Prof S N Rao 1
Working Capital Policy
Prof S N Rao 2
Working Capital Policy
Concepts of Working CapitalCharacteristics of current assetsFactors influencing Working Capital requirementLevel of current assetsCurrent asset financing policyOperating cycle analysisCash requirement for working capital
Prof S N Rao 3
Concepts of Working CapitalGross Working CapitalNet Working Capital
Prof S N Rao 4
Proportions of CAs &FAsCAs FAs Industry10-20 80-90 Hotels & Service Ind20-30 70-80 Electricity generation & distribution30-40 60-70 Aluminum, Shipping40-50 50-60 Iron and Steel, Chemicals50-60 40-50 Tea plantation60-70 30-40 Cotton textiles & Sugar70-80 20-30 Food Processing, Tobacco80-90 10-20 Trading & construction
Prof S N Rao 5
Characteristics of CAsShort life span & swift transformationCash: 7-10 daysDebtors: 30-60 days Inventories: 2-60 days
Prof S N Rao 6
Current Asset Cycle
CashRaw material
Work in process
Finished goods
Debtors
Prof S N Rao 7
Implications for WC MgtWorking capital decisions are repetitive and frequentThere is close interaction among working capital components
Prof S N Rao 8
Factors influencing WC requirements
Nature of businessSeasonality of operationsProduction policy/strategyMarket conditionsConditions of supply
Prof S N Rao 9
Working Capital Policy Decision
Current Asset PolicyWhat should be the level of current
assets in relation to sales (CA/Sales)?Current Asset Financing PolicyWhat should be the level of short-term
financing in relation to long-term financing? (ST loans/LT loans OR ST loans/NCA )
Prof S N Rao 10
Types of WC PolicyAggressive ORRestrictive Working Capital Policy
ModerateWorking Capital Policy
ModerateWorking Capital Policy
Conservative OR FlexibleWorking Capital Policy
Level of Current Assets (CA/Sales)
Level of Short Term Financing
(ST/LT)
Prof S N Rao 11
Optimal Level of CAs
costs
Level of Current Assets
Total costsCarrying costs
Shortage costs
CA*
Prof S N Rao 12
Financing of CAs
Time
FA requirement
Permanent CA
Fluctuating CA
Prof S N Rao 13
Matching PrincipleMaturity of the sources of financing should match the maturity of the assets being financedFixed assets and permanent current assets should be financed by long-term sources of financeFluctuating current assets should be financed by short-term sources of finance
Prof S N Rao 14
Operating Cycle and Cash Cycle
Order placed Stocks arrive
Inventory period A/R period
A/P periodCash paid for material
Operating cycle periodCash cycle period
Prof S N Rao 15
Operating Cycle for AL2002 2003 2004 2005
Avg Inventory 557 503 459 538COGS/Day 5.36 5.69 7.84 9.68Inventory period 104 88 59 56
Avg Debtors 580 506 462 432Net Sales/Day 6.37 7.55 9.42 11.64
Debtors period 91 67 49 37
Operating cycle period 195 155 108 93
Prof S N Rao 16
Operating Cycle for AL2002 2003 2004 2005
Avg Creditors 314 326 390 549
COGS-Emp cost 1698 1779 2545 3169
(COGS-Emp C)/day 4.65 4.87 6.97 8.68
Creditors period 68 67 56 63Operating cycle period 195 155 108 93Cash cycle period 127 88 52 30
Prof S N Rao 17
Estimation of Cash WC Requirement
Estimate the cash cost of various current assets required by the firmDeduct the spontaneous current liabilities from the sum of cash cost of current assetsThe difference, plus margin of safety, is Cash Working Capital required
Prof S N Rao 18
Working Capital Requirement on Cash Basis-Example
Sales (credit period: 2months) Rs.240 m
Materials (Credit period: 2 months) Rs.72 m
Wages (paid monthly in arrear) Rs.48 m
Mfg exp outstanding at the end of year(cash expenses,paid one month in arrear)
Rs.4
Total administrative exp,paid as incurred Rs.30
Prof S N Rao 19
Working Capital Requirement on Cash Basis
The company sells its products on gross profit of 25%, counting depreciation as part of the COPIt keeps two months stock of Rmonemonths stock of FG, and cash balance of Rs.5 mAssuming 10% safety margin, work out the WC requirements on cash basis (ignore WIP)
Prof S N Rao
Cash Management
20
Prof S N Rao
Cash ManagementShort-term cash forecasting (Cash Budgeting)Reports for ControlFactors for efficient cash managementInvestment of surplus funds
(treasury Mgt)
21
Prof S N Rao
Short-term Cash ForecastingHelpful in
Estimating cash requirements/surplusPlanning short-term financing/investmentsScheduling payments in connection with capital expenditure projectsPlanning purchases of materialsDeveloping credit policies
22
Prof S N Rao
Short-term Cash ForecastingReceipt item Basis of EstimationCash sales Est.sales and its division
between cash and cr. sales
Collection of A/R Credit policyInt. and div. receipts Firms portfolio of sec.
