Credit policyInt. and div. receipts Firms portfolio of sec.

Increase in loans, deposits, and issue of new securities

Firms financing plan

Sale of assets Proposed disposal of assets

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Prof S N Rao

Short-term Cash ForecastingPayment item Basis of EstimationCash purchases Estimated purchases

and its division between cash/credit purchase

Payment for purchases

Credit policy of suppliers

Wages and salaries Manpower employed and wages/salary structure

Mfg expenses Production plan24

Prof S N Rao

Short-term Cash ForecastingPayment item Basis of EstimationGen & Admin& sellig expenses

Admin&sales personnel and proposed sales promotion and distribution expenses

Capital equip purchases

Capital expenditure budget and payment pattern

Repayment of loans and retirement of securities

Financing plan

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Prof S N Rao

Reports for Monitoring and ControlDaily Cash Report:Opening BalanceReceipts:-Cash Sales-Collection of credit sales-Borrowings-Others

Total Receipts26

Prof S N Rao

Reports for Monitoring and ControlPayments:-Cash purchases of RM-Payments made for credit purchasesRepayment of loansOthersTotal PaymentsNet cash flowClosing Balance

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Prof S N Rao

Reports for Monitoring and ControlDaily Treasury ReportCashOpening balanceReceiptsPaymentsClosing balance

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Prof S N Rao

Reports for Monitoring and ControlDaily Treasury Report

Marketable SecuritiesOpening balancePurchasesSalesClosing balance

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Prof S N Rao

Reports for Monitoring and ControlDaily Treasury Report

Accounts ReceivableOpening balanceBills raisedCash receiptsClosing balance

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Prof S N Rao

Reports for Monitoring and ControlDaily Treasury Report

Accounts PayablesOpening balanceBills receivedCash paymentsClosing balance

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Prof S N Rao

Reports for Monitoring and ControlDaily Treasury ReportOpening net treasury position

Closing net treasury position

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Prof S N Rao

Factors for Efficient Cash Management

Prompt billingExpeditious collection of chequesCentralized purchases and payments to suppliers

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Prof S N Rao

Investing Surplus CashTwo basic problems

Determination of surplus cashDuring normal periodDuring peak period

Surplus cash = actual cash - Min cash req.

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Prof S N Rao

Investing Surplus CashDetermination of channels of investmentCriteria for investment:SecurityLiquidityYieldmaturity

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Prof S N Rao

Investing Surplus CashPurpose of holding surplus cash

Criteria for investment

To meet un-foreseen payments

Safety and liquidity

To make available on certain definite dates

Safety and maturity

General reserves not required to meet any specific payments

Safety and yield

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Prof S N Rao

Forms of LiquidityCash balance (4% -5% of CAs)Cash credit arrangementBenefits: lesser after tax costDisadvantages: imposition of penal

interest on under/over utilization and close scrutiny of budgets of the company by banks

Marketable securitiesT Bills,Govt Bonds,CPs,ICDs, CDs, Bill

Disc,other Capital market securities

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Prof S N Rao

Choice of Liquidity MixDepends on

Uncertainty surrounding the cash flow projectionsAttitude of the management towards riskAbility to raise non-bank fundsAbility to control its cash flows

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Prof S N Rao

Cash Management ModelsBaumol ModelMiller and Orr Model

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Prof S N Rao

Baumol ModelAssumptions It is possible to forecast cash

requirements with certaintyCash payments occur uniformly over the

periodOpportunity cost of holding cash is

known and it does not change over the period

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Prof S N Rao

Miller Orr ModelAssumptionsChanges in the cash balance over given

period are random in size as well as direction

Questions to be answeredWhen should transfer be effected

between marketable securities and cash?

What should be the magnitude of these transfers?

