Working Capital Management

Working Capital Management: An Overview

After Plant & Machinery has been installed and the manufacturing facility is put in place, the firm would require investment made in Short-term assets. Firms may be required to sell finished products/services on credit leading to Receivables (or Debtors), or maintain stocks of raw material/finished goods leading to Inventories. Investments in such short-term assets is called Working Capital.

Overview of Working Capital Management

Working Capital Management: An Overview

Two Concepts of Working Capital:  Gross Working Capital is the aggregate investment in Current Assets.
Focuses attention on (a) Trade-off between excessive and inadequate Current Assets; (b) Financing of Current Assets.

 Net Working Capital is the difference between the Current Assets and Current Liabilities of a firm.
Indicates the liquidity position of a firm and the suggests the extent to which working capital requirements may be financed by long-term sources. Current Assets should be sufficiently in excess of the current liabilities and form a buffer for maturing obligations within a operating cycle. Negative NWC means CL > CA, may prove harmful to the firm.

Overview of Working Capital Management

Working Capital Management

Current Assets: Those assets that are either in the form of cash or are expected to be converted into cash in the short term (usually defined as less than one year).  Inventories (R/M, WIP, FG),  Debtors,  Short Term Investments,  Cash. Current Liabilities: Those liabilities that are expected to be paid within a year.  Creditors,  Accrued expenses,  current portion of long-term liabilities.
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Overview of Working Capital Management

Why Working Capital is required?

Sales do not convert into Cash instantaneously as there is an OPERATING CYCLE Duration of time required to convert sales, after conversion of Raw Material into Finished Goods, into Cash. Cash

Realise Debtors

Purchase Raw Material Convert

OPERATING CYCLE Sale of Goods Finished Goods

Convert

Work-inProgress
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Overview of Working Capital Management

Fixed & Variable Working Capital

As Operating Cycle is a continuous process, hence Current Assets are required continuously but the quantum of Current Assets required may not remain constant throughout and may vary over time. Some part of the Working Capital is required continuously, which is called FIXED Working Capital represents the MINIMUM level of Current Assets. Depending upon changes in production & sales, the need for Working Capital over and above the Fixed Working Capital may fluctuate. Additional working capital required to support the changing production & sales level is called VARIABLE or TEMPORARY Woking Capital.
Overview of Working Capital Management 6

Fixed & Variable Working Capital (Contd.)

Variable Current Assets

Variable Current Assets Amount of Working Capital Amount of Working Capital

Fixed Current Assets

Fixed Current Assets

Time

Time

Overview of Working Capital Management

Approaches to Working Capital Financing

Based on the mix of Short Term(Spontaneous Sources/Current Liabilities) and Long term sources of financing working Capital, and the Fixed & Variable Current Assets, there are three approaches to Working Capital Financing. Matching Approach Conservative Approach Aggressive Approach

Overview of Working Capital Management

Matching Approach
Expected life of an asset should match the tenure of the financing source.
Amount of Working Capital Variable Current Assets
Short Term Sources

Fixed assets should be financed by long term sources while the current assets should be financed by short term sources. Applying to Working Capital Management, Fixed Current Assets should be financed by long-term sources while the Variable Current Assets should be financed by short-term sources.
Overview of Working Capital Management

Long Term Sources

Fixed Current Assets

Time
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Conservative Approach
Under this approach, more reliance is on long-term sources
Amount of Working Capital Variable Current Assets
Short Term Sources

Long term sources are used to finance Fixed Assets + Fixed Current Assets + Part of the Variable Current Assets. Lower level of risk of shortage of funds.

Long Term Sources

Fixed Assets

Time
Overview of Working Capital Management 10

Aggressive Approach
Under this approach, more reliance is on Short-term sources of funds to finance assets. Part of Fixed Current Assets + Temporary Current Assets are financed by short-term sources.
Variable Current Assets
Short Term Sources

Amount of Working Capital

Fixed Assets

Time
Overview of Working Capital Management 11

Short term vs. Long term

Short-term funds are less costly and more flexible but at the same time more Risky. Hence, a Risk-Return trade-off has to be achieved while deciding the financing mix.