Increase in loans, deposits, and issue of new securities
Firms financing plan
Sale of assets Proposed disposal of assets
23
Prof S N Rao
Short-term Cash ForecastingPayment item Basis of EstimationCash purchases Estimated purchases
and its division between cash/credit purchase
Payment for purchases
Credit policy of suppliers
Wages and salaries Manpower employed and wages/salary structure
Mfg expenses Production plan24
Prof S N Rao
Short-term Cash ForecastingPayment item Basis of EstimationGen & Admin& sellig expenses
Admin&sales personnel and proposed sales promotion and distribution expenses
Capital equip purchases
Capital expenditure budget and payment pattern
Repayment of loans and retirement of securities
Financing plan
25
Prof S N Rao
Reports for Monitoring and ControlDaily Cash Report:Opening BalanceReceipts:-Cash Sales-Collection of credit sales-Borrowings-Others
Total Receipts26
Prof S N Rao
Reports for Monitoring and ControlPayments:-Cash purchases of RM-Payments made for credit purchasesRepayment of loansOthersTotal PaymentsNet cash flowClosing Balance
27
Prof S N Rao
Reports for Monitoring and ControlDaily Treasury ReportCashOpening balanceReceiptsPaymentsClosing balance
28
Prof S N Rao
Reports for Monitoring and ControlDaily Treasury Report
Marketable SecuritiesOpening balancePurchasesSalesClosing balance
29
Prof S N Rao
Reports for Monitoring and ControlDaily Treasury Report
Accounts ReceivableOpening balanceBills raisedCash receiptsClosing balance
30
Prof S N Rao
Reports for Monitoring and ControlDaily Treasury Report
Accounts PayablesOpening balanceBills receivedCash paymentsClosing balance
31
Prof S N Rao
Reports for Monitoring and ControlDaily Treasury ReportOpening net treasury position
Closing net treasury position
32
Prof S N Rao
Factors for Efficient Cash Management
Prompt billingExpeditious collection of chequesCentralized purchases and payments to suppliers
33
Prof S N Rao
Investing Surplus CashTwo basic problems
Determination of surplus cashDuring normal periodDuring peak period
Surplus cash = actual cash - Min cash req.
34
Prof S N Rao
Investing Surplus CashDetermination of channels of investmentCriteria for investment:SecurityLiquidityYieldmaturity
35
Prof S N Rao
Investing Surplus CashPurpose of holding surplus cash
Criteria for investment
To meet un-foreseen payments
Safety and liquidity
To make available on certain definite dates
Safety and maturity
General reserves not required to meet any specific payments
Safety and yield
36
Prof S N Rao
Forms of LiquidityCash balance (4% -5% of CAs)Cash credit arrangementBenefits: lesser after tax costDisadvantages: imposition of penal
interest on under/over utilization and close scrutiny of budgets of the company by banks
Marketable securitiesT Bills,Govt Bonds,CPs,ICDs, CDs, Bill
Disc,other Capital market securities
37
Prof S N Rao
Choice of Liquidity MixDepends on
Uncertainty surrounding the cash flow projectionsAttitude of the management towards riskAbility to raise non-bank fundsAbility to control its cash flows
38
Prof S N Rao
Cash Management ModelsBaumol ModelMiller and Orr Model
39
Prof S N Rao
Baumol ModelAssumptions It is possible to forecast cash
requirements with certaintyCash payments occur uniformly over the
periodOpportunity cost of holding cash is
known and it does not change over the period
40
Prof S N Rao
Miller Orr ModelAssumptionsChanges in the cash balance over given
period are random in size as well as direction
Questions to be answeredWhen should transfer be effected
between marketable securities and cash?
What should be the magnitude of these transfers?
