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SUMMER TRAINING PROJECT REPORT
WORKING CAPITAL ANALYSIS OF
DABUR INDIA LTD.
DABUR INDIA LTD.
SUBMITTED IN THE PARTIAL FULFILLMENT OF
THE REQUIREMET OF
BACHELOR OF BUSINESS ADMINISTRATION (BBA)
GURU JAMBHESWAR UNIVERSITY OF SCIENCE AND
TECHNOLOGY, HISAR
Training Supervisor : Submitted By
Mr. Sandeep Gupta ANTIMA TYAGI
Branch Manager 08511242107
SESSION-2008-11
GURU JAMBHESWAR UNIVERSITY OF
SCIENCE AND TECHNOLOGY
HISAR
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ACKNOWLEDGEMENT
With deep sense of pleasure and satisfaction I complete this project on The Working
Capital Management and take this opportunity to thank Mr. sandeep gupta, Branch
manager Dabur India Limited, whose inestimable support rendered it possible.
I also express my deep sense of gratitude to my guide Mr. R Venkatesan, Manager
Accounts, Dabur India Limited, under whose guidance I have been able to complete
this study.
I would like to place on record my sincere gratitude to my facilitator, Mr. D P Sur
Accounts, whose immense support helped me completing this project.
I also wish to thank all the Executives and the staff members of Dabur India Limited,
in particular Mr. Atul Bansal and Mr. Arun gupta, who were immensely co-operative
through out my tenure with them.
Last but not the least, I would like to thank my parents whose blessings, cooperation
and guidance inspired me to complete this task easily.
(ANTIMA TYAGI)
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EXECUTIVE SUMMARY
The management of current assets deals with determination, maintenance, control and
monitoring the level of all the individual current assets. Current assets are referred to
as assets, which can normally be converted into cash within one year therefore
investment in current assets should be just adequate no more no less to the needs of
the business. Excessive investments in current assets should be avoided, because it
impairs firms profitability, as idle investment in current assets and are non-productive
and so they can earn nothing, on the other hand inadequate amount of working capital
can threaten solvency of the firm, if it fails to meet its current obligations.
Thus the working capital is a qualitative concept-
1. It indicates the liquidity position of the firm and
2. It suggests the extent to which working capital needs may be financed by
permanent source of fund. Current assets should be sufficiently in excess of
current liabilities to constitute a margin or buffer for maturing obligation
within the ordinary cycle of business.
The basic learning objective behind the study was-
Computation of Working Capital Management
Operating Cycle of the firm
Financial plan estimated for 2009-2010 and projected for 2010-2011
Working capital credit limits
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Ratio analysis
On the basis of above calculations following conclusions can be made-
Dabur India ltd. has both long term as well as short term sources for current
asset financing. It implies that company follows matching principle for raising
funds.
Right now company is following aggressive policy, which means that company
is maintaining lower ratio of current assets to fixed assets.
Dabur India ltd has high collection period which shows that money has been
unnecessarily blocked with the debtors. So to overcome the above problems
following are the recommendations.
Increase the proportion of current assets over fixed assets to come to proper
proportion of current assets and fixed assets as per the basic norms and
guidelines.
Company should shift from aggressive policy to conservative current assets
policy.
Company should reduce the holiday period else the company will have to pay
high carrying cost.
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Table of content
CHAPTER 1
INTRODUCTION
I.1 HISTORY
I.2 SWOT ANALYSIS
I.3 DABUR AT AGLANCE
I.4 CORPORATE GOVERNENCE
I.5 CERTIFICATION OF QUALITY
CHAPTER 2
COMPANY PROFILE
CHAPTER 3
RESEARCH METHODOLOGY
3.1 RESEARCH OBJECTIVES
3.2 DATA SOUCSES
3.3 DESCRIPTIVE RESEARCH
CHAPTER 4
CONCEPTUAL DISCUSSION
WORKING CAPITAL
4.1 ROTIO ANALYSIS
4.2 RECEIVABLE MGT
4.3 INVENTORY MGT
4. 4 CASH MGT
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CHAPTER 5
DATA ANALYSIS
CHAPTER 6
FINDING AND RECOMMENDATION
CHAPTER 7
CONCLUSION
CHAPTER 8
ANNEXURES
CHAPTER 9
BIBLIOGRAPHY
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CHAPTER-I
I. Introduction
I.IHISTORICAL BACKGROUND OF DABUR
Dabur derives its name from Devanagri rendition of Daktar Burman.
In 1884, the Dabur was bornin a small Calcutta pharmacy, where Dr. S.K. Burman
launches his mission of making health care products.
In 1896, with growing popularity of Dabur products, Dr. Burman expands his
operations by setting up a manufacturing plant for mass production of formulations.
In early 1900s, Dabur enters the specialized area of nature-based Ayurvedic
medicines, for which standardized drugs are not available in the market.
In 1919, the need to develop scientific processes and quality checks for mass
production of traditional Ayurvedic medicines leads to establishment of research
laboratories.
In 1920, Daburexpands further with new manufacturing units at Narendrapur and
Daburgram. The distribution of Dabur products spreads to other states like Bihar and
the North-East.
In 1936, Dabur becomes a full-fledged company - Dabur India (Dr. S. K. Burman)
Pvt. Ltd.
In 1972, Dabur's operations shift to Delhi. A new manufacturing plant is set up in
temporary premises in Faridabad, on the outskirts of Delhi.
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the first time in the history of Dabur, a non-family professional CEO sits at the helm
of the Company.
In 2000, Dabur establishes its market leadership status with a turnover of Rs.1,000
crores. From a small beginning and upholding the values of its founder, Dabur now
enters the august league of large corporate businesses.
2005 - Dabur announces bonus after 12 years
Dabur India announced issue of 1:1 Bonus share to the shareholders of the company,i.e. one share for every one share held. The Board also proposed an increase in the
authorized share capital of the company from existing Rs 50 crore to Rs 125 crore.
2009 - Dabur Red Toothpaste joins 'Billion Rupee Brands' club
Dabur Red Toothpaste becomes the Dabur's ninth Billion Rupee brand. Dabur Red
Toothpaste crosses the billion rupee turnover mark within five years of its launch.
SWOT ANALYSIS
STRENGTHS:
Century Old Company
Established BrandAyurvedic/ herbal Product line
Leader in Herbal Digestives where the product has 90% of
the market share
Innovativeness in Promotions
WEAKNESS:
Profitability is uneven across product line
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OPPORTUNITIES:
Extend Vatika brand to new categories like Skin Care
and body wash segments
Launch several OTC brands
Southern India Market
Exploring new geographical areas- local as well global
Oral Care Segment
Launching new Products like Hair oils, Herbal and Gel
Toothpastes etc
THREATS:
Competition in the FMCG sector from well established
names
Other fields of medicine- Allopathic and Homeopathic
Markets where Herbal products are not recognised
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DABUR AT A GLANCE
Dabur India Limited has marked its presence with significant achievements and today
commands a market leadership status. Our story of success is based on dedication to
nature, corporate and process hygiene, dynamic leadership and commitment to our
partners and stakeholders. The results of our policies and initiatives speak for
themselves.
Leading consumer goods company in India with a turnover of Rs. 2834.11
Crore (FY09)
3 major strategic business units (SBU) - Consumer Care Division (CCD),
Consumer Health Division (CHD) and International Business Division
(IBD)
3 Subsidiary Group companies - Dabur International, Fem Care Pharma
and newuand 8 step down subsidiaries: Dabur Nepal Pvt Ltd (Nepal),
Dabur Egypt Ltd (Egypt), Asian Consumer Care (Bangladesh), AsianConsumer Care (Pakistan), African Consumer Care (Nigeria), Naturelle
LLC (Ras Al Khaimah-UAE), Weikfield International (UAE) and Jaquline
Inc. (USA).
