caiib fondation

8/10/2019 caiib fondation

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CAIIB

CAIIB- FINANCIAL MANAGEMENT

- MODULEDWORKING CAPITAL &TERM LENDING

-Prof. R.S. Ullal

Consultant & Faculty


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Module D topics

Marginal Costing

Capital Budgeting

Cash Budget Working Capital


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COSTING

Cost accounting system provides informationabout cost

Aim : best use of resources and maximization

of returns cost = amount of expenditure incurred( actual+

notional)

Purposes +profit from each job/product,

division,segment+pricingdecision+control+profitplanning +inter firm comparison


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Marginal costing problems

Sales - variable cost = contribution

Contribution/ (divided by) sales

= C.S. Ratio Contribution=Fixed cost (at Break

even point)

Fixed Cost / (divided by) contributionper unit = break even units


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Basic formulaSales price (-) variable cost= contribution

SP less VC = Contribution

10 6 = 4

9 6 = 3

8 6 = 2

7 6 = 1

6 6 = 05 6 = (1)

4 6 = (2)


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SP = Rs.10, VC =Rs.6 Fixed CostRs.60000

Find

- Break even point (in Rs. & in units)

- C/S ratio

- Sales to get profit of Rs.20000


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Sales Rs.100000

Fixed Cost Rs.20000

B.E.Point Rs.80000 What is the profit ?


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Management decisions- assessingprofitability

CONTRIBUTION/SALES=C.S.RATIOProduct sp vc Contribtion c/s Ratio % ranking

A 20 10 10 10/20 50% 1

B 30 20 10 10/30 33% 2

C 40 30 10 10/40 25% 3


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DECISION when limiting factors

SP Rs.14 Rs.11

VC 8 7

Contribution

Per unit

6 4

Labour hr. pu 2 1

Contri.per hr 3 4


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DECISIONS

Make or buy decisions

Close department

Accept or reject order Conversion cost pricing


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Marginal costing

cost-volume-profit analysis is reliant upon aclassification of costs in which fixed and variablecosts are separated from one another. Fixed

costs are those which are generally time relatedand are not influenced by the level of activity.

Variable cost on the other hand are directlyrelated to the level of activity; if activity

increases, variable costs will increase andvice-versa if activity decreases.


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Marginal costing

USES OF COST-VOLUME-PROFIT ANALYSIS

The ability to analyse and use cost-volume-profitrelationship is an important management tool. Theknowledge of patterns of cost behaviour offers insights

valuable in planning and controlling short and long-runoperations. The example of increasing capacity is a goodillustrations of the power of the technique in planning.

The implications of changes in the level of activity can bemeasured by flexing a budget using knowledge of cost

behaviour, thereby permitting comparison to be made ofactual and budgeted performance for any level ofactivity.


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Marginal costing

LIMITATIONS OF COST-VOLUME-PROFIT ANALYSIS

A major limitation of conventional CVP analysis that wehave already identified is the assumption and use oflinear relationships. Yet another limitation relates to the

difficulty of dividing fixed costs among many productsand/or services. Whilst variable costs can usually beidentified with production services, most fixed costusually can only be divided by allocation andapportionment methods reliant upon a good deal of

judgement. However, perhaps the major limitation of thetechnique relates to the initial separation of fixed andvariable costs.


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Marginal costing

ADVANTAGES AND DISADVANTAGES OFMARGINAL COSTING

ADVANTAGES 1. More efficient pricing decisions can be made, since

their impact on the contribution margin can bemeasured. 2. Marginal costing can be adapted to all costing

system. 3. Profit varies in accordance with sales, and is not

distorted by changes in stock level. 4. It eliminates the confusion and misunderstandingthat may occur by the presence ofover-or-under-absorbed overhead costs in the profit andloss account.


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Marginal costing

5. The reports based on direct costing are far moreeffective for management control than those based onabsorption costing. First of all, the reports are moredirectly related to the profit objective or budget for theperiod. Deviations from standards are more readily

apparent and can be corrected more quickly. Thevariable cost of sales changes in direct proportion withvolume. The distorting effect of production on profit isavoided, especially in month following high productionwhen substantial amount of fixed costs are carried in

inventory over to next month. A substantial increase insales in the month after high production underabsorption costing will have a significant negative impacton the net operating profit as inventories are liquidated.