Overview of Working Capital Management

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Determinants of Working Capital

Large number of factors influence the working capital requirements. Each factor has different importance which varies over time as well. 1. Nature & Size of Business: As compared with Total assets, Trading companies require large investment in working capital (than investment in Fixed Assets), while Utility companies such as Power Generation Company, require low levels of working capital and huge investments in Fixed Assets. Size (Scale of operations) - Large company would require more working capital. 2. Manufacturing Cycle: Longer the Manufacturing cycle, larger will be requirement of working capital. 3. Sales Growth: As sales grow, more working capital would be required, though a definite relationship is difficult to determine.
Overview of Working Capital Management 13

Determinants of Working Capital 4. Demand Conditions: For seasonal products, as demand varies, so does the working capital varies. During Boom periods, as demand picks up, not only the variable, but the fixed working capital requirements also goes up. 5. Production Policy: Constant Production Policy would lead to accumulation of inventory in off-season. Cost of maintaining inventory Risks- damage; no- off take. To minimize - firm may choose to vary its production schedules. 6. Price Level Changes: Increase in prices, calls for higher investment in working capital. Though, the impact of increase in general prices may be different on different companies.
Overview of Working Capital Management 14

Determinants of Working Capital 7. Operating Efficiency: A firm should make optimum utilisation of its resources at minimum costs. Efficient utilisations of various factors of production, helps in reducing the overall quantum of working capital. 8. Credit Policy: Liberal Credit Policy means high debtors, high collection period, and high bad debts - hence more working capital would be required. Therefore, company should follow a rational credit policy evaluate the credit worthiness of customers and review them. 9. Availability of Credit from Suppliers: If a firm gets liberal credit from its suppliers, the requirements of working capital would be less. Suppliers credit finances the firms inventory and reduces the Also, if bank credit is easily available and on favourable conditions, company would require less working capital.
Overview of Working Capital Management 15

Inventory Management

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Inventory Management
Forms of Inventory Raw materials basic input materials Work-in-Progress Semi-manufactured goods Finished Goods Completely manufactured goods, ready for sale. Need for holding Inventories: Transactions motive: To facilitate smooth production & sales operations Precautionary motive: To guard against the risk of unpredictable changes in demand and supply forces Speculative motive:To take advantage of price fluctuations.
Inventory Management 17

Objectives of Inventory Management

A firm is faced two conflicting needs:  To maintain large inventory to ensure efficient and smooth productions and sales which shall tie-up funds in low yielding assets & excessive carrying costs  To maintain low inventory to reduce costs and maximize profitability which shall impair smooth production & marketing functions Both excessive and inadequate inventory levels are undesirable. Thus, a trade-off between these two conflicting needs have to be reached.
Inventory Management 18

Inventory Management Techniques

To trade-off the conflicting needs of a firm and to determine the optimum level of inventory, techniques of Inventory Management are used.

Economic Order Quantity (EOQ): What should be the size of the Order placed each time by the firm?

Re-Order Point: When should the firm place the Order for the inventory?

Inventory Management

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Economic Order Quantity

Ordering Costs
(Requisitioning; Order placing; Transportation ; Receiving and Inspecting Costs)

Carrying Costs
(Storage ; Insurance ; Obsolescence ; and Interest on Capital locked-up in Inventory)

Ordering Costs increases with the number of Orders To reduce Ordering Cost, place lesser no. of orders, but each order should be of large quantities.

Carrying costs increase with the inventory size.

To reduce Carrying Costs, keep minimum inventory by ordering smaller quantities in each Order.