17 ultra-modern manufacturing units spread around the globe
Products marketed in over60 countries
Wide and deep market penetration with 50 C&F agents, more than 5000
distributors and over2.8 million retail outlets all over India
Consumer Care Division (CCD) adresses consumer needs across the entire FMCG
spectrum through four distinct business portfolios of Personal Care, Health Care,
Home Care & Foods
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Master brands:
Dabur - Ayurvedic healthcare products
Vatika - Premium hair care
Hajmola - Tasty digestives
Ral - Fruit juices & beverages
Fem - Fairness bleaches & skin care products
9 Billion-Rupeebrands: Dabur Amla, Dabur
Chyawanprash, Vatika, Ral, Dabur Red Toothpaste,
Dabur Lal Dant Manjan, Babool, Hajmola and Dabur
Honey
Strategic positioning ofHoney as food product, leading
to market leadership (over75%) in branded honey
market
Dabur Chyawanprash the largest selling Ayurvedic
medicine with over 65% market share.
Vatika Shampoo has been the fastest selling shampoo
brand in India for three years in a row
Hajmola tablets in command with 60% market share of
digestive tablets category. About 2.5 crore Hajmola
tablets are consumed in India every day
Leader in herbal digestives with 90% market share
Consumer Health Division (CHD) offers a range of classical Ayurvedic
medicines and Ayurvedic OTC products that deliver the age-old benefits of Ayurveda
in modern ready-to-use formats
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Has more than 300 products sold through prescriptions as
well as over the counter
Major categories in traditional formulations include:
- Asav Arishtas
- Ras Rasayanas
- Churnas
- Medicated Oils
Proprietary Ayurvedic medicines developed by Dabur
include:
- Nature Care Isabgol
- Madhuvaani
- Trifgol
Division also works for promotion of Ayurveda through
organised community of traditional practitioners and
developing fresh batches of students
International Business Division (IBD) caters to the health and personal care needs of
customers across different international markets, spanning the Middle East, North &
West Africa, EU and the US with its brands Dabur & Vatika
Growing at a CAGR of 33% in the last 6 years and contributes to about 20% of
total sales
Leveraging the 'Natural' preference among local consumers to increase share in
perosnal care categories
Focus markets:
- GCC
- Egypt
- Nigeria
- Bangladesh
- Nepal
- US
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High level of localization of manufacturing and sales & marketing
C & F AGENTS, DISRIBUTORS & RETAILERS
The objective of appointment of Carrying and Forwarding Agents ('C&FA') is to
achieve improved service levels in despatches made, order processing, FMFO
issuance of stocks, transportation, efficient and proper maintenance of stocks and
sales return recording procedures. The outsourcing of the C&FA function ensures
smooth and efficient movement of products from the Company to its dealers,
stockists etc. There is a wide market penetration on the part of Dabur through 47
C&F agents, more than 5000 distributors and over1.5 million retail outlets all
over India. The company under restructuring exercise has started focussing on
distribution network. The company has shifted to zonal setup for its sales and
marketing. The company is planning to shift to C&F agents system and has
appointed more than 50 such agents in the market. It has also connected its C&F
agents and its key distributors online for better management of its stock. The
company has also implemented ERP system to cover all its activities. The
company also started its interactive website during the year. It has plans of going
for B2B and B2C transactions
CORPORATE GOVERNENCE
Good corporate governance and transparency in actions of the management is key
to a strong bond of trust with the Companys stakeholders. Dabur understands the
importance of good governance and has constantly avoided an arbitrary decision-
making process. Our initiatives towards this end include:
Professionalization of the board
Lean and active Board(reduced from 16 to 10 members)
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Less number of promoters on the Board
More professionals and independent Directors for better management
Governed through Board committees for Audit, Remuneration, Shareholder
Grievances, Compensation and Nominations
Meets all Corporate Governance Code requirements of SEBI
CERTIFICATION FOR QUALITY
ISO 9002
Dabur India Limited has been awarded the ISO 9002 certification after the
Quality Management Systems of the company were assessed in November
1995. The product areas assessed include Health care Products, Family and
Food Products, Bulk Drugs and Chemicals, Ayurvedic specialities and
Pharmaceutical products. This implies that for Dabur quality is an attitude that
has been translated into action. For the company quality is a culture and not a
stop gap arrangement and believe that quality is a corporate responsibility
towards its customers, employees and the environment in which it operates.
Sustaining consumer confidence for over a century is a true reflection of the
quality of the companys products.
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CRISIL GVC Level 2
CRISIL, the leading rating agency in India, has been assigning top credit
ratings to Dabur India limited for its institutional borrowings. Recently,
CRISIL launched the Governance and Value Creation Rating (GVC) and
Dabur India Limited was one of the first companies to volunteer for getting
itself rated on GVC. Dabur has been assigned `Crisil GVC Level 2 rating
which is the second highest rating on an 8-point scale. The rating indicates that
capability of the Company on wealth creation for all its stakeholders including
shareholders, employees, creditors, suppliers, dealers and society, while
adopting sound corporate governance practices is `high. This takes into
account past track record as well as future expectations of wealth creation by
the company.
Some of the quotes of CRISIL :
(1) The rating reflects Dabur Indias strong wealth management practices,
high disclosure standards, and satisfactory track
record on creating value for its various stakeholders.
(2) The managements long experience and good track record coupled with
Dabur Indias consistent performance in its existing businesses exemplify
its wealth management capabilities.
(3) Dabur India follows good disclosure standards in terms of its financial
performance and ownership pattern.
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CHAPTER-II
RESEARCH METHODOLOGY
II.1 RESEARCH OBJECTIVE
The project is aimed at evaluating the financial status of Dabur India Ltd and
then doing the comparative analysis with its competitors.
Studying the working capital management at Dabur India Ltd. and estimating
the working capital requirements for 2007-2008 and then forecasting for 2008-
2009
To find out if there is any relationship between the working capital, sales and
current assets of DABUR INDIA LTD
II.2 DATA SOURCES:
Primary data
The data that are still needed after that search is completed will have to be developedspecifically for the research project and are known as primary data .
Types Primary data
Interview
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Questionnaire
Survey
Observation
Secondary data
The secondary data that are available are relatively quick and inexpensive to obtain,
especially now that computerized bibliographic search services and databases are
available. The various sources of the secondary data and how they can be obtained and
used are described ahead.
Most secondary data are generated by specialized firms and are sold to marketers to
help them deal with a category of problems. Nielsens television ratings, which
marketers use in making advertising decisions, is the best-known example. Many of
these services, broadly categorized as audits, commercial surveys, and panels, allow
some degree of customization and thus fall between secondary and primary data.
These sources are treated in detail ahead.
Types of Secondary data
News paper
Books
Journals
Fairs and conference
Websites
Any data, which have been gathered earlier for some other purpose, are
secondary data in the hands of researcher. Those data collected first hand, either by the
researcher or by someone else, especially for the purpose of the study is known as
primary data. The data collected for this project has been taken from the secondary
source. Sources of secondary data are:-
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Internet
Magazines
Publications
Newspapers
Broachers
II.3 Descriptive research
This project is based on descriptive research. Descriptive research, also known as
statistical research, describes data and characteristics about the population or
phenomenon being studied. Descriptive research answers the questions who, what,
where, when and how...
Although the data description is factual, accurate and systematic, the research cannot
describe what caused a situation. Thus, Descriptive research cannot be used to create a
causal relationship, where one variable affects another. In other words, descriptive
research can be said to have a low requirement forinternal validity.
The description is used forfrequencies, averages and other statistical calculations.
Often the best approach, prior to writing descriptive research, is to conduct a survey
investigation. Qualitative research often has the aim of description and researchers
may follow-up with examinations of why the observations exist and what the
implications of the findings are.
In short descriptive research deals with everything that can be counted and studied.
But there are always restrictions to that. Your research must have an impact to the
lives of the people around you. For example, finding the most frequent disease that
affects the children of a town. The reader of the research will know what to do to
prevent that disease thus, more people will live a healthy life.
