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Financial Management Semester II
S.N.Selvaraj, Assistant Professor, E-mail: [email protected] Page 1
UNIT – IV: WORKING CAPITAL MANAGEMENT
Principles of Working Capital: Concepts – Needs – Determinants – Issues and
Estimation of Working Capital – Accounts Receivables Management and Factoring
– Inventory Management – Cash Management – Working Capital Finance: Trade
Credit – Bank Finance and Commercial Paper
PRINCIPLES OF WORKING CAPITAL
Working Capital refers to the cash a business requires for day-to-day operations or
more specifically, for financing the conversion of raw materials into finished goods,
which the company sells for payment. Among the most important items of working
capital are levels of inventory, debtors and creditors. These items are looked at for
signs of a company‟s efficiency and financial strength.
There are four principles of working capital:
Definitions of Working Capital
According to Shubin, “Working capital is the amount of funds necessary to cover the
cost of operating the enterprise”
According to Gerestenberg, “Circulating capital means current assets of a company
that are changed in the ordinary course of business from one form to another, as for
example, from cash to inventories, inventories to receivable, receivables into cash”.
Working capital, in general practice, refers to the excess of current assets over current
liabilities. Management of working capital therefore, is concerned with the problems
that arise in attempting to manage the current assets, the current liabilities and the
inter-relationship that exists between them. In other words it refers to all aspects of
administration of both current assets and current liabilities. It is also known as
revolving or circulating capital or short-term capital.
CONCEPTS OF WORKING CAPITAL
There are two concepts of working capital:
1) Gross Working Capital
2) New Working Capital
Principles of Working Capital
Principal of Risk Variation Principle of Cost Capital
Principal of Equity Position Principle of Maturity Payment
Financial Management Semester II
S.N.Selvaraj, Assistant Professor, E-mail: [email protected] Page 2
Gross Working Capital
In broad sense, the term working capital refers to the gross working capital and
represents the amount of funds invested in current assets. Thus, the gross working
capital is the capital invested in total current assets of the enterprise. Current assets are
those which in the ordinary course of business can be converted into cash within short
period of normally one accounting year.
Components of Current Assets
1) Cash in hand
2) Cash at bank
3) Bills receivables
4) Sundry debtors (or) Accounts receivable
5) Short-term loans and advances
6) Inventories of stocks
7) Temporary investment of surplus funds
8) Prepaid expenses
9) Accrued incomes
Net Working Capital
In a narrow sense, the term working capital refers to the net working capital is the
excess of current assets over current liabilities.
Net Working Capital = Current Assets – Current Liabilities.
New working capital may be positive or negative. When the current assets exceeds the
current liabilities the working capital is positive and vice versa.
Current liabilities are those which are intended to be paid in the ordinary course of
business within a short period of normally one accounting year out of the current
assets or the income of the business.
Components of Current Liabilities
1) Bills payable
2) Sundry creditors (or) Accounts payable
3) Accrued or Outstanding expenses
4) Short-term loans, advances and deposits
5) Dividends payable
6) Bank overdraft
7) Prepaid expenses
8) Provision for taxation
Financial Management Semester II
S.N.Selvaraj, Assistant Professor, E-mail: [email protected] Page 3
NEEDS OF WORKING CAPITAL
Working capital is needed for the following purposes:
DETERMINANTS OF WORKING CAPITAL
Following are the determinants generally influencing the working capital
requirements.
Needs for Working Capital
Replenishment of Inventory Provision for Operating Expenses
Support of Credit Sales Provision of a Safety Margin
Factors Determining Working Capital
Nature or Character of Business Size of Business
Production Policy Manufacturing Process
Seasonal Variations Working Capital Cycle
Rate of Stock Turnover Credit Policy
Business Cycles Rate of Growth of Business
Dividend Policy
Price Level Changes
Tax Level Other Factors
Financial Management Semester II
S.N.Selvaraj, Assistant Professor, E-mail: [email protected] Page 4
ISSUES OF WORKING CAPITAL
The financial manager must determine levels and composition of current assets. He
must see the right sources are tapped to fiancé current assets, and that current
liabilities are paid in time. There are many aspects of working capital management
which make it an important function of the financial manager:
1) Components: Components such as cash, marketable securities, receivables and
inventories.
2) Time: Working capital management requires much of the financial manager‟s
time. Time as either permanent or temporary working capital.
3) Investment: Working capital represents a large portion of the total investment in
assets.
4) Criticality: Working capital management has great significance for all firms but
it is very critical for small firms.
5) Growth: The need for working capital is directly related to the firm‟s growth.
Profitability-Liquidity Trade-Off
To maximize shareholder‟s wealth, optimal level of current assets should be
determined. There is always a conflict between the liquidity and the profitability
objectives. If current assets are held at a level more than the required one, profitability
is eroded; though there is enough liquidity. If current assets are maintained at a level
less than required, the solvency of the firm is threatened.
Therefore, a proper balance is to be maintained between these two so that profitability
is maximized without sacrificing solvency. Thus, a trade-off between risk and return is
attempted to be struck off. The optimum level is the point where the total cost is the
minimum.