These two conflicting objectives are to be resolved through Economic Order Quantity.
Inventory Management 20

Economic Order Quantity

Total Costs Ordering = (TC) Costs = No. of v Ordering Cost + Per Order Orders + Carrying Cost Average Carrying Inventory v Costs Q vc vP 2
Total Costs

U = vF Q
where, U= Annual Usage Q= Quantity Ordered F= Ordering Cost Per Order P= Price Per Unit c= Carrying Cost (%)
Inventory Management

Carrying Costs

Ordering Costs

Quantity

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Economic Order Quantity

Differentiating w.r.t Q and equating it to zero (for minimization), we get 2UF

EOQ(Q ) !

cP

2 v Annual Usage v Ordering Cost EOQ(Q ) ! Carrying Cost(%) v Pr ice per Unit


Given: Annual Usage (U) = 25,000 Units Purchase Price (P) = Rs 2,750 per Unit Ordering Cost per order (F) = Rs 550 per Order Carrying Cost (%) (c) = 25% of Purchase price EOQ = 2UF/Pc = (2*25000*550)/(2750*25%) = 200 Units
Inventory Management 22

Economic Order Quantity (Contd.)

Assumptions of EOQ: The yearly forecast usage of an item of inventory is known. The usage of the item is even and uniform throughout the period. Inventory orders can be replenished immediately i.e. there is no delay in placing and receiving the order. Ordering and Carrying are the only 2 distinguishable costs involved. Cost per Order remains constant irrespective of he Order size. Carrying cost is a fixed %age of the Average Inventory value.
Inventory Management 23

EOQ Quantity Discounts

To encourage customers to place larger orders, suppliers often offer Quantity Discounts.
Positive Impact Negative Impact

 Discount will reduce the per unit purchase price  By increasing the order size, the no. of orders shall reduce which shall reduce the ordering costs.

 As order size increases, the average inventory size will also increase, leading to an increase the carrying costs.

Therefore, a Cost-Benefit Analysis has to be made

Inventory Management 24

EOQ Quantity Discounts (Contd.) 1. Benefits:

Reduction in Purchase Price: = Annual Usage v Discount (UD) Reduction in Ordering Costs: = Decrease in No. of Orders v Ordering Cost per Order
U U *  vF Q1 Q

Increase in Carrying Costs: = Increase in Average Inventory v Carrying Cost

Q1(P  D)c Q*Pc  2 2
Inventory Management 25

EOQ Quantity Discounts (Contd.)

Given: Basic Data as in previous question Discount (D) = Rs 10 per Unit Order Size to Avail Quantity Discount (Q1)=1,200Units Impact of Quantity Discounts: UD = (25,000*10) = 2,50,000/ {U/Q* - U/Q1} F = {25000/200 - 25000/1200}550 = 57,292/ {Q1(P-D)c/2 Q*Pc/2 } = {1200(2750-10)25%/2 (200*2750*25%/2 }= 3,42,250/ Total Benefit = 2,50,000 + 57,292 - 3,42,250 = (34,958) As the change in profit is NEGATIVE, hence should NOT go for the higher order size and avail the quantity discount.

Inventory Management

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Receivables Management

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Receivables Management
When goods are sold on credit, finished goods are converted into Receivables(or Debtors) Granting of credit and creation of Book debts calls for blocking of the firms funds. Duration between the date of sale and the date of payment has to be financed out of the working capital. Quantum of a firms investment in debtors depends upon: Volume of Credit Sales & Collection Period.
Average Investment in Debtors
Receivables Management

Daily Credit Sales

Average Collection Period

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Why Firms Sell on Credit?

 Competition: High competition, liberal Credit.  Companys bargaining power: Monopoly product, Brand & financial strengths - lower credit.  Buyers Requirements: e.g. industrial products.  Buyers status: Large Buyers demand better credit terms.  Relationship with dealers- to build long-term relationship  Marketing tool: esp. when the product is new  Industry Practice: past practice; small firms follow large firms.
Receivables Management 29

Credit Policy Variables

While establishing the Credit Policy, the following variables are considered: 1. Credit Standards refers to the criteria which a firm follows in selecting customers for extending credit. 2. Credit Terms are the conditions under which a firm sells goods on credit.  Credit Period  Cash Discount 3. Collections Efforts are the steps taken by a firm to ensure timely realisation of receivables.
Receivables Management 30

Credit Standards
Tight Credit Standards: Mostly cash sales and credit sales to the most reliable and financially strong customers.  Such policy would result in Lower sales; Low baddebts; Low Collection Costs & Profits are forgone on lost sales Liberal Credit Standards:  Higher sales, higher bad-debts, higher collection costs. Thus, a trade-off between incremental profits and incremental costs has to be considered.
Receivables Management 31

Credit Standards (Contd.) A firm may typically categorize its customers into:  Good Accounts Financially strong , prompt payment.  Bad Accounts Financially weak, high risk customers  Marginal Accounts Customers with moderate financial health and risk.

