working capital mgmt ppts 4

8/8/2019 Working Capital Mgmt Ppts 4

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Presentation on Working

Capital


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Working capital

Introduction

Working capital typically means the firmsholding of current or short-term assetssuch as cash, receivables, inventory and

marketable securities. These items are also referred to as

circulating capital

Corporate executives devote aconsiderable amount of attention to themanagement of working capital.


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Definition of Working CapitalDefinition of Working

Capital

Working Capital refers to that part of theWorking Capital refers to that part of the

firms capital, which is required for financingfirms capital, which is required for financing

short-term or current assets such a cashshort-term or current assets such a cash

marketable securities, debtors andmarketable securities, debtors and

inventories. Funds thus, invested in currentinventories. Funds thus, invested in currentassets keep revolving fast and areassets keep revolving fast and are

constantly converted into cash and thisconstantly converted into cash and this

cash flow out again in exchange for othercash flow out again in exchange for other

current assets. Working Capital is alsocurrent assets. Working Capital is alsoknown asknown as revolving or circulating capital orrevolving

or circulating capital or

short-term capital.short-term cap

ital.


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What are Current Assets ?What are Current Assets ?

Assets which normally get convertedinto cash during the operating cycleof the firm.

Cash & Bank balances

Inventory

Receivables Advances to suppliers/others

Other Current assets like

consumables


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What are Working Capital Sources?

Own funds

Bank borrowings

Sundry CreditorsAdvances from customers

Deposits due in a year

Other current liabilities


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What are Current Liabilities?What are Current Liabilities?

Liabilities which normally are to bepaid in cash during the operating

cycle of the firm. Loan amount becoming due

Creditors

PayablesAdvances from sellers

Salary , other overheads.


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Concept of Working Capital

There are two possible interpretations ofworking capital concept:1. Balance sheet concept

2. Operating cycle concept

Balance sheet conceptThere are two interpretations of workingcapital under the balance sheet concept.

a. Excess of current assets over currentliabilities

b. gross or total current assets.


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Excess of current assets over current liabilitiesare called the net working capital or net current

assets. Working capital is really what a part of long term

finance is locked in and used for supportingcurrent activities.

The balance sheet definition of working capital ismeaningful only as an indication of the firmscurrent solvency in repaying its creditors.

When firms speak of shortage of working capital

they in fact possibly imply scarcity of cashresources. In fund flow analysis an increase in working

capital, as conventionally defined, representsemployment or application of funds.


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Operating cycle concept

A companys operating cycle typically consists ofthree primary activities: Purchasing resources,

Producing the product and

Distributing (selling) the product.

These activities create funds flows that are bothunsynchronized and uncertain.Unsynchronized because cash disbursements (for example,payments for resource purchases) usually take place beforecash receipts (for example collection of receivables).

They are uncertain because future sales and costs, whichgenerate the respective receipts and disbursements, cannotbe forecasted with complete accuracy.


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circulating capital means current assets of acirculating capital means current assets of a

company that are changed in the ordinary coursecompany that are changed in the ordinary courseof business from one form to another, as forof business from one form to another, as for

example, from cash to inventories, inventories toexample, from cash to inventories, inventories to

receivables, receivable to cashreceivables, receivable to cash

GenestenbregGenestenbreg


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The firm has to maintain cash balance topay the bills as they come due.

In addition, the company must invest ininventories to fill customer orderspromptly.

And finally, the company invests inaccounts receivable to extend credit tocustomers.

Operating cycle is equal to the length ofinventory and receivable conversionperiods.


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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


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Working Capital Cycle of Non-manufacturing unit

Cash

Receivables

Stock of finished goods


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Working Capital Cyclein manufacturing sector

5. InventoryRaw materials/consumables

6. Production 8. Sales

10. receipts2. Payments

4.Purchases

3. Tradepayables

7. InventoryWork in

progress/finishedgoods

9. Tradereceivables

1. Cash(equivalents)


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THE WORKING CAPITALTHE WORKING CAPITAL

CYCLECYCLE

(OPERATING CYCLE)(OPERATING CYCLE)

Accounts Payable

Cash

Raw

MaterialsW I P

Finished

Goods

Value Addition

Accounts

ReceivableSALES


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Operating cycle of a typical company

PayableDeferral period

Inventory conversionperiod

Cash conversioncycle

Operatingcycle

Pay forResourcespurchases

ReceiveCashPurchase

resources

SellProductOn credit

ReceivableConversion period


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Time & Money Concepts inTime & Money Concepts inWorking Capital CycleWorking Capital Cycle

Each component of working capital (namely inventory, receivables andEach component of working capital (namely inventory, receivables andpayables) has two dimensions ........TIME ......... and MONEY, when it comes topayables) has two dimensions ........TIME ......... and MONEY, when it comes to

managing working capitalmanaging working capital


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TIME IS MONEYTIME IS MONEY

You can get money toYou can get money to move fastermove fasteraround thearound the

cycle orcycle or reduce the amountreduce the amount of money tied up.of money tied up.Then, business will generate more cash or it willThen, business will generate more cash or it will

need to borrow less money to fund working capital.need to borrow less money to fund working capital.

As a consequence, you couldAs a consequence, you could reduce the costreduce the costof bank interestof bank interest or you'll have additionalor you'll have additional freefreemoney available to support additional sales growthmoney available to support additional sales growth

or investment.or investment.

Similarly, if you canSimilarly, if you can negotiate improved termsnegotiate improved termswith suppliers e.g. get longer credit or anwith suppliers e.g. get longer credit or anincreased credit limit, you effectively createincreased credit limit, you effectively create freefreefinance to help fund future sales.finance to help fund future sales.


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If youIf you ThenThen ............

Collect receivables (debtors)Collect receivables (debtors)

fasterfaster

You release cash from theYou release cash from the

cyclecycle

Collect receivables (debtors)Collect receivables (debtors)

slowerslower

Your receivables soak upYour receivables soak up

cashcash

Get better credit (in termsGet better credit (in terms

of duration or amount) fromof duration or amount) from

supplierssuppliers

You increase your cashYou increase your cash

resourcesresources

Shift inventory (stocks)Shift inventory (stocks)

fasterfaster

You free up cashYou free up cash

Move inventory (stocks)Move inventory (stocks)

slowerslower

You consume more cashYou consume more cash


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Inventory conversion period

Avg. inventory

= _________________Cost of sales/365

Receivable conversion periodAccounts receivable

= ___________________Annual credit sales/365

Payables deferral period

Accounts payable + Salaries, etc

= ___________________________

(Cost of sales + selling, general and admn. Expenses)/365


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Cash conversion cycle = operating cycle payables deferral period.

Importance of working capital Risk and uncertainty involved in managing the

cash flows

Uncertainty in demand and supply of goods,escalation in cost both operating andfinancing costs.

Strategies to overcome the problem Manage working capital investment or

financing such as


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Holding additional cash balances beyondexpected needs

Holding a reserve of short term marketablesecurities

Arrange for availability of additional short-termborrowing capacity

One of the ways to address the problem offixed set-up cost may be to hold inventory.