Policies/Strategies to Working Capital
So far the banks were the sole source of funds for working capital needs of business
sector. At present more finance options are available to a finance manager to see the
operations of his firm go smoothly. Depending on the risk exposure of business, the
following strategies are evolved to manage the working capital.
Matching
Policy
Policies/Strategies Working Capital
Aggressive
Policy
Conservative
Policy
Zero Working Capital
Policy
Financial Management Semester II
S.N.Selvaraj, Assistant Professor, E-mail: [email protected] Page 5
Matching Strategy
The firm can adopt a financial plan which involves the matching of the expected life
of assets with the expected life of the source of funds raised to finance assets. Thus, a
ten year loan may be raised to finance a plant with an expected life of ten years; stock
of goods to be sold in thirty days may be financed with a thirty-day bank loan and
soon.
Financing Strategy of Matching Strategy
Long-term funds = Fixed assets + Total permanent current assets
Short-term funds = Total temporary current assets
Conservative Strategy
Under a conservative plan, the firm finances its permanent current assets and a part of
temporary current assets with long term finance; it stores liability by investing surplus
funds into marketable securities. The conservative plan relies heavily on long-term
financing and therefore, is less risky.
Financing Strategy of Conservative Strategy
Long-term funds = Fixed assets + Total permanent current assets + Part of
temporary current assets
Short-term funds = Part of temporary current assets
Aggressive Strategy
A firm may be aggressive in financing its assets. An aggressive policy is said to be
followed by the firm when it uses short-term financing than warranted by the
matching plan. Under an aggressive policy, the firm finances a part of its permanent
current assets with short-term financing; some extremely aggressive firms may even
finance a part of their fixed assets with short-term financing. The relatively more use
of short-term financing makes the firm more risky.
Financing Strategy of Aggressive Strategy
Long-term funds = Fixed assets + Part of temporary current assets
Short-term funds = Part of temporary current assets + Total temporary
current assets
Zero Working Capital Strategy
This is one of the latest trends in working capital management. The idea is to have
zero working capital, i.e. at all times the current assets shall equal the current
liabilities. Excess investment in current assets is avoided and firm meets its current
liabilities out of the matching current assets.
Financing Strategy of Zero Working Capital Strategy
Total Current Assets = Total current liabilities (or)
Total Current Assets minusTotal current liabilities = Zero
Financial Management Semester II
S.N.Selvaraj, Assistant Professor, E-mail: [email protected] Page 6
ESTIMATION OF WORKING CAPITAL
A firm must estimate in advance as to how much net working capital will be required
for the smooth operations of the business. Only then, it can be bifurcated into
permanent working capital and temporary working capital. This bifurcation will help
in deciding the financing pattern i.e. how much working capital should be financed
from long term sources and how much be financed from short term sources.
There are different approaches available to estimate the working capital requirements
of a firm as follows:
1) Working Capital as a Percentage of Net Sales: This approach is based on the
assumption that higher the sales level, the greater would be the need for working
capital.
(a) To estimate total current assets as a % of estimated net sales.
(b) To estimate current liabilities as a % of estimated net sales and
(c) The difference between the two above is the net working capital as a % of
net sales.
2) Working Capital as Percentage of Total Assets or Fixed Assets: This approach of
estimation of working capital requirement is based on the fact that the total assets of
the firm are consisting of fixed assets and current assets. On the basis of past
experience, a relationship between
(a) Total current assets i.e. gross working capital; or net working capital,
i.e. current assets – current liabilities.
(b) Total fixed assets or a total asset of the firm is established. For example, a
firm is maintaining 20% of its total assets in the form of current assets and
expects to have total assets of Rs.50,00,000 next year. Thus, the current assets
of the firm would be Rs.10,00,000 (i.e. 20% of Rs.50,00,000).
3) Working Capital Based on Operating Cycle: The concept of operating cycle, helps
determining the time scale over which the current assets are maintained. The
operating cycle for different components of working capital gives the time for which
an asset is maintained, once it is acquired. However, the concept of operating cycle
does not talk of the funds invested in maintaining these current assets. It can
definitely be used to estimate the working capital requirements for any firm.
The different components of working capital may be enumerated as follows:
Current Assets Current Liabilities
Cash and Bank balances Creditors for purchases
Inventory of raw material Creditors for expenses
Inventory of work-in-progress
Inventory of finished goods
Receivables
Financial Management Semester II
S.N.Selvaraj, Assistant Professor, E-mail: [email protected] Page 7
Proforma for Assessment and Computation of Working Capital
(For Trading Concern) Statement of Working Capital Requirements
Amount Rs.
Current Assets: i) Cash - - ii) Debtors or Receivables (for …. month‟s sale) - - iii) Stocks (for …. month‟s sale) - - iv) Advance payments, if any - - v) Others - - Less: Current Liabilities - -
i) Creditors (for …. month‟s sale) - -
ii) Lag in payment of expenses
(outstanding expenses, if any) - -
Working Capital (CA – CL) - - Add: Provision / Margin for contingencies - - Net Working Capital Required - -
Proforma for Assessment and Computation of Working Capital
(For Manufacturing Concern) Statement of Working Capital Requirements
Amount Rs.