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Credit Management

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Credit Policy VariablesCredit standardsCredit periodCash discountCollection effort

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Credit Policy VariablesCredit standards What standard should be applied in accepting or

rejecting an account for granting credit?Not to extend credit to any customerExtend credit to every customer

Actual credit standards lie between the two extreme positions

Liberal credit standardsPush up salesLead to higher bad debt lossHigher collection costRequires more investment in receivables

Stiff credit standards have the opposite effects Change in credit standard has impact on profit

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Credit Policy VariablesCredit period Varies from 15-60 days Stated as net 30 or net 60 Lengthening of credit period

Pushes up salesResults in higher investment in debtorsLeads to higher bad debt loss

Shortening of credit period has opposite impact

Change in credit period has impact on profit

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Credit Policy VariablesCash discount Offered to induce customers to make prompt payments The discount percentage and discount period is reflected

in credit terms Example: 2/10, net 45 Liberalizing cash discount policy may mean higher

discount percent and/or longer discount period Results into

Higher salesLower average collection periodLower investment in debtorsHigher cost of discount

Tightening cash discount policy will have opposite effect Change in discount policy has impact on profit

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Credit Policy VariablesCollection effort Monitoring the state of receivables Dispatch of letters to customers whose due date is

approaching Electronic and telephonic advice to customers around

the due date Threat of legal action to overdue accounts Legal action against overdue accounts Rigorous collection efforts

tends to decrease salesShorten average collection periodReduce bad debt lossIncrease collection cost

Lax collection effort will have opposite effect Change in collection effort has impact on profit

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Credit EvaluationAssessment of credit riskHelps in establishing credit limitsErrorsType-I error: a low risk customer is

misclassified as a high risk customerType-II error: a high risk customer is

misclassified as a low risk customer

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Credit EvaluationTraditional Credit Evaluation Assessment of prospective customer in terms of

Character: willingness to honor obligationsCapacity: ability to meet obligations from OCFsCapital: availability of capital for meeting obligations in case OCFs are not sufficientCollateral: security offered by the customer in the form of pledged assetsConditions: the general conditions that affect the customers ability to meet obligations

Sources of informationFinancial statementsBank referenceExperience of the firmStock market performance of customer firm

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Credit EvaluationNumerical Credit Scoring Identify factors relevant for credit evaluation Assign weights to these factors that reflect

their relative importance Rate the customer on various factors using

suitable rating scale Convert factor into factor score Add all the factor scores to get the overall

customer rating index Based on the rating index, classify the

customer

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Credit EvaluationConstruction of Credit Rating Index (based on a 5 point rating scale)

Factor Factor weight Rating Factor Score

Past payment 0.30 4 1.2

Net profit margin

0.20 4 0.8

Current ratio 0.20 5 1.0

D/E ratio 0.10 4 0.40

Return on equity

0.20 5 1.0

Rating Index 4.20Prof S N Rao 51

Credit EvaluationRisk Classification Scheme

Category or Risk Class Description

1 Customer with no risk of default

2 Customers with negligible risk (default rate less than 2%)

3 Customers with little risk (default rate between 2%-5%)

4 Customers with some risk (default rate between 5%-10%)

5 Customers with significant risk (default rate of more than 10%)

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Credit EvaluationDiscriminant Analysis Identify two key variables for assessing credit

risk of customers Plot all the customers , both who paid dues in

time and who defaulted, on a graph based on these two variables

Identify dividing line between good customers and bad customers

Find the equation for the dividing line Compute the cutoff value Classify the customers based on the cut-off

valueProf S N Rao 53

Credit Granting DecisionCompute expected profit of offering credit without repeat order and with repeat order If it is positive, offer credit

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Control of Credit-Days Sales Outstanding (DSO)

Month SalesReceivables

Jan 150 400Feb 200 450Mar 250 500Apr 120 350May 220 380June 250 400

Month Sales Receivables

Jan 150 400Feb 156 450Mar 158 375Apr 160 420May 155 410June 158 380

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Control of Credit-Aging Schedule (AS)