One or combination of the above strategies

will target the problem Working capital cycle is the life-blood of

the firm


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Resource flows for a manufacturing firm

FixedAssets

Production

Process

Generates

Inventory

Via Sales Generator

Accountsreceivable

Used in

Accrued DirectLabour andmaterials

Accrued FixedOperatingexpenses

Cash andMarketableSecurities

SuppliersOf Capital

External Financing

Return on Capital

Collectionprocess

Used topurchase

Used topurchase

Used in

WorkingCapitalcycle


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FACTORS DETERMINING WORKING CAPITALFACTORS DETERMINING WORKING CAPITAL

1. Nature of the Industry1. Nature of the Industry

2. Demand of Industry2. Demand of Industry

3. Cash requirements3. Cash requirements

4. Nature of the Business4. Nature of the Business

5. Manufacturing time5. Manufacturing time

6. Volume of Sales6. Volume of Sales7. Terms of Purchase and Sales7. Terms of Purchase and Sales

8. Inventory Turnover8. Inventory Turnover

9. Business Turnover9. Business Turnover

10. Business Cycle10. Business Cycle11. Current Assets requirements11. Current Assets requirements

12. Production Cycle12. Production Cycle

contdcontd


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Working Capital Determinants (Contd)Working Capital Determinants (Contd)

13. Credit control13. Credit control

14. Inflation or Price level changes14. Inflation or Price level changes

15. Profit planning and control15. Profit planning and control

16. Repayment ability16. Repayment ability17. Cash reserves17. Cash reserves

18. Operation efficiency18. Operation efficiency

19. Change in Technology19. Change in Technology

20. Firms finance and dividend policy20. Firms finance and dividend policy

21. Attitude towards Risk21. Attitude towards Risk


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Points to be remembered while estimating WCPoints to be remembered while estimating WC

(1) Profits should be ignored while calculating working capital(1) Profits should be ignored while calculating working capitalrequirements for the following reasons.requirements for the following reasons.

(a) Profits may or may not be used as working capital(a) Profits may or may not be used as working capital

(b) Even if it is used, it may be reduced by the amount of Income tax,(b) Even if it is used, it may be reduced by the amount of Income tax,Drawings, Dividend paid etc.Drawings, Dividend paid etc.

(2) Calculation of WIP depends on the degree of completion as regards to(2) Calculation of WIP depends on the degree of completion as regards to

materials, labour and overheads. However, if nothing is mentioned in thematerials, labour and overheads. However, if nothing is mentioned in the

problem, take 100% of the value as WIP. Because in such a case, theproblem, take 100% of the value as WIP. Because in such a case, the

average period of WIP must have been calculated as equivalent period ofaverage period of WIP must have been calculated as equivalent period of

completed units.completed units.

(3) Calculation of Stocks of Finished Goods and Debtors should be made(3) Calculation of Stocks of Finished Goods and Debtors should be made

at cost unless otherwise asked in the question.at cost unless otherwise asked in the question.


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Computation of WC1.Estimation of Current Assets

1.Minimum desired cash & bank balances

2.Inventories

1.Raw Materials

2.Work in Progress

3.Finished Goods

3.Debtors (If the payment is received in advance,then the item would be listed in CL)

Total Current Assets

2 Estimation of C rrent Liabilities


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2.Estimation of Current Liabilities

Creditors (If advance payment is to be made tocreditors, then the item would appear under CA.

Wages

Overheads

3.Net working Capital (1-2)

Add margin for contingencies (Normally 10% istaken)

4. Net working Capital Required

E ti ti f C t A t


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Estimation of Current Assets

Raw Material Inventory

Budgeted Cost of Average InventoryProduction X Raw materials X holding period

(in units) (in units) (months / days)

Work in progress (W/P) Inventory

Budgeted Estimated Average time spanProduction X work-in-process X of work-in-progress

(in units) cost per unit inventory (months/days)

Finished Goods Inventory


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Finished Goods Inventory

Budgeted Cost of goods Finished goods

Production X produced per unit X holding period(in units) (Excluding Depreciation) (months/days)

Debtors

Budgeted Cost of sales Average debt

Credit sales X per unit X collection period(in units) (Excluding Depreciation) (months/days)

E ti ti f C t li biliti


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Estimation of Current liabilities

Trade Creditors

Budgeted yearly Raw material Credit periodallowed

Production X Cost per unit X by creditors

((in units) (months/days)

Direct Wages

Budgeted yearly Direct labour Average time-lag in

Production X cost per unit X payment of wages(in units) (months/days)


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Overheads (other than Depreciation & Amortization)

Budgeted yearly Overhead Average time-lag in

Production X Cost per unit X payments ofoverheads

(in units) (months/days)


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Working capital investment

The size and nature of investment incurrent assets is a function of differentfactors such as type of products

manufactured, the length of operatingcycle, the sales level, inventory policies,unexpected demand and unanticipated

delays in obtaining new inventories, creditpolicies and current assets.


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Three alternative working capitalinvestment policies

Sales (Rs.)

CurrentA

ssets(R

s.)

Policy C

Policy A

Policy B


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Policy A represents aggressive approach

Policy B represents a conservative approach

Policy C represents moderate approach

Optimal level of working capitalinvestment

Risk of long-term versus short-term debt


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Difference between permanent & temporary workingDifference between permanent & temporary working

capitalcapital

Amount Variable Working CapitalAmount Variable Working Capital

ofof

WorkingWorking

CapitalCapital

Permanent Working CapitalPermanent Working Capital

TimeTime


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Variable Working Capital

Amount

of

Working

Capital

Permanent Working Capital

Time


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Financing needs over time

Fixed Assets

Permanent Current Assets

Total Assets

Fluctuating Current Assets

Time

$


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Matching approach to asset financing

Fixed Assets


Total Assets


Time

Rs.

Short-termDebt

Long-termDebt +EquityCapital

Month Total funds reqd. Permanent reqd. Seasonal


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(1)q

(2)q

(3) requirement (4)

Jan 8500 6900 1600

Feb 8000 6900 1100

Mar 7500 6900 600

Apr 7000 6900 100

May 6900 6900 0

Jun 7150 6900 250Jul 8000 6900 1100

Aug 8350 6900 1450

Sep 8500 6900 1600

Oct 9000 6900 2100

Nov 8000 6900 1100

Dec 7500 6900 600

TOTAL 11600

Hedging / Matching / Aggressive approach


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Hedging / Matching / Aggressive approach

The term hedging can be said to refer to the process ofmatching maturities of debt financial of with maturities of

financial needs. Therefore it is also called matchingapproach.

With this approach, short term financial requirements

(Current Liabilities) should be just equal to the short termfinance available (Current Assets).

According to this approach, the permanent portion offunds required (col. 3) should be financed with long-termfunds and the seasonal portion (col.4) with short termfunds.


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Conservative approach to asset financing

Fixed Assets


Total Assets


Time

Rs.

Short-termDebt

Long-termDebt +Equitycapital

Month Total funds reqd. Permanent reqd. Seasonali t (4)


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(1) (2) (3) requirement (4)

Jan 8500 9000 0

Feb 8000 9000 0

Mar 7500 9000 0

Apr 7000 9000 0

May 6900 9000 0

Jun 7150 9000 0Jul 8000 9000 0

Aug 8350 9000 0

Sep 8500 9000 0

Oct 9000 9000 0

Nov 8000 9000 0

Dec 7500 9000 0

TOTAL 0

Conservative approach


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Conservative approach

This approach suggests that the estimated requirementof total funds should be met from long term sources. The

use of short-term funds should be restricted to onlyemergency situations or when there is unexpectedoutflow of funds.

Fixed Assets

Permanent requirements

Long term finance

Time

Rs.

Let us suppose that the cost of short-term loan is 3% &


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Let us suppose that the cost of short term loan is 3% &that of long-term loan is 8%.

With hedging approach,

Cost of short-term cost = (11600/12) X (3/100) = Rs.29

Cost of long-term cost = 6900 X (8/100) = Rs.552

Total Cost = Rs.581

With conservative approach,

Cost of long-term cost = 9000 X (8/100) = Rs.720

Trade off between the hedging & conservative approach


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Trade off between the hedging & conservative approach

This approach strikes-off balance and provides a financing planthat lies between the two extremes. The exact trade-off between

risk and profitability will differ from case to case depending uponthe risk perception of the decision makers. One possible trade-offcould be average of minimum & maximum monthly requirementsof funds during a given period of time.