41
Credit Management
Prof S N Rao 42
Credit Policy VariablesCredit standardsCredit periodCash discountCollection effort
Prof S N Rao 43
Credit Policy VariablesCredit standards What standard should be applied in accepting or
rejecting an account for granting credit?Not to extend credit to any customerExtend credit to every customer
Actual credit standards lie between the two extreme positions
Liberal credit standardsPush up salesLead to higher bad debt lossHigher collection costRequires more investment in receivables
Stiff credit standards have the opposite effects Change in credit standard has impact on profit
Prof S N Rao 44
Credit Policy VariablesCredit period Varies from 15-60 days Stated as net 30 or net 60 Lengthening of credit period
Pushes up salesResults in higher investment in debtorsLeads to higher bad debt loss
Shortening of credit period has opposite impact
Change in credit period has impact on profit
Prof S N Rao 45
Credit Policy VariablesCash discount Offered to induce customers to make prompt payments The discount percentage and discount period is reflected
in credit terms Example: 2/10, net 45 Liberalizing cash discount policy may mean higher
discount percent and/or longer discount period Results into
Higher salesLower average collection periodLower investment in debtorsHigher cost of discount
Tightening cash discount policy will have opposite effect Change in discount policy has impact on profit
Prof S N Rao 46
Credit Policy VariablesCollection effort Monitoring the state of receivables Dispatch of letters to customers whose due date is
approaching Electronic and telephonic advice to customers around
the due date Threat of legal action to overdue accounts Legal action against overdue accounts Rigorous collection efforts
tends to decrease salesShorten average collection periodReduce bad debt lossIncrease collection cost
Lax collection effort will have opposite effect Change in collection effort has impact on profit
Prof S N Rao 47
Credit EvaluationAssessment of credit riskHelps in establishing credit limitsErrorsType-I error: a low risk customer is
misclassified as a high risk customerType-II error: a high risk customer is
misclassified as a low risk customer
Prof S N Rao 48
Credit EvaluationTraditional Credit Evaluation Assessment of prospective customer in terms of
Character: willingness to honor obligationsCapacity: ability to meet obligations from OCFsCapital: availability of capital for meeting obligations in case OCFs are not sufficientCollateral: security offered by the customer in the form of pledged assetsConditions: the general conditions that affect the customers ability to meet obligations
Sources of informationFinancial statementsBank referenceExperience of the firmStock market performance of customer firm
Prof S N Rao 49
Credit EvaluationNumerical Credit Scoring Identify factors relevant for credit evaluation Assign weights to these factors that reflect
their relative importance Rate the customer on various factors using
suitable rating scale Convert factor into factor score Add all the factor scores to get the overall
customer rating index Based on the rating index, classify the
customer
Prof S N Rao 50
Credit EvaluationConstruction of Credit Rating Index (based on a 5 point rating scale)
Factor Factor weight Rating Factor Score
Past payment 0.30 4 1.2
Net profit margin
0.20 4 0.8
Current ratio 0.20 5 1.0
D/E ratio 0.10 4 0.40
Return on equity
0.20 5 1.0
Rating Index 4.20Prof S N Rao 51
Credit EvaluationRisk Classification Scheme
Category or Risk Class Description
1 Customer with no risk of default
2 Customers with negligible risk (default rate less than 2%)
3 Customers with little risk (default rate between 2%-5%)
4 Customers with some risk (default rate between 5%-10%)
5 Customers with significant risk (default rate of more than 10%)
Prof S N Rao 52
Credit EvaluationDiscriminant Analysis Identify two key variables for assessing credit
risk of customers Plot all the customers , both who paid dues in
time and who defaulted, on a graph based on these two variables
Identify dividing line between good customers and bad customers
Find the equation for the dividing line Compute the cutoff value Classify the customers based on the cut-off
valueProf S N Rao 53
Credit Granting DecisionCompute expected profit of offering credit without repeat order and with repeat order If it is positive, offer credit
Prof S N Rao 54