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CHAPTER-III
COMPANY PROFILE
Dabur India Limited (DIL) is an ayurvedic and natural health care company. The
Company is engaged in manufacturing and marketing fast moving consumer goods
and Ayurvedic products. The Company operates its business through three business
units: consumer care division (CCD), international business division (IBD) and
consumer healthcare division (CHD). DIL has manufacturing facilities in eight States
of India. As of March 31, 2010, the Company also had manufacturing facilities in
eight countries: India, Bangladesh, Nepal, Dubai, Sarjah, Ras-Al-Khaima, Egypt and
Nigeria. Major markets of the Company include India, Middle East, Nepal,
Bangladesh, United States and United Kingdom. As of March 31, 2010, the
Company's brands included Dabur Amla, Dabur Chyawanprash, Vatika, Hajmola,
FEM and Real. Its subsidiaries include Dabur Nepal Pvt Ltd, Dabur (UK) Ltd, H&B
Stores Ltd, Weikfield International (UAE) Ltd and Naturelle LLC. On April 1, 2009,
DIL completed the merger of Fem Care Pharma Ltd.
VISION
Vision 2010
After the successful implementation of the 4-year business plan from 2002 to 2006,
Dabur has launched another plan for 2010. The main objectives are:
Doubling of the sales figure from 2006
The new plan will focus on expansion, acquisition and innovation. Although
Daburs international business has done well growing by almost 29 per cent
to Rs.292 crore in 2006-07, plans are to increase it by leaps and bounds.
Growth will be achieved through international business, homecare, healthcare
and foods.
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Southern markets will remain as a focus area to increase its revenue share to 15
per cent.
With smoothly sailing through its previous plans, this vision seems possible. Time and
again, Dabur has made decisions that have led to its present position. However, if
Dabur could be more aggressive in its approach, it can rise to unprecedented levels.
PRINCIPLES
Ownership
This is our Company. We accept personal responsibility and accountability to meet
business needs.
Passion for Winning
We all are leaders in our area of responsibility, with a deep commitment to deliver
results. We are determined to be the best at doing what matters most.
People Development
People are our most important asset. We add value through result driven training and
we encourage & reward excellence.
Consumer Focus
We have superior understanding of consumer needs and develop products to fulfill
them better.
Team Work
We work together on the principle of mutual trust & transparency in a boundaryless
organization. Innovation
Continuous innovation in products & processes is the basis of our success.
PRODUCTS OF DABUR
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1 Amla Hair Oil
2 Amla Lite
3 Baby Olive Oil
4 Back Aid
5 Binaca Toothpowder
6 Chyawanprash
7 Dabur Balm
8 Glucose D
9 Gulabri10 Hajmola
11 Hajmola Candy
12 Hingoli
13 Honey
14 Itch Care
15 Jama Ghunti Honey
16 Lal Dantmanjan17 Lal Oil
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18 Nature Care
19 Pudin Hara
20 Pudin Hara G
21 Ring Ring
22 Sarbyna Strong
23 Sat Isabgol
24 Shilajit
25 Shankha Pushpi
26 Vatika
- Anti Dandruff Shampoo
- Hair oil
- Shampoo
Daburs Departments
1 IT(Information Technology)
2 HR(Human Resource)3 Training
4 Projects
5 Finance
6 CSCC(Central Supply Chain Cell)
7 CPPD(Central Purchase and Procurement Department)
8 Divisions
9 DRF(Dabur Research Foundation)
10 Operations
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11 Corporate Communication
FUTURE PLANS OF DABUR INDIA LIMITED
Speaking to Business Line, Mr. Sunil Duggal, Chief Executive Officer,
Dabur India, said: "The company's biggest growth areas in the current year
will be the personal and healthcare segments. Within the foods segment,
the strategy will be to consolidate existing products.''
The company has projected turnover of Rs. 2834.11 Crore by 2009.Some of
the company's slow-moving brands would be either phased out or divested
progressively as part of its portfolio rationalization. The company proposes
to enter unexplored areas of haircare, and introduce the brand at lower
price points and in sachets. Another category Dabur intends to enter this
year is mass skin care.
Dabur India's ad spends (both above-the-line and below-the-line) average
Rs 140 crore, and this figure could be ramped up by 10 per cent the
following year. They will move toward spending away from non-core to
core brands.
Dabur India Ltd announced the "virtual demerger" of its FMCG business
from its pharmaceutical business. It has restructured its Rs 162.9-crore
pharma business into a separate business unit (SBU). The pharma
business would be led by the Pharma Management Committee headed by
Dr Anand Burman, Vice-Chairman, Dabur India.
New Delhi Dabur India Ltd. has plans to launch an entire range of
Ayurvedic products in the domestic market soon. The company is also
focusing on exports of Ayurvedic products into new markets this year.
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Successful Implementation of Business Risk Management. With the
Business Risk Management Framework, every employee will now be
formally responsible for identifying business risks that surround their
functions and make business risk management as part of their normal
working practice said Mr.Rajan Varma, Chief Financial Officer, Dabur
India.
Dabur India, the fourth largest FMCG Company in the country, has forged
an alliance with FreeMarkets Services, a leading e-procurement consulting
company, for adopting the next level of sourcing practice e-Sourcing, for
reducing costs, providing greater transparencies and optimizing
procurement efficiencies.
We will be fully online and conducting the first few set of reverse
auctions next month i.e. February. Our association with Free-Markets
would give us a head start in terms of market making as they have over
1,50,000 suppliers in their database that will be available to us. Also, Free
Markets would vet suppliers from scratch that would cut lead-time added
Mr. Jude Magima.
CHAPTER - IV
CONCEPTUAL DISCUSSION
WORKING CAPITAL
Working Capital is the excess of Current Assets over Current Liabilities. It is also
called the net Current Assets. It is important from point of view of liquidity and
profitability. More precisely, management of Current Assets includes :
(1) Cash and Bank Balances
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(2) Inventories
(3) Receivables (including Debtors & Bills)
(4) Marketable Securities.
Current Assets can be described as those Assets which can be converted into cash /
equivalent within a year and which are required to meet day to day operations.
Factors determining Working Capital Requirements :
(1) Basic Nature and Size of Business
The quantum of money required for the operations of the business enterprise more
or less depends upon its nature and size. Bigger the size more will be therequirement. Similarly, the complex nature of the business demands for large
amount of working capital.
(2) Business Cycle Fluctuations
The working capital requirements has also been affected by the fluctuations in the
business environment. One of the essentials of any business activity is the element
of risk due to unforeseen future and uncertainty. The business should be well
equipped against such type of uncertainties.
(3) Seasonal Fluctuations
The liquidity of any business is necessary and can be used as a guard against
seasonal fluctuations. Howsoever, it should be remembered that it does not render
the undue blockage of the companys funds. It might be possible that firm will be
in acute shortage of flowing funds during the peak season say for wollens in winter
and blockage of funds in the off season say wollens in summer. So, here comes the
importance of the management of the working capital.
(4) Market Competitiveness
Monopoly situations can be served as an excuse for working capital but in the
current scenario of intense competition highly managed working capital is
essential to take the advantage of any opportunity while serving as a guard against
the possible threats at the same time.
(5) Credit Policy
The credit policy of the company should be such as to comply all of three
mentioned criteria for the optimum results:
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(a) Regarding credit extended by supplier of Raw Materials, Goods etc.
If the credit time allowed by the supplier is sufficient enough for the
company it can relax the operations of the firm as a feasible level and
also serve as a shoat term financing for the current assets.
(b) Similarly, credit extended to the customers determine the actual
requirement of the working capital funds needed by the company. If
the credit allowed by the company is for short period it would result in
the early realization of the funds which then be deployed in the other
potential areas of interest.
(c) Should take care of the monitoring of own credit policies in the
market and it should be in compliance with the prevailing credit
policies and trends in the ongoing market scenario so that there is the
societal acceptance of the company.
(6) Supply Conditions
Again to a large extent the determination of the working capital depends upon the
flow of trade in the actual encountered situations. Rigidity can be automatically
formed just by the insufficient availability of funds. The reason can be understood
on the pretext that matching the supply with the demand can only be the optimal
solution. It is better to stop production rather than to produce inventory.
Need for Adequate Working Capital :
A firm should maintained Optimum level of Working Capital. There should be neither
excessive Working Capital nor inadequate Working Capital.
Excessive Working Capital results in :
(1) Unnecessary accumulation of inventories resulting in wastes, thefts, damages etc.