Current Assets: 1) Stock of raw material (for ….. month‟s consumption) - 2) Work-in-progress (for …… months): -
i) Raw materials - -
ii) Direct labour -
iii) Overheads - 3) Stock of finished goods (for …. month‟s sale) -
i) Raw materials - -
ii) Labour -
iii) Overheads - 4) Sundry Debtors or Receivables (for …. month‟s sale) -
i) Raw materials - - ii) Labour -
iii) Overheads - 5) Payments in Advance (if any) - 6) Balance of Cash (Required to meet day-to-day expenses) - 7) Any other (if any) - Less: Current Liabilities -
i) Creditors (for …. month‟s purchases of raw material) -
ii) Lag in payment of expenses (outstanding expenses) -
iii) Others (if any) - Add: Provision / Margin for Contingencies - Net Working Capital Required -
Financial Management Semester II
S.N.Selvaraj, Assistant Professor, E-mail: [email protected] Page 8
Problem: EXE Ltd. is engaged in large-scale consumer retailing. From the following
information, you are required to forecast their working capital requirement:
a) Project annual sales – Rs.65 lacs.
b) Percentage of net profit on cost of sales – 25 percent
c) Average credit period allowed to debtors – 10 weeks
d) Average credit period allowed by creditors – 4 weeks
e) Average stock carrying (in terms of sales requirement) – 8 weeks
f) Add 10 percent to compute figures to allow for contingencies.
Solution
Rs.
Project annual sales 65,00,000
Project sales per week 1,25,000
Less: Net profit (25% on cost = 20% on sales) 25,000
Projected cost of goods per week 1,00,000
Working Capital Requirement Forecast
1) Current Assets: Rs. Rs.
Stock (1,00,000×8) 8,00,000
Debtors (1,25,000×10) 12,50,000 20,50,000
2) Current Liabilities
Creditors (1,00,000×4) 4,00,000 4,00,000
3) Working Capital (1 – 2) 16,50,000
Add: 10 percent for contingencies 1,65,000
4) Total requirement 18,15,000
Problem: The Board of Directors of Ruby Ltd. requests you to prepare a statement
showing the working capital requirements forecasts for a level of activity of 1,56,000
units of production. The following information is available for your calculation.
(Rs. Per Unit)
Raw material 90
Direct labour 40
Overheads 75
205
Profit 60
Selling pricing per unit 265
a) Raw materials are in stock on average one month
b) Materials are in process, on average 2 weeks
c) Finished goods are in stock, on average one month
d) Credit allowed by supplier – one month
e) Time lag in payment from debtors – 2 months
f) Lag in payment of wages – 1½ weeks
g) Lag in payment of overheads – one month
Financial Management Semester II
S.N.Selvaraj, Assistant Professor, E-mail: [email protected] Page 9
20% of the output is sold against cash. Cash in hand and at bank is expected to be
Rs.60,000. It is to be assumed that production is carried on evenly throughout the
year. Wages and overheads accrue similarly and a time period of 4 weeks is
equivalent to a month.
Solution
Statement of Working Capital Required
Current Assets: Rs. Rs.
Cash in hand and cash at bank 60,000 Stock in hand
Raw material 10,80,000
Work-in-process 8,85,000
Finished goods 24,60,000 44,25,000
Sundry Debtors 39,36,000
84,21,000 Current Liabilities:
Sundry creditors 10,80,000
Wages payable 1,80,000
Expenses payable 9,00,000 21,60,000
Net working capital employed (CA–CL) 62,61,000
Working Notes
1) Raw material = 1,56,000 units × 4 weeks×Rs.90 = Rs.10,80,000
52 weeks
2) Work-in-progress= 1,56,000 units × 2weeks = 6,000 units
52 weeks
Raw materials (6,000 units @ Rs.90) 5,40,000
Wages (6,000 units @ Rs.40×½) 1,20,000
Overheads (6,000 units @ Rs.75×½) 2,25,000
Total value of WIP 8,85,000
3) Finished goods = 1,56,000 units × 4 weeks×Rs.205 = Rs.24,60,000
52 weeks
4) Debtors = 1,56,000 units × 8 weeks×Rs.205×80 = Rs.39,36,000
52 weeks 100
5) Creditors = 1,56,000 units × 4 weeks×Rs.90 = Rs.10,80,000
52 weeks
6) Wages = 1,56,000 units × 1.5 weeks×Rs.40 = Rs.1,80,000
52 weeks
7) Expenses = 1,56,000 units × 4 weeks×Rs.75 = Rs.9,00,000
52 weeks
Financial Management Semester II
S.N.Selvaraj, Assistant Professor, E-mail: [email protected] Page 10
ACCOUNTS RECEIVABLES MANAGEMENT
Receivables represent amounts owed to the firm as a result of sale of goods or services
in the ordinary course of business. These are claims of the firm against its customers
and form part of its current assets. Receivables are also known as accounts
receivable, trade receivables, customer receivables or book debts.
Meaning of Receivables
Receivables management is the process of making decisions relating to investment in
trade debtors. Certain investment in receivables is necessary to increase the sales and
the profits of a firm. But at the same time investment in this asset involves cost
considerations also. Further, there is always a risk of bad debts too.
Definition of Receivables
According to Hampton, “Receivables are asset accounts representing amount owned
to firm as a result of sale of goods or services in ordinary course of business.”