Average funds = (6900 + 9000) / 2 = 15900 / 2 = Rs.7950

Month Total funds reqd. Permanent reqd. Seasonalrequirement (4)


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(1) (2) (3) requirement (4)

Jan 8500 7950 550

Feb 8000 7950 50

Mar 7500 7950 0

Apr 7000 7950 0

May 6900 7950 0

Jun 7150 7950 0Jul 8000 7950 50

Aug 8350 7950 400

Sep 8500 7950 550

Oct 9000 7950 1050

Nov 8000 7950 50

Dec 7500 7950 0

TOTAL 2700

Trade-off approach


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Trade off approach

Cost of financeCost of short-term cost = (2700/12) X (3/100) = Rs.6.75

Cost of long-term cost = 7950 X (8/100) = Rs.636Total Cost = Rs.642.75

Hedging

Policy A

Conservative

Policy B

Trade-off

Policy C

Cost of capital Rs.581 Rs.720 Rs.642.75

Liquidity Low High Moderate

Profitability High Low Moderate

Risk High Low Moderate


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Impact on Risk

Risk Analysis

PolicyPolicy RiskRiskAA highhigh

CC AverageAverage

BB LowLow

Risk increases as the levelof current assets are

reduced.

Optimal Amount (Level) of Current Assets

OUTPUT (units)

AS

SET

LEVEL(Rs.)

Current Assets

Policy APolicy A

PolicyPolicy BB

Policy CPolicy C

S f th O ti l


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Summary of the Optimal

Amount of Current Assets

SSUMMARYUMMARY OOFF OOPTIMALPTIMAL CCURRENTURRENT AASSETSSETAANALYSISNALYSIS

PolicyPolicy LiquidityLiquidity ProfitabilityProfitability RiskRisk

AA LowLow HighHigh HighHigh

BB AverageAverage AverageAverage AverageAverageCC HighHigh LowLow LowLow

1. Profitability varies inversely with liquidity.

2. Profitability moves together with risk.(risk and return go hand in hand!)


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Aggressive approach to asset financing

Fixed Assets


Total Assets


Time

$

Short-termDebt

Long-termDebt +Equitycapital


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EXCESS OR INADEQUATE WORKING CAPITALEXCESS OR INADEQUATE WORKING CAPITAL

Every business concern should have adequateEvery business concern should have adequateworking capital to run its business operations.working capital to run its business operations.

It should haveIt should have neither redundant or excessneither redundant or excess

working capital nor inadequate or shortage ofworking capital nor inadequate or shortage of

working capital.working capital.

Both excess as well as shortage of workingBoth excess as well as shortage of working

capital situations are bad for any business.capital situations are bad for any business.

However, out of the two, inadequacy or shortageHowever, out of the two, inadequacy or shortage

of working capital is more dangerous from theof working capital is more dangerous from the

point of view of the firm.point of view of the firm.

Disadvantages of Redundant or ExcessDisadvantag

es of Redundant or Excess


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ggWorking CapitalWorking Capital

Idle funds, non-profitable for business,Idle funds, non-profitable for business,poor ROIpoor ROI

Unnecessary purchasing & accumulationUnnecessary purchasing & accumulationof inventories over required levelof inventories over required level

Excessive debtors and defective creditExcessive debtors and defective creditpolicy, higher incidence of B/D.policy, higher incidence of B/D.

Overall inefficiency in the organization.Overall inefficiency in the organization.When there is excessive working capital,When there is excessive working capital,Credit worthiness suffersCredit worthiness suffers Due to low rate of return onDue to low rate of return oninvestments, the market value of shares mayinvestments, the market value of shares may

fallfall


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Disadvantages or Dangers of Inadequate orDisadvantages or Dangers of Inadequate or

Short Working CapitalShort Working Capital

Cant pay off its short-term liabilities inCant pay off its short-term liabilities intime.time.

Economies of scale are not possible.Economies of scale are not possible. Difficult for the firm to exploit favourableDifficult for the firm to exploit favourablemarket situationsmarket situations

Day-to-day liquidity worsensDay-to-day liquidity worsens Improper utilization the fixed assets andImproper utilization the fixed assets andROA/ROI falls sharplyROA/ROI falls sharply


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MANAGEMENT OF WORKING CAPITAL ( WCM )MANAGEMENT OF WORKING CAPITAL ( WCM )

Management of working capital is concernedManagement of working capital is concernedwithwith the problems that arise in attempting tothe problems that arise in attempting to

manage the current assets, the current liabilitiesmanage the current assets, the current liabilities

and the inter-relationship that exists betweenand the inter-relationship that exists between

them.them. In other words, it refers to all aspects ofIn other words, it refers to all aspects ofadministration of CA and CL.administration of CA and CL.

Working Capital Management Policies of a firmWorking Capital Management Policies of a firm

have a great effect on itshave a great effect on its profitability, liquidity profitability, liquidityand structural health of the organization.and structural health of the organization.


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3D Nature of Working Capital Management3D Nature of Working Capital Management

Dimension I

Profitability,

Risk, & Liquidity

Dimension I

Profitability,

Risk, & Liquidity

Dimensi

onII

Composit

ion&L

evel

ofCA

Dimensi

onII

Composi

tion&L

evel

ofCA

DimensionIII

Composition&Level

ofCL

DimensionIII

Composition&Level

ofCL


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PRINCIPLES OF WORKING CAPITALPRINCIPLES OF WORKING CAPITAL

MANAGEMENT / POLICYMANAGEMENT / POLICY

PRINCIPLES OF

WORKING CAPITAL

MANAGEMENT

Principle of

Risk

Variation

Principle

of Cost of

Capital

Principle of

Equity

Position

Principle of

Maturity of

Payment

FORECASTING / ESTIMATION OF WORKING CAPITALFORECASTING / ESTIMATION OF WORKING CAPITAL


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FORECASTING / ESTIMATION OF WORKING CAPITALFORECASTING / ESTIMATION OF WORKING CAPITAL

REQUIREMENTSREQUIREMENTS

Factors to be consideredFactors to be considered

Total costs incurred onTotal costs incurred on materials, wages and overheadsmaterials, wages and overheads

TheThe length of timelength of time for which raw materials remain in stores before they arefor which raw materials remain in stores before they areissued to production.issued to production.

The length of the production cycle or WIP, i.e.,The length of the production cycle or WIP, i.e., the time taken for conversion ofthe time taken for conversion ofRM into FG.RM into FG.

TheThe length of the Sales Cyclelength of the Sales Cycle during which FG are to be kept waiting for sales.during which FG are to be kept waiting for sales.

The average period ofThe average period of

credit allowed to customers.credit allowed to customers.

TheThe amount of cash required to pay day-to-day expenses of the business.amount of cash required to pay day-to-day expenses of the business.

TheThe amount of cash required for advance payments if any.amount of cash required for advance payments if any.

The average period ofThe average period ofcredit to be allowed by suppliers.credit to be allowed by suppliers.

Time lag in the payment of wages and other overheadsTime lag in the payment of wages and other overheads


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Management of Cash

Cash

Cash Means Liquid Asset that a business owns. It is a readycurrency to which all liquid assets can be reduced.

Near Cash

It implies marketable securities viewed as the same way as cashbecause of their high liquidity. E.g Marketing securities and timedeposits in bank.

Motives of holding cash


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g

1. Transaction Motive It is a motive under which cash is held tomeet routine cash requirement in normal course of business.Cash is held to meet anticipated obligations whose timing is notperfectly synchronized with cash receipts. E.g wages, taxes,electricity bills etc.