Age group Percent of receivables

0-30 35

31-60 40

61-90 20

>90 5

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Limitations of DSO & ASInfluenced by sales patternPayment behavior of customersIf sales are increasing/decreasing DSO and the AS will defer from what they would be if sales are constant This holds even when payment behavior of the customer remain unchanged

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Collection Matrix/Payment Pattern%of ARs collected during the

Jan Feb Mar

Month of sales 10 10 10

One month after sales 30 25 20

Two months after sales 30 35 20

Three months after sales

30 25 20

Four months after sales - 5 30

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Credit Management in IndiaCredit Policy

No formalization of credit policyToo general statement of policyCredit period: 0-60 daysCash discount for prompt payments is not common

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Credit Management in IndiaCredit Analysis

No detailed analysis of financial statementsCustomers are required to furnish 2-3 referencesIndependent agencies for credit rating are coming upCredit information from bank is too generalLarge companies classify customers based on credit worthiness

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Credit Management in IndiaControl of Receivables

No systematic methods for controlling and monitoring receivablesNormal measures of credit managementBad debt lossesAverage collection periodAging schedule

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Inventory Management

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Inventory ManagementTypes of InventoryEOQ ModelOrder pointFactors affecting inventory levelsValuation of StockMonitoring and Control of Inventory

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Types of InventoryProcess inventoryMovement inventoryOrganization inventory

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EOQ ModelAssumptions

Usage is knownEven usageImmediate replenishmentOnly two costs: ordering and carryingOrdering cost is constantCarrying cost is fixed % of the avg inventory

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Ordering PointIf lead time and usage are stable:

Ordering point = lead time for procurement X daily usage

If lead time and usage are volatileOrdering point= ( Avg lead time for procurement X

Average daily usage) + Safety stock

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Factors Influencing level of inventory

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Factors influencing inventoryAnticipated scarcityExpected price changeObsolescence riskGovt restrictionsMarketing considerations

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Pricing of Raw MaterialFIFO MethodLIFO MethodWA Cost MethodStd Cost MethodCurrent Cost Method

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Valuation of InventoryDirect/Variable CostingFixed Mfg exp are treated as period

costValue of WIP&FG is lower under this

methodAbsorption/Total CostingFixed Mfg exp are treated as product

costValue of WIP & FG is higher under

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Monitoring and Control of InventoryABC AnalysisRatio AnalysisJITOut sourcingComputerized inventory control system

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Inventory Management in IndiaInventory levels in India are high due to

Sever penalty for stock out and no penalty for excess inventoryLengthy and cumbersome import processHigh inflationLack of standardizationLong lead time

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Inventory Management in IndiaCommon tools of Inventory Mgt

FSN AnalysisInventory turn over ratiosABC Analysis

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Sources of WC Finance

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Sources of WC FinanceAccrualsTrade AdvancesTrade creditsCPsPublic depositsBank FinanceICDsRights DebenturesFactoring

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AccrualsWages &TaxesCost free sourcesNot amenable to control by Mgt

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Trade advancesCommon in cases of expensive productsMonopoly marketsCost free?

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Trade CreditRepresents the credit extended by the supplier of goods and servicesSpontaneous source of financeConstitutes 25%-50% of WC financeIs it cost free?

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Commercial PaperIntroduced in Jan 1990In FY 2012-13 alone, Corporate India raised about Rs.3.72 lakh Cr. through 4,856 issues (Prime Database).Maturity period: 7-364 daysSold at discount redeemed at face valueTraded on SBI-DFHIGenerally held till maturity

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Commercial PaperRegulations

Net worth of at least Rs. 4 crSanctioned WC limit by Banks/FIsFV of CPs issued should not exceed WC limitListed company

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Commercial PaperRated P1/A2 Enjoys health code no 1Min issue size is Rs.25 lakh and min denomination is Rs.5 lakhCost?