(2) Delays in collection of receivables resulting in more liberal credit terms to
customers than warranted by the Market conditions.
(3) Adverse influence on the performance of the management.
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If there is Inadequate Working Capital, then it means :
(1) Fixed Assets may not be optimally used.
(2) Firms growth may remain stagnant.
(3) Interruptions in Production schedule may occur ultimately resulting in lowering of
the profit of the firm.
(4) Firm may not be able to take benefit of the opportunity.
(5) Goodwill is affected if not meeting liabilities on time.
Therefore, an Optimum quantum of Working Capital should be maintained as it
provides :
(1) Solvency of the business : Optimum working capital helps in maintaining
solvency of the business concern to make prompt
payments and hence helps in creating and maintaining goodwill.
(2) Goodwill : Sufficient working capital enables a business concern to make prompt
payments and thus, assist in building goodwill.
(3) Easy Loans : A concern having adequate working capital, high solvency and good
credit standing can arrange loans from banks and others on easy and favorable
terms.
(4) Cash Discounts : Adequate working capital also enable a concern to avail cash
discounts on the purchases and hence reduces the costs of procurement.
(5) Regular Supply of Raw material : Sufficient working capital ensures regular
supply of raw materials and uninterrupted production processes.
(6) Regular payment of salaries, wages and other day-to-day commitments : A
company which has ample working capital can make regular payment of salaries,
wages and day-to-day commitments which raises the morale of the employees &
increases their efficiencies.
(7) Exploitation of favorable market conditions : Only concerns with adequate
working capital can exploit favorable market conditions such as purchasing its
requirements in bulk when the prices are lower.
(8) Ability to face crisis : Optimum working capital enables a concern to face
business crisis whether it being financial, behavioral or cultural to certain extent or
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depression periods in the ongoing business cycle as in these time maximum
pressure is on the working capital.
(9) Quick and regular return on the investments : Every individual invest money in
the company with a view to earn returns on his investments. Therefore it is an
obligation on the part of company to reward its investors from time to time & this
regular practice is being facilitated by adequate surplus in the hands of the
company.
(10)High Morale : Optimality of working capital creates an environment of security,
confidence, high morale and overall efficiency of the business enterprises.
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Comparison between Current and Fixed Assets :
(1) Funds required for management of Current Assets are determined under Working
Capital techniques and for management of Fixed Assets are determined under
Capital Budgeting techniques.
(2) Current Assets generally referred to short term period say for one year while Fixed
Assets are concerned with longer tenures say more than one year.
(3) Time Value of money isnt considered in calculating Working Capital
requirements while it is an important part of decision making in any materialCapital investment.
(4) Decisions regarding Current Assets affect the short term liquidity position of the
firm whereas decisions regarding Fixed Assets affect the long term profitability of
the firm.
(5) Lastly, Working Capital Decisions can be modified without much implications
whereas Capital budgeting decisions are irreversible.
In Working Capital Management, a Finance Manager is faced with a decision
involving some of the considerations as follows :
(1) What should be the total investment in Working Capital of the Firm ?
(2) What should be the level of individual Current Assets ?
(3) What should be the relative proportion of different sources to Finance the Working
Capital requirement ?
The extent to which the payments to these Current Liabilities are delayed, the Firm
gets the availability of funds for that period. So, a part of the funds required to
maintain Current Assets is provided by the Current Liabilities.
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THE OPERATING CYCLE AND WORKING CAPITAL NEEDS :
The Operating Cycle may be defined as the time duration starting from the
procurement of goods or raw materials and ending with Sales realization. The length
and nature of the Operating Cycle may differ from one Firm to another depending
upon the size and nature of the Firm.
What is required on the part of a firm is to make adjustments and arrangements so that
the uncertainty and non synchronization of these cash flows can be taken care of.
Operating Cycle of a Firm consists of the time required for :
(1) Procurement of Raw Materials and Services
(2) Conversion of Raw Materials into Work in Progress
(3) Conversion of Work in Progress into Finished Goods
(4) Sale of Finished Goods (Cash or Credit)
(5) Conversion of Receivables into Cash
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Receivable conversion period
(RCP) Raw material storage
Conversion period (RMSCP)
Cash received from debtors ad paid to
Suppliers of
Raw materials Raw material
introduced into process
Goods
Finished Goods
Produced
Work in process
Sales of finished Finished goods
goods conversion
Period (FGCP)
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For calculation of TOCP & NOC, various Conversion Periods may be calculated as
follows :
RMCP = Average Raw Material Stock * 365
Total Raw Material Consumption
WPCP = Average Work in Progress * 365
Total Cost of Production
FGCP = Average Finished Goods * 365
Total Cost of Goods Sold
RCP = Average Receivables * 365
Total Credit Sales
DP = Average Creditors * 365
Total Credit Purchases
Some Important Reminders :
(1) Average Value in Numerator is the average of the Opening & Closing balances.
However, if only Closing balance is given, it can be assumed to be average.
(2) No hard and fast rule of 365 days. We can also take 360 days a year.
(3) In calculation of RMCP, WPCP, FGCP, the denominator is calculated on cost
basis and the profit margin has to be excluded. The reason being that there is no
investment of funds in profits as such.
Approaches to Working Capital Requirements :
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(1) Hedging Approach:
It is also known as Matching Approach. The Hedging Approach guides a firms debtmaturity financing decisions. The Hedging principle states that the financing maturity
should follow the cash flow characteristics of the assets being financed. For example,
an asset that is expected to provide cash flows over a period of say, 5 years, then it
should be financed with a debt having similar pattern of cash flow requirements. The
Hedging Approach involves matching the cash flows generating characteristics of an
asset with the maturity of the source of financing used to finance it.
The general rule is that the length of the finance should match with the life duration of
the assets. That is why the fixed assets are financed by long term sources only. So, the
permanent Working Capital needs are financed by long term sources. On the other
hand, the temporary Working Capital needs are financed by short term sources only.
In other words, the core or fixed working capital is financed by long term sources of
funds while the additional or fluctuating working capital needs are financed by the
short term sources.
(2) Conservative Approach:
Under Conservative Approach, the finance manager doesnt undertake risk. As a
result, all the working capital needs are primarily financed by long term sources and
the use of short term sources may be restricted to unexpected and emergency situation
only. The Working Capital policy of a firm is called a Conservative policy when all or
most of the working capital needs are met by the long term sources and thus the firm
avoids the risk of insolvency.
In case, the firm has no temporary working capital need then the idle long term funds
can be invested in marketable securities. This will help the firm to earn some income.
(3) Aggressive Approach :
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A working Capital policy is called an Aggressive policy if the firm decides to finance
a part of permanent working capital by short term sources. The Aggressive policy
seeks to minimize excess liquidity while meeting the short term requirements. The
firm may accept even greater risk of insolvency in order to save cost of long term
financing and thus in order to earn greater return.
Thus, the Hedging Approach suggests a low cost - high risk situation while the
Conservative Approach attempts at high cost - low risk situation. Neither the Hedging
Approach nor the Conservative Approach can be used by any firm in the strict sense.
Therefore, the financial manager should try to have a trade - off between the Hedging
& the Conservative approach.
Liquidity versus Profitability - A Risk-Return Trade off :
Having a large Working Capital may reduce the liquidity risk faced by the firm, but it
can have a negative effect on the cash flows. Therefore, the net effect on the value of
the firm should be use to determine the optimal amount of the working capital. The
risk return trade off involved in managing the firms working capital is a trade off
between the firms liquidity and its profitability.
The discussion regarding the financing pattern of current assets point out a conflict
between the short term and long term sources of finance. This conflict between the
two arises because of the fact that these sources have different costs of financing and
different risk associated with them. A Financial Manager should therefore strive for a
trade-off between the risk and return associated with the financing mix.
One way of achieving a trade-off is to find out, the average working capital required
(on the basis of maximum and minimum during the period). Then this average
working capital may be financed by long term sources and other requirements, if any,
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arising from time to time may be met from short term sources. For example, a firm
may require a maximum and minimum working capital of Rs. 50000 and Rs. 30000
respectively during a particular year. The firm can have long term sources of Rs.