Objectives of Receivables Management
The objectives of receivables management are to improve sales, eliminate bad debts
and reduce transaction costs incidental to maintenance of accounts and collection of
sales proceeds and finally enhance profits of the firm. Credit sales help the
organization to make extra profit. It is a known fact; firms charge a higher price,
when sold on credit, compared to normal price.
Cost of Maintaining Receivables
Cost of Financing:
Administration Cost:
Delinquency Costs:
Cost of Default by Customers: Factors Affecting the Size of Receivables
Besides sales, a number of other factors also influence the size of receivables. The
following factors directly and indirectly affect the size of receivables.
a) Size of Credit Sales:
b) Credit Policies: c) Terms of Trade: d) Relation with Profits: e) Credit Collection Efforts
f) Stability of Sales:
g) Size and Policy of Cash Discount: h) Bill Discounting and Endorsement:
Financial Management Semester II
S.N.Selvaraj, Assistant Professor, E-mail: [email protected] Page 11
Importance of Receivables Management
FACTORING
The word „factoring’ has its origin from Latin „factor‟ which means „doer‟. The
Webster‟s New Collegiate Dictionary defines a factor as “one who lends money to
producers and dealers on the security of accounts receivables”.
Factoring is a financial transaction whereby a business sells its accounts receivables
(i.e. invoices) to a third party (called a factor) at a discount in exchange for immediate
money with which to finance continued business.
Definition of Factoring
According to C.S.Kalyanasundaram, “Factoring is the outright purchase of credit
approved account receivables with the factor assuming bad debt losses”.
According to AlamCalpin, “Factoring is a system designated to eliminate payment risk
in overseas sales and ensure that the seller receives prompt settlements”.
A factor is thus a financial institution which manages the collection of account
receivables of the companies on their behalf and bears the credit risk associated with
those accounts. In general, factoring means selling, with or without recourse, the
receivables by the firm to a factor. By factoring, the company relieves itself of the
organization, procedures and internal expenses of collecting its receivables.
There are three main parties in factoring arrangements:
1) The Factor
2) The Client (seller)
3) The Customer (buyer)
The arrangements are governed by a contract between the factor and the client, and
this contract is for a fixed period, usually a year, which is normally renewed
automatically. The contract can be cancelled only with sufficient prior notice.
Importance of Receivables Management
Determining Credit Policy
Determining Credit Terms
Evaluating the Credit Application
Determining Collection Policies and Methods
Control and Analysis of Receivables
Financial Management Semester II
S.N.Selvaraj, Assistant Professor, E-mail: [email protected] Page 12
Features of Factoring
a) The period for factoring is 90 to 150 days. Some factoring companies allow
even more than 150 days.
b) Factoring is considered to be a costly source of finance compared to other
sources of short-term borrowings.
c) Factoring receivables is an ideal financial solution for new and emerging firms
without strong financials.
d) Bad debts will not be considered for factoring.
e) Credit rating is not mandatory but factoring companies carry out credit risk
analysis.
f) Factoring is a method of off balance sheet financing.
g) Cost of factoring =Finance cost + Operating cost.
h) Indian firms offer factoring for invoices as low as Rs.1000.
i) For delayed payments beyond the approved credit period, penal charge of
around 1%-2% per month over and above the normal cost is charged.
Types of Factoring
ing
Working/Mechanism of Factoring
Factoring business is generated by credit sales in the normal course of business. The
main function of factor is realization of sales. One the transaction takes place, the role
of factor steps, is to realize the sales/collect receivables. Thus, factor acts as an
intermediary between the seller and sometimes along with the seller‟s bank together.
When the payment is received by the factor, the account of the firm is credited by the
factor after deducting its fees, charges, interest, etc. as agreed.
Types of Factoring
Recourse Factoring Non-Recourse Factoring
Advance Factoring Bank Participation Factoring
Maturing Factoring Notified and Undisclosed
Factoring
Full Factoring Invoicing Factoring
Buyer-based, Seller-based, and
Selective Factoring Export Factoring
Financial Management Semester II
S.N.Selvaraj, Assistant Professor, E-mail: [email protected] Page 13
The mechanism of factoring is described in the following figure:
1) Customer places an order with the client for goods and or service on credit;
client delivers the goods and sends invoice to customers.
2) Client assigns invoice to factor.
3) Factor makes pre-payment up to 80 percent and sends periodical statements.
4) Monthly statement of accounts to customer and follow-up.
5) Customer makes payment to factor.
6) Factor makes balance 20 percent payment on realization to the client.
1
2 3 Send invoice
Assign Payment 6 to customer
Invoice up to 80% Balance 20% on realization
to factor 4 Statement to customer
5 Payment to factor
Figure: Working of Factoring
INVENTORY MANAGEMENT
The word „Inventory‟ is understood differently by various authors. In accounting
language it may mean stock of finished goods only. In a manufacturing concern, it
may include raw materials, work in process and stores, etc.
International Accounting Standard Committeedefines inventories as „Tangible property‟
Held for sale in the ordinary course of business
In the process of production for such sale or,
To be consumed in the process of production of goods or services for sale
The American Institute of Certified Public Account (AICPA) defines “Inventory in the
sense of tangible goods, which are held for sale, in process of production and available
for ready consumption”.