2. Precautionary Motive the purpose of holding cash is to meet

unexpected contingencies or demand for cash. It acts as acushion to meet unpredictable obligations. This motive isdefensive in approach. E.g

1. Floods, strike

2. Bills may be presented for settlement earlier than expected

3. Unexpected slow down in collection of A/Cs receivables.

4. Cancellation of orders

5. Sudden and sharp increase in the cost of raw material.


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Speculative motive It refers to the desire of the firm to takeadvantage of opportunities which present themselves at

unexpected moments and which are typically outside the normalcourse of business. This motive is positive & aggressive inapproach. E.g. Interest rate movement

Making purchases at favourable prices, etc.

Compensative Motive The purpose of this motive is tocompensate banks or other financial institutions in the form of

commission or fees for providing certain services. E.g. Transfer offunds, supply of credit information, etc.


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Objectives of Cash Management -

1.To meet Cash Disbursement as per Payment Schedule2.To meet Cash Collection as per Repayment Schedule3.To minimize funds locked up as Cash Balance by maintainingOptimum Cash Balance4.To maximize funds available for investing4.To maximize funds available for investing

5. Accurate and timely information for budgeting and forecasting5. Accurate and timely information for budgeting and forecasting6. Accurate and timely information for borrowing and internal6. Accurate and timely information for borrowing and internallendinglending

7. Accurate and timely forecast of capital available for investment7. Accurate and timely forecast of capital available for investment

MANAGEMENT OF CASHMANAGEMENT OF CASH


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MANAGEMENT OF CASHMANAGEMENT OF CASH

Importance of CashImportance of CashWhen planning the short or long-termWhen planning the short or long-termfunding requirements of a business, it isfunding requirements of a business, it is

more important to forecast the likely cashmore important to forecast the likely cashrequirements than to project profitabilityrequirements than to project profitabilityetc.etc.

Bear in mind that more businesses failBear in mind that more businesses failfor lack of cash than for want of profit.for lack of cash than for want of profit.


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Importance of Cash Management

1. Most Significant & Least Productive Asset2. Difficult to predict Cash Flows (Inflows & Outflows)3. Smallest Portion of Total Current Assets4. Cash Planning

5. Cash Forecasting:1. Receipt & Disbursement Method2. Adjusted Net Income Method

6. It is a qualitative concept which indicates firms ability to meetits operating expenses and short term operating cost.

7. It indicates the margin of protection available to the short termcreditors.

8. Indicator of financial soundness of an enterprise.

Benefits / Advantages of Cash Management


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1. Maintains solvency of business.

2. Helps in creating & maintaining goodwill3. Helps in arranging loans from banks & others on easy and

favourable terms4. Enables an organization to avail cash discount and hence

reduce cost5. Ensures regular supply of raw material6. Regular payment of salaries, wages &other day to day

commitments.7. Exploitation of favourable market conditions

8. Enables a firm to face business crisis.

Benefits / Advantages of Cash Management

Factors determining cash needs


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g

1. Synchronization of cash flow

2. Short cash Expenses incurred as a result of shortfallsare called short cost.

1. Transactional cost Brokerage paid for the sale of securities.

2. Borrowing costs Interest on loan

3. Loss of cash discount

4. Cost associated with deterioration of the credit rating higherBank charges, stoppage of cash supplies, etc.

3. Excess cash balance cost The lost of interest on deposits

4. Procurement and Management Cost associated withestablishing & operating cash management staff

5. Uncertainty and Cash Management.

Determining cash needs


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Determining cash needs

There are two approaches to derive optimalcash balances, namely

1. Minimizing cost cash balances

1. Baumol Model2. Miller Orr Model

3. Orgler Model

2. Cash Budget

Baumols Model


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1. It provides for cost-efficient transactional balances

2. Assumes that the demand for cash can be predicted with

certainty

3. Determines the optimal conversion size / lot.

4. Total cost associated with cash management has two elements

1. Cost of converting marketable securities into cash

2. The lost opportunity cost

3. Total conversion cost per period = Tb/C

1. T=Total transaction cash needs for the period

2. b=cost per conversion

3. C=value of marketable securities sold at each

conversion.

Miller-Orr Model


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1. Provides for cost-efficient transactional balances.

2. Assumes uncertain cash flows.

3. Determines upper limit and return point for cash balances(optimum cash balances).

C=bE (N)/t + iE (M)

b= fixed cost per conversion

E (N)= Expected numbers of conversions

t=the total number of days in the period

i= lost opportunity cost

E(M)= Expected average daily cash balance

C= total cash management cost

Orglers model


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1. Provides for integration of cash management with productionand other aspects of the firm

2. Comprises of three sections-

1. Selection of appropriate planning horizon

2. Selection of appropriate decision variables

1. Payment schedule

2. Short-term financing

3. Transaction of marketable securities

4. Cash balance.

Cash Budget


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g

Cash Budget is a statement of the inflows and outflows of cashthat is used to estimate its short term requirements.

It is probably the most important tool in cash management. It is adevice that helps the firm to plan and control the use of cash.

The purpose of cash budget are

To coordinate the timings of cash needs

To pinpoint the periods when there is likely to be excess cash

To enables a firm to take advantage of cash discount on its

account payables

To pay obligations when due


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To pay obligations when due

To formulate dividend policy

To plan financing of capital expansion

To help unify the production schedule during the year

To help in arranging needed funds on the most favourable termsand conditions and to prevent the accumulation of excess funds.


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Elements / Preparation of Cash Budget

The preparation of cash budget involves various steps

Planning Horizon:- The time span and the sub-period within thattime span over which the cash flows are to be projected.

Nature of cash flows

Operating cash flows:- Generated by the operations of thefirm

Financial cash flows:- Generated by the financial activities of

the firm

Operating Cash flows


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Operating Cash flows

Inflows / Cash Receipts

Cash sales

Collection of accountsreceivables

Disposal of fixed assets

Outflows / Disbursement

Accounts payable

Purchase of raw material

Wages and salaries

Factory expenses

Administrative & sellingexpenses

Maintenance expenses

Purchase of fixed assets

Financial Cash flow items


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Cash inflows / Receipts

Loans / Borrowings

Sales of securities

Interest received Dividend received

Rent received

Refund of tax

Issue of new shares andsecurities

Cash outflows / Payments

Income tax / Tax payments

Redemption of loan

Repurchase of shares Interest paid

Dividend paid

2 Cash s Profit2 Cash vs Profit


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2. Cash vs Profit2. Cash vs Profit

Sales and costs and, therefore, profits do notSales and costs and, therefore, profits do not

necessarily coincide with their associated cashnecessarily coincide with their associated cashinflows and outflows.inflows and outflows.

The net result is that cash receipts often lag cashThe net result is that cash receipts often lag cash

payments and, whilst profits may be reported, the payments and, whilst profits may be reported, thebusiness may experience a short-term cash shortfall.business may experience a short-term cash shortfall.

For this reason it is essential to forecast cashFor this reason it is essential to forecast cash

flows as well as project likely profits.flows as well as project likely profits.

C l l ti C h FlCalculating Cash Flows


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Calculating Cash FlowsCalculating Cash Flows

Project cumulative positive net cash flow over severalProject cumulative positive net cash flow over severalperiods and, conversely, a cumulative negative cash flowperiods and, conversely, a cumulative negative cash flow

Cash flow planningCash flow planning entails forecasting andentails forecasting andtabulating all significant cash inflowstabulating all significant cash inflows relating to sales,relating to sales,new loans, interest received etc., and thennew loans, interest received etc., and then analyzing inanalyzing in

detail the timing of expected paymentsdetail the timing of expected payments relating torelating tosuppliers, wages, other expenses, capital expenditure,suppliers, wages, other expenses, capital expenditure,loan repayments, dividends, tax, interest payments etc.loan repayments, dividends, tax, interest payments etc.