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Marginal costing

6. Marginal costing can help to pinpointresponsibility according to organisational lines:individual performance can be evaluated onreliable and appropriate data based on current

period activity. Operating reports can beprepared for all segments of the company, withcosts separated into fixed and variable and thenature of any variance clearly shown. Theresponsibility for costs and variances can then

be more readily attributed to specific individualsand functions, from top management to downmanagement


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Marginal costing

DISADVANTAGES OF MARGINAL COSTING 1. Difficulty may be experienced in trying to segregate

the fixed and variable elements of overhead costs for thepurpose of marginal costing.

2. The misuse of marginal costing approaches topricing decisions may result in setting selling prices thatdo not allow the full recovery of overhead costs.

3. Since production cannot be achieved withoutincurring fixed costs, such costs are related toproduction, and total absorprtion costing attempts tomake an allowance for this relationship. This avoids thedanger inherent in marginal costing of creating theillusion that fixed costs have nothing to do withproduction.


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CAPITAL BUDGETING

It involves current outlay of funds in theexpectation of a stream of benefits

extending far into the futureYear Cash flow

0 (100000)

1 300002 40000

3 50000

4 50000


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CAPITAL BUDGETING

A capital budgeting decision is one that involves theallocation of funds to projects that will have a life ofatleast one year and usually much longer.

Examples would include the development of a major new

product, a plant site location, or an equipmentreplacement decision.

Capital budgeting decision must be approached withgreat care because of the following reasons:

1. Long time period: consequences of capital expenditureextends into the future and will have to be endured for alonger period whether the decision is good or bad.


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CAPITAL BUDGETING

2. Substantial expenditure: it involves large sumsof money and necessitates a careful planningand evaluation.

3. Irreversibility: the decisions are quite often

irreversible, because there is little or no secondhand market for may types of capital goods.4. Over and under capacity: an erroneous

forecast of asset requirements can result in

serious consequences. First the equipmentmust be modern and secondly it has to be ofadequate capacity


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CAPITAL BUDGETING

Methods of classifying investments

Independent Dependent Mutually exclusive Economically independent and statistically

dependent Investment may fall into two basic categories,

profit-maintaining and profit-adding when viewed

from the perspective of a business, or servicemaintaining and service-adding when viewedfrom the perspective of a government or agency.


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CAPITAL BUDGETING

Expansion and new product investment

1. Expansion of current production to meetincreased demand

2. Expansion of production into fields closelyrelated to current operation horizontalintegration and vertical integration.

3. Expansion of production into new fields not

associated with the current operations.4. Research and development of new products.


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CAPITAL BUDGETING

Reasons for using cash flows

Economic value of a proposed investment can beascertained by use of cash flows.

Use of cash flows avoids accounting ambiguities

Cash flows approach takes into account the time valueof money

For any investment project generating either expandedrevenues or cost savings for the firm, the appropriate

cash flows used in evaluating the project must beincremental cash flow.

The computation of incremental cash flow should followthe with and without principle rather than the beforeand afterprinciple


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Types of capital investments

New unit

Expansion

Diversification Replacement

Research & Development


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Significance of capital budgeting

Huge outlay

Long term effects

Irreversibility Problems in measuring future cash flows


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Facets of project analysis

Market analysis

Technical analysis

Financial analysis Economic analysis

Managerial analysis

Ecological analysis


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Decision process

PLANNING PHASE

EVALUATION PHASE

SELECTION PHASE

IMPLEMENTATION PHASE

CONTROL PHASE

AUDITING PHASE

INVESTMENT OPPORTUNITIES

PROPOSALS

ONLINE PROJECTS

PROJECTS

ACCEPTED PROJECTS

PROJECT TERMINATION

PROPOSALS

Improvementinplanning&Evalu

ationprocedure

Improvementinplanning&Evalu

ationprocedure

NEWIN

VESTMENTOPPOR

TUNITIES


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Methods of capital investmentappraisal

DISCOUNTING NON-DISCOUNTING

Net present value (NPV) Pay back period

Internal rate of return(IRR)

Accounting rate of return

Profitability Index orBenefit cost ratio


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resen va ue o cas ow


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resen va ue o cas owstream- (cash outlay Rs.15000

)@10%Year Cash flow PV factor @10% PV1 2000 0.909 1818

2 2000 0.826 1652

3 2000 0.751 1502

4 3000 0.683 2049

5 3000 0.621 1863

6 4000 0.564 2256

7 4000 0.513 2052

8 5000 0.466 2330

15522


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CAPITAL BUDGETING

The advantages of IRR over NPV are: 1. It gives a percentage return which is easy to

understanding at all levels of management. 2. The discount rate/required rate of return

does not have to be known to calculate IRR. Itdoes have to be decided upon at sometimebecause IRR must be compared with something.The discussion as to what is an acceptable rate

of return can however be left until much laterstage. In a NPV calculation the discount ratemust be specified prior to any calculation beingperformed.