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CP issue of ONGC Videsh Ltd (OVL)

Issue size: Rs.5,250 crThe largest CP issue in IndiaMaturity: 1 yearImplied yield: 8.15%Post-tax interest cost: 5.5%Yield on 1-year T-bill: 4.75%Guaranteed by ONGC which Cash balance of Rs.25,000 crsIssue date: First week of Jan 2009

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CP issue of ONGC Videsh Ltd (OVL)

Objective: To part finance the acquisition of UK based Imperial EnergyTotal acquisition price: USD 2.1 bCP issue amount: around USD 1bBalance amount is provided by ONGC as long-term debt

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Public DepositsCan not exceed 25% of NWMaturity: 6 months 3 yearsDRRDisclosure of financial performanceCost?

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Public Deposit Schemes of Tata MotorsScheme-A: Quarterly Income Plan

Scheme-BCumulative Deposit Plan

Period Min Amt

Int Rate (p.a)

Period Min Amt

Int Rate (p.a.)

Maturity value

Implied yield

1 year 20000 10% 1 year 20000 10% 22 076 10.36%

2 years 20000 10.5% 2 years 20000 10.5% 24 607 10.92%

3 years 20000 11% 3 years 20000 11% 27 696 11.46%

0.5% additional interest for senior citizens/shareholders/employeesThe issue was floated in Nov 2009

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Public Deposit Schemes of Bombay Dyeing Period: 36 months Interest rate: 10.5% p.a. payable quarterly Effective interest rate: 10.36% Floated in Jan 2009

Godrej & Boyce Mfg Company Period: 3 years Interest rate: 10% p.a. payable half yearly Effective interest rate: 10.25% Floated in August 2008

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Public DepositsMaturity HDFC Bajaj Fin M&M Fin Shriram

TFC

12 months 8.75% 9.75% 9.25% 9.25%

24 months 9.05% 9.75% 10% 9.75%

36 months 9.15% 10% 10.25% 10.75%

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Bank FinanceCC/ODLoansPurchase/Discount of BillsLCsSecurity Hypothecation Pledge Mortgage

MPBF & Margin Cost?

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ICDsCall depositsThree-month depositsSix-month depositsNo regulationsSecrecyImportance of personal contactsCost?

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Rights DebenturesAmount should not exceed 20% of the (GWC LT funds available

for WCF) OR20% of paid-up capital incl Pref Cap and

free reserves , whichever is lowerD/E ratio, including proposed debenture

issue, should not exceed 1:1 Cost?

90Prof S N Rao

Debenture Issue of Shriram Transport Finance Co. Ltd

Issue size: Rs.500 cr with option to retain over subscription upto Rs.500 crIssue period: 27 Jul 2009-14 Aug 2009Min amount: Rs.10000Maturity: 3 years/5 yearsInterest rateL 10.75% to 11.5%

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FactoringIt is a powerful financial instrument

specially designed to meet the post sales working capital requirements of the industrial, trade & service sectors, it is a portfolio of complementary financial services. Besides financing up to 80% of the invoice value, the package includes:

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FactoringSales ledger administrationDebtor collectionCredit information servicesAdvisory services

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FactoringTypes of Factoring

With recourse factoringWithout-recourse factoringUndisclosed factoring

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FactoringBenefits of Factoring

Instant access to cashMake payments to creditors, avail cash discountsMaintenance of sales ledgerCollection of debtorsClients can focus on other functions

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FactoringEligibility

Mfg, trading or services companyShould have sound financial baseTurnover of not less than Rs.50 lacsStrong and prompt customer base

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Factoring

Where Factoring is not suitableWhere large volume of cash sales take placeEngaged in speculative businessSelling highly specialized capital equipments or made-to-order goods

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FactoringWhere credit period offered to the buyers is more than 180 daysWhere there is consignment saleWhere sales are to the sister/associated companiesWhere sales are to the public at largeCost?

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Some Factoring CompaniesCabank Factors SBI FactorsIFCI Factors

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