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CASH MANAGEMENT STRATEGIESCASH MANAGEMENT STRATEGIES

Cash PlanningCash Planning

Cash Forecasts and BudgetingCash Forecasts and BudgetingReceipts and Disbursements MethodReceipts and Disbursements Method

Adjusted Net Income Method (Sources andAdjusted Net Income Method (Sources and

Uses of Cash)Uses of Cash)


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Cash Management Techniques/ProcessesCash Management Techniques/Processes

After estimating cash flows, efforts should beAfter estimating cash flows, efforts should bemade to adhere to the estimates of receipts andmade to adhere to the estimates of receipts and

payments of cash.payments of cash.

Cash Management will be successful only ifCash Management will be successful only if

cash collections arecash collections are acceleratedaccelerated andand cashcashpaymentspayments (disbursements), as far as possible,(disbursements), as far as possible,

areare delayeddelayed..

Methods of accelerating cash inflowsMethods of accelerating cash inflows


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Prompt payment from customers (Debtors)Prompt payment from customers (Debtors)

Speedy cash collectionsSpeedy cash collections

Quick conversion of payment into cashQuick conversion of payment into cash Decentralized collections / Concentration BankingDecentralized collections / Concentration Banking

Lock Box System (collecting centers at different locations)Lock Box System (collecting centers at different locations)

Traditional LockboxTraditional Lockbox

A post office box maintained by a firms bank that is used as a receivingpoint for customer remittances.

Electronic LockboxElectronic Lockbox

A collection service provided by a firms bank that receives electronicpayments and accompanying remittance data and communicates this

information to the company in a specified format.

Lockbox Process


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Customers are instructed to mailtheir remittances to the lockbox

location.

Bank picks up remittances several times daily from the lockbox.

Bank deposits remittances in the customers account and

provides a deposit slip with a list of payments.

Company receives the list and any additional mailed items.

Methods of decelerating cash outflowsPaying on the last date


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Paying on the last datePayment through Cheques and DraftAdjusting Payroll Funds (Reducing frequency of payments)

Centralization of PaymentsInter-bank transfersAccrualsZero Balance Account (ZBA):

A corporate checking account in which a zero balanceis maintained. The account requires a master (parent)account from which funds are drawn to cover negativebalances or to which excess balances are sent.

Eliminates the need to accurately estimate eachEliminates the need to accurately estimate eachdisbursement account.disbursement account.

Only need to forecastOnly need to forecast overall cash needs.cash needs.

Making use of Float (Difference between balance in BankPass Book and Bank Column of Cash Book)


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Mail Float: time the cheque is in the mail.

Collection FloatCollection Float: total time between the mailing of the chequeby the customer and the availability of cash to the receiving firm.

Processing Float: time it takes a company to process the

cheque internally.

Availability Float: time consumed in clearing the chequethrough the banking system.

Deposit Float: time during which the Cheque received by thefirm remains uncollected funds.Paying from distant bankCheque encashment analysis

Compensating Balances


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Demand deposits or minimum amount of balance in an accountwhich is to be maintained by a firm to compensate a bank forservices provided, credit lines, or loans.

This is done to compensate banks for a rise in interest ratesspecially during pending loan.

Compensating Balance can be in two formsAn absolute minimum amountA minimum average balance

Marketable Securities


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MARKET: Place where people buy & sell securities

SECURITIES Definition:- According to the Securities Contract

Regulation Act 1956, securities include shares, scrip's, stocks,bonds, debentures and other marketable like securities of anyincorporated company or other body corporate, or government

Marketable securities are investments that are highly liquid,meaning that they can be quickly sold in the secondary financialmarkets in large amounts for cash.

Tradeable financial securities listed with a securities exchange

Securities that can be purchased or sold quickly and easily on the

market at quoted prices. Example Bonds and Stocks.

Classification of securities


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On the basis ofreturn

Fixed incomesecurities: e.g. Bonds,

Debentures &preference shares

Variable incomesecurities: e.g.Equities

Source of issue

Government

Semi government Corporates

EQUITY SHARES :


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EQUITY SHARES The share capital of a company is divided intonumber of small units of equal value is termed as SHARES

SHARE CERTIFICATE is a certificate under common seal of thecompany specifying the number of shares held by any member.Various forms of Equity shares Sweat Equity Non-voting share

Right shares & Bonus shares

SWEAT EQUITY


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SWEAT EQUITY :

SWEAT EQUITY New instrument came in force from 1998 with anewly inserted section 79A of the Companies Act 1956. Sweat

equities can be issued .. At a discount to employees anddirectors As a consideration other than cash for contributions.

NON-VOTING SHARES :


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NON-VOTING SHARES Came in force in 1994 under board

guidelines Special Features No voting rights to the shareholdersCarry additional dividends Right to participate in the bonus issueMaximum 25% of voting stock can be issued 20% more dividend

Automatic voting rights if dividend not paid for 2 years

RIGHT SHARES :


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RIGHT SHARES New Shares issued to the existing share holdersas a matter of legal rights. Regulated under the provisions of

Companies Act & SEBI Time period for issue of rights shares. Canbe forfeited by the share holders through a special resolution.Renounce in the favor of shareholders nominee. May be partly

paid. Minimum subscription limit is prescribed.

BONUS SHARES :


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BONUS SHARES Indication of higher future profits. Main aim to

capitalize the free reserves Conditions:- Issued only to existingshare holders Fully paid-up shareholders Distributed in addition tocash dividend Issued without any payment of cash

PREFERENCE SHARES :


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PREFERENCE SHARES Resembles features of bonds & equity.No voting rights Dividends paid at the discretion of the Board of

Directors. Forms of Preference shares:- Cumulative preferenceshares Non- cumulative preference shares Convertible preferenceshares as quasi-equity shares Redeemable preference shares

Irredeemable preference shares

DEBENTURES :


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DEBENTURES According to Companies Act 1956 Debenture

includes debenture stock, bonds and any other securities ofcompany, whether constituting a charge on the assets of thecompany or not. Characteristics:- Certificate of indebtedness

specifying date of redemption & interest rate Fixed rate of interest /coupon rate Redemption (creation of sinking fund) Indenture trust

deed between the company & debenture trustee

Types of debentures :Types of debentures Classified on the basis of Security &

convertibility Secured or Unsecured (property involvement) Fullyconvertible carries low interest rate Partly convertible, Non-

convertible

BONDS :


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BONDS Long term debt instrument ,promises to pay a fixed annualsum as interest for specified period of time Features:- Face value,

issued at par or discount Fixed / floating interest rate Specifiedmaturity date Stated redemption value Traded in the stock market

Types of Bonds :Types of Bonds Secured bonds & unsecured bonds Perpetual

bonds & redeemable bonds Fixed interest rate bonds & floating

interest rate bonds Deep discount bonds issued by IDBI & ICICICapital indexed bonds Zero coupon bonds traced in U.S securitymarket

Zero coupon bonds :


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Zero coupon bonds :Zero coupon bonds E.g. Present value=Face value of the bond(1+R)n A bond matures in 20 years time with the face value of

Rs.50,000 would be sold for Rs.5185 to give a return of 12 %.

WARRANTS :

WARRANTS Is a bearer document of title to buy specified numberof equity shares at a specified price.

INVESTMENT INFORMATION :

INVESTMENT INFORMATION International Affairs National AffairsIndustry information Company information Stock market information

Reason for holding marketable securities


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There are many reasons why an entity would hold marketable

securities. Few of them are:

Earning a higher rate of return than the one available in abank account (i.e., cash).

The securities market is usually quite liquid, so suchinvestments can be readily converted into cash.

Management of these investments does not require ongoingoperational decisions. Rather, just a decision as to whether tobuy or to sell is necessary.


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They serve as a substitute for cash balances for transactionbalances, precautionary balances, for speculative balances offor all three. In most cases the securities are held primarily forprecautionary purposes or as a guard against a possibleshortage of bank credit.

They held as a temporary investment where a return is earnedwhile funds are temporarily idle.

They are built up to meet known financial requirements such

as tax payments, maturing bond issue and so on.