Receivables Management

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Credit Standards (Contd.) XYZ Ltd. is contemplating change in the credit standards. It has categorised the customers into three categories- A, B, and C .(A being the least risky customers). The company is currently selling to A & B category customers but now wants to sell to category C as well. The potential sales, Average Collection Period & Bad-Debt ratio relating to C category are Rs 160 Lacs, 90 days & 10% respectively. Variable cost ratio is 75% and Post-tax rate of return is 15%. Tax rate is 35%. Collection costs would be 8% for this category. Should the firm liberlise the credit standards?
Receivables Management 33

Credit Standards (Contd.)

Particulars 1. 2. 3. 4. 5. 6. 7. Incremental Sales Incremental Contribution ( Sales*c)=160*25% Incremental Bad-debts & Collection Costs ( Sales*b+d)=160*(10%+8%) Incremental OPAT (2-3)*(1-t) Incremental Investment in Debtors ( Sales/360)*ACP = (160/360) * 90 Marginal Rate of Return ( OPAT/( Debtors) = 4/5 Incremental PAT ( OPAT less (r* Debtors) Rs Lacs 160.00 40.00 28.80 7.28 40.00 18.26% 1.28
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Receivables Management

Credit Terms
Credit Terms are the stipulations under which the firm sells on credit to customers. It includes: (a) Credit Period; & (b) Cash Discount. Credit Period: Duration for which the credit is given. net 40 customer is required to pay the net amount due within 40 days.

Receivables Management

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Credit Terms (Contd.) Hotline Ltd. wants to increase its credit period from net, 30 to net 60. This move is expected to push the sales from Rs.395 Lacs to Rs.550 Lacs & ACP from 45 days to 65 days. The companys contribution margin is 20% and collection costs of 3% of Sales, bad-debt loss of 4% of Sales. If the firms post-tax rate of return is 18% and tax rate as 35%, should the firm change its credit terms?

Receivables Management

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Credit Period (Contd.)

1. 2. 3. 4. 5. Particulars Incremental Sales ( Sales) Incremental Contribution ( Sales*c)=155*20% Incremental Bad-debts & Collection Costs ( Sales*b+d)=155*(4%+3%) Incremental OPAT (2-3)*(1-t) Incremental Investment in Debtors (SalesN/360)*ACPN less (SalesO/360)*ACPO =(550/360) * 65 less (395/360) * 45 Marginal Rate of Return ( OPAT/( Debtors) = 4/5 Incremental PAT ( OPAT less (r* Debtors) Rs Lacs 155.00 31.00 10.85 13.10 49.93

6. 7.

26.23% 4.11
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Receivables Management

Credit Terms

Cash Discounts

As an incentive for customers to pay early. Firms offer a discount 3/15, net 40 3% discount , if paid within 15 days or pay the full amount in 40 days.

Receivables Management

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Cash Discounts(Contd.)

Phoenix Shoes Ltd. presently sells Rs 242 Lacs worth of goods on net 30, but wants to change to 2/10, net 30. This will reduce ACP from 40 days to 25 days. No change in Sales is expected due to this move. It is expected that 75% of the customers will take advantage of this changed credit terms. If the firms post-tax rate of return is 16% and tax rate as 35%, should the firm change the cash discount?

Receivables Management

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Cash Discounts (Contd.)