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The advantages of NPV over IRR are: 1. NPV gives an absolute measure of profitability and hence

immediately shows the increase in shareholders wealth due to aninvestment decision.

2. NPV gives a clear answer in an accept/reject decision. IRRgives multiple answers.

3. NPV always gives the correct ranking for mutually exclusiveproject while IRR may not.

4. NPVs of projects are additive while IRRs are not. 5. Any changes in discount rates over the life of a project can

more easily be incorporated into the NPV calculation.

The NPV approach provides as absolute measure that fullyrepresents in value of the company if a particular project isundertaken. The IRR by contrast, provides a percentage figure fromwhich the size of the benefits in terms of wealth creation cannotalways be grasped.


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The timing of the cash flows is critical for

determining the Project's value.

below the line for cash investments or

above the line for returns.

Rs.51 La kh Rs.51 La kh Rs.61 La kh

Year 1 Year 2 Year 3

Rs.102 lakh

Year 0


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Net Present Value

Year Cash Flow Dis. Factor Present

@10% Value

0 -102 1 -1021 51 0.91 46.36

2 51 0.83 42.15

3 61 0.75 45.83NPV 32.34


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The evaluation of any projectdepends on the magnitude of thecash flows, the timing and thediscount rate.

The discount rate is highlysubjective. The higher the rate , theless a rupee in the future would beworth today.

The risk of the project shoulddetermine the discount rate.


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Internal Rate of Return(IRR)IRR is the rate at whichthe discounted cash flowsin the future equal thevalue of the investmenttoday. To find the IRR onemust try different ratesuntil the NPV equals zero.


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Future value

Assume that an investor has $1000 andwishes to know its worth after four years ifit grows at 10 percent per year. At the end

of the first year, he will have $1000 X 1.10or 1,100. By the end of the year two, the$1,100 will have grown to $1,210 ($1,100

X 1.10). The four-year pattern is indicatedbelow.


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BUDGET

Quantitative expression ofmanagement objective

Budgets and standards Budgetary control

Cash budget


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PROFIT PLANNING

Budget & budgetary control

Marginal costing

CVP and break even point Comparative cost analysis

ROCE


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PRICING DECISIONS

pricing

Full cost pricing

Conversion cost pricing Marginal cost pricing

Market based


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PRICING DECISIONS

PRICING AND ITS OBJECTIVES The objective of pricing in practice will probably be

one of the following:

(a) To skim the market (in the case of newproducts) by the use of high prices;

(b) To penetrate deeply into the market (again withnew products) at an early stage, before competitionproduces similar goods;

(c) To earn a particular rate of return on the fundsinvested via the generating of revenue; and

(d) To make a profit on the product range as awhole, which may involve using certain items in therange as loss leaders, and so forth.


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PRICING DECISIONS

Full cost pricing The object is to recover all costs incurred

plus a percentage of profit. It is a method

best used where the product is clearlydifferentiated and not in immediate, directcompetition. It would not lend itself tosituation where price tended to bedetermined by the market,


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PRICING DECISIONS

Conversion cost pricing

Conversion cost consists of direct labourcost and factory overhead, ignoring thecost of the raw material on the groundsthat profit should be made within thefactory and not upon materials bought

from suppliers.


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PRICING DECISIONS

Marginal cost pricing Briefly it is that cost which would not be incurred if the

production of the product were discontinued. Animportant advantage of differential cost of pricing is the

flexibility it gives to meet special short-termcircumstances, while accepting that full costs must berecovered in the long term. This is by no means alwaysdesirable in the short term. For example, there may besurplus productive capacity in a factory, in which case

any opportunity to accept an order which coversdifferential cost and makes a contribution to fixed costand profit should be accepted. Any contribution is betterthan none.


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PRICING DECISIONS

Market based pricing

This can be based on the value to a customer ofgoods or services and involves variable pricing.It also takes account of the price he is able andwilling to pay for the goods or services.Businesses using this approach develop specialproducts or services which command premium

prices. The other market-based approach is to price onthe basis of what competitors are charging.