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Treasury Bills


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T-bills are short-term securities that mature in one year or lessfrom their issue date. They are issued with three-month, six-monthand one-year maturities. T-bills are purchased for a price that is

less than their par (face) value; when they mature, thegovernment pays the holder the full par value. Effectively, yourinterest is the difference between the purchase price of thesecurity and what you get at maturity.

Treasury Bills

Negotiable Certificate of Deposits (CD)


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g p ( )

A negotiable certificate of deposit (CD) is a financial savingsvehicle offered by a financial institution like a bank that usuallyrequires a high minimum deposit. It is a time deposit with a bank.CDs are generally issued by commercial banks but they can be

bought through brokerages. They bear a specific maturity date(from three months to five years), a specified interest rate, andcan be issued in any denomination, much like bonds. Like all timedeposits, the funds may not be withdrawn on demand like those ina checking account.

Commercial Paper (CP)


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Commercial paper is an unsecured, short-term loan issued by a

corporation, typically for financing accounts receivable andinventories. It is usually issued at a discount, reflecting currentmarket interest rates. Maturities on commercial paper are usuallyno longer than nine months, with maturities of between one and

two months being the average.

For the most part, commercial paper is a very safe investmentbecause the financial situation of a company can easily bepredicted over a few months. Furthermore, typically onlycompanies with high credit ratings and credit worthiness issuecommercial paper.

Bankers Acceptance


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Bankers Acceptance

A type of short-term negotiable debt instrument issued by a non-financial corporation, such as Tata or General Motors, but

guaranteed as to principal and interest by its bank. The guaranteereduces risk and therefore results in a higher issue price andconsequent lower yield.

Repurchase Agreement (Repo.)


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p g ( p )

The rate at which the Reserve Bank lends to commercial banks.

A form of short-term borrowing for dealers in governmentsecurities. The dealer sells the government securities toinvestors, usually on an overnight basis, and buys them back the

following day.

Whenever the banks have any shortage of funds they canborrow it from RBI. Repo rate is the rate at which our banksborrow rupees from RBI. A reduction in the repo rate will helpbanks to get money at a cheaper rate. When the repo rateincreases borrowing from RBI becomes more expensive.

Units


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Here, the units means units of mutual funds.

The units of mutual funds offer a reasonably convenientalternative avenue for investing surplus liquid when there is

A very active secondary market

Income from units are tax free

Units appreciate in a fairly predictable manner

Inter Corporate Deposits


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Inter Corporate Deposits are short term deposits with other

companies. The rate of return is quite high, ranging 12% to 15%.But one months time is required to convert them into cash.

Inter corporate Deposits suffer from high degree of risk.

Bills Discounting

Bill f h lf li id ti i t t


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Bill of exchange are self liquidating instruments.

Cashing or trading a bill of exchange at less than its par value and

before its maturity date. The cash thus realized varies accordingto the number of days until maturity and the risk involved.

Bills / invoiced issued to clients are discounted with the bank

(normally) sometimes by specialized institutions. Because youneed money and your customer is paying you according to creditperiod.

Example:


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Your Company issued Invoiced amounting to 100,000 and youwant to realized this amount now since your customer will pay in90 days. You negotiated with the Bank and they given you rate ofsay : 10%.After formal documentation Bank will discount your Bill by 100,000

X 10% X 90 / 360 =2500and will pay you remaining amount = 100,000 - 2500 = 97,500Bank will receive money from customer.If customer doesnt pay money , this money will be taken from

you.

Money Market Mutual Funds / Liquid Funds


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These are professionally Managed portfolios of popular

marketable securities having instant liquidity. It has competitiveyield and low transactional cost.

Choice of Securities

1 The choice of security depends upon various factors Few of


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1. The choice of security depends upon various factors. Few ofthem are

2. Risk such as1. Default risk. the risk that the issuer of the security cannot

pay the principal or interest at due dates.

2. Interest rate risk. the risk of declines in market values of the

security due to rising interest rate.

3. Inflation rate. the risk that inflation will reduce the real valueof the investment. in periods of rising prices, inflation risk is

lower on investments whose returns tend to rise withinflation than on investment whose return are fixed.

3. MaturityMarketable Securities held should mature or can be sold at the

same time cost is re uired.

3 Yi ld t iti


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3. Yield or returns on securities.1. Generally, the higher a security's risk the higher its required

return. Corporate investors, like other investors must makea trade-off between risk and return when choosingmarketable securities because these securities aregenerally held either for specific known need or for use inemergencies. The portfolio should consist of highly liquidshort-term securities issued by the government or verystrong Corporations. Treasurers should not sacrifice safetyfor higher rates of return.

3. Marketability (liquidity) riskThis refers to the risk that securities cannot be sold at closeto the quoted market price and is closely associated withliquidity risk.

MANAGEMENT OF RECEVABLESMANAGEMENT OF RECEVABLES


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The term receivables is defined as debt owed to theThe term receivables is defined as debt owed to thefirm by customers arising from credit sale of goods &firm by customers arising from credit sale of goods &services in the ordinary course of business.services in the ordinary course of business.

A concern is required to allow credit in order to expandA concern is required to allow credit in order to expand

its sales volume.its sales volume.

Receivables contribute a significant portion of currentReceivables contribute a significant portion of currentassets.assets.

But for investment in receivables the firm has to incurBut for investment in receivables the firm has to incur

certain costs (opportunity cost and time value )certain costs (opportunity cost and time value )

Further, there is a risk of BAD DEBTS also.Further, there is a risk of BAD DEBTS also.

It is, therefore very necessary to have a proper controlIt is, therefore very necessary to have a proper controland management of receivables.and management of receivables.

Cost of maintaining receivables


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The major categories of cost associated with the extension ofcredit and account receivable are:

1. Collection Cost

2. Capital Cost

3. Delinquency Cost4. Default Cost

Collection Cost


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Collection cost is the administrative cost incurred in the collectingthe receivables. In this there are two categories of cost involved

Additional expenses on the creation and maintenance ofcredit department with staff, accounting records, stationary,

postage and other related items.

Expenses involved in acquiring credit information eitherthrough outside agencies or by the staff itself.

Capital Cost


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Capital cost is the cost on the use of additional capital tosupport credit sales which alternatively could have beenprofitably employed elsewhere. It is therefore a part ofthe cost of extending credit or receivables.

Delinquency Cost

It is the cost arising out of failure of customers to pay ondue date. The important component of this cost are:

Blocking-up of funds for an extended period

Cost associated with steps that have to be initiated tocollect the overdues such as, reminders and othercollection efforts, legal charges, where ever necessaryand so on.

Default Cost


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The cost which cannot be recovered from the customers, due todeath or inability to pay are known as default costs. Such costs

are associated with credit sales.

OBJECTIVESOBJECTIVES


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The objective of ReceivablesThe objective of Receivables

Management isManagement is to take sound decision asto take sound decision asregards to investment in Debtors.regards to investment in Debtors. In theIn the

words ofwords of BOLTON S E.,BOLTON S E., the objective ofthe objective of

receivables management isreceivables management is

to promote sales and profits until that to promote sales and profits until that

point is reached where the return onpoint is reached where the return on

investment in further funding ofinvestment in further funding of

receivables is less than the cost of fundsreceivables is less than the cost of funds

raised to finance that additional creditraised to finance that additional credit

DIMENSIONS OF RECEIVABLES MANAGEMENTDIMENSIONS OF RECEIVABLES MANAGEMENT


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OPTIMUM LEVEL OF INVESTMENT IN TRADE RECEIVABLESOPTIMUM LEVEL OF INVESTMENT IN TRADE RECEIVABLES

ProfitabilityProfitability

Costs &Costs &

ProfitabilityProfitability Optimum LevelOptimum Level

LiquidityLiquidity

StringentStringent LiberalLiberal

AVERAGE COLLECTION PERIOD AND AGEINGAVERAGE COLLECTION PERIOD AND AGEING

SCHEDULESCHEDULE


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The collection of BOOK DEBTS can be monitoredThe collection of BOOK DEBTS can be monitoredwith the use of average collection period andwith the use of average collection period andageing schedule.ageing schedule.

