Working Capital

• Working capital typically means the firm’s holding of current or short-term assets such as cash, receivables, inventory and marketable securities.

• Working Capital refers to that part of the firm’s capital, which is required for financing short-term or current assets.

• These items are also referred to as circulating capital.

Working capital: Concept

There are two possible interpretations of working capital concept:

1. Balance sheet concept2. Operating cycle concept

Balance sheet concept: There are two interpretations of working capital under the balance sheet concept.

a. Excess of current assets over current liabilities

b. Gross or total current assets.

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

Concept of working capital

Operating cycle concept

• A company’s operating cycle typically consists of three primary activities:– Purchasing resources,– Producing the product and– Distributing (selling) the product.

These activities create funds flows that are both unsynchronized and uncertain.

Unsynchronized because cash disbursements usually take place before cash receipts.

Uncertain because future sales and costs cannot be forecasted with complete accuracy.

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

• In addition, the company must invest in inventories to fill customer orders promptly.

• And finally, the company invests in accounts receivable to extend credit to customers.

• Operating cycle is equal to the length of inventory and receivable conversion periods.

Operating cycle concept

Operating cycle of a typical company

Payable Deferral period

Inventory conversionperiod

Cash conversioncycle

Operating cycle

Pay forResourcespurchases

Receive CashPurchase

resources

SellProductOn credit

Receivable Conversion period

THE WORKING CAPITAL CYCLE

(OPERATING CYCLE)

Accounts Payable

Cash

RawMaterials

W I P

Finished Goods

Value Addition

AccountsReceivable

SALES

If you Then ......

Collect receivables (debtors) faster

You release cash from the cycle

Collect receivables (debtors) slower

Your receivables soak up cash

Get better credit (in terms of duration or amount) from suppliers

You increase your cash resources

Shift inventory (stocks) faster

You free up cash

Move inventory (stocks) slower

You consume more cash

• Raw material storage peiod: = Average stock of raw material Cost of raw material consumed/365

• WIP holding period: Average WIP inventory/ Cost of production/365• Finished goods storage period: Average stock of finished goods/Cost of goods

sold/365• Inventory conversion period: Avg. inventory/ Cost of sales/365• Receivable conversion period:Accounts receivable/Annual credit sales/365• Payables deferral period: Accounts payable/(Credit purchases)/365

Operating cycle: Inventory conversion period + receivable conversion period.

Cash conversion cycle = operating cycle – payables deferral period.

TYPES OF WORKING CAPITAL

WORKING CAPITAL

BASIS OF CONCEPT

BASIS OF TIME

Gross Working Capital

Net Working Capital

Permanent / Fixed

WC

Temporary / Variable

WC

Regular WC

Reserve WC

Special WC

Seasonal WC

• The size and nature of investment in current assets is a function of different factors such as – Type of products manufactured, – Length of operating cycle, – Sales level, – Inventory policies, – Unexpected demand and – Unanticipated delays in obtaining new inventories, – Credit policies and – Current assets.

Working capital investment

Difference between permanent & temporary working capital

Amount Variable Working Capitalof WorkingCapital

Permanent Working Capital

Time

Variable Working CapitalAmount of WorkingCapital

Permanent Working Capital

Time

Matching approach to asset financing

Fixed Assets

Permanent Current Assets

Total Assets

Fluctuating Current Assets

Time

Rs

Short-termDebt

Long-termDebt +EquityCapital

Conservative approach to asset financing

Fixed Assets

Permanent Current Assets

Total Assets

Fluctuating Current Assets

Time

Rs

Short-termDebt

Long-termDebt +Equity capital

Aggressive approach to asset financing

Fixed Assets

Permanent Current Assets

Total Assets

Fluctuating Current Assets

Time

RS

Short-termDebt

Long-termDebt +Equity capital

FACTORS DETERMINING WORKING CAPITAL

1. Nature of the Industry2. Demand of Industry3. Cash requirements

4. Nature of the Business5. Manufacturing time

6. Volume of Sales7. Terms of Purchase and Sales

8. Inventory Turnover9. Business Turnover

10. Business Cycle11. Current Assets requirements

12. Production Cycle

Working capital estimation

Satyam Ltd profit and loss A/c and balance sheet for the year ended 31.12.15 are given below. You required to calculate the working capital requirement under operating cycle method:

Opening stockRaw material 10,000WIP

30,000Finished goods 5,000

Credit purchase 35,000Manufacturing expn 15,000Gross profit 55,000

150,000Administration expn 15,000Selling &distrbtn expn 10,000Net profit 30,000

55,000

Credit sales 1,00,000Closing stock

Raw material 11,000

WIP 30,500Finished goods 8,500

150,000Gross profit 55,000

.55,000

LiabilitiesEquities (16,000@Rs.10) 160,000Net Profit 30,000Creditors 10,000

2,00,000

AssetsFixed Assets1,00,000Debtors 30,500Cash and Bank 19,500Closing stock

Raw material 11,000

WIP 30,500Finished goods 8,500

2,00,000

Opening debtors (excluding profit) and opening creditor were Rs.6,500 and Rs.5,000 respectively

Calculation of operating cycle

Raw material Average raw material /Raw material consumed

per day=10,500/34,000/365 = Work in progressAverage WIP /Total cost of production per day=30,250/48500/365 =

Calculation of operating cycle

Finished goodsAverage stock/ Total cost of goods sold per day=6750/45,000/365 =Debtors Average Debtors/ credit sales per day=18,500/ 100,000/365 =

Calculation of operating cycle

Creditor Average creditor/credit purchases per day=7500/35,000/365Net Operating Cycle isTotal days – Credit allowed by creditors=

Estimation of Net Working capital requirement for Exl Ltd from the data given belowCost of production (per unit) Amount(per unit )Raw materials 100Direct labour 40Overheads 80

220The following are the additional information:Selling price per unit Rs.240Level of activity 1,04,000 units p.aRaw material in stock Average 4 weeksWork In Progress (Assume 100% stage of completion of materials and 50 percent for

labor and overheads) Average 2 weeksFinished goods in stock Average 4 weeksCredit allowed by supplier Average 4 weeksCredit allowed by debtors Average 8 weeks Lag in payment of wages Average 1.50 weeksCash at bank is expected to Rs.25,000. Production is sustained during 52 weeks of year

Statement of Working Capital RequirementParticulars Amount Raw materials 2,000 x 4 x 100 8,00,000

WIP

•Raw materials 2,000 x 2 x 100 4,00,000

•Wages (2,000 x 2 x 40)50% 80,000

•Overheads (2,000 x 2 x 80) 50% 1,60,000 6,40,000

Finished stock 2,000 x 4 x 220 17,60,000

Debtors 2,000 x 8 x 220 35,20,000

Cash 25,000

Total Current Assets 67,45,000Creditors 2,000 x 4 x 100 8,00,000

Outstanding wages 2,000 x 4 x 1.5 1,20,000

Total current liabilities 9,20,000

Net working capital (TCA - TCL) 58,25,000

INVENTORY

MEANING• Held for SALE• Consumed in the PRODUCTION of goods and

services Forms of Inventory for Manufacturing firm.

Raw materials, Work in process, Finished goods and stores & spares.

Inventory Management- objectives

Minimize investments in inventory

Meet the demand for products by efficiently organizing the production & sales operations.

RISK OF HOLDING INVENTORY

• Price decline

• Product Deterioration

• Product Obsolescence

COSTS OF HOLDING INVENTORIES

• Ordering costs

• Inventory Carrying/storage costs

• Opportunity costs of funds blocked

• Shortage

TOOLS & TECHNIQUES OF INVENTORY MANAGEMENT/ CONTROL

• ABC Analysis• Economic Ordering Quantity (EOQ)• Order Point Problem

ABC analysis

• ABC analysis is an inventory categorization method which consists in dividing items into three categories, A, B and C: – A being the most valuable items, – C being the least valuable ones.

• This method aims to draw managers’ attention on the critical few (A-items) and not on the minor many (C-items).

ABC AnalysisCATEGORY NO. OF ITEMS(%) ITEM VALUE(%) MANAGEMENT

CONTROL

A 15 70 (HIGHEST) MAXIMUM

B 30 20(MODERATE) MODERATE

C 55 10(LEAST) MINIMUM

TOTAL 100 100

ExampleABC Analysis

Stock Number Annual Volume Percent of Annual Volume

J24 12,500 46.2R26 9,000 33.3L02 3,200 11.8M12 1,550 5.8P33 620 2.3T72 65 0.2S67 53 0.2Q47 32 0.1V20 30 0.1

Total = 100.0

SolutionABC Groups

Class Items Annual Volume

Percent of Volume

A J24, R26 21,500 79.5

B L02, M12 4,750 17.6

C P33, T72, S67, Q47, V20 800 2.9

      S = 100.0

Economic Ordering Quantity (EOQ)