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Working capital

Current assets less current liabilities = networking capital or net current assets

Permanent working capital vs. variable

working capital


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Working capital cycle

cash> Raw material > Work in progress >finished goods > Sales > Debtors > Cash>

Operating cycle it is a length of time

between outlay on RM /wages /othersAND inflow of cash from the sale of thegoods


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Matching approach to asset financing

Fixed Assets

Permanent Current Assets

Total Assets

Fluctuating Current Assets

Time

$

Short-termDebt

Long-termDebt +EquityCapital


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THE WORKING CAPITAL

CYCLE

(OPERATING CYCLE)

Accounts Payable

Cash

Raw

MaterialsW I P

Finished

Goods

Value Addition

Accounts

ReceivableSALES


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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 bothunsynchronizedand uncertain.

Unsynchronized because cash disbursements (forexample, payments for resource purchases) usually takeplace before cash receipts (for example collection of

receivables).They are uncertain because future sales and costs, which

generate the respective receipts and disbursements,cannot be forecasted with complete accuracy.

Working capital cycleWorking capital cycle


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Working capital

FACTORS DETERMINING WORKING CAPITAL

1. Nature of the Industry

2. Demand of Industry

3. Cash requirements

4. Nature of the Business

5. Manufacturing time

6. Volume of Sales

7. Terms of Purchase and Sales

8. Inventory Turnover

9. Business Turnover

10. Business Cycle11. Current Assets requirements

12. Production Cycle


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Working capital

Working Capital Determinants (Contd)

13. Credit control

14. Inflation or Price level changes

15. Profit planning and control

16. Repayment ability

17. Cash reserves

18. Operation efficiency

19. Change in Technology

20. Firms finance and dividend policy

21. Attitude towards Risk

TYPES OF WORKING CAPITAL


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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

Working Capital Levels in Different Industries

A retailing company usually has high levels offinished goods stock and very low levels of debtors.Most of the retailers sales will be for cash, and an

independent credit card company or a financialsubsidiary of the retail business (which onoccasions is not consolidated in the groupaccounts). The retailing company, however, usuallyhas high levels of creditors. It pays its suppliers after

an agreed period of credit. The levels of workingcapital required are therefore low:


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Working capital

Excess of current assets over current liabilities are calledthe net working capital or net current assets.

Working capital is really what a part of long term financeis locked in and used for supporting current activities.

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

When firms speak of shortage of working capital they infact possibly imply scarcity of cash resources.

In fund flow analysis an increase in working capital, asconventionally defined, represents employment orapplication of funds.


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Working capital

In contrast, a manufacturing company willrequire relatively high levels of workingcapital with investments in raw materials,

work-in-progress and finished goodsstocks, and with high levels of debtors.The credit terms offered on sales andtaken on purchases will be influenced by

the normal contractual arrangements inthe industry.


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Working capital

Debtors Volume of credit sales Length of credit given Effective credit control and cash collection Stocks Lead time & safety level Variability of demand Production cycle No. of product lines Volume of planned output actual output sales Payables Volume of purchases Length of credit allowed

Length of credit takenDiscounts Short-term finance All the above Other payments/receipts Availability of credit Interest rates


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Working capital

Cash Levels it is necessary to prepare a cash budget where the

minimum balances needed from month to month willbe defined.

business is seasonal, cash shortages may arise in

certain periods. Generally it is thought better to keeponly sufficient cash to satisfy short-term needs, and toborrow if longer-term requirements occur

The problem, of course, is to balance the cost of thisborrowing against any income that might be obtained

from investing the cash balances. The size of the cash balance that a company might need

depends on the availability of other sources of funds atshort notice, the credit standing of the company and thecontrol of debtors and creditors


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Working capital

Debtors The debtors problem again revolves around the

choice between profitability and liquidity. It might,for instance, be possible to increase sales by

allowing customers more time to pay, but sincethis policy would reduce the companys liquidresources it would not necessarily result inhigher Profits.

historical analysis or the use of establishedcredit ratings to classify groups of customers interms of credit risk


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Working capital

1. Establish clear credit practices as a matter ofcompany policy.

2. Make sure that these practices are clearlyunderstood by staff, suppliers and customers.

3. Be professional when accepting new accounts, and

especially larger ones.4. Check out each customer thoroughly before you

offer credit. Use credit agencies, bank references,industry sources etc.

5. Establish credit limits for each customer... and

stick to them.6. Have the right mental attitude to the control of

credit and make sure that it gets the priority itdeserves.


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Working capital

7. Continuously review these limits when you suspect tough timesare coming or if operating in a volatile sector.

8. Keep very close to your larger customers.

9. Invoice promptly and clearly.

10. Consider charging penalties on overdue accounts.

11. Consider accepting credit /debit cards as a payment

option.