40000 (i.e. average of Rs. 50000 and Rs. 30000) and any additional requirements
above Rs. 40000 may be met out of short term sources as and when the need arises.
BANK CREDIT FOR WORKING CAPITAL
Credit facility provided by commercial banks to meet the working capital requirement
has been an important source of short term funds to business firms. In India, bank
credit has been the main institutional source of short term financing requirements. This
short term financing to business firm is regarded as self-liquidating in the sense that
the uses to which the borrowing firm is expected to put the funds are ordinarily
expected to generate cash flows adequate to repay the loan within a year. Further, the
banks motive to provide finance is to meet the seasonal demand. In India, banks may
give financial assistance in different shapes and forms. The usual form of bank credit
are as follows :
(1) Overdraft
It is the simplest form of bank credit. In this case, the borrowing firm is allowed to
withdraw more (up to a specified limit) over and above the balance in the current
account. The firm has to pay interest at a predetermined rate only for the period during
which the amount was withdrawn.
(2) Cash Credit
Under the Cash Credit, a loan limit is sanctioned by bank and the borrowing firm can
withdraw any amount at any time, within that limit. The interest is charged at a
specified rate on the amount withdrawn and for the relevant period.
(3) Bills Purchased and Bills Discounting
Commercial banks also provide short term credit by discounting the bill of exchange
emerging out of commercial transactions of sale and purchase. However, if the seller
wants the money before the maturity date of the bill, he can get the bill discounted by
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the bank which will pay the amount of the bill to the seller after charging some
discount.
(4) Letter of Credit
A letter of credit is a guarantee provide by the buyers banker to the seller that in the
case of default or failure of the buyer, the bank shall make the payment to the seller.
So, in fact, the letter of credit becomes a security of the bill and any bank will have no
problem in discounting the bill.
(5) Working Capital Term Loans
Generally, the banks while granting working capital facility to a customer stipulates
that a margin of 25% would be required to be provide by the customers and hence the
bank borrowing remains only limited to 75% of the security offered. The working
Capital Term Loan is to be repaid in a phased manner varying between a period of two
to five years.
(6) Funded Interest Term Loans
Sometimes, a company is unable to pay the interest charges on its working capital cash
credit facility. Such accumulation of unserviced interest makes the cash credit account
irregular and in excess of the sanctioned limit. This unserviced accumulated interest
may transfer by the bank from cash credit account to Funded Interest Term Loan
(FITL). This will enable the firm to operate its cash credit account. The FITL is
considered seprately for repayment.
TRENDS IN FINANCING OF WORKING CAPIATAL BY BANKS
Traditionally, the bank credit has been an easily accessible source of meeting the
working capital needs of the borrowing firms. Convenience in getting the bank credit
has been an important factor for the growth of bank credit in fulfilling the requirement
of industries. However, it also resulted in distortion of allocation of bank resources in
favour of industry. Consequently, the bank credit has been subject to various rules,
regulations and controls. The reserve Bank of India has appointed different study
groups from time to time to suggest ways and means to make the bank credit as an
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effective instrument of industrialization as well as to ensure equitable distribution of
bank resources namely :
(1) Dehejia Committee
(2) Tandon Committee
(3) Chore Committee
(4) Marathe Committee
(5) Nayak Committee
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IV.1 RATIO ANALYSIS
Ratio measures the relationship between two data expressed in mathematical terms in
some logical manner; Male-Female Ratio of the population of a country, Ratio of
students passed among those appeared in an examination a re the two examples.
Absolute comparison between two figures does not carry much sense. When spoken in
terms of ratio, it becomes much more penetrating and meaningful. Not for comparison
only, ratios convert the data in precise form for easy understanding. Ratios can be
expressed as proportion or percentage. The Ratio Analysis has emerged as a principal
technique for analysis of the Financial Statements.
Steps in Ratio Analysis : The Ratio Analysis requires two steps as follows :
(1). Calculation of a ratio and
(2). Comparing the ratio with some predetermined standard. The standard ratio may
be the past ratio of the same firm or industrys average ratio or a projected ratio or the
ratio of the most successful firm in the industry. In interpreting the ratio of a particular
firm, the analyst could not reach any fruitful conclusion unless the calculated ratio is
compared with the standard one. The importance of a correct standard is obvious as
the conclusion is going to be based on the standard itself.
Types of comparisons : The ratios can be compared in three different ways :
(1). Cross Section Analysis : One way of comparing the ratio or ratios of a firm is to
compare them with the ratio or ratios of some other selected firm in the same industry
at the same point of time. The cross section analysis helps the analyst to find out as to
how particular firm has performed in relation to its competitors. It is easy to be
undertaken as most of the data is freely available in the financial statements of the
firms.
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(2). Time Series Analysis : The analysis is called Time Series Analysis when the
performance of the firm is evaluated over a period of time. By comparing the present
performance of a firm with the performance of the same firm over last few years, an
assessment can be made about the trend and the direction of the progress of the firm.
The information generated by the Time Series Analysis can be of immense help to the
firm to make planning for future operations.
(3). Combined Analysis : If the Cross Section and Time Series Analyses, both are
combined together to study the behavior and pattern of the ratios, then meaningful and
comprehensive evaluation of the performance of the firm can definitely be made.
Pre requisite to Ratio Analysis :
(1). The dates of different financial statements from where data is taken must be same.
(2). If possible, only audited financial statements should be considered. Otherwise
there must be sufficient evidence that the data is correct.
(3). Accounting Policies followed by the different firms should be same otherwise the
results will get distorted.
(4). One ratio may not throw light on any area of performance of the firm. Therefore, a
group of ratios must be preferred. This will also be conductive to counter checks.
(5). Last, but not the least, the analyst must find out that the two figures being used to
calculate a ratio must be related to each other, otherwise, there is no purpose of
calculating a ratio.
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Categorization of Ratios :
The ratios can be categorized under different names and different groups depending
upon the purpose they ought to be served. There is no hard and fast rule regarding this
matter. Therefore, it might be possible that a ratio serving a particular purpose in a
company falls under a separate category in comparison to another company or a ratio
of utmost importance for a company comes out to be a wastage for another.
Howsoever, with due respect to all the possible sayings, here the ratios are divided
under six sub-heads namely:
(1). Cash Position Ratios
(2). Short Term Solvency Ratios / Liquidity Ratios
(3). Long Term Solvency Ratios / Capital Structure Ratios
(4). Profitability Ratios
(5). Activity Ratios
(6). Capital Market Ratios
(1). CASH POSITION RATIO :
Cash position ratio show the cash reservoir of the business. Cash is the most liquid
asset; Cash reservoir is constituted of cash in hand and cash in bank (which can be
freely used for the day to day operations) and marketable securities (which can be
disposed of readily). Marketable Securities may also be part of trade investments,
which the business would not dispose of, although readily marketable. So, it is better
to take marketable securities from non-trade investment categories.
(1). Absolute Cash Ratio : The purpose of this ratio is to show how far cash reservoir
is sufficient to meet the current liabilities. Although Provisions do not represent
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current liabilities, some provisions have the characteristics of current liabilities.
Examples are tax provision and proposed dividend. It is almost certain that some
liabilities will arise in the near future.
(2). Cash Interval Ratio : Interval Measure indicates the ability of the cash reservoir
to meet cash expenses. The businessman is interested to know how many days he can
run the business using his cash reservoir if there is no further cash inflow. Higher
reserve gives better protection against unforeseen events for which the business may
have to depend exclusively on its cash reservoir. Average daily cash expenditure is
determined by taking away depreciation and similar other non-cash expenditure from
the total expenses charged to the profit and loss account and dividing the total net
expenses by 365 days.
(3). Cash Position to Total Assets Ratio : This ratio is a measure of liquid layer of
the assets deployed by business. It has been discussed earlier that cash is the most
liquid business asset. How much cash is maintained by others who are in the same
business or how much was maintained in the business earlier may give some idea
about the ideal cash position to total assets ratio.