According to Bolten S.E., “Inventory refers to stock-pile of product, a firm is offering
for sale and components that make up the product”.
Meaning of Inventory Management
The investment in inventory is very high in most of the undertaking engaged
manufacturing, whole-sale and retail trade. The amount of investment is sometimes
more in inventory than in other assets. About 90 percent part of the working capital
invested in inventories. It is necessary for every management to give proper attention
CLIENT
FACTOR CUSTOMER
Financial Management Semester II
S.N.Selvaraj, Assistant Professor, E-mail: [email protected] Page 14
to inventory management. A proper planning of purchasing, handling, storing and
accounting should form a part of inventory management. An efficient system of
inventory manager will determine (a) What to purchase? (b) How much to purchase?
(c) From where to purchase? (d) Where to store? etc.
Objectives of Inventory Management
The objectives of inventory management may be discussed under two heads:
Operating Objectives
Financial Objectives
Operational objectives refer to material and other parts which are available in
sufficient quantity. It includes:
(a) Availability of Materials
(b) Minimizing the Wastages
(c) Promotion of Manufacturing Efficiency
(d) Better Service to Customers
(e) Control of Production Level
(f) Optimal Level of Inventories
Financial objectives mean that investment in inventories must not remain idle and
minimum capital must be locked in it. It includes:
(a) Economy in Purchasing
(b) Optimum Investment and Efficient
(c) Reasonable Price
(d) Minimizing Costs
Elements of Inventory
Inventory includes the following things:
1) Raw Materials: It includes the materials used in the manufacture of a product.
The purpose of holding raw material is to ensure uninterrupted production in
the event of delaying delivery.
(a) Direct Materials: It is the primary classification for raw materials in
manufacturing operations. It is directly related to the final product.
(b) Indirect Materials: It is the class of materials in the manufacturing process
that does not actually ship to the customer as part of the final product. For
example, the gas used to heat the furnaces that melt the steel in the
manufacture of hammers, is an indirect material.
2) Work-in-progress: It includes partly finished goods and material held between
manufacturing stages. It can also be stated that those raw materials which are
used in production process but are not finally converted into final product are
work-in-progress.
3) Consumables: Consumables are products that consumers buy recurrently, i.e.
items which „get used-up‟ or discarded. For example, consumable office
supplies are such products as paper, pens, file, folders computer disks, etc.
Financial Management Semester II
S.N.Selvaraj, Assistant Professor, E-mail: [email protected] Page 15
4) Finished Goods: The goods ready for sale or distribution comes under this class.
It helps to reduce the risk associated with stoppage in output on account of
strikes, breakdowns, shortage of materials, etc.
5) Stores and Spares: This category includes those products which are accessories
to the main products produced for the purpose of sale. For example, bolts and
nuts, clamps, screws, etc.
The following are a few examples of the type of inventory held by various
organizations. Since the final product (output) of a service organization such as bank,
hospital, etc. cannot be stored for use in the near future; the concept of inventory
control for them is associated with the various forms of productive capacity.
Type of Organizations Type of Inventories Held
Manufacturer Raw materials, spare parts, semi-finished goods,
finished goods
Hospital Number of beds, stock of drugs, specialized personnel
Bank Cash reserves, tellers
Airline company Seating capacity, spare parts, special maintenance crew
Motives of Holding Inventories
There are three main purposes of motives of holding inventories:
Transaction Motive: Precautionary Motive: Speculative Motive:
Types of Inventory
Movement Inventories:
Buffer Inventories:
Anticipation Inventories:
Decoupling Inventories:
Cycle Inventories:
Independent Demand Inventory:
Dependent Demand Inventories:
Costs of Inventory
In determining an optimal inventory policy, the criterion most often is the cost
function. The classical inventory analysis identifies four major cost components:
Financial Management Semester II
S.N.Selvaraj, Assistant Professor, E-mail: [email protected] Page 16
Inventory Management Techniques
Several Techniques of inventory control are in use and it depends on the convenience
of the firm to adopt any of the techniques. What should be stressed, however, is the
need to cover all items of inventory and all stages, i.e. from the stage of receipt from
suppliers to the stage of their use. The techniques most commonly used are the
following:
Economic Order Quantity
Levels of Stock
Perpetual Inventory System
ABC Analysis
Just in Time
Inventory Turnover
Inventory Control of Spares and Slow Moving Items
Economic Order Quantity:
EOQ is an important factor in controlling the inventory. It is a quantity of inventory
which can reasonably be ordered economically at a time. It is also known as
“Standard Order Quantity”, “Economic Lot Size” or “Economic Ordering Quantity”.
In determining this point ordering costs and carrying costs are taken into
consideration.
The quantity may be calculated with the help of the following formula:
EOQ = √2AC † h
where, A = Annual quantity used (in units), C = Cost of placing an order
(fixed cost) and h = Cost of holding one unit.
For example, calculate EOQ from the following data.