Control of Credit-Days Sales Outstanding (DSO)
Month SalesReceivables
Jan 150 400Feb 200 450Mar 250 500Apr 120 350May 220 380June 250 400
Month Sales Receivables
Jan 150 400Feb 156 450Mar 158 375Apr 160 420May 155 410June 158 380
Prof S N Rao 55
Control of Credit-Aging Schedule (AS)
Age group Percent of receivables
0-30 35
31-60 40
61-90 20
>90 5
Prof S N Rao 56
Limitations of DSO & ASInfluenced by sales patternPayment behavior of customersIf sales are increasing/decreasing DSO and the AS will defer from what they would be if sales are constant This holds even when payment behavior of the customer remain unchanged
Prof S N Rao 57
Collection Matrix/Payment Pattern%of ARs collected during the
Jan Feb Mar
Month of sales 10 10 10
One month after sales 30 25 20
Two months after sales 30 35 20
Three months after sales
30 25 20
Four months after sales - 5 30
Prof S N Rao 58
Credit Management in IndiaCredit Policy
No formalization of credit policyToo general statement of policyCredit period: 0-60 daysCash discount for prompt payments is not common
Prof S N Rao 59
Credit Management in IndiaCredit Analysis
No detailed analysis of financial statementsCustomers are required to furnish 2-3 referencesIndependent agencies for credit rating are coming upCredit information from bank is too generalLarge companies classify customers based on credit worthiness
Prof S N Rao 60
Credit Management in IndiaControl of Receivables
No systematic methods for controlling and monitoring receivablesNormal measures of credit managementBad debt lossesAverage collection periodAging schedule
Prof S N Rao 61
Inventory Management
62Prof S N Rao
Inventory ManagementTypes of InventoryEOQ ModelOrder pointFactors affecting inventory levelsValuation of StockMonitoring and Control of Inventory
63Prof S N Rao
Types of InventoryProcess inventoryMovement inventoryOrganization inventory
64Prof S N Rao
EOQ ModelAssumptions
Usage is knownEven usageImmediate replenishmentOnly two costs: ordering and carryingOrdering cost is constantCarrying cost is fixed % of the avg inventory
65Prof S N Rao
Ordering PointIf lead time and usage are stable:
Ordering point = lead time for procurement X daily usage
If lead time and usage are volatileOrdering point= ( Avg lead time for procurement X
Average daily usage) + Safety stock
66Prof S N Rao
Factors Influencing level of inventory
67Prof S N Rao
Factors influencing inventoryAnticipated scarcityExpected price changeObsolescence riskGovt restrictionsMarketing considerations
68Prof S N Rao
Pricing of Raw MaterialFIFO MethodLIFO MethodWA Cost MethodStd Cost MethodCurrent Cost Method
69Prof S N Rao
Valuation of InventoryDirect/Variable CostingFixed Mfg exp are treated as period
costValue of WIP&FG is lower under this
methodAbsorption/Total CostingFixed Mfg exp are treated as product
costValue of WIP & FG is higher under
this method70Prof S N Rao
Monitoring and Control of InventoryABC AnalysisRatio AnalysisJITOut sourcingComputerized inventory control system
71Prof S N Rao
Inventory Management in IndiaInventory levels in India are high due to
Sever penalty for stock out and no penalty for excess inventoryLengthy and cumbersome import processHigh inflationLack of standardizationLong lead time
72Prof S N Rao
Inventory Management in IndiaCommon tools of Inventory Mgt
FSN AnalysisInventory turn over ratiosABC Analysis
73Prof S N Rao
Sources of WC Finance
Prof S N Rao 74
Sources of WC FinanceAccrualsTrade AdvancesTrade creditsCPsPublic depositsBank FinanceICDsRights DebenturesFactoring
75Prof S N Rao
AccrualsWages &TaxesCost free sourcesNot amenable to control by Mgt
76Prof S N Rao
Trade advancesCommon in cases of expensive productsMonopoly marketsCost free?
Prof S N Rao 77
Trade CreditRepresents the credit extended by the supplier of goods and servicesSpontaneous source of financeConstitutes 25%-50% of WC financeIs it cost free?
78Prof S N Rao
Commercial PaperIntroduced in Jan 1990In FY 2012-13 alone, Corporate India raised about Rs.3.72 lakh Cr. through 4,856 issues (Prime Database).Maturity period: 7-364 daysSold at discount redeemed at face valueTraded on SBI-DFHIGenerally held till maturity
79Prof S N Rao
Commercial PaperRegulations
Net worth of at least Rs. 4 crSanctioned WC limit by Banks/FIsFV of CPs issued should not exceed WC limitListed company
80Prof S N Rao
Commercial PaperRated P1/A2 Enjoys health code no 1Min issue size is Rs.25 lakh and min denomination is Rs.5 lakhCost?