(2). SHORT TERM SOLVENCY RATIO / LIQUIDITY RATIO :
The Terms liquidity and short term solvency are used synonymously. Liquidity means
ability of the business to pay-off its short term liabilities. Inability to pay short term
liabilities affect the credibility of the business. It also lowers its credit rating. A
continuos default on the part of the business to pay-off its liability may even create
hindrance to its day to day operations.
(1). Current Ratio : Current Ratio is given by current assets as a ratio of current
liabilities. Higher the current ratio better is the liquidity position. The traditional belief
is that 2:1 current ratio is an indicator of good liquidity position. The Chore
Committee recommended that 1.33:1 current ratio should be attained by an enterprise
for a good liquidity position.
(2). Quick Ratio : Very often presence of slow moving inventories make some
portion of current assets illiquid even at a higher degree. Also there are current
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liabilities like bank overdraft, cash credit and short term borrowings which are used as
a means of financing
current assets. So, these short term liabilities (if any) are excluded from current
liabilities while quantifying liquidity.
Thus, if quick ratio is more than current ratio, this is caused by
(a). Low proportion of non-liquid current assets (like inventory).
(b). Low proportion of quick liabilities.
If quick ratio is less than current ratio, this is due to
(a). High proportion of non-liquid current assets.
(b). High proportion of quick liabilities.
Quick Ratio is taken as ultimate test of liquidity.
(3). LONG TERM SOLVENCY RATIO / CAPITAL STRUCTURE RATIO :
Capital Structure of a business consists of long term funds, which are not repayable in
the short run and short term funds, which are repayable in the short run. Here the short
run can be taken as a period of one year or so. Long Term funds are :
(a). Shareholders Funds
(b). Loan Funds excluding cash credit, bank overdraft and other short term loans.
(1). Debt Equity Ratio : Debt Equity ratio is popularly used as Capital Structure
Ratio. It is also called Leverage Ratio. Debt means long term loan funds and Equity
means shareholders funds. It shows the long term solvency of the business. Higher
the debt fund used in the capital structure, greater is the risk. The risk is technically
called financial risk. Debt-equity ratio is also called leverage ratio. This lever operates
favourable if rate of interest is lower than return on capital employed.
(2). Proprietary ratio : Proprietary Ratio is calculated to judge the owners
contribution to total fund applications. This ratio indicates share of proprietary fund
against each rupee of investment. It can be calculated by dividing the Proprietors
funds from the Total Assets
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(3). Capital Gearing Ratio : It gives the proportion of interest bearing fund to non-
interest bearing fund. It is different from debt-equity ratio. Preference Share capital is
fixed dividend bearing fund. Likewise, other long term and short term borrowed funds
carry fixed interest. Equity share capital and reserves and surplus do not carry fixed
dividend. The word gear is used to indicate the proportion of fixed interest /
dividend bearing fund. Higher the proportion of fixed interest / dividend bearing fund
to non interest / dividend bearing fund, higher is the gearing and as a consequence
commitment to pay fixed interest / dividend out of profit is higher. This ratio seems to
be better than the debt equity ratio as debt does not include all interest bearing fund.
Also equity includes redeemable preference shares which carry fixed dividend. There
are two further ways to highlight the respective positions via Financial Leverage and
Operating Leverage.
(4). PROFITABILITY RATIO :
A business is run primarily for profit. So its performance has been measured in terms
of profit. Profitability ratios give some yardsticks to measure profit in relative terms,
either with reference to sales or assets or capital employed.
(1). Gross Profit Ratio : This ratio provides us the proportion of gross profit incurred
with respect to sales. Moreover the percentage of this ratio for any specified industry
remain more or less same as this profit takes into account the direct cost of production
which are in contrast to all the firms in the same industry.
(2). Net Profit Ratio : This ratio reflects the net profit earned by a firm after taking
into consideration all the cash and non cash expenditure for a specified period of time.
Generally this work as a yardstick to measure and compare the respective position of
the firms on the basis of the profitability.
(3). Return on Capital Employed : A popularly used measure of profitability based
on capital employed is Return on Capital Employed. It can be worked out by dividing
the net profit before interest and tax by average capital employed during the year.
Through this ratio, one is in a position to know the results reaping out from the
respective quantum of the capital employed.
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(4). Return on Shareholders fund : This ratio reflects the proportion of profit which
is left out with the firm, after payment of interest, tax and preference dividend to the
shareholders fund. Shareholders want the maximum possible dividend while the
management wants to withhold with the entire lot of funds and earnings. Therefore, an
eye should be regularly kept on the prevailing proportion.
(5). Operating Ratio : This ratio is a good indicator of the operational efficiency of
the firm. It takes into account the operating cost which is sum total of Cost of goods
sold and Selling & Administration costs; and not the total cost. The ratio of this
operating cost with the net sales gives a fair view of the operational efficiency of the
firm.
(6). Operating Profit Ratio : This ratio takes into consideration operating profit
which is the difference between the sales figure and operating costs. This provides the
Firm, an idea about how efficiently and effectively, its resources are being used in the
respective areas over a specified period of time.
(5). ACTIVITY RATIO :
Activity Turnover Ratios generally indicate relationship between sales and assets and
these are indicators of efficiency of asset use. However, sometimes, turnover ratios are
expressed in relation to cost of goods sold. Current Liabilities are also often linked
with turnover or cost of goods sold.
(1).Working Capital Turnover Ratio : Working Capital Turnover Ratio can be
provided by dividing Sales from the average working capital employed by the firm
during a specified period of time. Thus, a relative status can be judged for the working
capital employed in order to achieve the respective sales figure. The higher the ratio,
the lower is the investment in the working capital and higher would be the
profitability.
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(2).Capital Turnover Ratio : Capital Turnover Ratio reflects the relationship of Sales
with the average capital employed by the firm. It can be helpful in determining the
excessive or inadequate amount of capital employed as far as sales are concerned. The
higher the ratio, the greater is the sales made per rupee of capital employed.
(3).Fixed Assets Turnover Ratio : Again the sales figure achieved by the respective
average fixed assets employed by the firm is being reflected by this ratio. The
contribution of fixed assets can be judged in respect of the sales figure achieved by the
firm.
(4).Total Assets Turnover Ratio : The proportion of quantum of Sales with respect to
average total assets i.e. sum of fixed and current assets is being called as Total Assets
turnover Ratio.
(5).Inventory Turnover Ratio : Inventory Turnover Ratio reflects the proportion of
total sales with the average inventory maintained by the firm during a specified time
period. Difference in the inventory ratios of the different industries may result from
the different characteristics of various industries. Since this ratio is a test of efficient
inventory management, the higher the ratio, the better it is.
(6).Debtors Turnover Ratio : Debtors turnover ratio is calculated to judge the credit
policy of the firm. Higher is the Debtor Turnover, lower is the credit period offered to
customers. It can be calculated by dividing annual net credit sales with the average
debtors.
(7).Average Collection Period : This ratio provides the number of days in which the
debtors of the company are expected to be realized. In other words, a high receivable
turnover ratio or a low average collection period depicts highly liquid position on one
hand and a very restrictive credit policy on the other.
(8).Creditors Turnover Ratio : Like Debtors turnover ratio, this ratio indicates the
credit period enjoyed by the firm from its suppliers. Since trade credit is a popularly
used financing source of working capital, it is important to look at this ratio. It shows
the velocity of debt payment by a firm.
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(9).Average Payment Period : This ratio reflects the period in which the company
ought to pay its creditors during a specified period of time. To the extent possible, a
firm should try to maintain the average payment period which is approximately equal
to the credit terms of the supplier.
(6). CAPITAL MARKET RATIO :
Capital Market Ratios are used to reflect the market position of the company. It works
as a yardstick for the company to compare its various aspects with the prevailing
market trends, competitors share and also with its own previous performance.
(1). Earning Per Share : Earning Per Share can be calculated by dividing the net
profit after interest, tax and preference dividend with the number of equity shares. It
measures the profitability in terms of the total funds and explain the return as a
percentage of the funds.
(2). Earning Yield Ratio : This ratio reflects the proportion of the earnings of a
shareholder in respect of the prevailing market price. The Yield is defined as the rate
of return on the amount invested. It can be observed that Earning Yield is the inverse
of the Price Earning ratio.