12. Monitor your debtor balances and ageing schedules,

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

DIMENSIONS OF RECEIVABLES MANAGEMENT


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OPTIMUM LEVEL OF INVESTMENT IN TRADE RECEIVABLES

Profitability

Costs &Profitability Optimum Level

Liquidity

Stringent Liberal


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Working capital-FACTORING

FactoringDefinition:

Factoring is defined as a continuing legal relationshipbetween a financial institution (the factor) and a business

concern (the client), selling goods or providing servicesto trade customers (the customers) on open accountbasis whereby the Factor purchases the clients bookdebts (accounts receivables) either with or withoutrecourse to the client and in relation thereto controls the

credit extended to customers and administers the salesledgers.


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It is the outright purchase of credit approvedaccounts receivables with the factor assumingbad debt losses.

Factoring provides sales accounting service, useof finance and protection against bad debts.

Factoring is a process of invoice discounting bywhich a capital market agency purchases all

trade debts and offers resources against them.


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Debt administration:

The factor manages the sales ledger ofthe client company. The client will be

saved of the administrative cost of bookkeeping, invoicing, credit control and debtcollection. The factor uses his computer

system to render the sales ledgeradministration services.


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Different kinds of factoring services Credit Information: Factors provide credit

intelligence to their client and supply periodicinformation with various customer-wise analysis.

Credit Protection: Some factors also insureagainst bad debts and provide without recoursefinancing.

Invoice Discounting or Financing : Factors

advance 75% to 80% against the invoice of theirclients. The clients mark a copy of the invoice tothe factors as and when they raise the invoiceon their customers.

W ki i l FACTORING


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Services rendered by factor Factor evaluated creditworthiness of the customer (buyer

of goods)

Factor fixes limits for the client (seller) which is an

aggregation of the limits fixed for each of the customer(buyer).

Client sells goods/services.

Client assigns the debt in favour of the factor

Client notifies on the invoice a direction to the customerto pay the invoice value of the factor.

W ki it l FACTORING


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Client forwards invoice/copy to factor along withreceipted delivery challans.

Factor provides credit to client to the extent of80% of the invoice value and also notifies to the

customer Factor periodically follows with the customer When the customer pays the amount of the

invoice the balance of 20% of the invoice value

is passed to the client recovering necessaryinterest and other charges. If the customer does not pay, the factor takes

recourse to the client.

W ki it l FACTORING


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Benefits of factoring The client will be relieved of the work relating to sales ledger

administration and debt collection The client can therefore concentrate more on planning production

and sales. The charges paid to a factor which will be marginally high at 1 to

1.5% than the bank charges will be more than compensated byreductions in administrative expenditure.

This will also improve the current ratio of the client and consequentlyhis credit rating.

The subsidiaries of the various banks have been rendering thefactoring services.

The factoring service is more comprehensive in nature than thebook debt or receivable financing by the bankers.

Working capital- INVENTORY


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Working capital- INVENTORYMANAGEMENT

Managing inventory is a juggling act.

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

Insufficient stocks can result in lost sales, delaysfor customers etc.

INVENTORIES INCLUDE RAW MATERIALS, WIP & FINISHED GOODS

FACTORS INFLUENCING INVENTORY


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FACTORS INFLUENCING INVENTORY

MANAGEMENT

Lead TimeCost of Holding Inventory

Material Costs

Ordering Costs

Carrying Costs

Cost of tying-up of Funds

Cost of Under stocking

Cost of Overstocking

W ki it l


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Working capital

Cost of Working capital The other aspect of the working capital problem

concerns obtaining short-term funds. Every source offinance, including taking credit from suppliers, has acost; the point is to keep this cost to the minimum. Thecost involved in using trade credit might include forfeitingthe discount normally given for prompt payment, or lossof goodwill through relying on this strategy to the point ofabuse. Some other sources of short-term funds are bank

credit, overdrafts and loans from other institutions. Thesecan be unsecured or secured, with charges madeagainst inventories, specific assets or general assets.

W ki it l


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Working capital

Disadvantages of Redundant or Excess Working Capital

Idle funds, non-profitable for business, poor ROI

Unnecessary purchasing & accumulation of inventories over

required level

Excessive debtors and defective credit policy, higherincidence of B/D.

Overall inefficiency in the organization.

When there is excessive working capital, Credit worthiness

suffers

Due to low rate of return on investments, the market value ofshares may fall


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E N D


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E N D

THANK YOU VERY MUCH FOR YOUR

PATIENCE; I TRUST IT WAS USEFUL.

ANY QUERIES MAY BE ADDRESSED TO

[email protected]

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