Estimated requirement for the year 600 units
Cost per unit Rs.20
Ordering cost (per order) Rs.12
Carrying cost (% of average inventory) 20%
EOQ = √2AC † h = √(2×600×12)÷ (20×20%) = 60 units
Cost of Inventory
Purchase Cost Ordering Cost / Set-up Cost
Carrying Cost Stock out Cost
Financial Management Semester II
S.N.Selvaraj, Assistant Professor, E-mail: [email protected] Page 17
CASH MANAGEMENT
Cash is one of the currents of a business. It is needed at all times to keep the business
going. A business concern should always keep sufficient cash for meeting its
obligations. Any shortage of cash will hamper the operation of a concern and any
excess of it will be unproductive. Idle cash is the most unproductive of all the assets.
The fixed assets like machinery, plant, etc. and current assets such as inventory will
help the business in increasing its earnings capacity. But cash in hand idle will not
add anything to the concern.
Motives for holding cash
The firm‟s needs for cash may be attributed to the following needs: Transactions
motive, Precautionary motive and Speculative motive. Some people are of the view
that a business requires cash only for the first two motives while others feel that
speculative motive also remains. o Transaction Motive: o Precautionary Motive: o Speculative Motive: o Compensation Motive
Determining Cash Needs
The amount of cash for transaction requirements is predictable and depends upon a
variety of factors which are as follows:
Credit position of the firm
Status of firm‟s receivable
Status of firm‟s inventory account
Nature of business enterprise
Management‟s attitude towards risk
Amount of sales in relation to assets
Cash inflows and Cash outflows
Cost of Cash Balance
Meaning of Cash Management
Cash management refers to management of cash balance and the bank balance
including the short term deposits. For cash management purpose, the term cash is used
in this broader sense i.e. it covers cash, cash equivalents and those assets which are
immediately convertible into cash.
Objectives of Cash Management
The basic objectives of cash management are two-fold:
1) Meeting the Payment Schedule: 2) Minimizing Funds Committed to Cash Balance:
Advantages of Adequate Cash
It prevents insolvency or bankruptcy arising out of the inability of a firm to
meet its obligation.
The relationship with the bank is not strained
Financial Management Semester II
S.N.Selvaraj, Assistant Professor, E-mail: [email protected] Page 18
It helps in fostering good relations with trade creditors and suppliers of raw
materials as prompt payment may help their own cash management.
A trade discount can be availed, if payment is made within the due date.
It leads to a strong credit rating which enables the firm to purchase goods on
favourable terms.
The firm can meet unanticipated cash expenditure with a minimum of strain
during emergencies, such as strikes, fires or a new marketing campaign by
competitors.
Keeping large cash balances however, implies a high cost. The advantage of prompt
payment of cash can well be realized by sufficient cash and not excessive cash.
Importance of Cash Management
Cash management consists of taking the necessary actions to maintain adequate levels
of cash to meet operational and capital requirements and to obtain the maximum yield
on short-term investment of pooled, idle cash. A good management program is a very
significant component of the overall financial management of a municipality. Such a
program benefits the city or town by increasing non-tax revenues, improving the
control and superintendence of cash. Also increasing contacts with members of the
financial community and lowering borrowing costs, while at the same time
maintaining the safety of the municipality‟s funds.
Basic strategies for Cash Management
The broad cash management strategies are essentially related to the cash turnover
process, that is, the cash cycle together with the cash turnover. The cash cycle refers to
the process by which cash is used to purchase materials from which goods are
produced, which are then sold to customers, who later pay the bills.
Details of Cash Cycle
A B C D E F GH I
A = Materials ordered; B = Materials received; C = Payments;
D = Cheque clearance; E = Goods sold; F = Customer‟s payments
G = Payment received H = Cheques deposited I = Funds collected
Tools /Techniques of Cash Management
There are some specific techniques and processes for speedy collection of receivables
from customers and slowing disbursements.
1) Cash Management Planning
2) Cash Management Control
(i) Accelerating Cash Flows,
(ii) Controlling Cash Flows
3) Determining Optimum Cash Balance
Financial Management Semester II
S.N.Selvaraj, Assistant Professor, E-mail: [email protected] Page 19
Problem
Prepare cash budget for the months of June, July, August, 2011 from the following
information:
a) Opening cash balance in June Rs.7000/-
b) Cash sales for June Rs.20,000; July Rs.30,000; and August Rs.40,000
c) Wages payable Rs.6000 per month.
d) Interest receivable Rs.500 in the month of August
e) Purchase of furniture for Rs.16,000 in July.
f) Cash purchases for June Rs.10,000; July Rs.9000; and August Rs.14,000
Solution Cash Budget for the period June to August 2011
Particulars June July August
Opening Cash Balance
Add: Estimated Cash Receipts
Cash Sales
Interest receivable
Total Receipts
Less: Estimated Cash Payments
Cash Purchases
Payment of Wages
Purchase of Furniture
Total Payments
Closing Balance (surplus/deficit)
7,000
20,000
--
27,000
10,000
6,000
--
16,000
11,000
11,000
30,000
41,000
9,000
6,000
16,000
31,000
10,000
10,000
40.000
500
50,500
14,000
6,000
--
20,000
30,500
Cash Management Models
Two important cash management models which lead to determination of optimum
cash balance.