(3). Price Earning Ratio : Price earning ratio can be obtained by dividing the market
price with the earning per share. The PE Ratio indicates the expectations of the equity
investors about the earnings of the firm. The investors expectations are reflected in
the market price of the share and therefore the PE Ratio gives an idea of investors
perception of the EPS.
(4). Dividend Pay-Out Ratio : This ratio provides the proportion of Dividend per
share with respect to Earning per share in the prevailing market trends. It refers to the
proportion of the Earning Per Share which has been distributed by the company as
dividends.
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(5). Dividend Yield Ratio : This ratio can be obtained by dividing the Dividend per
share with the prevailing market price per share for a specified period of time. Both
the Earning Yield and the Dividend Yield evaluate the profitability of the firm in
terms of the market price of the share and hence are useful measures from the point of
view of a prospective investor who is evaluating a share worth to take a buy or not to
buy decision.
IV.2RECEIVABLE MANAGEMENT
Receivables are almost certain and inevitable to arise in the ordinary course ofbusiness. They represent extension of credit and investment of funds and must be
carefully managed. Every firm must develop a credit policy that includes setting credit
standards, defining credit terms and employing methods for timely collection of
receivables. The Receivables (including the debtors and the bills) constitute a
significant portion of the working capital and is an important element of it. Since
credit sales assumes a sizeable proportion of total sales in any firm, the receivable
management becomes an area of attention. Higher credit sales at more liberal terms
will no doubt increase the profit of the firm, but simultaneously also increases the risk
of bad debts as well as results in more and more funds blocking in the receivables. The
term RM may be defined as collection of steps and procedure required to properly
weigh the costs and benefits attached with the credit policies. The RM consists of
matching the costs of increasing sales (particularly credit sales) with the benefits
arising out of increased sales with the objective of maximizing the return on
investment of the firm.
COSTS OF RECEIVABLES :
(1). Cost of Financing : The credit sales delays the time of sales realization and
therefore the time gap between the cost and the sales realization is extended. This
results in the blocking of the funds for a longer period. The firm on the other hand, has
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to arrange funds to meets its own obligation at some explicit or implicit costs. This is
known as the cost of financing the Receivables.
(2). Administrative Costs : A firm will also be required to incur various costs in order
to maintain the record of credit customers both before the credit sales as well as after
the credit sales.
(3). Delinquency Costs : Over and above the normal administrative cost of
maintaining and collection of receivables, the firm may have to incur the additional
delinquency costs, if there is delay in payment by a customer; in the form of
reminders, phone calls, postage, legal notices etc. Moreover, there is always an
opportunity cost of the funds tied up in the receivables due to delay in the payment.
(4). Cost of Default by Customers : If there is a default by a customer and the
receivable becomes, partly or wholly, unrealizable, then this amount, known as bad
debt, also becomes a cost to the firms. This cost does not appear in the case of cash
sales.
BENEFITS OF RECEIVABLES :
(1). Increase in Sales : Almost all the firms are required to sell goods on credit, either
because of trade customs or other conditions. The sales can further be increased by
liberalizing the credit terms. This will attract more customers to the firm resulting in
higher sales and growth of the firm.
(2). Increase in Profits : Increase in sales will help the firm to easily recover the fixed
expenses & attaining the break even level, and increase the operating profit of the
firm.
(3). Extra Profits : Sometimes, the firms make the credit sales at a price which is
higher than the usual cash selling price. This brings an opportunity to the firm to make
extra profit over and above the normal profit.
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TRADE-OFF ON RECEIVABLES :
Firms offer credit to customer for a number of reasons, but the ultimate objective is to
generate sales that would not have occurred otherwise. The costs associated with
offering credit are twofold: Firstly, granting credit exposes the firm to the possibility
that the customer will default. Secondly, the foregone interest between the time of
sales and the sales realization. This cost can however be partially or wholly set off by
charging customers interest cost for buying goods on credit. In fact, in cases where
the firm can charge higher interest rate from the customer, such interest income
becomes a profit instead of a cost to the firm.
The trade-off on receivables can be applied to find out whether to liberalize the credit
terms or not. When a firm adopts more liberal credit policies, the sales increase
resulting in higher profits. However, the chances of bad debts will also increase and
there will be a decrease in liquidity of the firm. On the other hand, a stringent credit
policy reduces the profitability but increases the liquidity of the firm. The opposite
forces of profitability and liquidity have an inverse relationship. Thus, a firm should
try to frame its credit policy in such a way as to attain the best possible combination of
profitability and liquidity.
Therefore, the receivables management must be attempted by adopting a systematic
approach and considering the following aspects of the receivable management :
(1). The Credit Policy.
(2). The Credit Evaluation.
(3). The Credit Control.
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CREDIT POLICY :
A firm makes significant investment by extending credit to its customers and thus
requires a suitable and effective credit policy to control the level of total investment in
the receivables. The basic decision to be made regarding receivables is to decide how
much credit to be extended to a customer and on what terms. This is what is known as
credit policy. The credit policy may be defined as the set of parameters and principles
that govern the extension of credit to the customers. This requires the determination of
the credit standard i.e. the conditions that the customer must meet before being granted
credit, and the credit terms i.e. the terms and conditions on which the credit is
extended to the customers.
(1). Credit Standards : When a firm sells on credit, it takes a risk about the paying
capacity of the customers. Therefore, the problem is to balance the benefits of
additional sales against the cost of increasing bad debts. Effect of the credit standard
on the sales volume, total bad debts of the firm and on the total collection costs are
worth noting. The credit standard will help setting the level which must be satisfied by
a customer before being selected for making credit sales. However, even after
selecting the customers, all of them need not necessarily be offered the same terms and
conditions.
(2). Credit Terms : The credit terms refer to the set of stipulations under which the
credit is extended to the customers. The credit terms specify how the credit will be
offered, including the length of the period for which the credit will be offered, the
interest rate on the credit and the cost of default. The credit terms may relate to the
following :
Credit Period : It refers to the length of the time over which the customers are
allowed to delay the payment. There is no hard and fast rule regarding the credit
period and it may differ from one market to another. Customary practices are
important factor in deciding the credit period.
Discount Terms : The customers are generally offered cash discount to induce
them to make prompt payments. Different discount rates are offered for different
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periods e.g. 5% discount if payment made within 10 days; 3% discount if payment
made within 20 days etc.
When a firm offers a cash discount, its intention is to accelerate the flow of cash into
the firm to improve its cash position. The length of cash discount affects the collection
period. Some customers, who were not paying promptly, may be tempted to avail the
discount and may pay earlier. This will result in shortening of the average collection
period.
However, there is always a cost of cash discount. If a firm has an average collection
period of 40 days, and in order to reduce the average collection period, it offers a cash
discount of 3% if payment is made in 10 days. A customer having a balance of Rs.100,
who was paying in 40 days, now avails the discount of 3% and pays Rs.97 on the 10th
day.
So, firm will be having Rs.97 for a period of 30 days (40-10), and the cost is Rs.3. The
annual cost of this discount can be calculated as follows :
Annual financing cost = Rs. 3 * 365 * 100 = 37.6%
Rs. 97 30
So, the annual cost of offering cash discount is 37.6%. This may be compared with the
cost of financing from other sources to decide whether to offer discount to customers
or not. The annual financing cost may be ascertained as follows :
Annual financing cost = % Discount * 365 * 100
100-% Discount Credit Period - Discount Period
Increase in discount rate will tantamount to reducing the ultimate selling price
resulting in increase in sales. Increasing the collection period results in increasing the
amount of receivables and hence the higher cost of receivables. Therefore, any change
in the discount terms should be evaluated in terms of costs and benefits of such
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change. The competition requires that the credit terms should match the credit terms of
other firms.
CREDIT EVALUATION :
The receivables are generally considered a relatively low risk asset. Under normal
circumstances, the total bad debts losses a firm will experience can be forecast with
reasonable accuracy, especially if the firm sells to a large number of customers and
does not change its credit policies. These normal losses can be considered purely a
cost of extending credit.