Particulars 1. Cash Discount (Sales* % Taking Discount*Discount%) (242*75%*2%) 2. Post Tax Cost of Discount (Discount*1-t) 3. Incremental Investment in Debtors (SalesN/360)*ACPN less (SalesO/360)*ACPO
= (242/360)*(25-40)
(r* Debtors) less Post Tax Cash Discount = (16%*10.08)-2.36
Receivables Management

Rs Lacs 3.63

2.36 (10.08) Savings (0.75)

4. Net Change in PAT (SAVINGS Less COSTS) Loss

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Collection Efforts
A firms collection programme aimed at timely collection of receivables. What the firm should do in case a customer has not paid up & his credit period is over.
Monitoring the state of receivables; Despatch of letters to customers whose due date is; polite vs. strongly worded reminders Telegraphic / Telephonic advice to the customers around the due date Personal visits Threat of legal action to overdue accounts Legal action against overdue accounts Check the customers financial status- if weak, legal action Receivables Management would only hasten his insolvency.

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Factoring
Factoring involves transfer of the collection of receivables and the related book-keeping (Sales Administration functions by a firm (Client) to a financial intermediary(Factor). Sometimes the Factor also provides a line of credit against the receivables of the firm. Thus, Factoring is the sale of the book-debts by the firm to a financial intermediary on the understanding that the factor will pay for the debts as and when they are realized/collected or on a guaranteed payment date.

Receivables Management

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Process of Factoring
Client (Seller) 2b 2a 1 Customer (Buyer)

Factor

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Process of Factoring
1. The client makes a Credit Sale to its customer. 2a.Client sends the customers account to the Factor. 2b.Client simultaneously informs the customer about his contract with the factor. 3. Factor makes part-payment of the credit sales to the client after adjusting for commission and interest on the advance. 4. Factor maintains the Sales Ledger & follows-up for payment with the customer. 5. Customer remits the amount due to the Factor. 6. Factor makes the final payment to the client , when the amount is collected or on the guaranteed payment date.

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Services provided by Factor

Factor typically provides the following services: a. Maintenance of Sales Ledger b. Collection of Receivables c. Financing of the Client For services (a) & (b), the factor charges Factor Commission, which is a % age of the value of receivables purchased, usually collected up-front. For service (c), the factor charges Factor Interest for the duration between the date of advance payment & the date of collection or the guaranteed payment date. Factor does not provide 100% finance. It maintains a margin(Factor Reserve) to provide for contingencies.
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Forms of Factoring
Depending upon the features built into the factoring contract between the Factor and the client, various types of factoring are as follows: (a) Recourse Factoring: Factor has recourse to the client in case of bad-debts. (b) Non-Recourse Factoring: Factor assumes the credit risk. (c) Advance Factoring: Factor pays 75-80% in advance, balance upon collection or on the guaranteed payment date. (d) Maturity Factoring: Payment on guaranteed payment date or on collection. (e) Full Factoring: Non-Recourse, Advance Factoring.
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Cost Benefit Analysis

Given: Credit Sales Average Collection Period Bad debt Loss Collection Costs Factor Commission Factor Interest Factor Reserve 6,000,000 90 1.50% 120,000 2.25% 18% 15% p.a. days p.a. p.a.

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Cost Benefit Analysis

1. Average Investment in Debtors 1,500,000 (Daily Credit Sales * ACP) 2. Factor Commission 33,750 (Av. Receivables*Factor Commission) 3. Factor Reserve 225,000 (Av. Receivables*Factor Reserve) 4. Maximum Advance (1-2-3) 1,241,250 5. Factor Interest 55,856 (Max Advance * Factor Interest for Days used) 6. Net Amount Payable (4-5) 1,185,394

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Cost Benefit Analysis

A. Effective Costs Annualized Factoring Costs: - Factor Commission - Factor Interest TOTAL FACTORING COSTS Costs Avoided Due to Factoring: - Collection Costs - Bad Debts TOTAL SAVINGS Net Cost (A-B) Funds Made available by Factoring Effective Cost of Factoring (C/D)

135,000 223,425 358,425 120,000 90,000 210,000 148,425 1,185,394 12.52%

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B.

C. D. E.