Optimum Cash Balance under Certainty: Baumol’s Model
The Baumol cash management model provides a formal approach for determining a
firm‟s optimumcash balance under certainty. It considers cash management similar to
an inventory management problem. As such, the firm attempts to minimize the sum of
Cash Management Models
Optimum Cash Balance under
Certainty: Baumol‟s Model Optimum Cash Balance under
Uncertainty
Miller-Orr Model Stone Model
Financial Management Semester II
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the cost of holding cash (inventory of cash) and the cost of converting marketable
securities to cash.
Assumptions of Baumol’s Model
1) The firm is able to forecast its cash needs with certainty.
2) The firm‟s cash payment occurs uniformly over a period of time.
3) The opportunity cost of holding cash is known and it does not change over
time.
4) The firm will incur the same transaction cost whenever it converts securities to
cash.
Let us assume that the firm sells securities and starts with a cash balance of C rupees.
As the firm spends cash, its cash balance decreases steadily and reaches to zero. The
firm replenishes its cash balance to C rupees by selling marketable securities. This
pattern continues over time. Since the cash balance decreases steadily, the average
cash balance will be: C/2. The pattern is shown in the following figure:
Figure: Baumol’s Model for Cash Balance
Cash Balance
C
C/2 Average
Time
0 T1 T2 T3
The firm incurs a holding cost for keeping the cash balance. It is an opportunity cost;
that is, the return foregone on the marketable securities. If the opportunity cost is k,
then the firm‟s holding cost for maintaining an average cash balance is as:
Holding Cost = k(C/2)
The firm incurs a transaction cost whenever it converts its marketable securities to
cash. Total number of transactions during the year will be total funds requirement, T,
divided by the cash balance, C, i.e. T/C. The per-transaction cost is assumed to be
constant. If per transaction cost is c, then the total transaction cost will be:
Transaction cost = c(T/C)
The total annual cost of the demand for cash will be:
Total Cost = k(C/2) + c(T/C)
The holding cost increases as demand for cash, C, increases. However, the transaction
cost reduces because with increasing C the number of transactions will decline. Thus,
Financial Management Semester II
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there is a trade-off between the holding cost and the transaction cost. The following
figure depicts this trade-off.
Figure: Cost Trade-off Baumol’s Model
Cost Total
Cost
Holding Cost
Transaction Cost
Cash
Balance
The optimum cash balance, C*, is obtained when the total cost is minimum. The
formula for the optimum cash balance is as:
C* = √2cT /k Where,
C* is the optimum cash balance
c is the cost per transaction
T is the total cash needed during the year
k is the opportunity cost of holding cash balance
The optimum cash balance will increase with increase in per-transaction cost and total
funds required and decrease with the opportunity cost.
Limitations of the Baumol Model
1. Assumes a constant disbursement rate.
2. Ignores cash receipts during the period
3. Does not allow for safety cash reserves.
In spite of limitations, the model has a theoretical value. It gives an idea as to how the
holding cost and transaction cost should optimized by the firm. The cash balance
being maintained by the firm should be a level close to optimum level as given by the
model so that the total cost is minimized.
Optimum Cash Balance under Uncertainty
There are two optimum cash balance under uncertainty.
1) Miller-Orr Model
2) Stone Model
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Miller-Orr Model
The Miller-Orr (MO) model is also known as stochastic model. This model overcome
the shortcoming of Baumol’s model and allows for daily cash flow variation. It
assumes that net cash flows are normally distributed with a zero value of mean and a
standard deviation. The MO model provides for two control limits – the upper control
limit and the lower control limit as well as a return point. If the firm‟s cash flows
fluctuate randomly and hit the upper limit, then it buys sufficient marketable securities
to come back to normal level of cash balance (the return point).
Similarly, when the firm‟s cash flows wander and hit the lower limit, it sells sufficient
marketable securities to bring the cash balance back to the normal level i.e. the return
point. Figure: Miller-Orr Model
Cash Balance Upper Limit
Purchase of securities
Return point
Sale of securities
Lower Limit
Time
The firm sets the lower control limit as per its requirement of maintaining minimum
cash balance. At what distance the upper control limit will be set? The difference
between the upper limit and the lower limit depends on the following factors:
(1) Transaction Cost (c); (2) Interest Rate (i); (3) standard deviation (σ) of net cash
flows.
The formula for determining the distance between upper and lower control limits
(called Z) is as follows:
Upper Limit – Lower Limit)
= (¾ × Transaction Cost × Cash Flow Variance /Interest Rate)⅓
= (¾ × cσ2 /i)
⅓
Stone Model
Like the Miller-Orr model, the Stone model takes a control limits approach; when
cash balances fall outside the control limits, the firm is signaled to do something. But
in the Stone model, the signal does not automatically result in an investment or
disinvestment; the recommended action depends on management‟s estimates of future
cash flows; i.e. the model signals an evaluation by management rather than an action.
Financial Management Semester II
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To do this, the Stone model uses two sets of control limits, the inner control limits
(UCL1 and LCL1) and the outer control limits (UCL2 and LCL2).