Credit Evaluation involves determination of the type of the customers who are going
to qualify for the trade credit. Several costs are associated with extending credit to less
credit-worthy customers. When more time is spent investigating the less credit-worthy
customers, the cost of credit investigation increases. As the customers credit rating
declines, the chance that the amount will not be paid on time increases. Collection
costs also increase as the quality of the customer declines.
There are three basic factor of credit worthiness of a customer. First, the character i.e.
the willingness and the practice of the customer to honor his obligations by paying as
agreed. Second, the capacity i.e. the financial ability of the customer to pay as agreed,
and third, the collateral i.e. the security offered by the customer against the credit.
Evaluation of credit worthiness of a customer is a two step procedure (1). collection of
information, and (2). analysis of information.
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(1). Collection of Information :
In order to make better decisions, the firm may collect information from various
sources on the prospective credit customers. Some of the sources are listed below :
(a). Bank Reference
(b). Credit Agency Report
(c). Published Information
(d). Credit Scoring
Information collection is often costly and therefore, the firms also weigh the benefits
of gathering information against its costs.
(2). Analysis of Information :
The five well known Cs of credit : Character, Capacity, Capital, Collateral and
Conditions provide a framework for the evaluation of a customer. These
characteristics can throw light on the credit worthiness or default-risk of the customer.
The difficulty arises in case of those customer who are marginally credit worthy. In
such a situation, the financial manager must attempt to balance the potential
profitability against the potential loss from the default.
CONTROLS OF RECEIVABLES :
Since the credit has been extended to a customer as per the credit policy, the next
important step in the management of receivables is the control of these receivables. In
this reference, the efforts may be required in the following directions :
(1). The Collection Procedure :
Once a firm decides to extend credit and defines the terms of credit sales; it must
develop a policy for dealing with delinquent or slow paying customers. There is a
cost of both : Delinquent customers create bad debts and other costs associated
with repossession of goods, whereas the slow paying customer cause more cash
being tied up in receivables and the increased interest costs. A strict collection
policy can affect the goodwill and damage the growth prospects of the sales. If a
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firm has a lenient credit policy, the customers with a natural tendency towards
slow payments, may become even slower to settle his accounts. Overly aggressive
collection policy may offend good customers who inadvertently have failed to pay
in time. One possible way of ensuring early payments from customers may be to
charge interest on over due balances. But this penal interest and the rate thereof
must be agreed in advance and better written in sales document. Thus, the
objective of collection procedure and policies should be to speed up the slow
paying customer and reduce the incidence of bad debts.
(2). Monitoring of Receivables :
In order to control the level of receivables, the firm should apply regular
checks and there should be a continuous monitoring system. For the purpose,
number of measures are available as follows :
(a). A common method to monitor the receivables is the collection period or
number of days outstanding receivables. The average collection period may be
found by dividing the average receivables by the amount of credit sales per day
i.e.,
Average collection period = Average Receivables
Credit Sales per day
(b). Another technique available for monitoring the receivables is known as
AgingSchedule. The quality of the receivables of a firm can be measured by
looking at the age of receivables. The older the receivable, the lower is the
quality and higher or greater the likelihood of a default.
(3). Lines of Credit :
Another control measure for receivables management is the line of credit
which refers to the maximum amount a particular customer may have as due to
the firm at any time. However, if a new order is going to increase the
indebtedness of a customer beyond his line of credit, then the case must be
taken for an approval for a temporary increase in the line of credit.
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(4). Accounting Ratios :
Accounting information may be of good help in order to control the
receivables. Though, several ratios may be calculated in this regard, two
accounting ratios, in particular may be calculated to find out the changing
patterns of receivables. These are (a). Receivables Turnover Ratio, and (b).
Average Collection Period.
FACORING AND RECEIVABLES MANAGEMENT :
Factoring may be defined as the relationship between the seller of goods and a
financial firm, the factor, whereby the latter purchases the receivables of the former
and also administer the receivables of the former. Factoring involves sale of
receivables of a firm to another firm under an already existing agreement between the
firm and the factor. So, the factoring is a tool to release the working capital tied up in
credit extended to the customers, for more profitable uses and thereby relieving the
management from sales collection chores so that they can concentrate on other
important activities. There are two types of Factoring : (1). Non-recourse factoring
(Full Factoring) where factor firm purchases the receivables from the selling firm and
(2). Recourse Factoring (Pure Factoring) where factor firm does only collection work
of receivables & thus does not bear any risk of default by the receivable.
IV.3 INVENTORY MANAGEMENT
The Inventory absorbs a major part of Working Capital funds; the key of efficient
working capital management lies in inventory management. Inventories are assets of
the firm and require investment and hence involve the commitment of firms
resources. If the inventories are too big, they become a strain on the resources,
however if they are too small, the firm may loose the sales. Therefore, the firm must
have an optimum level of inventories. Managing the level of inventories is like
maintaining the level of water in a bath tub with an open drain. The water is flowing
out continuously. If water is let in too slowly, the tub is soon empty. If water is let in
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too fast, the tub over flows. Like the water in the tub, the particular item in the
inventory keeps changing, but level may remain the same.
TYPES OF INVENTORIES :
(1). RAW MATERIAL : This consists of basic materials that have been committed to
the production in a manufacturing concern. The purposes of maintaining raw material
inventory is to uncouple the purchase function from the production so that delays in
the shipment of raw material do not cause production delays. Carrying extra inventory
means tying up money in the resources. When money is converted into inventories, it
leads to additional costs in the form of storage, security, supervision, insurance,
obsolescence etc. in addition to loss of an opportunity to earn a return on money.
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(2). WORK IN PROGRESS : This Category includes those materials, which have
been committed to the production process but have not been completed. The more
complex and lengthy production process the larger will be the investment in the work
in process inventory. Work in Progress refers to the raw materials engaged in various
phases of production schedule. The degree of completion may be varying for different
units. The value of Work in Progress includes the raw material costs, the direct wages
and expenses already incurred and the overheads, if any. So, the Work in Progress
inventory consists of partially produced / completed goods.
(3). FINISHED GOODS : These are the goods which are either being purchased by
the firm or are being produced or processed in the firm. These are completed products
awaiting sales. The purpose of finished goods inventory is to uncouple the production
and the sale function so that it is not necessary to produce the goods before the sales
can occur and therefore sales can be made directly out of inventory. It is necessary to
decide on the safety stock of finished goods to be carried to meet the fluctuations in
the demand as well as other uncertainties that are present in the nature of business.
PURPOSE OF MAINTAINING INVENTORY :
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We have seen that the purpose of carrying inventory is to uncouple the operations of
the firm i.e. to make each function of the firm independent of other functions so that
delays in one area do not affect the production and sales activities. Any firm will like
hold higher levels of inventory. This will enable the firm to be more flexible in
supplying to the customers and will find ease in its production schedule. Given the
benefits of holding inventories and costs of stock-outs, a firm will be tempted to hold
maximum possible inventories. But this is costly too, because the funds blocked in
inventory always have an opportunity costs. Thus, the objective of inventory
management is to determine the optimal level of inventory i.e. the level at which the
interest of all the departments are taken care of. The motives for holding inventory
may be enumerated as follows :
(1). Transactionary Motive :
Every firm has to maintain some level of inventory to meet the day to day
requirements of sales, production process, customer demand etc. This motive makes
the firm to keep the inventory of finished goods as well as raw materials.
(2). Precautionary Motive :
A firm should keep some inventory for unforeseen circumstances also. For example
the fresh supply of the raw material may not reach the factory due to strike by the
transporters or due to natural calamities in a particular area. There may be labor
problem in the factory and the production process may halt. So, the firm must have
inventory of raw materials as well as finished goods for meeting such emergencies.
(3). Speculative Motive :
The firm may be tempted to keep some inventory in order to capitalize an opportunity
to make profit e.g. sufficient level of inventory may help the firm to earn extra profit
in case of expected shortage in the market.
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COSTS OF INVENTORY :
(1). Carrying Costs :
This is the cost incurred in keeping or maintaining an inventory of one unit of raw
material or work in progress or finished goods. Two costs associated with it are: (a).
Cost of storage: This