• Level of Inventory at which

• Total Cost* of Inventory is MINIMUM*(Ordering and Carrying Cost)

EOQ MODEL

2AOQ =

SQ = Economic Order Quantity

A = Annual usage/demand

O= Cost of Placing an order

S = Storage cost per unit per order

* Where Storage cost is given in % , it is always calculated by multiplying the % with the purchase price of raw material per unit, i.e Storage cost = % X Purchase price of raw material

BEHAVIOR OF INVENTORY RELATED COSTS

CostsTotal costs

Carrying costs

Ordering costs

Quantity ordered

BEHAVIOUR OF INVENTORY RELATED COSTS

• Total cost of Inventory = Ordering cost + Holding cost

– Ordering cost = Annual Demand*Ordering cost/Q

– Holding cost = Q*Holding cost /2

EOQ- Example• A firm’s annual inventory is 1,600 units. • The cost of placing an order is Rs 50, purchase price of raw

material/unit is Rs.10 and the carrying costs is expected to be 10% per unit p.a.

• Calculate EOQ? A=1600, O= Rs. 50, S= .10 x Rs.10=Rs.1

EOQ = 2 x 1600 x 501

= 400 units

Order Point Problem• The re-order point is that level of inventory when a fresh

order should be placed with suppliers. It is that inventory level which is equal to the consumption during the lead time or procurement time.

• Re-order level = (Daily usage × Lead time) + Safety stock.

• Safety stock is minimum level of inventory that a firm keeps in hand. The firm reorders more inventory if the current inventory falls to safety level.

• Safety Stock = (Maximum Daily Usage − Average Daily Usage) × Lead Time

Example

• ABC Ltd. is engaged in production of tires. It purchases rims from DEL Ltd. an external supplier. DEL Ltd. takes 10 days in manufacturing and delivering an order.

• ABC's requires 10,000 units of rims per year. Its ordering cost is Rs.1,000 per order and its carrying costs are Rs.3 per unit per year.

• The maximum usage per day could be 50 per day. Calculate economic order quantity, total cost of inventory, reorder level and safety stock.

Solution

• EOQ, (Q) = (2*Annual Demand*Ordering Cost Per Unit / Carrying Cost Per Unit)^1/2

• Q = (2*10,000*1,000/3)^1/2 = 2582• Total cost of Inventory = Ordering cost +

Holding cost – Ordering cost = Annual Demand*Ordering cost/Q= 10,000*1,000/2582– Holding cost = Q*Holding cost /2– =

Reorder point

• Safety Stock = (Maximum Daily Usage − Average Daily Usage) × Lead Time

• Reorder Level = Safety Stock + Average Daily Usage × Lead Time

ExampleAssume you have a product with the following parameters:Annual Demand: 360; Holding cost per unit: Rs.1; Cost per order: Rs.100The maximum daily demand is 3 units per day1. What is the EOQ?2. Given the data, and assuming a 300-day work year; how many orders

should be processed per year? What is the expected time between orders?

3. What is the total cost for the inventory policy used ?4. Assume that the demand was actually higher than estimated (i.e., 500 units

instead of 360 units). What will be the actual annual total cost?

Solution

EOQ Demand Order costHolding cost

items 2 2 360 100

172000 268* * * *

N DemandQ

orders per year 360268

134.

T Working daysExpected number of orders

days between orders

300 134 224/ .

• Total cost of Inventory = Ordering cost + Holding cost

• Ordering cost = Annual Demand *Ordering cost/Q = 360* 100/268 = 134

• Holding cost = Q*Holding cost /2 = 268*1/2 =

• Total Cost of inventory =

JUST-IN-TIME (JIT) INVENTORY CONTROL

• The JIT control system implies that the firm should maintain a minimal level of inventory and rely on suppliers to provide parts and components ‘just-in-time’ to meet its assembly requirements.

• JIT also known as Zero Inventory Production Systems(ZIPS), Zero Inventories(ZIN), Materials as Needed(MAN), or Neck of Time(N0T)

Cash Management

Definition

Cash Management refers to management of cash & bank balance and also includes the management of short term deposits.

Motives of cash management

• Transaction motive: Business firm keep cash to meet their demand for cash arising from day to day transactions.

• Precautionary motive: Maintenance of cash balance to act as buffer against unexpected events.

• Speculative motive: Cash balance to take advantage of potential profit making situations that may occur in future.