The transactions are the same as those in the Miller-Orr model. Investments are made
sufficient to bring the cash balance back to the return point if the upper control limit is
exceeded; corresponding disinvestments are made if the lower control limit is
exceeded. Optimal procedures for setting the return point, the two sets of control
limits and the number of days a firm looks ahead are net specific; the outer control
limits could be set by the Miller-Orr model or could be based on the cash manager‟s
feeling for the best limits. Figure: Control Limits for the Stone Model
400 UCL2
300UCL1
200 Return Point
LCL1
LCL2
100
0 1 2 3 4 5
WORKING CAPITAL FINANCE: TRADE CREDIT
Working capital financing concerns how a firm finances its current assets. It is very
essential to any growing business. It helps to keep the business efficient and
competitive in the market.
Trade Credit
Trade Credit refers to the credit extended by the suppliers of goods in the normal
course of business. As present day commerce is build upon credit, the trade credit
arrangement of a firm with its suppliers in an important source of short-term finance.
The credit-worthiness of a firm and the confidence of its suppliers are the main basis
of securing trade credit.
Management of Trade Credit
The firm should exploit the possibilities of trade credit to the full extent, because it is
an important source of financing working capital needs of the firm. To facilitate the
management‟s decision-making the following financial ratios can be of great use.
Trade Credit to Total Current Assets Ratio: This ratio indicates the magnitude of the use
of trade credit in financing total current assets of a firm. The lower the ratio, the better
will be liquidity position of the firm.
Financial Management Semester II
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Trade Credit to Total Current Assets Ratio
= Trade Credit / Total Current Assets
Trade Credit to Total Current Liabilities Ratio: This ratio indicates the proportion of
trade credit to total current liabilities. It speaks on the financing mix adopted by the
company. A high ratio means increased dependence on spontaneous sources and
difficult in getting funds from negotiated sources.
Trade Credit to Total Current Assets Ratio
= Trade Credit / Total Current Liabilities
Trade Credit to Sales Ratio: This ratio is also very useful form the
Trade Credit to Total Current Assets Ratio
= Trade Credit / Total Current Liabilities
Percentage Change in Trade Credit to Percentage Change in Sales Ratio: This ratio
indicates the behavioral relationship between sales and trade credit. Generally
speaking, increasing sales demand increasing use of trade credit facilities. The rate of
change in sales must always be higher than the rate of change in trade credit.
Percentage Change in Trade Credit to Percentage Change in Sales Ratio = (% Change in Trade Credit) / (% Change in Sales)
BANK FINANCE AND COMMERCIAL PAPER
Banks are the main institutional sources of working capital finance in India. After
trade credit, bank credit is the most important source of financing working capital
requirements of firms in India. The amount approved by the bank for the firm‟s
working capital is called credit limit. Credit limit is the maximum funds which a firm
can obtain from the banking system. Banks are required to fix separate limits, for the
„peak level‟ credit requirements and „normal non-peak level‟ credit requirements
indicating the periods during which the separate limits will be utilized by the
borrower.
In practice, banks do not lend 100% of the credit limit; they deduct margin money.
Margin requirement is based on the principle of conservatism and is meant to ensure
security. If the margin requirement is 25%, bank will lend only up to 75% of the value
of the asset. This implies that the security of bank‟s lending should be maintained
even if the asset‟s value falls by 25%.
Forms of Bank Credit
A firm can draw funds from a bank within the maximum credit limit sanctioned. It can
draw funds in the following forms:
Secured Term Loans/ Bank Loans: Cash Credit: Overdrafts:
Financial Management Semester II
S.N.Selvaraj, Assistant Professor, E-mail: [email protected] Page 25
Commercial Paper
Commercial paper (CP) is an important money market instrument in advanced
countries like U.S.A. to raise short-term funds. In India, on the recommendation of the
Vaghul Working Group, the Reserve Bank of India introduced commercial paper in
the Indian money market. Commercial paper, as it is known in the advanced countries,
is a form of unsecured promissory note issued by firms to raise short-term funds. The
commercial papermarket in USA is a blue-chip market where financially sound and
highest rated companies are able to issue commercial papers.
o Duration:
o Denomination and Size:
o Maximum Amount:
Advantages of Commercial Paper
It is an alternative source of raising short-term finance, and proves to be handy
during periods of tight bank credit.
It is a cheaper source of finance in comparison to the bank credit. Usually,
interest yield of commercial paper is less than the prime rate of interest.
Disadvantages of Commercial Paper
It is impersonal method of financing.
It is available always to financially sound and highest rated companies.
It cannot be redeemed until maturity.
Text Books
1. M.Y.Khan and P.K.Jain, “Financial Management” Tata McGraw Hill, 6th
Edition, 2011.
2. I.M.Pandey, “Financial Management” Vikas Publishing House Pvt. Ltd., 10th
Education 2012. References
1. AswatDamodaran, Corporate Finance Theory and Practice, John Wiley &
Sons, 2011.
2. James C Vanhorne, Fundamentals of Financial Management, PHI Learning,
11th
Edition, 2012.
3. Brigham Ehrhardt, Financial Management Theory and Practice, Cengage
Learning, 12th
Edition, 2010.
4. Prasanna Chandra, Financial Management, Tata McGraw Hill, 9th
Edition,
2012.
5. Srivatsava, Mishra, Financial Management, Oxford University Press, 2011.