81Prof S N Rao
CP issue of ONGC Videsh Ltd (OVL)
Issue size: Rs.5,250 crThe largest CP issue in IndiaMaturity: 1 yearImplied yield: 8.15%Post-tax interest cost: 5.5%Yield on 1-year T-bill: 4.75%Guaranteed by ONGC which Cash balance of Rs.25,000 crsIssue date: First week of Jan 2009
82Prof S N Rao
CP issue of ONGC Videsh Ltd (OVL)
Objective: To part finance the acquisition of UK based Imperial EnergyTotal acquisition price: USD 2.1 bCP issue amount: around USD 1bBalance amount is provided by ONGC as long-term debt
83Prof S N Rao
Public DepositsCan not exceed 25% of NWMaturity: 6 months 3 yearsDRRDisclosure of financial performanceCost?
84Prof S N Rao
Public Deposit Schemes of Tata MotorsScheme-A: Quarterly Income Plan
Scheme-BCumulative Deposit Plan
Period Min Amt
Int Rate (p.a)
Period Min Amt
Int Rate (p.a.)
Maturity value
Implied yield
1 year 20000 10% 1 year 20000 10% 22 076 10.36%
2 years 20000 10.5% 2 years 20000 10.5% 24 607 10.92%
3 years 20000 11% 3 years 20000 11% 27 696 11.46%
0.5% additional interest for senior citizens/shareholders/employeesThe issue was floated in Nov 2009
85Prof S N Rao
Public Deposit Schemes of Bombay Dyeing Period: 36 months Interest rate: 10.5% p.a. payable quarterly Effective interest rate: 10.36% Floated in Jan 2009
Godrej & Boyce Mfg Company Period: 3 years Interest rate: 10% p.a. payable half yearly Effective interest rate: 10.25% Floated in August 2008
86Prof S N Rao
Public DepositsMaturity HDFC Bajaj Fin M&M Fin Shriram
TFC
12 months 8.75% 9.75% 9.25% 9.25%
24 months 9.05% 9.75% 10% 9.75%
36 months 9.15% 10% 10.25% 10.75%
Prof S N Rao 87
Bank FinanceCC/ODLoansPurchase/Discount of BillsLCsSecurity Hypothecation Pledge Mortgage
MPBF & Margin Cost?
88Prof S N Rao
ICDsCall depositsThree-month depositsSix-month depositsNo regulationsSecrecyImportance of personal contactsCost?
89Prof S N Rao
Rights DebenturesAmount should not exceed 20% of the (GWC LT funds available
for WCF) OR20% of paid-up capital incl Pref Cap and
free reserves , whichever is lowerD/E ratio, including proposed debenture
issue, should not exceed 1:1 Cost?
90Prof S N Rao
Debenture Issue of Shriram Transport Finance Co. Ltd
Issue size: Rs.500 cr with option to retain over subscription upto Rs.500 crIssue period: 27 Jul 2009-14 Aug 2009Min amount: Rs.10000Maturity: 3 years/5 yearsInterest rateL 10.75% to 11.5%
91Prof S N Rao
FactoringIt is a powerful financial instrument
specially designed to meet the post sales working capital requirements of the industrial, trade & service sectors, it is a portfolio of complementary financial services. Besides financing up to 80% of the invoice value, the package includes:
92Prof S N Rao
FactoringSales ledger administrationDebtor collectionCredit information servicesAdvisory services
93Prof S N Rao
FactoringTypes of Factoring
With recourse factoringWithout-recourse factoringUndisclosed factoring
94Prof S N Rao
FactoringBenefits of Factoring
Instant access to cashMake payments to creditors, avail cash discountsMaintenance of sales ledgerCollection of debtorsClients can focus on other functions
95Prof S N Rao
FactoringEligibility
Mfg, trading or services companyShould have sound financial baseTurnover of not less than Rs.50 lacsStrong and prompt customer base
96Prof S N Rao
Factoring
Where Factoring is not suitableWhere large volume of cash sales take placeEngaged in speculative businessSelling highly specialized capital equipments or made-to-order goods
97Prof S N Rao
FactoringWhere credit period offered to the buyers is more than 180 daysWhere there is consignment saleWhere sales are to the sister/associated companiesWhere sales are to the public at largeCost?
98Prof S N Rao
Some Factoring CompaniesCabank Factors SBI FactorsIFCI Factors
Prof S N Rao 99
Prof S N Rao 100
?
Top Related