Optimum Cash Balance

• Baumol’s model• Miller-orr model

Baumol’s model• Suggested by William J. Baumol (1952)• The model attempts to balance the income foregone on cash held by the

firm against the transaction cost of converting cash into marketable securities or vice versa.

• This model can be presented on assumption as follows:– Fixed Cash flow : The Baumol’s model assumes that the firm uses cash

at an already known rate per period and that this rate of use is constant.

– Holding cost: The holding cost is the opportunity cost in terms of interest foregone on investment in cash.

– Transaction cost: whenever cash is invested in marketable securities, there is cost involved like brokerage or commission.

Illustration• The annual cash requirement of A Ltd. is Rs 10 lakhs. The

company has marketable securities in lot sizes of Rs 50,000, Rs 1, 00,000, Rs 2, 00,000, Rs 2, 50,000 and Rs 5, 00,000.

• Cost of conversion of marketable securities per lot is Rs.1,000. The company can earn 5% annual yield on its securities.

• You are required to prepare a table indicating which lot size will have to be sold by the company. Also estimate the economic lot size can be obtained by the Baumol Model.

Baumol model

C= 2A*F/OWhere A= Annual requirement = 10 lakh

F = Fixed conversion charges = 1000O = opportunity 5%

C = 2*10,00,000*1000/0.05 = 2,00,000

Table indicating lot sizeS. No Particulars Situation 1 Situtation2 Situation 3

A Annual cash requirement (Given)

10,00,000 10,00,000 10,00,000

B Lot size of securities (Given) 50,000 1, 00,000 2,00,000

C No. of lot sizes (A/B) 20 10 5

D Average holding OF CASH (B/2) 25,000 50,000 1,00,000

E Opportunity cost of holding cash (D x 0.05)

1250 2500 5000

F Fixed conversion cost (given) 1000 1000 1000

G Total conversion cost (C x F) 20,000 10,000 5,000

H Total cost (E+G) 21,250 12,500 10,000

The above illustration shown that the minimum cost is Rs.10,000 when the lot size is 2,00,000

Miller and Orr model

• Baumol’s model is based on the basic assumption that the size and timing of cash flows are known with certainty. Whereas, in real situation, the cash flows of a firm are neither uniform nor certain.

• M.H. Miller and Daniel Orr (A Model of the Demand for Money) expanded on the Baumol model and developed Stochastic Model for firms with uncertain cash inflows and cash outflows.

The Miller and Orr (MO) model provides two control limits-the upper control limit and the lower control limit along-with a return point as shown in the figure below:

Miller and Orr model• If the cash balance touches the upper control limit (H), marketable

securities are purchased to the extent of (H-Z) to return back to the normal cash balance of Z.

• If the cash balance touches lower control limit (O), the firm will sell the marketable securities to the extent of O-Z to again return to the normal cash balance.

• The spread between the upper and lower cash balance limits (called Z) can be computed using Miller-Orr model as below:

Receivables Management

• Accounts receivables for the selling firm is same as an account payable for the purchaser.

• The purpose of credit analysis is to assess the credit worthiness of potential customers and the corresponding risk of late payments or default.

Receivables Management

• Credit analysis consists of:1. Gathering information about the potential

customer2. Analyzing the information to derive a credit

decision about the payment terms and amount of trade credit granted

Credit agencies provide credit ratings and reports on companies.

STEPS IN CREDIT ANALYSIS

The 5 C’s of Credit Analysis• Character - Reputation, Track Record • Capacity - Ability to repay.• Capital - Financial Position of the co. • Collateral - The type and kind of assets pledged • Conditions - Economic conditions &

competitive factors that may affect the profitability of the customer.

Credit planning

Aspects of credit planning• Credit policy• Credit standards• Credit terms

Credit policy

A company's policy related to trading off the profit on additional sales that arises due to credit sales and the cost of carrying those debtors and probable bad debts.

Credit standards

• The guidelines issued by a company that are used to determine if a potential borrower is creditworthy.

• Credit standards are often created after careful analysis of past borrowers and market conditions, and are designed to limit the risk of a borrower not making credit payments or defaulting on loaned money.

Credit terms

• The terms which indicate when payment is due for sales made on account (or credit). – Credit period– Discount period– Discount rate

• The general credit terms are expressed as 2/10, net 30. This means the amount is due in 30 days; however, if the amount is paid in 10 days a discount of 2% will be permitted.

Calculation of annualized return

• If credit term is expressed as a/b,net c then; • Annualized return = a/(1-a) * 360/(c-b)

Which of the below terms have lower cost to company?

1. 2/10, net 302. 5/10, net 60