The ACTUAL AVERAGE COLLECTION PERIOD ISThe ACTUAL AVERAGE COLLECTION PERIOD ISCOMPARED WITH THE STANDARD COLLECTIONCOMPARED WITH THE STANDARD COLLECTIONPERIOD to evaluate the efficiency of collection so thatPERIOD to evaluate the efficiency of collection so thatnecessary corrective action can be initiated andnecessary corrective action can be initiated andtaken.taken.

THE AGEING SCHEDULE HIGHLIGHTS THETHE AGEING SCHEDULE HIGHLIGHTS THE

DEBTORS ACCORDING TO THE AGE OR LENGTHDEBTORS ACCORDING TO THE AGE OR LENGTH

OF TIME OF THE OUTSTANDING DEBTORS


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OF TIME OF THE OUTSTANDING DEBTORS.OF TIME OF THE OUTSTANDING DEBTORS.

The following table presents the ageing scheduleThe following table presents the ageing schedule

AGEING SCHEDULEAGEING SCHEDULE

Outstanding PeriodOutstanding Period O/s Amount of DebtorsO/s Amount of Debtors % of% of

DebtorsDebtors

0 30 Days0 30 Days 5,00,0005,00,000 5050

31 40 Days31 40 Days 1,00,0001,00,000 1010

41 60 Days41 60 Days 2,00,0002,00,000 2020

61 90 Days61 90 Days 1,00,0001,00,000 1010Over 60 DaysOver 60 Days 1,00,0001,00,000 1010

TotalTotal 10,00,00010,00,000 100100

Guidelines for Effective Receivables ManagementGuidelines for Effective Receivables Management

11 H th i ht t l ttit d t th t l f dit dH th i ht t l ttit d t th t l f dit d


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1.1. Have the right mental attitude to the control of credit andHave the right mental attitude to the control of credit and

make sure that it gets the priority it deserves.make sure that it gets the priority it deserves.

2.2. Establish clear credit practices as a matter of companyEstablish clear credit practices as a matter of companypolicy.policy.

3.3. Make sure that these practices are clearly understood byMake sure that these practices are clearly understood by

staff, suppliers and customers.staff, suppliers and customers.

4.4. Be professional when accepting new accounts, andBe professional when accepting new accounts, andespecially larger ones.especially larger ones.

5.5. Check out each customer thoroughly before you offerCheck out each customer thoroughly before you offer

credit. Use credit agencies, bank references, industrycredit. Use credit agencies, bank references, industry

sources etc.sources etc.6.6. Establish credit limits for each customer... and stick toEstablish credit limits for each customer... and stick to

them.them.

7. Continuously review these limits when you suspect7. Continuously review these limits when you suspect

tough times are coming or if operating in a volatiletough times are coming or if operating in a volatile


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g g p gg g p g

sector.sector.

8. Keep very close to your larger customers.8. Keep very close to your larger customers.

9. Invoice promptly and clearly.9. Invoice promptly and clearly.

10. Consider charging penalties on overdue accounts.10. Consider charging penalties on overdue accounts.

11. Consider accepting credit /debit cards as payment11. Consider accepting credit /debit cards as payment

option.option.

12. Monitor your debtor balances and age in schedules,12. Monitor your debtor balances and age in schedules,

and don't let any debts get too large or too old.and don't let any debts get too large or too old.

MANAGEMENT OF INVENTORIESMANAGEMENT OF INVENTORIES

Managing inventory is a juggling actManaging inventory is a juggling act.


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Managing inventory is a juggling act.Managing inventory is a juggling act.

Excessive stocks can place a heavy burden onExcessive stocks can place a heavy burden onthe cash resources of a business.the cash resources of a business.

Insufficient stocks can result in lost sales,Insufficient stocks can result in lost sales,

delays for customers etc.delays for customers etc.

INVENTORIES INCLUDEINVENTORIES INCLUDE

RAW MATERIALS, WIP & FINISHEDRAW MATERIALS, WIP & FINISHED

GOODSGOODS

FACTORS INFLUENCING INVENTORY MANAGEMENTFACTORS INFLUENCING INVENTORY MANAGEMENT


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FACTORS INFLUENCING INVENTORY MANAGEMENT

Lead TimeLead Time Cost of Holding InventoryCost of Holding Inventory

Material CostsMaterial Costs

Ordering CostsOrdering CostsCarrying CostsCarrying Costs

Cost of tying-up of FundsCost of tying-up of Funds

Cost of Under stockingCost of Under stockingCost of OverstockingCost of Overstocking

ContdContd

Stock LevelsStock Levels

R d L l


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Reorder LevelReorder Level

Maximum LevelMaximum LevelMinimum LevelMinimum Level

Safety Level / Danger LevelSafety Level / Danger Level

Variety ReductionVariety Reduction

Materials PlanningMaterials Planning

Service LevelsService Levels

Obsolete Inventory and ScrapObsolete Inventory and Scrap

Quantity DiscountsQuantity Discounts

INVENTORY MANAGEMENT TECHNIQUESINVENTORY MANAGEMENT TECHNIQUES


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MANAGING INVENTORIES EFFICIENTLYMANAGING INVENTORIES EFFICIENTLY

DEPENDS ON TWO QUESTIONSDEPENDS ON TWO QUESTIONS

1.1. How much should be ordered?How much should be ordered?

2.2. When it should be ordered?When it should be ordered?

The first questionThe first question how much to orderhow much to order

relates torelates to ECONOMIC ORDER QUANTITYECONOMIC ORDER QUANTITY andand

The second questionThe second question when to orderwhen to orderarisesarisesbecause of uncertainty and relates tobecause of uncertainty and relates to

determining thedetermining the RE-ORDER POINTRE-ORDER POINT

ECONOMIC ORDER QUANTITY [ EOQ ]ECONOMIC ORDER QUANTITY [ EOQ ]


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The ordering quantity problems are solved byThe ordering quantity problems are solved by

the firm by determining the EOQ ( or thethe firm by determining the EOQ ( or the

Economic Lot Size ) that is the optimum levelEconomic Lot Size ) that is the optimum level

of inventory.of inventory.

There are two types of costs involved in thisThere are two types of costs involved in thismodel.model.

ordering costsordering costs

carrying costscarrying costs

The EOQ is that level of inventory whichThe EOQ is that level of inventory which

MINIMIZES the total of ordering and carryingMINIMIZES the total of ordering and carrying

ORDERING COSTSORDERING COSTS CARRYING COSTSCARRYING COSTS


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RequisitioningRequisitioning

WarehousingWarehousing

Order PlacingOrder Placing HandlingHandling

TransportationTransportation

Clerical StaffClerical Staff

Receiving,Receiving,InspectingInspecting && StoringStoring

InsuranceInsurance

Clerical & StaffClerical & Staff Deterioration &Deterioration &ObsolescenceObsolescence

EOQ FORMULAEOQ FORMULA

F d t i i EOQ th f ll i


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For determining EOQ the followingFor determining EOQ the following

symbols are usedsymbols are usedCC = Consumption /Annual Usage / Demand= Consumption /Annual Usage / Demand

QQ = Quantity Ordered= Quantity Ordered

OO = Ordering Cost per Order= Ordering Cost per Order

II = Inventory Carrying Cost (as a % on P )= Inventory Carrying Cost (as a % on P )

PP = Price per Unit= Price per Unit

TCTC = Total Cost of Ordering & Carrying= Total Cost of Ordering & Carrying

2 CO / PI2 CO / PI


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Total Cost of ordering & carrying inventoryTotal Cost of ordering & carrying inventory

are equal to ( TC ) =are equal to ( TC ) =

CC QQ

x O + x P x Ix O + x P x I

QQ 22

TC is minimized at EOQTC is minimized at EOQ

EOQ GRAPHICAL APPROACHEOQ GRAPHICAL APPROACH


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Co s ts

Co s ts

CarryingC

osts

CarryingC

osts

Ordering CostOrdering Cost

Order Size QOrder Size QEOQEOQ

Minimum TotalMinimum Total

CostsCosts

QUANTITY DISCOUNTS & EOQQUANTITY DISCOUNTS & EOQ


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TheThe standard EOQ analysisstandard EOQ analysis is based on theis based on theassumption that theassumption that the price per unit remains constantprice per unit remains constant

irrespective of the order size. When quantityirrespective of the order size. When quantitydiscounts are availablediscounts are available (very usual)(very usual) thenthen price perprice perunit is influenced by the order quantityunit is influenced by the order quantity. To. Todetermine the optimum lot size with price discounts,determine the optimum lot size with price discounts,the following procedure is adoptedthe following procedure is adopted

1.1. Determine the normal EOQ assuming no discount.Determine the normal EOQ assuming no discount.Call it Q*Call it Q*

2.2. If Q* enables the firm to get the quantity discountIf Q* enables the firm to get the quantity discountthen it represents the optimum lot size.then it represents the optimum lot size.

3.3. If Q* is less than the minimum order size ( Q )If Q* is less than the minimum order size ( Q )required for quantity discount compute the changerequired for quantity discount compute the changein profit as a result of increasing Q* to Qin profit as a result of increasing Q* to Q

The formula for change in profit is given asThe formula for change in profit is given as

C C Q( P-D ) I Q* PIC C Q( P-D ) I Q* PI


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C C Q ( P D ) I Q PIC C Q ( P D ) I Q PI

= CD + - O - -= CD + - O - -

Q* Q 2Q* Q 2 22

wherewhere

= = change in profitchange in profitCC = Annual Consumption / Usage /= Annual Consumption / Usage /

DemandDemand

DD = Discount per unit when available= Discount per unit when available

Q*Q* = EOQ without Quantity Discount= EOQ without Quantity Discount

QQ = Min order size required for Discount= Min order size required for Discount

OO = Fixed Ordering Cost= Fixed Ordering Cost

SELECTIVE CONTROL OF INVENTORYSELECTIVE CONTROL OF INVENTORYDifferent classification methodsDifferent classification methods

ClassificationClassification BasisBasis


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C ass cat o as s

ABCABC

[Always Better Control ][Always Better Control ]

Value of items consumedValue of items consumed

VED[ Vital, Essential,VED[ Vital, Essential,Desirable ]Desirable ]

The importance orThe importance orcriticalitycriticality

FSNFSN

[ Fast-moving, Slow-[ Fast-moving, Slow-moving, Non-moving ]moving, Non-moving ]

The pace at which theThe pace at which the

material movesmaterial moves

HMLHML

[ High, Medium, Low ][ High, Medium, Low ]

Unit price of materialsUnit price of materials

SDESDE

[ Scarce, Difficult, Easy ][ Scarce, Difficult, Easy ]

Procurement DifficultiesProcurement Difficulties

XYZXYZ Value of items in storageValue of items in storage

An eye-opener to Inventory ManagementAn eye-opener to Inventory Management


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For better stock/inventory control, try the following:For better stock/inventory control, try the following:

Review the effectiveness of existing purchasing andReview the effectiveness of existing purchasing andinventory systems.inventory systems.

Know the stock turn for all major items of inventory.Know the stock turn for all major items of inventory.

Apply tight controls to theApply tight controls to the significant fewsignificant fewitems and simplifyitems and simplifycontrols for thecontrols for the trivial manytrivial many..

Sell off outdated or slow moving merchandise - it gets moreSell off outdated or slow moving merchandise - it gets moredifficult to sell the longer you keep it.difficult to sell the longer you keep it.

Consider having part of your product outsourced to anotherConsider having part of your product outsourced to anothermanufacturer rather than make it yourself.manufacturer rather than make it yourself.

Review your security procedures to ensure that no stock "isReview your security procedures to ensure that no stock "isgoing out the back door !"going out the back door !"

MANAGEMENT OF ACCOUNTS PAYABLEMANAGEMENT OF ACCOUNTS PAYABLE


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Creditors are a vital part of effectiveCreditors are a vital part of effectivecash management and should becash management and should be

managed carefully to enhance themanaged carefully to enhance the

cash position.cash position.Purchasing initiates cash outflowsPurchasing initiates cash outflows

and an over-zealous purchasingand an over-zealous purchasing

function can create liquidity problems.function can create liquidity problems.

Guidelines for effective managementGuidelines for effective management

of Accounts Payableof Accounts Payable

Who authorizes purchasing in your company - is it tightlyWho authorizes purchasing in your company - is it tightlymanaged or spread among a number of (junior) people?managed or spread among a number of (junior) people?

A h titi d t d d f t ?Are purchase quantities geared to demand forecasts?


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Are purchase quantities geared to demand forecasts?Are purchase quantities geared to demand forecasts?

Do you use order quantities which take account of stock-Do you use order quantities which take account of stock-holding and purchasing costs?holding and purchasing costs?

Do you know the cost to the company of carrying stock ?Do you know the cost to the company of carrying stock ?

Do you have alternative sources of supply ? If not, getDo you have alternative sources of supply ? If not, getquotes from major suppliers and shop around for the bestquotes from major suppliers and shop around for the best

discounts, credit terms, and reduce dependence on adiscounts, credit terms, and reduce dependence on a

single supplier.single supplier.

How many of your suppliers have a returns policy ?How many of your suppliers have a returns policy ?

Are you in a position to pass on cost increases quicklyAre you in a position to pass on cost increases quickly

through price increases to your customers ?through price increases to your customers ?

If a supplier of goods or services lets you down can youIf a supplier of goods or services lets you down can youcharge back the cost of the delay ?charge back the cost of the delay ?

Can you arrange (with confidence !) to have delivery ofCan you arrange (with confidence !) to have delivery of

Ratios associated with WCMRatios associated with WCM

St k T R ti (Ti )Stock Turnover Ratio (Times) COGSCOGS


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Stock Turnover Ratio (Times)Stock Turnover Ratio (Times) COGSCOGS

AVERAGE STOCKAVERAGE STOCK

Stock Turnover Ratio (Days)Stock Turnover Ratio (Days) Average Stock x 365Average Stock x 365

COGSCOGS

Receivables Turnover RatioReceivables Turnover Ratio(Times)(Times)

Net Credit SalesNet Credit Sales

Average Accounts ReceivableAverage Accounts Receivable

Average Receivables PeriodAverage Receivables Period(Days)(Days)

Avg A/C Receivable x 365Avg A/C Receivable x 365


Payables Turnover RatioPayables Turnover Ratio(Times)(Times)

Net Credit PurchasesNet Credit Purchases

Average Accounts ReceivableAverage Accounts Receivable

Average Payables PeriodAverage Payables Period(Days)(Days)

Avg A/C Receivable x 365Avg A/C Receivable x 365


C rrent RatioCurrent Ratio C rrent AssetsCurrent Assets


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Current RatioCurrent Ratio Current AssetsCurrent Assets

Current LiabilitiesCurrent Liabilities

Quick RatioQuick Ratio CA StockCA Stock

Current LiabilitiesCurrent Liabilities

Working Capital TurnoverWorking Capital TurnoverRatioRatio

Net SalesNet Sales

Net Working CapitalNet Working Capital

working capital mgmt ppts 4

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